Every few years, I go to the Apple store and turn my wallet upside down to get the newest iPhone. It’s always a pleasant surprise when they hand me a couple of hundred dollars back to trade in my current one.
Replacing business assets looks similar to getting a new iPhone. The money I get back on my old phone is known as its salvage value, or its worth when I’m done using it.
Overview: What is salvage value?
Salvage value is an asset’s estimated worth when it’s no longer of use to your business. Say your carnival business owns an industrial cotton candy machine that costs you $1,000 new. At the end of its five-year service, you could sell it for $150. That $150 is its salvage value.
When businesses buy fixed assets — machinery, cars, or other equipment that lasts more than one year — you need to consider its salvage value, also called its residual value.
Generally Accepted Accounting Principles (GAAP) require accrual accounting method businesses to depreciate, or slowly expense over time, fixed assets instead of booking one expense on the purchase date. Under most methods, you need to know an asset’s salvage value to calculate depreciation.
Cash method businesses don’t depreciate assets on their books since they track revenue and expenses as cash comes and goes. However, calculating salvage value helps all companies estimate how much money they can expect to get out of the asset when its useful life expires.
Salvage value generally doesn’t apply to tax depreciation. The Internal Revenue Service (IRS) uses a proprietary depreciation method called the Modified Accelerated Cost Recovery System (MACRS), which does not incorporate salvage values.
However, MACRS does not apply to intangible assets, or things of value that you can’t see or touch. Intangible assets are amortized using the straight-line method and usually have no salvage value, meaning they’re worthless at the end of their useful lives. Talk to a tax accountant before calculating tax depreciation.
How to determine an asset’s salvage value
An asset’s salvage value is its resale price at the end of its useful life. Follow these steps to determine your asset’s salvage value.
1. Estimate the asset’s useful life
Useful life is the number of years your business plans to keep an asset in service. It’s just an estimate since your business may be able to continue using an asset past its useful life without incident.
For tax purposes, the IRS dictates an asset’s useful life. If you’re unsure of your asset’s useful life for book purposes, you can’t go wrong following the useful lives laid out in the IRS Publication 946 Chapter Four.
2. Find similar assets in the marketplace
Once you have the asset’s useful life, take a look at the market for similar assets.
Say you’ve estimated your 2020 Hyundai Elantra to have a five-year useful life, the standard for cars. Take a look at similarly equipped 2015 Hyundai Elantras on the market and average the selling prices.
Be careful not to consider a similar asset’s asking price since, in most used-asset markets, things will sell below their asking price. Go by the prices for which the assets sold.
You might learn through research that your asset will be worthless at the end of its useful life. If that’s the case, your salvage value is $0, and that’s perfectly acceptable.
How to calculate and record depreciation with salvage value
Once you’ve determined the asset’s salvage value, you’re ready to calculate depreciation. Follow these steps.
1. Calculate the asset purchase price
Let’s figure out how much you paid for the asset, including all depreciable costs. GAAP says to include sales tax and installation fees in an asset’s purchase price.
Say you own a chocolate business that bought an industrial refrigerator to store all of your sweet treats. You paid $10,000 for the fridge, $1,000 in sales tax, and $500 for installation. Therefore, your refrigerator’s total purchase price is $11,500.
$10,000 (Refrigerator) + $1,000 (Sales Tax) + $500 (Installation Fee) = $11,500
2. Find the depreciable value
The asset’s depreciable value is the difference between the purchase price and the salvage value. Use the following formula:
Asset Purchase Price – Salvage Value = Depreciable Value
Say that a refrigerator’s useful life is seven years, and seven-year-old industrial refrigerators go for $1,000 on average. The fridge’s depreciable value is $10,500 ($11,500 purchase price minus the $1,000 salvage value).
3. Choose a depreciation method
GAAP lets you choose your depreciation method. You must remain consistent with like assets; if you have two fridges, they can’t be on different depreciation methods.
You have four depreciation methods at your disposal:
• Straight line
• Double-declining balance
• Sum-of-the-years’ digits
• Units of production
Most businesses opt for the straight-line method, which recognizes a uniform depreciation expense over the asset’s useful life. However, you may choose a depreciation method that roughly matches how the item loses value over time.
For example, the double-declining balance method suits new cars well since they tend to lose a significant amount of value in the first couple of years. Unlike the other methods, the double-declining balance method doesn’t use salvage value in its calculation.
4. Create a depreciation schedule
You’re now ready to calculate depreciation for your fixed asset. Map out the asset’s monthly or annual depreciation by creating a depreciation schedule.
I’m going to use the straight-line method for the refrigerator. To calculate annual depreciation with the straight-line method, use this formula:
Depreciable Value ÷ Useful Life in Years = Annual Straight Line Depreciation
Annual straight line depreciation for the refrigerator is $1,500 ($10,500 depreciable value ÷ seven-year useful life).
I recommend creating depreciation schedules using Microsoft Excel. By using a spreadsheet, you reduce the likelihood of arithmetic errors.
You know you’ve correctly calculated annual straight-line depreciation when the asset’s ending value is the salvage value. In the depreciation schedule above, the refrigerator’s ending book value in year seven is $1,000, the same as the salvage value.
5. Prepare a depreciation journal entry
At the end of the accounting period — either a month, quarter, or year — record a depreciation journal entry.
The depreciation journal entry accounts are the same every time — a debit to depreciation expense and a credit to accumulated depreciation. Here’s the annual journal entry for the refrigerator’s depreciation.
When you’re using straight-line depreciation, you can set up a recurring journal entry in your accounting software so you don’t have to go in and manually prepare one every time.
2 best practices when using salvage values
Here are two tips to keep in mind when determining an asset’s salvage value.
1. Do market research to determine salvage value
Many business owners don’t put too much thought into an asset’s salvage value. If you want the most accurate books possible — and I know you do — spend some time looking at the market for similar assets that recently sold in a condition similar to your asset at the end of its useful life.
The Financial Accounting Standards Board (FASB) recommends using “level one” inputs to find the fair value of an asset. In other words, the best place to find an asset’s market value is where similar goods are sold, or where you can get the best price for it.
For example, you probably wouldn’t go to eBay to sell a piece of fine jewelry. You’d go to a trusted jeweler who knows how much similar jewelry sells for in stores.
2. Don’t be afraid of no salvage value
Some assets are truly worthless when they’re no longer of use to your business. If there’s no resale market for your asset, it likely has a zero salvage value.
You might have designed the asset to have no value at the end of its useful life. Perhaps you hyper-customized a machine to the point where nobody would want it once you’re through with it. Even some intangible assets, such as patents, lose all worth once they expire.
You can still calculate depreciation without a salvage value; just put a $0 in any place where you need to enter a salvage value.
Salvage your bookkeeping
One of the first things you should do after purchasing a depreciable asset is to create a depreciation schedule. Through that process, you’re forced to determine the asset’s useful life, salvage value, and depreciation method.
You want your accounting records to reflect the true status of your business’s finances, so don’t wait until tax season to start thinking about depreciation.