Updated July 17, 2023
Introduction of Residual Value
The residual value is defined as the estimated future value of a fixed asset at the end of asset’s lease term or useful life. Generally, if the asset has a longer useful life or lease period, its residual value will be low.
The residual value is dependent on what a firm expects to obtain on selling or parting out the fixed asset at the end of its lease term or useful life. Various industries uses various ways to calculate the residual value.
For example, a company’s printing machine value depreciates every year. When it completely cease to function or collapse, it has some residual value. The residual value for the printing machine will be calculated based on some past models which are based on net cash inflow when the machine will be sold at the end of its life span.
In industries where prices of assets are regulated by the government, the residual value can be negative due to net cash outflow in disposing of the asset. Such as, nuclear energy plants has to keep nuclear waste at the end of their life span. The cost incurred here is a major contributing factor in determining residual value. In general, the residual value of an asset is inversely proportional to the useful life or lease period of that asset. If the asset has a longer useful life or lease period, its residual value will be low.
Examples of Residual Value
Let’s take an example, John lease a car for four years. Its residual value will be dependent on how much it will be worth at the end of four years. The residual value of car is determined by the bank that issues the lease, which is calculated based on past mathematical models and future predictions model. The car’s monthly lease payments are highly influenced by residual value along with interest rate and taxes.
Let’s consider another example, A printing machinery costs $25,000, which has an estimated service life of fifteen years. It has been estimated that at the end of its service life that is approx. after 15 years, it can be sold as scrap metal to the dumping ground for $4000. The cost of disposing of the machinery is $100.
Hence, scrap value of Printing Machinery = 4000 – 100 = $3900
Factors Affecting Residual Value
- Service Life: Residual Value is highly dependent on Service Life or useful life of an Asset. If the service life of an asset is higher, it’s Residual value will be low, while if the service life of an asset is lower, its residual value will be higher.
- Future Value: The residual value is dependent on what a company is expecting to obtain in place for selling or parting out the asset at the end of its lease term or useful life. While calculating Residual value, we basically estimate the future value of the asset, Hence, if the asset’s estimated future value is higher, it’s Residual value will be higher and vice-versa.
- Usage of Asset: Assets usage another factor that highly affect residual value. Assets that are expected to be used regularly will be having low residual value while the assets which are expected to be used less will be having high residual value.
- Maintenance: Maintenance is how the asset is going to be used and maintained over the life span, it highly impacts the Residual value.
- Recent Market Trends: Residual value is also dependent on recent market trends and the market value of an asset. For example, the residual value of a car is highly dependent on its mileage, life cycle, brand.
Residual Value in Depreciation
Sometimes, Residual Value is also accounted into the entity’s calculation of depreciation or amortization. Let’s take an example, a company acquires a new software program to track purchase orders. The software has an initial purchase value of $20,000 and a useful life of ten years. In order to derive amortization per year for accounting purposes, the business needs to calculate the residual value of software.
Let’s assume that the residual value is $2000 and the business is using the straight-line method to calculate the amortization of the software program. Hence, in this case, the business should first deduct the residual value of $2000 from the $20,000 of the purchase value and then divide the resultant by software’s useful life, which is ten years here, to calculate its amortization per year.
- Amortization per Year = $20000 – $2000 / 10
- Amortization per Year = $1800
Hence in this case, if the residual value for the software program is $2,000, the amortization per year would be $1,800. An investor would use the same above calculation for assets like Bike, Car, or Machinery. Instead of amortizing the asset completely over its useful life, he would depreciate it by residual value. When the residual value is deducted from the initial value, the resultant value is referred to as the “depreciable base.”
Residual Value vs Salvage Value
In accounting, salvage value is defined as an estimated value that is expected to be obtain at the end of an asset’s useful life. Disposal value, residual value, scrap value are some of the names given to Salvage Value. The estimated salvage value is deducted from the total asset value in order to estimate the depreciation of asset during its entire life span. Income tax regulations assume that salvage value for assets in a firm will have zero value. Due to which, the entire cost of the asset gets depreciated over the years when the asset was in use.
Benefits of Residual Value
Some of the benefits of residual value are given below:
- It helps in estimating the overall depreciation of an asset over its entire life span.
- It helps provides a view on the future value of asset.
- It helps in determining monthly lease payment for an asset when on lease.
- It helps in comparing two assets and making a decision on which one to lease. If you take on lease two cars with the same cost but having different residual value than the one having high residual value will be preferable as it will worth higher after 4 years than other cars.
Conclusion
The residual value is dependent on what a firm expects to obtain on selling or parting out the fixed asset at the end of its lease term or useful life. Various industries use various ways to calculate the residual value. Generally, if the asset has a longer useful life or lease period, its residual value will be low.
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