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.
Over 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.
Other-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 Assets
If 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.
Whether 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.
We recommend that you consult with a professional adviser if you have any questions about the issues addressed in this alert.
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.