A Look at Salvage Value and Depreciation
To compute depreciation, three pieces of information are required: the asset’s cost, the asset’s salvage value and the asset’s estimated useful life. To compute annual depreciation expense, the depreciable cost (asset cost less salvage value) is divided by the estimated useful life. Each of these components will have a material effect on the amount of depreciation recorded each period.
Let’s consider salvage value with respect to an acquisition of real estate. Since real estate generally appreciates, the salvage value will be higher than cost and there should be NO depreciation expense reported on the income statement. Interesting point, right? The case outlined below illustrates the impact that salvage value has on the calculation of depreciation expense on real estate assets.
Facts of the Case
An auditor is auditing fixed assets at a client. The client purchased a new warehouse in the current year for $1,000,000. The auditor notices that the client has not provided any depreciation expense on that building. When the auditor enquires about the lack of depreciation, the controller says that the company followed the accounting standards related to depreciation. The factors that went into the company’s calculation are as follows:
- Cost: $1,000,000
- Salvage value: $1,000,000
- Estimated useful life: 30 years
- Depreciation method: Straight-line
The client says that depreciation is calculated by dividing the depreciable cost by the estimated useful life. Using the factors shown above, the depreciation expense would compute to zero.
The auditor asks the controller why the company used a salvage value equal to the cost. The controller presents the textbook definition of salvage value: Salvage value is an estimate of the asset’s value at the end of its useful life. This value may be based on the asset's worth as scrap or on its expected trade-in value. Like useful life, salvage value is an estimate. In making the estimate, management considers how it plans to dispose of the asset and its experience with similar assets.1
The controller explains that, based on the company’s experience with similar assets (real estate), the value of the buildings upon sale (at the end of their “useful life”) was at least equal to the building’s historical cost. The controller also says that the recently purchased building is in a very popular commercial real estate park. Buildings in that park have appreciated more than 75 percent in the last 10 years.
The auditor tells the controller that generally accepted accounting principles require the use of the expense recognition (matching) principle where companies recognize expenses in the period in which they make efforts (consume assets or incur liabilities) to generate revenue and match expenses with revenues in the period when the company makes efforts to generate those revenues.1
Depreciation is one of those expenses that should be recorded as you utilize your plant assets. As defined, depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. Such cost allocation enables companies to properly record expenses (efforts) with associated revenues (results) in accordance with the expense recognition principle.1 The auditor’s argument would support recording some depreciation expense related to the building.
Analysis of the Case
Is the client’s position sustainable? Has the client made a bad estimate? The company appears to be following the accounting rules. Is such a discussion with the client outside of the realm of possibility?
Here are some questions to consider:
- Is it possible a real estate company (e.g., apartment complex) can show no depreciation expense?
- Should salvage value (for real estate) be abolished so a company reflects depreciation expense (as part of operating expenses) as the asset is used and as the company produces revenue?
- Should the Financial Accounting Standards Board look into the concept of salvage value?
Food for thought.
1 Definitions from Financial Accounting, Eleventh Edition, by Jerry J. Weygandt, Ph.D., CPA, Paul D. Kimmel, Ph.D., CPA, and Donald E. Kieso, Ph.D., CPA
Evan C. Wasserman
Evan C. Wasserman, CPA, MBA, is an assistant professor of professional practice at Rutgers Business School. He is a member of the NJCPA.
Marshall E. Saunders
Marshall Saunders, CPA, MBA, is an instructor of professional practice at Rutgers Business School. He is a director of the NJCPA Passaic County Chapter.
This article appeared in the Winter 2021/22 issue of New Jersey CPA magazine. Read the full issue.