If you are a company that carries inventory, you should most likely have an inventory reserve accounting policy in place. Creating an inventory reserve is a proactive and conservative accounting approach that companies use to prepare for events such as spoilage, theft, obsolescence, and other adverse situations on their inventories. An inventory reserve is a contra asset account in which a company retains an estimated charge for inventory that it has not yet specifically identified, but expects is present. Because of this, a company must reduce the carrying value of its inventory to some amount that is less than the cost at which it is currently recorded.
There are a number of techniques for identifying potential slow-moving or obsolete inventory. Below is a list of just a few common techniques:
- Perform an annual physical count of the inventory and use physical inventory count tags to identify potential slow-moving or obsolete inventory.
- Use a computerized inventory tracking system to identify unused or slow moving inventory by running a report showing a “last used (or sold)” date. Review aged inventory items and identify if the inventory will likely be used or sold in the future and, if so, in what amounts.
- Using a computerized inventory tracking system, run or create a report that shows the amount of inventory on hand versus historical sales trends on an item by item basis. Review slow-moving inventory items to identify if reserves are necessary for potential slow-moving inventory.
- Use a certain percentage of inventory based on past experiences as long as there has not been any major changes in the current period.
When you have determined the amount of inventory that you want to reserve and you create the reserve, you should charge an expense to the cost of goods sold for the amount by which you want to increase any existing inventory reserve, and you should credit the inventory reserve account for that same amount. Later when there is an identifiable reduction in the valuation of the inventory, you should reduce the amount of the inventory reserve with a debit, and credit the inventory asset account for the same amount. Thus, the expense is recognized prior to identification of a specific inventory issue which may not occur for some time.
A company’s inventory reserve accounting policy is not a fool-proof way to ensure that slow-moving and obsolete inventory is properly accounted for. A company must consider changes in its business operations, the industry it operates in, its customers, and any other factors that impact held inventory, to determine if changes to the accounting for slow-moving and obsolete inventory are necessary.
By Ryan Wojdacz, CPA