Why Create a Depreciation Reserve?
Companies create a reserve for replacing their assets as -- and when -- they stop functioning. This reserve is called "depreciation reserve." Money is transferred into this reserve at the end of every year throughout the asset's useful life. Through this mechanism, the company has already amassed sufficient funds to replace the asset when it stops working.
The reserve for depreciation ensures that by the time the asset stops functioning, the company already collected sufficient necessary funds to buy new ones. The company does not suffer losses when the situation arises. Constant usage, wear-and-tear and obsolescence are responsible for the decline in the value of the asset. Also, the availability of better and more improved assets in the market causes the value to diminish.
The depreciation reserve account is shown on the company's financial statements. It is listed under the "long-term liabilities" head. The depreciation reserve account is also referred to as accumulated depreciation. The amount by which the asset is depreciated each year is deducted from the value of the asset. Each year, the amount set aside is deducted from the asset to show the value at its true price. This is the price that the asset would command if it were to be sold today in the market.
Every asset that the company owns has its own depreciation reserve account. The yearly depreciation on the asset is added to the depreciation reserve account. For example, say the company bought the asset for $50,000 and then decides to depreciate the asset at a constant rate of rate of 25 percent and assumes the productive life to be four years and the scrap value to be $10,000. Each year $10,000 would be added to the depreciation reserve account and $10,000 would be subtracted from the asset account.
The depreciation reserve provides tax benefits to the company. Companies are not liable to be taxed on the depreciation reserve money. This increases the company's profitability. This money is then either distributed to the shareholders as dividends or retained back into the business for its growth initiatives. When the extra money is paid out as dividends, the company has greater numbers of satisfied shareholders. A company's financial standing and goodwill increase tremendously. When the money is retained back, the company gets a chance to research further and try to improve its products, services and systems.