option c correctly shows cash flow B u s i n e s s F i n a n c e

option c correctly shows cash flow B u s i n e s s F i n a n c e

You are part of the auditing staff at Willis, Willis, and Willis, CPAs. Starship Entertainment, Inc. (“Starship”), a client of your firm, is a private company that operates one cruise ship. Starship purchased the cruise ship with nonrecourse debt. 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 (yes, pirates!) in the area in which the cruise ship operates, its operating performance has significantly declined, which has directly contributed to a decline in its overall fair value. During 2020, Starship’s annual operating cash flows from the cruise ship declined by 30 percent to $1.5 million, and its annual operating cash flows are expected to continue to decline in the future. Because of this decline in the cruise ship’s fair value and operating performance, Starships’ management is evaluating the following possible options for proceeding into 2021 and beyond:

  1. Continue operating the ship in the current area.
  2. Operate the ship in a new pirate-free area.
  3. Operate the ship in the current area through December 31, 2021, then turn the ship over to the lender (have the lender foreclose on the ship on January 1, 2022). Since Starship will let the ship be foreclosed on January 1, 2022, no repairs or maintenance will be done during 2021 so the net cash flows from operations will be a bit higher than Option A.

The following table presents the management of Starship’s estimate of future cash flows from each of the alternatives. Management has also estimated how likely they are to follow alternative A, B or C.

Estimated Cash Flows

(in $ millions)

Option

Probability of Occurring

2021

2022

2023

2024

2025

Total

A

15%

$1.0

$0.9

$0.7

$0.7

$0.8

$4.1

B

25%

$0.6

$0.8

$1.1

$1.5

$1.9

$5.9

C

60%

$1.1

$3.1[1]

$4.2

Your firm has been engaged to audit the financial statements for the year ended December 31, 2020. 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 is in order.

As of December 31, 2020, the cruise ship’s estimated fair value is $3.1 million, net book value is $4.8 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 $100,000 of cash in the bank account directly attributable to the cruise ship. These are the only assets you must consider. Starship has other lines of business but they are unrelated to the cruise line.

Note: The fact that the debt is nonrecourse means that, for purposes of estimating cash flow from the foreclosure, debt up to the fair value of the ship is included. Debt in excess of the fair value of the ship is not part of cash flows. Option C correctly shows cash flow for the foreclosure on January 1, 2022.

Required

You have been asked to prepare an Accounting Research Memo to Eve Chu, CPA, an audit partner at your firm. A copy of your memo should go to the Starship Entertainment, Inc. 2020 Audit File.

Be sure to include a discussion of the following in your memo:

  • What assets and liabilities should be included in the “asset group” as defined for purposes of performing the recoverability test?
  • How do the multiple operating scenarios impact the recoverability test? Hint: find the weighted average approach in the Codification topic.
  • What impact should the potential foreclosure and extinguishment of debt have on the cash flows used to perform the recoverability test?
  • Describe the impairment test and whether or not recognition of impairment is required. If so, how much is the impairment write-down? Which asset(s) will be adjusted?

[1] Properly includes the ship’s FMV of $3.1 million as cash flow. Cash flows from foreclosure of nonrecourse debt is limited to the FMV of the surrendered asset.

 
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