Secret reserves are those reserves that exist in the business to strengthen its financial position but are not disclosed in the Balance Sheet. As these reserves are not apparent on the Balance Sheet, therefore, it is also known as Hidden Reserve or Inner Reserves. These reserves are created by showing the profit at a much lower figure or by understating the assets and overstating the liabilities of the business. The presence of such reserves in the business restrains the Balance Sheet to reveal its true financial position. Due to the existence of these reserves the actual position of the business is much better than what is actually depicted by the Balance Sheet. The creation of secret reserves is not permitted by the Companies Act, 1956 except in the cases of Banking Companies and Insurance Companies.
Ways of Creating Secret Reserves
The following are the various ways through which the secret reserves may be created.
- By undervaluation of assets.
- By overvaluation of liabilities and provisions.
- By creating excessive provision for doubtful debts.
- By charging excessive depreciation on the fixed assets.
- By treating capital expenditure as revenue expenditure.
- By ignoring the prepaid expenses.
- By ignoring outstanding incomes.
- By treating contingent liability as an actual liability.
- By understating the goodwill.
- By suppressing the sales.
Benefits of Secret Reserves
The given below are some benefits of creating secret reserves.
Financial Soundness: Secret reserves help in enhancing and improving the financial soundness of the business without intimating it to the shareholders and outsiders.
Reduced Competition: The secret reserves are created by revealing the actual profits of the business at much lower figures. This helps the management to avoid competition in the market.
Writing-off Unexpected Losses: Secret reserves help in writing off the huge unexpected losses of the business without bringing it to the notice of the public and also without affecting the regular profits of the business.
Regular Dividends: In the adverse conditions of the business, when there are low profits, the secret reserves can be utilized to maintain uniformity in the payment of dividends to its shareholders.
Prevention from Higher Income Tax: The disclosure of reduced profits in the books leads to the reduction in income tax liabilities.
Drawbacks of Secret Reserves
Besides various benefits of secret reserves, there also exist some drawbacks. These are as follows.
Reveals False Financial Position: Secret reserves restrain the Profit and Loss Account from revealing the true profits and Balance Sheet from disclosing the true and fair financial position of the business.
Adverse Effects on Shareholders: These reserves lead to losses to the shareholders due to the concealment of actual profits in the books. Therefore, they are not able to get their due share of actual profits.
Personal Advantage: The management or directors can take undue advantage of such reserves for their personal purposes.
Misuse by the Management: These reserves can be utilized by the management for hiding their mistakes and fraudulent activities.
Reduction in the Value of Share: The creation of secret reserves leads to a decline in the price of shares in the market.
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