Salvage value is the amount of money a company can receive for an asset at the end of the item’s useful life. This figure impacts the depreciation process because accountants must subtract the salvage value from the asset’s book value in order to calculate depreciation. In most cases, national accounting standards will provide guidance on how to determine the salvage value of an asset. The most common way is to estimate what willing buyers will pay for the asset based on its age and remaining useful life.
To figure the impact of salvage value on depreciation, accountants follow a basic depreciation formula. This formula is book value less salvage value divided by the number of useful years for the asset. For example, a machine costing $150,000 United States Dollars (USD) with a salvage value of $25,000 USD has a depreciable amount of $125,000 USD. If the salvage value is higher, the company will depreciate less of the asset, resulting in lower expenses and higher net income. While not overtly bad on the surface, an inappropriate calculation can severely increase the impact of salvage value on depreciation.
Because salvage value is an estimate, it can result in companies losing benefits from the depreciation calculation. In some cases, accountants will place an asset’s salvage value at zero. This removes the need for determining what a company can sell an asset for in a future time period. In some cases, the company may have to write off any residual salvage value once it sells the asset. Poor salvage value estimates can result in a significant one-time expense that will reduce net income. This is particularly dangerous for publicly held companies, whose stock prices may fall if investors are wary of the lower net income or a loss on operations.
Auditors often pay close attention to the impact of salvage value on depreciation as calculated by the company. Companies will often calculate salvage values based on the current market value for assets that are similar in the expected age or useful life. In some cases, government agencies may provide an asset class with predetermined salvage estimates. Auditors will need to review either the internal calculations or the selected asset class for tax purposes.
Auditors will often discuss the calculations with the company’s management and request to see any working papers associated with the salvage value on depreciation for assets. Reports from depreciation audits will list any inappropriate calculations relating to the salvage value and suggested corrections. Most companies will need to make these corrections in the current year so taxes filed with the government are not incorrect.