In Chapter 7, you learned and discussed bad debts as assets. This week you are e
ID: 2501036 • Letter: I
Question
In Chapter 7, you learned and discussed bad debts as assets. This week you are exploring ways to account for tangible and intangible assets. Assume you are an assistant controller for a company. While you are preparing quarterly budget figures, it occurs to you that there are no residual values for the long-lived assets. You discuss this with the division director and he has specified that assets be given a residual value of zero. The director believes that estimates are “accounting magic” and have doubtful value. Although he can accept the estimate of a finite useful life, he believes that the residual is no more than a guess and has no place in his business. “Who knows what they’ll be worth when we’re through with them?” He says that the division always negotiates the best price possible when the assets are replaced, and takes any gain or loss at that time, when a “real” number is available. What should you do? What is a residual value? How is it determined? Why is it subtracted from cost before depreciation expense is calculated?
Explanation / Answer
Determining a residual value assuming to be zero at end of assets useful life may impact the company forecasting in case of replacement of long lived assets. The impact is explained as follows :-
Definition :-
The residual value represents the cash flows associated with the eventual disposition of the asset , which may include items such as the selling costs and/or salvage value of the asset or asset group that remains at the end/at the time of replacement of the primary asset's useful life.
Why subtracted from cost before depreciation is calculated?
Some depreciable/ assets have short life and inexpensive and may have little value at the end of their Useful Lives. Other assets will have significant value at the end of their lives and can be sold or traded-in for a new asset.Hence, its an important factor to the determine the Cost of asset for estimating cash flows .
In any case, the amount of depreciation that can be taken for a fixed asset should not exceed its Salvage Value and should not be a negative number
Incorrect or mis-estimated Salvage Value will result in error prone depreciation calculations and can have the following harmful impacts on your company, especially if Salvage Value is set too high:
On the other hand, if Salvage Value is set too low:
How the residual value determined?
International Accounting Standard (IAS) 16: Property, Plant and Equipment defines
The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.
From the definition we understand:
Some of the ways , by which it can be determined, as :-