To: Smooth Sailing
From: The consulting group
Date: May 6, 2012
Subject: Recoverability/Impairment of cruise ship
Smooth Sailing is a private company that operates one cruise ship. Smooth Sailing’s purchase of the cruise ship was financed with nonrecourse debt. The cruise ship has its own identifiable cash flows that are largely independent of the cash flows of other asset groups. Because of an increased presence of pirates in the area in which Smooth Sailing cruises, the cruise ship’s operating performance has significantly declined, which has directly contributed to a decline in its overall fair value. Smooth Sailings’ management is evaluating the following possible options for proceeding into 2011 and beyond:
| Probability of Occurring
| Continue operating the cruise ship in current area
| Operate the cruise ship in a new area where there are no pirates
| For 2011, operate the cruise ship in the current area despite the increased presence of pirates. On December 31, 2011 turn the cruise ship back to lender
| These events indicate that the carrying amount of the asset group may not be recoverable and, therefore, Smooth Sailing will test the asset group for recoverability and potential impairment in accordance with ASC 360-10 as of the end of the current fiscal year, December 31, 2010. As of December 31, 2010, the cruise ship’s estimated fair value is $3.0 million, net book value is $4.6 million, and estimated remaining useful life is five years. In addition, the net carrying value of the nonrecourse debt is $4.0 million, there is $0.1 million of networking capital (carried at fair value) directly attributable to the cruise ship, and Smooth Sailing has determined that an annual discount rate of 7 percent is appropriate.
1. How should Smooth Sailings’ management perform the recoverability test for the cruise ship as of December 31, 2010? a. What assets and liabilities should be included in the “asset group” as defined by ASC 360-10 for purposes of performing the recoverability test? b. How should the multiple operating scenarios impact the recoverability test? c. What impact should the potential foreclosure and extinguishment of debt have on the cash flows used to perform the recoverability test? 2. What impairment loss, if any, should be recorded as of December 31, 2010?
1. The recoverability test follows steps described below in the discussion section. a. The asset group should include the cruise ship and the net working capital associated with the cruise ship. b. When there are multiple operating scenarios a probability-weighted approach should be used. The expected cash flow that is used to determine the recoverability of the asset group is the aggregate of the expected cash flows under each scenario multiplied by its respectively probability of occurrence. c. The probability of the foreclosure is 70%, this has a significant effect on the test under a probability-weighted method due to its larger probability of occurrence relative to the other operating scenarios. 2. No impairment loss should be recorded. The carrying amount of the asset group does not exceed the sum of the expected cash flows.
1. ASC 360-10-35-29 provides that, “[e]stimates of future cash flows used to test the recoverability of a long-lived asset (asset group) shall include only the future cash flows (cash inflows less associated cash outflows) that are directly associated with and that are expected to arise as a direct result of the use and eventual disposition of the asset (asset group). Those estimates...
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