Secret Reserve-Definition,Objectives,Advantages and Disadvantages

It's common practice for organizations to set aside some funds as a reserve to ensure their financial stability. These reserves are typically reflected in the balance sheet at the end of an accounting period. However, there are instances where organizations might choose not to reveal their reserves in the balance sheet, leading to the formation of what is known as a secret reserve. A "secret reserve" is a term used in accounting to describe a situation where a company understates its actual profits or overstates its liabilities, creating a hidden surplus or reserve that is not disclosed in its financial statements. Secret reserves are typically used for various reasons, including providing a buffer against future losses or to present a more conservative image to stakeholders. However, they can also be controversial because they lack transparency and can mislead investors and other financial stakeholders.

Secret Reserve is a very widely asked topic in commerce related competitive exams such as UGC-NET Commerce Examination and is to be studied in detail.

In this article, the readers will be able to learn about the secret reserve in detail.

What is Secret Reserve?

Secret reserve meaning can be understood as hinted by the name, is a type of reserve that is not openly declared in the organization's balance sheet. It's also referred to as a concealed reserve or an internal reserve.

The creation of a secret reserve involves deliberately understating the actual net profit or presenting a net profit that is less than the actual on the organization's balance sheet. Secret reserves are typically maintained by financial institutions such as insurance companies and banks.

According to the Companies Act, joint stock companies are prohibited from creating secret reserves. However, exceptions are made for financial institutions like banks and insurance companies

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Why Create a Secret Reserve?

Here are some reasons why organizations opt to create a secret reserve:

• To strengthen the financial standing of the company.
• To improve the organization's solvency.
• To have funds available for unexpected financial needs.
• To ensure consistent dividend payments.
• To keep competitors guessing about the organization's profitability.
• To serve as an additional source of working capital for the organization.

How is a Secret Reserve Created?

Secret reserves can be created through the following methods:

• By overstating the depreciation on fixed assets.
• By undervaluing current assets.
• By completely removing an asset from the organization's books.
• By overestimating liabilities.
• By treating accrued income as a liability.
• By setting aside a large portion of profit as a reserve for future uncertainties.

Merits and Demerits of Secret Reserve

The details are stated below.

Benefits of a Secret Reserve

The benefits have been stated below.

• Enhances the financial health of the company.
• Serves as a source of funds and working capital.
• Prevents unnecessary competition by hiding the true profit from rivals.
• Provides stability to the organization.

Drawbacks of a Secret Reserve

Drawbacks have been stated below.

• As it's confidential, only the management is privy to this information.
• It offers a distorted view of the organization's financial situation.
• It can potentially be used to cover up fraudulent activities.

Secret Reserve in Auditing

In auditing, the term "secret reserve" refers to undisclosed reserves or provisions that a company may maintain in its financial records. These hidden reserves are not disclosed in the financial statements but are kept within the company's internal accounting records. Auditors play a crucial role in assessing and, if necessary, disclosing these secret reserves to ensure transparency and compliance with accounting standards and regulations.

Conclusion

The concept of secret reserves, though used historically for various reasons by companies, is considered contrary to the principles of transparency, integrity, and accurate financial reporting in modern accounting and auditing practices. In auditing, secret reserves are closely scrutinized, and auditors play a pivotal role in uncovering and addressing such hidden provisions to ensure compliance with accounting standards and to maintain the trust of stakeholders.

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