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Other-Than-Temporary Impairment: Identifying the Amount of Credit Loss
The preparation of OTTI in the now recovering global economy is a matter of concern because of its direct impact on capital. The write-down on OTTI directly affects the credit risk profile of institutions and particularly, their cost of financing or their ability to secure financing. The new rules instituted in 2009 not only determine if a security has OTTI, but also regulate how to calculate it and on what portions of credit-loss or earnings to calculate it from (Rees & Ruta, 2010). These have made the management of OTTI a little more specific for financial institutions, depending on the value of the security, as affected by various economic entities such as interest rates and Forex rates.
Although the new guidelines have translated to higher capital levels and increased levels of reported earnings, they have caused the process to be more complicated because of the various criteria for determining if a security is liable for OTTI. Specifically, there are two methods for doing these calculations; one is specific to debt securities that are considered to be of beneficial interest, while the other is for all other debt securities. The interesting thing with these calculations is that they often yield the same OTTI result, but in some cases could yield different results. This means that the OTTI amount needs to be separated into factors that directly affect credit loss, because the amount then will be calculated under earnings, and other factors affecting OTTI, which will be calculated under OCI.
In order to get these calculations in order, the entity reporting OTTI needs to evaluate the terms of payment of the impaired security thoroughly, in order to make accurate estimations on the amount that the security will generate otherwise, the impairment test will not yield reliable results. The process of determining the fair value on a security is also detailed and requires careful scrutiny. Determining an appropriate rate of discount on securities is also not very clear as there is no set discount rate. This translates to inconsistent results that do not always reflect market economics. Split-rate and floating rate securities are even more complicated to determine when calculating for discount rates. Although using multiple discount rates at different stages of calculation makes a lot more sense than applying a single discount rate, securities are likely to result in OTTI when calculated under the discounted cash flow test because the results of calculating on a single discount rate yield awkward results.
Other complications arising are that a security may qualify for impairment based on the test, but not be categorised as such, based on the variances in market rates at the time the security was issued compared to the time that it was being reviewed for OTTI. Another scenario would be the return on the principal of the security may not be anticipated, but when reviewed through the test, still does not qualify for impairment. The reverse could also be true where the return on the principal is expected, but at a much later date. This translates to the security earning interest over that period making the declaration of impairment debatable.
In conclusion, although the revised system for calculating impairment has taken into consideration various market factors, the process is much more detailed and not clear at every stage. Consequently, reporting entities need to be cautious by beginning the process early; having complete and clear documentation at every step (where this is not possible, then whatever accounting policy that is in effect by the reporting entity should be clearly outlined and followed consistently) and consultation with experts to provide the advice and guidance required to ensure that there are no missteps in this arduous process.
Ress, T., & Ruta, D. (2010). Other-Than-Temporary Impairment: Identifying the Amount of Credit Loss. Journal of Banking and Finance , 1 -9