An inventory reserve is an asset contra account in which a company retains an estimated charge for inventory that it has not yet specifically identified, but which it expects is present and for which it must write down the value to some amount less than the cost at which it is currently recorded. There may be a variety of causes for such a write down, such as the obsolescence, spoilage, or theft of inventory.
When you create an inventory reserve, charge an expense to the cost of goods sold for the incremental amount by which you want to increase any existing inventory reserve (or use a separate account within the cost of goods sold classification), and credit the inventory reserve account. Later, when there is an identifiable reduction in the valuation of the inventory, reduce the amount of the inventory reserve with a debit, and credit the inventory asset account for the same amount. Thus, the expense is recognized prior to the identification of a specific inventory issue, which may not occur for some time.
For example, ABC International's controller decides to maintain a 3% inventory reserve, based on the company's historical experience with inventory losses. This amounts to a $30,000 debit to the cost of goods sold, and a $30,000 credit to the inventory reserve contra account. The company later identifies $10,000 of obsolete inventory; it writes down the value of the inventory with a $10,000 debit to the inventory reserve contra account and a credit to the inventory account. This leaves a $20,000 balance in the reserve account.
The use of an inventory reserve is considered conservative accounting, since a business is taking the initiative in estimating inventory losses even before it has certain knowledge that they have occurred. If you were to not use a reserve and also did not make use of cycle counting to provide evidence of inventory counts, then you might be adversely surprised by a lower-than-expected inventory valuation at the end of the year, for which you would have to record a large year-end charge. You would have avoided this unexpected one-time charge with an ongoing series of smaller charges to build an inventory reserve over the course of the year.
Conversely, you could also commit a minor amount of reporting fraud by increasing the size of the inventory reserve during profitable periods, and using this inflated reserve to draw down the balance when you need to increase reported profits. This sort of behavior is not condoned, and may be spotted by auditors who want to see a valid justification for any unusual changes to the reserve.