Meaning
Balance sheet allocations for the potential loss of value in aging inventory ensure that assets are not overvalued. An obsolescence reserve is necessary when products become outdated due to technological advances or changes in consumer taste. This accounting practice ensures that the assets of a company are accurately represented in its financial reports.
Accounting Treatment
Setting aside funds for this purpose reduces the reported profit in the current period to reflect the likely future loss. The size of the obsolescence reserve is based on a historical analysis of how much inventory typically goes to waste. When the items are finally disposed of or sold at a discount, the loss is charged against this specific fund rather than the current operating budget.
Inventory Turnover
Slow moving parts that have been sitting in the warehouse for over a year are the primary candidates for this reserve. Monitoring the age of every item allows the finance team to adjust the obsolescence reserve as the product lifecycle progresses. High turnover rates reduce the need for large reserves because the goods are sold before they have a chance to become obsolete.
Market Risk
Sudden shifts in industry standards can make an entire category of components worthless overnight. The obsolescence reserve acts as a buffer that protects the company from a massive write down that could damage its credit rating. Managers must balance the cost of holding extra inventory against the risk that those items will never be used.
The cost of calling a project ready for production without a plan for the old stock is a pile of useless assets that drain the company cash.
