BLM11025 – Lease accounting: lease classification: residual values and guarantees

The residual value of an asset is the expected value of the asset at the end of the term of the lease.

Operating lessors (and, rarely and to a smaller extent, finance lessors) may be exposed to the risk that the residual value is less than expected and so there is a market for guarantees which reduce that risk.

The lessor may seek to guarantee all or part of the residual value.

Where part of the residual value is guaranteed it can be the top, bottom, or middle slice of that value. For example, if the residual value is expected to be £1,000,000 the lessor might take out a guarantee that will pay out if the value is less than £750,000 (thus restricting his exposure to £250,000).

Alternatively, the lessor might insure the top slice of £250,000, thus receiving compensation if the value falls to between £750,000 and £1,000,000, but no compensation for a fall in value below £750,000.

The middle slice may be insured with, for example, payout being made if the value lies between £250,000 and £750,000.

Paragraph 26 of SSAP 21 defines the ‘unguaranteed residual value’ as that portion of the residual value of the leased asset (estimated at the inception of the lease), the realisation of which by the lessor is not assured or is guaranteed solely by a party related to the lessor. The IAS definition in paragraph 4 is essentially the same.

IAS 17 also defines the guaranteed residual value from the perspective of the lessee and the lessor. The guaranteed residual value is

• for a lessee, that part of the residual value that is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could, in any event, become payable); and
• for a lessor, that part of the residual value that is guaranteed by the lessee or by a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.

Where the guarantee is entered into at inception it may make the lease a finance lease.

A residual value guarantee entered into some time after inception would not normally affect the classification of the lease, but see BLM22070 where the lease is a long funding lease.