Financial Reporting Alert 08-2: Auction Rate Securities Warrant Scrutiny for Impairment
January 10, 2008
Many issuances of auction rate securities (ARS) 1 have been adversely affected by the turmoil in the credit markets; thus, their current fair value is at a discount, sometimes substantial, from par value. These securities, among the most popular investments for excess cash, are widely found in portfolios of commercial enterprises, insurance and finance companies, pension and other benefit plans, endowment funds, not-for-profit enterprises, etc. This Financial Reporting Alert reminds auditors and preparers about the importance of determining appropriate current balance sheet fair values for these popular investments and, when the investments are classified as held-for-maturity or available-for-sale, of the need to evaluate for other-than-temporary impairments. 2
Auction rate securities (ARS) are distinct from other, more traditional securities. ARS generally have long-term stated maturities; the issuer is not required to redeem the security until 20 to 30 years after issuance. However, for the investor, these securities have certain economic characteristics of short-term investments because of their rate-setting mechanism. The return on these securities is designed to track short-term interest rates through a "Dutch" auction process, which resets the coupon rate (or dividend rate).
The auction process gives an investor three options as of each re-marketing date: (1) hold its ARS “at market” without participating in the auction process; (2) hold its ARS “at rate,” allowing the investor to participate in the auction process; or (3) tender its ARS, allowing the investor to sell its securities into the auction process provided that the auction does not fail. Existing investors that choose to hold their ARS “at rate” and potential new investors enter into a "blind" competitive-bid process in which they specify the lowest interest/dividend rate and quantity they are willing to accept. The lowest rate at which all of the securities can be placed (including to investors that choose the “at market” option) becomes the interest/dividend rate for these securities until the next auction date.
A failed auction may occur if there is not sufficient demand for the ARS to allow existing ARS investors to liquidate their holdings in the auction process. 1 For example, if there is a lack of demand for an ARS issuance and no rate is established in the auction process that would clear the entire issue, a failed auction would occur and current investors would be forced to continue holding their positions (generally, investors in a failed auction will receive a maximum predetermined interest rate from the issuer unless and until sufficient bids are received by the next auction date). In typical ARS issuances, investors cannot require the issuer to redeem the securities resulting from a failed auction.
An investor may sell its ARS into the secondary market. However, when an auction has failed, the secondary market for the ARS may be inactive or nonexistent and the fair value of the ARS may be less than par. Depending on market conditions and the underlying collateral of the ARS, the discount from par may be significant.
1 This may be the case for more complex ARS issued by trusts in which the underlying collateral of the trust is made up of asset-backed securities, including securities backed by sub prime mortgage loans. Given the complexity of many ARS and the credit profile and other risks associated with the underlying collateral, the potential exists for a failed auction.
Current Market Conditions and Other-Than-Temporary Impairment Considerations
While many sectors of the credit markets are experiencing distress, ARS deserve particular attention. The following are important considerations for auditors and preparers when evaluating ARS for other-than-temporary impairment.
- ARS are a common investment product used by many organizations in their cash management and treasury strategies. Preparers and auditors must carefully evaluate all investment products to ensure ARS are appropriately identified and analyzed. Note that because many entities assumed that these securities were economically equivalent to cash (even if they are not the accounting equivalent of cash), investments may not be on the “radar screen” as companies consider their loss exposures in the current environment.
- Similarly, entities might not appreciate the potential for significant declines in value and may not have prepared a rigorous analysis supporting an explicit or implicit conclusion that the securities are not other-than-temporarily impaired.
- Q&A FASB 95: 8-1 originally was added to the Accounting Manual in early 2005 to address whether ARS may be considered cash equivalents. Although failed auctions were rare at that time, many have failed recently because of investors’ avoidance of structured products and complex instruments. A failed auction is a strong indicator of a credit deterioration in the issuer or the underlying assets of ARS. An investor must consider whether an actual credit loss will be sustained. If it is probable that the investor will not collect all amounts due, an other-than-temporary impairment has occurred. However, other-than-temporary impairments may exist in the absence of a probable credit loss.
- Regardless of whether actual credit loss will be sustained, the severity of a decline in value, in and of itself, is an important factor in evaluating whether a security is other-than-temporarily impaired. In some ARS issuances, the current fair value represents a substantial discount from par (e.g., 40 cents on the dollar).
- A conclusion that a security is not impaired often requires an entity to determine that the instrument will not be sold during a holding or recovery period. Holders should remember that these instruments typically have long maturities. Provided that the auction process for a particular issue has not already failed, investors should not necessarily assume that future auctions will allow them to “cash out” in the short term.
- Current fair value is the appropriate measure of impairment even if the investor is convinced that the market is undervaluing the instrument. Note that all nontrading securities whose fair value is less than amortized cost should be evaluated for other-than-temporary impairments, even if the investor concludes that full repayment is likely or that decreases in fair value are attributable solely to interest rates. If a security is determined to be other-than-temporarily impaired, the cost basis of the security must be written down to fair value, regardless of whether the investor expects to recover principal and interest that are in excess of fair value.
- Because the terms of ARS are complex, investors must carefully evaluate them when determining fair value. In more complex ARS issuances, the security is backed by other structured products. To fully understand the severity of a credit deterioration and to determine the fair value of the security, an investor may need to perform a full analysis of the underlying collateral and cash flows.
- Investors should be mindful of the guidance on, and disclosure requirements for, other-than-temporary impairments in Statement 115, 5 FSP FAS 115/124-1, 6 SAS 92, 7 and SAB Topic 5.M 8 (not-for-profit organizations should consider footnote 3(a) of Statement 124 9).
Investors that have not adopted Statement 157 10 should consider the Center of Audit Quality (CAQ) white paper Fair Value Measurement in Illiquid (or Less Liquid) Markets. (For more information, see Deloitte & Touche LLP’s September 27, 2007, and October 3, 2007, Financial Reporting Alerts.) 11 In that white paper, the CAQ recommends that entities provide disclosures similar to those required by Statement 157 if fair value measurements are based on significant unobservable inputs.
1 For a more detailed discussion about ARS and the auction process, see "Best Practices for Broker-Dealers of Auction Rate Securities," prepared by the Securities Industry and Financial Markets Association.
2 See Q&A FASB 115: 16-1 through Q&A FASB 115: 16-28 for Deloitte & Touche LLP’s interpretive guidance on evaluating an other-then-temporary impairment.
3 Q&As FASB 95: 8-1 and FASB 115: 16-28 conclude that ARS generally are not cash equivalents under FASB Statement No. 95, Statement of Cash Flows. In January 2008, these Q&As were amended to (1) address balance sheet classification and presentation, (2) update the description of ARS in the background section, and (3) describe the consequences of classifying ARS as current assets on an other-than-temporary impairment evaluation.
4 The Deloitte Accounting Manual is available to all Deloitte professionals and is also available by subscription to Technical Library: The Deloitte Accounting Research Tool.
5 FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.
6 FASB Staff Position No. FAS 115-1/124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.
7 AICPA Statement on Auditing Standards No. 92 (AU Section 332), Auditing Derivative Instruments, Hedging Activities, and Investments in Securities.
8 SEC Staff Accounting Bulletin Topic 5.M, “Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities.”
9 FASB Statement No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations.
10 FASB Statement No. 157, Fair Value Measurements.