Impairment and sale considerations for debt securities
The recent increase in interest rates has in many cases caused unrealized losses on fixed-rate debt securities to increase significantly, as well as cause securities that were in a gain position to move to an unrealized loss position. This movement into an unrealized loss position or more significant unrealized loss position has triggered questions regarding when impairment should be recognized in the income statement and the ramifications if management decides to sell impaired securities. This article provides guidance to address these questions in the context of debt securities. The evaluation and recognition of impairment for equity securities is subject to significantly different guidance and beyond the scope of this article.
Summary of guidance
As a refresher, securities are deemed to be impaired if the fair value of an individual security is less than the amortized cost amount as of the reporting date. In the context of debt securities, impairment is other than temporary if any of the following circumstances exist as of the reporting date:
- The entity intends to sell the debt security
- It is more likely than not that the entity will be required to sell the security before the recovery of its amortized cost basis due to liquidity needs, contractual or regulatory obligations or for other reasons
- With consideration given to cash flows expected to be collected, the entity does not expect to recover the entire amortized cost basis of the security (i.e. a credit loss exists)
If an unrealized loss is determined to be other than temporary, the amount of the other-than-temporary impairment (OTTI) recognized in earnings depends on whether the entity: (a) intends to sell the security or (b) more likely than not will be required to sell the security before recovery of its amortized cost basis. If so, the OTTI recognized in earnings is equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance-sheet date. If the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, the OTTI is separated into two components: (1) the amount representing the credit loss and (2) the amount related to all other factors. The amount representing credit loss is recognized in earnings and the amount related to other factors is recognized in other comprehensive income.
Frequent questions in applying the guidance
The following is a partial list of commonly asked questions.
If an entity sells an impaired security shortly after a reporting period end, should an impairment loss be recognized in the reporting period prior to the sale?
To answer this question, it is necessary to consider whether as of the period end prior to the sale, any of the three circumstances outlined above existed that would warrant recognition of an impairment loss in that period end. As such, consideration needs to be given to when management made the decision to sell the security and (or) if the security was required to be sold, when the circumstances resulting in the need to sell arose. For this reason, it is important for management to contemporaneously document the timing of any decisions to sell securities and perform a documented assessment at each reporting period end of the circumstances that could likely require a sale and the probability of those circumstances occurring before the securities’ forecasted recovery.
Specific examples include the following:
- At March 31, 20X3, management does not intend to sell an impaired security. On April 5, 20X3, they are approached by a dealer who expresses an interest in purchasing the security. The terms are attractive to management and the sale is conducted at the end of April. Assuming no likely requirement to sell existed at March 31 and the entity expected to fully recover the amortized cost basis as is elaborated on above, no impairment should be recognized in March.
- Management sells an impaired security in April 20X3 due to its liquidity needs. Management had not previously identified the security as being other than temporarily impaired nor did they have the intent to sell prior to April. Under these circumstances, consideration should be given to whether as of March 31, 20X3, or an earlier period, it was more likely than not the entity would be required to sell the security prior to recovering the amortized cost basis. The reason for the sale and close proximity to the balance-sheet date would suggest a likely requirement to sell existed at the balance-sheet date.
If management sells an impaired security shortly after documenting that they had no intent to sell impaired securities, does this call in to question the validity of management’s intent for the specific security sold or other securities?
Generally, no. Unlike the guidance currently in existence for equity securities and relevant to debt securities prior to 2009, the expression of intent now relevant to debt securities is not to hold an instrument until it recovers or to maturity, but is rather just that as of the reporting period end, management does not have the intent to sell. We expect that generally the period of time from when the intent to sell arises (i.e., a decision to sell a specific security has been made) until the sale occurs, will be relatively brief.
How has (or how should) the current interest rate environment impacted the analysis of a likely requirement to sell?
Interest rates had been at historically low levels for an extended period of time. As interest rates increase and trigger unrealized losses on fixed-rate securities, it is important to keep in mind that these securities may not recover and return to a gain position for an extended period of time. Management is required to forecast a recovery period, which may not be until maturity, in order to evaluate whether it more likely than not will be required to sell impaired securities before the forecasted recovery.
What additional considerations should management be aware of if considering selling securities designated as held to maturity?
As is elaborated on in the Financial Accounting Standards Board’s Accounting Standards Codification, paragraphs 320-10-35-8 and 9, depending on the circumstances surrounding the sale, sales of securities classified as held to maturity (HTM) can call in to question the entity’s intent about all securities that remain in the HTM category, and necessitate the transfer of the remaining HTM securities to the available-for-sale category. Additionally, management may be precluded from using the HTM category for new purchases for a period of time.