Inventory reserve is contra account in the business’s balance sheet, and it’s recorded in line with the prudence concept of accounting. Let’s understand the concept in detail.
Ideally, the closing balance of the inventory should be equal to sales minus purchases. However, that’s not the case with most businesses around the globe. So, there is a greater probability that closing valuation at the end of the year will be less than the ideal value in the equation.
That’s because inventory gets obsolete, damaged, goes out of season, and disappears. So, if the business decides to charge all the write-off expenses at the last month of the accounting year, it can bring massive impact on the profit and loss statement of the last month.
It’s also against the prudence concept of accounting, as the write-off does not pertain to the last month of the accounting year. Hence, there is a need to create inventory reserves in contra account that decreases the assets and increases the expenses throughout the accounting year. It helps to comply with the prudence concept of accounting and distributes write-off expenses in different months.
The prudence concept of accounting states that expected future losses need to be recorded in the business books. On the other hand, the gain needs to be recorded when realized.
Journal entry for recording the amount in the inventory reserve
Following journal entries can be used for recording the amount in the inventory reserves account.
|Profit and Loss A/C (Administrative expenses)||XXX|
|Inventory reserves A/C||XXX|
The debit impact of the transaction is a recording of the expenses in the profit and loss statement, this amount increases expenses for the business and decreases profitability. On the other hand, the credit impact of the transaction is a reduction in the amount for the inventory balance. So, the debit impact is recorded in the income statement, and the credit impact is recorded in the balance sheet.
It’s important to note that parking the reserves in the balance sheet is not a final entry. There is a need to pass an adjusting entry once the final physical inventory is counted and provision for the inventory is calculated. So, the final provision required is compared with the amount already recorded in the accounting record. Hence, any difference in amount is accounted for via adjusting entry.
Determination of the amount to be recorded in the reserves
In practice, the business records reserves based on their experience with the write-off. It’s logical to obtain last year’s figure for the write-off and divide it by 12. It converts the yearly write-off expense to the monthly amount for the write-off. So, recording the monthly reserves leads to compliance with the prudence concept of accounting.
In addition to this, the businesses also set a certain percentage of the closing balance of the inventory account. The selection of percentage to be applied is subjective, and businesses elect this one with their prior experience of defect, spoilage, stolen, and misplacement, etc.
Why the business should record reserves for the inventory
The businesses exposed to seasonal variations and selling fragile products are more exposed to the risk of obsolesce and write off. So, the businesses that maintain the significant balance of inventory with seasonal variations need to closely analyze the situation and record reserves in the business’s financial statement. It helps to distribute the reserves throughout the months in the accounting year.
Fraudulent financial reporting and the inventory reserves
Since the amount to be recorded as the reserve is a subjective matter and depends on the discretion of the management. Suppose the business is doing great and the expected profit is higher, the management of the business decides to artificially increase the reserves and control the profit to reduce tax expense. Likewise, if there is some expected decrease in the business profit, the reserves can be artificially reduced to show sustained and artificial performance.
So, the auditors need to assess the accuracy of the reserve amount to verify the fairness of the profit and assets reported in the financial statement.
Example for the recording inventory reserves journal entry
Suppose management of the Zima plc decides to set a reserves percentage of 12% per annum on the opening balance of the inventory account. The reserve percentage is based on the prior experience of the Zima plc to write off. The opening balance of the inventory amounts to $100,000.
So, the amount to be charged in the financial statement is $12,000 ($100,000×12%). It means $1,000 can be charged in the monthly financial statement for each month. This will lead to the recording of the $12,000 in the business financial statement for a whole year.
However, at the end of the year, physical inventory is conducted, and it’s discovered that reserves to be charged amount to $10,000. It means the amount of $2,000 remains in the business books as reserves. Although, this balance can be adjusted in future accounting periods.
The given transaction can be recorded as a journal entry in the following form.
|Profit and Loss A/C (Administrative expenses)||12,000|
|Inventory reserves A/C||12,000|
The debit impact of the transaction is that it increases the expenses for the business and decreases business profitability.
On the other hand, the credit impact of the transaction is a credit of the asset leading to a creation of the reserve that will be adjusted in the next periods of accounting.
The business needs to record discrepancies in the inventory taking place throughout the year. So, it may not be fair to allocate all the expenses in the last month of the accounting year. Hence, to tackle the situation, the reserve is created in the business books, and the estimated amount under write-off is recorded; this helps comply with the prudence concept of accounting.
The journal entry to record the inventory reserves is simple. The profit and loss statement of the business is debited, and the asset reserves in the balance sheet is credited. In addition to this, recording the inventory reserves is subjective and judgmental. Hence, it’s exposed to the risk of fraud. For instance, if the business wants to increase the profit, the reserves can be artificially reduced and vice versa.
It’s important to note that reserves need to be adjusted against actual removal of the inventory from business books.
Frequently asked questions
How is inventory valued as per accounting standards?
In line with the provisions of the accounting standards, the inventory is valued lower of the cost and net realizable value. Cost is the amount paid for purchasing the inventory. Similarly, net realizable value is calculated by deducting the selling cost from the revenue of the inventory.
How can inventory reserve be computed?
Inventory reserve can be computed by a physical count of the inventory and ensuring the existence of the inventory. However, to comply with the prudence concept of accounting, the reserve is recorded in line with the entity’s experience.
How is EBITDA affected by the inventory reserves?
EBITDA is inversely proportional to the inventory reserves. If inventory reserve is recorded, it increases expense and leads to a decrease in the EBITDA/profitability.
Where is inventory reserve recorded in the balance sheet?
Inventory reserves are contra account in the balance sheet of the business. So, it’s just a parked account in the balance sheet. Once the amount for the inventory reserves is calculated at the end of the accounting period, the contra account (inventory reserves) is compared with the required reserves, and adjustment entry is passed in the accounting system.
Can we reverse the reserves in the inventory account?
The balance in the inventory reserves can be reversed if related inventory is sold at a price where the reserve is no longer required.
What is obsolete inventory?
Obsolete inventory is the business inventory that has not been sold for longer. Further, the inventory is not expected to be sold in the future, and such inventory needs to be charged in the business’s income statement.