This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
Nearly all well-managed corporations charge against the profits of each year an estimated sum, or a number of distinct estimated sums, which are intended to provide for losses and expenses that will probably arise in the future but which are incident to the operations of the current period. The sums so charged are credited to reserve accounts, which are carried on the balance sheet of the company. As to the nature and use of these reserve accounts, there is much misunderstanding. They do not consist, as people seem sometimes to imagine, of funds of cash or property set aside for the purpose of meeting future expenses. It is, in fact, easily possible that a company may accumulate large reserve accounts and yet be quite unable to meet the anticipated expenses when they actually arise. The essential character of all reserves lies in the fact that they constitute a deduction from profits. The reserves exist only in the form of entries and figures in the company's books of account. It is quite possible that a firm which carries no reserves on its balance sheet may be just as conservatively managed as the one which has large reserves. But the probabilities are the other way, for the reason that proper estimates in favor of reserve accounts assist the officers and stockholders of a company in gauging the true status of the business and therefore discredit exaggerated optimism.
The most common form of reserve is that for depreciation in the value of fixed assets, due to wear and tear, obsolescence, etc. Depreciation on account of wear and tear may be estimated in advance with some accuracy, but depreciation for obsolescence is always of uncertain amount. No one can foresee what changes in taste or fashion, what unthought-of inventions, or what improvements in organization may take place, which will perhaps render useless, or partly useless, much of the company's plant, machinery, or other assets. The best that can be done is to make a fairly liberal estimate, based on the experience of the past and trust that it will be sufficient to keep the book value of fixed assets always well within the limits of actual value. If this result is not accomplished, then the depreciation reserve is insufficient and net income is overstated.
Although the presence of depreciation as an actual factor in every business can scarcely be denied, yet the absence of any depreciation charges and reserve accounts on the books of certain corporations is defended by fallacious arguments. For example, many street railway companies and other public utility corporations decline to make any deduction for depreciation charges from gross income. The claim which many of them advance is that the value of their franchises is constantly increasing and is sufficient to offset the admitted decline in value of their road-bed and equipment. This kind of argument is apparently advanced simply to justify a line of action previously determined upon. It is based upon a two-fold fallacy. First of all, granting that there is a steady rise in the value of the company's franchises and that this rise should be taken into the income account, it should then be valued by itself and shown as a source of income, while depreciation charges should be shown as a deduction from income; otherwise there is not even an attempt to make up a fair and reliable income statement. In the second place, experience has by this time shown that the alleged increase in the value of franchises is a highly uncertain factor. Most public utility enterprises are subject in a peculiar degree to legislative control and the legislature usually takes care that franchise values are not permitted to increase with excessive rapidity. The better managed public utility companies are gradually falling into line and are forming adequate depreciation reserves.
Another fallacy is clearly seen from the last annual report of the Canadian Locomotive Company, which includes this remarkable assertion: "We have not added anything to depreciation reserve account as we feel that, our plant being new, the $75,000 already at the credit of this account is sufficient".
Following out the line of reasoning of the directors of this company, it is evident that depreciation reserves are to be set aside only when the period has arrived in which they are actually needed. This makes the so-called depreciation reserve and the account for repairs and maintenance, practically identical, and does away with the only genuine reason for the creation of a depreciation reserve. The London Economist has put the truth of the situation clearly in the following words: "Depreciation allowances are all the more necessary in a boom period, because there is always the practical certainty that the boom will decline more or less suddenly and will leave overvalued stock on hand." Companies that have new plants and are enjoying prosperity are the very ones which should be setting aside liberal reserves for depreciation.
It is not intended in this last sentence, however, to suggest that the practice of writing off depreciation reserve irregularly by arbitrarily setting aside such sums as can conveniently be spared out of the annual surplus, is one to be encouraged. This practice is followed, it is true, by some of our greatest and best-managed concerns, notably by the United States Steel Corporation. But it is essentially unsound. Depreciation is not a theory or a vague notion in some one's head; it is an actual element in the operation of every business; it is going on night and day; through all seasons; year after year; in periods of depression as well as in periods of prosperity. The losses due to depreciation should constitute, therefore, a regular charge against gross income. The amount of that charge should be estimated as accurately as possible and should be adhered to year after year; otherwise we get a purely fictitious showing of net profits. If large sums are charged off in one year and nothing is charged off the next year, the final showing of profits in the two years may be about uniform, whereas the business has perhaps really suffered an enormous fluctuation. The purpose of accounting should be not to conceal such facts, but faithfully and clearly to set them forth.
Depreciation of intangible assets, as well as depreciation of plant, road-bed, equipment, and the like, should be liberally estimated and provided for. In fact, it is generally agreed that the practice should be to "write off" intangible assets at an especially rapid rate, even though their real value may not be decreasing. Many bankers and other financial men have a very high regard for what is called a "clean" balance sheet, that is to say, one which includes only tangible assets at their cost value with ample depreciation reserves. This preference seems to be in many cases little more than a prejudice, inasmuch as such assets as patents, copyrights, goodwill, and the like may be permanent and productive, and may properly be carried as real assets. Nevertheless, even where this is the case, it is often advisable to cater to the prejudice that has been created through the unscrupulous and reckless valuation sometimes placed on intangible assets, and to carry out the policy of "writing off" with considerable rigor. One company which follows this practice is the Eastman Kodak Company, which carries depreciation reserves of over 25% against its book valuation of "properties, patents, good-will, etc".
There are many other kinds of reserves which should be carried if the business of a company is to be based on sound accounting and finance. The business of many companies, for example, requires them to enter into contracts which involve immediate payment on the part of the purchaser of their products, combined with a liability assumed by the company to render future service. A company publishing a magazine usually collects subscription payments in advance and contracts to deliver the magazine over a twelve months' period. This being the case, it is clear that the company actually earns the subscription payment only as it proceeds through the year with the delivery of its magazine, and that it would be improper to credit the subscription payment as income of the week or month in which it is received. The modern custom among magazine publishers is to credit an account usually called "Unearned Subscriptions" for payments sent in by subscribers, and at the close of each month to debit this account and credit another account called "Subscription Earnings" for the proportion actually earned by sending out magazines during that month.
Various asphalt paving companies include in their paving contracts guarantees to keep the streets which they pave in repair for a certain number of years. At first the guarantee was usually 5 years, which in New York was extended to 15 years, and in some other cities to 10 years; later the guarantee period was gradually reduced to from 2 to 5 years. At the time when the guarantee system was first introduced, insufficient reserves to cover expenditures under these guarantees were set aside, and consequently profits at this stage were greatly overestimated. During 1899 the accounting methods of the Barber Asphalt Paving Company showed a nominal profit of $474,000. Later, the Audit Company of New York estimated the actual profits to have been $35,700. Most of the discrepancy between the two figures was due to the fact that the company originally failed to set aside sufficient reserves to enable it to meet its guarantees.
Future outgo on contracts that are taken into current income account should be watched and provided for with the greatest care. Companies that are conservatively managed will look out for future or contingent expenses of this kind. In a recent balance sheet of Babcock and Wilcox, for example, one item consists of "Reserves for further estimated expenditure on orders invoiced." An account under some such title should be included on many other balance sheets where it is now missing.