A reserve which maintained to strengthen the financial position of the business without disclosing it in the book is known as secret reserve. Secret reserve is hidden reserve which is not disclosed by the balance sheet. Secret reserve is also known as internal reserve. It is created by showing the figure of net profit less than actual. Its existence makes the financial position of the business better than what the balance sheet is disclosing. Generally, it is maintained by bank, Insurance and other financial institutions.
A secret reserve is created in any of the following ways:
- High Value Of Goodwill: In the balance sheet if value of good will is shown nominal or how but infact its value is high reserve may be created.
- Shown More Bad Debts: If management has made excessive provisions for bad debts. Infact these are less than the reserves allocated. So keeping in view the difference secret reserves can be created.
- Shown More Depreciation: By providing too much depreciation on fixed assets, management creates secret reserves.
- More Liabilities Shown: By over valuing the liabilities, management may create the secret reserves. Due to this profits reduce.
- Low Value Of Fixed Assets: In the balance sheet the value of fixed asset is shown very low real value is very high. In this situation secret reserves may be created.
- Under Value Of Current Assets: Management shows less value of current asset in the balance sheet actual value of the current asset is greater. So the secret reserves may be created.
- Contingent Liabilities As Red Liabilities: To create secret reserves management show the contingent liabilities as real liabilities in the balance sheet. So profits and reserves may be reduced equal to the secret reserves.
- Fictitious Liabilities Shown: To create the secret reserves management shows the fictitious as actual liabilities.
- Capital Expenditure To Revenue: Sometimes to create the secret reserves management charges the capital expenditure to revenue. The profit is reduced.
- By Omitting: Sometimes management omits some assets from the balance sheet and in this way it creates the secret reserves.
Objectives And Advantages Of Secret Reserve
The following are the objectives and advantages of secret reserve:
- Source Of Power: Secret reserves makes the company financially more strong. In the period of depression it enables the company to maintain dividends due to secret reserves and company’s shares prices will remain stable.
- To Meet Future Loss: If the company suffers a loss in future, secret reserve can be used to meet this loss without disclosing this fact to the outsiders and shareholders.
- Financial Stability: The profits after making the payment of dividend remain in the business and increases the working capital due to this financial stability of the business improves.
- Safety From Competitors: Some times trade competitors also create some problem when firm is making progress. So profit is shown less and secret reserves are created to with hold the progress information.
- To Use In A lean Year: Some times in case of abnormal profit company creates the secret reserves keeping in view that it will be utilized in the lean year.
- Useful In Crises: The important benefit of secret reserve is that management can meet the financial crises easily in the rainy days. The loan facility may not be available but company can meet the crises.
- Increase In Working Capital: The shortage of capital may become the course of business failure. But to make the business successful secret reserves improve the financial condition of the business.
- Public Confidence: Secret reserves play very important role in winning the confidence of the people. Sometimes when there is no profit in the business these reserves are utilized for the declaration of bonus. It increases the confidence of the people.
- Stable Dividend Rate: In case of greater profit, there is no need to use the reserves. While in case of loss or low profit these reserves can be used to pay dividend. So fluctuation in profit can not affect the dividend rate.
Disadvantages Of Secret Reserve
The following are the disadvantages of secret reserve:
- True Condition Not Disclosed: It is the main disadvantage of secret reserves. The purpose of audit cannot be achieved. The financial statement cannot show the true and fair position of the business.
- Problem Of Loan In Crises: During the financial crises management may fails to generate funds because when business does not look favorable then lenders may refuse to grant loans.
- Insurance Claim Problem: It is the demerit of secret reserves that insurance cannot be claimed. If asset is lost and it is not in the balance sheet then company can not claim for loss.
- Loan Problem: If business condition is good and profit is high but due to secret reserves it is shown poor. In this situation it will be difficult to borrow the loan.
- Difficult To Sell The business: Due to the creation of secret reserves the financial condition is shown poor. The poor condition of business cannot attract the customers and business cannot be sold at reasonable price.
- Misuse Of Asset: When the assets are not shown in the balance sheet management can steal or use it for private purpose. It is business loss.
- Speculation: Due to secret reserves prices of shares go up and down and investor losses the investment in share. It creates panic in them.
- Conceals Poor Performance: Poor management may be able to run the business for several years and conceals the poor performance by using the secret reserves.
- Low Value Of Share: As the company creates the secret reserve the value of shares goes down. It is not a healthy sign for the business activity.
- Low Profit: When secret reserves are created then profit will be low for the shareholders. The shareholders will be unhappy on this act of management.