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.

Purpose of Hidden Reserves

Hidden reserves may be deliberately created for strategic purposes, such as any of the following:

To act as a risk buffer. Hidden reserves can act as a safety net to cover unexpected losses or financial downturns without revealing instability to stakeholders.
To smooth reported income. By using hidden reserves, businesses can smooth out fluctuations in profits, presenting a more stable financial performance over time.
To defer a tax liability. By understating profits through hidden reserves, a company may reduce its taxable income in a given period. This could delay tax payments and improve cash flow temporarily.
To avoid share price volatility. Hidden reserves can help in avoiding the appearance of excessive profits, which might lead to speculative activity or volatility in the company’s stock price.

While creating hidden reserves can be beneficial, it also carries risks, such as regulatory scrutiny or potential loss of trust from investors and stakeholders if uncovered. It’s typically seen as a strategy to be used cautiously and within legal and ethical boundaries.

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.