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Lease classification

How should Lessor Corp classifying the lease?

Analysis

Lessor Corp should classify the lease as an operating lease. When determining whether the present
value of the lease payments and the residual value guarantee amount to substantially all the fair value
of the underlying asset, Lessor Corp would consider the nominal amount of retained risk of $100,000,
rather than the fair value of its retained risk. Assuming that the present value of the $100,000
unguaranteed residual value is great enough, the present value of the lease payments and the
guaranteed residual will not amount to substantially all the fair value of the underlying asset. In that
case, and considering that at lease commencement, the lease did not meet any of the criteria to be
classified as a sales-type lease, the lease would not meet the criteria to be classified as a direct finance
lease.

The same conclusion would be reached if the residual value guarantee was provided by Lessee Corp as
opposed to a third party.

Loan guarantees and loans to the lessor

Similar to ASC 840-10-25-5(b), ASC 842-10-30-6 specifically excludes lessee guarantees of the lessor’s
debt from the definition of lease payments, and does not address loans by the lessee to the lessor.
Consistent with long-standing practice, we believe that a lessee’s guarantee of the lessor’s debt or a
loan to the lessor may, in some circumstances, be considered a residual value guarantee and should be
treated as such in the assessment of lease classification.

For example, if the lessor’s debt is nonrecourse, or the lessor has no significant assets other than the
underlying leased assets, the substance of the lessee’s remaining guarantee at the expiration of the
lease term may be a guarantee of the residual value of the underlying assets. This is because there is
little substantive difference between a payment by the lessee to the lessor’s nonrecourse lender
pursuant to a loan guarantee and a direct payment by the lessee to the lessor under a residual value
guarantee.

Portfolio level residual value guarantees

ASC 842-10-55-9 and 55-10 discuss portfolio level residual value guarantees.

ASC 842-10-55-9

Lessors may obtain residual value guarantees for a portfolio of underlying assets for which settlement
is not solely based on the residual value of the individual underlying assets. In such cases, the lessor is
economically assured of receiving a minimum residual value for a portfolio of assets that are subject to
separate leases but not for each individual asset. Accordingly, when an asset has a residual value in
excess of the “guaranteed” amount, that excess is offset against shortfalls in residual value that exist in
other assets in the portfolio.

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