Residual Values-Accounting for Exchanges of Risk and Value

ELT, Jul/Aug 2006 by Schuldt, Theo

Conservatism must be your guide.

Equipment ownership is a hallmark of equipment leasing that sets it apart from other types of financing transactions. However, an equipment lessor may not desire to be exposed to all the risks of equipment ownership, especially the risk of a decline in the value of the equipment at the end of the lease term below the lessor's expected value. An equipment lessor can reduce its exposure to a decrease in value of leased equipment by purchasing a residual value guarantee. Another way an equipment lessor may reduce its residual exposure is to realize value from its residual interest earlier than the end of the lease term by selling or exchanging all or a portion of its residual value.

Residual values are the non-financial component of a lease investment. Unlike accounting standards for transfers, exchanges and guarantees of financial assets, there is minimal accounting guidance pertaining to residual value transactions. As a result, accounting for these transactions relies on the application of principles rather than specific rules, especially since these transactions often involve considering the residual value component of a lease separately from the financial component of the lease. Fortunately, the applicable principles are familiar to accountants: recognizing transfers of risks and rewards, recognizing obligations incurred, and conservatism. In fact, conservatism is the overriding theme of the applicable accounting standards.

Residual Value Guarantees

Residual value guarantees may vary in specific form, but they all function to ensure that the lessor will realize some minimum value for the leased equipment at the end of the lease term by converting equipment value risk to guarantor credit risk. Examples of residual value guarantees include: a guarantor's promise to purchase the leased asset at the end of the lease term for a stated price; a put option written by a guarantor that gives the lessee the right to sell the leased asset to the guarantor at the end of the lease term for a stated price; and a guarantor's promise to pay the lessor the deficiency, if any, between the equipment value at lease end and the guaranteed amount. The guarantor may receive an up-front fee, a fee during the term of the guarantee, a portion of the sales proceeds upon sale of the leased asset at lease maturity, or some combination of these receipts, as compensation for providing the guarantee.

Guarantor accounting-The guarantor's accounting for a residual value guarantee is prescribed by FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57, 107 and rescission of FASB Interpretation No. 34 (FIN 45). However, FIN 45 specifically excludes guarantees issued by insurance companies that are accounted for in accordance with accounting standards for insurance companies, including residual value insurance accounted for under those accounting standards. Also, this discussion assumes the guarantor is a third party to the lease transaction, not the lessee. FIN 45 also excludes lessee residual value guarantees from its scope when the lease is a capital lease.

Under FIN 45, the guarantor must recognize the guarantee on its balance sheet by recording a liability, even if it never expects to actually make a payment as a result of the guarantee. The liability is the accounting entry required to acknowledge the fact that, as described in FIN 45, the guarantor has obligated itself to stand ready to perform under the terms of the guarantee. The initial amount of the liability must be its fair value. FIN 45 specifically distinguishes this liability from the liability the guarantor would incur if it had to make a payment under the guarantee. The easiest way to think about the initial fair value of the obligation to stand ready to perform is as the flip side of the fee a guarantor would charge to enter into the guarantee, assuming it is a stand-alone transaction. In this simple situation, the fee collected is equal to the liability incurred. And, because the guarantor collected a fee, the fee received is the offset to the initial liability entry. After recording the initial liability and fee received, the guarantor must determine when it can recognize the fee as income and when to reduce the liability, if appropriate, ultimately to zero.

Revenue should generally be recognized equally each period during the guarantee term, which is typically the same as the lease term. This revenue recognition method is supported by analogy to Emerging Issues Task Force Issue No. 85-20, Recognition of Fees for Guaranteeing a Loan (EITF85-20). EITF85-20 requires a guarantor of another party's debt to recognize any fees received in exchange for the guarantee over the term of the guarantee. As guarantee fee income is recognized, the initial liability will be reduced. The liability will be zero at the end of the guarantee/lease term and all of the fee income will have been recognized. If the guarantor is entitled to additional compensation based on the sales price of the leased asset at lease termination, this additional income should not be recognized until the leased asset is sold and the amount earned is known with certainty and fully realizable.