How to determine lease residual value
The residual value calculation
Residual value is the salvage value of an asset. That is, it represents the amount of value that the owner of an asset can expect to eventually obtain when the asset is dispositioned.
The key issue with the residual value concept is how to estimate the eventual amount that an owner will obtain from an asset as of a future date. There are several ways to do this, as noted below:
- No residual value. The most common option for lower-value assets is to conduct no residual value calculation at all; instead, assets are assumed to have no residual value at their end-of-use dates. Many accountants prefer this approach, since it simplifies the subsequent calculation of depreciation. This is a particularly efficient approach when the amount of any likely residual value falls below a predetermined threshold level. However, the resulting amount of depreciation recognized will be higher than would have been the case if a residual value had been used.
- Comparables. If a residual value is to be calculated at all, the most defensible approach is to use the residual values of comparable assets, especially those traded in a well-organized market.
For example, there is a large market in used vehicles that can be the basis for a residual value calculation for similar types of vehicles.
- Policy. There may be a company policy that the residual value for all assets within a certain class of assets is always the same. This approach is not defensible if the policy-derived value is higher than market value, since using it would reduce the depreciation expense for a business. Thus, this approach is not usually used unless the policy-based values are deliberately set at a conservative level.
As an example of a residual value calculation, a company purchases a truck for $100,000, which it assumes will be used for 80,000 miles over the next five years. Based on that usage level, the market prices of similar vehicles indicate that a reasonable residual value would be $25,000. The company then uses this figure as the official salvage value for the truck, and only depreciates the $75,000 portion of the truck's cost that is expected to be used over the expected five-year life of the asset.
Residual value is also known as salvage value .
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