Smooth Sailing
Background
Smooth Sailing is a private company that operates one cruise ship. Smooth Sailing's purchase 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. In addition, there is a cash account directly related to the cruise ship.
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. During 2015, Smooth Sailing's annual operating cash flows 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 2016 and beyond:
Continue operating the ship in the current area.
Operate the ship in a new pirate-free area.
Operate the ship in the current area through December 31, 2017, then turn the ship over to the lender (have the lender foreclose on the ship).
The following table presents management's estimate of future cash flows from each of the possible courses of action.
|
|
Estimated Future Cash Inflows - Undiscounted
(in $ millions)
|
|
|
Option
|
Probability of Occurring
|
2016
|
2017
|
2018
|
2019
|
2020
|
Total
|
Probability
Weighted
|
|
A
|
10%
|
$1.0
|
$.9
|
$.7
|
$.7
|
$.7
|
$4.0
|
|
|
B
|
20%
|
.6
|
.8
|
1.1
|
1.6
|
1.9
|
6.0
|
|
|
C
|
70%
|
$1.0
|
$3.0[1]
|
$0
|
$0
|
$0
|
$4.0
|
|
|
Total
|
|
|
|
|
|
|
|
|
Includes the ship's FMV of $3 million treated as forgiveness of debt associated with the foreclosure up to FMV of the asset.
(Note: A copy of this table is available on Blackboard for your review)
Your firm, Barrett & Blackstone LLP, has been engaged to audit the financial statements for the year ended December 31, 2015. The problems with the cruise ship were discussed during your meeting with management earlier this month. Since the events indicate that the carrying amount of the asset group may not be recoverable a test for recoverability and possible asset impairment under ASC 360-10 is in order.
As of December 31, 2015, 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 and there is $0.1 million of cash in the bank account directly attributable to the cruise ship.
Smooth Sailing has determined that an annual discount rate of 7 percent is appropriate.
Read ASC 360-10-35; Impairment testing of Long-Lived Assets Classified as Held and Used by McGladrey. You may want to have Impairment or Disposal of Long Lived Assets EY Financial Reporting Developments available as necessary.
Required
You have been asked to prepare a memo to Peggy Anderson, CPA, an audit partner at your firm.
[1] Includes the ship's FMV of $3 million treated as forgiveness of debt associated with the foreclosure up to FMV of the asset.