Inventory reserve
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Inventory reserve an inventory reserve is a contra asset account on a company's balance sheet made in anticipation of inventory that will not be able to be sold. Every year a company has inventory that cannot be sold for a variety of reasons. It may spoil, fall out of fashion or become technologically obsolete. A term that refers to a reserve used to account for inventory that is not sold at its cost. This type of entry is used on the balance sheet to show earnings deductions on the worth of inventoried assets. The product placed by the handler in the primary inventory reserve must have been produced in either the current or the preceding two crop years. Inventory reserve portion shall be equal to the sum of the products obtained by multiplying the weight or volume of them in each lot of acquired during the fiscal period.
Inventory reserves are those items that are committed to someone but still appear on the shelf and in the on-hand quantity figure. It might be that an inside salesperson just took a will-call order and committed certain inventory to a customer but those items have not yet been pulled. Or perhaps a branch manager just called in, checked stock and asked for a commitment on a certain item.
That commitment to a branch should be set up as a reserve so that if it is the last item on the shelf the commitment will be honored[1].
Off-premise inventory reserve
Any handler may, upon notification to the Board, arrange to hold inventory reserve, of his or her own production or which was purchased, on the premises of another handler or in an approved commercial storage facility in the same manner as though the inventory reserve were on the handler's own premises[2].
Secondary inventory reserve
Specific rules[3]:
- In the event the inventory reserve established of this part is at its maximum volume, and the Board has announced, in accordance with that volume regulation will be necessary to maintain an orderly supply of quality products for the market, handlers in a regulated district may elect to place in a secondary inventory reserve all or a portion of the products the volume regulation would otherwise require them to divert in accordance.
- Should any handler in a regulated district exercise his or her right to establish a secondary inventory reserve under paragraph of this section all costs of maintaining that reserve, as well as inspection costs, will be the responsibility of the individual handler.
- The secondary inventory reserve shall be established in accordance with other rules and regulations which the Board, with the approval of the Secretary, may establish.
- The Board shall retain control over the release of any products from the secondary inventory reserve. No products may be released from the secondary reserve until all products in any primary inventory reserve are established.
Examples of Inventory reserve
- A company has a set amount of inventory that it expects to sell over a certain period of time. However, due to a variety of factors, some of this inventory may not be sold. To account for this, the company sets up an inventory reserve to cover the expected lost or unsold inventory. This reserve is a contra asset account on the company’s balance sheet and is used to offset the value of the inventory that is not sold.
- A retail store may use an inventory reserve to account for seasonal goods that may not be sold. For example, a store that specializes in winter clothing may set up an inventory reserve for sweaters, coats and other winter apparel that may not be sold before the season is over. This reserve can be used to offset the cost of the unsold items and prevent the company from taking a loss on the inventory.
- A company may also use an inventory reserve to account for goods that become obsolete or have an expiration date. For example, a technology company may have a reserve for products that become outdated and cannot be sold. This reserve can be used to reduce the cost of the obsolete inventory and prevent the company from taking a loss.
Advantages of Inventory reserve
The inventory reserve provides many advantages for a business. It allows for the deduction of potential losses from inventories and can help improve financial performance. Specifically, the advantages of an inventory reserve include:
- Improved Financial Performance: When businesses set up an inventory reserve, they are able to deduct the potential losses associated with the inventory. This can help businesses save money, as they are able to reduce their taxable income.
- Increased Profits: When businesses are able to reduce their taxable income, this can lead to increased profits. This can help businesses invest more in research and development, hire more employees, and expand operations.
- Reduced Risk of Inventory Losses: An inventory reserve helps businesses mitigate the risk of inventory loss. By setting up a reserve, businesses are able to absorb potential losses, which can help protect the business from financial losses associated with inventory that cannot be sold.
- Improved Cash Flow: By reducing losses associated with inventory, businesses are able to improve their cash flow. This can help increase the working capital that is available to the business, allowing them to fund operations and invest in new projects.
Limitations of Inventory reserve
An inventory reserve has certain limitations that should be considered when accounting for inventory. These include:
- Misjudged demand: Companies may overestimate the demand for certain products and end up with excess inventory which is not sold, leading to higher inventory reserves.
- Out of date products: Products that become outdated or obsolete due to technological advances can become difficult to sell, resulting in higher inventory reserves.
- Poor forecasting: Companies may fail to accurately forecast the demand for products, leading to excess inventory and resulting in higher inventory reserves.
- Loss of value: If products lose value due to market changes, companies may be unable to sell them at the original cost, leading to inventory reserves.
- Disposal costs: Companies may be required to pay disposal costs in order to dispose of their excess inventory, leading to higher inventory reserves.
Apart from the contra asset account, there are various other approaches that can be used to account for inventory reserves.
- Inventory revaluation: This approach is used to adjust the value of a company’s inventory when it has been affected by external factors such as market fluctuations or changes in technology. The revaluation process involves determining the current value of the inventory and then recording the difference between its original value and the current value as a reserve.
- Inventory write-down: This approach is used to adjust the value of a company’s inventory when it can no longer be sold at its original cost. The write-down process involves determining the current value of the inventory and then recording the difference between its original value and the current value as a reserve.
- Inventory obsolescence: This approach is used to account for the inventory that has become obsolete due to technological advances or changes in customer preferences. The obsolescence process involves determining the current value of the inventory and then recording the difference between its original value and the current value as a reserve.
In summary, inventory reserves can be accounted for using a contra asset account, revaluation, write-down, or obsolescence. Companies must carefully consider which approach is the most appropriate for their particular situation.
Footnotes
References
- Bragg M.S, (2014). Just-in-Time Accounting: How to Decrease Costs and Increase Efficiency ,John Wiley & Sons, INC.
- Broeckelmann R., (2010). Inventory Classification Innovation , CRC Press.
- Code of Federal Regulations., (2012). Agriculture Office of the Federal Register.
Author: Patrycja Bajda
