In short, residual value is the estimated fair value of the leased asset at the end of the lease, and can be either guaranteed or unguaranteed by the lessee. Guaranteed residual values are usually included in the minimum lease payments.

Both guaranteed and unguaranteed residual values affect accounting by the lessee and lessor. For the lessor the determination of the lease payments with a residual value is also different.

This post discusses residual value of leased asset and how it affects the accounting by both lessee and lessor. It comes with case examples, computation and the required journal entries. But before that, I would do a quick overview on some elements of a capital lease which is important to enable you to understand computation main topic. Read on…

## Important Elements of a Capital Lease

The computation and entries required in a capital lease depend on a good understanding of the following four elements:

1. Minimum Lease Payments – They are the payments accepted or required to be paid by the lessee to the lessor. They include the following:

• Minimum Rental Payments which are the minimum required payments by the lessee under the lease terms.
• Guaranteed Residual Value which is an estimated residual value of the leased property as guaranteed by the lessee or a third party, unrelated to the lessor. It is the amount that the lessor has the right to require the lessee to purchase the asset that the lessor is guaranteed to realize.
• Penalty on Failure to Renew or Extend the lease that is sometimes required of the lessee.
• Bargain Purchase Option which is an option at the inception of the lease, to purchase the lease property at the end of the lease term at a fixed price sufficiently below the expected fair value to make the purchase reasonably assured.

2. Executory Costs – Which are the ownership-type costs, such as insurance, maintenance and tax expenses, to be excluded, if born by the lessee, from the computation of present value of the minimum lease payments.

3. The Discount Rate – Which is used in the computation of the present value of the minimum lease payments and included after:

• The Lessee’s Incremental Borrowing rate defined as: ‘‘the rate that, at inception of the lease, the lessee would have incurred to borrow the funds necessary to buy the leased asset on a secured loan with repayment terms similar to the payment schedule called for in the lease’’; or
• The Lessor’s Interest Rate implicit in the lease if known by the lessee and it is less than the lessee’s incremental borrowing rate. It is the discount rate that equates the present value of the minimum lease payments and any unguaranteed residual value acquiring the lease to the fair value of the leased property to the lessor.

## Lease Example With Residual Value

For example, let’s suppose that the Lie Dharma Company expected the Chinese restaurant equipment to have a residual value of \$2,500. It would compute the lease payments as follows:

Fair Market Value of Equipment of the Lie Dharma Company = \$50,000

Less Present Value of Residual Value (\$2500 x 0.62092 = \$1,552.30

Amount to be recovered by the Lie Dharma Company through the lease payments is \$50,000 – \$1,552.30 = \$48,447.70

Five Periodic Lease Payments (\$48447.70/4.16986) = \$11,618.54

## Lease Example With Guaranteed Residual Value

The guaranteed residual value is included in the minimum lease payments which require that the lessee capitalize the present value of the amount guaranteed. To illustrate, let’s return to the Lie Dharma Company as the lessor and Putra Company as the lessee example and assume that Putra Company agrees to guarantee the entire amount of the residual value of \$2,500. The capitalized amount for Putra Company is as follows:

1. Present value of five annual rental payments discounted at 10% (\$11,618.543 x 4.16986) = \$48,447.70

Plus

2. Present value of a single sum of \$2,500 (the guaranteed residual value) discounted at 10% (\$2,500 x 0.62092) = \$1,552.30

3. Present value of minimum lease payments = \$50,000.00

Here is Putra Company’s lease amortization schedule, using ‘Annuity Due Basis’ with ‘Guaranteed Residual Value’:

Notes:

*rounded

(a) Required lease payments

(b) Executory costs paid by the lessee and included in rental payments

(c) Column (e) at the preceding balance x 10% except for 1/1/2011

(d) (a) – (b) – (c)

(e) Preceding balance – (d)

The above lease amortization schedule is the basis for the following journal entries:

1. Capitalization of lease on January 1, 2011.

[Debit]. Leased Equipment under Capital Leases = \$50,000

[Credit]. Obligation under Capital Leases = \$50,000

2. First rental payment on January 1, 2011

[Debit]. Property Tax Expense = \$3,000.00

[Credit]. Obligations under Capital Leases = \$11,618.543

[Credit]. Cash = \$14,618.543

3. Recognition of accrued interest on December 31, 2011

[Debit]. Interest Expense = \$3,838.145

[Credit]. Interest Payable (or Accrued Interest Obligation under Capital Leases) = \$3,838.145

4. Recognition of the annual depreciation of leased equipment on December 31, 2011.

[Debit]. Depreciation Expense-Capital Leases = \$9,500.00

[Credit]. Accumulated Deprecation–Capital Leases [(\$50,000 – \$2,500)/5 years] = \$9,500.00

5. At the end of the year 2011, the Obligation Under Capital Leases in the balance sheet is divided into its current and noncurrent portions as follows:

A. Current Liabilities

Interest Payable =  \$3,838.145

Obligations under Capital Leases = \$7,780.398

B. Noncurrent Liabilities

Obligations under Lease = \$30,601.059

6. Recording the second rental payments in advance January 1, 2012

[Debit]. Property Tax Expense = \$3,000.00

[Debit]. Obligations under Capital Leases = \$7,780.398

[Debit]. Accrued Interest on Obligations under Capital Leases = \$3,838.398

[Credit]. Cash = \$14,618.543

7. The same patterns of entries are followed through the year zero

Lease Example With Unguaranteed Residual Value

The lessee does not recognize the unguaranteed residual value in the computation of the minimum lease payments and the capitalization of the leased asset under obligation. To illustrate, let’s return to the Lie Dharma Company as the lessor and Putra Company as the lessee example and assume that Putra Company does not agree to guarantee the entire amount of the residual value of \$2,500.

The capitalized amount for Putra Company is as follows:

1. Present value of five annual rental payments discounted at 10% (\$11,681.543 x 4.16986) = \$48,447.70

Plus

2. Unguaranteed residual value of \$2,500 not capitalized = \$0

Present value of minimum lease payments = \$48,447.70

Here is Putra Company’s lease amortization schedule, using ‘Annuity Due Basis’ with ‘Unguaranteed Residual Value’:

The above amortization schedule is the basis for the following journal entries:

1. Capitalization of lease on January 1, 2011

[Debit]. Leased Equipment under Capital Leases = \$48,447.70

[Credit]. Obligation under Capital Leases = \$48,447.70

2. First rental payment on January 1, 2011

[Debit]. Property Tax Expense = \$3,000.00

[Debit]. Obligations under Capital Leases = \$11,618.543

[Credit]. Cash = \$14,618.543

3. Recognition of accrued interest on December 31, 2011

[Debit]. Interest Expense = \$3,682.915

[Credit]. Interest Payable = \$3,682.915

4. Recognition of annual depreciation expense on December 31, 2011

[Debit]. Depreciation Expense–Capital Leases = \$9,689.54

[Credit]. Accumulated Depreciation–Capital Leases = \$9,689.54

(\$48,447.70/5 years)

5. At the end of the year 2011 the Obligation under Capital Leases in the balance sheet is divided into its current and noncurrent portions as follows:

A. Current Liabilities

Interest Payable = \$3,682.915

Obligations under Capital Leases = \$7,935.628

B. Noncurrent Liabilities

Obligation under Capital Leases = \$28,893.529

6. Recording the second rental payment on January 1, 2012

[Debit]. Property Tax Expense = \$3,000.00

[Debit]. Obligations under Capital Leases = \$3,682.915

[Debit]. Accrued Interest on Obligations under Capital Leases = \$7,935.628

[Credit]. Cash = \$14,618.543

7. The same patterns of entries are followed through the year zero.

## Recording Lease With Residual Value On Lessor’s Book

For the lessor the assumption is that the residual value will be realized whether it is guaranteed or unguaranteed. Returning to the previous example of the Lie Dharma Company as the lessor and Putra Company as the lessee and the residual value of \$2,500 (whether guaranteed or unguaranteed), the following information is relevant to the lessor:

1. Gross Investment: (\$11,618.543 x 5) + \$2,500 = \$60,592.7152.

2. Unearned interest revenue: \$60,592.715 – \$50,000 = \$10,592.7153.

3. Net Investment = \$60,592.715 – \$10,592.715 = \$50,000.00

And, here is Lie Dharma’s lease amortization schedule, using ‘Annuity Due Basis’, with ‘Guaranteed Residual Value’:

Notes:

*rounded

(a) required lease payments

(b) Executory costs paid by the lessee and included in rental payments

(c) Column (e) at the preceding balance x 10% except for 1/1/2011

(d) (a) – (b) – (c)

(e) Preceding balance – (d)

The lease amortization schedule for the lessor above is the basis of the following journal entries:

1. Initial recording of the lease at its inception on January 1, 2011

[Debit]. Lease Payments Receivable = \$60,592.715

[Credit]. Equipment = \$50,000.00

[Credit]. Unearned Interest Revenue–Leases = \$10,592.715

2. Recording of first rental payment on January 1, 2011

[Debit]. Cash = \$14,618.543

[Credit]. Lease Payments Receivable = \$11,618.543

[Credit]. Property Tax Expense/Property Tax Payable = \$3,000.00

3. Recognition of accrued interest on December 31, 2011

[Debit]. Unearned Interest Revenue Leases = \$3,838.145

[Credit]. Interest Revenue-Leases = \$3,838.145