Final answer:
The statement about reserves not being allowed for tax purposes due to the economic performance test not being satisfied is true. While financial accounting allows for setting aside reserves for estimated expenses, tax regulations require the costs to be tied to actual economic performance.
Step-by-step explanation:
The statement that "reserves for estimated expenses such as warranties and bad debts are often deducted for financial accounting purposes before the specific expense is identified, BUT these reserves are NOT allowed for TAX PURPOSES because the economic performance test cannot be satisfied" is true. In financial accounting, companies are allowed to create reserves for future estimated expenses like warranties and bad debts, with such estimates being based on historical data and expected future costs. This conservative approach aligns with the Generally Accepted Accounting Principles (GAAP), which encourage the recognition of expenses when they are reasonably foreseeable, and revenues when they are earned.
However, for tax purposes, under the Internal Revenue Code, the criteria for deducting expenses are stricter. The Economic Performance test generally requires that the actual services have been provided or the property has been used before an expense can be deducted. Since reserves represent estimated future expenses rather than funds explicitly tied to actual performed services or used property, they do not satisfy the economic performance requirement and hence are disallowed as current tax deductions.
Banks, as part of their financial regulation, must adhere to specified reserve requirements set by the Federal Reserve. Reserve requirements mandate that a bank keep a certain portion of depositors' funds easily accessible. These reserves are not immediately tied to specific expenses but serve as a cushion to ensure liquidity and stability in the banking system.