What Is a Reserve for Depreciation in Accounting?

“Reserve for depreciation” is an older accounting phrase now known as “accumulated depreciation.” This account tracks the total cost of an asset that has been expensed since it was put into service, representing the portion of its value considered used up.

This concept is part of accrual accounting, matching an asset’s cost to the revenues it helps generate over its life. This process ensures financial statements reflect the declining value of tangible assets like buildings and machinery. The account is an accounting entry, not a cash fund set aside for asset replacement.

Calculating Annual Depreciation

To determine the annual depreciation, a company needs three pieces of information. The first is the asset’s initial cost, including the purchase price and any costs to get it ready for use, like shipping and installation fees. The second is its estimated useful life, which is how long the company expects the asset to be productive. The final piece is the estimated salvage value, or the amount the company expects to sell the asset for at the end of its useful life.

The most common method for calculating this annual figure is the straight-line method, which spreads the cost of the asset evenly over its useful life. The calculation involves subtracting the asset’s salvage value from its initial cost to find the depreciable base. This amount is then divided by the estimated useful life to arrive at the annual depreciation expense.

For example, imagine a business purchases equipment for $50,000. It estimates the machine will have a useful life of ten years and a salvage value of $5,000. The depreciable base would be $45,000 ($50,000 cost – $5,000 salvage value). The annual depreciation expense would then be $4,500 ($45,000 / 10 years), an amount recorded each year for ten years.

Depreciation on the Financial Statements

The process of depreciation affects two primary financial statements: the income statement and the balance sheet. Each year, the calculated depreciation amount is recorded as “Depreciation Expense” on the income statement. This entry functions like any other operating expense, reducing the company’s reported net income and its taxable income for the period.

Simultaneously, this amount is added to the “Accumulated Depreciation” account on the balance sheet. This is a contra asset account, meaning its balance is used to offset the value of a related asset. It appears in the Property, Plant, and Equipment (PP&E) section of the balance sheet directly below the asset it relates to.

The net amount, calculated as the asset’s original cost minus its accumulated depreciation, is called its “book value” or “carrying value.” For instance, if a building was purchased for $500,000 and has $150,000 in accumulated depreciation, the PP&E section would show the building at its cost of $500,000, less the accumulated depreciation of $150,000, resulting in a book value of $350,000.

Handling Asset Disposal

When a company sells or retires a fixed asset, it must remove the asset from its accounting records. This involves eliminating both the asset’s original cost from the Property, Plant, and Equipment (PP&E) section and its total accumulated depreciation. This prevents misstating the company’s financial position by showing assets it no longer owns.

A financial gain or loss on the disposal is calculated by comparing the cash received from the sale to the asset’s book value at that time. If the cash received is greater than the book value, the company records a gain on disposal. If the cash is less than the book value, it records a loss.

Continuing the earlier example, suppose the equipment with a $50,000 cost and a book value of $27,500 (after five years of $4,500 annual depreciation) is sold. If the company receives $30,000 in cash, it would recognize a $2,500 gain ($30,000 cash – $27,500 book value). Conversely, if it only received $20,000, it would recognize a $7,500 loss. This gain or loss is then reported on the income statement.