4 proper uses of Residual value
IAS 16 Definition: 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.
Following are areas in which residual-value is used in IFRSs.
IFRS 15 Revenue from contracts with customers
Original Equipment Manufacturers (OEMs) may sell vehicles with a repurchase option or residual-value guarantee (e.g. when they sell fleets to rental car companies). Under a residual-value guarantee, OEMs agree to compensate the customer (‘make whole’) for the difference between the resale price the customer obtains in an open market and the guaranteed minimum resale value. Customers in these cases are importer, distributor or reseller (see also IFRS 15 Sale with a right of return).
Contracts that include residual-value guarantees and make whole provisions may qualify for sale accounting under IFRS 15 and also may include a component of variable consideration. This assessment will require considerable judgement.
An entity that sells equipment may use a sales incentive program under which it guarantees that the customer will receive a minimum resale amount when the customer disposes of that piece of equipment (this is a residual-value guarantee). If the customer holds a put option and has a significant economic incentive to exercise, the customer is effectively restricted in it ability to consume, modify or sell the asset.
In contrast, when the entity guarantees that the customer will receive a minimum amount of sales proceeds, the customer is not constrained in its ability to direct the use of, and obtain substantially all benefits from the asset. Accordingly the Board decided that it was not necessary to expand the application guidance on repurchase agreements to consider guaranteed amounts of resale.
Therefore it is important entities make sure that its contracts do not included a residual value guarantee through a repurchase provision, such as a put within the sales contract (e.g. the customer has the right to require the entity to repurchase equipment two years after the date of purchase at 85% of the original purchase price).
If a put option is present, the entity has to use the below decision tree to determine whether the existence of a put option precludes the customer from obtaining control of the acquired equipment. In such circumstance, the entity would determine whether the customer has a significant economic incentive to exercise the put.
If the entity concludes that there is no significant economic incentive, the transaction would be accounted for as a sale with a right of return. Alternatively, if the entity concludes there is a significant economic incentive for the customer to exercise its right, the transaction would be accounted for as a lease (IFRS 15 Example 62).
|Note – IFRS 15 provides application guidance in respect of written put options where there was limited guidance under previous standards. However, IFRS 15 does not provide any guidance on determining whether ‘a significant economic incentive’ exists and judgement may be required to make this determination.|
However, assume the transaction includes a residual value guarantee in which no put option is present. If the entity guarantees that it will compensate the customer (or ‘make whole’) on a qualifying future sale if the customer receives less then 85% of the initial sale price, the application guidance on repurchase agreements in IFRS 15 would not apply. This is because the entity is not repurchasing the asset.
IAS 16 Property, Plant and Equipment
In most cases the residual-value of an asset is likely to be immaterial. If it is likely to be of any significant value, that value must be estimated at the date of purchase or any subsequent revaluation. The amount of residual-value should be estimated based on the current situation with other similar assets, used in the same way, which are now at the end of their useful lives. Any expected costs of disposal should be offset against the gross residual value.
IAS 16 Definition: Depreciable amount of a depreciable asset is the historical cost or other amount substituted for cost in the financial statements, less the estimated residual-value.
The residual value and the useful life of an asset shall be reviewed at least at each financial year-end and, if expectations differ from previous estimates, the change(s) shall be accounted for as a change in an accounting estimate in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. (IAS 16 51)
Upon revaluing the carrying amount of property, plant and equipment the residual amount must be adjusted with each revaluation.
IAS 38 Intangible assets
The residual-value of an intangible asset with a finite useful life shall be assumed to be zero unless:
- there is a commitment by a third party to purchase the asset at the end of its useful life; or
- there is an active market (as defined in IFRS 13) for the asset and:
- residual value can be determined by reference to that market; and
- it is probable that such a market will exist at the end of the asset’s useful life. (IAS 38 100)
A residual-value other than zero implies that an entity expects to dispose of the intangible asset before the end of its economic life.
IFRS 16 Leases
Residual-value of a leased asset is the estimated fair value of the asset at the end of the lease term used in calculating the net present value of the right-of-use asset and lease liability at initial recognition of a lease contract (see below).
There are two types of guaranteed residual-value (or residual-value guarantee) for the parties involved in a lease contract (IFRS 16 definitions):
- Guaranteed residual-value – in the case of the lessee, that part of the residual value which is guaranteed by the lessee or by a party on behalf of the lessee (the amount of the guarantee being the maximum amount that could, in any event, become payable) (or by IFRS 16 Definition: A guarantee made to a lessor by a party unrelated to the lessor that the value (or part of the value) of an underlying asset at the end of a lease will be at least a specified amount); and
- Unguaranteed residual-value – in the case of the lessor, that part of the residual value which is guaranteed by or on behalf of the lessee, or by an independent third party who is financially capable of discharging the obligations under the guarantee (or by IFRS 16 Definition: That portion of the residual value of the underlying asset, the realisation of which by a lessor is not assured or is guaranteed solely by a party related to the lessor).
The unguaranteed residual-value of a leased asset can also consist of the amount by which the residual value of the asset exceeds its guaranteed residual value.
The lease liability is in fact all payments not paid at the commencement date discounted to present value using the interest rate implicit in the lease (or incremental borrowing rate if the implicit rate cannot bet set). These payments may include fixed payments, variable payments, payment (receipts) under residual value guarantees, purchase price if the purchase option will be exercised etc.
The right-of-use asset is measured in the amount of the lease liability and initial direct costs. This may be adjusted by the lease payments made before or on commencement date, lease incentives received, and any estimate of dismantling and restoration costs.
The gross investment in the lease is the aggregate of the minimum lease payments from the standpoint of the lessor and any unguaranteed residual value accruing to the lessor.
A lessor assesses its entire net investment in a lease for impairment – i.e. including the unguaranteed residual-value and recognise any impairment loss. A lessor does not separately evaluate the unguaranteed residual asset for impairment unless it sells the lease receivable and retains the unguaranteed residual asset.
Similar definitions and definitions including residual-value
In the definition of entity-specific value or value in use an ending value similar to residual-value is used as follows:
Entity–specific value is the present value of the cash flows an entity expects to arise from the continuing use of an asset and from its disposal at the end of its useful life or expects to incur when settling a liability.
Value in use is almost identical: Value in use is the present value of the cash flows that an entity expects to derive from the continuing use of an asset or cash-generating unit and from its disposal at the end of its useful life (combination of IAS 36 6 and IFRS 5 Definition).
Recoverable value or recoverable amount of an asset or a cash-generating unit is the higher of its fair value less costs of disposal and its value in use. (IAS 16 6, IAS 36 6, IFRS 5 Appendix A Definitions)
Goodwill is the residual value or the difference between consideration transferred and the net asset value of all assets and liabilities in a Business Combination valued at fair value at acquisition date
See also: Investopedia: Residual value
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