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Secret Reserves
It has been defined as "any reserve which is not apparent on
the face of the balance sheet". It is sometimes called "hidden reserve", or
'internal reserve' or 'inner reserve.' This reserve represents the surplus of
assets over liabilities and capital. It does not appear in the ledger. The
creation of secret reserves strengthens the financial position of the concern.
Its financial position would be better than what it would appear on the face of
the balance sheet. Secret reserve is created usually by joint stock companies
especially banking, insurance and financial concerns.
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 its profits.
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.
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