Residual value is the projected value of an asset at the end of its useful life, affecting depreciation calculations. Junk value is used in insurance to determine payouts for written-off assets. Depreciation divides total loss into annual parts for accounting and tax purposes.
Residual value is a term used primarily in finance in connection with depreciation. It is the projected value of an asset at the end of its projected useful life. This value affects the calculations used to generate the depreciation figures for the financial accounts. The term “junk” can also be used for a related meaning in insurance, specifically to decide the payout if a car is written off.
Depreciation is both the concept that an asset loses value over time and the accounting practices used to reflect this concept. Loss of value can be the result of physical deterioration, for example a machine that wears out. It could also be the result of an asset becoming obsolete, for example a computer that eventually can’t run the latest edition of the software a business needs to use.
Both US accounting customs and tax laws allow companies to break this total loss of value into annual parts, rather than waiting until the asset is truly worthless. This helps prevent the accounts from showing a significant loss that can give a misleading impression in the company’s annual accounts. It also extends the benefit the company makes by counting a portion of the loss against its taxable profit.
Once an accountant has assigned an expected useful life to the asset, which may be fixed by tax laws, he or she must decide what scrap value the asset will have at the end of this useful life. This figure is also known as residual value. The value of scrap metal can vary wildly: in the worn-out machine example, it may simply be the money that can be raised by selling the metal to a salvage yard; In the computer example, it might be a reasonable proportion of the purchase price if it’s still in working condition, and might be useful to a used buyer with less demanding software needs.
The accountant then deducts the scrap value from the purchase price to determine the full amount of depreciation for accounting purposes, and then divides this amount into chunks to classify it as a loss for each of the years over the asset’s projected useful life. The exact way the amount is divided can vary: it may simply be equal portions, but other systems involve allocating larger portions for the first few years. At the end of the useful life, the actual scrap value of the asset must be calculated. The difference between this and the original projected scrap value must be added to the accounts for that year as a gain or loss to balance the books.
Junk value can also be used for insurance purposes, especially auto insurance. If a car is involved in an accident and the insurer estimates that the repair costs would exceed the current value of the car, they will write off the car and pay what is known as a total loss settlement. This is the current market price for the car of the age and condition it was in before the accident, less the salvage value. This reflects the fact that, theoretically at least, the owner could recoup some money by selling the wreck to salvage it.
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