Definition: The dollar value that a company estimates newly-purchased equipment will have at the end of its useful life.
Example: SAL Distribution Corp. purchases a $16,000 forklift for use in its warehouse. This is its cost basis. It plans to use the forklift for five years, which is its useful life. At that point the company believes it’ll be able to resell the forklift for $1,000. This estimated amount is the equipment’s salvage value.
Investeach explains: Why might a five year-old forklift be worth $1,000? One explanation is that the buyer owns other models like it and will sacrifice the forklift to use its parts to keep those other forklifts running.
Alternately, it is not uncommon for companies to estimate an equipment salvage value of $0.
It is important that the salvage value be estimated when the equipment is purchased because the value is an important part of the calculation of the annual depreciation that must be recorded each year. The total amount of depreciation to be recorded is the equipment’s cost minus its salvage value. In our example, that’s $16,000 – $1,000, or $15,000. This $15,000 of total depreciation has to be recorded over the five-year useful life of the forklift, beginning with the first year.
Incidentally, if a piece of equipment that has been depreciated down to its salvage value is sold for more than that value, the company will record an extraordinary gain in the amount of the difference. If it is sold for less, an extraordinary loss will be recorded.
Finally, salvage value is ignored under the Modified Accelerate Cost Recovery System (MACRS) the system the government implemented to allow companies to use higher depreciation when computing their income tax liabilities.
Riddle me this:
1. At what point does a company need to estimate the salvage value of a piece of equipment?
2. Why would another company purchase equipment that is toward the end of its life?
3. What can a company estimate the salvage value to be if it believes the equipment will be worthless at the end of its useful life?
4. What will happen if depreciated equipment is sold for more than its salvage value? For less?