Guaranteed + unguaranteed residual values = total residual value (or expected value of the asset at lease end)
The residual value of a lease is the expected value of an asset at the end of the lease. A leased asset’s residual value can be guaranteed or unguaranteed by the lessee. If guaranteed, and the asset’s fair market value comes in below the guaranteed residual value at the end of the lease, the lessee will make a final payment to the lessor.
The guaranteed lease value paid at the end of the lease term is calculated as the guaranteed amount less the fair market value of the asset. If the fair market value of the asset is greater than the guaranteed amount, no payment is made by the lessee. Any amount that is reasonably certain of being required to be paid by the lessee due to a residual value guarantee is included in the initial calculation of the lease liability.
Unguaranteed residual values mean the lessor isn't guaranteed to receive a set residual value at the end of the lease. The residual value of the lessor’s asset will be the fair market value. The lessee is less concerned with the asset’s fair value at the end of the lease in this case. They won't have to pay the lessor, even if the asset’s value is zero at the end of the lease.
A guaranteed residual value can also be guaranteed by a third party that’s not related to the lessor. If the third party is related to the lessor, the residual value is considered unguaranteed.
Example:
A local municipality enters into a lease agreement for a piece of office equipment. The lease is for five years and includes a guaranteed residual value. The guaranteed residual value is set at $100,000. Thus, if the asset’s fair value at the end of the lease is less than $100,000, the municipality will need to pay to cover the difference.
At the end of the lease term, the office equipment has a fair market value of $25,000. Since the entity guarantees a residual value of $100,000 for the leased asset, it will make a final payment to the lessor in the amount of $75,000.
Lease residual values can be guaranteed or unguaranteed by the lessee. A residual value guarantee will be included as part of the lease terms and is paid at the end of the lease. The residual value can be large when the lease term is much less than the asset’s economic life.
How well the lessee maintains the asset has a major impact on the residual value at the lease end. Any amount that is reasonably certain of being required to be paid by the lessee due to a residual value guarantee is included in the initial calculation of the lease liability.
What’s important here?
Contracting for a guaranteed residual value at the lease end not only provides a set return for the lessor but also encourages the lessee to maintain the asset.
