What are hidden assets?

In financial accounting, the concept of ‘secret reserves’ or ‘hidden reserves’ plays an important role in how a company’s true financial health is perceived. These reserves are not typically visible in the regular financial statements but may significantly affect a company’s overall valuation. In this article, we will explore what secret reserves are, how they arise, give examples, and explain how to dissolve them. Let’s dive into the details to help you better understand these financial concepts.

What are secret reserves?

Secret reserves, also referred to as unrealised reserves or off-balance-sheet reserves, are assets that a company holds, but they are not reflected in the balance sheet or are understated in value. These reserves provide a financial cushion, often used strategically to manage taxes, mitigate risks, or prepare for future investments. The hidden asset may come from undervalued inventory, depreciation of assets, or even excessive provisions. Because they are not fully disclosed, these reserves are considered ‘hidden’, giving a company the ability to manage its financial appearance and respond to market changes more flexibly.

In simple terms, a secret reserve is a form of financial cushion that companies can tap into in times of need. It’s an asset that is not disclosed in a straightforward manner but can be accessed when required for future growth or stability.

How are secret reserves created? Four examples

Secret reserves are often established intentionally, but they can also emerge due to accounting practices, market fluctuations, or strategic decisions. Here are four common examples:

1. Understating the value of assets

One of the most common ways secret reserves are created is by undervaluing assets on the balance sheet. For instance, a company might undervalue its real estate or equipment, leaving the true market value hidden. In this case, the undervalued asset is essentially a secret reserve that can be revealed later.

For example, if a company owns a building that has appreciated significantly over time, but it continues to report the building at its original purchase price, the difference between the book value and market value is a secret reserve. This reserve can be revealed when the company decides to sell the asset or revalue it.

Example: A company buys land for £1 million, but due to changes in the market, the land’s true value is £1.5 million. The £500,000 difference becomes a secret reserve.

2. Excessive depreciation

Depreciation is an expense that reduces the value of assets over time. Sometimes companies intentionally increase their depreciation expenses to reduce their taxable income. This can create secret reserves, as the actual value of the asset is higher than what is reflected in the financial statement. Later, when the depreciation is reversed, the company might reveal hidden value.

This depreciation reserve can be reversed in the future, thus releasing secret reserves. If the company finds that the depreciation was too high, it can adjust the book value of the asset upwards, revealing the secret reserves.

Example: A company might write off the depreciation of machinery over five years, but in reality, the machinery might last for 10 years. By speeding up depreciation, the company creates hidden reserves, which can later be unlocked by reducing depreciation when necessary.

3. Provisions for contingencies

Companies often set aside provisions for potential future expenses, such as lawsuits or warranty claims. If these provisions turn out to be larger than necessary, the excess can become a secret reserve. This reserve can be used when the actual costs are lower than anticipated, releasing additional value to the company.

For example, if a company sets aside £100,000 for potential warranty claims but only incurs £40,000 in claims, the remaining £60,000 becomes a secret reserve. This reserve can be used for future investments, dividends, or reinvestment in the business.

Example: A company might anticipate a large lawsuit and set aside a significant provision. If the case settles for less than expected, the difference between the provision and the actual cost becomes a secret reserve.

4. Inventory valuation

Another example of creating secret reserves is through inventory valuation. A company may choose to value its inventory conservatively, lowering the asset’s book value. As the market price increases, the company can sell the inventory at a higher price, thus realising the secret reserve.

For instance, during economic downturns, a company might decide to lower the value of its inventory for tax purposes, even though the actual market value may have remained constant or increased. When the company sells that inventory, it realises a profit, revealing the secret reserve.

Example: A company buys products worth £100,000, but due to a market slowdown, it records the inventory at £80,000. Later, when the market recovers, the company sells the inventory for £110,000, realising a secret reserve of £30,000.

How to dissolve secret reserves

Although secret reserves offer financial flexibility, they must eventually be released to present an accurate financial picture. This involves incorporating the hidden values into the financial statements. Common methods include:

1. Revaluing assets
Updating the book value of assets (e.g., real estate, equipment) to their current market value can release secret reserves and increase reported equity.

2. Adjusting provisions
Reversing unnecessary provisions (e.g., for lawsuits or warranties) converts secret reserves into income.

3. Inventory liquidation
Selling undervalued inventory at market prices allows companies to realise hidden gains.

4. Tax adjustments
Correcting overstated tax liabilities or deferred taxes can unlock secret reserves and reduce tax expenses.

Please note the legal disclaimer for this article.