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📈Financial Accounting II

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5.3 Impairment of Investments

6 min readLast Updated on July 30, 2024

Investments can lose value over time, potentially requiring impairment recognition. This topic covers how to identify impairment indicators, distinguish between temporary and other-than-temporary impairment, and account for impaired investments in financial statements.

Understanding impairment is crucial for accurately valuing investments and reporting their fair value. We'll explore how to calculate impairment losses, recognize them in financial statements, and handle subsequent changes in value for different types of securities.

Impairment Indicators for Investments

Significant Decline in Fair Value

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  • Significant decline in fair value below cost indicates potential impairment
    • Evaluate severity and duration of the decline to assess impairment
    • Compare the percentage decline to a predetermined threshold (20% decline)
    • Consider the length of time the fair value has been below cost (6 months)

Issuer-Specific Factors

  • Deterioration in the financial condition or near-term prospects of the issuer may indicate impairment
    • Assess issuer's financial statements and key ratios for signs of financial distress
    • Review issuer's earnings releases and management commentary for negative outlook
  • Adverse changes in the technological, market, economic, or legal environment in which the issuer operates could be indicators of impairment
    • Analyze industry-specific factors that may impact the issuer's business (regulatory changes, technological disruption)
    • Consider macroeconomic conditions affecting the issuer's market (recession, currency fluctuations)

Credit Risk Indicators

  • Missing scheduled interest or principal payments is a sign of credit deterioration and potential impairment
    • Monitor the issuer's payment history and any defaults or delinquencies
    • Assess the likelihood of future missed payments based on the issuer's financial condition
  • Change in the issuer's credit rating by a rating agency may point to increased credit risk and impairment
    • Review rating agency reports and any downgrades of the issuer's credit rating
    • Consider the magnitude of the rating change and the revised rating level (investment grade to speculative grade)

Temporary vs Other-Than-Temporary Impairment

Temporary Impairment

  • Temporary impairment is an unrealized loss expected to recover over time
    • Fair value decline is not considered permanent or long-lasting
    • Expectation that the investment's value will recover to its amortized cost
  • Temporary impairment does not impact the recorded cost basis of the investment
    • Unrealized losses are recorded in other comprehensive income for AFS securities
    • No adjustment to the carrying value on the balance sheet

Other-Than-Temporary Impairment (OTTI)

  • OTTI is a decline in fair value below the amortized cost basis not expected to recover
    • Fair value decline is considered permanent or long-lasting
    • No expectation of recovery to the original amortized cost
  • OTTI requires a write-down of the investment to its fair value
    • Loss is recognized in net income for the period
    • Carrying value on the balance sheet is adjusted to reflect the impairment
  • Factors to consider in assessing OTTI:
    • Length of time and extent of the fair value decline below cost
    • Financial health and near-term prospects of the issuer
    • Intent and ability to hold the investment until anticipated recovery
  • For debt securities, an inability to collect all amounts due according to the contractual terms indicates OTTI
    • Assess the issuer's ability to make future interest and principal payments
    • Consider any modifications to the contractual terms or restructuring of the debt

Accounting for Impaired Investments

Temporary Impairment Accounting

  • Temporary impairment of AFS and HTM securities does not affect the carrying value
    • Unrealized losses are recorded in other comprehensive income for AFS securities
    • No entry is made for HTM securities, as they are carried at amortized cost
  • Temporary impairment is not recognized in net income
    • Unrealized losses are disclosed in the footnotes to the financial statements
    • No impact on the reported earnings or regulatory capital

OTTI Accounting for Debt Securities

  • For OTTI of AFS and HTM debt securities, the investment is written down to fair value
    • Loss is recognized in net income for the period
    • Carrying value on the balance sheet is adjusted to reflect the impairment
  • If the OTTI is due to credit losses, that portion is recognized in net income
    • Credit loss component is calculated as the difference between amortized cost and the present value of expected future cash flows discounted at the original effective interest rate
  • The remaining OTTI related to other factors is recorded in other comprehensive income
    • Non-credit portion of OTTI is the remaining difference between fair value and amortized cost after subtracting the credit loss component
  • Subsequent increases in fair value of AFS debt securities are recorded in other comprehensive income
    • Recoveries in fair value are not reversed through net income
    • New amortized cost basis is not adjusted upward for subsequent increases in fair value
  • Subsequent decreases in fair value below the new amortized cost basis are additional OTTI recognized in net income
    • Further declines in fair value may indicate additional credit losses or other factors impacting the investment's value

OTTI Accounting for Equity Securities

  • OTTI of equity securities is recognized entirely in net income
    • Full difference between carrying value and fair value is recorded as an impairment loss
    • No allocation between credit losses and other factors for equity securities
  • The investment is written down to its fair value at the time of OTTI recognition
    • Fair value becomes the new cost basis for the equity security
    • Subsequent recovery in value is not reversed through net income
    • Increases in fair value after OTTI recognition are recorded in other comprehensive income for AFS equity securities

Impairment Loss Calculation

Measuring Impairment Loss

  • Impairment loss is measured as the difference between the investment's carrying amount (amortized cost) and its fair value
    • Compare the amortized cost basis to the current fair value of the investment
    • Excess of amortized cost over fair value represents the impairment loss
  • For AFS and HTM debt securities with OTTI, the credit loss component is calculated separately
    • Credit loss is the difference between amortized cost and the present value of expected future cash flows discounted at the original effective interest rate
    • Estimate the expected cash flows based on the issuer's financial condition and ability to make future payments
  • The non-credit portion of OTTI for debt securities is the remaining difference between fair value and amortized cost after subtracting the credit loss component
    • Non-credit portion represents losses due to factors other than credit risk (interest rates, liquidity)
    • Allocate the total OTTI between credit and non-credit components

Impairment Loss Recognition

  • Impairment loss for equity securities is the full difference between carrying value and fair value
    • No allocation between credit losses and other factors for equity securities
    • Recognize the entire impairment loss in net income
  • After recognizing OTTI, the fair value of the investment becomes its new amortized cost basis
    • Adjust the carrying value on the balance sheet to reflect the new cost basis
    • Future accretion of discount or amortization of premium is based on the new cost basis
  • Impairment losses recognized in net income cannot be reversed for debt securities
    • Subsequent recoveries in fair value are recorded in other comprehensive income for AFS debt securities
    • HTM debt securities continue to be carried at the new amortized cost basis
  • Impairment losses for equity securities cannot be reversed through net income
    • Subsequent increases in fair value are recorded in other comprehensive income for AFS equity securities
    • Trading securities continue to be measured at fair value with changes recognized in net income

Key Terms to Review (21)

Amortized cost: Amortized cost refers to the method of accounting for the cost of an asset, whereby the initial cost is gradually reduced over time through systematic allocation of expenses. This approach is particularly relevant for financial instruments, as it allows entities to recognize interest income and impairment losses accurately, reflecting the ongoing value of their investments. By using amortized cost, companies can ensure that their financial statements provide a true and fair view of the value of their investments over time.
Cash-generating unit: A cash-generating unit (CGU) is the smallest identifiable group of assets that generates cash inflows independently of other assets or groups of assets. In the context of assessing impairment, a CGU is crucial because it helps in determining whether the carrying amount of an asset or group of assets exceeds their recoverable amount, leading to potential impairment losses that must be recognized in financial statements.
Credit Risk Indicators: Credit risk indicators are metrics used to assess the likelihood of a borrower defaulting on a loan or financial obligation. These indicators help investors and lenders evaluate the financial health and creditworthiness of an entity, which is particularly important when determining potential impairment of investments due to credit deterioration.
Debt Securities: Debt securities are financial instruments that represent a loan made by an investor to a borrower, typically a corporation or government. They are used to raise capital and usually come with fixed interest payments and a repayment date, known as maturity. Understanding debt securities is crucial for assessing risk and return in investments, as well as their potential impairment when the issuer faces financial difficulties.
Discounted cash flow: Discounted cash flow (DCF) is a financial valuation method used to estimate the value of an investment based on its expected future cash flows, which are adjusted to account for the time value of money. This technique helps investors and analysts assess the attractiveness of an investment opportunity by determining how much those future cash flows are worth today. By discounting future cash flows back to their present value, it connects directly to evaluating investments, market valuations, and assessing the potential benefits of business combinations.
Equity Investments: Equity investments refer to the purchase of shares or ownership in a company, giving investors a claim on part of the company’s assets and earnings. This type of investment allows individuals or entities to benefit from the growth and profitability of the company, but it also carries risks, including the potential for loss if the company performs poorly. Understanding equity investments is essential, especially when evaluating their impairment, as changes in value can lead to significant financial implications.
Fair Value: Fair value is the estimated market value of an asset or liability, representing the price that would be received for selling an asset or paid to transfer a liability in an orderly transaction between market participants. This concept is essential in providing a transparent and consistent measurement basis for investments, helping investors and companies assess their financial standing in real time.
Financial Statement Notes: Financial statement notes provide additional information and context to the numbers presented in the financial statements. They are crucial for understanding the accounting policies, assumptions, and other details that can affect the interpretation of financial results, including specific issues like impairment of investments, goodwill recognition, and non-controlling interest accounting.
GAAP: GAAP, or Generally Accepted Accounting Principles, is a framework of accounting standards, principles, and procedures used in the preparation of financial statements. It ensures consistency and transparency in financial reporting, which is essential for stakeholders to make informed decisions based on comparable financial information across different organizations.
IFRS: International Financial Reporting Standards (IFRS) are a set of accounting standards developed by the International Accounting Standards Board (IASB) that aim to bring transparency, accountability, and efficiency to financial markets around the world. IFRS provides a common global language for business affairs, ensuring consistency in the financial reporting and making it easier for investors to compare financial statements from different countries.
Impairment Loss: Impairment loss refers to a permanent reduction in the carrying value of an asset, indicating that its market value has fallen below its book value and it cannot recover its original cost. This concept is critical as it affects the financial statements by recognizing losses when an asset's future cash flows are not expected to cover its carrying amount, influencing decisions related to investments and financial reporting.
Impairment reversal: Impairment reversal occurs when the value of an asset that was previously written down due to impairment is restored, reflecting an increase in the asset's recoverable amount. This adjustment can occur if market conditions improve or if new information emerges that indicates a better future cash flow than previously anticipated. It's important to note that impairment reversals can only be recognized up to the amount of the original impairment loss and are particularly relevant in assessing the carrying value of investments.
Loss Recognition: Loss recognition is the process of formally acknowledging and recording losses in financial statements when certain criteria are met. This concept is crucial for providing a true and fair view of a company's financial position, as it ensures that losses are reflected in the accounting records at the appropriate time, which can significantly affect investment valuations and decisions.
Market Approach: The market approach is a valuation method that determines the fair value of an asset based on the prices observed in the market for similar assets. This approach is grounded in the principle of substitution, suggesting that a knowledgeable buyer would not pay more for an asset than what they would pay for a comparable one in the open market. It plays a crucial role in assessing investments, fair value reporting, and understanding business combinations by providing relevant market data.
Other-than-temporary impairment: Other-than-temporary impairment (OTTI) refers to a situation where the fair value of an investment has declined significantly and is not expected to recover in the foreseeable future. This concept is crucial in determining when an investor must recognize a loss on their financial statements, ensuring that investments are accurately represented at their recoverable amounts rather than inflated values.
Present Value: Present value is a financial concept that determines the current worth of a sum of money that is to be received or paid in the future, discounted at a specific interest rate. This concept is crucial in various financial contexts as it helps to assess the value of future cash flows in today's terms, which is essential for decision-making regarding investments and liabilities.
Recoverable Amount: Recoverable amount refers to the higher value between an asset's fair value less costs to sell and its value in use. This term is crucial for determining whether an asset has been impaired, as it helps assess if the carrying amount of the asset can be recovered through future cash flows or by selling the asset. Understanding recoverable amount is essential for recognizing impairments in investments, as it directly influences financial statements and overall asset valuation.
Temporary impairment: Temporary impairment refers to a decline in the fair value of an investment below its carrying amount that is not expected to be permanent. This situation often arises from market fluctuations or other short-term factors affecting the investment's value. Investors need to assess whether the impairment is temporary or permanent, as it influences accounting treatment and potential future gains or losses.
Triggering Event: A triggering event is a significant occurrence that indicates a potential decline in the value of an investment, necessitating an assessment for impairment. This concept is essential for investors and businesses alike, as it prompts the reevaluation of assets and can lead to recognizing losses in financial statements. Understanding these events helps in maintaining accurate reporting and decision-making regarding investments.
Unrealized Loss: An unrealized loss occurs when the value of an investment decreases, but the asset has not yet been sold to realize that loss. This type of loss reflects a temporary dip in market value and is crucial in understanding how investments can fluctuate over time without impacting cash flow until they are sold. Recognizing unrealized losses helps investors gauge their portfolio's performance and make informed decisions about holding or selling assets.
Write-down: A write-down is an accounting process that reduces the carrying value of an asset on the balance sheet to reflect its current fair market value. This adjustment acknowledges a decline in the asset's value, usually due to impairment, market conditions, or obsolescence. It’s crucial for accurately representing a company's financial health and ensuring that assets are not overstated.
Amortized cost
See definition

Amortized cost refers to the method of accounting for the cost of an asset, whereby the initial cost is gradually reduced over time through systematic allocation of expenses. This approach is particularly relevant for financial instruments, as it allows entities to recognize interest income and impairment losses accurately, reflecting the ongoing value of their investments. By using amortized cost, companies can ensure that their financial statements provide a true and fair view of the value of their investments over time.

Term 1 of 21

Amortized cost
See definition

Amortized cost refers to the method of accounting for the cost of an asset, whereby the initial cost is gradually reduced over time through systematic allocation of expenses. This approach is particularly relevant for financial instruments, as it allows entities to recognize interest income and impairment losses accurately, reflecting the ongoing value of their investments. By using amortized cost, companies can ensure that their financial statements provide a true and fair view of the value of their investments over time.

Term 1 of 21



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© 2025 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.
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