Inventory Reserve Journal Entry
Inventory reserve is the inventory contra account that is used for direct inventory write-off. It will be net off with inventory to present on the balance sheet.
Inventory on hand needs to present at a lower cost or net realizable value which is conservative accounting. It prevents the company from overstating the assets and understating liability. Inventory will be written down due to obsolete, damage, thief, and so on.
Inventory on balance sheet must be present at cost less provision. The company needs to assess the inventory to provide an allowance of provision. It allows the company to record expenses before the inventory is actually written off, so the expense will spread over the financial statement. It will prevent the expense from hitting a particular accounting period and cause a significant impact on profit.
In accounting, we need to record expenses based on accrual basic. Inventory write-off expenses should be recorded within the time that the company holds inventory. It should not record in any particular period. That is why we need to estimate the expense and record it into an income statement before knowing the exact amount.
Inventory Reserve Journal Entry
In order to record inventory provision, we need to debit expense and credit inventory reserve which is the inventory contra account. Most companies use the cost of goods sold in the account to record this expense, but they may separate subaccounts for easy control. It simply deducts the inventory balance and increases the cost of goods sold balance.
| Account | Debit | Credit |
|---|---|---|
| Inventory write-down | 000 | |
| Inventory Reserve | 000 |
Inventory obsolete is the subaccount of the cost of goods sold which will deduct the company profit in the income statement. Inventory reserve is the contra account of inventory that will net off on balance sheet.
When actual inventory writes down incur, the company needs to make a journal entry by debiting inventory reserve and credit inventory.
| Account | Debit | Credit |
|---|---|---|
| Inventory Reserve | 000 | |
| Inventory | 000 |
Inventory Reserve Journal Entry Example
Company ABC is a retail store with hundred types of inventory. Inventory obsolete, damage, and expiration is very common for the company. SO the company always estimates the inventory write-down and records it into income statement.
On 31 Mar 202X, the inventory balance is $ 500,000, and management estimate inventory write-down of $ 5,000 which may cause by various reasons such as obsolete and damage.
On 05 Apr 202X, company has found that an inventory of $ 2,000 needs to write off due to damage. Please prepare a journal entry for both transactions.
Solution
On 31 Mar 202X, management needs to record inventory write-down expenses based on the management estimation. ABC need to debit inventory write down $ 5,000 and credit inventory reserve $ 5,000.
| Account | Debit | Credit |
|---|---|---|
| Inventory write-down | 5,000 | |
| Inventory Reserve | 5,000 |
Inventory write-down will impact the income statement by deducting profit of $ 5,000. Inventory present in balance sheet will decrease by $ 5,000 due to inventory reserve. The inventory will present as the following:
| Account | Balance | |
| Inventory | 500,000 | |
| Less: Inventory reserve | (5,000) | 450,000 |
Inventory only present $ 450,000 on the balance sheet as $ 5,000 was deducted by inventory reserve.
On 05 Apr 202X, company has found the actual damaged goods $2,000 which need to write off. So they need to record credit inventory to reduce the inventory balance. However, the company already record inventory write down $ 5,000 for the whole inventory, which already impacts income statement. So this actual damage will not impact income statement but the inventory reserve.
ABC needs to make journal entry by debiting inventory reserves and credit inventory $ 2,000.
| Account | Debit | Credit |
|---|---|---|
| Inventory Reserve | 2,000 | |
| Inventory | 2,000 |
This transaction does not have any impact on income statement and balance sheet. We do not record any expense as the company already estimate and record in the prior month. This entry deducts both inventory and inventory reserve, so it is not changing the inventory balance on the balance sheet. After this entry, Inventory balance equal to 480,000 (500,000 – 2,000) less 3,000 (5,000 – 2,000) which is 450,000.
Actual loss is higher or lower than inventory reserve
Inventory reserve allows the management to record expenses before the actual loss on the inventory. It helps management to allocate the inventory loss over its life and prevent the impact on any specific accounting period. When actual loss incurs, it will not increase additional expense as company already predicts and record the expense.
However, management estimates may not be correct as they depend on historical data and experience. The actual result may vary depending on the real situation.
If the actual loss is higher than the estimation, it means the company underestimates the inventory reserve. The company record less expense than the actual loss. So they need to record extra expenses. When we recognize inventory loss, we need to credit inventory and debit inventory reserve. But as the actual loss is higher so the amount of inventory that needs to be credited is higher than the inventory reserve available.
The journal entry is debiting inventory reserve and credit inventory, the difference between inventory loss and reserve needs to debit to expense (inventory write down).
| Account | Debit | Credit |
|---|---|---|
| Inventory Reserve | 000 | |
| Inventory Write down | 000 | |
| Inventory | 000 |
Inventory write-down will impact the income statement as the expense that reduces company profit. It is the balancing figure between inventory reserve and inventory. It only happens when inventory is higher than inventory write down.
If the actual loss is lower than the estimated expenses, the company already record expense more than it should be. The expense will record in the income statement and we cannot change the expense as it has already closed the report. It is the accounting estimate which depends on the company’s best estimation.
When the actual loss is lower, it means the inventory reserve is higher. So we need to keep the balance on balance sheet for future net off. The company still owns the inventory on the balance sheet, so the inventory reserve will be used to net off when actual loss incurs in the future. However, we have to check if the reserve is too high. It will impact the current provision overbalance.
Finally, we have to ensure that inventory reserve is eliminated if the company gets rid of all inventory on balance sheet. If we do not eliminate the reserve inventory, it will show the negative balance on the balance sheet as the inventory is already zero. So when we sold all inventory on balance sheet, we have to ensure that the inventory reserve is zero too. We could simply reverse back to the income statement by credit inventory write down.
FAQ
Is it compulsory to record inventory reserve?
No, not all inventory require to write down.
It is the management’s obligation to review the inventory valuation on the balance sheet. It should be recorded at a lower cost or net realizable value.
If the management has enough evidence to prove that inventories are not required to be written off it is fine to record at cost. However, they have to access the inventory valuation before making a conclusion, Auditor will access the management valuation and its reasonableness.
Is there any formula to calculate inventory reserve?
The answer is no. There is no standard formula to apply for kind of inventory and business operation.
Some inventory has a high rate of obsolete. Glass has a high rate of damage, so company needs to provide a proper reserve. Food has short expiration, so it is highly likely to be obsolete. The management needs to provide a high rate of provision for such kind of inventory as they have a high rate of loss due to damage or obsolete.
On the other hand, the inventory such as cloth, may not expire or be damaged but it may be out of date. So the management needs to estimate loss based on other criteria.
This is the reason that one formula does not fit all inventories and business types. The company has to figure it out by itself base on past experience, industry average, and nature of the product.
Can we perform an inventory count to calculate reserve inventory?
No, you can’t, inventory reserve is the estimated loss of inventory that may be happening in the future due to various reasons. So how can you count it?
However, we can perform a physical inspection to evaluate the inventory condition to provide a proper estimate. It can be one of the methods that company uses, but it is not inventory counting.
