It is hard to imagine any type of business without at least some time of long-term assets on its books. They are used in offices, in manufacturing facilities, to provide services, and so on. Most of these assets can be depreciated. This is done because it would be not reasonable and fair to count the full value of the asset in the financial statements when in reality it is no longer worth that amount.
When you dive a little deeper into the topic of depreciation, you will come across the concept of salvage value is applied to depreciable items of long-term assets. Their residual value, which means the same thing, is also their book value reduced by the accrued depreciation for the whole period of its useful life.
In other words, salvage value refers to the amount the business can still get for it by scrapping or selling when it no longer considers it to be, minus the probable costs of its disposal/sale. Now that you know what salvage value means, let’s learn how to calculate salvage value.
Salvage value for assets that accumulate depreciation can be calculated using a formula. Since fixed assets can be reflected in accounting at their original or replacement cost, the residual value of fixed assets is determined as:
Salvage Value = P – D, where
- P = initial (replacement) price of fixed asset, and
- D = accumulated depreciation, which is yearly depreciation amount x number of years the asset is considered useful.
The reference to the use of the original or replacement cost of fixed assets does not mean that the business has a choice of which valuation to use. It only means that if the object has a replacement value, it is used. If not, the original cost applies. Recall that the replacement cost is used only for fixed assets that have undergone revaluation at least once.
Nothing explains the concept better than an example. So, let’s look at two examples and how to calculate salvage value in each case.
A welding machine, purchased by the manufacturing company for $30,000, must, according to the decision, be using in the production facility for 3 years, after which it is supposed to be sold. The current market price for similar machines after their 3-year operation is $9,000. The cost of selling this piece of an asset in 3 years is expected to be $1,000.
Therefore, the net selling price (current market price for a used item less probable costs to sell) should be $9,000 less $1,000, or $8,000. This is the salvage value of the new car. Accordingly, the business will have a depreciation expense equal to a little over $7,300 each year or ($30,000 – $8,000)/3 years, assuming a straight-line method is used.
If we were given only how much the company paid initially ($30,000), the yearly depreciation ($7,333), and the number of years the company planned to use the asset, we could calculate the salvage value using the formula presented above. In other words, you would multiply $7,333 by 3 years and subtract this amount from $30,000. After doing some simple math, you will get $8,000 for your salvage value.
There might not be any salvage value left after the equipment or another asset is used. It may be zero if the estimated cost of its disposal or sale is equal to or close to the amount expected to be received for the asset. Accordingly, in this case, the amortized cost before the start of the asset usage will be equal to its original cost.
For instance, a consulting company buys 10 office desks. It expects these chairs will last 5 years, after which, according to preliminary estimates, they cannot be sold, since office chairs after such a long service life are not in demand on the market.
The probable proceeds for a possible sale of these chairs cannot be called significant enough to be recognized as their residual value. Therefore, the amortized cost is recognized as an amount equal to the initial cost of the office chair ($300), which means that its salvage value is zero. After 5 years, the depreciation expense entries will reduce the net book value of the chairs to zero, so there will be nothing to put under chairs for financial reports.
After-Tax Salvage Value
As you have learned now, salvage amount is how much a company receives or estimates it will receive for an asset when it will no longer be reasonable or possible to continue to use it. However, it does not necessarily mean that the potential buyer will be willing to give the seller the amount asked for just because this is what the bookkeeper says it is worth. In this case, it will report a loss, and there will be no tax liability associated with the sale of the asset.
Fortunately or unfortunately, it might happen so that the management is able to get significantly more for the fixed asset than what is declared on their accounting books. In this case, the company will have a gain on the sale of fixed assets. Since the income a business receives is taxable, the law requires businesses to pay taxes on the amount received on top of the residual value.
Plastic Manufacturing Co. purchased machinery for $60,000 that was working in a production facility for 10 years. On yearly basis, the bookkeeper has recorded a depreciation of $2,000, so currently, it is worth $40,000 on the books. The company decided to sell the machinery to replace it with more modern technology and the buyer paid $55,000 for it. Accordingly, the computation of this residual value is $55,000 less $40,000 or $15,000.
Since the company received more money than the asset was recorded for on its books, this extra money is considered to be a gain. Looking at the bookkeeping records, you will see a debit entry under Cash for $55,000, a credit entry under Fixed assets for $40,000, and the $15,000 it received on top will be recorded as a gain on the sale. Thus, the income received from the sale will be taxed.
Considering the need to pay taxes on excess money earned from the sale, the salvage value no longer seems as big as was initially measured. For instance, if the company had to pay 35% taxes on that gain from the sale, it actually received $9,750 from the sale of this asset. After all, it would not be fair to account for expenses associated with the scrapping of the fixed asset when calculating this figure and ignore the tax payment that is directly associated with the sale of a particular asset. Accordingly, the salvage value in this example is equal to $9,750.
Most businesses have at least a couple of assets that they would depreciate, so the concept of salvage value is valuable knowledge. This is an especially crucial concept for business owners who have multiple depreciable assets or they are expensive. Why? Without knowing this figure, how would a business owner know what amount to put in the bookkeeping records every year for depreciation? After all, this is a great opportunity to reduce its taxable income.
In fact, salvage value is something business owners calculate even before making a purchase. This allows them to evaluate how the purchase will affect business finances in the long term and properly plan for taxes. This value also serves as the basis for setting the price of an item when it is time to say goodbye to it. Despite this, as you saw earlier, a business does not necessarily have to sell for an amount equal to the salvage value.
Author: Charles Lutwidge