Secret Reserves | Methods of creation | Objectives | Duties of Auditor

What are Secret Reserves

The term secret reserve refers to a reserve the existence of which is not disclosed in the Balance Sheet. Secret reserves are also called Hidden Reserve or Internal Reserve. Such a reserve is not disclosed on the Balance Sheet. It can be said that there is a surplus of assets over liabilities and that surplus is not disclosed or shown by the Balance Sheet.

Who can and cannot create Secret Reserves?

The joint stock company’s Balance Sheet and Profit and Loss Account must exhibit a true and fair view of the financial position of the company. Any method for creation of secret reserve would defeat the provisions of section 211 of the Companies Act.

As per the provisions of the Companies Act a joint stock company is prohibited to create secret reserves but in the case of financial companies like the banking companies, insurance companies, and electricity supply companies have the provisions to create secret reserve. These companies are exempted from the provisions of the Schedule VI to the Companies Act.

Hence, mostly all banks and finance institutions create secret reserves with a view to equalize dividends or to provide a fund through which it may incur heavy losses. Such losses can be met with secret reserves.

The effect of secret reserve is to maintain the confidence of the customers and creditors by giving the impression of stability to a prosperous but fluctuating business, to check speculation in its shares and avoid disclosing information to competitors. There is, however, no doubt about the fact that where a secret reserve exists, the Balance Sheet of the business will not reveal the correct view of the financial affairs of the business.

Method of Creation of Secret Reserves

Secret reserves may be created in the following ways:

1. Providing excess depreciation on fixed assets such as plant, machinery, land & building, furniture and fixtures, etc.

2. Writing down an asset completely.

3. Understating goodwill.

4. Undervaluing assets such as stock, investments, etc. and showing them much below their cost or market value.

5. Non-recording of permanent rise or appreciation in value of a fixed asset, e.g., buildings.

6. Providing excessively for bad and doubtful debts..

7. Overvaluing liabilities.

8. Including of fictitious liabilities.

9. Showing contingent liabilities as real liabilities.

10. Suppression of accrued income and prepaid expenses.

11. Making excess provision for expenses.

Objects of Creating Secret Reserve

The inherent ideas of creating secret reserve are as follows:

1. Maintaining a strong financial position.

2. Improving the solvency position of the entity.

3. Meeting sudden future financial losses.

4. Facing competitions.

5. Confusing the rivals regarding profitability.

6. Providing additional working capital.

7. Maintaining a stable dividend payment.

8. Hiding a portion of profit.

9. Enabling the directors to tide over unfavorable time.

10. Helping the management not to distribute the hide portion of profit, which is retained in the business in the form of secret reserve to the shareholders in the interest of the business.

Auditor’s Duty in auditing secret reserves

While verifying the secret reserve, the auditor should keep the following points in mind:

1. He should enquire and find out what is the necessity of creating a secret reserve.

2. He should study thoroughly the Articles of Association and examine the legality or otherwise of creating a secret reserve. He should see whether the intentions of directors are quite honest.

3. He should try to collect as much information as possible about the creation of a secret reserve. He should satisfy himself about the method and the procedure of creating such a reserve.

4. Sometimes the managements create secret reserves by means of overvaluing liabilities or undervaluing assets. In such cases, the auditor should discuss the issue with the management and go deep into the policy and practices behind it.

5. Unless it is felt absolutely necessary to create a secret reserve, he should not accept the creation of a secret reserves valid and if he feels so he should ask the management to prepare the revised annual accounts.

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