What Is Other-Than-Temporary Impairment?

An other-than-temporary impairment (OTTI) is an accounting concept used to determine if a decline in an investment’s value was not expected to be short-lived. While the term is no longer used for debt securities under U.S. Generally Accepted Accounting Principles (GAAP), the principle of recognizing lasting losses ensures that a company’s financial statements are accurate. Acknowledging such a loss directly impacts reported earnings and the overall balance sheet.

This process requires companies to periodically review their investment portfolios for potential losses. The analysis prevents the overstatement of asset values on the balance sheet, giving investors, creditors, and other stakeholders a clearer picture of the company’s true financial health.

Identifying an Impairment Trigger

The first step in an impairment analysis is identifying a trigger event. An investment is considered impaired when its current fair value drops below its amortized cost basis. This unrealized loss does not automatically mean a loss must be recognized in earnings, but it is the starting point for the evaluation. This assessment must be performed for individual securities during each reporting period.

Multiple factors can trigger an impairment evaluation. These include broad market-based events, such as a downturn in the stock market, changes in benchmark interest rates, or negative economic shifts affecting an industry. For example, an increase in market interest rates can cause the fair value of existing fixed-rate bonds to fall, creating an unrealized loss.

Triggers can also be specific to the entity that issued the security. Such events include a deterioration in the issuer’s financial health, a credit rating downgrade, or negative news like pending litigation. The severity and duration of the decline are also considered, as a large drop that persists over several months is more likely to trigger a review.

Impairment Evaluation for Debt Securities

For debt securities like corporate or government bonds, a credit loss model is used. The evaluation is performed on an individual security basis each reporting period where the fair value is below the amortized cost.

The first step asks whether the company intends to sell the impaired debt security or if it is “more-likely-than-not” that it will be required to sell before its value recovers. If yes, the security’s cost basis is written down to its fair value, and the entire loss is recognized in net income.

If the company does not intend to sell, the next step is to identify a credit loss. A credit loss is the amount by which the security’s amortized cost exceeds the present value of the cash flows the company expects to collect. This calculation requires management to make detailed forecasts about future principal and interest payments.

If a credit loss exists, it is recorded through an allowance for credit losses and reported in net income. This allowance is limited to the total impairment amount, and any remaining portion from non-credit factors is recorded in other comprehensive income. Held-to-maturity securities are also assessed for impairment using a similar forward-looking expected credit loss model.

The Impairment Evaluation for Equity Securities

The impairment evaluation for equity securities, such as common stocks, is different from the model for debt. Following Accounting Standards Update (ASU) 2016-01, the OTTI concept was eliminated for most equity investments, streamlining the process.

For equity securities with a readily determinable fair value, the accounting is straightforward. At the end of each reporting period, these investments are measured at fair value. If the fair value is below the company’s original cost, an impairment loss is recognized immediately in net income for the full amount of the decline.

For less common equity securities without a readily determinable fair value, such as investments in private companies, a different approach is used. A company can measure the investment at cost, less any impairment. To identify impairment, the company performs a qualitative assessment each period for indicators like a deterioration in the investee’s earnings, credit rating, or business prospects. If this assessment indicates impairment, the investment is written down to its fair value, and the loss is recognized in net income.

Accounting for a Recognized Impairment

The accounting treatment to record an impairment loss depends on whether the security is a debt or an equity instrument.

For a debt security that a company intends to sell, the investment’s cost basis is written down to its fair value. The entire loss is recorded as a debit to a loss account on the income statement. If the impairment is due to a credit loss and there is no intent to sell, the credit-related portion is recognized in net income through an allowance for credit losses. The non-credit portion of the loss is recorded in Other Comprehensive Income (OCI).

For equity securities with readily determinable fair values, any decline in fair value below the cost basis is recognized as a loss directly in net income. The journal entry involves a debit to an investment loss account and a credit to the equity investment account on the balance sheet.

Required Financial Statement Disclosures

Companies are required to provide detailed disclosures in the notes to their financial statements regarding impaired investments. These disclosures give stakeholders insight into the nature and extent of the impairments recognized and illuminate the judgments and estimates management used in its analysis.

For debt securities, a company must provide both quantitative and qualitative information. This includes:

• The aggregate fair value and unrealized losses of securities in an unrealized loss position, broken down by how long they have been continuously in that position.
• A roll-forward of the allowance for credit losses, which shows the beginning balance, any additions for new credit losses, write-offs, and the ending balance.
• A description of the methodology and inputs used to measure credit losses, such as assumptions about future cash flows and prepayment speeds.

For all impaired securities, companies must explain the underlying causes of the loss. This narrative disclosure clarifies whether the loss was due to broad market conditions, industry-specific issues, or problems unique to the issuer.