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Monday, February 23, 2009

Security Analysis:Chapter 10

In this chapter we learn about the effect of reserves on the corporate income account. Readers should take note that there are also reserves on the balance sheet, but the balance-sheet reserves are less influential on the stock's value. Reserves usually are created to "fudge" true earnings, and, because of this, they cause much unneccessary confusion.

There are three prominent types of reserves:

Valuation Reserves:
These serve to mark down assets against
- receivables (for doubtful accounts)
- against fixed assets (depreciation/amortization)
- mark down marketable securities to current price
- mark down inventories to a figure below cost and market value

Liability Reserves:
These serve to reflect liabilities arising from the past, such as
- taxes (when nonrecurrent or amount is uncertain)
- renegotiation
- pensions
- workers' comp/benefits
- profit sharing/bonuses
- claims in litigation/similar liabilities
- losses, unearned premiums, policy reserves (for insurance companies only)
- injuries/damage (for transportation companies only)
- recapture of subsidy (for shipping companies only)
- unexpired subscriptions (for publishing companies only)

Reserves Against Future Developments:
These serve to account for possible future losses.

When reserves appear on the balance sheet, they appear explicitly or by reference by charges to the income account, a surplus account, or the capital account (this is rare, except in public utilities).

The readers will notice that the rules for the treatment of reserves in corporate income accounts are similar to the rules for the treatment of nonrecurrent items:

1 - small items are to be accepted as reported (all together they should total less than 10%)

2- reserve appropriation allowed for income tax purposes should be considered ordinary deductions from current income, unless they relate clearly to a nonrecurrent item

3 - reserve appropriations not allowed for income tax purposes should be ordinarily excluded from the income account (added back to) The use of such reserves will likely benefit the income account of future years, which makes a single year's analysis less reflective of the actual conditions prevailing in that year.

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