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An inventory reserve is a type of accounting entry that helps to identify the amount of deduction that is claimed on inventoried assets which have undergone some amount of depreciation or deterioration, or are considered obsolete in terms of the operation of the business. The idea behind this type of accounting entry is to allow for the fact that some assets that remain in the inventory are no longer capable of being sold at a rate that would cover the original purchase price. Use of this type of entry is in keeping with generally accepted accounting principles, and is used by many different types of businesses.
The usage of an inventory reserve is possible with just about any inventory model. The entry can be made whether the operation of the inventory is based on a first-in-first-out or FIFO model, or a last-in-first-out or LIFO model. In either situation, the entry causes the value of inventory on the balance sheet to be reduced. At the same time, the inventory reserve triggers an increase on the cost of goods sold as recorded on the income statement. Depending on the amount of the loss that is incurred from the entry, it may be listed as a separate line item on the income statement, rather than under the more general cost of goods sold section.
The use of an inventory reserve makes it possible to track situations where materials, equipment, and other assets that are no longer needed can be properly accounted for in the inventory. For example, if a textile company discontinues use of a particular type of carding or spinning machinery, all the replacement parts that are currently held in the plant storage area may be marked obsolete. While the goods may still be sold and a portion of the original expense be recouped, there is still a need to remove those items from the active inventory and thus limit the amount of tax that must be paid on the value of those items. Using an inventory reserve entry helps to minimize that tax burden, and thus create a more balanced financial picture for the company.
While there are a number of ways that an inventory reserve can benefit a business, the tool can also be used to create a false image of the financial stability of the company. This is true if the entry is used to manipulate the accounting in some manner. For example, if management chooses to pad the reserve during periods of prosperity, they can then remove some of those assets from the inventory reserve when the business is experiencing some sort of downturn, and thus present the image of being in better financial condition than is actually the case.
Why is scrapping the parts that are on inventory reserve, a bad thing for the company?