Salvage Value is the amount that a company expects to get at the end of the useful life of an asset. There are various terms for salvage value such as residual value, scrap value, and disposal value.
Let’s assume you buy a vehicle with a useful life of 15 years. After its useful life or after fifteen years, the vehicle should end up in a junkyard. The salvage value of the vehicle would be the price that the junkyard or a recycler might pay for it.
Usually, a company estimates the salvage value to assess the annual amount of depreciation expense during the asset’s useful life. For example, Company A buys a car costing $20000, and its useful life is ten years. After ten years, the company estimates its useful life of $2000. So, depreciation, in this case, will be (($20000 – $2000)/10) $1800 per year.
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Why it’s Important?
In the organization, salvage value is significant as it allows the companies to calculate the depreciation. For instance, Company A purchases machinery for $1 million and its useful life is ten years. The company would expect some value for the machine after ten years, let’s say $10,000. So, the company would record a depreciation expense on $990,000 over ten years.
As per the IRS (Internal Revenue Service), a company must estimate a “reasonable” salvage value.” The value primarily depends on the number of years that the company plans to use and the way the company uses the asset.
On the other hand, accountants and income tax regulations usually do not to take salvage value in the consideration. Or, take the scrap value as zero. Therefore, they depreciate the total cost of the asset over the number of years for which the asset is in use in the business.
Determining Salvage Value
There are three ways of determining the dollar amount of salvage value. In the first, we need to estimate the number of years an asset will be usable. Then we look at the sale price of similar assets of the same age on the market currently. In case, we find multiple values, we take an average.
For example, Company A buys a machine for $20000 whose useful life is ten years. Price of similar machines of the same age (ten years) on the market is $3000, $2500, $2800. In this case, the salvage value will be (($3000+$2500+$2900)/3) $2800.
The second approach is using the formula. The basic formula of salvage value is – S = P (1-i)y
S = Salvage Value; P = Original cost of the asset; i = depreciation rate; y = number of years
In order to find the salvage value, first, we need to determine the depreciation rate. Also, the company has to determine the number of years an asset would last or the useful life of the asset.
For instance, a company buys a car for business at $1000000 and expects its useful life to be twenty years. The depreciation rate is 20%. Now, scrap value will be $1000000 (1-20%)^20 or $11530 (approx).
Third and the most common approach is to take the salvage to zero. In this approach, there is no chance of people tricking accounts. There have been several cases when people underestimate or overestimate salvage value to inflate or deflate their income and tax. Analysts and tax experts see this approach as more practical and conservative. Such an approach does not result in auditing issues.
Under or Over Estimation of Salvage Value
As said above, the salvage value is important for businesses as they impact the size of a company’s depreciation expense. However, the companies just make their best estimates and not a definite number. We call it an estimate because one can only guess the real value of an asset after ten years.
The higher the scrap value of an asset, the less is the depreciation. And, this leads to higher profits. Thus, it becomes very important to assess the salvage value correctly. A wrong estimation might lead to various issues such as:
- Wrong estimation may result in wrong depreciation expense. This is turn could overestimate or underestimate the net income.
- It may lead to undervaluation or overvaluation of the equity (retained earnings) of the company in the balance sheet.
- Total fixed assets balance may also give an inaccurate picture in the balance sheet.
- Value of loan collateral and debt-to-equity ratio would also be inaccurate. This may make it difficult for the company to secure a loan.
Talking of a real-world example, a company by the name Waste Management, Inc did several frauds between 1992 and 1997 by misusing salvage value. The company tried to avoid depreciation by inflating the scrap value and increasing the useful life of assets. The company did this to meet earnings targets. In 1998, the company had to restate its earnings by $1.7 billion, the biggest restatement in history.
What Should You Do?
As we said above, the scrap value is an estimate of the value of an asset that becomes unusable for the original purposes. Also, even if the asset is usable, its efficiency is not the same. However, if we discount this scrap value to the present value, then it won’t be correct and feasible. Also, it will be difficult to find the right discounting rate.
It is, therefore, better to take zero value for applying depreciation on the asset. If we assume the value to be zero, then there would be no chance of reduction in the depreciation amount. This, in turn, would mean no chances of inflating profit due to depreciation.
The US Income Tax Regulations also ask taxpayers to assume the scrap value of the asset to be zero for calculating depreciation. And, if after the useful life, the asset fetches some value, then we can show it as a gain.