The following quote is taken from an article (by L. Bernstein) scrutinizing use of reserves to recognize future costs and losses.
The growing use of reserves for future costs and losses impairs the significance of periodically reported income and should be viewed with skepticism by the analyst of financial statements. That is especially true when the reserves are established in years of heavy losses, when they are established in an arbitrary amount designed to offset an extraordinary gain, or when they otherwise appear to have as their main purpose the relieving of future income or expenses properly chargeable to it. The basic justification in accounting for the recognition of future losses stems from the doctrine of conservatism that, according to one popular application, means that one should anticipate no gains, but take all the losses one can clearly see as already incurred.
Required:
a. Discuss the merits of Bernstein”s arguments and apprehensions regarding reserves.
b. Explain how this perspective can be factored into an analysis of past earnings trends, estimates of future earnings, and the valuation of common stock.
c. Cite examples of such reserves—you can draw on those in the chapter