An inventory reserve is an allowance account that holds the write-downs on stock you still hold. The inventory account keeps showing cost, and the balance sheet shows cost less the reserve. Under IFRS it is a write-down to net realisable value, based on the evidence at the reporting date.
It is not a cushion for losses that may come later, which is how many guides describe it. This guide sizes one from a Nairobi shop's own clearance history, in Kenyan shillings, and shows the entries and the ArmPOS steps.
Reserve, write-off, write-down or "depreciation"?
A reserve is the account; the write-down is what it holds. Use one when you estimate write-downs for a group of similar items, or want cost and the cut shown apart.
| Term | What it means | When it applies | The entry |
|---|---|---|---|
| Inventory write-off | Stock that is gone or worth nothing comes off the books at its full cost. | It was lost, stolen, destroyed or expired, and will fetch nothing. | Debit inventory losses (an expense), credit inventory. |
| Inventory write-down | Stock is cut from its cost to its net realisable value: what it will sell for, less the costs to sell it. | It will still sell, but for less than it cost. | Debit inventory write-downs (an expense), credit inventory or the inventory allowance. |
| Inventory reserve | An allowance account that holds the write-downs on stock still held, so the inventory account keeps showing cost. | You estimate the write-down for a group of similar items, or want cost and write-down shown apart. | Debit inventory write-downs, credit the inventory allowance. |
| "Inventory depreciation" | Not an accounting entry: stock is never depreciated. People mean value lost to expiry, damage, fashion or newer models. | Never as depreciation. Book the loss as a write-down or a write-off. | None of its own. |
Two other things share the name. "Reserve stock" is safety stock kept back to meet demand, which reorder points and safety stock covers. A lender's "inventory reserve" is a cut it makes to your stock's value before lending against it, as inventory financing explains.
How an inventory reserve works
The reserve sits under inventory as a contra asset: an account with a credit balance that is deducted from it. Gross inventory less the reserve is net inventory, the figure on your balance sheet.
- Gross inventory is everything you hold, at cost.
- You estimate how far some of it will sell below cost, line by line or for groups of similar items.
- That estimate is the reserve. You set it with an expense: debit inventory write-downs, credit the inventory allowance.
- Net inventory is gross inventory less the reserve.
- When reserved goods are sold or thrown out, the part of the reserve on them is used up.
- At each reporting date you work out the reserve again and post the difference, up or down.
The expense lands in the period you make the estimate, not the period you finally clear the goods. A write-down expense usually sits in cost of sales.
Inventory reserve vs inventory write-off
A reserve holds the expected loss on stock you still have; a write-off records a loss that has happened. The reserve is an estimate you revise each period.
- Reserve: the goods are on your shelves and will sell, but for less than they cost. The estimate can rise, fall or reverse.
- Write-off: the goods are gone, destroyed or worth nothing. You take their cost off the books, using any reserve already held against them first.
A reserve must never hide missing stock. Goods that walked out are inventory shrinkage, and you write them off when the count finds them gone.
What IFRS calls an inventory reserve
IFRS has no "inventory reserve". In IFRS, a reserve is part of equity (IAS 1, paragraphs 54 and 79), so the account is better called an inventory allowance.
What it holds is a write-down to net realisable value under IAS 2. Five rules follow from that:
- Evidence, not caution. Net realisable value rests on the most reliable evidence at the time (paragraph 30). Your own clearance prices are evidence; "we always lose some" is not.
- Groups of similar items only. You may group items in one product line with similar uses when they can't practicably be valued one by one (paragraph 29). A flat rate on "all finished goods" is ruled out by name.
- It reverses. When prices recover, the write-down comes back, up to the original cost (paragraph 33).
- A new method is not a restatement. Net realisable value is an accounting estimate (IAS 8, paragraph 32), so new rates apply from the period you change them. Past years stay as they were (paragraph 36).
- It is disclosed. Your notes give the amount written down in the year and any reversal (IAS 2, paragraph 36).
The IFRS for SMEs Standard says the same in paragraphs 27.2 to 27.4, where the cut is called an impairment loss. US GAAP differs on one point: a write-down sets a new cost that is not marked up later (ASC 330-10-35-14).
How to calculate an inventory reserve
Group similar items, sort them by age, and apply the share of cost each age band lost the last time you cleared it. That turns your own history into the evidence IAS 2 asks for.
- Take one product line, such as phone accessories, not your whole stock.
- Sort it into age bands by days in stock: 0-90, 91-180, 181-365 and over 365 suit most shop goods.
- For each band, find what similar stock fetched when you cleared it before, less the costs of selling it, as a share of cost.
- The reserve rate is 100% less that recovery, or nothing if the stock still sells at or above cost.
- Multiply each band's stock at cost by its rate, and add the bands.
- Override the bands where you know more: a recalled model or an expiring batch gets its own figure.
For example, a Nairobi phone and electronics shop sets its reserve for phone accessories on 31 December. These are illustrative figures in Kenyan shillings, not a real shop's.
| Days in stock | Stock at cost | Recovered when cleared last year, after selling costs | Reserve rate | Reserve |
|---|---|---|---|---|
| 0 to 90 | 600,000 | Sold at full price | 0% | 0 |
| 91 to 180 | 180,000 | 80% of cost | 20% | 36,000 |
| 181 to 365 | 90,000 | 45% of cost | 55% | 49,500 |
| Over 365 | 30,000 | 10% of cost | 90% | 27,000 |
| Total | 900,000 | 112,500 |
Net inventory for the line is KES 900,000 − 112,500 = KES 787,500. The entry on 31 December: debit Inventory write-downs KES 112,500, credit Inventory allowance KES 112,500.
The flat 2% of all stock that many guides teach would give KES 18,000. That understates this line's loss by KES 94,500, and IAS 2 doesn't allow a flat rate across a whole class of stock anyway.
The reserve through the year
The reserve moves as goods leave and as you re-measure. The same shop's next month looks like this:
| When | What happened | Entry | Reserve after |
|---|---|---|---|
| 31 December | Reserve set from the age bands | Debit inventory write-downs 112,500; credit inventory allowance 112,500 | 112,500 |
| January | The over-a-year stock, cost 30,000, fetches nothing and is thrown out | Debit inventory allowance 27,000 and inventory losses 3,000; credit inventory 30,000 | 85,500 |
| 31 January | The age bands, run again, call for 90,000 | Debit inventory write-downs 4,500; credit inventory allowance 4,500 | 90,000 |
The binned stock had been expected to fetch 10%, so the extra KES 3,000 is a loss of January. The reserve then rises only by what the new figures call for.
Why an inventory reserve matters
A reserve puts the loss in the period you can see it, so profit and stock aren't overstated until the clearance sale. Three people rely on that:
- You, when buying. A reserve that grows each quarter on one line says you are buying more than it sells, the classic route to overstocking.
- Your lender. A bank that lends against stock looks at its value net of the reserve.
- A buyer of the business. Net inventory is part of the price, so a buyer will test how the reserve was set.
Common misuses and fraud risks
A reserve is an estimate, so it can be bent to move profit between years. In the example, a 30% reserve in a strong year would be KES 270,000 instead of 112,500.
That moves KES 157,500 of profit into a later year, ready to be released when trading is weak. Cutting the reserve before a loan application or a sale does the reverse, and flatters net inventory.
Four habits keep it honest:
- Write the method down: the age bands, where each rate comes from, and who approves it.
- Use the same method every period, and change it only when the evidence changes.
- Have someone whose pay doesn't depend on profit check the rates against real clearance prices.
- Show the write-down and any reversal in your notes each year.
Tax offices may refuse a general reserve. South Africa's SARS wants a cut below cost shown item by item or by category, and rejects a blanket percentage (Interpretation Note 140). Check your own country's rule in inventory and taxes.
How to set up an inventory reserve in ArmPOS
ArmPOS gives you the ages and the costs; you set the rates and post the reserve as a journal entry. ArmPOS doesn't calculate or post a reserve by itself.
- Group the line. Each product sits in a Category, such as Phone accessories (Categories, brands and units).
- Age it. Open Reports › Stock Aging Report, choose the Warehouse and the Category, and type 90,180,365 in Buckets (Stock reports).
- Value it. Reports › Inventory Valuation gives each product's stock on hand and Cost. Multiply them in a spreadsheet, band by band.
- Find the recovery rates. The Product sales report shows what cleared lines sold for, and the Discount Summary Report what you gave away (Sales reports).
- Add two accounts in Accounting › Chart of Accounts: 5120 Inventory write-downs, Type Expense, and 1210 Inventory allowance, Type Asset, Parent 1200-INV.
- Post the reserve. In Accounting › Journal Entries, click Create, then debit 5120 and credit 1210. Check it says Balanced, click Save, then post it (The chart of accounts and journal entries).
- When reserved goods are thrown out, record a Damage for the quantity (Record damaged stock). Then post the entry from the January row above.
- Each month end, run the bands again and post only the difference.
The Stock Aging Report dates each product by its last delivery. A line restocked last week shows as new even if older units remain, so check those lines on the shelf or by batch.
On the Trial Balance, 1200-INV stays at cost and 1210 sits beside it. The Balance Sheet takes 1210's credit balance off your assets (Trial balance, profit and loss, balance sheet).
See what ArmPOS includes for shops in Kenya.
Frequently asked questions
Is an inventory reserve an asset or a liability?
Neither on its own. It is a contra asset with a credit balance, deducted from inventory on the balance sheet.
Is an inventory reserve allowed under IFRS?
Yes, as a way to hold write-downs to net realisable value, based on evidence at the reporting date. A general reserve for losses with no evidence yet is not.
What is a reasonable inventory reserve percentage?
No standard percentage exists. The right rate is what your own clearance history shows for each age band of each product line.
Is an inventory reserve tax deductible?
Often not as a general percentage. Some tax offices, such as South Africa's, want the fall in value shown item by item or by category, so check your country's rule.
What happens to the reserve when the goods sell?
The part held against them is used up, so their cost of sales reflects the lower value. Whatever the remaining stock no longer needs is released at the next month end.
Pick your slowest product line, sort it by age and check what each band fetched last time you cleared it. To see every product's age, cost and clearance prices in one place, create a free ArmPOS account.
