Hidden reserves are equity that is not visible in the balance sheet. Hidden reserves occur when expenses are overvalued and assets undervalued. This reduces the declared value of the company.
Building up hidden reserves
Hidden reserves are created, for example, when assets are undervalued. They are therefore worth less on the balance sheet than they actually are. An undervaluation is the result of too high a depreciation or an increase in the value of the asset (usually real estate).
Hidden reserves are also possible on the liabilities side of the balance sheet. For example, it is possible to make larger provisions for taxes or legal costs.
Here is a concrete example:
If a company buys a property for CHF 250,000, this value is entered in the balance sheet. If the value of the property increases over time to CHF 350,000, hidden reserves of CHF 100,000 are automatically created.
Dissolving hidden reserves
Hidden reserves often dissolve themselves. This is the case when assets on which hidden reserves have been created are sold, for example. Of course, a company can also intentionally dissolve hidden reserves when it adjusts the value of assets or liabilities in its balance sheet.
Why are hidden reserves allowed?
Hidden reserves are an advantage for companies on several levels. They can be dissolved in bad years and thus help the company to avoid losses. In addition, hidden reserves reduce equity, which ultimately also reduces the annual profit and tax burden of a company.