Case 19-10

Auditing 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 Asias products between Shanghai and Los Angeles. Trans Oceans 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 Oceans revenue contract with Asia, and Trans Oceans lease with Heavy.

Trans Oceans Revenue Contract With Asia

The revenue contracts 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 Oceans 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.

To mitigate risks, Trans Ocean negotiated the lease period and renewal options to mirror those of Trans Oceans 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.

Additional Facts

On December 1, 2019, Trans Ocean entered into a shipping contract with Eastern Manufacturing Company (Eastern) to ship Easterns products between Shanghai and Los Angeles. The contract with Eastern commences on January 1, 2020, and on the basis of Trans Oceans 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 Audit Activities:

Analyze the information above and perform the following activities:

1A.On the basis of the contract between Trans Ocean and Heavy, what is the risk of material misstatement (RoMM) that we may identify as part of our audit to address the valuation and allocation of the right-of-use (ROU) asset and lease liability, in determining the appropriate lease term in the lease contract?

1B. Considering the Additional Facts of the case, what additional RoMMs may we identify as part of our audit to address the completeness of identifying all events or circumstances that would require a reassessment of the lease term, the remeasurement of the ROU asset and lease liability, or both, to reflect the reassessment event?

Handout 1, the RoMMs matrix, may be used to assist with identifying the relevant RoMMs.

2. Identify internal controls that address the RoMMs identified in Activity 1. Handout 2, Trans Oceans internal control matrix, may be used to assist with identifying relevant internal controls.

3. Design substantive procedures that address the RoMMs identified in Activity 2.

Handout 1 Auditing the Terminator Risks of Material Misstatement (RoMMs) Leases

RoMM No.	RoMM Description
1	Right-of-use (ROU) assets and lease liabilities are not valued correctly, on the basis of the underlying assumptions (e.g., lease terms, discount rate, lease payments) and classification of the lease (i.e., operating or financing).
2	Lease expense recorded does not represent valid expense.
3	Contracts or arrangements containing a lease are not identified as a lease.
4	The lease is not appropriately classified on the basis of the criteria under ASC 842.
5	The entity identifies ROU assets and lease liabilities for which it does not have the rights or obligations to.
6	A reassessment event or circumstance occurs during the period but is not properly identified or accounted for (i.e., remeasured).
7	Contracts or arrangements are determined to be a lease when the criteria under ASC 842 have not been met.
8	Lease expense is not recorded (1) at correct amounts, (2) in the proper accounts, or (3) in the proper period.

Handout 2 Auditing the Terminator Internal Control Matrix Lease Process

Control No.	Control Title	Control Description
L 1	Contract Review Contract database is reviewed by each department leader.	On a quarterly basis, each department leader (e.g., Sales, Treasury, Human Resources, IT, Tax), with appropriate knowledge of the contracts entered into by his or her department, reviews the contract database to verify that (1) all contracts (i.e., new, existing, or modified), in accordance with the entitys accounting policies, have been included in the database. Each department leader provides representation to the Lease Accountant of the completeness and accuracy of the database, as well as the contracts identified that require reassessment to the best of his or her knowledge.
L2	Automated Control	Standard program algorithms perform the calculation of the ROU asset or lease liability for new leases, when applicable, and the lease expenses and other adjustments for existing leases.
L3	Lease Terms Review Controller reviews and approves the key contract terms entered into the lease software.	The Controller, with appropriate knowledge of the entitys lease arrangements and the accounting framework and principles under the requirements of ASC 842, reviews the contract listing (e.g., contract database extract) to verify that all the key contract terms for the entitys lease arrangements were entered by the Lease Accountant into the lease software. The Controller will verify the completeness and accuracy of the contract listing (e.g., contract database extract) by reviewing key terms against the lease contracts. Any differences identified as a result of the Controllers review are investigated and resolved, and all questions are addressed. The Controller then approves and signs off on the contract listing (e.g., contract database extract).
L4	Review of Reconciliations Controller reviews and approves all general ledger reconciliations for the lease specific accounts.	The Controller reviews the lease account balance reconciliations, on a quarterly basis, along with the detailed lease analysis supporting the amounts recorded, as prepared by the Lease Accountant. After performing the review, any differences identified as a result of the review are investigated and resolved, and all questions are addressed. The Controller then approves and signs off on the lease account balance reconciliations.
L5	Reassessment Review Controller assesses completeness of the identified reassessment events or circumstances.	The Controller, with appropriate knowledge of the entitys lease arrangements and the accounting framework and principles under the requirements of ASC 842, reviews the contract listing (e.g., contract database extract) for any contracts that have been modified to verify any reassessment events or circumstances, as defined in ASC 842, that have occurred have been identified and appropriately accounted for by the Lease Accountant. Any differences identified as a result of the Controllers review are investigated and resolved, and all questions are addressed and documented in the accounting conclusion memo. The Controller then approves and signs off on the accounting conclusion memo.
L6	Journal Entry Approval Controller reviews and approves the journal entries and supporting documentation.	The Controller reviews and approves the manual journal entries and supporting documentation prepared by the Lease Accountant. The Lease Accountant is responsible for posting the entries following the Controllers approval. Copies of each entry posted to the general ledger are retained, including supporting documentation. Any differences identified as a result of the Controllers review are investigated and resolved, and all questions are addressed. The Controller then approves and signs off on the manual journal entries, and documentation reviewed would include a detailed lease analysis with the relevant lease terms, discount rate, and lease payments, as well as other supporting documentation.