There are two main types of assets a business entity holds when it comes to consumption. Some assets are fully consumable and do not have any value at the end of their useful life. On the other hand, some assets are not fully consumable and are left with a residual value at the end of useful life. These assets are usually called capital assets.
Capital assets are fixed assets because their benefits to the business entity are extended over more than one financial period. The acquisition cost exceeds the company’s estimates. These assets are depreciated every financial year to realize the asset’s value as a part of the expense. The discussed properties of capital assets help differentiate them from ordinary assets.
A fixed asset’s residual value or salvage value is usually an important consideration for a business entity. The residual value serves as a base for several estimates, financial analysis, and calculations to the business entity.
Therefore, understanding residual value determination is important for a business entity and a financial analyst. This article will discuss the methods to calculate a fixed asset’s residual value and the importance of the calculation.
What Is Residual Value Of A Fixed Asset
The residual value is the dispose-off value if a fixed asset is sold by the business entity. The simplest definition of an asset’s residual value is its value after full depreciation.
It can be defined as,
Residual value or salvage value of an asset. Residual value is the amount that the owner of a fixed asset expects to receive if the asset is disposed of by selling it at the end of its useful life.
The useful life of an asset is an important consideration in determining an asset’s disposal value. The residual value determination assumes that the asset will reach the end of its useful life and will be in the expected condition at the end of useful life.
Residual Value Vs. Salvage Value
Residual value and salvage value are the terms interchangeably used for the end value of a fixed asset. However, the practical implications of residual and salvage value are different from each other. A business entity acquires assets by different methods, including purchasing an asset or leasing it from a financial institution. In both cases, the useful life and end-life value are estimated by the business.
The residual value of fixed assets is calculated for leased assets. However, the salvage value is the term generally used for the life-end value of purchased assets.
Understanding Residual Value
Business organizations often determine the residual value or the salvage value for the asset’s cash flow estimations and depreciation. The determination of an asset’s residual value varies from industry to industry. The residual value determination for capital budgeting projects is different from that for investment. The residual value in capital budgeting represents the amount expected to be recovered by selling an asset after it is no longer useful for cash flow generation.
The residual value in the case of investments is determined by subtracting the profit from the investment cost. The concept can be broken down into the leased assets and purchased assets.
Residual Value And Leases
Take an example of a car you have got from the bank on lease. The residual value for the car will be the car’s value at the end of the lease period. We can define the residual value of a leased car as the amount lessee can pay to take ownership of the car.
The financial institutions issuing the lease calculates the asset’s residual value at the time of the lease agreement. The amount is usually a fixed sum, and it is determined based on the past models and future predictions of financial institutions. The residual value of the lease is inversely proportional to its useful life. The higher the useful life, the lower the residual value of an asset.
For instance, a bank issued you a car on a lease, and the car has a value of 35,000 USD. According to the bank’s estimates, the car’s residual value will be 16,000 USD at the end of the lease period. The lessee will pay the difference of actual and residual value as lease payments during the lease period. If the asset’s residual value is higher, the monthly or annual lease payments are lower and vice versa.
Residual Value And Purchases
In the case of a purchased asset, the residual value is calculated by using salvage value. The salvage value equals the book value of assets after recognizing full depreciation during the useful life.
Take an example of a car you purchased that has an estimated useful life of 12 years. After 12 years, the business decided to dispose of the car. It was sold to a junk dealer for 700 USD. The cost of transporting the car was $80. The residual value of the car will be calculated as the difference between salvage value and disposal cost. The disposal cost, in this case, is the transportation cost of the car. Therefore, the car’s residual value will be equal to 620 USD, 700 USD – 80 USD.
Unlike the residual value of the leased assets, the purchased assets’ salvage value is analyzed annually, and estimates are revised for any market change.
How To Calculate Residual Value
The business entities are required to determine a ‘reasonable amount of the asset’s value as salvage or residual value. The implication is imposed by the IRS and is also necessary for the calculation of depreciation. The amount of residual value depends on the type of asset and its usage.
The asset having a longer useful life has a lower residual value. It is common across business entities to record salvage value as zero for the assets that are held and used for a longer time. The residual value also depends on the materiality and obsoletion. The residual value of an asset that becomes obsolete due to technological change is also recorded as zero.
It can be difficult to estimate the residual value of more expensive assets like a plant or machinery. As discussed earlier, technological advancements can make an asset lose its value quicker than expected. It can be a similar case for the plant or machinery that becomes obsolete due to new technology. In such cases, many business organizations choose to have residual value insurance to protect themselves from future unforeseen changes.
Methods For Calculating Residual Value
There are three methods of calculating the residual value. One we’ve already briefly discussed is zero value. Let’s discuss each of the methods.
Zero Residual Value
The zero residual value method is generally adopted for the assets that are low in value or are expected to be consumed fully by the end of their useful life. The no residual value method simplifies the depreciation calculation for the business entity.
The depreciation value for every financial period is higher in this method than the case when residual value estimates are used. The zero residual value method is also preferable for the assets expected to have a life-end value much below the predetermined threshold level.
The comparables approach is also widely used, and it takes into account the market norms for similar assets. The residual value estimates are compared to the residual value of similar assets traded in the market. The comparable approach is the most justifiable.
Take an example of a purchased car. The accounting experts will compare the car’s residual value with similar cars in the open market.
The third approach used for estimating an asset’s residual value is the company’s policy. A business entity might make a policy that assets belonging to a particular class will be determined to be the same. It is not preferable because the residual value can be higher for one asset in the market than the other. The policy approach is only followed if the company strictly follows conservative accounting principles when the estimates are made to the lowest possible value.
Importance Of Residual Value
The calculation of residual value is important for a business from many perspectives.
For the leased assets, the residual value helps in calculating the lease rates and lease payments. As discussed earlier, the higher the residual value lower the periodic lease payments and vice versa. The financial institutions calculate the residual value for determining periodic payments.
From a business perspective, the residual value facilitates the business entity in calculating depreciation and amortization. The annual depreciation expense is calculated by dividing the difference of the asset’s cost and residual value on the useful life. Similarly, the amortization of intangible assets is also determined by factoring in the residual value.
The calculation of residual value is a significant measure in accounting, but the realistic estimation is also critical. Suppose the business entity sets a residual value too high. In that case, the depreciation will be understated, income will be overstated, and retained earnings will also be overstated in the balance sheet.
Similalrly, setting a too low value is also not preferable. In that case, the asset’s depreciation will be overstated. Whereas the retained earnings, net income, and asset’s value will be understated in financial statements.
Therefore, a business entity must ensure that the most defensible method of estimating residual value is used by accounting personnel.