Question

Smooth Sailing is a private company that operates one cruise ship. Smooth Sailing’spurchase of the cruise ship was financed with nonrecourse debt. (Nonrecourse debt is a loan that is secured by a pledge of collateral, in this case the cruise ship, but for which the borrower is not personally liable. If the borrower defaults, the lender can seize the collateral, but the lender’s recovery is limited to the collateral.) 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 the ship’s overall fair value. In the current year (2010), Smooth Sailing’s annual operating cash flows have declined by 30 percent to $1.0 million, and its annual operating cash flows are expected to continue to decline in the near term. Because of this decline in the cruise ship’s fair value and operating performance, Smooth Sailings’ management is evaluating the following possible options for proceeding into 2011 and beyond:

			Estimated Future Cash Inflows — Undiscounted
Option		Probability of Occurring	2011	2012	2013	2014	2015	Total
A	Continue operating the cruise ship in the current area.	10%	$1.0M	$0.9M	$0.7M	$0.7M	$0.7M	$4.0M
B	Operate the cruise ship in a new area where there are no pirates.	20%	$0.8M	$1.0M	$1.3M	$1.5M	$1.9M	$6.5M
C	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 the lender (e.g., foreclosure).	70%	$1.0M	$4.0M	$0	$0	$0	$5.0M

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 $4.0 million, net book value is $5.4 million, and estimated remaining useful life is five years. In addition, there is $0.2 million of net working capital (carried at fair value) directly attributable to the cruise ship.

HowshouldSmoothSailings’managementperformtherecoverabilitytestfor the cruise ship as of December 31, 2010? In addressing this question, consider:

a) What assets and liabilities should be included in the “asset group” as defined by FASC 360-10 for purposes of performing the recoverability test?

b) Howshouldthemultipleoperatingscenariosimpacttherecoverabilitytest?

2) What impairment loss, if any, should be recorded as of December 31, 2010?

3) Would the outcome of the recoverability and impairment tests change if the probability assessment was revised such that there was a 20 percent, 70 percent, and 10 percent probability of scenarios A, B, and C occurring, respectively? If so, how?

Answer 1

1. For purposes of recognition and measurement of an impairment loss, a long-lived asset or assets shall
be grouped with other assets and liabilities at the bottum level for which identifiable cash flows are
largely independent of the cash flows of other assets and liabilities

Asset & Laibility are grouped together if there are related to eachother or part of same group and help to generate the joint cash flow

when Asset & Laibility are grouped for the purpose of a test for recoverability, they know as Asset Group 2. Estimates of future cash flows used to test the recoverability of a long-lived asset (asset group) shall incorporate the entity’s own assumptions about its use of the asset (asset group) and shall consider all available evidence. The assumptions used in developing those estimates shall be reasonable in relation to the assumptions used in developing other information used by the entity for comparable periods, such as internal budgets and projections, accruals related to incentive compensation plans, or information communicated to others. However, 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. See Example 2 (paragraph 360-10-55-23) for an illustration of this guidance. In given case, Fair value of Ship will be as follow (10% X $4M) + (20% X 6.5M)+ (70% X $5M) = $5.2M since FV of ship is less than its Book value so there will be Impairment loss to the extend of $ .4 M 3. As of 31st Dec, fair value of Ship is $4 M, which is less than its Book value i.e $5.4 M , Impairment Loss will be $1.4M which will be recorded in the book of accounts If probability is changed as per points 4 in above question, Expected Fair value of Ship would be as follow (20% X $4M) + (70% X 6.5M)+ (10% X $5M) = $5.85M Since as per above caculation, Fair value of Ship comes to $5.85M which is more than Book value of ship as on 31st Dec 2010, there will no Impairment for Year dec 2010