Accounting for Impairment of Investment

Investment impairment is an accounting concept that requires a company to reduce an investment’s carrying value on its financial statements. This reduction occurs when the asset’s value on the balance sheet is higher than its recoverable amount, which is its fair market value. Recognizing impairment ensures that assets are not shown at an inflated value.

Adjusting the investment’s value downward provides a more realistic representation of the company’s financial position for investors and creditors. This reflects the economic reality that an asset’s ability to generate future benefits has declined. Without impairment accounting, a company’s balance sheet could misrepresent its true worth and mask financial weakness.

Assessing Debt Security Impairment

The impairment of debt securities is governed by the Current Expected Credit Losses (CECL) model under Accounting Standards Codification (ASC) Topic 326. This standard applies to Held-to-Maturity (HTM) and Available-for-Sale (AFS) debt securities. HTM securities are those a company intends to hold until maturity, while AFS securities may be sold before their maturity date.

Under CECL, companies must recognize lifetime expected credit losses on debt securities from acquisition. This forward-looking approach requires estimating losses over the asset’s contractual life. To develop this estimate, a company considers historical data, current economic conditions, and reasonable forecasts about the future.

For HTM securities, expected losses are recorded using a contra-asset account called the “allowance for credit losses.” This allowance reduces the debt securities’ net carrying amount to the amount the company expects to collect, with a corresponding charge to earnings. The allowance is re-evaluated at each reporting date and adjusted based on changes in expected conditions.

The model for AFS debt securities is distinct. An AFS security is impaired when its fair value falls below its amortized cost. The company must first determine if any portion of the decline is related to a credit loss by comparing the present value of expected future cash flows with the security’s amortized cost.

If a credit loss exists, it is recorded through an allowance for credit losses and recognized in net income. Any remaining decline in fair value not related to credit is recognized in other comprehensive income (OCI). The credit loss recognized in earnings cannot exceed the total impairment amount, which is the difference between the security’s fair value and its amortized cost.

Evaluating Equity Security Impairment

Evaluating impairment for equity securities depends on how the security is measured. For equity securities with a readily determinable fair value, like those on a public exchange, a separate impairment test is not performed. These securities are measured at fair value each reporting date, and any changes are recorded directly in net income, which accounts for any decline in value.

Impairment testing focuses on equity securities that do not have a readily determinable fair value. For these, a company can elect a measurement alternative under ASC 321, allowing the security to be carried at its cost, less impairment, and adjusted for observable price changes of similar investments. This method avoids estimating fair value when a reliable market price is unavailable.

For these equity securities, a company performs a qualitative assessment each reporting period to identify potential impairment. This involves evaluating indicators such as a significant deterioration in the investee’s earnings performance, credit rating, or financial health, or a significant adverse change in the investee’s operating environment.

If the assessment indicates potential impairment, the company must estimate the security’s fair value. If the fair value is less than the carrying amount, an impairment loss is recognized by writing the investment down to its fair value, with the loss recorded in net income. This write-down establishes a new, lower cost basis and cannot be reversed if the fair value later recovers.

Testing Equity Method Investments for Impairment

Investments under the equity method follow an impairment model outlined in ASC 323. This method is used when an investor has significant influence over an investee, presumed at an ownership level of 20% to 50%. The impairment test is a two-step process triggered by indicators that the investment’s value may have declined.

The first step is to compare the investment’s fair value to its carrying amount. The carrying amount includes the initial cost, adjusted for the investor’s share of the investee’s earnings or losses and any dividends. If the fair value is greater than or equal to the carrying amount, no impairment is recognized.

If the fair value is less than the carrying amount, the company must determine if the decline is “other-than-temporary” (OTTI). This assessment requires reviewing all available evidence to determine if the investor can recover the investment’s carrying amount.

Factors considered when evaluating if a decline is OTTI include:

• The length of time and the extent to which the fair value has been below the carrying amount
• The financial condition and near-term prospects of the investee
• Any specific negative events affecting the investee
• The investor’s intent and ability to hold the investment long enough for a forecasted recovery in fair value

If the decline is deemed OTTI, an impairment loss is recognized. The investment is written down to its current fair value, and the loss is recorded in earnings.

Financial Statement Reporting and Disclosures

The presentation of impairment losses on financial statements provides transparency to stakeholders. An impairment loss impacts both the income statement and the balance sheet. On the income statement, the loss is reported as a separate line item, often within non-operating income or expense, to clearly show its impact on profitability.

On the balance sheet, the impairment loss reduces the investment asset’s carrying amount. This is achieved either through an allowance account for debt securities or a direct write-down for equity and equity method investments.

Companies must also provide detailed information in the footnotes to the financial statements. For debt securities under the CECL model, disclosures include quantitative information about the allowance for credit losses. This often involves a roll-forward schedule showing the beginning balance, current provisions, write-offs, and the ending balance of the allowance.

For equity securities and equity method investments, disclosures are more qualitative. A company must describe the facts and circumstances that led to the impairment. For equity securities under the measurement alternative, disclosures include details about the qualitative assessment and the inputs used to determine fair value when an impairment is recorded.