What is inventory reserve and how is it accounted for? In other words, how does it affect the balance sheet and income statement?Thanks,Tom
What is inventory reserve and how is it accounted for? In other words, how does it affect the balance sheet and income statement?The inventory reserve arises when a company uses the LIFO method (Last In, First Out) versus the FIFO method (First In, First Out).Quick note: LIFO/FIFO do not describe the actual flow of goods. It's just accountings way of making sense out of the flow of goods.Okay, LIFO. The last product in, is the first one to be sold. In an inflationary period this means higher costs are transferred from the Balance Sheet to the Income Statment (and Net Income will be lower) than under FIFO.The inventory on the Balance Sheet under LIFO is lower than what it would be under FIFO.The reserve is meant to show what the company's FIFO inventory would be had they used that method instead. FIFO represents, generally, replacement cost of inventory better than LIFO.If you're comparing two companies in the same industry and one uses LIFO and the other FIFO, you'll want to know that.The LIFO company, all else being equal, is going to report an inferior Balance Sheet and Net Income compared to the FIFO firm. To adjust for this add the LIFO reserve to Net Income and to the Balance Sheet's Inventory account. Then you're getting closer to apples-to-apples.Ryan
The inventory reserve arises when a company uses the LIFO method (Last In, First Out) versus the FIFO method (First In, First Out).Ryan, you described the "LIFO reserve," but the inventory reserve usually refers to the writedown to market when the lower-of-cost-or-market rule is applied (which applies to both FIFO and LIFO).For example, companies often have inventory reserves when their inventory has become obsolete and can't be sold for more than the cost.
So would you please explain it in terms of what happens to the balance sheet and income statement?Thanks,Tom
So would you please explain it in terms of what happens to the balance sheet and income statement?When an inventory reserve is recorded, Inventory (balance sheet) is reduced and Cost of Goods Sold (income statement) is increased by the amount of the loss (i.e. income is reduced). If the loss is "material" (i.e. large enough for investors/creditors to care about), then the loss is separately stated on the income statement instead of being added to Cost of Goods Sold.
So would you please explain it in terms of what happens to the balance sheet and income statement?Hey Tom,First, thanks to MC for pointing out that there are other forms of inventory reserves other than the LIFO reserve.I just wanted to add to MC's previous post.The inventory reserve we're discussing here can be viewed just like the Allowance for Bad Debt account (which applies to Accounts Receivable).The inventory reserve is mangement's estimate of inventory obsolescence or deterioration. Since it is an estimate, and is a reserve, it has the potential to be manipulated by managments.During good times a company could pad the reserves, then during lean times they could reverse some of the reserves (thus boosting income), or boost income by under-reserving.You should keep an eye on the reserve as it relates to inventory. Ideally gross inventory and the inventory reserve should trend together; if they don't, you might want to find out why. There could be a plausible explanation.The inventory reserve can turn into one of those Cookie-Jar reserves.Ryan
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