Salvage Value

What Is Salvage Value?

Salvage value is the estimated book value of an asset after depreciation is complete, based on what a company expects to receive in exchange for the asset at the end of its useful life. As such, an asset’s estimated salvage value is an important component in the calculation of a depreciation schedule. 

Understanding Salvage Value

An estimated salvage value can be determined for any asset that a company will be depreciating on its books over time. Every 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 so minimal. In general, the salvage value is important because it will be the carrying value of the asset on a company’s books after depreciation has been fully expensed. It is based on the value a company expects to receive from the sale of the asset at the end of its useful life. In some cases, salvage value may just be a value the company believes it can obtain by selling a depreciated, inoperable asset for parts.

Depreciation and Salvage Value Assumptions

Companies take into consideration the matching principle when making assumptions for asset depreciation and salvage value. The matching principle is an accrual accounting concept that requires a company to recognize expense in the same period as the related revenues are earned. If a company expects that an asset will contribute to revenue for a long period of time, it will have a long, useful life.

If a company is not sure of an asset’s useful life, it may estimate a lower number of years and a higher salvage value to carry the asset on its books after full depreciation or sell the asset at its salvage value. If a company wants to front load depreciation expenses, it can use an accelerated depreciation method that deducts more depreciation expenses upfront. Many companies use a salvage value of $0 because they believe that an asset’s utilization has fully matched its expense recognition with revenues over its useful life.

Depreciation Methods

There are several assumptions required for developing depreciation schedules. There are five primary methods of depreciation financial accountants can choose from: straight-line, declining balance, double-declining balance, sum-of-years digits, and units of production. The declining balance, double-declining balance, and sum of years digits methods are accelerated depreciation methods with higher depreciation expense upfront in earlier years.

Each of these methods requires consideration for salvage value. An asset's depreciable amount is its total accumulated depreciation after all depreciation expense has been recorded, which is also the result of historical cost minus salvage value. The carrying value of an asset as it is being depreciated is its historical cost minus accumulated depreciation to date.

Straight-Line Depreciation

Straight line depreciation is generally the most basic depreciation method. It includes equal depreciation expenses each year throughout the entire useful life until the entire asset is depreciated to its salvage value.

Assume, for example, that a company buys a machine at a cost of $5,000. The company decides on a salvage value of $1,000 and a useful life of five years. Based on these assumptions, the annual depreciation using the straight-line method is: ($5,000 cost - $1,000 salvage value) / 5 years, or $800 per year. This results in a depreciation percentage of 20% ($800/$4,000).

Declining Balance

The declining balance method is an accelerated depreciation method. This method depreciates the machine at its straight line depreciation percentage times its remaining depreciable amount each year. Because an asset's carrying value is higher in earlier years, the same percentage causes a larger depreciation expense amount in earlier years, declining each year.

Using the example above, the machine costs $5,000, has a salvage value of $1,000, a 5-year life, and is depreciated at 20% each year, so the expense is $800 in the first year ($4,000 depreciable amount * 20%), $640 in the second year (($4,000 - $800) * 20%), and so on.

Double-Declining Balance

The double-declining balance (DDB) method uses a depreciation rate that is twice the rate of straight-line depreciation. In the machine example, the depreciation percentage is 20%. Therefore, the DDB method would record depreciation expenses at (20% x 2) or 40% of the remaining depreciable amount per year.

Both declining balance and DDB require a company to set an initial salvage value to determine the depreciable amount.

Sum-of-Years Digits

This method creates a fraction for depreciation calculations. Using the example above, if the useful life is five years the denominator is 5+4+3+2+1=15. The numerator is the number of years left in the asset's useful life. The depreciation expense fraction for each of the five years is then 5/15, 4/15, 3/15, 2/15, and 1/15. Each fraction is multiplied times the total depreciable amount.

Sum of Years

15=5+4+3+2+1

Units of Production

This method requires an estimate for the total units an asset will produce over its useful life. Depreciation expense is then calculated per year based on the number of units produced. This method also calculates depreciation expenses based on the depreciable amount.