Rough Water Ahead
Assuming Smooth Sailing uses US GAAP to prepare its financial statements, how should Smooth Sailings’ management perform the recoverability test for 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” for purposes of performing the recoverability test? Ans. : According to FAS 144. 41, “Component of an entity” describes operations and cash flows that can be clearly distinguished from the reminder of the entity, both operationally and for financially reporting purposes.
A component of an entity may be an operating segment (as defined in FAS 131), a reporting unit (as defined in FAS 142). From the information given by the case, the cruise ship has its own identifiable cash flows that are largely independent of the cash flows of other asset groups. Therefore, each cruise ship can be classified as “Component of an entity”. An entity should also assess whether there is any indication that an “Component of an entity” may impair. If any such indication exists, the entity should estimate the asset’s recoverable amount.
The recoverable amount can be calculated as the higher of net selling price (value if sold) and value in use (prevent value of discounted expected future cash flows). Also, the operations and cash flows of the cruise ship must fulfill the following conditions. 1. The operations and cash flows of the cruise ship have been (or will be) eliminated from the ongoing operations of the entity following the disposal 2. The cruise ship will not have significant continuing involvement in the operations after disposal. From the information given, Smoothing Sailing fulfill the above two conditions.
Since Smoothing Sailing can calculated the estimated future cash flow, this can be used in performing the recoverability test. For liabilities, the cruise ship is financed with nonrecourse debt. If the borrower defaults , the lender can seize the collateral but the recovery is limited to the collateral. Therefore, it is reasonable to deduce that the recoverable amount is the value if sold in this case. According to FAS 144. 34-37, a long-lived asset classified as “held for sale” is initially measured at the lower of carrying amount or fair value less cost to sell.
How should the multiple operating scenarios impact the recoverability test? According to FAS 144. 22. fair value is the amount at which an asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale. The fair value may be determined with reference to the following three conditions sequentially. 1. Quoted market prices in active markets 2. Estimates based on the values of similar assets or 3. Estimates based on the results of valuation techniques
From the information given, there is no mentioning of any quoted market or any other value of similar assets. Therefore, according to FAS142. 23, if quoted market prices are not available, estimated fair values should be based on the best information available or other valuation methods, such as present values of future cash flows or multiples of earning or revenue. That is, we have to use the estimated results of valuation techniques. The next consideration is whether we have to discount the future cash flow. According to FAS144.
A review for impairment requires an estimate of the future cash flows expected to result from the use of the asset and its eventual disposition. Only if the sum of the expected future cash flows(undiscounted and without interest charges) is less than the carrying amount of the asset, should an impairment loss be recognized. The amount of the impairment loss should be assessed as the amount at which the carrying amount of the asset exceeds its fair value. Therefore we should estimate the future cash flows without discount. By considering the multiple scenarios, the expected future cash flows (recoverable value) should be,