Secret Reserve Accounting to Create Conflict between Management, Shareholders and Employees - Research Paper Example

Secret Reserve Accounting: A Critical Discussion on Issues and Conflicts Introduction Secret reserves can be categorised under the reserves that do not appear in the balance sheet. In other words, secret reserve has been defined as “any reserve which is not apparent on the face of the balance sheet.”(Kumar and Sharma, 2001, p.16). It is called “hidden reserve”, or “internal reserve”, or “inner reserve” (Kumar and Sharma, 2001, p.16). It would represent the surplus of available assets over the capital and liabilities. It is not apparent in the ledger too. Creating secret reserves is likely to strengthen the financial situation of the organisation concerned. The actual financial position and the financial position observed through the balance sheet would be different – the financial position of the company would be stronger than its apparent situation on records. As a result, conflicting inferences are likely to be obtained when it comes to secret reserve accounting. Creating secret reserves will definitely involve the management, some of the employees and the shareholders are likely to remain in dark. Secret reserve accounting will not show even under the suspense account and affect the capital flow in a concealed fashion. Undervaluation of available assets, omitting the rise in asset values, providing extra depreciation on the assets that are fixed, etc. are the methods of secret reserve accounting. In this context, the question is in the form of the following statement: Secret reserve accounting is likely to create conflict between management, shareholders and employees. – Critically discuss. The paper will examine the concepts related to the research question through literature review and then discuss the given statement supplemented by a viable conclusion. The essay will first focus on the literature review. This will involve examination of the existing literature in relation to secret reserve accounting both from old and new sources. Next, the effects of secret reserves will be analysed and their role in potential conflict creation will be assessed. After that, the various conflict scenarios between the management, shareholders and employees will be critically discussed. Last, the conclusion will be drawn with the final opinion about the research statement. Literature Review The academic literature in the context of secret reserves reveals interesting opinions and scholastic approaches. First, a view on the nature and scope of secret reserve as an accounting term should be considered. “Secret reserves – this accounting term has been made to cover a multitude of sins: whenever objection is taken to pessimistic writing off of invested values, or disproportionate charges of depreciation, or again to charges to operations or revenue, for capital expenditures which should have been applied to the increase of assets, the answer is, secret reserves.” (Esquerre, 1978) So if the owner of a corporation is creating secret reserve and implementing related accounting practices, his/her capital assets have likely been knocked down into the pit of secret reserves and that their book value, as it stood at the time, was likely preposterous. Hence the questions in issue would be: Does the owner want to deceive the shareholders, the government, the public or his own self? Does he wish to submit to the directors, the shareholders, the banks and the public, financial statements with a mental footnote to the effect that things are not in truth what they would show on their face? And if it is well to hide the owner’s wealth from some people (in his perspective), can it be believed that anyone capable of reading balance sheets is not in a position to follow accounting facts from year to year, and to point out fluctuations in wealth not supported by the statement of income submitted, and thus unearth secret reserves? (Esquerre, 1978) These analytical questions need to be answered in the context of the potential conflicts between the management or the owner, the shareholders and the employees. Secret reserve accounting can be meant to deceive the authorities and the shareholders in the company. The face value of the assets of the company would be lesser than the actual value, thus affecting the liabilities. The picture of the company’s fiscal affairs appears to be brighter when such practices are adopted. For example, these sorts of effects have been discernable in the case of HSBC during the later half of eighteenth century and the early twentieth century, when it deliberately practiced secret reserve accounting (Hui, 2010). This kind of practices involves overvaluation of liabilities, including imaginary liabilities and showing the contingent liabilities as the actual ones. Secret reserve accounting would make the financial position of a concern stronger. The example of HSBC has already been referenced in this context. Losses are concealed from the market and financial strength is maintained even in adverse situations. The working capital is considerably increased since profits do not drain in the form of dividends and bonuses and remain in the business. The trade competitors can be kept in dark with the help of secret reserve accounting (Kester, 1936). However, if truth and integrity are considered, then secret reserve accounting will give an untrue and unfair view of the balance sheet. The profit and loss account too will not give authentic results. Excess liabilities coupled with limited assets will show an overall depreciation, which will misguide the related financial institutions, trade unions and even the board of directors. Secret reserve accounting would eventually conceal mismanagement by hiding the losses incurred in the course of the business (Montgomery, 1922). Therefore, the effects of secret reserve accounting are complex. The interpretation of the effects largely depends on the respective views of the affected parties. Moreover, the parties are unaware of the financial activities that are being embarked on in relation to secret reserve accounting (Gray, 1980). In the context of the management, there can be arguments both in favour and against the utility of secret reserves in relation to the management’s communication with the shareholders and employees. Conflicts are likely to arise between the shareholders and the management when the actual financial position is unknown to the shareholders (Willcocks, 1991). The employees would not be able to claim bonuses, since the balance sheet will show excess reserves for doubtful and bad debts, depreciation of assets, overvalued liabilities and imaginary liabilities (Shermen, Hunt and Nesiba, 2008). Hence, conflicts inside the organisation would become inevitable. In the case of USA, increased merger activity in the 1960s was accompanied by earnings manipulation by management that was designed to boost stock prices to aid in acquisitions. This is an example of how secret reserve accounting can be analysed in the context of the markets (Markham, 2006). Further, analysis of the process of creation of the secret reserves violations of the basic auditing principles where the auditors are likely to enter a nexus with the management concerned (Montgomery, 1922). Therefore, secret reserve accounting appears to have limited good effects but potential and profound bad effects. Also, if the owner of a company obtains the power to regulate the share prices of his corporation, then it would be very hard for him to avoid financial manipulations with the help of the secret reserves. Effects of Secret Reserves: Creation of Conflicts Effects of secret reserves can be profound on the market and the industries. In order that the mechanism of conflict creation through secret reserve accounting among the management, shareholders and employees can be discussed, the effects of secret reserves have to be understood. This is not possible without discussing practical trends in the real world markets and other financial segments. Effect of Secret Reserve on Collaborative Business Models From a researcher’s point of view, auctions are the best examples of collaborative business models. Effects of secret reserves in this context can be explained in the words of Hinz and Spann (2008, p.351): “The interactive nature of the Internet promotes collaborative business models (e.g., auctions) and facilitates information-sharing via social networks. In Internet auctions, an important design option for sellers is the setting of a secret reserve price that has to be met by a buyer's bid for a successful purchase. Bidders have strong incentives to learn more about the secret reserve price in these auctions, thereby relying on their own network of friends or digital networks of users with similar interests and information needs.” In continuation of the view discussed above, Hinz and Spann held that the flow and sharing of information through the digital networks, both via communities and person-to-person can alter bidding behaviour. This can have significant inferences for sellers and buyers in the auctions involving secret reserve price. Hinz and Spann (2008) utilised a multiparadigm approach to examine the effects of information diffusion through the social networks on bidding activities in the secret reserve price auctions. First, an analytical model for the consequence of shared-information on the individual’s bidding activity in a secret reserve price auction with a single buyer vis-à-vis a lone seller similar to eBay's Best Offer and some variations of Name Your Own Price is developed. Next, implications from the analytical model thus developed are combined with relational data that explain the individual's situation in the social networks. Empirical tests of the results of the analytical model are further conducted, and the effect of information diffusion through social networks on the auction activities on the part of the bidder is examined. The field study involved the utilisation of a virtual world in the proxy of the real world environment and the real purchases made. And finally, Hinz and Spann (2008, p351) found “that the amount and dispersion of information in the individualized context, and betweenness centrality in the social network context, have a significant impact on bidding behaviour.” As the cumulative management practices at the sellers’ side trade on the secret reserves prices, profits are high, risk of tax imposition is less and the buyers’ confidence is maintained. However, the inferences obtained by Hinz and Spann can also explain the bidding behaviour of the various management boards and shareholders/stockholders in the context of acquisitions and mergers too. For example, a company which has secret reserves can hide the losses incurred and look lucrative in the eyes of a capable bidder. Effects of Secret Reserves on Mergers and Acquisitions According to Markham (2006), increased merger activity in the 1960s was accompanied by earnings manipulations by management that was designed to boost stock prices and aid in acquisitions. The “big bath” (Markham, 2006, p. 356) involved a large write-off in one accounting period in order to rid the company of prior losses that negatively impacted the earnings. Thos write-offs were often blamed on old management and allow it to report higher earnings in the future. Quasi-reorganizations of a corporation’s business were another way to write off accumulated losses and, in effect, to start over again. These big baths and reorganizations were said to be misleading because new shareholders looking at the company’s financial statement would not know the past losses. (Markham, 2006) In this context, Markham (2006) further notes that secret reserve accounts are tapped to increase earnings during difficult times. In sum, secret reserve accounting may increase acquisition and merger activities in the market, but the shareholders might not be properly benefited from such activities. Effect of Secret Reserves on Banking The discussion can further be based on more real world scenarios. Secret reserve accounting can profoundly affect the banking sector too. By hiding certain information and adding more liabilities to the balance sheet, banks can control the rates of interest and compromise dividends to their shareholders. According to Dicksee (1903), reserve fund at all is to enable the customary dividend to be paid, even in unprofitable years; but to employ the reserve fund for that purpose is somewhat illogically, and almost invariably, looked upon as a sign of the gravest weakness. Hence, the secret reserves have been created to at least temporarily cater to the needs of distributing the dividends. It is especially in connection with banks and other allied undertakings that secret reserves are most prevalent, and here they usually take the form of excessive provision for loss by way of bad and doubtful debts, the “secret” being maintained by deducting the amount of the debtors in the balance sheet without showing the figures in detail. Another form of secret reserve (which is certainly less defensible, as being of a purely artificial character) is the deliberate writing down of fixed assets such as premises, at a rate far in excess of all legitimate requirements in respect of depreciation. An extreme instance of this is afforded by the accounts of the Bank of England, which omit all reference to the freehold premises of the bank, which at a moderate computation have been estimated to be worth upwards of two millions sterling. (Dicksee, 1903) Thus, it can be deduced that the secret reserve accounting affect the management and shareholders and hence the employees of a company in numerous ways. Conflicts are likely to arise when clash of interests in this context of applied accountancy. Potential Conflicts between Management, Shareholders and Employees Secret reserve accounting creates difficulties for the parties involved in the running of a company in understanding what is true and what is not. As long as the effects of secret reserve do not become discernable, for example, share prices do not plunge all at a sudden, the shareholders and the employees of the company are likely to be unaware of the secret reserve accounting activities and hence conflicts are less likely to arise. But by secret reserve accounting, the management tends to defend its interests. In doing so by this process, it eventually harms the interests of the shareholders and the employees. Thenceforth, conflicts would be natural if damage control is not initiated in proper time. Management Perspective We have to understand that how conflicts are likely to be created by secret reserve accounting in relation to the management practices. In the next sections, the arguments both in favour and against secret reserve accounting from the management perspective would be discussed. Arguments in favour of secret reserve accounting are numerous. Secret reserve accounting is likely to make the financial position of a company look stronger. This benefits the management in certain ways. Losses can be concealed from the shareholders by completely denying their occurrence. In the course of retaining equilibrium in the company affairs, funds may not be used to pay extra dividends and bonuses. Since information sharing is barred at the very beginning of the process, nobody actually knows about the company’s financial performance and claims are not made in time. In this way, the funds are retained in the business and can be re-invested to earn more profits or save the company from an immediate financial slowdown or bankruptcy. By increasing the working capital, secret reserve accounting thus proves to be beneficial for the management, at least on a temporary basis. Also, creation of secret reserve would hide financial information about the progress of the company from its competitors hence providing immunity in the markets full of rivalries. If the real earning situation of the concern is exhibited, it is likely that more and more rivalling companies may appear in the field and offer aggressive competition. As a result, profits of the company would fall. (Kester, 1936) So, for a while, it may seem that the secret reserve accounting provides a mechanism to avoid conflicts. But that is not true. Numerous arguments are there against secret reserve accounting even from the management view point. By secret reserve accounting, the balance sheet is prevented from exhibiting fair and true view of the vital financial affairs of the company or organisation. In the same context profit and loss account would also show inaccurate results since increased provisions for reserve or depreciation may be made. The management can use secret reserves to hide its weakness in the terms of mismanagement. For example, losses incurred due to careless or bad managerial practices can be hidden and the shareholders are misguided by creating room for wild fiscal speculations. This may, however, harm the management itself by making it a mere paper tiger and creating confusion in the context of investment policies. Another risk in relation to secret reserves is proportional to the amount of assets undervalued. Insurance schemes are based only on the book value of the assets. Hence, in the case there is a man-made or natural disaster to the concern, the management would not be able to claim the full insurance claims since the insurance policy would not be based on the actual value of the assets damaged. Further, by secret reserve accounting, dividends are lowered and the directors get the chance to indulge in the speculation of share prices of the company. Once such an activity is uncovered, conflicts are inevitable with the shareholders and in such a situation the management may even face legal action. The shareholders, often unknowingly, suffer losses due to secret reserve accounting and hence the interests of the management and the shareholders may clash. Finally, the share prices of the company can be artificially controlled to send inaccurate signals to the market. This may create conflicts between the management, shareholders and employees once a merger or acquisition is completed on the basis of the balance sheet and profit and loss statement that are not authentic. (Briggs, 1966) So, any hidden or “secret” reserves (e.g. undervaluation of stocks, special depreciation) are eliminated from profits in cases where analysts are able to ascertain their existence … These can be used to create hidden or secret reserves. (Gray, 1980) Shareholders’ Perspective Secret reserve accounting is certainly conflict creating from the viewpoint of the shareholders. As a result of secret reserve accounting, the losses of the company are hidden and the shareholders are compelled to make investments or retain the shares they have bought. The process may eventually lower the share prices of the company, thus making the shareholders face losses that they do not deserve. The fiscal performance of the company is not in agreement with the actual financial situation and the shareholders might face conflicts with the claims made by the management. Communication is the key element in conflict management, particularly when dealing with the shareholders. Communication skills are necessary to avoid potential conflicts (Borisoff and Victor, 1998). However, secret reserve accounting impedes the very process of financial communication. Without authentic communication, the shareholders cannot invest when they should or they cannot sell their shares when the company is facing losses and further depreciation is actually underway. Members’ control of management is important as far as the shareholders are concerned. In order to execute derivative action, shareholders must have a say in the management. Moreover, the shareholders deserve and must obtain receivership. Shareholders also have the right to information (Willcocks, 1991). However, secret reserve accounting impedes honest communication and does not let the shareholders know what the management is actually doing despite the legal obligations. In this context, it is important to note that parties to a shareholders’ agreement might include all (if the agreement is to be a legal shareholders’ agreement) or some of the shareholders of the corporation, as well as the individual or controlling shareholders or corporate shareholders (Bollefer and Bernstein, 2009). Clearly, secret reserve accounting contradicts the integrity and viability of such shareholders’ agreements. Active involvement of the shareholders in the board of directors of the company concerned should be always welcome. But fraudulent activities on the part of the owner of the company would create serious discrepancies in relation to the capital account and the cash reserves of the company. Despite being the part of the board of directors, the shareholders are likely to be deceived outright in such circumstance. Secret reserves would apparently strengthen the position of the management but definitely harm the interests of the shareholders. So, in the case the analysts are able to unearth the secret reserves in a company, conflicts between the management and the shareholders are somewhat inevitable. Employees’ Perspective Implementation of secret reserve accounting affects management-employee relationships. In the case of industrial disputes between the management and the employees of a company, the case is likely to be settled through industrial tribunal. In the processes involved in the working of such tribunals, decisions are made on the basis of two major factors, intent and error. Whether the case lingers or the parties involved come to a mutual settlement is a question which can be answered by considering these two factors with respect to the case concerned (Knight and Latreille, 2000). Therefore, during an evidence based analysis, secret reserve accounting will not show on the financial records and the management is likely to obtain an upper hand in the course of the conflict. However, secret reserves remain prone to create conflicts between the management and the employees due to irregular financial behaviours of the company that are likely to surface with the lapse of time. If secret reserves are created and maintained, the interests of the employees may be hard hit. For example, if a financial company like a bank is exempted from the obligation of disclosing its reserve funds, particularly the secret reserves, the trade unions in relation to the concern would be prevented from effectively and fruitfully exercising the very concomitant right of collective and legitimate bargaining with respect to the issues related with bonus, wages, etc. before the industrial tribunals as the way to obtain relevant and important fiscal evidences are obstructed (Busse, 2004). In the same context, it can be further mentioned that many progressive economists who believe in the labour theory of value, hold that the transformation from labour hours to prices, along with conflict between labour and business in determining wages, describes the process by which the employees are exploited. This sort of labour hour to price transformations is a tricky way to create confusion, manipulate the accounts, and finally, exploit the employees (Sherman, Hunt and Nesiba, 2009). Secret reserve accounting can be said to be very instrumental in this context since it might help the management to compromise the wages and other benefits deserved by the employees of the company by concealing the real amounts of the profits. In such situations, the employees may even have to confront the controlling shareholders of the company who do not agree to compromise their dividends in the view of employees’ benefits due to wrong financial information and fraudulent use of secret reserves. In this way, the statement that secret reserve accounting is likely to create conflict between management, shareholders and employees appears to be valid. Conclusion Secret reserve accounting can prove to be instrumental in setting the market trends. It is mainly under the control of the management but the controlling factors may not always work in proper synchronisation. Critics contend that secret reserves allow a company to conceal a declining business. “That claim was given support by the bankruptcy of the Royal Mail Stream Packet Co., which had used its secret reserves to conceal its business problems until it was bankrupt.” (Markham, 2006, p.217) Communication, particularly the financial communication, is a key factor as far as the functionality of a company is concerned. Flow of financial information inside and outside the company is largely the responsibility of the management. The management must effectively communicate to the shareholders and the employees so that the company is run according to the standard business ethics (Drucker, 1999). However, secret reserve accounting is likely to impair honest communication. If not controlled in time, secret reserves may lead to bankruptcy which cannot be regarded as a desirable option for the management, the shareholders or the employees. Therefore, even after obtaining good financial support from the perspective of the management at the initial stages of the secret reserve accounting, things may not work well in the long run. Secret reserve accounting may benefit the management but the related conditions are not very favourable always. Effects of the secret reserves on the financial behaviour of the company are likely to lead to conflicts between the parties and stakeholders involved. To conclude, the final opinion is that secret reserve accounting is a risky financial activity which may create conflict between the management, shareholders and employees. Word count: 4016 Bibliography Berisoff, D. and Victor, D.A. (1998). Conflict Management: A Communication Skills Approach. Needham Heights: Allyn and Bacon Bollefer, S.F. and Bernstein, J. (2009). Shareholders’ Agreements: A Tax and Legal Guide. Toronto: CCH Canadian Ltd. Briggs, L.L. (1966). The Accounts Digest: Volumes 32-33. 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