What is a Hidden Reserve?

A hidden reserve is an understatement of an entity's net worth. This situation arises when an organization's assets are stated too low and/or its liabilities are stated too high. The situation can arise when certain accounting conventions mandate the most conservative possible treatment of an accounting transaction. Hidden reserves may also be used when the owners of an enterprise want to reduce the amount of taxable income on its income statement, and do so by warping financial results to create the reserves. A hidden reserve will eventually be used, resulting in an increase in income in future periods.

Example of a Hidden Reserve

As an example of a hidden reserve, Fortnight Corporation’s accountant sets up a warranty reserve of 5% of the net sales of its new electronic clock product, resulting in a reserve of $50,000. The problem is that similar product lines of the company only experience 1% warranty returns, so the firm’s warranty reserve is likely five times higher than it should be. This means that the company has a hidden reserve of $40,000. In effect, it should have reported an additional $40,000 of income in the current period.