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).