Rough Waters
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
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