What Is a Residual Value in a Lease?
The residual value of a leased asset is the estimated value of the underlying asset at the end of the lease term. It reflects the amount a lessor expects to recover through sale, re-lease, or other means once the lessee returns the asset.
Residual values are fundamental to lease pricing. A higher expected residual value generally results in lower lease payments, as the lessor anticipates recovering more value at the end of the lease term.
The residual value for lease purposes is split into two parts:
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Residual value guarantee
A guarantee made to a lessor by a party unrelated to the lessor that the value (or part of the value) of an underlying asset at the end of a lease will be at least a specified amount. Forms part of lease payments (note the nuance in definition between lessees and lessors) -
Unguaranteed residual value
That portion of the residual value, the realisation of which by a lessor is not assured or is guaranteed solely by a party related to the lessor.
Unguaranteed residual values are not part of lease payments but are included in the gross investment in the lease and discounted when determining the net investment.
This article forms part of our full IFRS 16 guide.
Residual Value Guarantees Explained
A residual value guarantee is:
A guarantee made to a lessor by a party unrelated to the lessor that the value (or part of the value) of an underlying asset at the end of a lease will be at least a specified amount.
The guarantee protects the lessor from the risk that the asset’s value will be lower than expected at the end of the lease. The guaranteeing party is often the lessee, but it may also be any third party unrelated to the lessor.
Lessees
Accounting for Residual Value Guarantees
For lessees, lease payments include (among others):
- amounts expected to be payable by the lessee under residual value guarantees;
A critical point is that the amount included is not necessarily the full guaranteed amount. Instead, it is only the difference that is expected to be paid in cash.
If the guaranteed amount is CU20,000 and the lessee expects the asset to be worth CU18,000 at lease end, only CU2,000 is included in lease payments.
Remeasurement of Lease Liabilities (IFRS 16.42–43)
IFRS 16.42 requires a lessee to remeasure the lease liability when:
There is a change in the amounts expected to be payable under a residual value guarantee.
The revised lease payments must reflect the updated expectations of the cash outflow.
IFRS 16.43 then specifies that the lessee must use an unchanged discount rate when remeasuring for changes in residual value guarantees.
This ensures that changes in measurement reflect changes in expected cash flows, rather than changes in financing assumptions.
Lessors
Residual Values and the Net Investment in the Lease
For lessors, residual values are embedded in the definition of the interest rate implicit in the lease (IRIL):
The rate of interest that causes the present value of
(a) the lease payments and
(b) the unguaranteed residual value
to equal the sum of
(i) the fair value of the underlying asset and
(ii) any initial direct costs of the lessor.
Residual values are therefore always presented on a discounted basis in lessor accounting.
Gross Investment and Net Investment in the Lease
-
Gross investment in the lease comprises:
- lease payments (including guaranteed residual values); and
- unguaranteed residual value.
-
Net investment in the lease is:
The gross investment in the lease discounted at the interest rate implicit in the lease.
Disclosure Requirements for Residual Value Guarantees (IFRS 16.B51)
Entities may need to disclose information that helps users assess:
- the reasons for providing residual value guarantees and their prevalence;
- the magnitude of exposure to residual value risk;
- the nature of the underlying assets subject to guarantees; and
- the operational and financial effects of those guarantees.
Illustrative Examples
Example 1 – Lessee
Residual value guarantee: CU10,000
Expected asset value at lease end: CU7,500
Amount included in lease payments:
CU10,000 − CU7,500 = CU2,500
Only CU2,500 is discounted and included in the lease liability.
Example 2 – Lessor
Lease payments (undiscounted): CU100,000
Guaranteed residual value: CU10,000
Unguaranteed residual value: CU5,000
Gross investment:
- CU100,000 + CU10,000 + CU5,000 = CU115,000
Net investment:
- CU115,000 discounted using the interest rate implicit in the lease.
Conclusion
Residual values and residual value guarantees are central to IFRS 16 measurement. For lessees, they affect lease payments and trigger remeasurement when expectations change. For lessors, they are embedded in the calculation of the net investment in the lease and the interest rate implicit in the lease. A clear distinction between guaranteed and unguaranteed residual values is essential to ensure accurate recognition, measurement, and disclosure.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.