What is Salvage Value?
Salvage value is the estimated amount that an asset is worth at the end of its useful life. It is also known as scrap value or residual value, and is used to determine the annual depreciation expense of an asset. The value of the asset is recorded on a company’s balance sheet, while the depreciation expense is recorded on its income statement.
Determining the Salvage Value of an Asset
The Internal Revenue Service (IRS) requires companies to estimate a “reasonable” salvage value. The value depends on how long the company expects to use the asset and how hard the asset is used. For example, if a company sells an asset before the end of its useful life, a higher value can be justified. Typically, companies set a salvage value of zero on assets that are used for a long time and are relatively inexpensive (5-year-old printer, 4-year-old laptop, etc.).
Importance of Salvage Value
If the salvage value is set too high or too low, it can be harmful to a company.
If set too high:
- Depreciation would be understated.
- Net income would be overstated.
- Total fixed assets and retained earnings would be overstated on the balance sheet.
If set too low:
- Depreciation would be overstated.
- Net income would be understated.
- Total fixed assets and retained earnings would be understated on the balance sheet.
- Values for the debt-to-equity ratio and loan collateral would be lower. This may result in difficulties securing future financing or in violation of loan covenants that require the company to maintain certain minimum debt ratio levels.
Using Salvage Value to Determine Depreciation
The estimated salvage value is deducted from the cost of the asset to determine the total amount that is depreciable on an asset.
For example, Company A purchases a computer for $1,000. The company estimates that the computer’s useful life is 4 years. It means that the computer will be used by Company A for 4 years and then sold afterward. The company also estimates that it would be able to sell the computer at a salvage value of $200 at the end of 4 years. The company follows a straight-line depreciation method.
The depreciation for this computer is determined by taking the purchase price and subtracting it from the estimated salvage value. In the example above, the total depreciation on this computer would be $1,000 – $200 = $800 depreciated over four years (the useful life of the asset). If the company uses a straight-line depreciation method, the computer would be depreciated annually by $200 ($800 / 4).
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Real-World Example of Salvage Value Fraud
Waste Management, Inc. is a waste company founded in 1968 and was the largest waste management and environmental services company in 1980. Between 1992 and 1997, Waste Management, Inc. committed fraud several times. Among other fraudulent activities, the company:
- Avoided depreciation expenses by inflating salvage values and extending the useful life of the company’s garbage trucks
- Assigned arbitrary salvage values to assets that previously did not possess salvage value
The fraud was perpetrated in an attempt to meet predetermined earnings targets. In 1998, the company restated its earnings by $1.7 billion – the largest restatement in history.
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