EXERCISE 2–1 A former Chairman of the SEC refers to hidden reserves on the balance sheet as “cookie-jar”

reserves. These reserves are built up in periods when earnings are strong and drawn down to bolster earnings in periods when earnings are weak.

Required:

Reserves for (1) bad debts and (2) inventory, along with the (3) large accruals associated with restructuring charges, are transactions that sometimes yield hidden reserves.

a. For each of these transactions, explain when and how a hidden reserve is created.

b. For each of these transactions, explain when and how a hidden reserve is drawn down to boost earnings.