ISSUES IN ACCOUNTING EDUCATION Vol. 25, No. 1 2010 pp. 59–70 American Accounting Association DOI: 10.2308/iace.2010.25.1.59 Snowy Ridge Ski Resort: Fair Value Measurement and the Impairment of Long-Term Assets Richard A. Gore and Paul J. Herz ABSTRACT: The Snowy Ridge Ski Resort case study illustrates the use the new Fair Value Measurement Standard (SFAS No. 157) with various assets in connection with the acquisition of a ski resort and subsequent test for impairment. The case study introduces students to the two primary approaches for measuring fair value (Market and Income). These approaches are then used to compute fair value for a variety of assets. In addition, students become familiar with the Fair Value Hierarchy and classify fair value measures in accordance with the hierarchy. The assets to which the fair value measures are generated include: marketable securities; property, plant, and equipment; real estate under development; and goodwill. The fair values and other input data are then used to test for impairment of the operating assets and goodwill. Thus, the case study illustrates the interplay between fair value measurement and impairment testing in a simple setting to give the student a foundation for understanding how fair value measurement is used in GAAP for operating assets. INTRODUCTION Kate Smith, chief accountant for Recreational Properties, Inc., couldn’t help but admire the view of the mountains as she sipped her coffee before getting down to work. It was July 20X2 and Kate was visiting the offices of Snowy Ridge Ski Resort, one of the subsidiariesof Recreational Properties. Her task for the day was to finalize the asset values to be reported on the year-end financial statements for the Snowy Ridge Ski Area. While Snowy Ridge seemed like a promising acquisition two years ago, below average snowfall and the current downturn in the real estate market had seriously impacted the initial projections for success. Accordingly, Kate’s assignment was to evaluate the assets for possible impairment. Background The Snowy Ridge Ski Resort is located in the San Juan Mountains of southwest Colorado. Annual snowfall near 250 inches attracts local skiers and snowboarders, and a four-star lodge at the base of the slopes attracts vacationers from Arizona, New Mexico, Texas, and Colorado. Richard A. Gore is an Associate Professor and Paul J. Herz is a Professor, both at Fort Lewis College. We appreciate the thoughtful comments of the editor and two anonymous reviewers, and our students who each in their own way helped us improve the case. Published Online: February 2010 59 60 Gore and Herz Recreational Properties, Inc., (RP) is a holding company for a portfolio of recreation-oriented corporations. These companies operate golf resorts, spas, fishing lodges, and dude ranches. Snowy Ridge is RP’s first venture into the ski and snowboard industry and is operated as a separate unit for which discrete financial information is available, and corporate regularly reviews the operating results of the resort. A lucrative sale of a golf resort provided the money to purchase the ski resort. The golf resort had been chosen by the PGA to host a nationally televised golf tournament, and the press and attention resulting from the event had put RP in a position to realize a profit well beyond its original investment. At the time, the Snowy Ridge acquisition seemed like the perfect oppor-tunity. Unfortunately, the weather and the economy did not cooperate. Purchase Information RP acquired Snowy Ridge two years ago on June 30, 20X0, for $ 46.5 million in a cash purchase. The fair value of identifiable assets and liabilities acquired are reported in Exhibit 1. These assets included the ski lifts and other infrastructure on the slopes, a four-star lodge at the base of the slopes, and real estate surrounding the base area. One attractive aspect of the acquisition was the undeveloped land surrounding the ski area that could be converted into residential lots for sale. The real estate market at that time suggested that this development could be very lucrative. As with most ski and snowboard areas in the western United States, the purchase included Special Use Permits, granting Snowy Ridge the right to use federal land as the site for its ski lifts, trails, and related activities. Snowy Ridge pays a fee to the Forest Service equal to 2 percent of its sales occurring on Forest Service land for the Special Use Permit. The Forest Service can terminate Snowy Ridge’s permit if the Service determines that termination is in the public interest. However, no Special Use Permit in connection with a ski resort has ever been terminated against the wishes of the permit holder. Snowy Ridge Operations Kate has concluded that the Snowy Ridge Ski Resort is considered a single reporting unit of RP because it is accounted for and operated separately from RP’s other properties. However, the operations of the Snowy Ridge Ski Resort are separated into three divisions: Mountain, Lodging, and Real Estate. Each division represents a separate business such that the cash flows of each division are largely independent of the other divisions. The Mountain division derives revenue from the sale of lift tickets and other services such as ski and snowboard lessons, equipment rentals, and other recreational activities. Ski resort operations are highly seasonal in nature, with the typical ski season beginning in mid-November and running through mid-April. In an effort to counterbalance the concentration of revenues in the winter months, Snowy Ridge offers non-ski season attractions such as guided hiking, sightseeing, and mountain biking in the summer and fall. The Lodge division generates revenue from renting rooms to skiers and other vacationers. The intent of the Lodge is to complement and enhance the ski resort. The Lodge consists of 85 rooms and is categorized by Smith Travel Research, a leading lodging industry research firm, as luxury accommodations. During the fiscal year, the Lodge generated average daily rates of $160. How-ever, due to the poor snowfall of the previous two years, Snowy Ridge experienced a lower average occupancy versus the general lodging industry. For the year ended June 30, 20X2, average occupancy was 61 percent. The Real Estate division is engaged in development of the land adjacent to the ski area into an Alpine Village of private homes. Currently the property is zoned for 145 home sites. The company plans to sell the home sites to individuals and custom builders. Infrastructure costs for Issues in Accounting Education American Accounting Association Volume 25, No. 1, 2010 Snowy Ridge Ski Resort 61 streets, water, and sewer since the acquisition have added $2.4 million to the costs of the lots. Sales of home site lots commenced in the last quarter of the most recent fiscal year, and were mildly disappointing. During the quarter the company sold five lots. There are significant barriers to entry for new ski areas, due to the limited private lands on which ski areas can be built and the difficulty in getting governmental approvals to build on public lands, as well as the significant capital needed to construct the necessary infrastructure. Nonetheless, the ski industry is highly competitive. A ski area’s profit and growth potential is largely dependent on attracting skiers away from other resorts. There are a variety of factors that contribute to a skier’s choice of ski resort, including terrain, weather, especially snowfall, and the availability and type of lodging. Due to the lack of snow and the real estate slowdown, Snowy Ridge has lost money in each of the last two years. The financial results for the most recent year are reported in Exhibit 2. Snowy Ridge’s balance sheet at year-end, June 30, 20X2, prior to fair value adjustments, is reported in Exhibit 3. Impairment Issue At the end of the current year, Snowy Ridge’s balance sheet is very similar to what it was when it was acquired by RP. For example, Snowy Ridge has continued the practice of selling deeply discounted season passes at the end of each ski season. The proceeds from the after-ski season sale are invested in debt securities until needed to fund autumn and pre-winter ski season costs. Hence, at year-end, investment in marketable securities remains a significant asset. The other assets remain basically the same, with account balances adjusted for subsequent activity and depreciation charges where appropriate. At the time of the acquisition, RP believed that it could enhance the profitability of Snowy Ridge through the development of the Alpine Village, expansion and improvements of the ski slopes, improvements in the operating efficiency of the operations, and cross-marketing efforts to increase its existing customer base. However, in light of the recent losses and the economic slowdown, management believes it is appropriate to undertake a comprehensive review of the Snowy Ridge Ski Area to determine if any assets should be impaired as of June 30, 20X2. In connection with this review, Kate reviewed the following data regarding the significant assets of Snowy Ridge at June 30, 20X2. Fair Value Information at June 30, 20X2 Kate received a memo from the chief executive officer of Snowy Ridge that the company had recently acquired a report from a qualified professional valuation specialist that the fair value of the entire Snowy Ridge Ski area including the real estate and the lodge net of its liabilities is $41 million. In addition, this fair value estimate has been appropriately classified as a Level 2 measure, per SFAS No. 157 (FASB 2006). Kate also notes that RP uses a 12 percent discount rate in calculating the present value of future cash flows of investments for internal analysis of projects. This discount rate is unique to RP and may be different from the appropriate rate for Snowy Ridge or its operating divisions. Additional information regarding specific assets is presented below: Investment in Marketable Securities The marketable securities held for investment are all publicly traded debt instruments and are classified as Available-for-Sale per SFAS No. 115 (FASB 1993). Accordingly, Kate verified the quoted market price for the bonds per the year-end brokerage statement. The market price of the bonds held by the company on June 30, 20X2, is reported in the following table: Issues in Accounting Education Volume 25, No. 1, 2010 American Accounting Association 62 Gore and Herz Description US Treasury Bonds GE Corporate Bonds JNJ Corporate Bonds Total Market Price $2,550,000 990,000 1,025,000 $4,565,000 Mountain Division Although there are no assets identical to the ski area of the resort, unlike the Marketable Securities, Kate notes that two other very similar ski areas (Mountain Divisions only) were sold in the last year. Kate recognizes that she can use these sales to compute a market multiple to estimate the value of Snowy Ridge’s Mountain Division. Her research indicates that these and other sales of ski areas (mountain division only) are often expressed as a multiple of sales revenue. The prior sales included the following: Sunset Mountain, which generated average annual sales revenue of $6,500,000, was sold for $11,375,000, and Crooked Creek, which generated average annual sales revenue of $13,000,000, was sold for $22,750,000. She notes that these sales include both the special use permit as well as the infrastructure related to the Mountain Division. Further, her review suggests that there are no unique or distinguishing characteristics at Sunset Mountain or Crooked Creek that would cause these resorts to generate sales prices significantly different from Snowy Ridge. The Snowy Ridge Ski Area has generated average annual sales revenue, over good years and bad, of $5,500,000. Hence, Kate believes this is a reasonable estimate to use in applying the market multiple derived from the sales of the other ski areas. Furthermore, Kate observes that although the Mountain Division is currently operating at a loss ($320,000), once depreciation expense is added back to the Division’s net income, it is operating at breakeven on a cash basis. Thus, the future undiscounted cash flows from operating the Mountain Division are expected to be marginal at best. Accordingly, by default Kate plans to use the Division’s current market price as an estimate of its undiscounted future cash flows. Lodge Division Kate notes that for the lodge, she has the necessary information to estimate fair value using either the income approach or the market approach. Under the income approach, she must discount some measure of the lodge’s future operating income at the appropriate discount rate. Her research indicates that the market discount or capitalization rate of similar lodges as of June 30, 20X2, based on the gross profit, is 6 percent. She notes that discount or capitalization rates are often used for real estate assets because of the relatively stable cash flows these assets generate. She recognizes that this discount rate has probably changed substantially since the end of Snowy Ridge’s fiscal year-end as the economic crisis has deepened after the year-end; however, that is next year’s problem. Her task is to compute fair value as of June 30, the balance sheet date. In addition, she also notes that this rate is lower than the 12 percent used by RP for its internal investment analysis. Kate’s discussion with the management of Snowy Ridge at June 30, 20X2, led her to believe that the Lodge’s future average occupancy based on average snow conditions should be 70 percent. Using the current average room rate of $160 per night, she prepared the following projection of future annual operating income for the Lodge division. Description Annual Projection Revenues Cost of Sales $3,474,800 2,779,840 Gross Profit Issues in Accounting Education American Accounting Association 1 $694,960 Volume 25, No. 1, 2010 Snowy Ridge Ski Resort 63 Alternatively, under the market approach, Kate notes that the fair value of lodges of this type is often expressed as a multiple of current year revenue. Her research reveals that the mean multiple of the five mountain resort lodges sold in the western United States within the last year were 3.75 times the prior year revenue of the lodge. Again, she notes that subsequent to June 30, 20X2, the market for hotel properties has deteriorated; however, that also is next year’s problem. Real Estate Division Management expects the home sites to sell out over the next four years per the following schedule despite the recent real estate downturn: Lots 20X3 20X4 20X5 20X6 20 35 40 45 Lot sales are expected to be slightly below initial projections, but are consistent with the five sales in the last quarter of the current year. Lot sales are expected to recover as the economy improves in 20X4 and the development matures. Furthermore, Kate notes that although real estate activity has slowed recently, sale prices are holding steady in the local market. The projected net selling price for each lot is $180,000. In addition, the company expects to incur $600,000 per year in overhead expenses. Given the unique nature of the real estate development, Kate does not believe there are any comparable developments she can use to find a market multiple for the project. However, given the finite nature of the project, Kate recognizes that she can compute the present value of the net cash flows the project is expected to generate. Discussion with the real estate executives for the company and a review of current market conditions suggest that the market discount rate for developments of this type is 20 percent. The relatively high discount is driven by the uncertainty regarding real estate developments in 20X3 and beyond. Liabilities The liabilities consist of accounts payable and a bank loan. The accounts payable are all currently due and are recorded in the accounting records at the face value of the debt. Details regarding the bank loan are noted in the footnotes to the financial statements in Exhibit 3. Kate has also confirmed that although the company is operating at a loss, it is very capitalized, and there has been no change in its credit rating. ASSIGNMENT 1. 2. 3. 1 Define fair value and explain the purpose and function of the Fair Value Hierarchy. Calculate the initial value of Goodwill resulting from the acquisition of the Snowy Ridge Ski Resort on June 30, 20X0, by Recreational Properties. Note that Goodwill has not been adjusted since the purchase. Determine the fair values of identifiable assets and liabilities that differ from their carrying value of the Snowy Ridge Ski Area as of June 30, 20X2. Also, identify the level per the Fair Value Hierarchy of each fair value measure. Use the following table to organize your results. Gross Profit may be assumed to approximate cash flow in the lodging industry. Issues in Accounting Education Volume 25, No. 1, 2010 American Accounting Association 64 Gore and Herz Valuation Approach Asset Level Calculation Fair Value Marketable Securities Mountain Division Lodge Division Lodge Division Final Lodge Division Value Real Estate Division 4. Asset Multiple lines are left for the lodge because information is provided to calculate its fair value two different ways. In addition, it is necessary to arrive at a single final fair value estimate of the Lodge to complete the remainder of the assignment. Include any assumptions you make regarding your estimates below the table. Test the operating assets, other than Goodwill, for impairment or fair value adjustment as of June 30, 20X2. (Hint: Impairment tests need to be performed for each of the three divisions: Mountain, Lodge, and Real Estate.) Kate has prepared the following work paper to organize her impairment testing. Carrying Value Impairment Table Undiscounted Recoverable Cash Flows Yes/No Fair Value Adjustment Dr (Cr) Marketable Securities Mountain Division Lodge Division Real Estate Division 5. 6. Test Goodwill for impairment as of June 30, 20X2. Prepare the necessary adjusting entries to record the Snowy Ridge balance sheet as of June 30, 20X2, in accordance with GAAP. Note that you may ignore deferred income taxes. 7. Prepare the Snowy Ridge Ski Resort Balance Sheet as of June 30, 20X2, in accordance with GAAP. For each asset and liability, identify the measurement attribute and its level, if applicable, per the Fair Value Hierarchy. 8. Write a memo to the RP management regarding your analysis and findings. Place your work in connection with Questions 3–7 of the case in an appendix to the memo. 9. Identify the significant assumptions you made in the measurement of fair value for each of the Divisions. Provide one numerical example of how the financial statements would have been altered if one of the assumptions had been changed. 10. Rank the assets and liabilities reported on the Snowy Ridge’s June 30, 20X2, balance sheet in terms of the level of confidence you have in their reported value. Discuss how your ranking compares to the levels in the Fair Value Hierarchy. 11. Assume after the end of the fiscal year ₃June 30, 20X2₃ the real estate markets and the overall economy continued to worsen such that a credit crisis developed. The result of this credit crisis was that the availability of loans to purchase real estate or lodging assets all but disappeared. Consequently, Kate estimates that if RP were forced to sell its assets in this new environment the selling price would be substantially reduced from the estimates of fair value at June 30, 20X2. Discuss how Kate would estimate fair value for the lodging and real estate assets in this environment and how the change in economic circumstances after year-end would impact the Snowy Ridge financial statements. 12. Discuss the advantages and disadvantages of using fair value measurement in the financial statements. Snowy Ridge Ski Resort 65 EXHIBIT 1 Snowy Ridge Ski Resort Fair Value of Identifiable Assets and Liabilities at Date of Acquisition June 30, 20X0 Description Fair Value Cash Investment in Debt Securities Real Estate/Land Held for Development Special Use Permit Ski Lifts and Infrastructure Lodge and Related Equipment Accounts Payable Net Fair Value $600,000 4,400,000 15,000,000 5,000,000 8,000,000 10,000,000 Description ₃500,000₃ $42,500,000 EXHIBIT 2 Snowy Ridge Ski Resort Income Statement June 30, 20X2 Mountain Lodge Real Estate Revenues Cost of Sales/Direct Costs Gross Profit Other Expenses Depreciation Expense Net Income ₃Loss₃ Issues in Accounting Education Total $5,500,000 ₃5,100,000₃ $3,028,040 ₃2,422,432₃ $800,000 ₃600,000₃ $9,328,040 ₃8,122,432₃ $400,000 ₃400,000₃ ₃320,000₃ $605,608 ₃400,608₃ ₃250,000₃ $200,000 ₃125,000₃ ₃0₃ $1,205,608 ₃925,608₃ ₃570,000₃ ₃$320,000₃ ₃$45,000₃ $75,000 ₃$290,000₃ Volume 25, No. 1, 2010 American Accounting Association 66 Gore and Herz EXHIBIT 3 Snowy Ridge Ski Resort Balance Sheet June 30, 20X2 Description Cash Investment in Marketable Securities Land held for Development ₃Real Estate Division₃ Special Use Permit ₃Mountain Division₃ Ski Lifts and Infrastructure ₃Mountain Division₃ Lodge ₃Lodge Division₃ Goodwill Total Assets Accounts Payable Bank Loan Total Liabilities Capital Investment Retained Earnings ₃deficit₃ Equity Total Liabilities and Equity $540,000 1 4,500,000 2 16,800,000 3 5,000,000 4 7,360,000 5 9,500,000 6 4,000,000 $47,700,000 $150,000 7 1,500,000 $1,650,000 46,500,0008 9 ₃450,000₃ $46,050,000 $47,700,000 1. Investment in Marketable Securities is classified as Available for Sale and consists of the following bonds at cost: Description Cost US Treasury Bonds $2,500,000 GE Corporate Bonds 1,000,000 JNJ Corporate Bonds 1,000,000 Total $4,500,000 2. The land held for development is comprised of available residential home sites. The balance sheet value represents the original purchase price of $15,000,000 plus $2,400,000 of improvements minus $600,000 of cost of sales from the most recent year. 3. The Special Use Permit has an indefinite life and is recorded at its initial acquisition price. 4. The Ski Lifts and related infrastructure are depreciated on a straight-line basis with an average life of 25 years. The balance sheet value is based on its original acquisition costs of $8,000,000 less Accumulated Depreciation of $640,000. 5. The Lodge and related equipment are depreciated on a straight-line basis with an average life of 30 years. The balance sheet value is based on its original acquisition price of $10,000,000 ₃allocated 75 percent to buildings and equipment and 25 percent to land₃ less Accumulated Depreciation of $500,000. 6. The Goodwill has an indefinite life and is recorded at its initial acquisition costs. 7. The Bank loan calls for interest-only payments for three years. The interest rate varies monthly and is set to prime plus 2 percent. The prime rate at the end of the year is 6.5 percent. 8. Capital Investment represents RP’s initial investment in Snowy Ridge. Note that Snowy Ridge is considered a separate reporting unit, but it is not a separate legal entity. 9. Retained Earnings represent the cumulative losses of the Snowy Ridge Ski Resort reporting unit since the date of its acquisition by Recreational Properties, Inc. Issues in Accounting Education American Accounting Association Volume 25, No. 1, 2010