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A lease structured such that the most likely outcome is that the lessee has no significant residual risk

Brief details of a motor vehicle lease are:

At the end of the lease, the lessee sells vehicle as agent for the lessor and if sold for:

(i) more than €3,000, 99% of the excess is repaid to the lessee; or

(ii) less than €3,000, lessee pays the deficit to the lessor up to a maximum of 0.4 pence per mile above 25,000 miles p.a. on average that the leased vehicle has done.

The net present value of the minimum lease payments excluding the guarantee amounts to €7,365.

This lease involves a guarantee by the lessee of the residual value of the leased vehicle of €3,000, as a result of (ii) above. However, the guarantee will only be called on if both:

(a) the vehicle’s actual residual value is less than €3,000; and

(b) the vehicle has travelled more than 25,000 miles per year on average over the lease term.

Further, the lessee is only liable to pay a certain level of the residual; namely, €100 for each 2,500 miles above 25,000 miles that the vehicle has done.

One could argue that the guarantee should be assumed to apply only to the extent that experience or expectations of the sales price and/or the mileage that vehicles have done (and the inter-relationship between these) indicate that a residual payment by the lessee will be made and if this best estimate is that a zero or minimal payment will be made, this should be used for the purposes of lease classification. This would be applying the principles in IAS 37 to the calculation of the liability. However, IAS 17 states that the amount of the guarantee is ‘the maximum amount that could, in any event, become payable’. Therefore, the standard appears to require the maximum guarantee of €3,000 to be taken into account.

By taking the maximum guarantee into account, the present value of the minimum lease payments might equal the fair value of the asset. This does not necessarily mean that the lease will automatically fall to be treated as a finance lease. This depends on the substance of the arrangement and the entity might take account of the residual it estimates it will actually pay in making this assessment. Another interpretation is given in below, in which the entity capitalises the full residual guarantee and factors the amount that it expects to recover into the residual value of the asset.