Hidden and non-hidden reserves strengthen a company’s balance sheet and provide a cushion for difficult times. But what margin for maneuver exists and what are the advantages and disadvantages of hidden reserves?
In principle, the Swiss legislator is in favor of the formation of hidden reserves. Hidden reserves are called hidden because they are not visible in the external commercial balance sheet and the tax balance sheet. In the external balance sheet, assets tend to be undervalued and liabilities tend to be overvalued. However, hidden reserves may only be formed for replacement purposes and “to ensure the permanent prosperity of the enterprise”. In Switzerland, the type and extent of hidden reserves is primarily regulated by the Swiss Code of Obligation and the tax law. For listed companies, the corresponding accounting standard applies. In principle, hidden reserves can be created in any company. However, it is recommended to observe the tax requirements.
Scope for action
To protect creditors, the Swiss Code of Obligations in principle stipulates that all assets of a company must be capitalized. The complete omission of assets is therefore against the law. Yet, there is some leeway. For example, if you buy a truck for CHF 300,000, it must be activated in the balance sheet, but from a commercial law perspective it may also be written off immediately after the purchase. The difference between the depreciation made under commercial law and the depreciation economically necessary then results in hidden reserves. However, the permitted amount of such depreciation varies from canton to canton. It is advisable to obtain the relevant information or expert advice in advance.
It should also be taken into consideration that hidden reserves on asset items may possibly result in a compulsory partial release. If the fixed assets are already fully depreciated before the end of their useful life, hidden reserves are automatically released over the remaining time. If debtors and inventories decrease compared to the previous year and hidden reserves were created in the past through the application of a general value adjustment, the release of hidden reserves are an automatic consequence. If the result is a net release that has a significant impact on profit, it must be disclosed in the notes to the annual financial statement.
The Pros
The creation of hidden reserves gives a company the possibility to build a cushion for bad times because the reserves have a lowering effect on the company’s profit and thus reduce taxes. However, tax savings are eroded at the latest again when the reserves are actually dissolved. The creation has another advantage, hidden reserves conserve solvency as the additional depreciation and impairment has no effect on liquidity, i.e. there is no additional outflow of funds.
The Contras
The creation of each hidden reserve increases the differences between the external and internal balance sheet. The informative value of annual financial statements for owners and shareholders is limited, thus the effective valuation becomes more complex for external parties. Hidden reserves accumulated over the years must be made transparent if a company is about to be sold or a succession plan is to be executed. Compared to the external balance sheet, insufficient returns on equity may suddenly arise and thus a takeover may appear unattractive.
In General
The creation of hidden reserves makes sense and is generally desired by the Swiss legislator. However, these optimizations should only be made during the preparation of the annual financial statements. Experts should be consulted at an early stage to avoid errors and to optimize the results` accuracy.
February 10, 2021
