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 and is also known as the salvage value of an asset. It represents that amount of value which the owner of that particular asset will obtain or expect to get eventually when the asset is dispositioned.
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 entirely estimated based on past models and future predictions. With interest rates and the relevant taxes, it is a crucial factor for determining the car’s monthly lease paymentsLease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration..
This concept is used regularly 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 methodStraight-line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. , this amount is then divided by the asset’s useful life in years to get the annual depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. 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 valueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not., which is then added to the market valuation of the project or the company. In cases of capital budgetingCapital BudgetingCapital budgeting is the planning process for the long-term investment that determines whether the projects are fruitful for the business and will provide the required returns in the future years or not. It is essential because capital expenditure requires a considerable amount of funds. 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 the 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. It is preferred by many accountants, as this helps in simplifying the calculation of depreciation. It 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 that comes by following this method is higher than the times when a 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 value of comparable assets, which are traded in a well-organized market. It 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 the calculation of residual value for a similar type of car.
#3 – Policy
The third one is Policy. There can be a company policy that the residual value of all assets which come under a particular 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 are kept at a very conservative
It must be kept in mind that Residual value of an asset should be calculated at the end of every year specifically. If there is a change in this value estimation while checking, then these changes should be kept in the record to keep a track on changes residual value in accounting estimates. Residual value, salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000., and scrap value are similar terms that 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 article has been a guide to what is Residual Value? Here we discuss its examples along with the top 3 ways to calculate the residual value. You may learn more about accounting from the following articles –