Farwah Jafri | November 28 2023
Salvage value is the remaining book value of something valuable (like a machine or equipment) after it has gone through wear and tear, based on what a company thinks it can get when it sells or exchanges that thing at the end of its useful life. So, when a company figures out how much something will lose value over time (depreciation), they also think about what it might still be worth at the end, and that’s the salvage value of that asset.
Companies determine the estimated after tax salvage value for anything valuable they plan to write off as losing value (depreciation) over time. Each company has its way of guessing how much something will be worth in the end. Some companies might say an item is worth nothing (zero dollars) after it’s all worn out because they don’t think they can get much. But generally, salvage value is important because it’s the value a company puts on the books for that thing after it’s fully depreciated. It’s based on what the company thinks they can get if they sell that thing when it’s no longer useful. Sometimes, salvage value is just what the company believes it can get by selling broken or old parts of something that’s not working anymore.
The after-tax salvage value formula is:
Salvage Value of Asset = Original Cost OR Sale Value of Assets – (Accumulated Depreciation + Tax paid on disposal of asset)
Companies consider the matching principle when they guess how much an item will lose value and what it might still be worth (salvage value). The matching principle can be considered to be a rule in accounting that says if you’re making money from something, you should also recognize the cost of that thing during the same period. If a company believes an item will be useful for a long time and make money for them, they might say it has a long useful life.
If a company is still determining how long something will be useful, they might guess a shorter time and say it’s worth more at the end (higher salvage value) to keep it on their books longer. Or, if they want to show more expenses early on, they might use a method that makes the item lose more value at the beginning (accelerated depreciation). Some companies say an item is worth nothing (salvage value of $0) because they think it has paid for itself by making money over time.
There are different ways companies can guess how much something will lose value over time (depreciation). They can choose from several methods, but for your ease of understanding, we are mentioning five major ones:
Some methods make the item lose more value at the start (accelerated methods), like declining balance, double-declining balance, and sum-of-the-years-digits. Each method needs to think about salvage value. The depreciable amount is like the total loss of value after all the loss has been recorded. It’s the historical cost minus the salvage value. The carrying value is what the item is worth on the books as it’s losing value. It’s the historical cost minus all the losses recorded so far.
The straight-line depreciation method is one of the simplest ways to calculate how much an asset’s value decreases over time. It spreads the decrease evenly over the asset’s useful life until it reaches its salvage value.
In formula format, this is what it looks like:
Depreciation Expense = (Cost of Asset – Salvage Value) / Useful Life
For instance, a company buys a machine for $5,000 with a salvage value of $1,000 and a useful life of five years. With straight-line depreciation, each year’s depreciation is $800 ($5,000 – $1,000 / 5 years), making the yearly depreciation percentage 20%.
The declining balance method is a faster way to depreciate an asset. It uses the straight-line percentage on the remaining value of the asset, which results in a larger depreciation expense in the earlier years.
This is what the formula for this method looks like:
Depreciation Expense = Book Value at the Beginning of the Year x Depreciation Rate
In the example, the machine costs $5,000, has a salvage value of $1,000, and a 5-year life. With a 20% depreciation rate, the first-year expense is $800, and the second year is $640, and so on.
The double-declining balance method doubles the straight-line rate for faster depreciation. With a 20% straight-line rate for the machine, the DDB method would use 40% for yearly depreciation.
This is what the formula looks like:
Depreciation Expense = 2 x (1 / Useful Life) x (Book Value at the Beginning of the Year)
Both declining balance and DDB methods need the company to set an initial salvage value.
This method creates a fraction for depreciation.
This is what the formula looks like:
Depreciation Expense = (Remaining Useful Life / Sum of the Years’ Digits) x (Cost of Asset – Salvage Value)
For a five-year asset, the fraction is 5/15, 4/15, 3/15, 2/15, and 1/15 for each year.
The 15 is arrived at by adding the digits of all the years being considered, i.e. 5 + 4 + 3 + 2 + 1 = 15
This method estimates depreciation based on the number of units an asset produces. The yearly depreciation is calculated per unit produced.
This is what the formula looks like:
Depreciation Expense = (Number of Units Produced / Total Units Expected) x (Cost of Asset – Accumulated Depreciation)
To estimate salvage value, a company can use the percentage of the original cost method or get an independent appraisal. The percentage of cost method multiplies the original cost by the salvage value percentage.
Companies can also use industry data or compare with similar existing assets to estimate salvage value. For example, a delivery company might look at the value of its old delivery trucks for guidance.
Salvage value helps to figure out how much your old stuff is worth when it’s done being useful. It’s the estimated value of something, like a machine or a vehicle, when it’s all worn out and ready to be sold. This differs from book value, which is the value written on a company’s papers, considering how much it’s been used up.
There’s also something called residual value, which is quite similar but can mean different things. Sometimes, it’s about predicting the value of the thing when a lease or loan ends. Other times, it’s about figuring out how much it’s worth when it’s done for good, minus the cost of getting rid of it. Salvage value might only focus on its worth when it’s done, without considering selling costs.
Then there’s scrap value, which is like salvage value but more specific. Scrap value might be when a company breaks something down into its basic parts, like taking apart an old company car to sell the metal. The money they get from this breakdown could also be seen as salvage value.
Salvage value can be considered the price a company could get for something when it’s all used up. Sometimes, the thing might be sold as is, but other times, it might be taken apart and the pieces sold. So, salvage value is the money a company expects to make when they get rid of something, even if it doesn’t include all the selling or throwing away costs.
After tax salvage value is like the retirement money for a company’s equipment. It’s the amount a company thinks it will get for something when it’s time to say goodbye to it. Companies use this value to figure out how much to subtract from the original cost of the thing when calculating its wear and tear. It’s also handy for guessing how much money they might make when they get rid of it.
Monily is a finance and accounting company that offers a wide range of services including tax preparation, bookkeeping, payroll and more. If you have any questions regarding your business or personal finances, talk to our experts and book a free consultation at https://monily.com/mfccalendly.
Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.