A secret reserve may be defined, after Spicer and Pegler, “as a reserve, the existence and amount of which is not disclosed on the face of the Balance Sheet”. It is also called “internal reserve” or “hidden reserve”. ‘
It means that there is a surplus of assets over capital and liabilities and that surplus is not disclosed. When there is a secret reserve, the actual financial position of the business is better than what is shown by its Balance Sheet. Consequently, the published accounts of the company become misleading, the Balance Sheet does not show the true financial position of the company.
Besides, the directors may conceal losses from shareholders, or may manipulate for the sake of fraudulent dealings in shares. The existence of secret reserves, however, seems to be justified in the case of companies (particularly banks, insurance companies, and the like), which depends for their success on public confidence. Secret reserves become a source of strength to such companies and enable them in bad times to preserve their credit. Except in the case of companies governed by special Acts such as banking, insurance and electricity supply companies, secret reserves can no longer be legally created.
Methods of Creating Secret Reserves
Secret reserves may be created by the following methods:
(1) By providing excessive depreciation on fixed assets.
(2) By writing down an asset below its real value.
(3) By undervaluing current assets such as stores, stocks or investments.
(4) By making excessive provision for doubtful debts, outstanding liabilities and contingencies.
(5) By overstating liabilities.
(6) By ignoring appreciation in the value of assets.
(7) By ignoring prepaid expenses or incomes accrued but not received.
(8) By charging capital expenditure to revenue.
(c) Auditor’s Duty Prior to the coming into operation of the Companies Act, 1956, many companies created secret reserves and consequently the auditor has been in a very awkward position. His risk of liability for not disclosing a secret reserve and also his absolute right to disclose, if he so desires, had been established in unmistakable terms in Newton vs. Birmingham Small Arms Co. Ltd. case as well as in Royal Mail Steam Packet Co. Ltd. case. But if he decided to report the existence of such a •reserve, it would no longer remain a secret and a bona. fide purpose of strengthening the financial position of the business would be frustrated.
After the coming into operation of the Companies Act the position of the auditor has become clear. The Act provides that the Balance Sheet and the Profit and Loss Account of a company must show a true and fair view of its financial position and its profits or loss. The concept of a “true and fair” view means that the accounts must disclose a position which is not misleading by being overstated or understated. The Act therefore requires that all transactions relating, to reserves and provisions must be fully disclosed in the company s accounts.
The effect is that secret reserves cannot be legally created. Hence it is the duty of the auditor to see that if any secret reserve is created it is clearly stated in the Balance Sheet. The Companies Act, however, provides that companies governed by special Acts such as banking, insurance and electricity companies can create secret reserves to a limited extent. In the case of such companies, the auditor is to carefully inquire into the necessity of creating such a reserve. If he finds
(I) that the intention of creating a reserve is honest,
(2) that the creation of a secret reserve would serve the interest of the company, and
(3) that the amount is reasonable, he need not qualify his report.
But if he is not satisfied, he must disclose that fact in his report. In the case of such companies, though the creation of secret reserves is not illegal, the auditor must see that no portion of secret reserve created in the past is utilised for augmenting current profits with a view to paying dividend, without disclosing this fact in the Profit and Loss Account. If he fails to do so, he would be held liable for negligence, as it was decided in the Royal Mail Steam Packet case for not disclosing the fact in his report. The similar opinion was expressed in the case of Shamdasani v. Pochkbanwale case, 1927, when their Lordships held: If any part of secret reserves is availed of to meet bad and doubtful book debts, it must be revealed in the Balance Sheet and not concealed.”