Salvage value refers to a value calculation for assets. It proves to be the estimated value for reselling assets at the conclusion of their natural and useful lives. The value is important because analysts subtract it out of the fixed assets’ original costs to learn what part of this cost may be depreciated for accounting and taxation purposes. This explains why the salvage values are critical parts of depreciation calculations.
The concept of salvage values also has to do with the anticipated returns businesses or personal owners will receive when they sell off such assets at the end of their natural lives. Such values are dependent on only estimates for the value of the asset at this point in time. There is also an official salvage value which the government calculates on many assets. In the United States, it is up to the IRS Internal Revenue Service to make such a determination and provide this fixed and preset calculation value.
It is this salvage value which analysts combine with the original purchase price of the assets. They utilize this with a particular method of accounting in order to decide what the fair yearly depreciation amount for the assets in question is. Business owners have two choices in calculating the depreciation for an asset. They might employ what experts call the straight line depreciation method.
In this commonplace means of calculating, an even dollar amount in depreciation will be determined and taken as a tax deduction every year of the useful life of the given asset. There is also the competing accelerated depreciation method. With this alternative means, the firm will accept a higher amount of depreciation for the initial years of the asset’s life and realize a lesser amount over the latter years of the practical life of the asset.
It is always a useful idea to look at some concrete examples of how the concept works out in real life. If a firm purchases a factory machine for $10,000, the salvage value of the machine might be $2,000 at the end of its practical five year life span. With a straight line method of annual depreciation employed, the calculations show that the $10,000 original cost minus the $2,000 salvage value results in an $8,000 depreciation value. The $8,000 depreciation value is divided by the five years practical asset life to come up with $1,600 per year in depreciation. The salvage value matters because the business will be able to sell the asset and recoup this final value amount.
With the alternative accelerated depreciation method, the company will instead depreciate the asset purchase value faster over the initial years of its practical life and slower over its latter years. A primary method for this is the DDB Double Declining Balance method. This assumes a depreciation rate which amounts to two times its straight line percentage.
Using the original factory machine example above, the yearly depreciation amount will be 40 percent per year for the initial year in this method. This amounts to a first year deduction of $3,200. Thanks to the fact that the DDB employs a double the normal rate of depreciation as does the straight line method, a greater amount of the total depreciation will be realized for the first years of this asset’s life.
Another important term related to the idea of salvage value is accumulated depreciation. This represents the aggregate depreciation that has been realized from the in-service date of the asset (from when it was purchased) to the present time. Eventually the book value of the asset in question (which is the cost minus the accumulated depreciation) will equal to the ultimate salvage value. At this point, there can not be any additional depreciation realized or taken for the asset. Companies will typically sell the asset then to obtain that salvage value which they have been assuming throughout the practical life of the asset.