What is the Residual Value?
Residual value is defined as the estimated scrap value of an asset at the end of its lease or its economic or useful life. It is also known as the salvage value of an asset. This represents that amount of value which the owner of that particular asset will obtain or expect to get eventually when the asset is dispositioned.
For different industries, this value has different meanings.
- In case of residual value in accounting the owner’s equity is taken to be the residual of assets minus the liabilities.
- And while doing investment evaluations this value is calculated by subtracting the cost of capital from profit. It is used for the calculation of depreciation.
- In many circumstances, the assumption for this value is taken to be nil because of small values of many fixed assets and the difficulties associated with forecasting what the value can be in the future.
- In order to get in this value of an asset, one must deduct the estimated costs required for disposing of the asset.
- This value of an asset is generally the calculation of residual value at its fair market value as decided by the agreement or mentioned in the appraisal.
Breaking down Residual Value
Suppose you lease out a car for the next five years then the residual value is the value of the car after five years. It is often fixed by the bank which issues the lease and is completely estimated on the basis of past models and future predictions. With interest rate and the relevant taxes, it is a very important factor for determining the car’s monthly lease payments.
This concept is used in a regular manner for calculation of an asset’s depreciation expense. Since this value is the ending value of an asset so it must be subtracted from the purchase amount to get the total amount which gives us the depreciation amount. In the straight-line method, this amount is then divided by the asset’s useful life in years to get the annual depreciation expense for each year. This method is also used in valuation processes.
In the domain of finance, the salvage value or the scrap value is used to find out the value of cash flows generated by a company after the time frame used for the forecast. If there is a forecast projection for 20 years with an assumption that the company will operate for the next twenty years, the cash flows projected for the remaining years must be valued. In this situation, the cash flows will be discounted to obtain their net present value which is then added to the market valuation of the project or the company. In cases of capital budgeting projects, it gives a clear understanding of the amount for which you can sell off the asset after the firm has finished using it or when the asset generated cash flows cannot be accurately forecasted.
Residual Value Example
Let us consider a Residual value example of printing machinery. The printing machinery costs $20,000 and we can safely assume that the estimated service life of the machinery is ten years. It can be estimated that at the end of its service life it can be sold as scrap metal to the dumping ground for $3000. And the cost of disposing of the machinery is $100 which the owner requires to pay for transporting the machine to the dump. Then the calculation of scrap value for the printing machinery is $2,900 ($3000-$100).
3 Ways to Calculate Residual Value
There are several ways to understand what an owner will get from an asset s of a future date. These ways are as follows:
#1 – No Value
The first and foremost option for the assets with lower value is to undergo a no residual value calculation. Here an assumption is made that these assets have no value at the end of their use date. This is preferred by many accountants as this helps in simplifying the calculation of depreciation. This is a very efficient method for those assets whose amount of any value comes much below the predetermined threshold level. But the final amount of depreciation which comes by following this method is higher than the times when residual value is taken into account.
#2 – Comparables
The second approach is Comparables when the residual value is calculated at all is compared to the residual value of comparable assets which are traded in a well-organized market. This is the most defensible approach which is used. For example, if there is a considerably big market in used cars then this can be used as the basis for calculation of residual value for a similar type of cars.
#3 – Policy
The third one is Policy. There can be a company policy that the residual value of all assets which come under a certain class is always taken to be the same. This approach cannot be termed as defensible since the policy derived value can be higher than the market value and using this method will reduce the depreciation expense for a business. So this approach is not followed until and unless the policy based values is kept at a very conservative
It must be kept in mind that this value of an asset should be calculated every year at the end of each year specifically. If there is a change in this value estimation while checking then these changes should be kept in the record so as to keep a track on changes residual value in accounting estimates. Residual value, salvage value, and scrap value are similar terms which are used to refer to the expected value of an asset at the end of its useful life and this amount is often assumed to be zero.
Residual Value Video
This has been a guide to what is Residual Value? Here we discuss its examples along with top 3 ways to calculate the residual value. You may learn more about accounting from the following articles –