The residual value of an asset is determined by considering the estimated amount that an asset's owner would earn by disposing of the asset, less any disposal cost. With residual value, it is assumed that the asset has reached the end of its useful life and is in the condition the asset was expected to be in at the end of its life. The residual value of an asset is important when determining the value of an asset at the end of a lease.

Key Takeaways

  • The residual value of an asset is the estimated amount that an asset's owner would earn by disposing of the asset, less any disposal cost.
  • With residual value, it's assumed that the asset has reached the end of its useful life.
  • The residual value of an asset is important when determining the value of an asset at the end of a lease.

Understanding How Residual Value is Determined

Residual value is sometimes referred to as an asset's salvage value, which is the asset's worth at the end of its estimated useful life. Assets can be purchased or leased, and at the end of an asset's useful life or the end of the lease term, the asset's worth is also called the residual value. Useful life is typically referred to as the length of time an asset generates revenue for a company or adds value to the owner. However, salvage value is typically used for purchased assets while residual value is typically used for leases.

Residual Value and Leases

When it comes to the residual value of a leased car, for example, it equals the estimated value of the car at the end of the lease. It is the price at which the lessee can purchase the car from the leasing company if it's been decided to keep the car at the end of the lease.

The bank or financial institution determines the residual value of the car in a lease agreement. The bank's calculated residual value can greatly impact the monthly payments. If, for example, a bank believes that a $32,000 car has a residual value of $15,000 at the end of the lease term, the lessee would need to pay the $17,000 difference. However, if another financial provider calculates the residual value of the same car as $8,000, the lessee would need to pay $24,000 in total payments ($32,000 - $8,000 residual value).

When leasing a vehicle, a rule thumb to remember is the higher the residual value, the lower the lease payments for the lessee.

Residual Value and Purchased Assets

If a person owns a car instead of leasing it, the residual value would equal the salvage value of the car minus any costs to dispose of the car. Imagine, for example, that a person has a 10-year-old car that is considered to be a clunker. The person might be able to sell the car to a buyer who needs the parts or a junk dealer for $500 to dispose of the car. If it costs $100 to transport the car to the junkyard, the residual value of the car would be $400.

The residual value of an asset should be checked at least once a year, at the end of each year. If the residual value estimate changes when checking its value, the change should be accounted for as a change in the accounting estimate.

Special Considerations

Residual value can be difficult to forecast for companies that purchase fixed assets, such as machinery and equipment. The more expensive the asset, the more challenging it can be to determine the residual value since it's hard to know how much usefulness the asset might have in serval years. Also, technology assets can lose value very quickly due to technological advances making the asset obsolete. As a result, some companies buy residual value insurance to protect them in case the asset depreciates in value by a greater amount than initially forecasted.