Hidden Reserves (#342)
/The Nature of a Hidden Reserve
What is a hidden reserve? It sounds kind of sneaky, like some sort of fraud scheme, but that’s usually not the case. A hidden reserve is present whenever assets are stated on the balance sheet at an amount that’s lower than their current market value. And the same thing goes for liabilities – there’s a hidden reserve when liabilities are stated on the balance sheet at an amount that’s higher than their actual value. This is fairly rare with short-term assets and liabilities, but it happens all the time with long-term ones. For example, you own some land and record it at the purchase price. Ten years later, someone wants to build a stadium next door, and presto, the land is worth multiples of what you paid for it – and that difference is a hidden reserve. Once you sell the land, then a profit is recognized, but the increase in value never appears on the balance sheet, because it’s not allowed under generally accepted accounting principles. Now, it is allowed as an option under international financial reporting standards, but even then, it’s just an option.
Let’s try another example. You’re supposed to depreciate an asset over its useful life, which means that at some point, the asset is recorded on your books at just its salvage value. Well, at that point its market value could very well be higher than the salvage value, and the difference is a hidden reserve.
There’s also a discretionary issue in that last example that can result in a hidden reserve. Let’s say that you assume the useful life of a fixed asset is ten years, but it’s really twenty years. If so, you’ve completely written off the value of the asset after ten years, but it still has some value for another ten years – and during that time, there’ll be a hidden reserve. So, sometimes using more conservative estimates for how assets are recorded can result in hidden reserves.
And for another example, internally generated intangible assets cannot be capitalized. So, if you spent a billion dollars on the research for an anti-gravity generator, the whole thing would have to be charged to expense as incurred, even though anti-gravity might have a lot of valuable applications. So when it comes to these kinds of assets, you could have a huge hidden reserve. In fact, because the accounting standards force a business to charge these expenditures straight to expense, they’re actually being forced to create hidden reserves. They don’t have any choice, because they can’t capitalize these expenditures into assets.
The concept also applies to liabilities, but it tends to be a lot smaller. For example, a nuclear power plant has recorded a massive asset retirement obligation for when it eventually shuts down, and has to dismantle the facility. After a few years, a new estimate says that the cost to dismantle has gone down. Until that new estimate is actually included in the retirement obligation, you’ve got another hidden reserve.
Or, as another example of a liability, you might build up a large reserve to pay for income taxes. But then the tax laws change, and you only owe half as much. The excess reserve is a hidden reserve, at least until you decide to reduce it.
Now keep in mind that a hidden reserve is just a theoretical value. No one has formally appraised it - the reserve just happened because market values diverged from book values. Also, keep in mind that hidden reserves eventually go away. For example, in regard to that piece of land that I was just talking about, the owner will eventually sell it, which generates a gain that now appears on the owner’s income statement as a profit. And in regard to the asset retirement obligation, the nuclear power plant is supposed to periodically adjust its recorded retirement obligation, so the difference only arises between adjustments.
The only case in which a hidden reserve does not go away is when the asset in question is never sold. So, for example, if a business owns a massive amount of land near a major city and chooses not to sell it off, then the land just keeps gaining in value as the city grows around it. But that’s rare. In most cases, the owners will realize that they can earn a pile of money by selling off the asset, so they do.
Hidden reserves can be interesting from the perspective of an acquirer. They’re always looking for target companies that have hidden reserves locked away, and which their managers may not even realize that they have. So, the acquirers spot these anomalies, buy the targets, and take advantage of the reserves.
Hidden Reserve Disclosures
So, what about disclosures? Are you supposed to report hidden reserves in the financial statement footnotes? Well, no. There’s no accounting standard that forces a business to continually re-appraise its long-term assets or long-term liabilities and report a hidden reserve. There is a requirement for the reverse, which is to test assets for impairment and write them down. But nothing in the opposite direction.
Hidden Reserve Examinations by Auditors
And for that matter, there’s no requirement for outside auditors to look for hidden reserves. And there’s a good reason for this. Accounting rules are based on being conservative, so auditors are always looking for assets that are over valued or liabilities that are undervalued – not the reverse. They simply have no incentive or requirement to look for these reserves.
Hidden Reserve Fraud
Now, having already stated that hidden reserves are not a fraud scheme, that can sometimes be the case. Some company owners want to reduce the amount of reported taxable income, so they can defer paying income taxes. An easy way to do this is to deliberately charge capital expenditures straight to expense. It might even look legitimate, if the company has an extremely high capitalization limit. So, for example, a formal cap limit of $100,000 might result in pretty much every expenditure being charged straight to expense, rather than being recognized as a fixed asset. Of course, when this is really blatant, the auditors are going to protest. But if there aren’t any auditors, a business owner might very well get away with it.
While this might sound like a dreadful breach of the law, it’s actually only a deferral of income tax payments; it’s not like they’re being avoided entirely.
So, in short, hidden reserves are really just a normal part of doing business. Most organizations will have some modest hidden reserves out there, while others might have massive ones. It just depends on how the market values and book values of its assets and liabilities differ over time.