Secret Reserves means a reserve which is not disclosed by the balance sheet. It would be revealed only when a correct valuation is made of assets and liabilities. Obviously the actual financial position of the enterprise with the secret reserves is better than what is disclosed by the balance sheet. Secret reserves may be created in the following ways.

(i)    Provision of excessive depreciation or overvaluation of a liability;

(ii)    Charging capital expenditure to revenue expenditure;

(iii)    Treatment a revenue receipt as a capital receipt e.g., crediting dividends received to investment account;

(iv)    Elimination of a valuable asset or undervaluation of an asset e.g. , closing stock;

(v)    Creating excessive provision for doubtful debts;

(vi)    Suppression of sales;

Advantages:

The benefits accruing from the secret reserves are:

(i)    Financial Stability:

Secret reserves promote financial stability in the sense that the same can be used to meet unexpected losses. The rate of dividends can be maintained; neither the shareholders nor the public having any knowledge of such happening; confidence in the working of company is not shaken by losses which merely are incidental to trading. It is therefore permissible of a bank to have a secret reserve to the extent considered necessary by the auditors to safeguard the positions of its assets. Banks usually create secret reserves by means of creating depreciation on investments and avoiding appreciations in the values.

(ii)    Tax Relief:

The liability for payment of taxes can be postponed by adopting a conservation basis of assets valuation.

(iii)    Internal Financing:

Secret reserves check the profits as dividends thus enabling the company to retain assets for internal financing.

(iv)    Competitions are warded off.

By concealing the actual profitability of the business enterprises under inflationary conditions, competition is warded off.

Disadvantages:

of secret reserves are listed as:

(i)    Concealment of actual state of affairs.

Since the shareholders are not aware of actual state of affairs, it is not possible for them to decide whether they should hold on their shares of dispose them of.

(ii)    Unfair presentation of final accounts.

Secret reserves are created by debiting profit and loss account with fictitious amounts in the form of excessive provision for depreciation, bad and doubtful debts, repairs etc. The assets are undervalued and liabilities are overvalued in the balance sheet. The result is that the income statement fails to disclose a true and fair figure of profit or loss and balance sheet does not disclose a true and fair view of financial position of the business enterprise.

(iii)    Misuse by the management.

Dishonest managements may take undue advantages by creating secret reserves. Profit may be suppressed to enable the vested interests to buy shares at a lower price and the secret reserves may be disclosed in the books to enable the vested interests to sell the shares at a higher price.

(iv)    Cover misdeeds of managements.

It weakens the hold of the shareholders on the management in so far as they do not come to know the misdeeds or mistakes of the management and are thus not able to criticize or guide it.

(v)    Loss of government revenue.

The government is not in a position to collect its legitimate dues by way of taxed since the true figure of profits is not disclosed.

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