Residual Value: Meaning, Use Cases, and Example Calculations
Learn what residual value is and how to calculate it.
What is Residual Value?
Residual value is an estimated value based on what a company believes it will net from the sale or disposal of a fixed asset at the end of its useful life. The term can also be used to refer to the anticipated value of a vehicle – or other asset – at the end of its lease term. In accounting, residual value is sometimes used interchangeably with salvage value. However, the two terms have slightly different definitions. The salvage value of an asset is used in the calculation for its residual value.
What Is The Formula For Residual Value?
The formula for residual value is:
Residual Value = Estimated Salvage Value - Estimated Costs of Disposal
How Do I Calculate Residual Value?
Residual value calculations may vary slightly by industry, but the theory is the same in all cases. The residual value is found by subtracting the estimated costs of disposal from the asset’s estimated salvage value. Because it is calculated early on in an asset’s life, its future value must be estimated.
Management can estimate the asset’s salvage value and potential disposal costs by reviewing recent transactions involving comparable assets in a similar industry. Often, the residual value of an asset is simply assumed to be zero.
Asset Salvage Value
An asset’s salvage value is the book value that remains on the company balance sheet at the end of its useful life. Its useful life is the length of time in which the asset can be expected to generate revenue for the company, and it is also the length of time over which the asset is depreciated. When it is fully depreciated on the company’s balance sheet, it may still hold some value for the company that can be realized at the eventual sale of the used asset. This value remains on the balance sheet until the asset is sold.
Asset Disposal Costs
An asset’s disposal costs include expenses directly related to the disposal of the asset. The company may incur costs to remove, sell, or destroy the asset. When these two estimated figures– salvage value and disposal costs– have been determined, the residual value can be calculated.
How Is Residual Value Used in a Car Lease?
In relation to car leases, residual value is the remaining value at the end of the lease term. The residual value of a car lease is determined by the lending agency based on historical data models and projected future estimates. A car lease’s residual value is used to calculate your monthly car lease payment. The higher the residual value of a car at the end of its lease term, the lower the monthly lease payments and vice versa.
The residual value of your vehicle is determined by the lending agency at the beginning of your lease term. The vehicle’s residual value is based on several factors including its anticipated resale value and reliability.
Example market factors that can affect vehicle residual value:
- Changes in consumer preferences
- Gas price fluctuations
- Competitor vehicle availability and supply
- Improvements and technological advances in newer vehicle models
If your vehicle’s residual value is higher, it means the vehicle’s expected depreciation over the lease term is lower. This generally correlates to a lower lease payment. Alternatively, a lower residual value means the vehicle is expected to experience greater depreciation in value over the lease term. In return, the lease payments will be higher.
Major factors that affect your car lease payment include:
- Vehicle residual value
- Current interest rate
- Applicable taxes
Closed-Ended Car Lease
With a close-ended lease, the lessor (company leasing you the car) takes on the risk of depreciation. If your vehicle’s fair market value at the end of your lease is less than the initial projected residual value the financing agency determined, you have no obligation to pay the difference.
Open-Ended Car Lease
With an open-ended lease, the lessee (the person leasing the car) takes on the risk of depreciation. If your vehicle’s fair market value at the end of your lease is less than the initial projected residual value the financing agency determined, you may have to pay the difference between the residual value of the car and its current fair market value.
How Is Residual Value Used When Calculating Depreciation?
The residual value of an asset is used to determine its depreciation basis. When a company purchases an asset, it records the asset on its balance sheet at its original acquisition cost.
Example acquisition costs:
- Purchase price (minus any discounts)
- Freight and shipping costs
- Sales tax
- Installation costs
- Other delivery or setup fees
The asset’s depreciation basis is its original acquisition cost minus its residual value. The depreciation basis is the total dollar value that will be depreciated over the course of the asset’s useful life. If the company uses straight-line depreciation, an asset’s annual depreciation expense can be found by dividing the depreciation basis by the number of years in its useful life.
The depreciation expense is reported on the company’s income statement each year. Additionally, an accumulated depreciation account reduces the net value of the asset on the balance sheet. Each year, the depreciation expense is added to the accumulated depreciation account– which carries a running balance. At the end of its useful life, the net between the asset’s original acquisition cost and its accumulated depreciation will equal the residual value.
The residual value does not appear as a specific line on the company balance sheet for investors to view, but the company will track the book value of its assets on a depreciation schedule.
Depreciation schedule key components:
- Asset acquisition cost
- Asset accumulated depreciation
- Current book value of assets
A depreciation schedule provides the line-by-line detail that tracks the value of an asset over a period of time. The asset value and accumulated depreciation calculated via the depreciation schedule ties to the amounts you can find listed in the assets section of a company balance sheet.
Changes to Residual Value
Occasionally, as a result of market changes, a company may need to adjust its estimate of the residual value of certain fixed assets on its books. When it makes a change in a residual value calculation, the amount must be reported in the footnotes of the financial statements. The note should also include the net increase or decrease in the company’s profit or loss as a result of the changes.
Example of Residual Value in Depreciation Calculation
Assume ABC company purchases a machine for $12,000. ABC also incurred $1,200 in shipping costs and spent $1,800 on installation. The company believes at the end of 5 years, the asset can be sold for $2,500 and thus determines the residual value of the asset is $2,500.
Calculating Asset Deprecation:
- Total acquisition cost = $12,000 + $1,200 + $1,800 = $15,000
- Residual value = $2,500
- Depreciation basis = $15,000 - $2,500 = $12,500
- Annual depreciation = $12,500 / 5 years = $2,500 / year
If ABC uses straight-line depreciation over a useful life of 5 years, it will recognize $2,500 ($12,500 depreciation basis / 5 years) of depreciation expense annually. At the end of 5 years, the balance sheet will include $15,000 for the asset’s original acquisition value and $12,500 in accumulated depreciation, for a residual value of $2,500.
Real Company Example: UPS Reduction in Estimated Residual Value
Financial statements in the United States are reported in accordance with Generally Accepted Accounting Principles (GAAP). However, a company may occasionally want to highlight the effect of a certain transaction in a way that does not follow GAAP.
In its first quarter 2023 earnings call, UPS notes that it incurred a one-time, non-cash charge in late 2022 that resulted from the reduction in the estimated residual value of its MD-11 fleet of cargo planes. In other words, the estimated resale value of these planes is now lower than initially expected. This one-time, non-cash charge lowered the operating profit on its GAAP-compliant income statement.
As a result, UPS reported supplemental non-GAAP financial measures in the footnotes of its financial statements in the 2022 annual report on Form 10-K. UPS explained that it included the supplemental presentation to exclude the impact of the non-cash charge. This allows financial statement readers to compare ongoing expenses more directly year-over-year.
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