By Peter R. Alfele, CPA
The recent economic downturn and declining investment markets have left many companies holding portfolios of impaired marketable securities. As a result, financial reporting executives must analyze their portfolios to decide how to report these losses and to defend their assertion that temporary losses will be recovered.
Reporting investments in securities
Companies investing in the securities of other entities are required to report their holdings based on a variety of factors. First, an entity must determine the nature of its investment by classifying it as either a debt security or an equity security.
Debt securities are characterized by a debtor/creditor relationship and generally include investments such as U.S. Treasury securities, U.S. government agency securities, municipal securities and corporate bonds. Equity securities, such as common, preferred or other capital stock, generally represent an ownership interest in an enterprise. Equity securities may also take the form of a right to acquire or dispose of an ownership interest (e.g., warrants, rights and call or put options).
Once the nature of a security has been defined, an entity must further analyze its equity securities to determine if the fair value is “readily determinable.” Generally, the fair value of an equity security is readily determinable if sales prices or quotations are currently available on a securities exchange such as the New York Stock Exchange, or in the case of mutual funds, the per share price is widely published. The term “marketable securities” is frequently used to refer to investments that encompass both debt securities and equity securities with readily determinable fair values.
Recording and classification
The purchase of a marketable security is initially recorded at cost. At acquisition, companies must classify their marketable securities into three groupings, based on their type (debt vs. equity) and on management’s intent to hold the security. These include:
- Held to maturity: Securities purchased with the positive intent and ability to hold to maturity. This category only applies to debt securities because equity securities, by definition, do not have maturity dates.
- Trading: Securities bought and held principally to be sold in the near-term. Trading securities are held usually by financial institutions and similar entities, and typically have a holding period measured in hours and days rather than months or years.
- Available for sale: Securities that do not meet the criterion to be classified as held to maturity or trading.
Classification is important because securities are reported in vastly different ways depending on how they are categorized. This article focuses on the accounting requirements of the “available for sale” category as the majority of operating businesses classify their securities as such.
As available for sale securities are sold, any difference between the purchase price and the sales price is reported in earnings. Securities held are adjusted to the fair value of the investment on the reporting date. Recognizing that fair value adjustments may cause volatility in an entity’s operating earnings, standard setters directed these “unrealized holding gains/losses” to be reported in other comprehensive income (OCI).
OCI is a segregated component of financial statements used to capture certain economic events of unrecognized transactions of a period. Because items included in OCI are usually excluded from analysis of a company’s performance in its core activities, management may be inclined to report negative results in OCI rather than earnings.
The impairment condition
A marketable security is considered impaired when its fair value is less than its cost. Once impaired, financial reporting standards require companies to further analyze their investment securities and disclose management’s determination of the potential to recover the price paid.
Accounting for impaired marketable securities classified as available for sale involves a determination of whether a decline is temporary. This determination is a critical matter of judgment because of the reporting ramifications. If the loss is considered temporary, the adjustment is reported in OCI and may be subsequently recovered if the value of the investment returns. However, if management considers the loss other-than-temporary, the loss is charged to operations and subsequent recoveries of fair value are not included in operating results until the investment is sold.
The impairment analysis
In performing an impairment analysis, the accounting standards outline a three-step process to 1.) determine when a security is deemed impaired; 2.) determine if the loss is temporary; and 3.) measure and recognize the loss.
As described above, an investment is generally considered impaired when its fair value is less than its cost. Cost includes adjustments for accretion, amortization, any previous impairment losses and hedging. The review for impaired securities must be conducted in each reporting period (including interim periods) at the individual security level. An analysis of a portfolio or provision of a general allowance is not an acceptable practice. However, separate lots of equity securities bearing the same Committee on Uniform Security Identification Procedures (CUSIP) number that were purchased at different dates may be combined on an average cost basis if the company follows this practice to determine its realized gains and losses.
Once a company has identified the individual securities that are in a loss position, management must conclude whether the loss is temporary or other-than-temporary. While the accounting literature does not specifically define the term “other-than-temporary,” it emphasizes that the phrase should not be interpreted to mean “permanent.”
Absent that guidance, standard-setters point to publications of regulators to lend some insight. In Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 59, Other than Temporary Impairment of Certain Investments in Equity Securities, the SEC staff urge that all available evidence should be considered and provided three factors that, either individually or in combination, may indicate that a security’s impairment is other-than-temporary:
- Time and extent of loss: As the length of time needed for recovery grows and/or the magnitude of the loss increases, the likelihood that impairment is other-than-temporary also increases. Assertions that securities that have been “underwater” for extensive periods of time are only temporary would need to be supported by more compelling evidence than those that have recently declined to a loss position.
- Issuer’s financial condition: An examination of the fiscal health of the investee may shed some light on when a turnaround in performance could be expected. Investees faced with significant changes in technology or who have recently reported the discontinuance of certain operations may provide clues that a recovery is not eminent.
- Intent and ability of the holder: An introspective look at the investor’s forecasted cash or working capital demands may indicate that the company must sell the securities in question in order to meet its own obligations before the investment is expected to recover. In addition, while the determination of the other-than-temporary impairment is to be hypothetically made as of the balance sheet date, the sale of the security subsequent to the balance sheet date and before the release of the statements is strong, although not by itself conclusive, indication that an other-than-temporary loss should be recorded.
The conclusion that an impaired loss is other-than-temporary requires a great deal of judgment. In order to avoid unnecessary scrutiny, management should consistently apply a systematic approach for classifying impaired securities. For instance, establishing evaluation criteria in advance and documenting the factors considered in the analysis and the conclusions reached will lend credibility to management’s assertions.
Reporting impairment losses
Once a loss is considered other-than-temporary, the difference between the cost and fair value of the investment at the balance sheet date is reported in earnings. The new cost basis is not changed for subsequent recoveries in fair value. A recovery in fair value is not recorded in earnings until the security is sold.
In addition, accounting standards require a company to disclose its investments that are in a loss position, grouped by those that have been in a continuous loss for less than 12 months and those that have been underwater for more than 12 months. Management must also include a narrative discussion essentially defending its position that unrealized losses are only temporary. This narrative should be straightforward and discuss what caused the loss as well as specific evidence supporting the expected recovery. While this narrative presents management with an opportunity to elaborate on its intentions, it should be based on defendable facts and objective viewpoints.
Income tax considerations
Although financial reporting standards require companies to write down the basis of securities deemed to be other-than-temporarily impaired, federal income tax regulations do not permit a deduction for such losses until the security is actually sold. As such, securities whose cost basis has been reduced by an impairment charge produce book-tax differences that result in deferred tax assets and the corresponding income tax provision is allocated to earnings (as opposed to OCI).
Comparison to International Financial Reporting Standards (IFRS)
The valuation of marketable securities is an area where U.S. reporting standards differ substantially from the rules followed by the global business community. While both U.S. reporting requirements and IFRS require impairment assessments based on relatively subjective criteria at each balance sheet date, the IFRS model is quite different.
For instance, the notion that a holding loss is “other-than-temporary” is not considered under IFRS. Additionally, the IFRS analysis permits assets to be evaluated in groups where U.S. standards require that the review be conducted at the security level. Further, while U.S. standards point to “indications” of impairment (time and extent of loss, issuers financial condition, intent and ability of the holder), IFRS generally requires certain occurrences before an impairment loss is recorded.
Specifically, recording a loss under IFRS requires “objective evidence of impairment as a result of one or more events” and that the “loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated.” Finally, unlike U.S. principles that restrict the recognition of the recovery of an impaired security beyond its adjusted basis until it is actually sold, IFRS permits subsequent gains under certain circumstances.
During periods of economic instability, a financial reporting executive’s judgment faces higher scrutiny. Decisions with regard to impaired marketable securities require a great deal of care and should be approached objectively and systematically in order to provide meaningful disclosures about a company’s investments and lend credibility to the financial statements.
Peter R. Alfele, CPA, is a partner at Cherry, Bekaert & Holland, LLP, in Virginia Beach. He has more than 12 years of experience providing audit and accounting services to a variety of commercial enterprises and closely held, middle market businesses. Contact him at [email protected] or search and connect with him on LinkedIn.