SCRAP VALUE: WHAT IT IS, HOW IT IS CALCULATED AND EXAMPLE - DUDAS - 2025

The scrap value is the estimated value that is paid to an owner when the asset is sold to the end of its useful life and is used to determine annual depreciation. It is used to determine the annual depreciation in the accounting records, and also to calculate the depreciation expense in the tax return.

This value is based on an estimate of the asset's value at the end of its useful life, but can also be determined by a regulatory body, such as the Internal Revenue Service.

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The value depends on how long the company expects to use the asset and how hard the asset is used. For example, if a company sells an asset before the end of its useful life, a higher value may be justified.

Typically, companies set a scrap value of zero on relatively inexpensive, long-used assets such as 5-year printers, 4-year laptops, etc.

What is the scrap value?

The scrap value is used in conjunction with the purchase price and a specific accounting method to determine the amount of the asset's annual depreciation. It is recorded in the balance sheet of the company. On the other hand, depreciation expense is recorded in your income statement.

If it is too difficult to determine a scrap value, or if the scrap value is expected to be minimal, it is not necessary to include it in the depreciation calculations.

Instead, the total cost of the fixed asset is simply depreciated over its useful life. Any income from the final disposal of the asset will be recorded as a gain.

The concept of scrap value can be used fraudulently by estimating a high value for certain assets. This results in an insufficient amount of depreciation and therefore higher earnings than would normally be the case.

Importance

Scrap values ​​are important in business because they affect the size of a company's depreciation expense. Therefore, they affect net income.

However, it is important to note that these are simple estimates. No one knows what an asset will be worth 10 years in advance.

If the scrap value is too high or too low, it can be detrimental to a business. If it is set too high:

- Depreciation would be underestimated.

- The net profit would be exaggerated.

- Total fixed assets and retained earnings would be overstated on the balance sheet.

If instead the scrap value is set too low:

- The depreciation would be exaggerated.

- The net profit would be underestimated.

- Total fixed assets and retained earnings would be underestimated on the balance sheet.

- The values ​​of the debt / equity ratio and the loan guarantee would be lower. This can cause difficulties in securing future financing or a violation of loan agreements, which require the company to maintain certain minimum levels of indebtedness.

Cost accounting

In cost accounting, the idea of ​​scrap value is slightly different from the concept of financial accounting. Scrap value is the raw material of the product that the manufacturer will sell as waste.

That means it has nothing to do with the obsolescence of an asset. Rather, it refers to raw materials that have no value to the manufacturing company.

How is it calculated?

In the business world, scrap values ​​are very important because they help companies calculate depreciation.

You can choose the straight-line depreciation method. This means that an equal amount of depreciation is recognized each year.

If instead an accelerated depreciation method is chosen, the company recognizes more depreciation in the early years and less in the later years of the asset's useful life.

Straight line amortization

Suppose a company buys a machine at a cost of $ 5,000. The machine has a scrap value of $ 1,000 and a useful life of five years.

Based on these assumptions, the annual straight-line depreciation is: ($ 5,000 cost - $ 1,000 scrap value) / 5 years, or $ 800 per year.

The asset's depreciable basis is cost less scrap value, or $ 4,000. Scrap value is subtracted from the cost of the asset in the depreciation calculation. This is because the owner will in theory sell the asset once the depreciation value decreases to the scrap value.

Accelerated deprecation methods

Accelerated depreciation means that the asset's depreciation is higher in the early years of its useful life and lower in later years.

One popular method is the double declining balance (DSD) method, which uses a depreciation rate that is twice the percentage of amortization in a straight line.

In the example of the machine, the annual depreciation rate is ($ 800 annual depreciation / $ 4,000 depreciation base), or 20%. The DSD method calculates the first year of depreciation on the machine as: ($ 5,000 machine cost x 40%), equal to $ 2,000.

Because DSD uses a rate that is twice 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 from the asset's purchase date. Once the asset's book value (cost less accumulated depreciation) reaches scrap value, no further depreciation is recognized and the asset is sold.

Examples

Example 1

ABC Company purchases an asset for $ 100,000 and estimates that its scrap value will be $ 10,000 in five years, when it plans to dispose of the asset.

This means that ABC will depreciate $ 90,000 of the cost of the asset over five years, leaving $ 10,000 of the cost remaining at the end of that time.

ABC then hopes to sell the asset for $ 10,000, which will remove the asset from its accounting records.

Example 2

Suppose Company XYZ buys machinery for $ 1 million, and that equipment is expected to last for 10 years. After that, the machinery is estimated to be worth, say, $ 10,000.

Therefore, Company XYZ would record a depreciation expense equal to $ 990,000 over 10 years.

References

1. Will Kenton (2018). Salvage Value. Investopedia. Taken from: investopedia.com.
2. Steven Bragg (2019). Salvage value. Accounting Tools. Taken from: accountingtools.com.
3. Investinganswers (2019). Salvage Value. Taken from: investinganswers.com.
4. CFI (2019). What is Salvage Value? Taken from: corporatefinanceinstitute.com.
5. Wall Street Mojo (2018). What Is Salvage Value (Scrap Value)? Taken from: wallstreetmojo.com.