CASE 1313 Residual Value Guarantee

Woodlawn Inc enters into a lease of non-specialized equipment with Kenwood Company. The fair value of the equipment at lease commencement is $600,000. Kenwood Company does not provide a residual value guarantee. Woodlawn Inc estimates that the fair value of the construction equipment at the end of the lease will be $200,000. While Woodlawn Inc acknowledges the value of the asset may decline below $200,000 in the future, Woodlawn Inc concludes there is less than a 1% chance of the value falling below $150,000. Therefore, to protect its investment, Woodlawn Inc obtains residual value insurance from a third party covering any loss incurred by Woodlawn Inc if the value declines to between $200,000 to $150,000. That is, if the residual value falls below $200,000, Woodlawn Inc is covered for the first $50,000 of loss. The risk of loss associated with the value of the equipment falling below $150,000 is retained by Woodlawn Inc.

Assume Woodlawn Inc has already evaluated the lease classification criteria and concluded the lease is not a sales-type lease.

Required:

How should Woodlawn Inc classify the lease?

Would your answer differ if Kenwood Company had guaranteed the residual value?