Question

Logical Logistics Inc. (Logical Logistics or the “Company”) provides transportation and logistics services to customers throughout a network of offices in North America, South America, and Asia. The Company contracts fleets of shipping vessels, trucks, and aircraft to provide regional, long-haul, and international shipments of customer goods. In addition, the Company contracts warehouse operators across North America for use of their facilities as distribution centers that temporarily store goods in transit. The Company has entered into the following contracts with the vendors identified below.

Logical Logistics enters into a contract with See Boat Inc. (See Boat) to use its shipping vessels to transport customer goods from North America to Asia. See Boat has a fleet of 25 multi-use shipping vessels, each of which has the capacity to hold 1,000 shipping containers.

Logical Logistics enters into a contract with Fly-By-Air Inc. (Fly-By-Air) to use its aircraft to transport customer goods from South America to North America. Fly-By-Air has a fleet of 50 multi-use aircraft, each of which has the capacity to hold 500 shipping pallets of customer goods.

Logical Logistics enters into a contract with Trucking Co. Inc. (Trucking Co.) to use its trucks to transport customer goods from distribution centers to retail stores across North America. Trucking Co. has a fleet of 1,500 multi-use long-haul trucking carriers, each of which has the capacity to hold 100 shipping pallets of goods.

Logical Logistics enters into a contract with Warehouse Co. Inc. (Warehouse Co.) to store up to 18,000 shipping pallets of customer goods at one of Warehouse Co.’s locations. Warehouse Co. has the capacity to store 20,000 shipping pallets of goods.

The terms of the shipping contracts are as follows:

• See Boat

o The contract term is for the voyage to transport Logical Logistics’s cargo from Los Angeles to Shanghai. Logical Logistics does not have discretion to change the departure or arrival ports without a renegotiation of the contract fees.

o SB0829, a commercial shipping vessel in See Boat’s fleet, is dedicated to delivering Logical Logistics’s cargo for the term of the contract. See Boat cannot substitute SB0829 with another vessel in its fleet.

o The contract identifies the shipping containers and acceptable cargo (e.g., semiconductors) to be transported on the ship as well as the transportation route. Logical Logistics does not have discretion to change the identified cargo without renegotiating the contract fees.

o See Boat is responsible for the safe passage of the cargo, as well as operation and maintenance of SB0829. The crew determines the ship’s route, speeds, and date of departure from Los Angeles. In addition, Logical Logistics cannot, under any circumstances, replace See Boat’s crew.

• Fly-By-Air o The contract term is five years.

o FBA1231, a commercial aircraft in Fly-By-Air’s fleet, is dedicated to delivering Logical Logistics’s shipping pallets during the term of the contract.

o Logical Logistics determines (1) the airports from and to which goods are shipped and received and (2) the order in which deliveries are made to the airports. Fly-By-Air provides the aircraft’s pilot and crew, and Logical Logistics instructs Fly-By-Air accordingly.

o While Logical Logistics determines what cargo will be transported throughout the term of the contract, certain restrictions prevent the Company from shipping flammable materials.

o Logical Logistics has the right to send the aircraft regardless of whether its cargo levels meet the full storage capacity of the aircraft. If FBA1231 is below capacity, Fly-By-Air cannot use the excess storage space to ship products of its other customers.

• Trucking Co.

o The contract term is five years.

o Trucking Co. must deliver Logical Logistics’s shipments within three weeks of the Company’s notification that it has pallets of customer goods ready for shipping.

o Trucking Co. may choose any truck from its fleet to fulfill the shipping request.

o Logical Logistics may request shipment of 25 to 100 shipping pallets of goods in a single request. (Individual shipping requests generally do not exceed 50 shipping pallets.)

o Trucking Co. has the right to use any excess storage space to ship products of its other customers.

o Trucking Co. determines the shipment’s delivery date (within the threeweek period), as well as the shipping route.

• Warehouse Co.

o The contract term is 10 years.

o Logical Logistics can store up to 18,000 shipping pallets at one specified Warehouse Co. location. Logical Logistics will be charged for storage of 18,000 shipping pallets, regardless of the actual number of pallets stored, and Warehouse Co. cannot use any of Logical Logistics’s unused storage space for other storage needs.

o Warehouse Co. can use the remaining space in its warehouse for other storage needs.

o Warehouse Co. cannot relocate Logical Logistics’s inventory to another facility.

o Logical Logistics has the right to decide which shipping pallets are placed in storage and when they can be removed.

o Warehouse Co. provides the loading and unloading services for the warehouse activities, both of which are dependent on Logical Logistics’s decisions about which shipping pallets are placed in storage and when they can be removed.

The CFO of Logical Logistics recognizes that the new leasing standard contains certain provisions that may affect how the Company treats contracts of this nature.

Required: Analyze the information above, and prepare a memorandum addressing the impact (if any) of the new leasing standard on Logical Logistics’s arrangements for the following considerations:

2. Determine whether each contract conveys the right to control the use of the identified asset to Logical Logistics.

Answer 1

Determining if a contract contains a lease

The first step in applying ASC 842 is determining whether a contract, which is defined as an agreement between two parties which creates enforceable rights and obligations, contains a lease. Basically the contract contains a lease if it conveys the right to control the use of identified property or equipment for a period of time.

In order to determine whether a customer has the right to control the use of the specified asset, for a period of time, the customer determines that it has both:

• The right to obtain substantially all of the economic benefits from the use of the asset, and
• The right to direct the use of such asset.
• An asset is identified, usually by specific terms in the contract; however, absent description in the contract, an asset can be implicitly identified at the time the asset is made available to the customer. For example, a lease for a forklift could be worded in two different ways:

1. The contract could specify the type, make and serial number of a specific forklift which is then provided to the customer, or
2. The contract could specify that a forklift will be provided and at the time of delivery.

In both cases, the customer has a specifically identified asset.

Substantive substitution right

It is possible that the contract permits the supplier to substitute one asset for another. In this situation, the customer must determine whether this is a substantive substitution right. If so, then the contract does not contain a lease. The supplier has a substantive right if both of these conditions exist:

a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).

b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).1

An entity should evaluate at the inception of the lease whether the rights are substantive and should exclude consideration of future events which are unlikely to occur. Certain indicators are noted in the ASC which make it unlikely that the supplier has a substantive right:

• If the asset is physically located at the customer premises, the cost of substitution tends to be higher and may make it more likely the supplier would not substitute.
• If the supplier can only substitute after a certain period or after the occurrence of a specified event, the right would not be considered substantive.
• An obligation to substitute another asset in order to make repairs or maintenance is not a substantive right.
• If it is not determinative if the supplier has such a right, the customer should assume it does not.

An example of the application of this concept:

Contract contains a lease

A trucking company enters into a contract with a supplier of refrigerated trailers for ten trailers to be used for a period of five years. The contract specifies the trailers. The trailers are to be maintained at the customer’s premises. The customer determines when the trailers are used and the freight carried; or may not place them into service, but uses them for terminal storage. The supplier cannot retrieve the trailers until the five years are completed.

This contract contains a lease of ten trailers, because the customer:

1. Controls the use of specific trailers;
2. Has the right to substantially all of the economic benefits of the use of the trailers; and
3. Has a right to direct use of the trailers for transport or storage.

Contract does not contain a lease

A customer enters into a contract with a supplier for transport of goods in refrigerated trailers for a period of five years. The volume specified in the contract will require the use of ten trailers at dates specified in the contract. The trucks and trailers are only at the customer’s premises for purposes of pickup and delivery. The supplier has the ability to substitute other trucks and trailers throughout the period. The supplier would benefit economically from the right of free substitution of equipment.

This contract does not contain a lease, because:

1. The assets employed in the contract are not specified; the supplier’s only obligation is to provide transport services;
2. The customer does not control the use of specific assets; and, thus,
3. The customer does not receive substantially all of the economic benefits associated with the equipment, as the supplier can freely substitute other equipment to fulfill the transport obligation.

Right to control the use of the identified asset

There are two requirements to meet this condition. The customer must have the right to obtain economic benefits from the use of the asset and the customer has the right to direct the use of the asset. These conditions are met as follows:

Right to obtain economic benefits

• The customer has the exclusive right to use the asset through the life of the contract.
• The customer obtains economic benefits by using, holding or subleasing the asset.
• These economic benefits include the direct output of the asset and the related cash flows or other benefits resulting from contracts with third parties.
• Conditions that may limit the scope of economic benefits, such as mileage limits on a vehicle, do not impair the economic benefits obtained. If so, the customer assesses whether substantially all of the economic benefits have been obtained for the period through the mileage limit, but not beyond.
• Additional payments made to the supplier above the base rate, such as a percentage of sales, do not offset the consideration of economic benefits; they are simply considered additional consideration for the use of the asset.

Right to direct the use of the asset

• The customer determines how the asset is used through the life of the contract; or
• The use of the asset is predetermined per the terms of the contract and the terms cannot be changed by the supplier during the life of the contract, or the customer has designed the asset in such a way that the use of the asset is predetermined by virtue of such design.

Separating the components of a contract

It is not uncommon for a contract that contains a lease to have other components included. A customer must analyze the contract to determine if there are other components. Typically, the lease is a separate lease component of the contract if the following conditions are met:

a. The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessoror other suppliers) or resources that the lessee already has obtained (from the lessor or from other transactions or events).

b. The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee’s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset, if each right of use significantly affects the other.2

The standard specifies that lease contracts that include land as well as other assets, must be separated with the right to use the land (sometimes referred to as a land easement or right of way) as a separate lease component.

Other lease contract components could include the transfer of other goods and services to the customer. If present, these obligations must be separated and considered separately from the lease, and the consideration in the contract shall be allocated among the components. However, consideration should not be allocated to routine administrative costs in setting up the contract or reimbursements for payments of the lessor’s costs, as they are not considered the transfer of goods or services.

If the contract contains separate components, then the lessee must allocate the consideration specified in the lease as follows:

• The customer shall determine the standalone selling price of the components based on observable prices; if observable prices are not available, the lessee shall estimate the standalone price maximizing the use of observable information.
• The lessee shall allocate the consideration based on the standalone selling prices.3

The consideration to be allocated includes all of the fixed payments, as well as variable payments based on an index or rate as determined at the inception of the lease.3

The standard provides a practical expedient. The customer need not account for the components separately if it makes an accounting policy election to the treat the components as one lease obligation.

Conclusion

Despite the detailed guidance provided in the standard for the most common leasing transaction, such as for space or equipment, the assessment of whether or not a contract contains a lease will be straightforward and unlikely to result in an answer different from current practice. More complex arrangements such as service contracts, which may have not been considered as containing a lease, may need to be reviewed to determine if the customer, as part of the service agreement, obtains the right to use a specified asset which provides substantially all of its economic benefit to the customer.

Making the relevant assessments and allocating lease consideration (when multiple components are elected to be accounted for separately) will need to be addressed as part of an entity’s internal control over financial reporting. For accelerated filers, this will likely be a focus for external auditors conducting an integrated audit.s