Salvage Value

Salvage value is the estimated value that an owner is paid when the item is sold at the end of its useful life and is used to determine annual depreciation. The salvage value is used to determine annual depreciation in the accounting records, and salvage value is used to calculate depreciation expense on 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 U.S. Internal Revenue Service (IRS).

The salvage value is used in conjunction with the purchase price and a specific accounting method to determine the amount of annual depreciation on 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 method of depreciation, the company recognizes more depreciation in the early years and less in the later years of the asset's useful life.

Assume, for example, that a company buys 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 base is the cost less salvage value, or $4,000. 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.

Accelerated depreciation means that the asset's depreciation is greater in the early years of the useful life and a smaller amount in later years. One popular method is the double-declining balance (DDB) method, which uses a depreciation rate that is twice is straight-line percentage. In the machine example, the rate of annual depreciation is ($800 annual depreciation / $4,000 depreciable base), or 20%. The DDB method calculates the first year of depreciation on the machine as ($5,000 machine cost X 40%), of $2,000. Because DDB uses a rate that is twice as large as the straight-line rate, more depreciation is recognized in the early years of the asset's useful life.

Accumulated depreciation is the total depreciation recognized since the asset's purchase date. Once the asset's book value (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 than the depreciation expense on the tax return.