You have been hired as a consultant for ABC Investment Group. ABC incorporated i

Question

You have been hired as a consultant for ABC Investment Group. ABC incorporated in 1999 and manages investment portfolios for small to medium size companies. The Director of the company is not up to speed on how unrealized gains and losses as well as realized gains and losses on bonds should be accounted for. The Director has been told that under certain conditions unrealized gains and losses can be accounted for in the income statement and accounted for as part of other comprehensive income under other conditions. The Director is also unclear as to how to determine whether a security is impaired and how to determine the amount that is required to be written down. You have been asked to look into these issues and determine the proper accounting treatment for bonds

Gather data from multiple sources and present that data in one to two pages (12-point font, double-spaced). Be sure to document your sources.

Explanation / Answer

In accounting, there is a difference between realized and unrealized gains and losses. Realized income or losses refer to profits or losses from completed transactions. Unrealized profit or losses refer to profits or losses that have occurred on paper, but the relevant transactions have not been completed. An unrealized gain or loss is also called a paper profit or paper loss, because it is recorded on paper but has not actually been realized.

Record realized income or losses on the income statement. These represent gains and losses from transactions both completed and recognized. Unrealized income or losses are recorded in an account called accumulated other comprehensive income, which is found in the owner’s equity section of the balance sheet. These represent gains and losses from changes in the value of assets or liabilities that have not yet been settled and recognized.:

Source with Examples: https://strategiccfo.com/realized-and-unrealized-gains-and-losses/

2. To determine whether a security is impaired and the amount that is required to be written down

Calculating Impairment Loss

The first step is to identify the factors that lead to the asset's impairment. Some factors may include changes in market conditions, new legislation or regulatory enforcement, turnover in the workforce or decreased asset functionality due to aging. In some circumstances, the asset itself may be functioning as well as ever, but new technology or new techniques may cause the fair market value of the asset to drop significantly.

Fair market calculation is key; asset impairment cannot be recognized without a good approximation of fair market value. Fair market value is the price the asset would fetch if it was sold on the market. This is sometimes described as the future cash flow the asset would expect to generate in continued business operations. Another term for this value is "recoverable amount." Once the fair market value is assigned, it is then compared to the carrying value of the asset as represented on the business' financial statements. Carrying value does not need to be recalculated at this time since it exists in previous accounting records. If the calculated costs of holding the asset exceed the calculated fair market value, the asset is considered to be impaired. If the asset in question is going to be disposed of, the costs associated with the disposal must be added back into the net of the future net value less the carrying value.

Impairment losses are either recognized through the cost model or the revaluation model, depending on whether the debited amount was changed through the new, adjusted fair market valuation described above. Even when impairment results in a small tax benefit for the company, the realization of impairment is bad for the company as a whole. It usually represents the need for an increased reinvestment.

PROCESS FOR ASSESSING I MPAIRMENT
Two accounting models are used to assess impairment on securities, and until recently, they were very distinct. One model is defined in Emerging Issues Task Force Issue no. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets, and applies to credit-sensitive mortgage and other asset-backed securities and certain prepayment-sensitive securities. For all other securities, except investments accounted for under the “equity” method, entities follow the approach in paragraph 16 of Statement no. 115 that is further explained in FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.

THE FASB 115 MODEL
FAS 115 and its amendments provide a three-step process for determining whether impairment should be considered other than temporary.

1. Determine whether the investment is impaired. An investment is impaired if its fair value is less than its amortized cost basis (book value). The cost basis of an investment includes adjustments made for accretion, amortization, other impairments and hedging. Entities should make this assessment at the individual security level each reporting period. (FSP FAS 115-1 also discusses how to assess impairment on “cost method investments.” The steps for assessing impairment are essentially the same as for marketable equity securities and debt instruments, but because the fair value of cost method investments may not be readily available, FSP FAS 115-1 describes a different approach for obtaining fair value and the related disclosures.)

2. Evaluate whether the impairment is other than temporary. Entities must evaluate impairment based on specific factors including the nature and extent of the decrease in fair value of the security below cost. This is a subjective assessment that is discussed in more detail below.

3. If the impairment is other than temporary, recognize an impairment loss equal to the difference between the investment’s cost and its fair value.The amount of the write-down is the difference between amortized cost and the fair value of the investment on the balance sheet date. When impairment is recognized, the fair value of the impaired security becomes the new cost basis of the investment, and subsequent recoveries in fair value are not recognized in earnings until the security is sold or matures.

THE REVISED EITF 99-20 MODEL
The previous EITF 99-20 model was more stringent than the Statement no. 115 model because it was triggered by any adverse change in the estimated timing or amount of cash flows that “market participants” would use as opposed to the more subjective assessment of whether impairment is other than temporary. The application of this model resulted in outcomes that some practitioners considered inappropriate because it did not permit management to consider the probability that all previously projected cash flows would be collected. For example, recently, there has not been an active market for CDOs and certain other structured mortgage securities. While most cash flow models indicate there have been adverse changes in the projected cash flows of these securities, the present value of those cash flows may be significantly higher than the observed fair value of the security in an illiquid market. In these situations, some practitioners believe that application of the EITF 99-20 model resulted in recognition of an impairment loss that would not have been required for similar securities under the FAS 115 approach.

Sources: https://www.investopedia.com/ask/answers/101314/how-impairment-loss-calculated.asp

https://www.journalofaccountancy.com/issues/2009/mar/weatheringotti.html

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