Unfortunately, when doing your annual accounts, it’s not always possible to know how much your operating expenses will be in advance. Because of this, you should always allocate a portion of your income for provisions and accruals. This way, you can avoid financial risks. But what do these terms mean, and how should they be recorded on your company’s balance sheet? This handy guide provides...
Hidden reserves: Explained.
The term hidden reserves usually appears in the context of a company balance sheet. It stands for existing values that do not appear on the balance sheet itself. Often, the term also carries a slightly negative connotation: hidden reserves operate like a dark secret on the edge of the law. The truth is, however, that these reserves are almost inevitable once the balance sheet has been cleared and are sometimes even desired by legislators to a certain extent. So, what exactly are hidden assets and what role do these hidden reserves play?
- What are hidden assets?
- Principles in conflict
- Silent burdens are not permitted
- How do you create hidden reserves? Four examples.
- Three different types of hidden reserves
- Dissolving hidden reserves
- The consequences of hidden reserves
What are hidden assets?
Hidden reserves, also often referred to as hidden assets, are created when an entity’s assets and liabilities are valued in a way that deviates from the actual value so that a hidden excess asset value is created. For example, if the current amount of assets is below current market values, or expected liabilities are overestimated, the annual balance sheet will not accurately reflect the actual value of a business. Hidden reserves are simply a theoretical amount and are not real until they are dissolved. If a fictional assessment is done and the value is overstated, then we are talking about hidden liabilities – the opposite of silent reserves.
In principle, hidden reserves are equities that do not appear on the company’s balance sheet. If the assets are valued too low or the debt is overestimated, then they reduce the reported value of the business compared to the actual value. Accordingly, discrepancies can occur in different places, both intentionally and unintentionally. When it comes to hidden reserves, the company creates invisible reserves which only become real once they are dissolved, i.e. converted into tangible values. Hidden reserves reduce the profit shown on the balance sheet. This means that the tax burden decreases, but then so does the income for shareholders and company owners.
Principles in conflict
When it comes to hidden reserves, there are two principles that often conflict during their assessment. On the one hand, hidden reserves result from the low value principle accordingly, assets must be disclosed at most at their purchase price minus depreciation, whereas, in the case of liabilities or provisions, the actual or reasonable amount must be set. This is to prevent the value of the company from appearing excessively high to third parties (creditors, shareholders and shareholders).
On the other hand, there is the balance sheet principle of reliability: every company has a duty to reflect the actual situation in its books and not to misrepresent any values. In the case of assets whose balance sheet value has been reduced by a special depreciation, the law even requires an increase in value if the reason for this depreciation has ceased. According to ASC 360-10-35-20 under U.S. GAAP, because an asset is considered to have a new cost basis after an impairment loss is recorded, the reversal (or "restoration") of a previously recognized impairment loss is prohibited.
Silent burdens are not permitted
The opposite of hidden reserves are silent liabilities. These are created by over-valuing assets and/or adding too little value to debts. Unlike hidden reserves, these are not permitted under any circumstances. For an initial valuation, the procurement price is the upper limit for assets, and any reduction requires a corresponding depreciation. Liabilities are to be set in value according to reasonable commercial assessment as stated in the law.
A hidden reserve in the singular is only used when referring to the valuation of a single item, not the complete balance sheet.
How do you create hidden reserves? Four examples.
Hidden reserves occur when the actual value of assets and liabilities exceed or fall below their valuation. This means that there are values in the company, which do not appear on the balance sheet. This can happen in different ways.
Suppose that an entrepreneur purchased a machine. The value of this machine must depreciate over the years, according to its wear and tear. Once it is worn out, the machine is completely written off, so it has a value of zero according to the company books. However, the device itself is still usable, and therefore could be sold off second-hand. The asset therefore still has a value to the company that no longer appears on its books: this asset is undervalued and represents a hidden asset.
The same applies to low value assets. Their acquisition costs are considered to be operating expenses rather than them becoming part of the initial operating assets. Nevertheless, these items have real value and could be sold second hand.
Based on the historical-cost principle, under GAAP, most assets held on the balance sheet are to be recorded at the historical cost even if they have significantly changed in value over time. For example, if a company buys a plot of land or building for $50,000, then that amount appears on their company books. However, if the market value of the property increases over time to $100,000, then the asset listed is undervalued. The result is a hidden asset of $50,000. In fact, according to the GAAP the property must remain on the balance sheet with its original purchase price.
Under current standards, in most cases US accounting standards do not allow capitalization of internally generated intangible assets and costs associated with their research and development are expensed during the current period. For example, if a company has applied for a patent, this may have a certain value by allowing products to be manufactured and sold. The patent could also be sold but the company does not have to include its assumed value in the balance sheet. As a result, the balance sheet value of the company is lower than its actual value. A hidden reserve has been created.
Silent reserves due to the overvaluation of liabilities may also occur, for example, when considering expected additional payments or tax payments. For example, say a company is informed that they will be taxed. The company then builds up a reserve of $2m so that it can pay the tax when the bill arrives. However, it turns out they are only required to pay $1m in tax. The remaining saved money is considered a hidden reserve.
Three different types of hidden reserves
Depending on how hidden reserves are created, three different types can be distinguished.
While intangible assets created have to become part of the company’s assets, this is not permissible for self-created trademarks, print titles, publishing rights, clients lists and others. In these cases, the company is forced to create corresponding hidden reserves. However, these values are difficult to quantify, which means that corresponding balance sheet items wouldn’t make sense. On the other hand, increases in value beyond acquisition cost, like in our property example, are far more concrete. Even in these cases, hidden reserves inevitably arise.
Disposition and discretionary reserves
Some values are not clearly measured and subsequently need to be valued by the company in the most positive way possible. Since a responsible merchant should exercise the precautionary principle, and, when in doubt, underestimate the assets and overestimate the debts, hidden reserves often end up occurring. The term disposal reserves is used when accounting and valuation voting rights are applied, i.e. someone has consciously decided whether or how to include certain values in the balance sheet. On the other hand, discretionary reserves are created by estimates – not just of a value, but also the useful life of depreciation plans.
While the first two types are more or less inescapable and are therefore allowed or even required, arbitrary reserves are not permitted. Arbitrary reserves arise when you are being negligent or intentionally violating rules and principles when creating reserves. For example, if you do not include assets that are subject to capitalization in the balance sheet, you may violate commercial and tax law, which could lead to criminal and civil consequences.
Dissolving hidden reserves
For the most part, hidden reserves dissolve themselves over time. For example, undervalued assets are sold and then appear on the balance sheet through their selling price. In other cases, companies resolve hidden reserves by correcting assets or liabilities on the balance sheet and adding a more appropriate value.
However, there are also hidden reserves that remain permanent. These include, for example, real estate that is increasing in value but used for long-term operations.
The consequences of hidden reserves
Hidden reserves reduce a company’s equity capital and, ultimately, its annual profit. This in turn leads to a lower tax burden. However, since almost all hidden reserves are eventually used, this effect is only temporary. You are simply moving the payment of taxes into the future.
Deliberately creating and dissolving hidden reserves can be part of an active balance sheet policy. This makes it possible for entrepreneurs to influence the design of balance sheets and to make profits when it would be most advantageous.
The bottom line is that hidden reserves are neither good nor bad for a company in terms of taxation, as they will only remain hidden temporarily. In some cases, it makes sense to create them and in other circumstances they inevitably arise. To a certain extent, their scope can be influenced, however this is usually legally dubious. As is so often the case, good judgement and legal council is crucial in this area.
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