Question

Case 19-1 The Terminator Trans Ocean Shipping (“Trans Ocean”) provides domestic and international transportation and logistics services to customers. The company contracts shipping vessels, trucks, and aircraft to provide regional, long-haul, and international shipments of customer goods. Trans Ocean has entered into the following contracts: In March 2019, Trans Ocean entered into a revenue contract with a customer, Asia Manufacturing (“Asia”), in which Trans Ocean would be the exclusive shipper of Asia’s products between Shanghai and Los Angeles. Trans Ocean’s contract with Asia is effective on July 1, 2019. Before signing the contract with Asia, Trans Ocean did not operate the ShanghaiLos Angeles route, and to satisfy the contract with Asia, in April 2019, Trans Ocean leases a cargo ship from Heavy Vessel Manufacturing (“Heavy”), which commences on July 1, 2019. Because the shipping route is new, on July 1, 2019,

(1) Trans Ocean has no other customers to deliver goods on the Shanghai-Los Angeles route and (2) because of operational costs, Trans Ocean does not have alternative uses for the leased cargo ship. Trans Ocean adopted ASC 842, Leases, on January 1, 2019. The following are relevant facts about Trans Ocean’s revenue contract with Asia, and Trans Ocean’s lease with Heavy. Trans Ocean’s Revenue Contract With Asia • The revenue contract’s stated term with Asia is for one year. • Asia can renew the contract annually for up to four additional years. Therefore, the revenue contract can extend to five full years. • Asia pays a significant up-front nonrefundable fee for the initial one-year term; the same amount is due at the beginning of every renewal period. • Asia can cancel at any time without incurring a penalty outside of forfeiting any up-front nonrefundable fees already paid or owed at the beginning of the initial contract term and any and each renewed period. • Although the contract is new, Trans Ocean and Asia have entered into similar arrangements with similar terms and historically, Asia has renewed for one or more years. • Trans Ocean appropriately concludes that (1) the revenue contract meets the scope of, and criteria in, ASC 606, Revenue From Contracts With Customers, and (2) the contract term for its revenue contract with Asia is one year. Trans Ocean’s Lease With Heavy • The contract between Trans Ocean and Heavy contains a lease under ASC 842. • Rental payments are at market and fixed each year. Case 19-1: The Terminator Page 2 Copyright © 2019 Deloitte Development LLC All Rights Reserved. • To mitigate risks, Trans Ocean negotiated the lease period and renewal options to mirror those of Trans Ocean’s revenue contract with Asia. As a result, the fixed, noncancelable term of the lease is one year, and Trans Ocean can renew annually for four additional years (i.e., up to five full years). Trans Ocean believes that since Asia can terminate the revenue contract after one year (even though Asia may need to ship products for longer than a year and has historically renewed under other similarly structured contracts), it is uncertain whether Asia will renew the revenue contract. Because of this uncertainty, Trans Ocean believes that the renewal options related to the lease are not reasonably certain at the commencement date of the lease. As a result, Trans Ocean concludes that the lease term for its lease contract with Heavy is also one year. Required:

2. What factors should Trans Ocean consider in supporting its conclusion related to the lease term? Additional Facts On December 1, 2019, Trans Ocean entered into a shipping contract with Eastern Manufacturing Company (“Eastern”) to ship Eastern’s products between Shanghai and Los Angeles. The contract with Eastern commences on January 1, 2020, and on the basis of Trans Ocean’s evaluation of its enforceable rights and obligations in the contract with Eastern, Trans Ocean concludes that term of the revenue contract with Eastern is for a period of two years. Further, Trans Ocean concludes that (1) because of its contract with Asia and Eastern, it would not be operationally feasible to deploy the leased cargo vessel on other routes; (2) the cargo vessel will have sufficient capacity to service both Asia and Eastern; and (3) the leased asset is needed for Trans Ocean to perform under its revenue contract with Eastern (because of economic reasons that would not allow Trans Ocean to use another vessel). Required: 3. Should Trans Ocean reassess the lease term of the cargo vessel? If so, why?

Answer 1

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1. Do you agree with Trans Ocean's conclusion that the lease term for the cargo vessel is one year because the revenue contract is for one year?

Yes, the conclusion of Trans Ocean is accurate.

Because, Recognizing the lease term for one year is a good conclusion because the revenue for the same lease term is accurate. This is because the contract may be renewed as asserted in the lease agreement for up to 5 years. But the lease contract would be there for more than one year because Trans Ocean would collect the fee at the commencement of the year. In this way, Trans Ocean would never be in loss. So, there is no issue if the contract is made for one year or more. Or in other terms, As Trans Ocean has leased the cargo only for the purpose of shipping the goods of Asia Manufacturing on that particular route, the conclusion made by it can be considered as correct. As, the entity, in this scenario, might have considered the fact that if the revenue contract with Asia Manufacturing will be getting terminated then that cargo will be of no use. However, in this situation, Trans Ocean must have thought of grabbing some new customers on that route so as to expand its business. Trans Ocean must consider the fact that shipping is its business and if a new customer for a new route can come to its entity then there could have been many other customers for that particular route. With the increase in the number of customers from the route, it can increase its revenue.

2. What factors should Trans Ocean consider in supporting its conclusion related to the lease term?

Factors to be considered are explained as follows: Factors that should consider by Trans Ocean to support its outcomes related to lease terms include:

• If the revenue contract is for one year, then the lease contract should also be for a year only. This was considered because Trans Ocean thought that Asia Manufacturing may not renew the contract.
• To alleviate the risk, a negotiation is done between Trans Ocean and the Heavy Vessel Manufacturing that one year is non-cancelled.
• All the disclosure related to ASC 842 and ASC 606 should be done and they should be discussed by both parties.

Alternatively, Trans Ocean should consider the fact that if it will not conclude its lease term after one year then it has to incur some additional expenses even without earning any revenue. Also, if the entity would not able to grab any new customers from that route then the cargo will be of no use.

3. Should Trans Ocean reassess the lease term of the cargo vessel? If so, why?

Yes, the contract can be reassessed.

Because, Taking the third party Eastern Manufacturing Company with Asia Manufacturing to transport their product in reassessing the lease term of cargo vessel is a reliable decision because Eastern Manufacturing Company wants the service for two years and Asia Manufacturing demands for a year. Therefore, the lease contract would be reassessed and may be renewed for a further year. Or in other terms, in such a scenario, the company should reassess the lease term of the cargo as in addition to Asia Manufacturing, the company is having another customer for that route. This means that by incurring same amount of expense, the company can earn additional revenue.

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