Understanding Salvage Value: Definition, Calculation, and Examples

What Is Salvage Value?

Salvage value represents the expected value a company anticipates after fully depreciating an asset at the end of its useful life. This concept aids in calculating depreciation schedules and impacts how companies manage their assets' book values. Understanding salvage value involves determining the asset's remaining worth, usually by appraisals, cost percentages, or historical data.

How to Estimate 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.

Salvage value is important because it becomes the asset's value on company books after depreciation. 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.

Key Assumptions for Depreciation and Salvage Value

Companies consider the matching principle when estimating 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 unsure of an asset's life, a company might use a shorter life estimate and a higher 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 set the salvage value at $0, believing the asset's use matches its revenue over its life.

Common Methods of Depreciation

Developing depreciation schedules involves several assumptions. There are five primary methods of depreciation that 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 method considers 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. In earlier years, an asset's higher value leads to larger depreciation expenses, which decrease annually.

Using the example above, the machine costs $5,000, has a salvage value of $1,000, a five-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% × 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.

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.

Salvage Value Calculation Methods

Companies can estimate an asset's salvage value in several ways. First, it may use the percentage of the original cost method. This method assumes that the salvage value is a percentage of the asset’s original cost. To calculate the salvage value using this method, multiply the asset’s original cost by the salvage value percentage.

Percentage of Cost Method: Original Cost * Anticipated Salvage Value Percentage

Companies can also get an appraisal of the asset by reaching out to an independent, third-party appraiser. This method involves obtaining an independent report of the asset’s value at the end of its useful life. This may also be done by using industry-specific data to estimate the asset’s value.

Companies can also use comparable data with existing assets they owned, especially if these assets are normally used during the course of business. For example, consider a delivery company that frequently turns over its delivery trucks. That company may have the best sense of data based on their prior use of trucks.

Comparing Salvage Value to Other Financial Values

Salvage value is the estimated value of an asset at the end of its useful life. It represents the amount that a company could sell the asset for after it has been fully depreciated. On the other hand, book value is the value of an asset as it appears on a company’s balance sheet. It is calculated by subtracting accumulated depreciation from the asset’s original cost. The balance sheet reports the book value, not the salvage value.

Salvage value is also similar to but still different from residual value. In some contexts, residual value refers to the estimated value of the asset at the end of the lease or loan term, which is used to determine the final payment or buyout price. In other contexts, residual value is the value of the asset at the end of its life less costs to dispose of the asset. In many cases, salvage value may only reflect the value of the asset at the end of its life without consideration of selling costs.

Last, salvage value is most comparable to scrap value. There may be a little nuisance as scrap value may assume the good is not being sold but instead being converted to a raw material. For example, a company may decide it wants to just scrap a company fleet vehicle for $1,000. This $1,000 may also be considered the salvage value, though scrap value is slightly more descriptive of how the company may dispose of the asset.

Example of Salvage Value

Imagine a situation where a company acquires a fleet of company vehicles. The company pays $250,000 for eight commuter vans it will use to deliver goods across town. If the company estimates that the entire fleet would be worthless at the end of its useful life, the salvage value would be $0, and the company would depreciate the full $250,000.

Let’s say the company assumes each vehicle will have a salvage value of $5,000. This means that of the $250,000 the company paid, the company expects to recover $40,000 at the end of the useful life.

To appropriately depreciate these assets, the company would depreciate the net of the cost and salvage value over the useful life of the assets. The total amount to be depreciated would be $210,000 ($250,000 less $40,000). If the assets have a useful life of seven years, the company would depreciate the assets by $30,000 each year.

The Bottom Line

Salvage value represents the expected amount a company can recover from an asset at the end of its useful life, often influencing depreciation calculations. Companies deduct the salvage value from an asset's original cost to determine its total depreciable amount. Accurate estimation of salvage value can aid in forecasting cash flows and anticipating future proceeds, though it's typically an estimate rather than a precise figure. Utilizing methods such as the percentage of cost, appraisals, or historical comparables helps companies make informed depreciation and financial planning decisions.