You run a company that makes gourmet food for pot-bellied pigs. You have $1 million of finished product in inventory...just bags and bags of feed sitting in your warehouse. You estimate that 5% of this inventory will eventually spoil without getting sold.
To recognize this fact on your books, you have to record an inventory reserve of $50,000 (0.05 x 1,000,000 = $50,000). The figure provides a quantified monetary version of your expectation that some amount of inventory will eventually go bad. That number represents the inventory reserve. You're setting aside (on your financial statements at least) some money, in anticipation of the fact that you'll end up having to eat the value of the spoiled inventory. (Hopefully, you don't end up literally having to eat the inventory. Even gourmet slop is still...slop.)
Inventory reserves are the accounting mechanism to account for inventory that will lose value in the future. This situation can happen for any number of reasons...spoilage, aging or obsolete products, or some change in the market (like...pot-bellied pigs are identified as carriers of the plague, and people stop keeping them as pets).
Related or Semi-related Video
Finance: What is inventory?2 Views
Finance allah shmoop What is inventory Well it's Just stuff
you have for sale in one form or another An
auto dealer Well all those cars she has sitting out
there in the sun is a dive bombing targets for
the birds Yeah while their inventory to the car dealership
the cars are inventory the loads of nose hair trimmers
sitting on the shelves at the well appointed nostril fine
store best nostril trimming store in the world Yet their
inventory albeit kind of gross ish inventory especially after use
the four thousand yards of denim cloth sitting in the
weaving factory waiting for thirteen year old girls in thailand
toe weave it all together to make levi's for the
gap Yep that cloth is inventory It isn't finished inventory
It's just a work in process not yet ready for
prime time or a prime thigh or whatever But it's
an asset for the company who owns it and it
is held as inventory on the balance sheet Work in
process right there at the balance sheet right there Okay
And when that inventory is sold and turned into revenues
it'll just become part of the expenses line on the
income statement usually has cost of goods sold or caw
Gse that's What people in the accounting bids say Cocks
thie Inventory is a good but inventory is always good
Of course as many a customer has learned after taking
a hefty shock straight to the hunger And that hurts
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Work-in-process inventory is just inventory... that is in the process of being built. In other words, it accounts for the inventory's asset value.