Any company manufacturing products knows its inventory won’t always sell as expected. For this reason, manufacturers, distributors, and retailers alike calculate what’s referred to as an inventory reserve.
Inventory reserves are a type of accounting entry that estimate the amount of products or raw materials a business expects will remain unsold.
By taking a conservative approach to its balance sheet and anticipating losses before they occur, companies can safeguard against any unpleasant surprises. Inventory reserves also break losses down into smaller increments that are much easier to assume and adjust to than a larger lump sum at the end of an accounting period.
What is an inventory reserve?
An inventory reserve is a contra-asset account on a balance sheet that estimates the amount of products or raw materials a company cannot sell or use during a given period. Unsold stock or overstock is typically due to obsolescence, spoilage, lack of market demand, or other reasons.
To calculate inventory reserves, companies typically draw from historical sales data, external market forces, such as economic and seasonal trends or changes in demand, or simply their best judgment.
The estimated inventory reserve is then deducted from the company’s gross inventory value, which results in a more accurate net inventory value.
When an inventory reserve entry is created, it’s important to also create an expense of the same amount in the cost of goods sold (COGS) on your income statement. This effectively recognizes the cost, even though it will still occur at a future date.
Inventory reserves are part of inventory accounting in generally accepted accounting principles (GAAP). It can be used in almost all inventory valuation methods, including first-in, first-out (FIFO), last-in, first-out (LIFO), and weighted average cost.
Inventory reserve vs. inventory write-off
Inventory reserves and inventory write-offs are two similar-sounding terms that have significant differences.
While an inventory reserve is the amount of inventory a company anticipates will be unsold in the future, an inventory write-off refers to inventory that has lost value today.
Additionally, inventory reserves are based on a percentage of the total value of inventory. Because this value is constantly changing, the percentage should be reassessed every sales cycle or accounting period.
Inventory write-offs, on the other hand, identify specific products that can no longer be sold and are therefore “written off.”
When your business may need an inventory reserve
While it’s inevitable that an amount of inventory will remain on shelves, companies that are product-focused or faced with frequently changing market demand will benefit from using inventory reserves in their balance sheet.
For example, say a company has been experiencing high amounts of breakage or spoilage in its inventory. An inventory reserve account ensures any unsold or unused inventory isn’t recorded as an asset.
By accounting for these as a contra-asset and reducing the total inventory value, companies are able to get a clear picture of their assets and overall business health. Improving the accuracy of your financial statements will ultimately increase the understanding of a company’s assets and help improve inventory management for greater future revenue.
Inventory reserves can also prompt further inventory analysis of other factors that may be contributing to unsold products. For instance, consistently high inventory reserves may be a symptom of a deeper problem in the supply chain or the sales forecast calculations.
Without inventory reserves, however, a company’s assets and valuation are often overstated. This means the inventory market value is actually less than the value listed on its balance sheet. Furthermore, the discrepancy will only continue to worsen the more inventory a company is unable to sell.
How do you account for an inventory reserve?
Before accounting for inventory reserves, your company must know its gross inventory, or the total value of all finished goods, raw materials, or work in process inventory prior to any deductions or adjustments.
Inventory reserves are calculated in one of three ways:
- As a percentage of projected sales revenue, using past financial and sales records as a reference
- As a percentage of its inventory
- As a percentage of COGS
The percentage is applied to the gross inventory to determine how much of the company’s products is expected to remain unsold in the future. This number is its inventory reserve entry for the period.
Even with a predetermined percentage, companies should always exercise their best judgment when it comes to inventory reserves. Inventory management software can help reveal changing inventory forecasts or trends that require adjustments to existing inventory reserves.
The inventory reserve is then deducted from gross inventory to calculate the company’s net inventory value.
Let’s look at an example: Say Company A sets its inventory reserve at 3%, based on data collected over the last few years. Its gross inventory is $250,000, which results in a negative balance of $7,500 for its inventory reserve.
$250,000 * 0.03 = $7,500
On its balance sheet, Company A records its net inventory value as $242,500, using the calculation below:
$250,000 - 7,500 = $252,500
As a final step, any increase in a company’s inventory reserves on the balance sheet prompts an equal increase in the COGS on the income statement. This effectively decreases both the gross profit and net income.
Conversely, any decrease in inventory reserves (which is recorded as a debit) creates an equal decrease in COGS, thereby increasing the gross profit and net income.
How QuickBooks Enterprise can help businesses avoid inventory reserves
Inventory reserve accounts are ultimately a tool for optimizing inventory management, which is further supported with QuickBooks Enterprise. Enterprise enables you to access real-time inventory levels across different locations, providing details on how many products are on hand, on sales order, or on a purchase order.
Sales orders are automatically tracked and accounted for by average costs and cost of goods sold (COGS). Inventory reports can also be customized using any of the 200-plus built-in reports, which includes balance sheets, income statements, and sales forecasting — all financial statements that are essential to managing inventory reserves.
By bringing together historical sales data and accurate inventory forecasts on one centralized platform, QuickBooks Enterprise makes it easy to determine which products should be reordered to minimize overstock or obsolete inventory, while maximizing sales and asset value.
Final thoughts
It can be easy for companies to disregard unsold stock or assume the inventory loss as part of doing business. However, expecting significant amounts of unsold inventory count can be an indication of other issues that need to be addressed. It may be a good time to reassess your supply chain, sourcing operations, sales forecasts, or other external market factors.
Inventory reserves keeps companies on top of any future inventory items that are not delivering expected value and helps refine its overall inventory management strategy.
