Other-Than-Temporary Impairment (OTTI)

Many debt and equity securities that are accounted for in accordance with FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (FAS 115), have experienced significant and extended declines in fair value due to current economic conditions. Companies should consider whether these declines represent an "other-than-temporary impairment" (OTTI). If they do represent an OTTI, companies will have to recognize any unrealized OTTI losses stemming from such debt and equity securities in earnings.

In FASB Staff Position FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Application to Certain Investments, the FASB staff describes the three steps a company should take in assessing an investment for OTTI and measuring the OTTI loss:

1. Determine whether an investment is impaired,
2. Determine if the impairment is other-than-temporary,
3. Recognize an impairment loss equal to the difference between the investment's cost and its fair value.

An investment is considered impaired when its fair value is less than its cost. A determination of whether such a decline in fair value is other-than-temporary is inherently judgmental, since the positive and negative factors that must be weighed are often subjective.

Some companies use predetermined parameters (e.g., a specified percentage of cost below which an investment's fair value has declined, or a specified duration beyond which the decline in fair value has lasted) as a guide to determine whether certain impairments are other-than-temporary. These predetermined parameters are not, in and of themselves, typically a sufficient basis for concluding whether an OTTI should be recognized. Companies must weigh all relevant evidence when determining whether a security has been other-than-temporarily impaired. Current market conditions may result in a determination that a security has become other-than-temporarily impaired over relatively short periods.

In general, a company must treat an impaired debt security as having an OTTI if it is probable that the company will be unable to collect all amounts due under the contractual terms of the security. Even if the inability to collect is not probable, a company may be required to recognize an OTTI if, for example, management does not have the intent and ability to hold the security until its fair value is recovered. As a result, declines in fair value that are due solely to interest rate changes may result in an OTTI for investments in debt securities.

PwC Observation: Unlike investments in debt securities, equity securities do not have contractual maturities; therefore, the investor cannot recover its investment simply by holding it until some future date. As a result, a forecasted recovery of an equity security is typically more subjective and less persuasive as evidence that no OTTI has occurred than a forecasted recovery of a debt security.

Debt securities that represent beneficial interests in trusts backed by other assets, including mortgage loans, are among the securities that have recently declined in fair value. The impairment process for such securities that are not of "high credit quality" is described by the Emerging Issue Task Force (EITF) in Issue 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets, which requires companies to determine whether there has been an adverse change in expected cash flows by considering the cash flow assumptions that a market participant would use in determining the securities' fair value. If an adverse change has occurred, the impairment would be considered other-than-temporary. As declines in fair value become more severe and take longer to resolve, there must be a greater degree of analysis and objective evidence supporting an assertion that, from a market participant's perspective, there has been no adverse change in cash flows.

PwC Observation: In general, companies should have a consistently applied OTTI policy that does not rely solely on pre-determined parameters in determining if an OTTI occurred. A company's application of its policy (including making significant judgments about the timing of the recognition or non-recognition of an OTTI) should include contemporaneous documentation supporting the conclusions reached. Companies should also have a process for assessing cost and equity method investments for OTTI.

Examples of OTTI Disclosures in Current Report on Form 8-K:
1. Charles Schwab to record Lehman, WaMu-related OTTI charges
2. First State Bancorp. to incur OTTI charge in Q3'08 for Freddie holding

Additional guidance on OTTI may be found in PricewaterhouseCoopers' DataLine 2008-22*, Accounting Considerations Related to Other-Than-Temporary Impairment of Certain Investments in Debt and Equity Securities, and in DataLine 2006-04*, Evaluating Whether Certain Investments Are Other-Than-Temporarily Impaired.
* DataLines are available through PwC's CFOdirect Network (http://cfodirect.pwc.com/CFODirectWeb).