What Is a Depreciation Reserve in Accounting?

A depreciation reserve is an accounting entry that methodically tracks the total depreciation recorded against a tangible asset since it was put into service. While “depreciation reserve” is an older term, it is synonymous with the more contemporary “accumulated depreciation.” The purpose of this account is to show how much of an asset’s economic benefit has been consumed over time, providing a more accurate picture of the asset’s current value on a company’s books.

Calculating the Annual Depreciation Amount

Calculating the annual depreciation requires three key figures. The first is the asset’s initial cost, which includes the purchase price plus any costs required to get the asset ready for its intended use, such as shipping and installation. The second is the asset’s estimated salvage value, its expected residual value at the end of its operational use. The third component is the asset’s estimated useful life, the period over which it is expected to generate economic benefits for the company.

The most common method for calculating annual depreciation is the straight-line method. The formula is (Asset Cost – Salvage Value) / Useful Life, which spreads the cost of the asset evenly over its lifespan. For instance, a delivery vehicle purchased for $45,000 with a five-year useful life and a $5,000 salvage value would have an annual depreciation of $8,000. Each year, the company records this amount, increasing the depreciation reserve. While other methods like declining balance exist, the straight-line approach is common for its simplicity.

The Depreciation Reserve on the Balance Sheet

The depreciation reserve is a contra-asset account, which is an asset account with a credit balance that offsets the debit balance of a corresponding fixed asset. It is paired with assets like buildings or equipment to reduce their carrying value on the balance sheet. This presentation provides a clearer picture of the asset’s value after accounting for its use.

When depreciation is recorded, a journal entry is made that debits Depreciation Expense and credits the Depreciation Reserve. The expense appears on the income statement, reducing the company’s reported net income. The credit to the reserve increases its balance on the balance sheet, which directly lowers the asset’s book value.

On the balance sheet, an asset is listed at its original historical cost, with the depreciation reserve shown as a deduction to arrive at the asset’s net book value. For example, if a piece of machinery was purchased for $100,000 and has a depreciation reserve of $40,000, the balance sheet would report it as: Machinery (at cost): $100,000; Less: Depreciation Reserve: ($40,000); Net Machinery: $60,000. This net figure represents the asset’s value for accounting purposes.

Accounting for Asset Disposal

When a company sells, retires, or otherwise disposes of a fixed asset, it must be removed from the financial records. The process involves eliminating both the asset’s original cost and its entire associated depreciation reserve from the balance sheet. This action ensures that the financial statements no longer reflect an asset that the company no longer owns or uses.

A gain or loss on the disposal is calculated by comparing the asset’s net book value at the time of disposal with any cash received. If the cash received is greater than the net book value, a gain is recorded. If the cash is less than the net book value, a loss is recorded.

For example, consider machinery with a cost of $100,000 and a depreciation reserve of $90,000, resulting in a net book value of $10,000. If the company sells the machinery for $12,000 in cash, it would recognize a $2,000 gain on the sale. The journal entry would debit Cash for $12,000 and the Depreciation Reserve for $90,000, and credit Machinery for $100,000 and Gain on Disposal of Asset for $2,000. This entry properly clears the asset and its reserve while recording the financial outcome of the transaction.