Each year, 10% to 40% of apparel products go unsold, according to trend forecasting firm WGSN. That means between eight billion and 60 billion garments never make it into customers’ hands.

If a fashion company expects a certain percentage of its products not to sell, counting that inventory as an asset wouldn’t tell the whole financial story. That’s where inventory reserves come in.

A company’s inventory reserve helps investors and company stakeholders understand the true value of the company’s assets, and ultimately, the state of the company’s financial health. Here’s a primer on what inventory reserves are and how inventory reserves work.

What is an inventory reserve?

In accounting, an inventory reserve account is a type of contra-asset account—an account linked to an asset that reduces the asset’s value. A business uses an inventory reserve to account for merchandise it suspects it will not be able to sell, like obsolete, expired, spoiled, or damaged items.

The inventory reserve carries a negative balance that reduces the value of the inventory asset. On a balance sheet, accountants subtract the inventory reserve from the company’s gross inventory to determine a net inventory value.

To determine inventory reserves, companies analyze past data to generate a prediction of how much unsold inventory they’ll have in the future.

Let’s take a look at an example. A snack company looks at its past inventory and sales data and finds that, on average, 2% of its inventory expires before being sold, and 1% of its inventory arrives damaged, making it unsellable. This means that a total of 3% of the company’s inventory normally doesn’t sell.

Now, let’s say the company normally holds $20,000 worth of inventory. Inventory is reported as an asset on a balance sheet, but reporting the full $20,000 as an asset wouldn’t show the full picture, since 3% of that inventory ($600) likely won’t sell. That $600 is the company’s inventory reserve. When that $600 worth of inventory goes bad or arrives damaged, it will be reported as a loss—not as an asset.

On its balance sheet, the snack company would add an inventory reserve entry of $600. It would then subtract that $600 from the gross inventory value ($20,000) to arrive at the net inventory value ($19,400). The company can then count this $19,400 as an asset.

Inventory reserve vs. inventory write-off

An inventory reserve and an inventory write-off are both related to unsellable inventory, but an inventory reserve is a prediction, while an inventory write-off is a real-time report of a loss. Not everything in an inventory reserve will end up written off as an actual loss: Maybe, for example, you end up having fewer products expire than you did in past years, or you end up having fewer products arrive at your warehouse damaged.

Here’s a breakdown of the two terms:

Inventory reserve

An inventory reserve is a forward-looking accounting entry. A business calculates an inventory reserve to account for inventory that it anticipates will be unsold due to factors like obsolescence and damage.

An inventory reserve can help businesses ensure that their financial statements adhere to the accounting conservatism principle, which dictates that all losses should be recorded as soon as possible, even if they’re uncertain.

For example, a clothing company looks at its historical data and finds that 15% of its inventory doesn’t sell because of quickly changing trends. The company expects this pattern to continue and sets its inventory reserve percentage at 15%. The company has $100,000 in inventory, so its inventory reserve value is $15,000 (15% x $100,000).

Inventory write-off

A company records an inventory write-off when individual inventory items have become completely worthless or unsellable. The value of the inventory write-off is deducted from the company’s cost of goods sold (COGS) and added to its write-off expense account. This directly reduces the company’s profit.

For example, let’s say the clothing company has 50 denim dresses in its inventory. Denim dresses go out of style, and the company decides to stop selling them. Now the 50 denim dresses have no value, so the company accounts for them as an inventory write-off. 

Why do businesses use inventory reserves?

Businesses use inventory reserves to ensure they’ve accurately recorded the current value of their inventory on their balance sheet. Balance sheets can give companies an accurate picture of their financial health (and C corps are required to file them with their taxes).

Businesses might also calculate their inventory reserve to apply for a business loan. Plus, businesses sometimes use inventory as collateral to qualify for a loan. This means that lenders might consider the company’s net inventory value (calculated by subtracting the reserve from the gross inventory) to avoid overestimating the borrower’s assets. 

How to calculate and record an inventory reserve

1. Establish a percentage
2. Find the inventory reserve value
3. Record the inventory reserve value
4. Continually monitor and adjust your totals

Here’s how to calculate inventory reserves:

1. Establish a percentage

Look at past inventory and sales data to determine the percentage of inventory that typically doesn’t sell. You’ll also want to consider current market conditions, then adjust your percentage accordingly.

For example, let’s say 2% of your business’s inventory has historically gone unsold. However, you now have a new competitor selling a similar product at a lower price point, and you anticipate that more of your inventory will go unsold this year. You might adjust your inventory reserve percentage to 2.5%.

2. Find the inventory reserve value

Once you’ve determined an inventory reserve percentage, multiply the percentage by your gross inventory value to find the inventory reserve value.

For example, let’s say your gross inventory value is $10,000. You multiply $10,000 by 2.5% to find that your inventory reserve value is $250.

3. Record the inventory reserve value

It’s now time to add accounting entries for the inventory reserve. This means debiting one account and crediting another as follows:

• Debit. You’ll debit an inventory expense account (part of cost of goods sold) on your income statement. This increases your company’s expenses on your income statement, reflecting your anticipated loss.

• Credit. You’ll credit an inventory reserve contra-asset account on your balance sheet. This reduces the value of your inventory asset.

The debit to your inventory expense account reduces your gross inventory value. For example, if your gross inventory is $10,000 and your inventory reserve value is $250, your net inventory value would be $9,750. On the income statement, the recorded cost of your inventory reserve expense increases the cost of goods sold.

4. Continually monitor and adjust your totals

As with most financial accounting maneuvers, calculating your inventory reserve isn’t a one-time event. Reevaluate your reserve every accounting period, with an eye toward changing sales patterns and market conditions. As inventory actually becomes unsellable, you’ll turn these inventory items into write-offs. 

Tips for creating an inventory reserve

The simplest way to create an inventory reserve is to leverage accounting software. But even if a computer is doing the heavy lifting, you can employ some best practices for optimal results.

1. Perform regular inventory counts. Before you can create an inventory reserve, you must have an accurate picture of your stock. This can help you determine whether your inventory is in line with past years’, which can help you correctly apply what you’ve learned from analyzing historical trends.

2. Keep your accounting methods consistent. Different companies may have slightly different methods for tracking inventory reserves. No matter how you approach it, stay consistent. Document your methodology and share it with others on your accounting team. This helps keep your financial data reliable from one reporting period to the next.

3. Monitor your supply chain. Disruptions or overproduction can leave you with more or less sellable inventory, which can affect your inventory reserve.

4. Look at external market factors. New competitors or changing government regulations (like tariff hikes) can significantly impact the amount of inventory you can sell. Take these factors into consideration as you determine your inventory reserve.