So-called secret reserves are brought about in various ways. Their creation may be intentional or accidental, but their source is the same in either case. Reserves of profits may be hidden either by undervaluation of the assets or overvaluation of the liabilities. Undervaluation of the assets may point to an ultra-conservative policy of management. Thus, some concerns write off the value of their fixed equipment of various kinds as rapidly as the net profits can absorb it and still leave sufficient for a reasonable dividend. Financial institutions in this way carry their furniture and fixtures and sometimes even banking houses, at ridiculously low figures or do not show them at all.
Undervaluations are accomplished in various ways. Charging an excessive rate of depreciation; making unnecessarily large reserves for uncollectible accounts, sales discounts, etc.; showing a more rapid depletion of natural assets than justified by the amounts used; charging the sums spent for assets to an operating expense; setting up an excessive cost of goods sold by means of inventory valuations of stock-in-trade at a figure lower than cost or market; crediting items of income to asset accounts instead of to income accounts, such as rentals on properties owned; crediting interest and dividends received to the stocks and bonds accounts—all of these serve the purpose of creating hidden reserves by means of a misstatement of fact.
Items wrongfully included among the liabilities bring about the same result. Here, however, the procedure is somewhat more patent because the creditors themselves check up on all actual liabilities. Liabilities can be settled only by an actual reduction of assets. Manipulation of the operating and contingent reserves explained above offers, however, an easy means of overvaluing the liabilities. A too liberal estimate of the amounts of these reserves makes them represent in part true proprietorship reserves but the proprietorship element in them is obscured by their title and their inclusion among the liabilities on the balance sheet.
It is, of course, apparent that no balance sheet containing secret reserves is a true statement of condition and the practice of creating secret reserves must usually—perhaps always—be condemned.
Argument for Secret Reserve
In justification of the secret reserve, it is sometimes said that in certain lines of business where the maintenance of unquestioned credit or the promotion of a stability ordinarily lacking in speculative enterprises is highly desirable, there is a very pressing need for the secret reserve. Through its use, extraordinary losses, which otherwise would result in very unfavorable fluctuations of stock values, may be absorbed by means of a charge to some undervalued asset and so bring it to its true value; or by a charge against an over-estimated liability reserve and so bring it to a true showing. This frees the current profit and loss from the charge, maintains a regularity of net profits, and prevents the disasters sometimes attendant upon violent fluctuations of stock values brought about by the knowledge of these extraordinary losses. That is the strongest case which can be made out in favor of the secret reserve.
Argument against Secret Reserve
The fact, however, must not be overlooked that without any understatement or misrepresentation of property values at any time there could just as easily be created an open “surplus” or margin of an amount equal to the secret reserve, against which these losses could as well be charged. The creation of such a margin can be justified on the same grounds on which the justification of the secret reserve is attempted, viz., the maintenance of high credit and stability. The reduction of the margin through its absorption of the loss would, of course, be somewhat more patent than the reappearance of values previously written off, although analysis of a balance sheet will invariably bring the true state of affairs to light. Furthermore, present stockholders, and certainly prospective investors and creditors, have a right to know the true condition of affairs. The appearance of a large proprietorship in addition to capital stock, revealed by a sizable margin, gives the stock a value in addition to that based solely on the dividend rate. A stockholder has a right to his share of the profits during the period of his ownership. If it is not received in the form of dividends, he should at least be partially recompensed when he disposes of his holdings, by an increased price for the stock as reflected by the portion of profits reinvested in the business.
The attitude occasionally taken that directors know best what information as to true condition of affairs should be given to the owners and what should be withheld, should, in these days of increasing publicity, be given no serious consideration. In the hands of unscrupulous directors, the secret reserve is an instrument for the covering up of questionable and even fraudulent practices. Stock values can be intentionally hammered down by a false showing of profits and so inure to the benefit of a group of prospective purchasers desiring to “freeze out” unsuspecting stockholders. All in all, therefore, little can be said in justification, but much in condemnation, of the practice of accumulating secret reserves.
Earmarking of Reserves