An other-than-temporary impairment charge arises when a security is classified as either available-for-sale or held-to-maturity and there is a decline in its market value below its amortized cost. This analysis must be performed in every reporting period. If market value is not readily determinable, evaluate if there have been any events or circumstances that might impact the fair value of an investment (such as a deterioration in the operating performance of the issuer of a security). Several rules regarding the determination of this other-than-temporary impairment are:
- Debt security. If the business plans to sell a debt security, an other-than-temporary impairment is assumed to have occurred. The same rule applies if it is more likely than not that the company will have to sell the security before its amortized cost basis has been recovered; this is based on a comparison of the present value of cash flows expected to be collected from the security to its amortized cost.
- Equity security. If the business plans to sell an equity security and does not expect the fair value of the security to recover by the time of the sale, consider its impairment to be other-than-temporary when the decision to sell is made, not when the security is sold.
If an impairment loss on an equity security is considered to be other-than-temporary, recognize a loss in the amount of the difference between the cost and fair value of the security. Once the impairment is recorded, this becomes the new cost basis of the equity security, and cannot be adjusted upward if there is a subsequent recovery in the fair value of the security.
If an impairment loss on a debt security is considered to be other-than-temporary, recognize a loss based on the following criteria:
- If the business intends to sell the security or it is more likely than not that it will be forced to do so before there has been a recovery of the amortized cost of the security, recognize a loss in earnings in the amount of the difference between the amortized cost and fair value of the security.
- If the business does not intend to sell the security and it is more likely than not that it will not have to do so before there has been a recovery of the amortized cost of the security, separate the impairment into the amount representing a credit loss, and the amount relating to all other causes. Then recognize that portion of the impairment representing a credit loss in earnings. Recognize the remaining portion of the impairment in other comprehensive income, net of taxes.
Once the impairment is recorded, this becomes the new amortized cost basis of the debt security, and cannot be adjusted upward if there is a significant recovery in the fair value of the security.
Once an impairment has been recorded for a debt security, you should account for the difference between its new amortized cost basis and the cash flows you expect to collect from it as interest income.
If any portion of the other-than-temporary impairment of a debt security classified as held-to-maturity is recorded in other comprehensive income, use accretion to gradually increase the carrying amount of the security until it matures or is sold.
If there is a subsequent change in the fair value of available-for-sale debt securities, include these changes in other comprehensive income.
Armadillo Industries buys $250,000 of the equity securities of Currency Bank. A national liquidity crisis causes a downturn in Currency’s business, so a major credit rating agency lowers its rating for the bank’s securities. These events cause the quoted price of Armadillo’s holdings to decline by $50,000. The CFO of Armadillo believes that the liquidity crisis will end soon, resulting in a rebound of the fortunes of Currency Bank, and so authorizes the recordation of the $50,000 valuation decline in other comprehensive income.
In the following year, the prognostication abilities of the CFO are unfortunately not justified, as the liquidity crisis continues. Accordingly, the CFO authorizes shifting the $50,000 loss from other comprehensive income to earnings.