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Conservatism must be your guide.
Equipment ownership is a hallmark of equipment leasing that sets it apart from other types of financing transactions. However, an equipment lessor may not desire to be exposed to all the risks of equipment ownership, especially the risk of a decline in the value of the equipment at the end of the lease term below the lessor's expected value. An equipment lessor can reduce its exposure to a decrease in value of leased equipment by purchasing a residual value guarantee. Another way an equipment lessor may reduce its residual exposure is to realize value from its residual interest earlier than the end of the lease term by selling or exchanging all or a portion of its residual value.
Residual values are the non-financial component of a lease investment. Unlike accounting standards for transfers, exchanges and guarantees of financial assets, there is minimal accounting guidance pertaining to residual value transactions. As a result, accounting for these transactions relies on the application of principles rather than specific rules, especially since these transactions often involve considering the residual value component of a lease separately from the financial component of the lease. Fortunately, the applicable principles are familiar to accountants: recognizing transfers of risks and rewards, recognizing obligations incurred, and conservatism. In fact, conservatism is the overriding theme of the applicable accounting standards.
Residual Value Guarantees
Residual value guarantees may vary in specific form, but they all function to ensure that the lessor will realize some minimum value for the leased equipment at the end of the lease term by converting equipment value risk to guarantor credit risk. Examples of residual value guarantees include: a guarantor's promise to purchase the leased asset at the end of the lease term for a stated price; a put option written by a guarantor that gives the lessee the right to sell the leased asset to the guarantor at the end of the lease term for a stated price; and a guarantor's promise to pay the lessor the deficiency, if any, between the equipment value at lease end and the guaranteed amount. The guarantor may receive an up-front fee, a fee during the term of the guarantee, a portion of the sales proceeds upon sale of...