The role of residual value in lease agreements – What you need to know

Residual values are often set high for vehicles because leasing companies have a relatively accurate estimate of a car’s future value. For other equipment, where future values are harder to predict or there are fewer potential buyers, leasing companies tend to minimize their risk by setting lower residual values. This results in higher monthly costs for the lessee.

Residual value in operational and financial leases
Residual value is present in both operational and financial leases, but it is handled differently depending on the type of agreement.

In operational leases, the lessor takes back the asset at the end of the lease period and manages the residual value. The lessee may then be offered an opportunity to purchase the asset based on its market value, or the leasing company may sell the asset on the open market.

In financial leases, the responsibility lies with the company leasing the asset—they must find a buyer. At the end of the lease term, the company can either find a buyer, purchase the asset themselves, or continue leasing it. In financial leases, the residual value is typically predetermined and must therefore be considered in the accounting.

How residual value differs between Local GAAP and IFRS 16
When accounting for residual value under IFRS 16, the focus is on future cash flows from the lease agreement rather than the asset's actual value. This differs from the Local GAAP standard, where the entire asset value, including the residual value, is included in the balance sheet for financial leases.

– Under IFRS 16, only the lease payments expected to be made during the lease term are recognized.

Residual value in financial leasing under IFRS 16
For financial leases involving, for example, machinery with a long expected useful life, it may be relevant to include the residual value in the accounting.

– If a machine has an expected useful life of 15 years, but the lease term is only five years, it is appropriate to include the residual value in the accounting, explains Richard.

– Whether the residual value should be included in financial leasing depends on the company's expectations regarding the future use of the asset. For company cars, it is common not to include the residual value in the accounting, as businesses typically only pay for the lease during the term and then replace the car at the end of the lease. As such, both financial and operational leasing of cars are usually accounted for as operational leases.

A question of profit on residual value at sale
– A common question we receive regarding IFRS 16 and residual value is: What happens if a leased asset is sold at a profit? Richard explains.

The answer is that if an asset has a residual value after the lease period and the company makes a profit upon sale, the profit is recorded as "other operating income" in the accounting.

– It’s important to note that this income is not part of the lease agreement itself but arises from the sale of the asset, Richard concludes.