The term 'Secret Reserve' is applied to reserve, the existence of which does not appear on the face of the Balance Sheet. When secret reserves exist, the financial position of the business is better than what may appear on the face of the balance sheet.

The main purpose of creating secret reserve is to reduce the disclosed profit so that during bad period this hidden profit, or a portion of it, may be merged into the earnings and thus help in equalizing the dividends.

Methods of creating Secret Reserves : Secret Reserves may be created in one of the following ways:

i.Writing off excessible depreciation

ii.Undervaluation of closing stock

iii.Charging capital expenditure to Profit and Loss Account

iv.Making excessive provision for bad and doubtful debts

v.Showing contingent liabilities as actual liabilities

vi.Retaining appreciating assets at cost price

Despite certain merits, the following objections are raised against the practice of creating secret reserves.

i.Secret Reserves prevent the financial statements from showing the true and fair position of the business. The Profit and Loss Account charged with fictitious amount in respect of excessive depreciation, doubtful debts, or repairs etc., fails to disclose the true profits. Similarly, when the value of certain asset is understated or some liabilities are overstated, the Balance Sheet cannot be said to represent the true state of affairs of the business. Thus, the financial statements become unreliable.

ii.The shareholders cannot assess the value of their holding correctly.

iii.Management can conceal its inefficiency by making use of secret reserves.

iv.It permits misuse of secret reserves for personal gain by managers. Sometimes the management, or those close to them, having knowledge of willful suppression of net profits, may indulge in certain malpractices in the stock markets.