What it means
Accounting rules require assets to be shown at a figure that is not above what the business can expect to recover. Receivables may not all be collected, stock may not all be sold at full price and investments may fall in value.
A valuation reserve records this expected shortfall without removing the asset from the books. The reserve is a contra account, meaning it carries a credit balance that offsets the asset.
The asset stays at its original cost, and the reserve is subtracted to give the net figure. This keeps a record of the gross amount and shows readers how much the company expects to lose.
Creating or increasing a reserve is an expense in the income statement, so it reduces profit. When the reserve proves too high and is released, the profit rises again.
Because management has to estimate the amount, the reserve is an area where judgement can be used well or abused. Companies commonly name their reserves by purpose, such as the allowance for doubtful accounts, inventory obsolescence reserve or a valuation allowance on deferred tax assets.
Modern accounting standards often use the word allowance, but the idea is the same. In insurance, the asset valuation reserve is a related statutory reserve that protects insurers against losses on investments.
Setting the reserve involves analysing past experience. A business might look at how much of its receivables from each age bracket have gone unpaid in previous years and apply those rates to the current balances.
It then adjusts for current conditions, such as a downturn affecting customers. For managers outside finance, valuation reserves are a signal of how cautious the accounts are.
A very low reserve against old receivables might mean profit is overstated. A sudden big increase can point to trouble in the business or a one-off clean-up of the balance sheet.
In practice
Real-world examples.
Example
A wholesaler has $1,200,000 of receivables, of which $200,000 are more than 90 days overdue. It sets a reserve of 25% on the overdue balance and 2% on the rest, so it records 50,000 + 20,000 = $70,000. The credit controller reviews the ageing report each month, because the reserve should change as invoices get older.
Example
A fashion retailer has $800,000 of last season's stock that it expects to sell at a discount. It creates a reserve of $150,000 so the stock is shown at a more realistic value. The buyer also plans a clearance sale to speed up the disposal of the remaining stock before it loses more value.
Example
A company holds shares in a small supplier that has run into trouble. It sets up a valuation reserve to write down the investment from $400,000 to the $250,000 it now thinks it can recover. If the supplier recovers, the reserve can be reduced and the amount released will increase profit in that period.
Formula
Calculation
Net carrying value = gross asset value - valuation reserve
Suppose a company has trade receivables of $500,000 and, based on past experience, expects 4% to go uncollected. The valuation reserve is 500,000 x 0.04 = $20,000. The net receivables shown on the balance sheet are 500,000 - 20,000 = $480,000. The $20,000 is recorded as an expense in the income statement, which reduces profit for the period by the same amount before tax.Case study
Seen in the real world.
Windermere Trading is an illustrative, fictional distributor with $2,000,000 of receivables at the end of the year. Its finance manager has always reserved a flat 2%, which is $40,000.
A review of the ageing report shows that $300,000 is more than 120 days overdue, and past experience suggests that 30% of such debts are never collected. She calculates a reserve of 0.30 x 300,000 = $90,000 on the old balances and 1% on the other $1,700,000, which is $17,000.
In this illustrative story the new reserve is $107,000, so profit falls by $67,000 compared with the old approach. The auditors agree that the new figure is more realistic, and the board sees an earlier warning of customer payment problems. The finance manager also adds a note to the accounts explaining how the reserve is calculated, so readers understand the judgement involved.
Watch out
Common mistakes.
- Treating the reserve as cash set aside, when it is only an accounting deduction and no money is put into a separate fund.
- Using the same percentage every year, when the reserve should reflect current evidence and the age of balances.
- Writing the asset off directly without a reserve, which hides the gross amount and makes it hard to track.
Questions
People also ask.
Does a valuation reserve reduce profit?
Yes, creating or increasing it is an expense in the income statement, and releasing it adds to profit.
Is a valuation reserve the same as an allowance?
In most modern use the terms mean the same thing, though allowance is the preferred word in current standards.
Who decides the amount?
Management estimates it, and auditors review whether the estimate is reasonable.
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