One of the reasons for charging depreciation against the historical cost of the asset, revalued amount or simply carrying value of asset is that asset’s book value should be reduced to such residual value which was expected at the time of purchase. For that, depreciation expense charged in an accounting period is adjusted accordingly.
Residual value is also known as scrap value.
One of the confusions regarding residual value is whether residual value, which is estimated at the time of acquisition of asset and deducted from the cost of the asset to determine depreciable value, is the present value or the future value?
International Accounting Standard (IAS) 16: Property, Plant and Equipment was previously silent about this and entities were left to make their own interpretations in this regard. However, once updated the definition of residual value in IAS 16 is clear about this matter and defines residual value as follows:
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:
- Residual value is an estimate
- Residual value is determined after deducting disposal costs from disposal value
- Residual value is the amount that entity would currently obtain if we assume the asset is in the same condition and age that we expect it to be at the end of its useful life.
So we understood that residual value is not simply a present value of the asset which we can compute by discounting the future value rather it demands more assumptions and involves judgement on part of the management of the entity.
In simple words, residual value is determined not by making future estimates and then discounting such value rather, future conditions and circumstances are put in present frame of time and applied on the asset to determine its current residual value as per those conditions. This is expected to give more accurate figure of residual value of the asset.
However, in the examination situations, stating all such conditions and circumstances is not possible therefore, students are not required to get in such complexities and a straightforward figure of residual value is given in the question which is deducted from the cost of the asset if computation of depreciable value is required.