pany. If he is engaged by the directors of the company his report will necessarily be made to them; but the subject-matter of any certificate on the accounts will be made the same as if his election had taken place as described.

Undoubtedly the managers of a corporation are better able to judge as to what policy will make for greater success for the company than the ordinary stockholder who has not the opportunity or advantage of a full knowledge of matters affecting the conditions which surround its affairs; but the latter is entitled to a full and complete presentation of affairs, so that he may be informed as to the true value of his holdings, that he may not be misled into thinking that his property is of less value than a complete knowledge of the facts would disclose.

The following definition has been given, and may be of interest: "A secret reserve is a device by which the condition of a business is made to appear less favorable than it actually is, through the action of the managers, without the knowledge of the board of directors; or of the board itself, without the knowledge of the other stockholders."

A number of years ago there was a defalcation of $690,000.00 in the First National Bank of New York. It was stated by the officers of the bank that the entire amount could be taken care of without making any charge against the undivided profits account. It was not understood by very many people how this was possible, and only a few were much the wiser when informed that the bank had a large secret reserve.

There are many forms that the secret reserve may take, such as writing down, to a comparatively small figure, valuable assets; making excessive provision in the way of reserves for bad debts, or other contingencies; valuing stocks of material or goods on hand below cost; or including special reserves among active liabilities under the head of accounts payable, thus making them appear as active liabilities instead of nominal accounts which do not affect the real value of the assets against which they are set off. In the case of a bank, it is more easily done with stocks and bonds, or where it owns its own buildings which can be more or less under-valued.

In justification of secret reserves several arguments have been advanced, which it may be well to consider. Perhaps the chief reason given is to provide, out of excessive profits of pros

perous years, a fund which can be drawn upon to increase the profits of less prosperous ones-the idea being to prevent fluctuation in the affairs or standing of the company, and to obtain as nearly as possible a uniform status of conditions. This policy would not seem to be in dispute, and there is no contention as to the advisability of establishing a reserve. The only question in dispute is as to whether it should be secret or not, and if so, whether the establishment of such a reserve is justifiable without the knowledge of the directors, when created by the manager; or whether the directors only should be authorized to establish it, without the knowledge of the other stockholders.

In the case of a company having made abnormally large profits in one year, due to remarkably favorable conditions in either its buying or selling market, or both, the directors may deem it wise to conceal the excessive profits in order to preclude the necessity of explaining the following year why the profits have fallen below the high mark thus set, or perhaps even below the general average. The accountant is faced with the question as to whether the object to be gained, by making the profits of the business appear to be regular, is sufficient justification for the suppression of the true facts in regard to the transactions of any one or more years, and with respect to the true financial condition of the business which is the result of those transactions.

It is claimed by those who defend the establishment of a secret reserve that it is better to conceal abnormally large profits one year so as to provide against the necessity of showing actual losses in another year, the company being looked upon as an entity. In the case of a close corporation whose stockholders are conversant with all the facts about the business, there would be no serious objection. On the other hand, there would also be no good and sufficient reason for doing it, as there would be nothing gained. Again, in the case of a company whose shares are broadly scattered, and may be disposed of at almost any time on the basis of a published statement furnished by the company, it would seem difficult to find any justification for the practice. The seller of such shares is unquestionably deprived of the advanced price that would doubtless have been obtained, if the true condition had been known to him and to the one who made the purchase of the shares. Should the purchaser, by any chance,

be one of those on the inside, who is informed as to the existence of the secret reserve of which the seller is ignorant, obviously the injustice to the latter is still more flagrant. Referring again to the bank mentioned, the one item quoted amounted to fourteen per cent of the total capital. All sales made prior to the discovering of the shortage were based on wrong assumptions, to the detriment of the sellers.

Mr. Francis W. Pixley, one of the most noted accounting authorities in Great Britain, said in St. Louis at the congress of accountants in 1904:

"Many persons consider that the duties of auditors of companies are toward the shareholders for the time being, who have a right to the full profits earned during the actual time they are holders of their shares. If, of course, the statutes of a company provide that each year the profits of the year shall be divided amongst the shareholders, than perhaps this view is correct; but this is very rarely the case, the distribution of profits of companies being in Great Britain left to the discretion of the directors. I hold the view that the duties of the auditors of a company are to the company as an institution, and not to its individual shareholders; consequently I am of the opinion that what are known as 'secret reserves' are right and proper, and tend toward the maintenance of the company as a permanent institution, and that, in fact, without these reserves it is quite impossible, having regard to the fluctuation of both financial and trading operations, for any company to exist beyond a very limited period. At the same time, these reserves must be honestly made and in the interests of the company. For directors to create secret reserves with the object of withholding profits legitimately earned from distribution to the shareholders, so as to induce them to dispose of their holdings and acquire such holdings for themselves, is as flagrant an act of dishonesty as can be conceived; and should auditors have any reason to believe that reserves are being created through improper motives, they should protest against this, and if necessary, so report to their shareholders. When, however, reserves are made bona fide in the interests of the company, then-although the auditors may consider them beyond what may be actually required-they are in my opinion, justified in passing them without comment, knowing that in so doing, the financial position of the company will be strengthened."

It will be noted that Mr. Pixley takes the somewhat remarkable position that "the duties of auditors of a company are to that company as an institution and not to its individual shareholders."

Mr. A. Lowes Dickinson, who is considered a very high authority, says in this connection, "There is a consensus of opinion that an overstatement of profits knowingly made is improper, but the opposite proposition as to an understatement of profits has so far received little consideration and yet it is of considerable importance. Corporations are the property of the stockholders, and therefore primarily anything which the stockholders or the directors elected by them may approve may be considered to be within their power to decide as they like, provided that it is within the law; and it is not suggested that there is any general law which would prohibit an understatement of profits, as it would undoubtedly prohibit an overstatement. But inasmuch as the stocks of the majority of corporations are quoted on the stock exchanges throughout the country, the corporation is in some sense the property also of the public. It becomes therefore a great question to what extent it is legitimate or proper that it should publish a statement of its earnings or its position which materially underestimates either; and yet it is obviously within the discretion of the managers or directors to make reserves to meet possible contingencies, and the constitution and by-laws of most corporations give them such powers. Inasmuch as the majority of industrial corporations do not publish their gross earnings, such reserves can easily be made and are made continually in a form in which they do not appear in any way in the accounts and are known therefore only to the directors and managers.

"Each case must be judged on its own merits. Where the directors or managers have exercised a wise discretion in providing in advance for contingent losses which are incident to the nature of the business and cannot, from a reasonable point of view, be considered in excess of the amounts which a wise foresight would provide, it would seem that no exception should be taken to the undisclosed portion thereof. Where, however, reserves are made largely in excess of any possible contingencies, the amounts provided should be disclosed in the profit and loss account and probably also in the balance sheet, so that all those

interested may be in a position to form a reasonably correct opinion as to the financial position. For instance, a business such as banking is from its nature peculiarly liable to large and unexpected losses, the disclosure of which might prejudicially affect its credit and position in the eyes of the public and of its depositors, and possibly cause a disaster out of all proportion to the cause; and it is therefore obviously sound policy to accumulate such ample reserves as will enable losses to be met without any apparent disturbance of normal conditions; but so far as the majority of corporations and businesses are concerned, publicity in such matters is undoubtedly most desirable, and all reserves to meet contingencies which may occur in the future, but have not yet occurred, should be fully disclosed."

It will be observed by these remarks that Mr. Dickinson reasons that since it is conceded to be a good thing to establish adequate reserves against contingencies, therefore secret reserves are to be allowed, provided a wise discretion is observed. However, he does not say what a wise discretion is, nor who is to be judge of its wisdom.

The theory may be advanced that the secret reserve not infrequently obtains in items that have permanently or even temporarily advanced in market value above the cost at which they were placed on the books, and that the man who is conservative is indisposed to increase the book value, and show a profit that is yet to be realized. The answer in this connection would be that there is no objection to increasing the reserve itself, the concealment of it being the only point open to criticism. In fact, it would not be necessary to increase the value on the books if the increased value is indicated in the balance sheet, or other schedules submitted to the stockholders. As an example, in the case of stocks and bonds, the amount at which these are carried on the books would remain in the balance sheet, but there should be a note appended stating the market value as being greater than the figure at which they are carried.

So as to obtain a clear idea as to whether this practice is justifiable, it will be necessary only to look at the true nature of a corporation. In all probability no one would defend the managing partner of an ordinary co-partnership if he were deliberately to understate the profits so as to prevent his partners from drawing out greater dividends than in his judgment would