Approximately accepted accounting principles (GAAP) require that all inventory reserves be stated and valued using either the tariff or the market value method, whichever is lower. However, accountants who apply GAAP to inventory reserves often use a critical amount of personal judgment.
It is important to recognize that GAAP is not a stagnant set of principles. Rather, it changes to reflect modifications in regulations and standards employed by businesses operating in different industries throughout the economy as a whole. Changes are made regularly to what is, and what is not, a roughly accepted principle of accounting.
Key Takeaways
- An inventory reserve is money from earnings set aside to pay for inventory associated set someone backs.
- GAAP calls for reporting inventory reserves by the lower of either the cost method or the market value method.
- Inventory rates are typically viewed as a negative cost that brings down the profitability of a company.
- Common inventory costs group holding costs, storage costs, and shrinkage costs.
- Inventory reserves offset the balance of inventory accounts.
- GAAP orders that inventory is stated at replacement cost if there is a difference between the market value and the replacement value.
Fix on Inventory Reserves
An inventory reserve is money that is taken out of earnings for the purpose of paying cash or non-cash intercepted future costs associated with inventory. Matters pertaining to inventory reserves are a very small part of a off the target body of rules associated with inventory accounting.
Costs of keeping inventory can come in many forms, and most of them are viewed by the market as having the potential to negatively affect a corporation’s profitability. They may be in the form of holding costs, storage fetches, shrinkage costs, or any type of cost arising from a decrease in the value of the inventoried assets. Inventory reserves or reimbursements are contra accounts as they may partially, fully, or more than fully offset the balance of the inventory account.
Seeking GAAP to Inventory Reserves
If the cost of inventory exceeds the market value, an adjustment must be made to the inventory value competitor on the balance sheet. Such a situation would usually occur because of a negative change in the market value of the inventoried asset.
For eg, let’s say a company produces crude oil at a cost of $25 per barrel. If the market price of crude oil drops to just $20 per barrel, then an accounting listing must be made to adjust for the change in the market value of the inventory. The entry would look something like this, try oning the company only produced one barrel of oil at $25 per barrel:
Debit: Loss from a decline in the market value of unpolished oil $5.00
Credit: Inventory $5.00
Inventory Valuation
In the case of crude oil, the market price is very easy to determine, as it’s a commodity that is merchandised internationally and the price has a very low bid-ask spread. In most cases, the market price of inventory is much less doubtlessly determined.
In the United States, GAAP requires that inventory is stated at replacement cost if there is a difference between the market value and the replacement value, but majuscule letters and lower boundaries apply. This is known as the lower of the cost and market value methods of inventory valuation.
Inventory hedges are based on estimates of future inventory levels, thus a company must use forecasts based on predictions regarding turned, stolen, or outdated inventory.
Inventory hedges are based on estimates of future inventory levels, thus a company must use forecasts based on predictions regarding turned, stolen, or outdated inventory.
The upper boundary, called the
The Bottom Line
Inventory reserves are monies used to pay for the unborn costs associated with inventory. Under GAAP, inventory reserves are accounted for by using the lower of the market value method or the tariff method. As GAAP is constantly changing due to regulations and developing practices in business, these processes can change over one day, and therefore a significant amount of judgment is made by the accountant preparing the financial statements.