Salvage value is instrumental in determining the annual depreciation of an asset. This is because depreciation is calculated as an annual reduction in the difference between the asset’s original cost and its salvage value. [4] X Research source For example, imagine an asset that costs $12,000 and can be salvaged for $2,000 after its 5-year useful life. The annual depreciation would be calculated from the difference between it’s cost and salvage value, which would be $12,000 - $2,000, or $10,000. Using the straight-line method, the annual depreciation would then be $10,000/ 5 (for each year of useful life), or $2,000.
The straight-line is most commonly used by accountants to keep depreciation expense simple and constant throughout the asset’s life. Declining balance and sum-of-the-years’-digits methods are used to calculated depreciation for assets that are most productive or useful at the beginning of their lives, and become less so by the end. Production machines are sometimes depreciated in this manner, because they can operate faster and more cleanly at the beginning of their lives. Depreciation is a business expense that is deducted for income tax calculations.
To exemplify this method further, the depreciation expense in the second year would be based off of the first year-end book value, which is $10,000-$2,000, or $8,000. The depreciation expense in the second year would be 20% of $8,000, or $1,600, leaving us with a second year-end book value of $6,400 for the asset.
In this equation, “n” represents the numbers of years of the asset’s life remaining at the beginning of that year’s depreciation. For example, in the first year n would be 5. The bottom of the fraction represents the total of the digits in the useful life of the asset (if 5 years, 5 + 4 + 3 + 2 +1). [7] X Research source Imagine the salvage value of our $10,000 asset is $1,000 and it has a useful life of 5 years. Under this method, the depreciation expense in the first year would be ($10,000−$1,000)∗(55+4+3+2+1){\displaystyle ($10,000-$1,000)({\frac {5}{5+4+3+2+1}})}. This simplifies to $9,000(5/15){\displaystyle $9,000(5/15)} or $9,000∗(1/3){\displaystyle $9,000(1/3)}. Therefore, the depreciation expense in the first year is $3,000.
Note that the book value of the asset can never dip below the salvage value, even if the calculated expense that year is large enough to put it below this value. If it reaches this value before its final year, the asset’s book value will remain at salvage value there until it is sold, when its value will drop to $0.
Market value is the price a willing buyer would pay a willing seller. For example, a piece of manufacturing equipment was purchased for $10,000 and depreciation over 4 years totaled $4,000. The book value is now $6,000. However new technology has replaced this type of equipment so willing buyers believe the market value is only $2,000. In some cases, such as that of heavy machinery, the market value will be significantly higher than the book value. This means that even though these assets are old and thus heavily depreciated, they still perform adequately.
Cash, supplies and accounts receivable are typical current assets while land, office buildings and manufacturing equipment are usually considered long-term assets.
For example, if a company owns assets totaling $5 million, but has taken out $2 million in loans with some of the assets used for guarantees, the value of the company’s total assets is really only $3 million.
