The meaning of other-than-temporary impairment and its application

As originally issued, EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, provided guidance on assessing whether the impairment of a security within its scope was other than temporary and related disclosure requirements. Since the ratification of Issue No. 03-1 in April 2004, however, significant controversy has arisen about its application in practice, especially about the judgments required in the evaluation of whether an impairment is other than temporary. In September 2004, the Financial Accounting Standards Board (FASB) staff issued a FASB Staff Position (FSP) delaying the effective date of paragraphs 10-20 of Issue No. 03-1 concerning the evaluation of whether an impairment is other than temporary, the recognition of an impairment loss, and accounting considerations subsequent to the recognition of an other-than-temporary impairment.

Recently, the FASB directed its staff to issue FSP No. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which effectively nullifies the requirements of Issue No. 03-1. This FSP provides guidance on determining when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. Additionally, the FSP provides accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP is applicable for investments in:

Debt and equity securities that are within the scope of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities
Debt and equity securities that are within the scope of FASB Statement No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, and that are held by an investor that reports a “performance indicator” as defined in the AICPA Accounting and Audit Guide, Health Care Organizations
Equity securities accounted for at cost (thus, they are not subject to Statement Nos. 115 and 124 nor to APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock).

The FSP describes three steps in determining when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. In applying the first step, an investment is impaired if the fair value of the investment is less than its cost. For a cost-method investment for which a fair value has not been estimated, the FSP provides impairment indicators which should be used in evaluating whether an event or change in circumstances has occurred during the reporting period that may have a significant adverse effect on the fair value of the investment. When the cost or carrying value of an investment is impaired (that is, fair value is less than cost), then step two of the FSP is applied. Step two requires an assessment of whether the impairment is either temporary or other than temporary. The FSP provides no guidance on making this assessment (which is the most difficult and controversial aspect of this issue). Instead, an investor must apply other guidance that is pertinent to the determination of whether an impairment is other than temporary, such as paragraph 16 of Statement No. 115 (which references SEC Staff Accounting Bulletin Topic 5M, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities), paragraph 6 of Opinion No. 18 and EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets.” When an investor has decided to sell an impaired available-for-sale security and the investor does not expect the fair value of the security to fully recover prior to the expected time of sale, the security is deemed other-than-temporarily impaired in the period in which the decision to sell is made. However, an investor must recognize an impairment loss when the impairment is deemed other than temporary even if a decision to sell has not been made.

Step three provides that when it is determined that the impairment is other than temporary, then an impairment loss must be recognized in earnings equal to the entire difference between the investment's cost and its fair value at the balance sheet date of the reporting period for which the assessment is made. In periods subsequent to the recognition of an other-than-temporary impairment loss for debt securities, an investor must account for the other-than-temporarily impaired debt security as if the debt security had been purchased on the measurement date of the other-than-temporary impairment. That is, the discount or reduced premium recorded for the debt security, based on the new cost basis, would be amortized over the remaining life of the debt security in a prospective manner based on the amount and timing of future estimated cash flows.

The FSP carries forward the requirements in Issue No. 03-1 regarding required disclosures in the financial statements.

The guidance in this FSP must be applied to reporting periods beginning after December 15, 2005. Earlier application is permitted. The FSP is available in full at www.fasb.org/fasb_staff_positions/fsp_fas115-1&fas124-1.pdf.