Financial Lease Example / Lease With Unguaranteed Residual Value and Required Restoration Cost
Below is a sample transaction of a lease with unguaranteed residual value.
Unguaranteed residual value refers to the value of a leased asset at the end of the lease which is not the responsibility of the lessee.
Transaction Details
On January 1, 2022, Luz Company leased a machine from Noel Company for 10 years with the details as follows:
| Annual rental payments on December 31 | CU2,000,000 |
| Initial direct cost paid | 500,000 |
| Payment to the lessor to obtain the long-term lease | 300,000 |
| Unguaranteed residual value | 1,000,000 |
| Annual executory cost | 150,000 |
| Cost of restoring the asset as required in the contract | 800,000 |
| Useful life of the machine | 12 years |
| Incremental borrowing rate | 14% |
| Implicit interest rate | 12% |
| Present value of an ordinary annuity of 1 for 10 periods | |
| 12% | 5.6502 |
| 14% | 5.2161 |
| Present value of 1 for 10 periods | |
| 12% | 0.3220 |
| 14% | 0.2697 |
The mathematical table for the present value of 1 and an ordinary annuity can be obtained here – https://accountingupgrade.com/mathematical-tables/.
There is neither a transfer of title to the lessee nor a purchase option and the machine shall revert to the lessor upon the end of the lease on December 31, 2031.
Computation for Lease With Unguaranteed Residual Value
| Lease liability (2,000,000 x 5.6502) | 11,300,400 |
| Payment to the lessor to obtain the long-term lease | 300,000 |
| Present value of restoration cost (800,000 x 0.3220) | 257,600 |
| Total cost of right of use asset | 11,858,000 |
Since a lease with unguaranteed value is executed, the residual value it is not anymore included in the computation of the right-of-use asset and lease liability.
Meanwhile, since the contract requires the restoration cost, its present value will be included in the total cost of the right-of-use asset.
However, the annual executory cost is treated as an outright expense in the year it was incurred.
Right of Use Asset Depreciation Table – Lease With Unguaranteed Residual Value and Estimated Restoration Cost
| Year | Depreciation | Accumulated | ROU asset |
| Start | 11,858,000 | ||
| 2022 | 1,185,800 | 1,185,800 | 10,672,200 |
| 2023 | 1,185,800 | 2,371,600 | 9,486,400 |
| 2024 | 1,185,800 | 3,557,400 | 8,300,600 |
| 2025 | 1,185,800 | 4,743,200 | 7,114,800 |
| 2026 | 1,185,800 | 5,929,000 | 5,929,000 |
| 2027 | 1,185,800 | 7,114,800 | 4,743,200 |
| 2028 | 1,185,800 | 8,300,600 | 3,557,400 |
| 2029 | 1,185,800 | 9,486,400 | 2,371,600 |
| 2030 | 1,185,800 | 10,672,200 | 1,185,800 |
| 2031 | 1,185,800 | 11,858,000 | 0 |
Lease Liability Amortization Table
| Date | Payment | Interest | Principal | Present Value |
| Jan. 1, 2022 | 11,300,400 | |||
| Dec. 31, 2022 | 2,000,000 | 1,356,048 | 643,952 | 10,656,448 |
| Dec. 31, 2023 | 2,000,000 | 1,278,774 | 721,226 | 9,935,222 |
| Dec. 31, 2024 | 2,000,000 | 1,192,227 | 807,773 | 9,127,448 |
| Dec. 31, 2025 | 2,000,000 | 1,095,294 | 904,706 | 8,222,742 |
| Dec. 31, 2026 | 2,000,000 | 986,729 | 1,013,271 | 7,209,471 |
| Dec. 31, 2027 | 2,000,000 | 865,137 | 1,134,863 | 6,074,608 |
| Dec. 31, 2028 | 2,000,000 | 728,953 | 1,271,047 | 4,803,561 |
| Dec. 31, 2029 | 2,000,000 | 576,427 | 1,423,573 | 3,379,988 |
| Dec. 31, 2030 | 2,000,000 | 405,599 | 1,594,401 | 1,785,587 |
| Dec. 31, 2031 | 2,000,000 | 214,413 | 1,785,587 | – |
Amortization Table for Estimated Restoration Cost
| Date | Interest | Est. Restoration |
| Jan. 1, 2022 | 257,600 | |
| Dec. 31, 2022 | 30,912 | 288,512 |
| Dec. 31, 2023 | 34,621 | 323,133 |
| Dec. 31, 2024 | 38,776 | 361,909 |
| Dec. 31, 2025 | 43,429 | 405,339 |
| Dec. 31, 2026 | 48,641 | 453,979 |
| Dec. 31, 2027 | 54,478 | 508,457 |
| Dec. 31, 2028 | 61,015 | 569,472 |
| Dec. 31, 2029 | 68,337 | 637,808 |
| Dec. 31, 2030 | 76,537 | 714,345 |
| Dec. 31, 2031 | 85,655 | 800,000 |
Journal Entries For 2022 – Lease With Unguaranteed Residual Value
1. To record the cost of the right-of-use asset and the related lease liability.
| Dr. Right of use assets | 11,858,000 | |
| Cr. Lease liability | 11,300,400 | |
| Cr. Cash | 300,000 | |
| Cr. Estimated liability for restoration cost | 257,600 |
2. To record the payment of executory costs.
| Dr. Executory costs | 150,000 | |
| Cr. Cash | 150,000 |
Executory costs such as utilities, repairs, maintenance, and others are expensed as incurred.
3. To record the first lease payment on December 31, 2022.
| Dr. Interest expense | 1,356,048 | |
| Dr. Lease liability | 643,952 | |
| Cr. Cash | 2,000,000 |
4. To record the first-year depreciation.
| Dr. Depreciation | 1,185,800 | |
| Cr. Accumulated depreciation | 1,185,800 |
The asset is depreciated over the 10-year lease term since there is neither a transfer of asset to the lessee nor a purchase option.
5. To accrue interest on the liability for the required restoration cost.
| Dr. Interest expense | 30,912 | |
| Cr. Estimated liability for restoration | 30,912 |
Return of Machine to the Lessor
On December 31, 2031, the lessee will return the asset to the lessor with the entries as follows:
| Dr. Accumulated depreciation | 11,858,000 | |
| Cr. Right of use asset | 11,858,000 |
The entries are the same whether the fair value on December 31, 2031 is higher or lower than the unguaranteed residual value. This is because the lessee has no financial obligation to the lessor other than to eturn the asset to the lessor.
Payment of Liability for the Restoration Cost
On December 31, 2031, the carrying amount of the estimated liability for restoration will be CU 800,000 after accruing the interest expense for 10 years using the effective interest method.
Here then is the entry to settle the liability for the restoration cost.
| Dr. Estimated liability for restoration | 800,000 | |
| Cr. Cash | 800,000 |