Rough Waters Ahead

Case 12-9 Rough Waters Ahead 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. 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. 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:
O ption A B Continue operating the cruise ship in the 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 the lender (e.g., foreclosure). Probability of O ccurring 10% 20% 2011 $1.0M $0.6M Estimate d Future Cash Inflows — Undiscounte d 2012 2013 2014 2015 Total $0.9M $0.8M $0.7M $1.1M $0.7M $1.6M $0.7M $1.9M $4.0M $6.0M

C

70%

$ 1.0M

$0

$0

$0

$0

$1.0M

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