In this podcast episode, we discuss the reserve for obsolete inventory. Key points made are noted below.

The Need for the Reserve for Obsolete Inventory

This reserve means that you recognize an expense in advance for inventory that’s already on hand, and which is likely to be thrown out or disposed of in some other way. The presence or absence of a reserve can be a big deal when a company has a large amount of inventory on hand and it’s not doing a good job of managing it. In this case, who knows how much of the inventory is obsolete? A quarter? Maybe a third? No one knows. From my experience, the proportion is frighteningly high. But that doesn’t mean you need a reserve in all cases.

Where a reserve is needed is when the inventory turnover level is low, the investment in inventory is medium to high, and there’s not a good system for tracking it. When those conditions are present, there’s bound to be a lot of old inventory that should be eliminated.

Now, just turn around those conditions to figure out if you don’t need a reserve. The inventory turnover level is high, so the inventory is being flushed out rapidly, and doesn’t have time to become obsolete. The investment in inventory is low, so even if there is obsolete inventory, the write-off is minimal. And third, if there’s a good inventory monitoring system in place, then management already knows which items are getting stale and is taking steps to eliminate them.

So let’s assume you’re in the first group, so there’s likely to be obsolete inventory mixed in with the other inventory. In this case, there’s something else to think about before you go anywhere near creating a reserve for it – which is that the management team routinely denies the truth and claims that there’s no obsolete inventory. They do this because creating a reserve triggers a hit to profits. In essence, they can put off recognizing a loss until next year, so let’s just leave things the way they are.

How to Set up a Reserve

This is a real problem if you’re the accountant and you’re trying to do the right thing and set up a reserve. Your best bet is to get the auditors on your side and have them demand the reserve. Even then, management is going to press for a really small reserve, but at least it’s a start.

Now, how do you figure out the amount of the reserve? There’re a couple of ways to do it. One is to have an experienced group of users examine the entire inventory on an ongoing basis and figure out exactly which items are obsolete. Then estimate the amount that the company could earn by dispositioning the inventory in the most profitable way. The difference between the book value of this inventory and the proceeds from dispositioning it is the amount that the company is going to lose. That’s the amount of the reserve.

But there are a couple of problems with this approach. First of all, it assumes that there’s a well-organized system in place for figuring out which inventory is obsolete and how much it can be sold for; which may not be the case.

As another issue, consider that a reserve is really intended for losses that you don’t yet know about. Which is to say, once the obsolete inventory is identified, would it make more sense to write down its value to its disposition price right away, rather than messing around with a reserve?

To take that concept one step further, a precise identification of obsolete inventory is probably going to fall short of the actual total amount of obsolete inventory, since there’s always some amount that will be unknowable. So keep these shortcomings in mind.

An alternative approach is to just make an estimate. To do so, compile the cost of the obsolete inventory that you’ve disposed of in the past year, and divide it by the average cost of the total inventory for the same period. And that’s your obsolete inventory percentage, which is the basis for creating a reserve. This approach works pretty well, but only if you’re tracking charge-offs due to obsolete inventory.

If you’re not, and people are just throwing away old inventory, then there’s no way to make the estimate. Instead, the lost inventory just means that the ending inventory valuation is now lower, which means that the obsolescence losses are being dumped into the general cost of goods sold expense. To get around this problem, set up a system for charging off the cost of these throwaways to a special account for obsolete inventory losses. After a few months, you should have a reasonable idea of the cost of this inventory.

But – and it’s a large but – only if management is willing to part with the inventory. If the warehouse staff is under orders from management to never throw away anything without their express consent, then you may find that the cost charged to this account is really small – if not zero.

Accounting for a Reserve for Obsolete Inventory

Despite the issues I’ve just noted, using a general obsolete inventory percentage as the basis for setting up a reserve is usually the best way to go. So let’s assume that you want to set up the reserve. How do you do that? Create a contra account that’s paired with the inventory asset account. That means the contra account has a natural credit balance, so that its balance offsets the natural debit balance in the inventory account.

Then charge the initial reserve amount to the contra account – which is a credit. The offset is an expense, which can be to the general cost of goods sold account, or a special expense account that’s just for obsolete inventory. Then, when you actually have obsolete inventory, write its book value down to the value the company can earn from its disposition. That’s a credit to the inventory asset account. Meanwhile, the debit is to the reserve account, which reduces the amount of the reserve.

What all of this means is that recognition of the expense is accelerated, rather than delayed if you were to just charge it to expense when something is eventually identified as obsolete.

So, what about dealing with the reserve on a going forward basis? The reserve amount as a percentage of the total inventory valuation should be kept fairly consistent, unless there’s a significant change in the underlying obsolete inventory amount that needs to be reflected in the reserve. Otherwise, you just need to make minor adjustments to the reserve on an ongoing basis to keep it at the right size.

Dealing with Management Opposition

I’ve kept mentioning that management wants to oppose this process. Even if you manage to create a reserve and it’s initially of the right size, expect management to push for a smaller reserve over time, so that they can delay the recognition of an expense into a later period. There is a way to combat this. Prepare an annual schedule that compares the size of the reserve as a percentage of the total inventory valuation, and run it back for a bunch of years. Then give it to the auditors when they show up for the year-end audit. They can then use this information to make inquiries regarding why management wants to have a smaller reserve.