6.7 Amounts That It Is Probable That the Lessee Will Owe Under a Residual Value Guarantee

ASC 842-10

30-5 At the commencement date, the lease payments shall consist of the following payments relating to the use of the underlying asset during the lease term: . . .

f. For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs 842-10-55-34 through 55-36).

ASC 842-10 — Glossary

Residual Value Guarantee

A guarantee made to a lessor that the value of an underlying asset returned to the lessor at the end of a lease will be at least a specified amount.

ASC 842-10

55-34 A lease provision requiring the lessee to make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive usage is similar to variable lease payments in that the amount is not determinable at the commencement date. Such a provision does not constitute a lessee guarantee of the residual value.

55-35 If the lessor has the right to require the lessee to purchase the underlying asset by the end of the lease term, the stated purchase price is included in lease payments. That amount is, in effect, a guaranteed residual value that the lessee is obligated to pay on the basis of circumstances outside its control.

If a lease contract contains a provision under which the lessee guarantees to the lessor the residual value of the leased asset at the end of the lease term, the lessee should include in its lease payments the amount that it is probable that the lessee will owe at the end of the lease term. Paragraph BC214 of ASU 2016-02 explains the FASB’s rationale for requiring lessees to include in their lease payments amounts that it is probable that the lessee will owe under residual value guarantees:

In the Board’s view, payments probable of being owed under residual value guarantees meet the definition of a liability and are part of the cost of the right-of-use asset and, thus, should be recognized and measured as part of the lease liability and the right-of-use asset. That is because those payments cannot be avoided by the lessee — the lessee has an unconditional obligation to pay the lessor if the market price of the underlying asset moves in a particular way. Accordingly, any uncertainty does not relate to whether the lessee has an obligation. Instead, it relates to the amount that the lessee may have to pay, which can vary on the basis of movements in the market price for the underlying asset. In that respect, residual value guarantees are similar to variable lease payments that depend on an index or a rate for the lessee.

A lessee should remeasure its lease payments when there is a change in the amount that it is probable that the lessee will owe under a residual value guarantee. However, a lessor would not remeasure its lease payments in such circumstances. See Section 6.10 for more information about the requirements for lessees and lessors to remeasure lease payments.

Connecting the Dots

Requirements Related to Residual Value Guarantees for Lessees Differ From Those for Lessors

The requirement to include a portion of any residual value guarantee in the lease payments applies only to lessees. Although the guidance states that a lessor should not include any residual value guarantee amounts in its lease payments, the lessor would initially measure residual value guarantee amounts because, in accordance with ASC 842-30-30-1(a), a lessor would include in its lease receivable the full amount at which the residual asset is guaranteed by the lessee (or a third party). (See Chapter 9 for more information about how to calculate a lessor’s lease receivable.) In addition, a lessor would consider the full amount at which the residual asset is guaranteed when classifying a lease in accordance with ASC 842-10-25-2(d) and ASC 842-10-25-3(b). The example below illustrates how the accounting for a residual value guarantee for lessees differs from that for lessors.

Example 6-15

A lessor leases equipment to a lessee for five years at $10,000 per year. The lessee guarantees that the equipment will have a residual value of at least $9,000 at the end of the lease. The expected residual value at the end of the lease term is $20,000.

Lessee Accounting

In its lease payment calculation, the lessee would only include the amount that it is probable that the lessee will owe under the residual value guarantee at the end of the lease term. Accordingly, the lessee would not include any amount in the initial measurement of the lease liability and ROU asset, because the expected residual value ($20,000) is greater than the guaranteed amount ($9,000). If the expected residual value was $8,000 instead of $20,000, the lessee would include the $1,000 difference between the expected residual value and the guaranteed residual value in its lease payments.

Lessor Accounting

The lessor would not include any amount of the residual value guarantee in its lease payment calculation. However, if the lease were classified as a sales-type lease or a direct financing lease in measuring its lease receivable, the lessor would include the entire portion of the residual asset guaranteed by the lessee (or any other party). Accordingly, in addition to the present value of the five annual lease payments of $10,000, the lessor would include the present value of the $9,000 guaranteed amount in its calculation of the lease receivable. The lessor’s net investment in the lease would consist of the total receivable (including the residual value guarantee) and the present value of the unguaranteed residual asset of $11,000.

Changing Lanes

Full Amount of Residual Value Guarantee Versus Amount That It Is Probable That the Lessee Will Owe in Lease Payments

Under ASC 840, a lessee included in its minimum lease payments the entire amount of the residual value guarantee; however, under ASC 842, a lessee only includes in its lease payments those amounts that it is probable that the lessee will owe under the residual value guarantee at the end of the lease term. As a result, a lower ROU asset and lease liability will generally be recognized on the lessee’s balance sheet for new leases under ASC 842 compared with situations in which that lease was classified as a capital lease under ASC 840.

However, with respect to performing the lease classification test in ASC 842-10-25-2(d), we do not expect a difference between ASC 840 and ASC 842 because ASC 842-10-25-2(d) requires a lessee to include the full amount of any residual value guarantee, regardless of whether it is probable that the amount will be owed. (See Section 8.3.3.6 for a detailed discussion of a lessee’s application of the classification criterion in ASC 842-10-25-2(d).) This is consistent with the requirement under ASC 840 for the lessee to include the full amount of any residual value guarantee in its minimum lease payments when performing the lease classification test.

Entities should also consider whether the lessee has guaranteed the residual value for a group of leased assets when performing the lease classification test in ASC 842-10-25-2(d). Lessees often enter into lease agreements to lease multiple similar assets from a lessor. In these circumstances, lessees will often guarantee the residual value for the group of assets being leased rather than that for each individual underlying asset. Lessees should take into account the impact of the portfolio residual value guarantee (PRVG) when classifying the individual leases within a portfolio. Depending on the facts and circumstances, lessees should use either an “all-in approach” or a “pro-rata approach” to allocate the PRVG when classifying a lease. See Section 8.3.3.6.1 for further discussion of the impact of PRVGs on lessees and an example illustrating application of the all-in approach and pro rata approach. In addition, we believe that, in certain circumstances, lessors may take into account the impact of PRVGs when classifying the individual leases within a portfolio. See Section 9.2.1.4.4 for further discussion of the impact of PRVGs on lessors.

Connecting the Dots

Synthetic Lease Arrangements

As discussed above, under ASC 842, a lessee would include in its lease payments only those amounts related to a residual value guarantee that it is probable that the lessee will owe at the end of the lease term. Lease arrangements (e.g., synthetic lease arrangements) in which a significant portion of the lease payments is structured as a residual value guarantee could therefore result in ROU assets and lease liabilities that are significantly lower than those in arrangements in which more of the lessee’s obligation takes the form of fixed rental payments. For example, since many real estate assets are expected to hold their value over the lease term, amounts that it is probable the lessee will owe under residual value guarantees may be nominal. Accordingly, while these arrangements will be brought onto the balance sheet, synthetic leases and other lease arrangements in which a significant portion of the economics of the lease are structured as a residual value guarantee may continue to yield favorable accounting results (e.g., reduced leverage) under ASC 842.

6.7.1 Sales Proceeds in Excess of Residual Value Guarantee

Some lease contracts may include a provision under which the lessee is entitled to receive any proceeds in excess of the residual amount guaranteed by the lessee upon the sale of the underlying asset at the end of the lease term. Sales proceeds in excess of the residual value guaranteed by the lessee represent a contingent gain for the lessee. Therefore, the lessee should apply the guidance in ASC 450-30 on gain contingencies in accounting for such proceeds. ASC 450-30-25-1 precludes an entity from recognizing a gain contingency in its financial statements until the underlying contingency is resolved. Accordingly, a lessee should not recognize anticipated excess sales proceeds as a reduction in lease payments, or as a gain in its income statement, until the underlying asset is sold and the contingency is resolved.

6.7.2 Residual Value Guarantee Obtained From Unrelated Third Party

ASC 842-10

55-36 A residual value guarantee obtained by the lessee from an unrelated third party for the benefit of the lessor should not be used to reduce the amount of the lessee’s lease payments under paragraph 842-10-30-5(f) except to the extent that the lessor explicitly releases the lessee from obligation, including the secondary obligation, which is if the guarantor defaults, a residual value deficiency must be made up. Amounts paid in consideration for a guarantee by an unrelated third party are executory costs and are not included in the lessee’s lease payments.

To reduce its exposure associated with a residual value guarantee, a lessee may obtain a guarantee from an unrelated third party, such as an insurance company, for part or all of the value of the lessee’s residual value guarantee owed to the lessor.

The residual value guarantee obtained from an unrelated third party reduces the lessee’s lease payments only if the lessor explicitly releases the lessee from its obligation under the residual value guarantee provision in the lease contract between the lessee and lessor. The lessor must release the lessee not only from its primary obligation but also from any secondary obligation (i.e., the lessee’s obligation to pay the lessor if the insurance company defaults on its obligation).

Example 6-16

Lessee K leases equipment from Lessor W for five years in exchange for a fixed payment of $10,000 per year. Lessee K guarantees that the equipment will have a residual value of at least $5,000 at the end of the lease. To reduce its exposure associated with the $5,000 residual value guarantee, K obtains a matching guarantee from an insurance company. Therefore, in the event that the residual value of the equipment is less than $5,000 at the end of the lease term, the insurance company has agreed to pay the lessor the difference. The expected residual value at the end of the lease term is $1,000.

Case A — Lessor Does Not Release the Lessee From Its Obligation

In this case, W does not explicitly release K from its obligation to pay the residual value guarantee if the insurance company defaults on its obligation. Therefore, even though K may not be primarily obligated to pay the residual value guarantee, it still has a secondary obligation to W. Lessee K should not reduce its lease payments for the guarantee provided by the insurance company because W has not explicitly released K from its obligations related to the residual value guarantee. Therefore, K should include $4,000 in its lease payments, which represents the amount that it is probable W will be owed at the end of the lease term ($5,000 guaranteed amount less $1,000 expected residual value).

Case B — Lessor Fully Releases the Lessee From Its Obligation

In this case, because W has fully released K from any primary or secondary obligation related to the residual value guarantee, K should not include any amounts related to the residual value guarantee in its lease payments.

In certain situations, a lessee may be obligated by the lessor or the lease agreement to obtain residual value insurance for the benefit of the lessor. In such cases, the lessee should include the costs incurred to secure the third-party guarantee of residual value in its lease payments (e.g., the amount of the insurance premium needed to obtain the residual value insurance). These types of costs are similar to payments made to an insurance company in which the payor does not benefit (i.e., the lessee pays the insurance company but the lessor is the beneficiary of the policy).

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.