Salvage value is defined as an estimated or expected resale value of an asset at the end of its useful life. It is a parameter that is associated with the depreciation of the assets used in the business. Depreciation is defined as the reduction in the market value of an asset due to time, wear and tear and obsolescence.
More features of salvage value and its estimation procedures are briefly explained in the article.
Features of Salvage Value
The salvage value is determined without taking into consideration the cost of dismantling and removal of the item. This but include the cost of scrap. This means that at the end of an asset's service life if it is sold even as scrap then it posses a salvage value.
In other words, a salvage value can be defined as the estimated market value of the asset an owner receives at the end of its useful life. The expected number of years the given asset is useful for the generation of revenue is called a useful life.
Residual Value and Salvage Value
The two terms are used to refer to the expected value of a property, plant or equipment at the end of its useful life. These are used for the calculation of the depreciation expense of an asset. In most cases, this value is assumed to be zero.
Residual value is defined as the estimated value of a leased asset at the end of its lease period or lease term. Salvage value is the expected value of an asset at the end of its useful period. Both the salvage value and residual value are called scrap values based on the commodity or asset.
Determination of Salvage Value
The determination of salvage value is a tough process. If the value is expected to be very small, then it is neglected and not used for calculating depreciation.
The significance of salvage value is that it allows to calculate the value of depreciation especially for calculating depreciation of an construction equipment.
So based on the industry the determination of salvage value varies. Three ways followed are:
- Method 1: The number of years the asset is found usable is calculated. Then the sales price of the similar asset is determined. If both the values varies, then the average of both is taken.
- Method 2: Determination of salvage value using formula, SV = P(1-i)y; Where, P is the original cost of the asset, i is the depreciation rate and 'y' is the number of years.
- Method 3: In some cases the salvage value can be taken zero.
Under or Overestimation of Salvage Value
Salvage value is very important for a business as it influences the company's depreciation expense. The company tries to make the best depreciation value possible that may not be a definite number.
Higher value scrap value implies lesser depreciation, which in turn leads to high profits. So, proper estimation is an important requirement. The wrong estimation might result in various issues like:
- Developing the wrong depreciation expense. This results in under or overestimation of the net income.
- The total fixed asset balance sheet would give an inaccurate picture.