Other-than-temporary impairment

Definition

Other-than-temporary impairment (OTTI) refers to a significant decline in the fair value of an investment in securities that is not expected to be recovered in the near term. This concept is crucial for accounting and financial reporting, as it impacts how certain securities are valued on the balance sheet and can affect earnings recognition. Recognizing OTTI may require companies to write down the value of their securities, which has implications for reported income and financial ratios.

5 Must Know Facts For Your Next Test

1. OTTI is triggered when the fair value of an investment falls significantly below its carrying amount and is not expected to recover.
2. When an OTTI is recognized, it results in an immediate loss recorded on the income statement, affecting net income.
3. For held-to-maturity securities, the determination of OTTI involves assessing both the credit risk and the market conditions affecting the investment's value.
4. The evaluation for OTTI must occur at least quarterly, ensuring that any potential impairments are recognized in a timely manner.
5. If an investment is deemed to have an OTTI, it can no longer be classified as held-to-maturity; it must then be reported at fair value.

Review Questions

• How does recognizing an other-than-temporary impairment affect a company's financial statements?
  • Recognizing an other-than-temporary impairment affects a company's financial statements by creating an impairment loss that reduces net income on the income statement. This loss also leads to a decrease in the carrying amount of the impaired asset on the balance sheet. As a result, it can negatively impact key financial ratios such as return on assets and equity, ultimately affecting how investors perceive the company's financial health.
• Discuss the criteria that must be met for a security to be classified as other-than-temporarily impaired under accounting standards.
  • For a security to be classified as other-than-temporarily impaired, it must meet specific criteria indicating that its decline in fair value is significant and not expected to recover. This involves evaluating factors like the duration of the decline, the financial health of the issuer, and overall market conditions. If these indicators suggest that recovery is unlikely within a reasonable timeframe, the investment must be written down to its fair value, resulting in recognition of an OTTI.
• Evaluate the impact of other-than-temporary impairment recognition on investment strategy and portfolio management for companies holding securities.
  • The recognition of other-than-temporary impairment has substantial implications for investment strategy and portfolio management. Companies must constantly monitor their investments' performance and market conditions to avoid unexpected write-downs. Additionally, recognizing OTTI can lead firms to reconsider their investment strategies, potentially moving away from certain high-risk securities or adjusting their portfolio allocations to mitigate future impairments. This proactive approach can help maintain investor confidence and stabilize financial performance over time.

Related terms

Fair Value: The estimated market price at which an asset could be bought or sold in a current transaction between willing parties.

Impairment Loss: A reduction in the carrying amount of an asset when its market value is less than its book value, leading to a write-down.

Held-to-Maturity Securities: Debt securities that a company intends to hold until they mature, requiring specific accounting treatment under GAAP.