In this chapter we examine some of the reserves mentioned in the previous chapters more closely, specifically the inventory valuations, inventory reserves, and contingency reserves.
Depreciation and inventory valuation go hand in hand in corporate income analysis as they both affect the income of the company. The standard method for evaluating inventory is to carry the items at cost or at market, whichever is lower. For depreciation, the practice is to write down each item from cost to salvage value by regular charges against the income extended over its expected life.
When examining inventory and depreciation, the security analyst must decide how to treat both in order to calculate correctly the normal earnings for the company, and he must also be sure to apply the same treatment to other companies in the same industry so that he can compare accurately.
The two standard methods for calculating inventory are FIFO (first-in, first-out) and LIFO (last-in, first-out). The methods vary considerably, and both often show different earnings for the same transactions. LIFO is more stable, as normally it will show the true profits for each year, when FIFO can be confusing. However, if the current price of the items drops below original cost, LIFO will be subject to irregularities as well.
Next, we learn of the normal-stock method. Using the normal stock-method, one will write-down all items to a very low price, so low that the market-value of the item should never fall below the marked price. The usual normal-stock method allocates a large portion of the total inventory to this normal-stock pricing, with the remainder kept under FIFO or a current-replacement-cost method. When part of a normal-stock inventory is sold, it is necessary to charge earnings with a reserve for the replacement of the deficiency; thus, it cancels out the large profit made on the sale.
Next we will look at contingency reserves.
Contingency reserves are reservations made to protect against future events, either being charged to earnings or surplus, or charging it to profit and loss after the payment of dividends.
Basically, a company, during a good year, would take out a reserve on the earnings, thereby showing smaller earnings for that year. Afterwards, during a bad year, they would charge the shrinkage to the reserve instead of current earnings, making the earnings appear higher.
Some companies execute a different strategy - taking reserves out during a good year, but they charge it to accumulated surplus instead of current earnings; this way, the current earnings are still high. During a bad year, they can charge the shrinkage to this reserve; thus, the losses will not be reflected in the income account in any year.
Some companies apply a different strategy; they will take out a similar reserve during a year when they have a deficit, and then they will boost their profits the next good year. The reason for this is that stock prices are indeed affected by a deficit, but the amount of the deficit isn't very important. A $4 deficit isn't much better than a $6 deficit (in the market's mind). Profits also influence the stock's price; however, the amount does make a big difference. A $6 profit is much better than a $4 profit. So, the company will take out the reserve during a year where they are already negative anyway, because not much will change. Then, the next good year, they can boost profits. In a sense, they are boosting profits for free.
An idea held by some is that the reserves should only be connected with the surplus accounts and never the income. This way, the earnings will never be affected. The reserves instead will serve more like a warning or a good omen. When the security analyst examines these reserves, he should adjust them to follow this method, so that the company's operating results are more reflective of the true earnings. He can make an exception for LIFO inventory reserves, however, to adjust for the differences in market values of the inventory items.
In conclusion, we see that the "real" purpose of reserves is to skew earnings to make them appear more favorable, except in the case of inventory reserves for LIFO calculations, where it serves to absorb the rise and fall of market values of the inventory items.