Salvage Value, also known as residual value or scrap value, is the estimated book value of the asset at the end of its useful life. It is not used under MACRS.
Every company has its criteria for determining salvage value. Some companies may choose to depreciate an asset to $0 if its salvage value is minimal or negligible, whereas other companies do consider the salvage value that they get by selling the asset after depreciation when it is substantial and can impact the financial statements under materiality concept.
The salvage value is used to determine the annual depreciation expense of an asset. The asset’s value is recorded on the company’s balance sheet while the annual depreciation expense is recorded on the company’s income statement.
Why is Salvage Value important?
Salvage Value is important because it affects the company’s record if recorded incorrectly. The Internal Revenue Service (IRS) wants the companies to estimate a “reasonable” salvage value which depends on how long the asset is going to be useful for the company and how the asset is actually used.
If the salvage value is set too high
Depreciation would result in a lower value for assets over time, leading to an understatement.
Due to lower depreciation, this would in turn overstate net income and cause overstatement of total fixed assets and retained earnings on the balance sheet.
If the salvage value is set too low
If depreciation is overstated, it will lead to an understatement of net income.
This will also cause the total fixed assets and retained earnings to be understated on the balance sheet.
The values for the debt-to-equity ratio and loan collateral would be lower. As a result, the company may encounter difficulties in securing future financing or may violate loan covenants that require the company to maintain certain minimum debt ratio levels.
The impact of the salvage value assumption on the asset’s annual depreciation is as follows:
Purchase Price: It refers to the cost of the asset at which it is purchased including the item price, commission, installation, testing, etc.
Annual Depreciation: It refers to the asset’s value that is recorded when the asset is used up. To find the annual depreciation, the depreciable cost is divided by the asset’s useful life assumption.
Useful life: It refers to the estimated time the assets are expected to be useful for the company.
Steps to Calculate the Salvage Value
Step 1: Establish the Asset’s Initial Cost
This involves figuring out the asset’s acquisition price as well as any additional expenses related to preparing it for usage.
Step 2: Calculate the Asset’s Useful Life
Establish how long the asset is anticipated to be used. Years, months, or any other time unit may be used for this.
Step 3: Choose the Depreciation technique
To compute the annual depreciation expense, choose the suitable depreciation technique (such as straight-line, decreasing balance, units of production, etc.).
Step 4: Determine the Total Depreciation Expense
Over the asset’s useful life, determine the total depreciation expense using the selected depreciation method.
Step 5: Take the Total Depreciation and Subtract It from the Original Cost
The asset’s salvage value is its remaining value after depreciation is taken into consideration.
Example of Salvage Value
Drone Private Limited brought a computer for $1,000. The company estimated the useful life as 4 years and the rate of depreciation is 10%. The company follows the straight-line depreciation method. Calculate the salvage value.
Solution:
Asset’s Useful Life = 4 years ( given)
Rate of depreciation = 10% (given)
Annual depreciation = $100
Year
Book Value (at the beginning)
Annual Depreciation
Book Value (at the end)
1st
$1000
$100
$900
2nd
$900
$100
$800
3rd
$800
$100
$700
4th
$700
$100
$600
Salvage Value= 1000 – (100*4)
= $600
Merits of Salvage Value
Making Well-Informed Decisions: Businesses can make more informed decisions about when to replace assets by knowing the salvage value. When an asset nears the end of its useful life, it makes better decisions about whether to sell it or keep using it.
Planning for Asset Disposal: Salvage value plays a role in asset disposal planning. Companies are able to project the amount of money they might get from selling the asset and incorporate that into their financial plans.
Tax Regulations: A lot of tax authorities mandate that salvage value be taken into account when calculating depreciation. Accurately recording it guarantees adherence to tax laws, possibly preventing fines.
Resource Optimization: Businesses are encouraged to make the most use of their assets by taking salvage value into consideration, which reduces waste and boosts overall economic efficiency.
Lower Depreciation Costs: Companies can cut their annual depreciation expenditure by taking salvage value into consideration. As a result, financial statements are more accurate and accurately reflect the true cost of using assets.
Demerits of Salvage Value
Requirements for Adjustment: Previous depreciation calculations may need to be modified if the projected salvage value evolves over time as a result of fresh data or shifting market dynamics. Financial records may become more complicated.
Management of Earnings: Businesses may alter estimations of salvage value in order to control earnings.
Capital Allocation Distortions: A company’s capital allocation decisions may be distorted if salvage values are consistently overestimated or underestimated.
Conclusion
Salvage value represents the amount a company expects to receive for an asset at the end of its useful life. It is deducted from the original cost of the asset to calculate depreciation. Every business must calculate the salvage value accurately based on the asset type and its usage as it can be used to predict cash flow and expected future proceeds.
