Explain the concept of 'secret reserve'.
Secret reserve is a reserve which does not appear in the balance sheet. It is termed as 'Secret Reserve' because it is not known to outside stakeholders.
Secret reserve may help to reduce the disclosed profits and also the tax liability. It can be merged with the profits during the lean periods to show improved profits. Management may resort to creation of secret reserve by charging higher depreciation than required.
Secret reserve can also be created by other methods such as:
- Undervaluation of inventories/stock
- Charging capital expenditure to profit and loss account
- Making excessive provision for doubtful debts
- Showing contingent liabilities as actual liabilities
Creation of secret reserves within reasonable limits is justifiable on grounds of expediency, prudence and preventing competition from other firms.
Explanation
This answer covers the definition of secret reserve, its purpose (reducing disclosed profits and tax liability), why it's called 'secret' (not known to outside stakeholders), and the various methods of creating it as mentioned in the textbook context. The answer is structured in multiple paragraphs as required for a 3-mark question.
Solution Steps
Step 1: Define secret reserve as a reserve not appearing in balance sheet
Step 2: Explain its purpose - reducing profits/tax liability and use during lean periods
Step 3: List the methods of creation - higher depreciation, undervaluation of stock, charging capital expenditure to P&L, excessive provisions, showing contingent liabilities as actual