Is it a lease? Last month’s blog covered the analysis that goes into making this determination but the real challenge comes when we try to apply it. Let’s begin with a quick overview of the concepts from last month and then we can apply those concepts to our analysis in the examples in this blog. The definition of a lease, as noted in the standard is as follows:

A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce).

Breaking it Down

The key focus here will be on the terms “control” and “identified asset.” In the old standard (ASC 840), a customer did not need to both obtain substantially all the economic benefits and direct the use of the asset to control the use of the asset. An arrangement could contain a lease even without control of the use of the asset if the customer took substantially all of the output over the term of the arrangement. However, the new standard (ASC 842) dictates that in order to meet the criteria for control, the customer must have the right to:

1. obtain substantially all of the economic benefits from using the asset, and
2. direct the use of the asset (i.e., determine how and for what purpose the asset will be used throughout the period of use).

The concept of economically benefiting from the substitution also discussed in last month’s blog is a new concept under ASC 842. As a recap, for a substitution right to be substantive and thus preclude lease accounting, the supplier must both:

1. have the practical ability to substitute the asset, and
2. economically benefit from the substitution.

So, in summary, the questions we are going to focus on in this blog are:

1. Is there a specifically identified asset?
2. Does the supplier have a substantive substitution right?
3. Does the customer have the right to obtain substantially all of the economic benefits from use of the asset? (first element of control)?
4. Does the customer have the right to direct the use of the asset? (second element of control)?

Now, Let’s Apply the Concepts!

Scenario 1: Shopping Mall Booth

A cell phone accessory carrier (the Customer) enters into a contract with a shopping mall (the Supplier) to use a space in the mall to sell its accessories for a period of five years. According to the contract, the amount of space allocated to the Customer will be 200 square feet and the space can be located in one of several spots, some of which are near mall entrances. The Customer agrees to this since the Customer owns a booth, which can easily be moves from one location to another. The Supplier will incur minimal costs as a result of changing the location and there are several available options for space that would meet the contract requirements for size and other specifications. Is it a lease?

In this case, the answer is, NO. In order to analyze whether this contract is or contains a lease, let’s refer back to our questions above and take it step-by-step. We first ask the following: Is there an identified asset and does the Supplier have substantive substitution rights? There is no identified asset since the unit has not been specifically identified (i.e., retail unit A). Even if we did have an identified asset, it doesn’t take too much digging in to realize that the Supplier does have substantive substitution rights – in this case, both criteria have been met. Remember, for a substitution right to be substantive and thus preclude lease accounting, the supplier must both have the practical ability to substitute the asset and economically benefit from the substitution.

In this case, the Supplier does have the practical ability to substitute the asset as we are told that the Supplier can change the location and incur minimal costs as a result. The Supplier may also benefit economically from the substitution. For example, the Supplier may decide to move the Customer to a new location and give the original location to a new tenant who is willing to pay more for it. So in summary, the Supplier does have a substantive substitution right. As a result, in this scenario, we do not have a lease.

Scenario 2a: Cable Company (Part I)

A Customer enters into a ten-year contract with a cable company (the Supplier) for the right to use three specified fibers within a larger cable. The three fibers are physically distinct. The Customer makes all the decisions about how the fibers are going to be used, specifically, the Customer decides what data will be transported using the fibers, how much data will be transported, when the data will be transported, etc. However, if any of the fibers malfunction, the Supplier will replace the malfunctioned fibers. According to the contract, the Supplier can only substitute fibers in the case of malfunction and in this case, the Supplier is contractually obligated to replace the malfunctioned fiber(s). Is it a lease?

In this case, the answer is, YES. Let’s dig right into analyzing! Is there an identified asset and does the Supplier have substantive substitution rights? Well, we do have an identified asset in this case, i.e., the three specifically identifiable, physically distinct fibers so we meet that requirement. Next, let’s consider the Supplier’s substantive substitution rights. The Supplier will replace malfunctioned fiber(s) so the Supplier can in fact replace one fiber for another. So the first criterion (the supplier has the practical ability to substitute the asset) has been met. But the second criterion (the Supplier will economically benefit from the substitution) has not been met. The Supplier can only substitute a fiber if it malfunctions. The Supplier cannot substitute it for any other reason (so it is unlikely that the Supplier benefiting economically from the replacement). So far, so good. We have an identifiable asset and the Supplier does not have a substantive substitution right.

Next, let’s look at the elements of control. To determine whether a contract conveys the right to control the use of an identified asset a period of time, an entity shall assess whether, throughout the period of use, the customer has both the right to obtain substantially all of the economic benefits from use of the identified asset and the right to direct the use of the identified asset

In this scenario, the Customer meets both criteria. The Customer has the right to obtain substantially all the economic benefits from the use of the identified asset and has the right to direct the use. After analyzing the facts related to this contract in the context of the four criteria listed above, we conclude that the contract is a lease.

Scenario 2b: Cable Company (Part II)

Now let’s mix the facts up a bit. Assume we have the same Supplier and Customer as in the scenario above (Part I). However, the contract is for the Customer to use a specified amount of data capacity within the larger cable. The amount has been defined as equivalent to the Customer having the use of the entire capacity of three strands within the larger cable. The Supplier makes the decisions about which fibers will be used. Is it a lease?

In this case, the answer is, NO. We begin with the same pair of questions: Is there an identified asset and does the Supplier have substantive substitution rights? We don’t need to go very far with this one before we arrive at the answer. We do not have an identifiable asset since the contract does not specify which fibers will be used. Instead, the contract states that the Customer will have access to three strands within the larger cable. Based on this information, we cannot determine specifically which strands the Customer will be using (we cannot identify an asset). So we can stop there and conclude that we do not have a lease. In the scenario above, the contract was very specific about which fibers the Customer will have access to (three specified physically distinct fibers) and therefore we had an identified asset.

Scenario 3: Store in Complex

A Customer enters into a contract with a Supplier who owns a retail rental building. The space is one of many units in a large complex. The contract is to use the space (retail unit A) for ten years and during that time, the Supplier can require the Customer to relocate to another unit. If the Customer had to relocate, the Supplier would have to provide a unit that met the specifications in the contract and would also have to cover all relocation costs. The contract requires that the Customer operate its store during the hours the complex is open only. While the Customer decides how it will use the unit, i.e., which goods it will sell, when it will order goods, what the pricing will be, etc., the Supplier provides advertising services. In addition, the Customer must pay the Supplier an amount equal to two percent of all sales revenue. Is it a lease?

In this case, the answer is, YES. Let’s analyze. Is there an identified asset and does the Supplier have substantive substitution rights? Yes, retail unit A is the identified asset. The Supplier does not have substantive substitution rights. Even though the Supplier can move the tenant from one unit to another, the Supplier would not benefit economically from doing so as the Supplier would have to find a tenant that would pay at such a favorable rate as to cover (and exceed) the costs of relocating the Customer to a new unit. This is unlikely to happen and is also beyond the control of the Supplier. Next, let’s look at the elements of control. Firstly, does the Customer have the right to obtain substantially all of the economic benefits from use of the asset? The answer is yes. The fact that a portion of the sales revenue will go to the Supplier does not affect control – that just represents payment for using the space. Secondly, does the Customer have the right to direct the use of the asset? The answer is yes. The advertising services that the Supplier provides does not affect the Customer’s control of the space. So in this scenario, the contract is a lease.

Scenario 4a: Transporting Cargo (Part I)

A Customer enters into a contract with an owner of a large ship to transport its goods across the ocean on a specified ship. The Supplier does not have substantive substitution rights. The specifics of the contract dictate that the Customer cannot use its own ship operator – the Supplier will provide the operator. The Supplier will also decide what type of cargo will be transported and where the ship will sail. The cargo that the Customer ships will occupy substantially all of the ship’s capacity. Is it a lease?

In this case, the answer is, NO. As we begin our analysis, we determine that we do have an identified asset (the ship) and the Supplier does not have substantive substitution rights. So far, so good so let’s continue and look at the elements of control. Does the customer have the right to obtain substantially all of the economic benefits from use of the asset? Yes – the contract specifies that the Customer’s goods will occupy substantially all of the capacity of the ship. Does the customer have the right to direct the use of the asset? No – the Customer cannot direct how and for what purpose the ship is being used. Note that the Supplier decides what type of cargo will be transported and where the ship will sail. This contract is not a lease.

Scenario 4b: Transporting Cargo (Part II)

Assume we have the same set of facts as the scenario above except that in this case, the Customer decides what type of cargo will be transported and where the ship will sail. However, the contract does place restrictions on where the ship can sail, specifically stating that the ship cannot sail into certain areas that would cause a risk of sinking and the Customer cannot carry explosives on the ship. The Supplier operates the ship and the Customer is prohibited from using its own operator. Is it a lease?

In this case, the answer is, YES. The difference here is that we meet the elements of control. Specifically, the Customer does have the right to direct the use of the asset (in this case the Customer decides what type of cargo will be transported and where the ship will sail). Note that the restriction placed in the contract prohibiting the Customer from carrying explosives on the ship or sailing into dangerous areas does not take away from the element of control. These restrictions are “protective rights” (see last months’ blog post “Is it a Lease? ASC 842: Breaking Down the Definition of a Lease for an explanation of protective rights) and do not impact the element of control.

Conclusion

The requirements set forth by the new lease standard (ASC 842) have created a need for detailed analysis of all contracts and arrangements. Arrangements that may not have been considered lease arrangements before ASC 842 can now fall into the lease category, based on the definition of a lease set forth by ASC 842. As practitioners, we need to be diligent when analyzing contracts and arrangements to ensure that all leases are accounted for and ultimately make it to the balance sheet. As exemplified above, one seemingly minor fact can mean the difference between a contract that is a lease and a contract that is not a lease. Careful analysis is the key. Go down the list of questions one by one: 1) Is there a specifically identified asset? 2) Does the supplier have a substantive substitution right? 3) Does the customer have the right to obtain substantially all of the economic benefits from use of the asset? 4) Does the customer have the right to direct the use of the asset? Based on your assessment, once you arrive at an answer that would preclude lease accounting, you do not have a lease. Otherwise, if you meet all the requirements, it is a lease!

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