 Hello and welcome to this session in which we will discuss the guaranteed residual value or not guaranteed residual value when it comes to leases specifically we're going to be looking from the less sees perspective the less see is the renter now the first thing we have to understand is what is guaranteed residual value well guaranteed residual value is when the less see guaranteed specific value residual value at the end of the lease term what does that mean it means let's assume you leased an asset for five years one two three four five and you bring back the asset after five years the less sore the owner of the asset is expecting a certain value residual value for example ten thousand dollar for this asset simply put if they want to sell it today you gave it you gave it back to them does it have a ten thousand residual value well if the answer is yes then good you guaranteed the residual value if the answer is it's only worth six thousand and you guaranteed that residual value then you have to came up with the difference from an accounting perspective we have to find out what do we how do we deal with this guaranteed or unguaranteed residual value for two purposes for the purpose of computing the liability of the lease and the purpose of the test 90 test to determine whether the lease is a finance or an operating lease simply put for the 90 percent test why the 90 percent test remember when we have a lease we have to determine whether a lease is an operating lease or a finance lease one one of the test is to do what is to compute the present value of the lease payment to find out if they if they are equal or greater than 90 percent of the fair value of the test so the question is do we include this residual value in the computation of 90 percent that's one thing we have to do then the second thing we have to determine is whether we compute this residual value when we compute the liability so remember when we have an asset whether it's a finance asset or an operating asset remember we debit an asset credit the liability at the commencement of the lease from the less see do we include this residual value and liability and this is what we have to learn in this session so that's why we have to be aware whether the lease is guaranteed or not let's start with unguaranteed well good start with the easy part unguaranteed residual value guess what you don't include in the lease liability so for the lease liability purposes you ignore or the 90 percent test which is the classification test you also ignore simply put if you are not guaranteeing the residual value just it doesn't exist you're not guaranteeing anything you are not in quote responsible for anything to include that thing that number in your computation so that's easy if it's unguaranteed for the less see if it's a guaranteed residual value now we have to know the rules if the that residual value is guaranteed now if it's guaranteed and the expected value and the expected residual value is greater than the guaranteed value remember I said you're guaranteeing $10,000 value for that machinery and you expect you know it's going to be at least 15,000 just you know this if that's the expectation then guess what you follow as if it's an unguaranteed residual value simply put you ignore it you don't have to include it in anything if the expected residual value expected to be less than the guaranteed residual value so you're you are expecting 10 but the guaranteed I'm sorry you are guaranteed in 10 but the expectation it's going to be seven well you're going to have a shortage you're going to have a shortage of $3,000 guess what under those circumstances you would include this 3,000 in the least liability you don't include it at gross amount you will discount the 3,000 the shortage and you would include the shortage in your least liability don't worry we're going to work an example illustrating this concept but those are simply the rules when it comes to when it comes to guaranteed or unguaranteed residual value well let's take a look at an example to illustrate the concept Adam leases a machinery with a fair value of $10,000 from HP manufacturing it's an uncancellable term of 50 month rental payment is $200 per month annuity do it means we're going to go ahead and make the first payment immediately Adam guarantees a residual value of $800 at the end of the lease and Adam believes the residual value to be greater than 800 what does that mean it means we are under those under these circumstances here what do we have to do we don't include we don't include in the lease we don't include in the lease liability why because if we if we think it's going to be worth than $800 then what are we responsible for we're not really responsible for anything because we are we are guaranteed so it's there it's there for estimated economic life of the machinery is 60 month and Adam incremental borrowing rate is 6% which is from a monthly perspective because we are dealing with a monthly payment is 0.5% per month and HP manufacturing implicit rate is unknown so the question becomes compute the present value for the 90% test and to determine the lease liability okay now let's start with the 90% test then we'll determine the lease liability what should be included now before we compute the 90% test and the lease liability most likely you are watching because you are either an accounting student or a CPA candidate looking for some help about this topic great you have arrived let's go a step further go to farhatlectures.com where you can find additional resources lectures multiple choice true false that's going to help you tremendously in your accounting courses and CPA preparation i don't replace your CPA review course i'm only a supplemental material if you have not connected with me on social media connect with me on LinkedIn like this recording share it with other connect with me on instagram facebook twitter and reddit so for the 90% test since the amount is guaranteed since the amount is guaranteed we are going to include the guaranteed value in the test so simply put we're going to take $200 the payment times the present value of the annuity well we have an annuity do here n equal to 50 i equal to 0.5% so this is basically the factor and for the purpose of this exercise i'm not teaching you the time value of money this is only just to show you the computation if you want to learn more about time value of money just go to farhat lectures to my time value to my time value lessons so this is going to give us the present value of the payment and for the 90% test we're going to take the guaranteed residual value times 0.77924 which is n equal to 50 i equal to 0.5% again here we are talking about a single amount 623 together they're going to give us 9497 now if we take 9497 divided by 10 000 that's going to give us 97.93 percentage which is above 90% so for the purpose of 90% we are going to always include the residual value of guaranteed one more time of guaranteed always include whether we are going to be short of it or not short of it for the 90% we included now well how about the liability purpose how do we compute the liability purpose well we're going to take 200 times 44.3635 which is equal to 8873 now notice we ignored the residual value of 800 why because adam believes there is a dual value to be greater than 800 therefore we don't have to worry about it therefore we don't include it in the liability now let's change the scenario a little bit and assume that adam expects the residual value to be 300 rather than greater than 800 well if you notice here 300 is less than 800 now we have a shortage how do we compute the liability for the 90% test we don't change anything how do we compute the liability well we're going to take 200 times the present value of the annuity do plus the shortage the shortage it's $500 times 0.77929 which is the present value of a single amount together will give us the liability of 9263 so notice the liability here is greater than the liability here why because we are guaranteeing an additional $500 in the liability in the amortization schedule so if we look at the amortization schedule we see that when there is when when we are good when the guaranteed is the guaranteed amount is guaranteed or greater the liability is starting at 88 73 and we're gonna go ahead and have 50 payments notices this schedule goes from payment 6 to payment 44 because so I can show you the whole thing on one page versus this liability when the guaranteed we felt we felt short of the liability we felt short of the residual value which we have to add to the liability the liability starting at 9263 it means in the last year we have an additional payment of $500 to bring the liability down to zero so notice we are starting at a greater liability and let's assume when it comes after not 50 years after 50 months for this deal we had to come up with $600 rather than $500 the additional $100 will be technically a loss or an additional expense so basically if that's the case it's not a big deal just it's we were short therefore we have to make up the short it's a form of a loss what should you do now to learn more about residual value for guaranteed or unguaranteed residual value for leases I would suggest you go to farhatlectures.com subscribe or multiple choice through faults and exercises the next session we would look at guaranteed residual value or unguaranteed unguaranteed residual value from the less source perspective whether the less sort is the owner of the asset study hard good luck the CPA exam is worth it your accounting courses are worth it and stay safe