How Reserves Affect Income Statements

There are a lot of inputs in an income statement. Some accounts are what actually happened, such as sales. Other accounts are supposed to match up with sales because of the matching principle in accounting. You are trying to figure out the costs that went into each sale. These accounts also include reserves. Although they are beneficial in the accounting sense, they are also dangerous because management has a lot of leeway with how to calculate reserves.

Reserves are very important in accounting. They are a company's projections for cash expenses that will be incurred after a sale. For example, if a company sells warranty with its televisions, then the company will estimate how many of these televisions will have malfunctions that they will have to fix. That estimate is the warranty reserve and is expensed during the year the televisions were sold. Because expenses are subtracted from income, reserves decrease income and a company's profits.

Reserves are a necessary evil. A company usually will not be an all-cash company, in which all the cash inflows and outflows occur during a transaction. There are other reserves, such as bad debt expenses, that management has to estimate also. This comprehensive approach provides a clearer picture for investors of how the time frame being accounted for went for the company.

Management has significant discretion over how they can treat reserves, which allows management to manipulate reserve estimates for its benefit. For example, if a company is set to report earnings, and the earnings are going to fall a bit short of what analysts expect, the company can set its reserve for the quarter a bit lower to juice up its reporting earnings. If earnings are very high, a company can raise its reserves to have a safety net for future quarters in case earnings are not as strong.

There is a way to see through what management is doing. Although not a very popular way to research stocks, looking through SEC filings such as 10-Ks and 10-Qs is very important. In these documents you can see what companies are estimating in their reserves. If a number is too high, then you can easily tell what management is doing. If you notice a pattern that reserves are consistently high, or way above industry averages, it may be a sign that management is under-reporting earnings and an opportunity to buy the stock. Eventually these reserves have to be released.