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Lease classification

them or to obtain more favorable pricing for the leased asset. Lessors may also secure residual value
guarantees from a third party to reduce or eliminate their risk in the residual value of the asset.

Residual value guarantees provided by a lessee

If the present value of the lease payments and any residual value guarantees provided by the lessee
guarantees a lessor the recovery of substantially all of the fair value of its underlying asset, the
arrangement is a finance lease for the lessee and sales-type lease for the lessor.

Lessees and lessors should include the full amount of the potential payment payable under a residual
value guarantee in fixed lease payments when evaluating lease classification under ASC 842-10-25-2
(d) (i.e., the lease payments criterion). While the terms of certain residual value guarantees may
eliminate virtually all of the lessor’s risk in the underlying asset, the likelihood of loss by the lessor is
not a factor that should be considered when classifying a lease.

The requirement to include the full amount of the potential payment payable under a residual value
guarantee differs from the measurement guidance, which requires that lessees and lessors consider
only the present value of any payment under a lessee residual value guarantee that is probable of being
owed.

A lessee may choose to obtain residual value insurance from an unrelated third party to protect against
any exposure created by the provision of a residual value guarantee to a lessor. For example, if the
residual value of the underlying asset was lower than the guaranteed amount at the end of a lease, the
third party would make the necessary payments to satisfy the lessee’s residual value guarantee to the
lessor. When third-party insurance is for the benefit of the lessor, a lessee may not reduce lease
payments when measuring the lease unless the lessor explicitly releases the lessee from their
obligation under the residual value guarantee, including any obligation should the third party default.
Additionally, any payments by a lessee to acquire third party residual value insurance are executory
costs, which should not be included in lease payments.

If a lease contains a provision that provides the lessor with the right to require the lessee to purchase
the underlying asset by the end of the lease term, the stated purchase price should be included in lease
payments. This is because the purchase price is effectively a residual value guarantee that the lessee is
required to pay (i.e., the payment of the purchase price is outside of the lessee’s control).

Question 3-12

Should a lessee consider a residual value guarantee in the lease classification determination differently
than how it considers the guarantee when measuring its lease liability?

PwC response
Yes. The probability of having to satisfy a residual value guarantee is not considered for purposes of
lease classification, but is considered when measuring a lease liability. To illustrate, a lessee may
provide a guarantee that the leased property will have a value that is no less than $100 at the end of
the lease. The lessee believes it is probable it will owe $15 under this guarantee. In such a situation, it
would include the present value of the full residual value guarantee amount (i.e., $100) when
determining how to classify the lease, but it would include only the present value of the amount it is
probable of owing (i.e., $15) when measuring its lease liability.

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