Residual ValueAn Asset's worth at the end of its useful life or lease term

When a long-term asset reaches the end of its useful life, a business will typically dispose of it.

The business has options on how it will dispose of its fully depreciated asset.

It can simply just throw away the asset as if it was junk.

Or it can dismantle the asset for scrap.

But if the business finds that the asset still has value even if it’s fully depreciated, then it will sell the asset.

This value at the end of the asset’s useful life is what we refer to as its residual value (a.k.a. salvage value).

Residual value influences the depreciable amount of an asset.

In general, the longer the useful life of an asset is, the lower its residual value will be.

For example, an asset that has a useful life of 10 years will relatively have a lower residual value than an asset that has a useful life of 5 years (assuming they have the same original cost).

In leasing, residual value refers to the asset’s worth after the lease period.

Just like with depreciation, residual value influences the lease payments.

Also, the longer the lease term is, the lower the residual value will be.

In this article, we will be talking about what residual value is.

How does it affect the calculation of depreciation or lease payments?

What are the factors that determine an asset’s residual value?

How can one determine an asset’s residual value?

Can a business opt to not consider an asset’s residual value in the calculation of its depreciation?

We will try to answer these questions as we go along with the article.

What is Residual Value?

Residual value (a.k.a. salvage value) refers to the estimated value of a long-term asset at the end of its useful life or lease term.

It’s one of the factors that affect an asset’s depreciable amount.

In leasing, residual value influences how much the lessee pays in lease payments.

As a rule of thumb, an asset’s residual value is inversely related to its useful life or lease term.

This means that the longer the useful life or lease term, the lower the asset’s residual value will relatively be.

Residual value in the context of depreciation

Residual value is often referred to as salvage value or scrap value in the context of depreciation.

It is the amount that the business expects to receive at the end of the asset’s useful life.

It influences the calculation of depreciation in that it affects the depreciable amount of the asset.

In context, this is how we typically calculate an asset’s annual depreciation using the straight-line method:

Depreciation = (Asset’s Original Cost – Residual Value) ÷ Useful Life

The higher the residual value, the lower the depreciable amount will be.

For example, two assets have the same cost and useful life.

Where they differ is that one asset has a residual value of $2,000 while the other has $0.

If we calculate the depreciation of these two assets, the asset that has a higher residual value will have a lower depreciation amount.

Residual value in the context of leasing

In the context of leasing, residual value affects how much the lessee pays in lease payments.

It is often defined as a percentage of the asset’s list price or market value.

For example, let’s say that an asset has a list price of $10,000 today.

After a lease term of 3 years, the residual value of the asset is expected to be 50% (which is $5,000).

This amount will determine how much the lessee will pay in lease payments.

In this case, the lessee will have to pay at least $5,000 ($10,000 – $5,000) of lease payments in total.

I say at least because there are still additional to consider such as interest and taxes.

Residual value also influences an asset’s lease buyout.

A lease buyout is an option that allows the lessee to buy the leased asset at the end of the lease term.

Lessors will often base the buyout on the asset’s residual value.

Zero Residual Value

In some cases, accountants opt to not include the asset’s residual in the calculation of its depreciation.

This is most common for lower-value assets that have relatively insignificant amounts of residual value.

The benefit of doing this is that it simplifies the calculation of depreciation.

However, it can also result in higher recognition of depreciation expense.

An asset may also have zero residual value if the business does not plan to sell it at the end of its useful life (even if it has market value).

Since the business does not expect to receive any amount at the end of the asset’s useful life, it’ll be pointless to assign it a receive a residual value.

The asset will be worthless by the time it becomes fully depreciated.

Assigning it a residual value will only overstate the total assets of the business.

Thus, it’ll be then more logical to depreciate the whole cost of the asset to ensure that it doesn’t have any worth on the balance sheet (once it reaches the end of its useful life).

Factors That Can Affect Residual Value

At the end of the day, an asset’s residual value is still an estimate.

It may not always be an accurate representation of an asset’s future value.

However, there are certain factors that we can consider in assigning the most accurate residual value possible.

These factors are the following:

The asset’s useful life

As a rule of thumb, an asset’s residual value is inversely related to its useful life.

The longer the useful life, the lower the residual value will be.

Conversely, an asset that has a shorter useful life will have a relatively higher residual value.

Usage of the asset

Another factor that can affect residual value is asset usage (or how the asset will be used).

Assets that are expected to be used regularly will naturally depreciate faster.

Thus, these assets will have lower residual values.

In contrast, assets that will be used sparingly will depreciate slower.

Thus, these assets will have higher residual values.

Maintenance and condition of the asset

The condition of the asset will affect its residual value.

Purchasers of used items will often haggle if they find faults in the condition of the item.

A well-maintained item will have fewer of these faults.

Thus, if an asset is properly used and well-maintained, it will have a higher residual value.

Marketability of the asset

Residual value is essentially the amount that the asset owner expects to receive at the end of the asset’s useful life or lease term.

In order to receive such an amount, there must be someone else willing to pay for it.

Thus, a need for a market for the asset.

Depending on the marketability of the asset, it may have a higher or lower residual value.

Assets that are highly niche will probably have lower residual values.

For example, let’s say that a bottling company owns a certain piece of machinery.

It is heavily modified to cater to the design of the company’s bottles.

Thus, this piece of machinery is highly niche.

The market for such an asset is limited, and thus, we should expect that it has a lower residual value.