As with most matters related to generally accepted accounting principles (GAAP), accountants assigned with the task of applying GAAP to inventory reserves often use a significant amount of personal judgment. Unfortunately, the judgments made are usually only as accurate as the accountants are honest. With that in mind, let's explain inventory reserves.
An inventory reserve is money that is taken out of earnings for the purpose of paying cash or non-cash anticipated future costs associated with inventory. Matters pertaining to inventory reserves are a very small part of a wide body of rules associated with inventory accounting. Costs of keeping inventory can come in many forms, and most of them are seen by the market as having the potential to negatively affect a corporation's profitability. Such costs may be holding costs, storage costs, shrinkage costs, or any type of cost arising from a decrease in the value of the inventoried assets. Inventory reserves or allowances are contra accounts as they may partially, fully or more than fully offset the balance of the inventory account.
GAAP requires that all inventory reserves be stated and valued using either the cost or the market value method - whichever is lower. If the cost of inventory exceeds the market value, an adjustment must be made to the inventory value entry on the balance sheet. Since it is unlikely that a company would produce and inventory a product at a cost to the company that exceeds market value, such a situation would usually occur because of a negative change in the market value of the inventoried asset. For example, let's say a company produces crude oil at a cost of $25.00 per barrel. If the market price of crude oil drops to just $20.00 per barrel, then an accounting entry must be made to adjust for the change in the market value of the inventory. The entry would look something like this, assuming the company only produced one barrel of oil at $25.00 per barrel:
In the case of crude oil, market price is very easy to determine, as it's a commodity that is traded internationally and the price has a very low bid-ask spread. In most cases, the market price of inventory is much less easily determined. In the United States GAAP requires that inventory be stated at replacement cost, if there is a difference between the market value and the replacement value, but upper and lower boundaries are applied to the replacement cost of the inventory. This is known as the lower of cost and market value method of inventory valuation.
The upper boundary is called the ceiling. The ceiling applied to the market value of inventory is such that the market value must be below the net realizable value (NRV), which is a reasonable estimation of the eventual selling price of the asset in inventory minus the costs of the sale or disposal of the asset. The ceiling is in place to remove the opportunity for a company to overstate the value of its inventoried assets.
The lower boundary is called the floor. The floor applied to the market value of inventory is such that the stated market value must not be lower than the NRV minus an approximation of profit realized from the asset's sale. The floor is in place to remove the opportunity for a company to unrealistically overstate profit by understating the value of its inventoried assets.
It is important to recognize that GAAP is not a stagnant set of principles: rather, it changes to reflect changes in regulation and changes in 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 generally accepted principle of accounting.
(For further reading, see Inventory Valuation For Investors: FIFO Vs LIFO and Measuring Company Efficiency.)