Companies create reserves in anticipation of probable future costs or losses whose amounts can be reasonably estimated, as happens with inventory reserves and loan-loss provisions, or, in order to ensure comparability across accounting methods as happens with LIFO reserves.
While operational excellence should be the lodestar guiding managers, there is a great temptation to use reserves to manage earnings. In order to ward off the effects of earnings management, ensure comparability across business, and reveal timing of recurring cash flows from operations, the change in LIFO reserves, other inventory reserves and loan loss reserves year-over-year are added to my calculation of net operating profit after tax (NOPAT).
“Change in Reserves”, Joseph Noko
The worries expressed in my short note on the change in reserves, pertain to the balance sheet as well, with managers well capable of adulterating asset values through the innocent exercise of the discretion that the rules allow. Reserves are added back to assets as part of my invested capital calculation.