Inasmuch as these reserves must from the nature of things always be estimates, the probability exists of an under-or over-estimate. It is apparent that an under-estimate effects an inflation of profits due to an overvaluation of the assets. Equally apparent is it that an over-estimate brings about an understatement of profits due to an undervaluation of the assets. The effect of this is to make the valuation reserve account a mixed account. Instead of its content being solely a suspended credit to an asset, it includes also a true reserve of profits. If at any time the facts indicate a too liberal or too parsimonious estimate in the past, adjustment should be made to accord with the newly determined facts of experience. An immediate adjustment is usually preferable to a gradual one effected by an allowance below or above the new basis determined for the estimate.
Depletion Reserves
Similar to the depreciation reserve is the depletion reserve. On the basis of the value at which the wasting or depleting asset was originally brought upon the books, a periodic estimate of the portion used up in operation is necessary to show the true present value of the asset. Thus, timber and mining properties require for their periodic appraisal an estimate of the extent of exhaustion of the natural product. This is neither required by law nor always by business policy. But when the estimate is made it is in the nature of a valuation reserve and will be so classed here.
Operating Reserves for Accrued Costs
Another group of items, frequently carried under the title reserves, includes estimates of expenses the exact amount of which is not known at the time of closing the books, and sometimes those of which the exact amount is known but which are unpaid as on that date. Among the first are such items as taxes, sales discounts, and the like. Among the second are wages, salaries, rents, etc., accrued. These two classes are together sometimes called “operating reserves.”
There is some difference of opinion with regard to the proper allocation of taxes and estimated sales discounts. Inasmuch as taxes are not usually determined, or at least payable, during the period covered by them, there is a temptation to defer their incidence to a later period. If the taxes become a claim of the state against the property as on a given date, certainly they should be treated as applicable to the period covered by the claim even though the amount of them cannot with accuracy be determined.
With regard to sales discount, the situation is somewhat analogous. At the close of any fiscal period, some of the open claims against customers are by the sales contract subject to discount, and experience proves that some of these discounts will be taken advantage of. Here also, difference of opinion prevails as to the proper allocation of the expense. Should the period in which the sale is made suffer the loss, or should it be charged to the one in which the discount is taken? If sales discount is looked upon either as a direct deduction from sales or as a selling expense, certainly it should be charged to the period making the sale. On the other hand, if it is regarded as an item of financial management, a means of securing ready funds, it is sometimes argued (though this is not the usual point of view) that the period enjoying the benefit should also be charged with the expense of securing the benefit. Against this argument it may be pointed out that the current period carrying the customers’ accounts which are subject to discount fails to show its liability, based on the sales agreement, to accept something less than the face amount of the claims. A balance sheet in which no suitable provision is made therefor is one which does not reflect the true status of all items, and to that extent is not a good balance sheet. Provision should be made not only for those expenses which are known to have been incurred and which remain unpaid, but also for those which the statistics of experience show will have to be met. Conservative practice, therefore, requires the inclusion of this estimate and applies it as an expense of the period in which the originating transaction took place. All the costs of the contract entered into, of which expected sales discount is one, are made to apply to the period giving rise to the contract.
Collection Costs not under Contract
The above argument is occasionally made use of in support of the inclusion of expected collection costs on claims against customers outstanding at the close of a period. From a theoretical aspect the point may be argued, but, unlike the item of sales discount, these are not costs which the concern is liable for under contract. From a practical standpoint, except under very unusual conditions, it is an undesirable refinement of the principle of allocation of costs as between periods. Where a collection department is maintained, costs of collection are practically uniform from period to period and are best considered as expenses of the period in which the cost is incurred.
Sales Discounts on the Balance Sheet