Audit and Enterprise Risk
Services Accounting for Impaired
Debt Securities Financial Reporting Alert 13-2 This alert applies to all entities with holdings of impaired1 debt securities and outlines accounting and disclosure considerations for affected entities. BackgroundOver
the past year, interest-rate volatility has increased because of, among other
factors, the impact of monetary policy. This increased volatility could lead
reporting entities to recognize significant unrealized losses in accumulated
other comprehensive income (AOCI) for debt securities classified as available
for sale (AFS) under ASC 320.2 This alert addresses
certain accounting matters that reporting entities should consider for AFS
debt securities with unrealized loss balances recorded in AOCI as well as
impaired debt securities classified as held to maturity (HTM) under ASC 320. Accounting ConsiderationsOther-Than-Temporary Impairment (OTTI)Under
ASC 320, a debt security is considered impaired if its fair value is less
than its amortized cost basis. When a security is impaired, an entity must
determine whether the impairment is other than temporary (see ASC
320-10-35-30). To do so, the entity must first consider whether it intends to
sell the debt security (i.e., whether it has decided to sell the security).3
In assessing whether the intent to sell exists, the entity should consider
all available evidence. The following factors, among others, may indicate
that the intent to sell a security exists:4 · The entity or its agent (e.g., a third party that manages the entity's securities portfolio) has approved the sale of the security. · The entity directs its agent to sell the security, which is contingent on an event that is expected to occur. · The security is part of a group of securities that the entity or its agent has identified for sale. · The security or the group of securities is being marketed to be sold at a price that does not significantly exceed fair value. · The security is sold shortly after the balance sheet date and facts and circumstances suggest that the decision to sell was made before the balance sheet date. If the
intent to sell does not exist, the entity must next determine whether it is
more likely than not that it will be required to sell the impaired debt
security before recovery of its amortized cost basis. In making this
determination, the entity should consider (1) the factors that might require
the entity to sell the security (e.g., working capital requirements or
regulatory obligations) and (2) the probability that those factors will occur
during the anticipated recovery period (i.e., the estimated period until the
amortized cost basis of the security equals or exceeds fair value, less
current-period credit losses). If an
entity does intend to sell the security, or it is more likely than not that
it will be required to sell an impaired debt security before recovery, an
OTTI exists and the entity must record an impairment loss equal to the
difference between the fair value and amortized cost basis of the debt
security (see ASC 320-10-35-33A and 35-33B).5
However, if the entity does not intend to sell the security, and it is not
more likely than not that it will be required to sell the debt security
before recovery of its amortized cost basis, it still must assess whether it
expects to recover the entire amortized cost basis of the security (i.e.,
whether a credit loss exists). To
determine whether a credit loss exists, an entity must determine the present
value of its best estimate of the cash flows expected to be collected. If the
present value of the cash flows expected to be collected is less than the
amortized cost basis of the security, the impairment is considered other than
temporary. However, in such cases, the entity only records the credit-related
portion of the impairment loss in earnings (i.e., the difference between the
present value of the security’s expected cash flows and its amortized cost
basis). The noncredit portion of the impairment loss (i.e., the difference
between the security's fair value and the present value of expected cash
flows) is recognized in other comprehensive income (OCI), net of applicable
taxes (see ASC 320-10-35-34C through 35-34E). In
assessing whether subsequent sales of impaired debt securities are consistent
with an entity's "lack of intent to sell" assertion as of the
balance sheet date, an entity should determine when it decided to sell the
impaired debt security. In doing so, an entity should consider factors that
include, but are not limited to, the following: · How soon the entity sold the security after the balance sheet date. · When the process of selling the security started and how long it took to sell the security (e.g., the length of the marketing period). The entity should consider whether the security is actively traded and whether the period between the decision to sell and the actual selling was in line with the customary marketing period for the security. · Whether there were standing orders to sell the security as of the balance sheet date. In all
OTTI analyses, an entity must use professional judgment in determining the
relevant facts and circumstances to consider. Furthermore, the entity should
document all conclusions, including (1) whether it intends to sell a debt
security, or whether it is more likely than not that it will be required to
sell the impaired debt security before recovery; (2) management’s assessment
of the recovery period; and (3) whether a credit loss exists. Deferred Tax AssetsIf an
unrealized holding loss on a debt security would be tax-deductible if
realized, the difference between the carrying amount of the debt security and
its tax basis is a deductible temporary difference that gives rise to a
deferred tax asset (DTA). The temporary differences associated with
unrealized gains and losses on debt securities, however, are unlike other
types of temporary differences because they do not affect comprehensive
income or the tax return if the securities are held until recovery of the debt
securities' amortized cost. If an
unrealized loss from a debt security is recorded in OCI and a tax benefit for
that loss can be recognized in the same period, the tax benefit would also be
recorded in OCI, in accordance with the intraperiod
tax allocation rules in ASC 740-20-45. To
date, the SEC staff has accepted two alternative views on the evaluation of
the need for a valuation allowance related to a DTA recognized as a result of
an unrealized loss on a debt security that is recognized in OCI when the
entity has the intent and ability to hold the debt security until recovery: · View 1 — If an entity has the intent and ability to hold the debt security until recovery of its amortized cost basis, increases in the security's fair value up to its amortized cost basis will reverse the unrealized loss recorded in AOCI over the contractual life of the investment, resulting in no cumulative change in the entity's comprehensive income or taxable income. Accordingly, the DTAs related to these securities are excluded from other DTAs being evaluated for realization because the DTA recognized for unrealized losses of a debt security included in OCI does not require a source of future taxable income for realization (since the accounting assertions would imply that the unrealized loss will never be realized and that no tax loss will therefore ever be reported on any tax return). · View 2 — Even if the entity has the intent and ability to hold the debt security until recovery, the DTAs related to the tax basis in excess of the financial reporting basis equal to the amount recorded as unrealized losses in OCI are not, under ASC 740, excluded from the normal assessment of realizability for all DTAs. In other words, while the ability and intent to hold a debt security until recovery imply a source of future taxable income for this particular deductible temporary difference, this fact is not considered in isolation. Rather, this source of future income is combined with the entity’s other sources of future taxable income and the DTAs are combined with the other DTAs in the assessment of the realizability of the total DTAs of a given tax-paying component of the entity. If the future income (including the expected recovery of value related to the debt securities) is not sufficient to realize the DTAs, a valuation allowance is required. Selection
of either alternative is an accounting policy decision that, once made, must
be consistently applied. DisclosuresWhether
or not it holds debt securities that are other-than-temporarily impaired, an
entity with impaired debt securities must disclose the information required
by ASC 320-10-50-2 through 50-8B. These paragraphs require entities to
provide qualitative and quantitative disclosures regarding, among other
items, the amount and cause of impairment losses for debt securities. Entities
should ensure that the information disclosed in their financial statements
and MD&A is consistent with their assertion about whether they intend to
sell an impaired debt security, or whether it is more likely than not that
they will be required, to sell an impaired debt security before recovery of
its amortized cost basis. Next StepsWe
recommend that you consult with a professional adviser if you have any
questions about the issues addressed in this alert. __________________ 1 Under ASC 320-10-35-21, a debt security “is impaired if the fair value of the [security] is less than its cost.” 2 For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.” 3 The determination of whether the entity intends to sell the security is different from the determination of whether the entity intends to hold the security until recovery. Generally, it is easier to support an assertion that the entity does not intend to sell a debt security than it is to support an assertion that the entity has the intent and ability to hold the debt security until recovery (or maturity). 4 ASC 320 significantly limits the situations in which an entity is permitted to sell debt securities classified as HTM. However, the mere fact that the security is classified as HTM is not sufficient to support an assertion that the entity does not intend to sell the security. 5 If an entity decided to sell an impaired debt security in a prior period (and thus recognized an OTTI in that prior period) but had not sold the security by the end of a subsequent period, the entity would be required to assess whether it still intended to sell the security as of the end of the subsequent period. If an entity continues to intend to sell the debt security, any further declines in fair value should be recognized as an OTTI through earnings. If the entity revokes its decision to sell in a subsequent period, thereby asserting that it no longer intends to sell the security, the entity is not permitted to reverse any prior-period OTTIs recognized in earnings. |
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