At its March 17-18, 2004 meeting, the Financial Accounting Standards Board’s (FASB) Emerging Issues Task Force (EITF) issued EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, to provide guidance for evaluating whether an investment is other-than-temporarily impaired.1 As originally proposed, this guidance would have been effective for other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. However, despite the rather public nature of EITF discussions and the publication of EITF minutes, it was not until the final consensus was published that financial institution executives and their external auditors began to realize the full implications of this interpretation of existing generally accepted accounting principles (GAAP).
FASB listened to and heard the industry’s concerns and, on September 30, 2004, issued FASB Staff Position No. EITF Issue 03-1-1, delaying the implementation of the proposed measurement and recognition paragraphs.2 However, FASB noted that entities would still be required to recognize other-than-temporary impairments as required by existing authoritative literature and comply with the disclosure guidance in paragraphs 21 and 22 of EITF 03-1.
This article reviews the original EITF 03-1 proposal, the industry’s concerns, and the current status of the issue. Management should also monitor the status of any resolution to EITF 03-1 through trade publications, the media, or FASB’s EITF website at www.fasb.org/eitf/agenda.shtml.
What was the Issue?
As proposed, EITF 03-1 would not have changed GAAP accounting for impaired investment securities. However, at least one major accounting firm interpreted EITF 03-1 to mean that the sale of any impaired available-for-sale security, even one impaired or in an unrealized loss position only because of a change in interest rates, would taint the entire portfolio of available-for-sale securities with unrealized losses, requiring the portfolio’s unrealized losses to pass through earnings. In a rising interest rate environment, such as the one existing today, financial institutions could be forced to recognize significant unrealized losses from debt securities due solely to a change in interest rates. At the extreme, institutions could have been forced to choose between never selling an available-for-sale security with an unrealized loss, which would limit liquidity and risk management options, or recognizing any unrealized loss on all available-for-sale securities during each reporting period.
The lack of consistent interpretation of EITF 03-1 by the major accounting firms, coupled with the potential for significant balance sheet and income statement impacts in a rising interest rate environment, caused FASB to take rather swift action. In September 2004, FASB directed staff to issue two FASB Staff Positions (FSPs). Proposed FSP EITF 03-1-a provides guidance for applying paragraph 16 of EITF 03-1 to debt securities that are impaired because of interest rate and/or sector spread increases.3 FSP EITF 03-1-1 delays the effective date of EITF 03-1 paragraphs 10 – 20 that relate to the measurement and recognition of impairment. Importantly, FSP EITF 03-1-1 did not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature, nor did it delay the disclosure guidance in paragraphs 21 and 22 of EITF 03-1.
Current Accounting for Securities Impairment
Accounting for securities is generally covered by FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. (FAS 115).4 Paragraph 16 of FAS 115 requires that other-than-temporarily impaired securities be written down to fair value with a loss recorded through earnings in the period in which the impairment is determined to be other-than-temporary. Under other FAS 115 paragraphs, the appropriate treatment of temporary unrealized losses on securities depends on the nature of the security. Securities that are classified by management as held-to-maturity remain on the balance sheet at amortized cost, with separate disclosure of their book and fair values. Securities that are classified by management as trading are reported in the balance sheet at fair value, with gains and losses recorded in earnings. Finally, both increases and temporary decreases in the value of securities that are classified as available-for-sale are recorded directly in equity as other comprehensive income. While these rules are fairly straightforward, there is significant diversity in current practice in defining when an impairment is “other-than-temporary.”
Because of the diversity in practice for identifying other-than temporary impairment of investment securities, the EITF attempted to clarify the impairment guidance currently existing in FAS 115 and other standards. In EITF 03-1, the EITF proposed a three-step process for evaluating investment securities for impairment.
The first step would be to determine whether an investment was impaired. Paragraph six stated that an investment would be impaired if the fair value of the investment was less than its cost, including adjustments made to cost for accretion, amortization, previous other-than-temporary impairments, foreign exchange, and hedging (this is referred to simply as “cost” throughout EITF 03-1). The comparison of fair value and cost generally would be made at each reporting period. If management determined that an investment was impaired, then a second step would be necessary.
The second step would be to evaluate whether an impairment was other-than-temporary. The criteria for determining whether an impairment was other-than-temporary would vary with the nature of the security. In general, for equity securities and debt securities that could be contractually prepaid, paragraph ten provided that an impairment would be deemed other-than-temporary unless both of the following conditions were met.
For investment securities not within the scope of paragraph ten (for example, debt securities that could not be contractually prepaid), paragraph 16 provided that an impairment would be deemed other-than-temporary if the investor did not have the ability and intent to hold an investment until a forecasted recovery of fair value up to or beyond the cost of the investment or it is probable that the investor would be unable to collect all amounts due according to the contractual terms of the debt security.
If the impairment was deemed to be other than temporary, then the third step would be to recognize an impairment loss equal to the difference between the investment’s cost and its fair value. The impairment loss would be taken through earnings in the period in which the impairment was determined to be other-than-temporary. In addition, such an impairment loss would create a new cost basis for the investment, and the investment could not be adjusted for subsequent recoveries in fair value.
To Taint or Not to Taint?
Perhaps the most significant issue arising from EITF 03-1 was whether the sale of even one available-for-sale security with an unrealized loss would taint the entire available-for-sale portfolio. Proposed EITF 03-1-a would provide clarification on when such a sale would not taint other available-for-sale securities, drawing an analogy to the circumstances under which a sale of a held-to-maturity security would not taint the entire held-to-maturity portfolio.
For debt securities that were impaired because of interest rate and/or sector spread increases and that would be analyzed for impairment under paragraph 16 of EITF 03-1, the proposal suggested that the following circumstances would not necessarily call into question the investor’s ability or intent to hold other securities to recovery.
In addition, proposed EITF 03-1-a would provide that a sale of an available-for-sale security subject to paragraph 16 for which the investor had not previously asserted its ability and intent to hold to recovery would not call into question the investor’s ability and intent to hold the securities for which the investor had previously asserted its ability and intent to hold to recovery. However, other-than-temporary impairments on securities for which the investor had not asserted its ability and intent to hold to recovery would need to be recognized currently in earnings.
If adopted, this latter proposed staff position could lead to, in effect, a bifurcation of the securities in the available-for-sale portfolio that are subject to paragraph 16 into two “subportfolios.” A sale from the subportfolio for which the investor had asserted its ability and intent to hold to recovery (importantly, not maturity) could risk taint, subject to the FAS 115 analogy exceptions noted above. A sale from the subportfolio for which the investor had not asserted its ability and intent to hold to recovery would not risk taint, but any other-than-temporary impairments of those securities would need to be reflected in earnings.
EITF 03-1-1 does provide some implementation relief, while proposed FSP EITF 03-1-a would provide additional implementation guidance. However, neither FSP changes the fact that financial institutions will likely experience additional scrutiny of available-for-sale securities with unrealized losses, particularly since EITF 03-1 requires that such securities be disclosed in the financial statements whether or not an impairment loss is taken.
While EITF 03-1-1 delays the effective date of the measurement and recognition guidance contained in EITF 03-1 paragraphs 10 – 20, it does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. During this interim period, financial institutions should continue to follow applicable guidance, such as the following.
Until additional guidance is issued, financial institution management
should ensure that measurement and recognition practices are consistent
with GAAP and that their disclosure practices are in accordance
with paragraphs 21 and 22 of EITF 03-1 and other relevant literature.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.