Salvage value is the estimated value paid to the owner when the item is sold at the end of its useful life. The value is used to determine the annual depreciation in the accounting records, and the salvage value is used to calculate the depreciation expense in the tax return. The value is based on an estimate of the asset’s value, or the value can be determined by a regulatory body, such as the United States Internal Revenue Service (IRS).
DOWN ‘Salvage Value’
The salvage value is used in conjunction with the purchase price and a specific accounting method to determine the amount of annual depreciation of the asset. A business owner can choose the straight-line depreciation method, which means that an equal amount of depreciation is recognized each year. If instead the owner chooses an accelerated depreciation method, the business recognizes more depreciation in the early years and less in the later years of the asset’s useful life.
How does straight line depreciation work?
Suppose, for example, that a company purchases a machine at a cost of $ 5,000, and that the machine has a salvage value of $ 1,000 and a useful life of five years. Based on these assumptions, the annual depreciation using the straight-line method is: ($ 5,000 cost – $ 1,000 salvage value) / 5 years, or $ 800 per year. The asset’s depreciable basis is cost less salvage value, or $ 4,000. The salvage value is subtracted from the cost of the asset in the depreciation calculation, because the owner sells the asset once the depreciated value declines to the salvage value.
Factor accelerated depreciation methods
Accelerated depreciation means that the asset’s depreciation is greater in the early years of its useful life and less in later years. A popular method is the double declining balance (DDB) method, which uses a depreciation rate that is twice the straight-line percentage. In the machine example, the annual depreciation rate is ($ 800 annual depreciation / $ 4,000 depreciable basis) or 20%. The DDB method calculates the first year of depreciation on the machine as ($ 5,000 machine cost X 40%) of $ 2,000. Since DDB uses a rate that is twice the straight-line rate, we recognizes more depreciation in the early years of the asset’s useful life.
Accumulated depreciation is the total depreciation recognized from the asset purchase date. Once the asset’s carrying amount (cost less accumulated depreciation) reaches the salvage value, no further depreciation is recognized and the asset is sold. The depreciation method used for accounting purposes may be different from the depreciation expense in the tax return.