What is a Secret Reserve?

A secret reserve is the amount by which the assets of an organization are understated or its liabilities are overstated. An entity might establish a secret reserve for competitive reasons, to hide from other businesses that it is in a better financial position than appears in its financial statements. However, a secret reserve means that the information provided to shareholders is false and misleading.

A side effect of the secret reserve concept is that both reported income and taxable income are reduced.

How to Create a Secret Reserve

There are several ways to establish a secret reserve, such as the following:

Accelerate the depreciation of fixed assets. Depending on the depreciation method used, this can double the amount of depreciation expense recognition in the first few years of an asset’s useful life.
Write off assets entirely. This approach can be quite a stretch from an accounting standpoint, if there is any possibility that an asset will be used again at some point in the future.
Undervalue the market value of assets. This is outright fraud, since it represents an intentional reduction in the reported value of an asset.
Create excessively large reserves. This is a conservative treatment, since it means that the large reserves were created with up-front write-offs.