Rough Waters

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Background

Smooth Sailing is a private company that operates one cruise ship. Recently, pirate activity in the area where the cruise ship operates has increased, thus affecting the cruise ship’s potential future cash flows. The cash flow decline has directly contributed to a decline in the overall fair value of the cruise ship.

Smooth Sailing has determined three possible options for its future, along with the probabilities of occurrence and estimated cash flows (ECF): 1.Continue operating the cruise ship in current area. (10% probability with $4.0 million ECF) 2.Operate cruise ship in new area with fewer pirates. (20% probability with $6.0 million ECF) 3.Operate for one more year and then return ship to lender. (70% probability with $1.0 million ECF) These events show that the carrying amount of the asset group may not be recoverable; thus, Smooth Sailing will need to test the asset group for recoverability and potential impairment in accordance with ASC 360-10 at the end of the current fiscal year.

As of 31 December 2010, the cruise ship’s estimated fair value is $3.0 million, the net book value is $4.6 million, and the estimated remaining useful life is five years. We also assume that no matter which decision is made, the net working capital will be released for use and can be used for calculations in ECF. This is because no matter when and how the ship will be retired or sold back, the net working capital will be released.

The main issue Smooth Sailing needs to consider is how to properly and fairly display the amount of the cruise ship on its books. It needs to determine whether an impairment issue exists and, if it does, the amount of that impairment loss. The reason accounting for impairment is so important is the deep effect it has on a company’s financial statements. If a company has improperly accounted for an impaired asset and left it at the carrying value, assets will be inflated, net income will be overstated, and cash flows will be understated to the extent of the favorable tax recovery effect. These impairment effects could have a great impact on the decisions made by the users of the financial statements.

In the following sections we will first give an explanation for possible accounting alternatives for US GAAP and IFRS. Included in these alternatives will be relevant industry examples. We will then conclude with a recommendation for Smooth Sailing.

Acceptable Authoritative Literature
FASB Accounting Standards Codification (ASC) 360-10, Property, Plant, and Equipment - Overall FASB Financial Accounting Standard (FAS) 144 - Accounting for the Impairment or Disposal of Long-Lived Assets IASC International Accounting Standard (IAS) 16, Property, Plant, and Equipment IASC International Accounting Standard (IAS) 36, Impairment of Assets IASC International Accounting Standard (IAS) 37, Provisions, Contingent Liabilities, and Contingent Assets

Discussion of Alternatives

GAAP
US GAAP Alternative with Initial Probabilities: The first issue to be taken into consideration is whether or not the asset is impaired. According to FASB 360-10-35-17, the first step to determine impairment is to apply a recoverability test. This test compares the asset’s current carrying value to the undiscounted future cash flows (UFCF). We calculated the total UFCF by multiplying each option’s probability by their estimated cash flows, taking the sum for each decision, and adding the net working capital. As stated in the codification, when the UFCF is less than the current carrying value of the assets, the asset is considered impaired. Following the FASB guidelines, the loss on impairment is calculated as the carrying value less the fair value. For the case of Smooth Sailing, the ship would be impaired and a loss would be recognized.

In examining similar companies within the industry, such as Royal Caribbean Cruises, Carnival Cruises, and Disney Cruises, we found that these cruise lines use...
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