Business makes a practical assumption while acquiring inventory that all its inventory will never be sold or consumed. Business identifies a rate of depreciation with each inventory and accordingly allocates a certain amount to be deducted from the original inventory value.
This amount which is being deducted from the original inventory value to reflect the actual inventory value is called the Inventory Reserve.
Inventory Reserve can be a Markdown Reserve or Obsolete Reserve.
Markdown Reserve is associated with goods whose value has depreciated but still could be sold at a certain price.
Say a company acquires $10000 of inventory stock which it had thought could be sold within a month. After a month, the value of this inventory stock would start depreciating at the rate of say 20% per month.
In this first month the company is able to sell $6000 of the stock resulting in a remaining stock of $4000. However because of depreciation the markdown reserve associated with the stock would be $800 and hence the actual value of the remaining inventory is $3200.
This can be very well associated with goods which have a fixed shelf life.
Obsolete Reserve would be associated with inventory which has become obsolete and could not be used.
For example a printing press had piled up $3000 of inventory in terms of printing ink which it had planned to use. However, the company decided to go for a technology upgrade and decided to replace the old printing machine with a new one which could not use the earlier ink purchased. This $3000 of inventory is reserved as obsolete.
Inventory falls under the 'asset' category in the company's balance sheet and inventory reserve can be used to reflect the actual inventory. Inventory reserve can also be used to save tax by reporting the actual value of inventory.
It is not true that all items depreciate with time. There are items like wine and watches which actually appreciate with time. The inventory reserve value in such cases would be a positive value to be added to the original inventory value.