Every organisation maintains a reserve for ensuring a stable financial position of the organisation. In general, the reserve is shown on the balance sheet at the end of the accounting period. However, sometimes organisations do not disclose their reserves in the balance sheet, which results in the creation of the secret reserve.
Secret reserve definition
Secret reserve, as the name suggests, is a kind of reserve whose existence is not disclosed in the balance sheet of the organisation. It is also known as a hidden reserve or an internal reserve.
A secret reserve is created by intentionally hiding the actual net profit or showing net profit less than actual in the balance sheet of the organisation. Secret reserves are maintained by organisations such as insurance companies, banks and other types of financial institutions.
As per the provisions of the Companies Act, any joint stock company is unable to create secret reserves, but exemptions are applicable for financial institutions such as banks and insurance companies.
Objectives of Secret Reserve
The following are the objectives of creating a secret reserve:
- To ensure a strong financial position of the company.
- For better solvency of the organisation.
- To meet sudden financial expenses.
- To ensure stable payment of dividends.
- To confuse competitors regarding the profitability of the organisation.
- To provide a source of additional working capital for the organisation.
Methods of Secret Reserve Creation
Secret reserves are created in the following ways:
- By showing excess depreciation on the fixed assets.
- By undervaluation of current assets.
- By removing an asset completely from the books of the organisation.
- By overvaluing liabilities.
- By treating the income accrued as a liability.
- By setting aside a high amount of profit as a reserve for future contingencies.
Advantages of Secret Reserve
The following are some of the advantages of creating a secret reserve:
- Achieving a better financial position.
- Act as a source of funds and working capital.
- Eliminates unhealthy competition by concealing true profit from competitors.
- Provide stability to the organisation.
Disadvantages of Secret Reserve
- As it is classified information, it is known only to the management.
- It provides an inaccurate view of the financial position of the organisation.
- It can be used as a potential means of covering frauds.