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Chapter15: Leases

Residual Value

The residual value or salvage value, the amount the company expects to receive for the asset at the end of its service life less any anticipated disposal costs. of leased property is an estimate of what its commercial value will be at the end of the lease term. In our previous examples of capital leases for which no BPOs were present, we assumed that the residual value was negligible. Now let's consider the economic effect of a leased asset that does have a material residual value and how that will affect the way both the lessee and the lessor account for the lease agreement.

   Suppose the copier leased in Illustration 15-3 was expected to be worth $60,000 at the end of the six-year lease term. Should this influence the lessor's (CompuDec) calculation of periodic rental payments? Other than the possible influence on rental payments, should the lessee (Sans Serif Publishers) be concerned with the residual value of the leased assets? The answer to both questions is maybe. We'll use Illustration 15-5 to see why.

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ILLUSTRATION 15-5

Residual Value

On January 1, 2011, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015. The estimated useful life of the copier is seven years. At the end of the six-year lease term, ending December 31, 2016, the copier is expected to be worth $60,000. CompuDec manufactured the copier at a cost of $300,000* and its interest rate for financing the transaction is 10%.

*This provision is for consistency with Illustration 15–3 , which described a sales-type lease. However, our discussion of the effect of a residual value would be precisely the same if our illustration were of a direct financing lease (for instance, if the lessor’s cost were $479,079). except that neither sales revenue nor cost of goods sold would be recorded in a direct financing lease.

   We consider the lessee first.

p. 828

Effect on the Lessee of a Residual Value

Should the lessee view the residual value as an additional “payment” by the lessee as it did for the BPO price in the previous section? That depends on whether the lessee guarantees the residual value to be a particular amount at the end of the lease term.

GUARANTEED RESIDUAL VALUE.    Sometimes the lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessor's risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value. The lessee promises to return not only the property but also sufficient cash to provide the lessor with a minimum combined value. In effect, the guaranteed residual value is an additional lease payment that is to be paid in property, or cash, or both. As such, it is included in the minimum lease payments and affects the amount the lessee records as both a leased asset and a lease liability, as shown in Illustration 15-5A.

 

The guaranteed residual value is considered an additional lease payment that is to be paid in property, or cash, or both.

ILLUSTRATION 15-5A

Lessee's Calculation of the Present Value of Minimum Lease Payments Including a Guaranteed Residual Value

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*Present value of an annuity due of $1: n = 6, i = 10%.
Present value of $1: n = 6, i = 10%.

You should recognize this as the same calculation we used in the previous section when we had a BPO, and so the BPO price was considered an additional lease payment. In fact, the amortization schedule is precisely the same as in Graphic 15-9 on p. 826 when we had a BPO.

   A question you might have at this point is: Why did we ignore the residual value earlier when we had a BPO? The reason is obvious when you recall an essential characteristic of a BPO—it's expected to be exercised. So, when it is exercised, title to the leased asset passes to the lessee and, with title, any residual value. When that happens, the residual value cannot be considered an additional lease payment to the lessor.

 

If the lessee obtains title, the lessor's computation of rental payments is unaffected by any residual value.

UNGUARANTEED RESIDUAL VALUE.    The previous example demonstrates that when the residual value is guaranteed, the lessee views it as a component of minimum lease payments. But what if the lessee does not guarantee the residual value? In that case, the lessee is not obligated to make any payments other than the periodic rental payments. As a result, the present value of the minimum lease payments—recorded as a leased asset and a lease liability—is simply the present value of periodic rental payments ($445,211). The same is true when the residual value is guaranteed by a third-party guarantor. (Insurance companies sometimes assume this role.)

Effect on the Lessor of a Residual Value

GUARANTEED RESIDUAL VALUE.    When the residual value is guaranteed, the lessor as well as the lessee views it as a component of minimum lease payments. In fact, even if it is not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both. If CompuDec retains title to the asset at the end of the lease term, then it would anticipate receiving the $60,000 residual value at the conclusion of the lease term. That amount would contribute to the total amount to be recovered by the lessor and would reduce the amount needed to be recovered from the lessee through periodic rental payments. The amount of each payment would be reduced from $100,000 to $92,931, calculated in Illustration 15-5B.

 

The lessor subtractsthe PV of the residual value to determine rental payments.

p. 829

ILLUSTRATION 15-5B

Lessor's Calculation of Rental Payments When Lessor Retains Residual Value

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*Present value of $1: n = 6, i = 10%.
Present value of an annuity due of $1: n = 6, i = 10%.

   You should notice that the lessor's calculation of periodic rental payments is precisely the same as when we had the $60,000 BPO price in a previous section. It also is precisely the reverse of the lessee's calculation of the amount to capitalize when the residual value is guaranteed. This is because when the residual value is guaranteed, both view it as an additional lease payment. In accordance with GAAP, the guaranteed residual value is a component of the minimum lease payments for both the lessor and lessee.23 In fact, the amortization schedule is precisely the same as in Graphic 15-9 on p. 826 when we had a BPO.

   If CompuDec had acquired the copier for the $479,079 “selling price,” it would be a direct financing lease recorded as follows:

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   Illustration 15-5, though, states that CompuDec manufactured it at a cost of $300,000, making it a sales-type lease. In Illustration 15-5C, we see the lessor's entries for this sales-type lease along with the lessee's entries for comparison. Only the lessor's initial entry on January 1, 2011, is different. All other entries in Illustration 15-5C are the same whether it's a sales-type lease or a direct financing lease.

ILLUSTRATION 15-5C

Sales-Type Lease with Guaranteed Residual Value

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The lessor's minimum lease payments include a residual value only if it is guaranteed (by either the lessee or a third-party guarantor).

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*Minimum lease payments include the $60,000 residual value because it’s guaranteed.

   Notice, too, that the timing of the $60,000 payment is December 31, 2016, the end of the lease term. Remember, the final periodic cash payment on December 31, 2015, is at the beginning of the final year. The journal entries that accompany this final cash payment are shown in Illustration 15-5D.

p. 830

ILLUSTRATION 15-5D

Entries to Accompany Final Periodic Payment

The residual value reduces the asset's depreciable cost to $419,079.

As the outstanding balance becomes less toward the end of the lease term, the portion of each payment that represents interest also becomes less.

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       *The depreciable cost is reduced by the lessee-guaranteed residual value.

   At December 31, 2016, the lessee's book value of the fully depreciated copier is its $60,000 estimated residual value. If we assume that the actual residual value also is at least $60,000, then the lessee is not obligated to pay cash in addition to returning the copier to the lessor (demonstrated in Illustration 15-5E).24

ILLUSTRATION 15-5E

End of Lease Term—Actual Residual Value Equals the Guaranteed Amount

The sixth and final depreciation charge increases the balance in accumulated depreciation to $419,079.

The copier is reinstated on the books of the lessor at its fair value at the end of the lease term.

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*The depreciable cost is reduced by the lessee-guaranteed residual value.

   However, if we assume that the actual residual value at December 31, 2016, is only $25,000, then the lessee is required to pay $35,000 cash to the lessor in addition to returning the copier. The lessee records this payment as a loss.25

UNGUARANTEED RESIDUAL VALUE.    The previous example demonstrates that when the residual value is guaranteed, both the lessor and lessee view it as a component of minimum lease payments. But what if the lessee does not guarantee the residual value? From the lessor's perspective, the residual value is a component of minimum lease payments only if it is guaranteed (by either the lessee or a third-party guarantor). Yet, even if it is not guaranteed, the lessor still expects to receive it. So, if we modify the previous illustration to assume the residual value is not guaranteed, the lessor's receivable still is $479,079, the present value of the lease payments, including the residual value, so a direct financing lease would be the same as if the residual value is guaranteed.

 

The lessor's minimum lease payments include a residual value only if it is guaranteed (by either the lessee or a third-party guarantor).

p. 831

However, the sales revenue is only $445,211—the present value of the minimum lease payments not including the residual value. In other words, sales revenue includes the present value only of the periodic rental payments, not the unguaranteed residual value. Cost of goods sold is similarly reduced by the present value of the unguaranteed residual value, so the initial lessor entry would be modified as follows:

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*Also can be calculated as the present value of the lessor’s minimum lease payments, which do not include the unguaranteed residual value.

   Sales revenue does not include the unguaranteed residual value because the revenue to be recovered from the lessee is lease payments only. The remainder of the lessor's investment is to be recovered—not from payment by the lessee (as is presumed when the residual value is guaranteed), but by selling, re-leasing, or otherwise obtaining value from the asset when it reverts back to the lessor. You might want to view the situation this way: The portion of the asset sold is the portion not represented by the unguaranteed residual value. So, both the asset's cost and its selling price are reduced by the present value of the portion not sold.

   When the residual value is not guaranteed, the lessor bears any loss that results from the actual residual value of the leased asset being less than the original estimate.

 

When the lessee doesn't guarantee the residual value, the lessee's net liability ($445,211) and the lessor's net receivable ($479,079) will differ because the former does not include the unguaranteed residual amount.

   Graphic 15-10 summarizes the effect of the residual value of a leased asset for each of the various possibilities regarding the nature of the residual value.

GRAPHIC 15-10

Effect of a Residual Value: A Summary

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(a)The lessor, when computing periodic rental payments, subtracts the present value of the residual value from the amount to be recovered (fair value) to determine the amount that must be recovered from the lessee through the periodic rent payments.
(b)The present value of the lessor’s minimum lease payments is the lease receivable and, in a sales-type lease, the sales revenue.
(c)The present value of the lessee’s minimum lease payments is the amount to be capitalized as an asset and a liability.

   We have seen how minimum lease payments are affected by a residual value and by a bargain purchase option. Let's now consider how maintenance, insurance, taxes, and other costs usually associated with ownership (called executory costs) affect minimum lease payments.




23Later you will see that when the residual value is not guaranteed, it is not considered a component of minimum lease payments for either the lessor or the lessee; but it still affects the amount of periodic lease payments.

24If the actual value is more than the estimated residual value, the lessor may realize a gain if and when the asset subsequently is sold, but the potential gain does not affect the entries at the end of the lease term.

25Sometimes by mutual agreement the lessee will sell the leased asset at the end of the lease term and remit the proceeds (plus any deficiency under the guarantee) to the lessor.

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