A private company Smooth Sailing operates a cruise ship the purchase of which was financed with the help of nonrecourse debt. However, the presence of pirates has significantly increased in the area where Smooth Sailing cruises. As a result, the operating performance of the ship has considerably declined as well as its overall fair value. In fact, in 2010, the annual operating cash flows of Smooth Sailing declined by 30% and amounted to $1.0 million (“Case 12-9: Rough waters ahead,” n.d.). At the same time, in the nearest future, the ship’s fair value and the company’s operating performance were supposed to continue to decline.
That is why Smooth Sailing decided to evaluate several possible options and test the asset group for potential impairment and recoverability at the end of the 2010 fiscal year for proceeding into 2011 and beyond (“Case 12-9: Rough waters ahead,” n.d.). Potential solutions were to continue operating the cruise ship in the current area, to operate the ship in a new area without pirates, and to operate the cruise ship in the current area in 2011 and turn it back to the lender at the end of the year (“Case 12-9: Rough waters ahead,” n.d.). The estimated fair value of the cruise ship was $3.0 million and it’s estimated remaining useful life was five years.
In general, the multiple operating scenarios have a substantial impact on the recoverability test as they require the company’s management to perform multiple calculations based on every possible scenario and its influence on the asset group’s total value and its generated cash flows. According to 360-35-30 of Accounting Standards Codification, “if alternative courses of action to recover the carrying amount of a long-lived asset (asset group) are under consideration or if a range is estimated for the amount of possible future cash flows associated with the likely course of action, the likelihood of those possible outcomes shall be considered. A probability-weighted approach may be useful in considering the likelihood of those possible outcomes” (FASB, n.d.). All estimations of future cash flows that are used to test a long-lived asset’s recoverability should be reliable, take into consideration all available evidence and factors, and include the entity’s assumptions concerning the asset’s use.
In addition, as previously mentioned, multiple scenarios are required for the evaluation of potential impairment. According to 360-35-17 of Accounting Standards Codification, “an impairment loss shall be recognized only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the discounted cash flows expected to result from the use and eventual disposition of the asset (asset group)” (FASB, n.d.). Concerning the case of Smooth Sailing, its discounted cash flows based on potential solutions may be counted in the following way:
- If the company continues operating the cruise ship in the current area – $0.4 million as the probability of occurring is only 10%;
- If the company operates the ship in a new area without pirates – $1.2 million as the probability of occurring is 20%;
- If the company operates the cruise ship in the current area in 2011 and turns it back to the lender at the end of the year – $0.7 million as the probability of occurring is 70%.
As a result, the total sum of the discounted cash flows expected to result from the use and eventual disposition of the asset is $2.3 million. In this case, it is possible to conclude that an impairment loss will occur, as this sum exceeds neither the asset’s fair value ($3.0 million) nor the asset’s carrying amount ($ 4.0 million).
References
Case 12-9: Rough waters ahead. (n.d.). Web.
FASB. (n.d.). Accounting Standards Codification. FASB. Web.