An inventory reserve is an accounting entry used to deduct the value of assets that have depreciated, deteriorated, or become obsolete. It can be used with any inventory model and helps to properly account for unused assets while minimizing tax burdens. However, it can also be manipulated to create a false financial image.
An inventory reserve is a type of accounting entry that helps identify the amount of deduction claimed on inventoried assets that have suffered depreciation or deterioration, or are considered obsolete in terms of business operation. The idea behind this type of accounting entry is to allow for the fact that some assets that remain in inventory can no longer be sold at a rate that covers the original purchase price. The use of this type of entry is in accordance with generally accepted accounting principles, and is used by many different types of businesses.
Using an inventory reserve is possible with almost any inventory model. Entry can be performed if the inventory transaction 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 decrease. At the same time, the inventory reserve causes an increase in the cost of goods sold as recorded on the income statement. Depending on the amount of the loss that is incurred on entry, it may appear as a separate item on the income statement, rather than in the more general cost of goods sold section.
Using 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 inventory. For example, if a textile company stops using a particular type of spinning or carding machinery, all the spare parts currently sitting in the plant’s storage area may become obsolete. Although the products may still be sold and recover a portion of the original expense, it is still necessary to remove those items from active inventory and therefore limit the amount of tax that must be paid on the value of those items. Using an inventory reserve entry helps minimize that tax burden and therefore create a more balanced financial picture for the business.
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 a company’s financial stability. This is true if the input is used to manipulate accounting in some way. For example, if management chooses to pad the reserve during periods of prosperity, it may remove some of those assets from the inventory reserve when the business is experiencing some type of downturn and thus present the image of being in better shape. financial than is actually the case.
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