Reserves & Allowances

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DON GEORGE, COLUMBIA UNIVERSITY PRESS

The AAUP Business Handbook >> Part Two: Accounting, Budgeting, and Financial Management >> Financial Reporting and Audits

Contents

What Is a Reserve?

A reserve is an amount set aside from either current or retained earnings in expectation of either possible future expenses or reductions in asset values. The "reserves" that concern university presses most directly are more properly called "allowances." An allowance is an amount, often shown on the balance sheet as a contra-asset account, that is subtracted or offset from an asset to reflect the asset's diminished value. A contra-account is useful in that it allows changes in value to be shown on the balance sheet without affecting the original information in the primary account. Sometimes an allowance does not appear as a separate contra-asset on the balance sheet, but merely in a note explaining the netted value shown in the balance sheet.


Show the allowance as a contra-asset account:

Trade accounts receivable $1,000,000
Less allowance for bad debt ($50,000)
Net trade accounts receivable $950,000


Or show the allowance in a note, with the accounts receivable given as a netted value:

Net trade accounts receivable $950,000*


*After netting out bad debt allowance of $50,000.


Which Reserves?

The reserves most commonly used by university presses include:

  • A reserve/allowance for bad debt.
  • A reserve/allowance for inventory write-down.
  • A reserve/allowance for unrecoverable author advances.
  • A reserve/allowance for returns.

There are other reserves, but most of us don't routinely deal with them. They include:

  • A reserve for pensions (the estimated liability for employee pensions).
  • A reserve for unused vacation (the estimated liability for vacations carried beyond the end of the fiscal year).
  • A reserve for product warranties (the estimated liability under product warranties). This may be come more common as more of us go into CD-ROM production. Microsoft's reserve for warranties and exchanges was over $10 million on June 30, 1994, and Hatchette's (Grolier, Childrens Press, Franklin Watts) December 1993 reserve for its audiovisual plan amounted to £975 million, or a staggering $185 million, and this was in addition to a reserve for returns of more than $48 million.
  • A reserve for retiree medical benefits (actuarial liability for present and future retiree medical plan costs). The Financial Accounting Standards Board (FASB) 106 ruling created this requirement, and for McGraw-Hill this amounted to $365 million as of December 31, 1991.

Some of these latter reserves may be addressed by the university personnel department, but some of the separately incorporated presses have to deal with these issues firsthand. Incidentally, these latter reserves are not contra-accounts and should appear in the balance sheet as liability accounts.


Why Reserves?

The Publishers Weekly headline read "Fiscal '94 Sales Rise at S & S, But Income Tumbles," and in the article a company official was quoted as saying that "due to all the changes going on in the publishing industry we have adjusted our assets to a prudent, realizable value" (my emphasis). In essence, that is what reserves are all about!

Risk and uncertainty exist in many facets of the publishing cycle. For example, some books will undoubtedly be printed in quantities that greatly exceed lifetime sales, some sales will be made to what eventually prove to be uncollectible accounts, sales of some editions will not be sufficient to recover author advances for that edition (the Simon & Schuster article described an $84.3 million write-down of royalty advances), and excessive returns for some editions may spill over into, or occur in, fiscal periods following the year of sale.

An annual review of assets and a timely provision of modest additions to reserve accounts will go a long way toward smoothing earnings and preventing what could be a substantial loss in the current period resulting from accumulated unforeseen reversals impacting one fiscal period. For example, consider the benefit of having established and built up a modest 5% of net sales allowance for bad debt to absorb the impact of a major account that goes bankrupt and becomes uncollectible. The sales that generated the accounts receivable, which now becomes bad debt, very likely occurred in a previous fiscal period or periods, so why shouldn't the impact of establishing an offsetting reserve also have occurred in the same period(s)? A strict interpretation of the generally accepted principle of the matching of revenues and expenses also argues for this approach.


How to Set Up Reserves/Allowances

Allowance for Bad Debt

A contra-asset account may accompany the accounts receivable (A/R) on the balance sheet, or the A/R may be stated as net of the reserve with a note in the financial statements. Either way is acceptable. Paramount Communications (Simon & Schuster, Prentice Hall, Silver Burdett, Ginn) prefers to display its A/R net of reserves with a note in its comments explaining the reserve, while McGraw-Hill juxtaposes the allowance to its A/R for ready identification. In both cases the allowance serves to reduce the A/R and is a reminder that not all the A/R amount listed is expected to be received.

Often, potential bad debt accounts cannot be specifically identified, but most presses are able to rely on their experience, the aging of their A/R (if repeated efforts to collect old, outstanding accounts haven't met with success, they are prime candidates for eventual write-off), and industry norms in setting up appropriate bad debt reserves. The first criterion should weigh heavily in setting and maintaining a reserve: experience, coupled with management's judgment as to an appropriate reserve, should go a long way toward establishing the reserve amount. Industry data can also serve as a guideline. The AAUP annual statistical survey shows that a reserve of 5% is the norm. Data for the commercial sector is also available from AAP surveys and from annual financial statements issued by individual publishers.


Allowance for Inventory Write-down

Generally accepted accounting principles (GAAP) require that inventory be stated at the lower of cost or market value. Inventory overstocks are a fact of life, and it is doubtful that most inventory could be liquidated in its entirety at anywhere near cost (this being the requirement for categorizing inventory as a current asset, i.e., that it could be turned into cash at or for more than its stated value within one year), but would more likely go for pennies on the dollar per unit in the remainder market. Accurate determination of the liquidity of inventory is an important component of determining working capital, and if it is overstated it does not yield an accurate measurement of a press's ability to meet its maturing current liabilities.

The treatment of plant costs and paper, printing, and binding costs (PP&B) in both the initial valuation of inventory and then in the subsequent write-down, or establishment of a reserve for write-down, is routinely being addressed by most presses. Evidence of this may be found in the results of the AAUP annual statistical survey. Here we see that while there are a variety of techniques being employed, there is a steady trend toward facing up to the inevitability of unsalable stock (and thus over valued inventory) and toward recognizing the benefits of writing inventory down on a systematic basis. While methods abound, most presses approach the exercise by first determining whether plant cost will be written off differently than PP&B and then establishing a systematic procedure whereby inventories are adjusted to more realizable values. This entails developing and sticking to a formula for writing off inventory over periods of anywhere from three to five years, and not leaving it totally unadjusted or adjusted at the whim of the press management and thus susceptible to subjective analysis as to its salability. This is decidedly better than waking up one day and realizing that what for most presses is their largest asset is in fact grossly overstated.


Allowance for Unrecoverable Author Advances

Increased competition in the pursuit of attractive manuscripts has resulted in a significant increase in author advance balances for many presses. Some presses treat their author advances by netting them out against their royalties payable. This is a questionable practice because authors to whom they have advanced royalties may or may not be the same ones to whom they owe royalties, and even if they are the same, it is rare that a contract allows recovery of an advance for one work from the sales of another work by the same author. Author advances should be shown as assets, and the allowance for unrecoverable author advances should appear as a contra below the advances account.

The process for determining the amount of the reserve is somewhat similar to that of the bad debt reserve. Sales of published editions will very quickly establish a pattern that will enable management to determine whether an advance will earn out and what portion, if any, of an advance should be reserved. If an advance for an unpublished work is becoming old and no manuscript is on the horizon, then a reserve equal to that advance seems prudent.


Allowance for Returns

The sales return reserve continues to draw a lot of attention from the major accounting firms, and it is appearing more commonly on commercial publishers' balance sheets. This is also an item that may or may not appear on the balance sheet. For example, Houghton Mifflin displays its returns allowance on the balance sheet as a contra-A/R account, and in financial notes as well, with the statement, "A provision for estimated returns, consisting of the sales value less related inventory value and royalty costs, is made at the time of sale." Given the returns policies of most presses, there is a high probability that some of the sales made in one accounting period will be returned in a later fiscal period. Some might argue that while in theory this is a problem, current practices of not providing reserves can be justified on the grounds that the amount of returns subsequent to the period of sale is relatively constant from year to year. This would be true if market conditions, list profiles, and publication rates did not change.

Unfortunately, many presses are experiencing a steady increase in their returns rate. The desire to grow and to publish more general interest titles is almost universal. The appearance of one or more of these trade titles late in one fiscal year almost guarantees heavy returns in the next fiscal period.

An appropriate reserve based on historical returns, present trends, and the impact of sales of books with higher-than-average returns rates during the third or fourth quarters should prove relatively easy to quantify. Once established, the reserve may be increased each year if returns rates continue to increase, as they have in the past.


The AAUP Business Handbook >> Part Two: Accounting, Budgeting, and Financial Management >> Financial Reporting and Audits

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