How Secret reserve is created?
A secret reserve is created by the following methods:
1. By under valuation of assets much below their cost or market value, such as investment, stock in trade, etc.
2. By not writing up the value of an asset, the price of which has permanently gone up.
3. By creating excessive reserve for bad and doubtful debts or discount on sundry debtors.
4. By providing, excessive depreciation on fixed assets.
5. By writing down goodwill to a nominal value.
6. By omitting some of the assets altogether from balance sheet.
7. By changing capital expenditure to revenue account and thus showing the value of assets to be less than their actual value.
8. By overvaluing the liabilities.
9. By the inclusion of fictitious liabilities.
10. By showing contingent liabilities as actual liabilities.
Object of creating secret reserve
1. Secret reserves strengthen the financial position of a concern, losses can be made good without disclosing their occurrence to the shareholders and others. This helps the concern to remain financially strong in spite of a period of adversity.
2. It may best utilized for equalization of dividends, thereby maintaining the financial stability of the company.
3. The profits which would have been utilized for the payment of dividend remain in the business and increase the working capital of the company.
4. Secret reserve is created to withhold information of the progress of the company from trade competitors. If the true earning position of the company is shown it is possible that more rival companies may come into the field and compete with it, thus bringing down
Objections to secret reserves
1. Balance sheet does not exhibit true and fair view of the financial affairs of the concern if secret reserve is created and maintained. At the same time, the profit and loss account also does not give the correct results since excessive provision for depreciation or reserve may be made for its creation.
2. Secret reserves may be utilized by the management to conceal their weakness in the term of mismanagement. It may conceal losses arising out of bad or careless management or even reckless speculation.
3. If fixed assets are undervalued for the purpose of creating secret reserve, and if there is a fire, the company will not be able to claim the full value of the assets because the insurance company will pay according to the book value of the asset destroyed or damaged and hence cause a loss to the company. .
4. By creating secret reserves, and thus lowering the dividend, the directors may indulge in speculation in the shares of the company.
5. The shareholders of the company suffer a loss due to less dividends on account of the creation of secret reserves.
6. Due to the creation of secret reserves, the value of shares in the market falls.