Secret Reserve

Secret Reserve

A secret reserve is a reserve that does not appear in the balance sheet. It is hidden from the view of outsiders — shareholders, creditors, and the general public — because the financial statements do not show its existence. The term 'secret' is used precisely because only the management knows about it.

The creation of a secret reserve has two immediate effects. First, it reduces the disclosed profits of the business. Second, because profits are lower, the tax liability also becomes lower. During lean periods when actual profits are low, the secret reserve can be merged back into the profit and loss account to show improved profits. This gives management the flexibility to smooth out reported earnings over time.

How a Secret Reserve is Created

The most common method is charging higher depreciation than is actually required. If the useful life of an asset is 10 years but the management depreciates it as if its life were 8 years, the extra depreciation charged each year builds up a hidden reserve. The asset appears in the balance sheet at a value lower than its true worth, and the excess depreciation reduces reported profits.

Other methods include:

• Undervaluation of inventories/stock — showing stock at a value lower than its actual cost or market value
• Charging capital expenditure to profit and loss account — treating an asset purchase as a revenue expense, which immediately reduces profit and understates assets
• Making excessive provision for doubtful debts — creating a provision larger than what is reasonably needed to cover expected bad debts
• Showing contingent liabilities as actual liabilities — recording a possible future obligation as a definite liability, which overstates liabilities and reduces profit

Justification and Purpose

Creation of secret reserves within reasonable limits is considered justifiable on grounds of expediency, prudence, and preventing competition from other firms. A business that appears less profitable may attract less competition. The practice also helps the business comply with legal requirements or accounting practices.

Utilisation of Secret Reserve

A secret reserve can be utilised for specific purposes as provided in the law in force. Common uses include writing off capital losses or issuing bonus shares. The key point is that the utilisation must be in accordance with legal provisions.

Accounting Treatment

There is no separate journal entry for creating a secret reserve. The reserve is created indirectly through the entries that overstate expenses or understate assets. For example, when excess depreciation is charged: