When first recognizing an asset on the balance sheet as a part of property, plant and equipment or part of intangibles, you should come across with the term ‘residual value’. I say that you ‘should’ because most accounting standards (at least the ones based on IFRS) are referring to the need to determine one.

The general rule is that the difference between cost and residual value is charged as depreciation over the useful life on an asset. When cost value is something that is easier to grasp as a definition, the term ‘residual value’ is too many times misinterpreted.

What the residual value means is the value that you’d get from realizing the asset at the balance sheet date if it was in the condition it will be after the end of the useful life. Say that you have a building, which you have determined to have a useful life of 20 years. You build it in year 2010 for 10 million EUR and as at 31 December 2010 you recognize it on the balance sheet. The residual value would be the amount you would get from selling the building if it was 20 years older at the very same balance sheet date.

And to come back to the general rule, if you determine the residual value is for an example 3 million EUR, the depreciation charge is the difference between 10 and 3, which is 7 million EUR, charged over the useful life, which in this example is 20 years. The annual depreciation charge would be in this case 0.35 million EUR (7/20 = 0.35).

What I have seen happening is accountants and management determining the residual value based on the market rates for building similar building as at certain balance sheet date. This is however clearly the wrong approach and when not giving material differences, should not be practiced. Residual value is essentially something you would receive from this asset not something that you’d be require to give away for keeping or building the asset as a new one.