Salvage Value for Fixed Asset Financial Reporting
Salvage Value is a key component in accurately calculating the deprecation of fixed assets for financial reporting purposes, but is generally not a factor for tax depreciation under MACRS.
In essence, Salvage Value is the anticipated value of a depreciable asset when it reaches the end of its Useful Life.
The Cost of an Asset minus Salvage Value equals its Depreciable Basis. The depreciation method is then applied to the Depreciable Basis over the Useful Life in order to calculate depreciation for each accounting period—a pretty straightforward process.
- Some depreciable assets are short-lived and inexpensive and will likely have little, if any value at the end of their Useful Lives. Other assets will have significant value at the end of their lives and can be sold or traded-in for a new asset. In any case, the amount of depreciation that can be taken for a fixed asset should not exceed its Salvage Value and should not be a negative number (in the event projected disposal costs exceed Salvage Value).
While, Salvage Value puts a cap on depreciation (unless adjusted in the future), MACRS tax rules allow you to depreciate a fixed asset to zero. There is no consideration of Salvage Value under MACRS. The entire cost of the asset can be recovered for tax purposes, but not financial reporting.
Whether your depreciation calculation is correct depends upon the reasonableness of the Useful Life and Salvage Value. (For more insight into Useful Life see the following two articles: www.634.02e.myftpupload.com/recovery-periods-tax-depreciation and www.634.02e.myftpupload.com/useful-life-of-fixed-assets-for-tax-and-reporting-purposes.)
Useful Life and Salvage Value are linked together. The assumptions made when determining an asset’s Useful Life will also factor into Salvage Value considerations.
Salvage Value is established by estimate at the time that an asset is placed in service. You are attempting to estimate the future value of the asset at the end of its Useful Life along with its anticipated condition. The assumed condition and method of disposition at the end of the asset’s Useful Life are major factors in estimating Salvage Value.
Salvage Value Matters
Incorrect or mis-estimated Salvage Value will result in erroneous depreciation calculations and can have the following harmful impacts on your company, especially if Salvage Value is set too high:
- Depreciation will be under-expensed over the Useful Life.
- Net income will be over-stated.
- On the Balance Sheet: Total Fixed Assets and Retained Earnings will both be overstated.
On the other hand, if Salvage Value is set too low:
- Depreciation over-expensed and Net Income will be understated. Total Assets and Retained Earnings will be understated as well.
- Balance Sheet Metrics will be adversely impacted: Debt-To-Equity Ratio and Loan Collateral values will be lower. This might violate loan covenants and /or impair your ability to obtain necessary financing in the future.
Naturally, the intentional manipulation of Useful Life and Salvage Value in order to reduce depreciation cost and increase reported profits in order to induce others to do business or invest in a company is a passport to expensive litigation, destroyed reputation and worse.
A Reasonable Estimate
Salvage Value estimates need to be reasonable and supportable, not drawn from whole cloth. At the same time, Salvage Value is an estimate, not a prophecy of future value. The key to a reasonable and supportable estimate is to create a rational procedure that is followed when addressing the subject.
Salvage Value can be looked at several different ways. Key questions to address include:
- What will happen to the asset at the end of its useful life? Will it be simply retired and placed in storage, repurposed, sold or traded-in?
- Based upon anticipated use (wear-and-tear), what will be the condition of the asset at the end of its useful life?
- Based upon the expected disposition and condition of the asset at the end of its useful life, what, if any, will be the proceeds and costs associated with its eventual disposition?
Internal versus External Disposition of a Fixed Asset
A fixed asset can be disposed of internally or externally. Examples of internal disposition include:
- Rebuild or retrofit the asset so that it has renewed life and value to the business,
- Repurpose or transfer the asset to another department or unit for productive use within the organization,
- Retire the asset from service and either leave it in place or put it into storage, or
- Cannibalize the asset to provide spare parts and components to other similar assets.
An asset can also be disposed of externally at the end of its Useful Life. Generally, such disposal options include:
- Selling the asset directly, via auction or through an intermediary such as an equipment dealer,
- Trading or exchanging it for another asset (similar or dissimilar),
- Donating it to a charitable organization,
- Selling in its entirety to a scrap or junk dealer, or
- Selling its components piecemeal as scrap.
Challenges of Establishing Values in the Future
When the time comes to dispose of a fixed asset, the price that the asset will fetch will be determined by the condition of the asset, the manner of disposal and the market conditions for the asset. Estimating these factors is challenging, at best. The challenges include the unknowns and uncertainties that go with the passage of time. This is a knottier problem for expensive and long-lived assets because it is more difficult to foresee conditions further into the future. The key assumptions are:
- The planned method of disposal.
- The condition of the asset based upon maintenance and the amount of wear-and-tear accumulated during its Useful Life.
- The degree of obsolescence and availability of new technologies or equipment along with the prevailing regulatory environment.
- The market conditions (supply and demand) and selling price for comparable assets at the time of disposal.
Arriving at assumptions for points 1 and 2 can be made without too much difficulty because they are factors that are within the control of management. Points 3 and 4, on the other hand, require a little more consideration to arrive at a reasonable estimate.
Finding a Foundation for a Reasonable Estimate
Certain assets, such as computers and short-lived, low-cost items may hold little future value. It is not uncommon for a business to assume that such assets will have zero Salvage Value. Higher value and longer-lived assets may have significant Salvage Values.
So, where can you look for guidance when establishing a fixed asset’s Salvage Value?
The first choice is to look for available data, actual facts that you can work with. In the absence of data, then a reasonable estimate is the best you can do.
Sources of data include:
- Previous experience and history with similar assets, while not an absolute predictor, can provide a good starting point for reasonable starting estimate.
- You can consider how much the same piece of equipment is selling for today compared to the original cost and apply that percentage.
- An equipment appraisal (only reasonable for high value assets because of the expense).
- Equipment leasing companies and asset-based lenders. These funding sources have a fairly good idea of Residual Values, especially for automobiles and rolling stock.
- Property and Casualty underwriters can also provide insight to the likely future value of a given fix asset.
It is also important to consider any restrictions that would inhibit your ability to dispose of the asset or that might mandate specific disposal procedures that need to be complied with. Consider whether there are any contracts or agreements with customers, technology providers or any governmental entity that could restrict the ability to transfer the property or that stipulate how the asset is to be disposed.
Finally, the costs of disposal or liquidation can be deducted from the estimated future value—especially when such costs are significant or will have a material impact on the projected net value of the asset upon disposition.
Definitions of Value
Salvage Value is sometimes also referred to as Residual Value, Scrap Value or even Junk Value. While each one of these definitions have commonality with Salvage Value, there are some important distinctions that you might want to consider:
- Residual Value is the resale value of the asset at the end of the depreciable period. A good example would be the anticipated trade-in or resale value of a car or truck. Naturally, this is an estimate based upon prior experience, assumed wear-and-tear and the expected condition of the asset when brought to the market.
- Scrap Value is the value of the component parts if they were sold piecemeal. A given piece of equipment can include software, circuitry components, structural components and metals that can be sold at market.
- Junk Value is the amount that you might expect to realize if the depreciable asset is hauled away intact to junk dealer.
This article examined Salvage Value (and to a lesser degree, Useful Life) within the context of depreciation for financial reporting. The next article will explore the different definitions for the value of fixed assets from a broader, more general perspective because the fixed assets can represent a significant portion of a company’s productive capacity and business value. Asset managers, accountants, business advisors and financials decision makers within small, middle, or large-bracket enterprises can benefit by enriching their understandings of value and valuation concepts to better create returns for their stakeholders.