What is Salvage Value?
Eventually, an asset will reach the end of its serviceable life. When it does, a company might choose to sell it. Whatever the company can get for it at that time is its salvage value. It’s the estimated book value of a depreciable asset at the end of its expected useful life.
As companies seek to better understand asset depreciation, salvage value becomes an important factor to consider. Not only does it represent recouped cost in the future, it plays a role in determining the straight-line depreciation of a particular asset.
Here’s a look at how companies calculate an asset’s salvage value and what it means in the broader picture of enterprise asset management.
How to Calculate Salvage Value
There is no formula for calculating the salvage value of an asset. This is because resale values are always in flux, unique to every specific asset. It’s effectively what someone is willing to pay for the asset in its current condition—the variables behind this are too numerous to formulate. Instead, companies make assumptions based on similar assets in the resale market.
Resale value tends to be higher on gently used assets or those still “within the date.” Take a vehicle for example. Late-model vehicles tend to have a higher salvage value than aging models. Similarly, vehicles with less mileage tend to fetch a better resale value than those with more miles on the odometer.
Ultimately, the IRS requires companies to estimate a “reasonable” salvage value based on the asset type, condition, market demand and other tangible factors that may affect its resale value.
Why is it Useful?
Salvage value serves two purposes. First, it’s used in estimating the depreciation schedule of an asset. Second, it’s part of enterprise asset management—specifically, end-of-life management.
Companies need to know salvage value when calculating straight-line depreciation. This amount is subtracted from the asset’s cost, then divided by its estimated useful life to deliver an annual depreciation figure.
As part of asset management, it helps companies look ahead to how they’ll effectively remove the asset from the balance sheet and account for that income. It’s also useful for looking at ROI figures for the life of the asset, factoring in upfront cost and salvage value.
The Problem With Salvage Value
Salvage value is, at best, an educated guess and, at worst, an unpredictability. Why? Because there’s no telling what something will be worth in the future based on the marketplace need.
For example, say that a company purchases a Widget Machine for $100,000, with an expected lifespan of 10 years. A decade from now, the Widget Machine might sell for just $15,000 used—especially if it’s an antiquated model with outdated hardware. However, if the equipment producer goes out of business and the serviceable life of the machine is 20 years, its value after a decade might be $40,000. There’s simply no way to tell which scenario is more probable.
Because of its unreliability as a future metric, many companies choose to depreciate assets down to zero. This takes salvage value out of the equation when factoring in straight-line depreciation, for a more straightforward calculation.
What Happens if Salvage Value is too High/Low?
Estimating salvage value that’s too high or too low can cause accounting headaches for a company. Here’s a look at what happens if assumptions are too high or too low:
- Too high. Overestimating salvage value means the annual depreciated amount will be too low. This, in turn, means the company will overstate its net income, as well as fixed assets and net earnings. Essentially, it artificially inflates the company’s numbers, which can mislead investors.
- Too low. Understating salvage value overstates depreciation metrics. This drives down net income and causes the company to understate fixed assets and net earnings. It’s a debacle that can throw off debt-to-equity ratios.
Generally, companies are very careful in estimating salvage value for known assets. For those with a longer usable life or assets subject to fluctuating values, a company might choose to estimate a zero-dollar sum, to avoid accounting errors.
Salvage Value as a Donation Metric
When donating (not selling) used assets such as electronics or automobiles, companies need to use salvage value to qualify the value of the asset for tax purposes. This amount is typically close to the fair market price someone might be willing to pay if the asset was for sale. For example, ABC Company might buy a truck for $50,000; then, after 10 years, donate that truck. The donation isn’t the original amount paid ($50,000); rather, it might be $4,000: the truck’s current value in the marketplace.
As mentioned, the trouble here is marketplace volatility. The price different groups are willing to pay for used goods depends on a wide variety of circumstances, which can change unpredictably. For this reason, the IRS pegs the salvage value of an item to the exact date it’s donated.
Salvage Value is an Assumption
Asset management—particularly depreciation—is a game of assumptions. Companies model the serviceable life and salvage value of an asset based on forward-looking predictions… which may or may not come to fruition. And while this value in particular is an important figure to consider when looking at the total life cycle of an asset, it’s vital to remember that it’s an assumption. Assumed correctly, it’s a powerful factor in calculating depreciation. Assumed incorrectly and it could leave the business with no shortage of accounting headaches.