Residual Value

Residual value is the estimated amount a business expects to obtain from an asset at the end of its useful life, or at the end of a lease, after deducting the expected costs of disposal. In depreciation it is the part of an asset's cost that is not expected to be used up, so it is excluded from the amount charged as depreciation. In leasing it is the expected value of the asset when it is returned to the lessor, which strongly influences the lease payments.

In US practice the same idea is usually called salvage value or scrap value when discussing depreciation of fixed assets, while residual value is the standard term in IFRS and in leasing. This entry focuses on how residual value is defined and reviewed under accounting standards and how it works in leases.

The amount to be depreciated over an asset's life is its depreciable cost:

Here $\text{Cost}$ is the purchase price plus costs to get the asset ready for use and $\text{Residual value}$ is the estimated net disposal proceeds at the end of its useful life. Under IAS 16, residual value is defined as the amount the entity would currently obtain from disposing of the asset if it were already of the age and condition expected at the end of its useful life. This means it is estimated in today's prices, not inflated future prices. IAS 16 also requires residual value and useful life to be reviewed at least at each financial year end. If the residual value rises to equal or exceed the asset's carrying amount, depreciation stops until it falls back below. US GAAP is less prescriptive but also expects estimates to be revisited when circumstances change.

A revision to residual value is a change in accounting estimate. It is applied prospectively, adjusting depreciation for the current and future periods, without restating past years.

A company buys a delivery van for $50,000, expecting to use it for five years and then sell it for $10,000 net of selling costs. Straight-line depreciation is $50,000 minus $10,000, divided by 5, or $8,000 a year. After two years the carrying amount is $34,000. The company then finds that used vans are selling for less and cuts the residual value estimate to $4,000. The remaining depreciable amount is $34,000 minus $4,000, or $30,000, spread over the three remaining years, so depreciation rises to $10,000 a year.

If the van is eventually sold for $6,000 when its carrying amount is $4,000, the company records a $2,000 gain on sale of assets. Under the declining balance method, the residual value is not deducted when calculating each year's charge, but depreciation stops once the carrying amount reaches it.

For a lease, the residual value is the lessor's estimate of what the asset will be worth at the end of the lease term. A car leased for three years might have a residual value set at 55 percent of its list price. The lessee essentially pays for the expected loss in value over the term plus interest, so a higher residual value means lower monthly payments. If the car is worth less than the residual value at the end, the lessor bears the loss, unless the lessee has guaranteed the residual value.

Guaranteed residual values matter in lease accounting. Under ASC 842 and IFRS 16, amounts the lessee expects to pay under a residual value guarantee are included in the lease liability. Lessors track unguaranteed residual values as part of their net investment in sales-type and finance leases.

Estimates draw on used-asset markets, industry guides, the company's own disposal history and expected technological change. Many businesses assume a residual value of zero for assets such as computers or specialized machinery that will have little resale value. Overestimating residual value understates depreciation and overstates profit, which is why auditors review the assumptions, particularly for fleets, aircraft and other assets where residual values are large.