Other-than-temporary impairment

Definition

Other-than-temporary impairment (OTTI) refers to a situation where the fair value of an investment has declined significantly and is not expected to recover in the foreseeable future. This concept is crucial in determining when an investor must recognize a loss on their financial statements, ensuring that investments are accurately represented at their recoverable amounts rather than inflated values.

5 Must Know Facts For Your Next Test

1. OTTI must be assessed when there is evidence that the investment's fair value is less than its carrying amount and this decline is deemed significant and prolonged.
2. Investments are generally evaluated for OTTI on a quarterly basis, ensuring timely recognition of potential losses in financial reporting.
3. When recognizing OTTI, the loss is recorded in earnings rather than other comprehensive income, impacting the income statement directly.
4. The assessment of whether an impairment is other-than-temporary involves considering various factors, including market conditions and the specific circumstances of the investment.
5. Investors can also reverse previous OTTI losses if future evaluations show that the fair value of the investment has recovered, reflecting changes in market conditions.

Review Questions

• How does an investor determine if an impairment of an investment is other-than-temporary?
  • To determine if an impairment is other-than-temporary, an investor evaluates whether the decline in fair value is significant and prolonged compared to the investment's carrying amount. This assessment includes analyzing market conditions, industry trends, and specific factors related to the investment itself. If these conditions indicate that recovery is unlikely in the foreseeable future, then it qualifies as OTTI.
• What are the financial reporting implications when an investment is deemed to have other-than-temporary impairment?
  • When an investment is identified as having other-than-temporary impairment, it must be recorded as a loss on the income statement, which directly affects net income. The carrying amount of the investment is adjusted down to its fair value at the time of recognition. This ensures that financial statements reflect a more accurate picture of the company's financial position and performance by acknowledging potential losses.
• Critically evaluate how the concept of other-than-temporary impairment affects investor behavior and market perceptions of securities.
  • The concept of other-than-temporary impairment significantly influences investor behavior by necessitating prompt recognition of losses, which can lead to more conservative investment strategies. Investors may become wary of securities that show signs of potential OTTI due to their immediate impact on reported earnings. Additionally, frequent occurrences of OTTI among certain investments can alter market perceptions, creating volatility and impacting investor confidence as they reassess their risk tolerance and portfolio allocations based on perceived underlying asset values.

Related terms

Fair Value:

The estimated price at which an asset would trade in a competitive auction setting, representing the market's perception of the asset's value.

Impairment Loss:

The amount by which the carrying value of an asset exceeds its recoverable amount, requiring recognition in financial statements.

Securities: Financial instruments that represent an ownership position, creditor relationship, or rights to ownership, commonly subject to impairment assessments.