As to the manner of showing expected sales discounts on the balance sheet, practice is not uniform. It is sometimes shown added to the reserve for doubtful accounts and the sum of the two deducted from claims against customers, indicating thus the amount which it is expected can be realized therefrom. Others show it among the liabilities, on the ground that it differs from the estimate for bad debts in that it is an expense for which the concern has made itself liable under its sales contract. The distinction is finely drawn but probably well taken.
Distinction between Reserves and Accrued Items
The use of the title reserve for some of the items included as operating reserves is unfortunate and leads to confusion both in terminology and in understanding. Why unpaid expenses of any kind should be called reserves for expenses when the amount of them is definitely known has never been satisfactorily explained; yet the practice is sometimes met. There is some excuse in the case of expense items the amount of which cannot be definitely determined either from the nature of the item itself or other conditions over which the concern has no control. Thus, “Reserve for Wages” is usually a misnomer, the title “Wages Accrued” showing the item correctly; but “Reserve for Taxes,” while just as true a liability as the other item, may be justified on the ground that the latter is only an estimate subject to correction when the exact amount is known, whereas the former is already definitely known.
Contingent Reserves
So-called contingent reserves are sometimes handled as a part of this group, although best classified by themselves. A contingent reserve is one which represents an effort to provide for certain contingencies, such as guarantees on work done or products sold, lawsuits pending adjudication, etc. As R. H. Montgomery[62] so pertinently says: “the reserve should be based on evidence more tangible than a mere desire to be conservative. A vague feeling that something might have been overlooked which would decrease the assets or increase the liabilities is not the proper subject for a reserve. Conservative management ‘reserves’ part of its surplus for such contingencies, but it appears as surplus and not as a liability.” As mentioned above, sometimes the reserve for bad debts is classed as a contingent reserve. Contingency is inherent in the item but the certainty of its occurrence cannot be reasoned away. The use of contingent reserves may therefore well be limited to provision against contingent liabilities. In other words, they represent the best available estimate of the amount of such liabilities. To draw a dividing line between operating and contingent reserves is extremely difficult; both are created by charges to various expense accounts. It is merely a matter of degree as to the certainty of the events’ happening for which provision is being made. On the border line between the two are such items as reserves for insurance where the concern carries its own insurance and must make a periodic expense charge in lieu of the usual premiums; reserves for pensions where a pension policy is in effect, the charge creating it being here viewed as a part of the wages expense—the share of wages to be paid in the future which must be borne by the current period; reserves for sick benefits, which are in all respects similar to pension reserves; and so on. In some cases reserves for supersession of patents, or other assets whose length of service life is dependent on extreme contingency, are classed with this group.
Deferred Income—Misuse of Term
Deferred income is sometimes classed as a reserve. Thus, insurance companies carry the portion of their unearned premiums as on a given date, as a reserve. The use of the title is well established in that connection and the nature of the items is well understood. On commercial balance sheets where no outside authority can give a definite meaning to the term, its use for deferred income is to be deprecated and discouraged. Deferred income is a liability and not a reserve; the current period has not rendered the service to earn the income and is liable to the period in which the service is rendered.
Proprietorship Reserves
This disposes of all the asset and liability reserves and leaves for consideration the true profits or proprietorship reserves. As between these two main classes of reserves, as their titles indicate, the proper allocation of the one is among the assets or liabilities, while the other must be shown as a part of the net worth of the corporation. As to the nature of proprietorship reserves little more need be said. There are just two classes of items met here, viz., those shown as such openly on the balance sheet and those which are hidden or secret, latent among the various other items on the balance sheet. Proprietorship reserves represent profits reinvested in the business. Any profits, operating or capital, not paid out as dividends give rise to proprietorship reserves.
Secret Reserves