An investor records an impairment charge in earnings when the decline in value below the carrying amount of its equity method investment is determined to be other than temporary. “Other than temporary” does not mean that the decline is of a permanent nature. The unit of account for assessing whether there is an other-than-temporary impairment (OTTI) is the carrying value of the equity method investment as a whole.
A loss in value of an investment that is other than a temporary decline shall be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity that would justify the carrying amount of the investment. A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors that shall be evaluated.
Continued operating losses at the investee may suggest that the investor would not recover all or a portion of the carrying value of its investment, and therefore that the decline in value is other than temporary.
A series of operating losses of an investee or other factors may indicate that a decrease in value of the investment has occurred that is other than temporary and that shall be recognized even though the decrease in value is in excess of what would otherwise be recognized by application of the equity method.
All available evidence should be considered in assessing whether a decline in value is other than temporary. The relative weight placed on individual factors may vary depending on the situation.
Factors to consider in assessing whether a decline in value is other than temporary include:
- The length of time (duration) and the extent (severity) to which the market value has been less than cost.
- The financial condition and near-term prospects of the investee, including any specific events which may influence the operations of the investee, such as changes in technology that impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential.
- The intent and ability of the investor to retain its investment in the investee for a period of time sufficient to allow for any anticipated recovery in market value.
Investors should also consider the reasons for the impairment and the period over which the investment is expected to recover. The longer the expected period of recovery, the stronger and more objective the positive evidence needs to be in order to overcome the presumption that the impairment is other than temporary. As the level of negative evidence grows, more positive evidence is needed to overcome the need for an impairment charge. The positive evidence should be verifiable and objective.
Figure EM 4-2 contain examples of negative evidence that may suggest that a decline in value is other than temporary. Figure EM 4-3 contains examples of positive evidence that may suggest a decline in value is not other than temporary. These examples are not all-inclusive, and investors should assess all relevant facts and circumstances.
Figure EM 4-2
Negative evidence that indicates decline is other than temporary
- A prolonged period during which the fair value of the security remains at a level below the investor’s cost
- The investee’s deteriorating financial condition and a decrease in the quality of the investee’s asset, without positive near-term prospects for recovery. For example, adverse changes in key ratios and/or factors, such as the current ratio, quick ratio, debt to equity ratio, the ratio of stockholders’ equity to assets, return on sales, and return on assets. With respect to financial institutions, examples of adverse changes are large increases in nonperforming loans, repossessed property, and loan charge-offs
- The investee’s level of earnings or the quality of its assets is below that of the investee’s peers
- Severe losses sustained by the investee in the current year or in both current and prior years
- A reduction or cessation in the investee’s dividend payments
- A change in the economic or technological environment in which the investee operates that is expected to adversely affect the investee’s ability to achieve profitability in its operations
- Suspension of trading in the security
- A qualification in the accountant’s report on the investee because of the investee’s liquidity or due to problems that jeopardize the investee’s ability to continue as a going concern
- The investee’s announcement of adverse changes or events, such as changes in senior management, salary reductions and/or freezes, elimination of positions, sale of assets, or problems with equity investments
- A downgrading of the investee’s debt rating
- A weakening of the general market condition of either the geographic area or industry in which the investee operates, with no immediate prospect of recovery
- Factors, such as an order or action by a regulator, that (1) require an investee to (a) reduce or scale back operations or, (b) dispose of significant assets, or (2) impair the investee’s ability to recover the carrying amount of assets
- Unusual changes in reserves (such as loan losses, product liability, or litigation reserves), or inventory write-downs due to changes in market conditions for products
- The investee loses a principal customer or supplier
- Other factors that raise doubt about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working-capital deficiencies, or noncompliance with statutory capital requirements
- The investee records goodwill, intangible or long-lived asset impairment charges
Figure EM 4-3
Positive evidence indicating decline is not other than temporary
- Recoveries in fair value subsequent to the balance sheet date
- The investee’s financial performance and near-term prospects (as indicated by factors such as earnings trends, dividend payments, analyst reports, asset quality, and specific events)
- The financial condition and prospects for the investee’s geographic region and industry
In situations where the fair value is known, such as in the case of an investment with a quoted price or when an investee stock transaction occurs, and that fair value is below the investor’s carrying amount, the investor would need to assess whether that impairment is other than temporary. The fact that the fair value is below the carrying amount does not automatically require an impairment charge to be recognized. All facts and circumstances would need to be considered.
Excerpt from ASC 323-10-35-32
A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors that shall be evaluated.
For investments in private companies, information that would usually be considered includes:
- The price per share of the most recent round of equity investments
- The expected timing of the next round of financing
- The history of operating losses and negative cash flow
- Earnings and cash flow outlook and expected cash burn rate
- Technological feasibility of the company’s products
Once a determination is made that an OTTI exists, the investment should be written down to its fair value in accordance with ASC 820
at the reporting date, which establishes a new cost basis. Any bifurcation of declines in value between “temporary” and “other than temporary” is not allowed. Subsequent declines or recoveries after the reporting date are not considered in the impairment recognized. A previously recognized OTTI also cannot subsequently be reversed when fair value is in excess of the carrying amount.
When an investor records an OTTI charge, the investor is required to attribute the impairment charge to the underlying equity method memo accounts of its investment. The attribution may create new basis differences or impact existing basis differences. ASC 323
does not provide guidance on attributing the amount of an OTTI charge to the investor’s equity method memo accounts. We believe there are several acceptable methods to attribute the charge; however, the method applied should be reasonable given the nature of the OTTI charge. Two acceptable methods include the specific identification method and the fair value method. Under the specific identification method, the investor would create a new basis difference or adjust an existing one for the specific items (e.g., litigation) that resulted in the OTTI charge and eliminate related AOCI balances, if any. Under the fair value method, the investor would reset all its basis difference, including those related to AOCI balances, as if the investor had acquired the investment on the date of recording the OTTI charge. See Example EM 3-13 for more discussion of allocating the cost basis to assets, liabilities, and AOCI.
Example EM 4-9 illustrates the adjustment of an existing basis difference under the specific identification method.
EXAMPLE EM 4-9
Subsequent accounting for negative basis differences created by an impairment charge
In 20X1, Investor acquired a 40% investment in Investee (a public company) for $25 million. At the date of the acquisition, the book value of the net assets of Investee totaled $50 million and the fair value of the net assets totaled $62.5 million. The assets held by Investee consisted primarily of net current assets with a carrying value and fair value of $30 million and long-lived assets with remaining useful lives of 10 years, a carrying value of $20 million, and a fair value of $32.5 million. As a result, the carrying value of Investor’s proportionate interest in the net assets of Investee was $20 million. The $5 million basis difference was attributed entirely to fixed assets.
Five years later (i.e., in year 20X6), Investee lost the contract of a significant customer and experienced some production issues. No impairment charge was recorded within Investee’s financial statements (impairment was tested under the long-lived asset impairment model using the undiscounted future cash flows, which were in excess of the book value of the assets). However, the market price per share of Investee declined below Investor’s investment balance per share, representing a potential impairment of $5 million. Based on all available information, Investor concluded that the decline in value of Investee’s market price per share was other than temporary. For simplicity, all tax implications are ignored.
How should Investor subsequently account for negative basis differences created by an impairment charge?
Assuming Investor determines that the decline in value of $5 million is other than temporary, Investor would record an impairment charge of $5 million against the investment in Investee.
Given the nature of Investee’s operations and asset base (principally working capital and fixed assets), this loss could be considered attributable to Investee’s fixed assets. As a result, the impairment charge would eliminate the remaining fixed asset basis difference of $2.5 million ($5.0 million × 5/10 years amortized), and create an additional $2.5 million negative basis difference.
The negative basis difference would be amortized over the remaining asset lives. Investor would need to determine the appropriate amortization period. While there are 5 years remaining of the original 10-year useful life determined at the date of the initial investment, the estimated remaining lives of Investee’s fixed assets at the date of impairment should be considered in determining the appropriate amortization period. For this example, we have assumed 5 years.
Investee’s net income would include $2,000,000 of depreciation expense ($20,000,000 [investee’s carrying value of its fixed assets]/10 years [estimated useful life]), which reflects the carrying value of the fixed assets as reported in Investee’s financial statements. Investor would recognize its proportionate share of Investee’s net income; however, Investor should also amortize $500,000 ($2.5 million/5 years) of the negative basis difference as an increase (credit) to equity method earnings in order to reflect Investor’s lower cost basis in Investee’s fixed assets, which results in lower annual depreciation expense.