SALVAGE VALUE: How To Calculate Salvage Value

SALVAGE VALUE: How To Calculate Salvage Value
SALVAGE VALUE: How To Calculate Salvage Value

Estimated salvage value can be determined for any asset that a company will depreciate on its books over time.  Each company will have its own standards for estimating salvage value. 

Some companies may choose to always depreciate an asset to $0 because its salvage value is minimal.  In general, salvage value is important because it will be the asset’s book value on the company’s books after depreciation has been fully expensed.

What Is Salvage Value?

Salvage value is the estimated value of an asset after its useful life has expired and therefore cannot be used for its original purpose. 

For example, if a company’s equipment has a useful life of 5 years and at the end of the 5 years its value is only $5,000, then the $5,000 is the salvage value.

Another name for this value is scrap value.  And this is only an approximate estimate.  Ten years from now, no one knows how much equipment or technology will cost.  Part of the asset may also end up in a landfill.

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How Does It Work?

Salvage value (also often called “scrap value” or “residual value”) is the value of an asset at the end of its useful life. In other words, if equipment is purchased for your business needs, it should be designated as an asset. 

Over time, due to use or new technology, this asset begins to lose value, and this is tracked using depreciation.

The amount a product is worth at the end of its “useful life” (when it no longer functions properly or when it is no longer needed by your business) is the salvage value of that particular asset and can be taken into account for resale or write-off prices (if applicable).

Since residual value is based on the value of the product at the end of the period it is used for your business, tracking depreciation starts at the purchase price.  This acts as the initial value.

  This means that even if you purchased a used asset, such as machinery or computer equipment, the purchase price is the value at the time the asset was acquired.  When setting up depreciation, this is the amount required to start applying the depreciation method.

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Salvage Value Example

For example: A photographer buys a new specialist digital SLR camera for £1249.  As it relates specifically to his business, it can be marked as an asset.  When entering the original cost of the asset, they will enter the price paid on purchase (£1249).

If they estimate that they will use this camera for 7 years, after which they will likely purchase a newer camera due to technological advances etc., this time period can be entered for depreciation purposes.  Depending on the depreciation method used, the value of the camera at the end of those 7 years is the salvage value of that asset.

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How To Determine The Salvage Value Of An Asset

The Internal Revenue Service (IRS) requires companies to estimate a “reasonable” liquidation value.  The cost depends on how long the company plans to use the asset and how intensively it is used. 

For example, if a company sells an asset before the end of its useful life, a higher cost may be justified.  Typically, companies set zero salvage value for assets that have been in use for a long time, are relatively inexpensive, or if the technology is rapidly becoming obsolete (5-year-old printer, 4-year-old laptop, etc.).

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How To Use Salvage Value to Determine Depreciation

Estimated salvage value is deducted from the cost of the asset to determine the total amount of the depreciable asset. For example, Company A buys a computer for $1,000.  According to the company’s estimates, the useful life of the computer is 4 years. 

This means that the computer will be used by Company A for 4 years and then sold.  The company also believes that after 4 years they will be able to sell the computer for a residual value of $200.  The company follows the straight-line method of depreciation.

Salvage Value of Cars

The liquidation value is usually much lower than the value of the used car, depending on several factors, primarily whether the car is refurbished or not.

If the car has not been repaired after a serious accident, the salvage value will be only 10% to 50% of the value of the used car.  Even if you spend out-of-pocket for major repairs or insurance pays for them, you’ll likely get about 70% of the value of a used car that’s never been damaged.

In any case, the NADA car value is rarely an adequate indicator of your car’s value, as dealers and used car buyers will try to discount even pristine used cars to cover their bases and increase their profits.

When you own your car, it can be difficult to sell 70% off a used car that hasn’t been in a major accident.  This means that any time, effort or money you spend on car repairs is potentially wasted, so you’re better off cutting your losses and switching to a new car.

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How is Salvage Value Calculated?

Once you have determined the asset’s salvage value, you are ready to calculate depreciation.  Follow these steps.

Calculate the purchase price of the asset

Let’s determine how much you paid for the asset, including all depreciable costs.  GAAP says to include sales tax and installation fees in the purchase price of an asset.

Let’s say you’re a chocolate business owner who bought an industrial refrigerator to store all your sweets.  You paid $10,000 for the refrigerator, $1,000 in sales tax, and $500 in installation. 

So the total cost of your refrigerator is $11,500.  $10,000 (refrigerator) + $1,000 (sales tax) + $500 (installation fee) = $11,500

Find the depreciable cost

The cost of a depreciable asset is the difference between the purchase price and the salvage value.  Use the following formula:  Asset acquisition price – Liquidation value = Depreciable value

Let’s say a refrigerator has a useful life of seven years, and seven-year-old industrial refrigerators cost an average of $1,000.  The depreciable cost of the refrigerator is $10,500 (purchase price of $11,500 less salvage value of $1,000).

Selection of the depreciation method

GAAP allows you to choose a depreciation method.  You must remain consistent across similar assets; if you have two refrigerators, they cannot use different depreciation methods.  There are four depreciation methods at your disposal:

  • Straight line
  • Halving balance
  • Figures of sum of years
  • Units of production

Most businesses choose the straight-line method, which recognizes straight-line depreciation expense over the asset’s useful life.  However, you can choose a depreciation method that approximates how the asset loses value over time.

For example, the double-declining balance method works well for new cars because they tend to lose a significant amount of value in the first couple of years.  Unlike other methods, the double-declining balance method does not use residual value in its calculation.

Create a schedule of depreciation

You are now ready to calculate the depreciation for your fixed asset.  Create a depreciation schedule using monthly or annual asset depreciation.

For the refrigerator, I will use the straight line method.  To calculate annual depreciation using the straight-line method, use the following formula:  Depreciable cost ÷ Useful life in years = Annual depreciation

Annual straight-line depreciation for the refrigerator is $1,500 ($10,500 depreciable ÷ seven-year useful life).

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Conclusion

In different accounting standards, different valuation methods are provided for calculating the liquidation value.  Liquidation value plays an important role in determining the annual depreciation of an asset. 

Generally, the salvage value is very minimal compared to the original cost because the assets are fully utilized.  The depreciation base is calculated by subtracting the salvage value from the original cost to determine the annual depreciation value.

If the salvage value is too difficult to determine or the salvage value is expected to be minimal, then there is no need to include the salvage value in the depreciation calculations.  Instead, simply depreciate the entire cost of the fixed asset over its useful life.  Any proceeds from the final disposal of the asset will be recorded as a gain.

Salvage Value FAQs

Can Salvage Value Concept Be Used In A Fraudulent Manner?

The concept of salvage value can be used fraudulently to estimate the high salvage value of certain assets, leading to understatement of depreciation and thus higher than normal profits.  When this happens, a loss will eventually be recorded when the assets are eventually disposed of at the end of their useful lives.  Auditors should review salvage value levels as part of their year-end audit procedures relating to property, plant and equipment to see if they are reasonable.

How Does Straight-Line Depreciation Work?

There are several different methods of tracking the depreciation of an asset.  The most common method is known as straight-line depreciation.  This method takes into account the type of asset.  For example, electronics depreciate faster than other types of assets due to the rapid pace of development.

What Happens To Salvage Vehicles?

Used vehicles are usually sent directly to the junkyard by insurance companies, but sometimes the ownership of used cars can be obtained by those drivers who do not want to part with their beloved vehicle or sell it at auction, or restore it to near factory specifications and resell it to the public.

References

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