There is a lot of input in income statements. Some accounts are what has actually happened, such as sales. Other accounts must match the revenue due to the principle of matching in accounting. You’re trying to figure out the cost per sale. These accounts also include reserves. Although they are accounting beneficial, they are also dangerous because management has many difficulties with the calculation of reserves.
Reserves are very important in accounting. They are the company’s prediction of the cash costs that will arise after the sale. For example, if a company sells its televisions under warranty, then that company will estimate how many of these televisions will have to be repaired. It is estimated that is a warranty reserve and is used in the year the TV is sold. Because the costs are subtracted from income, reserves reduce the income and profitability of the company.
Reserve is a necessary evil. A company will usually not be a company that uses all the cash, in which all cash in and out flows occur in one transaction. There are other provisions, such as the cost of bad re-collection debt, which the board of directors must also estimate. This comprehensive approach provides a clearer picture for investors about how the timeframe is taken into use with the company.
The Board of Directors has the full authority to decide on how they can handle the reserves, which allows the Board of Directors to manipulate reserve estimates for their benefit. For example, if a company is set to report earnings and earnings will fall slightly below what analysts expect, it could set reserves for the quarter slightly lower to boost its reported earnings. If the income is very high, a company can increase its reserves to have a safety net for future quarters in case the income is not high.
There’s a way to take a look at what management is doing. While not a common way to study stocks, it is important to look at SEC records like 10-K and 10-Q. In these documents, you can see what companies are estimating in their reserves. If a number is too high, then you can easily know what the management is doing. If you notice that the reserve model is always high or above the industry average, it could be a sign that management is reporting lower earnings and an opportunity to buy stocks. Eventually, these reserves must be released.