Secret Reserve

Many companies and businesses choose to create a secret reserve for their company. As the name may suggest, a secret reserve helps strengthen the business’s financial position. Such a strategy is especially useful in warding off competitors. Competitors are kept in the dark regarding the company’s true financial position and are unaware of its performance. 

While a secret reserve sounds good in practice, it also has its fair share of drawbacks. Let’s take a closer look at the merits and demerits of the secret reserve, as well as how these reserves are created.

What is a Secret Reserve?

A secret reserve helps strengthen the business’s financial position without being immediately disclosed in any book, i.e., it is kept secret. A secret reserve is also often called an ‘internal reserve’. The balance sheet displays nothing in regards to the secret reserve. 

In other words, you can also say that a secret reserve works by understating the organisation’s assets or by overstating its liabilities. The net profit earned by the organisation is shown to be less than its actual value. In either case, the organisation comes across as poorer than it is. In reality, the business’s financial position is better than shown.

What motivates a company to create a secret reserve? The most common reason cited for doing so is a competitive one. The company doesn’t want its competitors to know its true financial position and falsifies the information that appears in its financial statements. However, this information not only misleads competitors but shareholders as well. 

Insurance companies, financial institutions, and banks are the main organisations that help companies and organisations maintain secret reserves.

How is a Secret Reserve Created?

A secret reserve can be created in several ways. Some of these are as follows: 

• More bad debts are shown: If provisions have been made for debts the company incurred, these can be overvalued on the balance sheet 
• Current assets are undervalued: The company’s current assets are undervalued on the balance sheet
• The true value of the assets is greater than shown
• Fixed assets have reduced value: The value of the company’s fixed assets is shown lower than it is
• Fake liabilities are shown: Liabilities that don’t exist are reflected on the balance sheet
• Contingent liabilities portrayed as real liabilities: Even though these liabilities are yet to occur, a company may choose to portray them as already occurred and reduce their profits and losses accordingly
• More liabilities are shown: The organisation may overvalue its liabilities and show reduced profits
• Value of goodwill: A goodwill with high value may be deliberately shown as having a lower value to create a secret reserve
• Depreciation of assets: Fixed assets may be assigned a higher depreciation value than accurate
• These are often much higher than required
• Omission: Not all assets may be included in the balance sheet. Some may be intentionally omitted for secret reserve purposes 
• Capital Expenditure to Revenue: Management can also choose to charge capital expenditure to revenue expenditure to reduce profits shown

Merits of Secret Reserve

Following are some merits of maintaining a secret reserve:

• Financial stability: Once a dividend has been successfully paid, the obtained profits are kept in the business
• This helps increase the working capital available, which in turn boosts the business’s financial stability
• Helpful during crisis: Easier to deal with unexpected financial crises
• Protection from competitors: Falsifying profit data gives better protection 
• Grants more power: If the economy falls and depression occurs, the company will still maintain its credit and dividends
• Future loss: If the company encounters a damaging loss in the future, it can use funds from the secret reserve to resolve this crisis without alerting its shareholders and competitors
• Public confidence: When profits haven’t been made in a specific term, funds from the secret reserve can be used as a ‘bonus’, thus pleasing the masses
• Useful during lean years: Extra funds are useful during lean years 
• Working capital is increased: More working capital for business use
• Stable dividend rate: When the company goes through lower profits or greater losses, the secret reserve can pay a dividend
• Thus, even when there is a fluctuation in profit, the dividend rate remains unaffected

Demerits of Secret Reserve

Secret reserves have their fair share of demerits as well. This includes:

• Problems with loans: Loans aren’t easily borrowed
• Loans during crisis: Loans are even harder to obtain
• Assets are misused: Assets may be stolen and used for their purposes
• The true condition remains undisclosed: The actual position of the business remains unclear 
• Speculation: Secret reserves make share prices fluctuate wildly and make it difficult for investors to remain
• Selling the business becomes difficult: Selling a ‘poor’ business is very difficult
• Insurance claim: If an asset is lost and isn’t covered in the balance sheet, you will not be able to claim insurance for it
• Share value reduces: The value of shares goes down with secret reserves 
• Poor performance is hidden: The shareholders and public never realise how bad things are
• Profits are low: Shareholders earn far less than they actually should

Conclusion

Companies and businesses should think long and hard before creating a secret reserve. While it may help them against their competitors, their shareholders and the general public would not appreciate being lied to. The decision to go through with a secret reserve must be considered carefully before taking further steps.