Latent reserves: definition and examples

hidden reserve

Visit hidden reserve is a hidden reserve in accounting. It is the difference between the equity capital shown on the balance sheet and the actual equity capital. In Switzerland, hidden reserves are authorized and commonly used. Find out more about their uses and examples in this article.

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Definition

The Swiss Accounting and Financial Reporting Act permits the creation of so-called "hidden reserves".

Unrealized reserves correspond to the difference between book values and the maximum amounts authorized for assets, or the amounts required for liabilities, under accounting law.

They can be created through additional depreciation and provisions set aside for replacement purposes or to ensure the company's continued operation.

Creation of hidden reserves

Hidden reserves are built up either by undervaluing assets (e.g., by recording inventories at a value lower than their economic value, or by excessive depreciation, e.g., by underestimating the useful life of assets or omitting to revalue them at market value), or by overestimating liabilities (e.g., by setting aside excessive provisions). This artificially reduces the company's economic profitability.

Examples

Provisions

Unrealized reserves may be created as part of provisions to protect the company against various disputes.

Building reserves

A reserve on a building or fixed asset can be created by applying a rate lower to the external rate.

Earnings will therefore be affected by the difference. Consequently, it will be reduced.

Release of undisclosed reserves

The dissolution of hidden reserves results in too little being spent (too high a return) on the external balance sheet, resulting in too high a profit.
 
The annual financial statements of every Swiss company are expected to present a true and fair view of the company's assets and liabilities, financial position and results of operations.
 
To ensure that creditors and employees are not misled as to the true nature and profitability of operations, public limited companies are required to disclose in a note to the financial statements the dissolution of hidden reserves when these have had a significant impact on the balance sheet. Auditors are also in a position to help avoid this type of oversight.

Frequently asked questions about hidden reserves

Yes, hidden reserves are legal in Switzerland.

Hidden reserves are a real asset for companies.

They can be dissolved in difficult times, protecting the company against losses.

In addition, hidden reserves reduce shareholders' equity, which in turn reduces a company's profit and tax burden.

There are two ways of creating a latent reserve:

  • to assets: listing a property at a value below market value - thus undervaluing the property

  • liabilities: by recording the asset at a value higher than the amount of the liability - thus overvaluing the debt

There are several types of reserves.

Discretionary reserves: These reserves are created when assets are deliberately undervalued and liabilities deliberately overvalued.

Administrative reserves: These reserves are created by decision of the Board of Directors. They are intended to guarantee the continuity of operations during a difficult period.

Compulsory (or automatic) reserves: Mandatory reserves result from the ceilings set by the Swiss Code of Obligations (Art. 960 CO).