Financial Reporting Alert 09-1: Impact of Credit Downgrades on the OTTI Analysis of Perpetual Preferred Securities
February 18, 2009
Entities may evaluate investments in certain perpetual preferred securities (PPSs) for other-than-temporary-impairment (OTTI) by applying a model similar to the impairment model applied to debt securities because the PPSs are considered “debt-like.” Recently, a number of PPSs have experienced credit rating downgrades to below investment grade, which may result in these securities no longer continuing to be considered debt-like. Accordingly, these securities may now be required to be analyzed for OTTI under an impairment model similar to that applied to equity securities.
As discussed in Financial Reporting Alert 08-16, SEC Issues Letter Clarifying Other-Than-Temporary Impairment Guidance for Perpetual Preferred Securities , Conrad Hewitt, then chief accountant of the SEC's Office of the Chief Accountant (OCA), sent a letter regarding the OTTI assessment of PPSs to FASB Chairman Robert Herz. Mr. Hewitt acknowledged that although PPSs are structured like equity securities, they often possess significant "debt-like" characteristics, including (1) periodic dividends (e.g., recurring fixed dividend payments or dividend payments that are indexed to market interest rates), (2) call features (e.g., those that allow the issuer of the PPS to redeem the security at par), (3) credit ratings similar to those of debt securities, and (4) pricing similar to that of long-term callable bonds. The letter further states that a PPS has debt-like characteristics when there has been no evidence of deterioration in credit of the issuer (e.g., a decline in the cash flows from holding the investment or a reduction in the rating of the security to below investment grade).
Mr. Hewitt stated in his letter that when PPSs possess characteristics similar to those of debt securities, the OCA will not object to registrants’ applying an OTTI model similar to the impairment model applied to debt securities. In these situations, there is no limit to the forecasted recovery period an entity can use in its analysis as long as the entity has the intent and ability to hold the PPS indefinitely.
Impact of a Credit Downgrade on the OTTI Analysis
On the basis of informal discussions with the SEC staff, we understand that a downgrading of a PPS below investment grade may call into question whether the PPS has “debt-like” characteristics. Consequently, an entity may not be able to use the OTTI model applicable to debt securities when analyzing the investment for impairment. Instead, it would evaluate the PPS for OTTI as an equity security.
An entity holding a PPS should apply professional judgment in determining whether a credit downgrade below investment grade affects the impairment model to be used in the impairment analysis. This includes assessing whether, under the entity’s current policies or practices, the downgraded PPS continues to be considered debt-like. The entity will need to consider various factors, including the number of rating agencies that have downgraded the security below investment grade, the security’s rating in the noninvestment grade category, and other factors related to the financial condition of the issuer.
Under the OTTI model for equity securities, an entity can avoid recognizing an OTTI only if it has the intent and ability to hold the security until an anticipated recovery (which cannot exceed a reasonable period). The SEC noted in its Current Accounting and Disclosure Issues in the Division of Corporation Finance (as updated in December 2005) that “[s]ince the typical equity security does not have a contractual cash flow at maturity on which to rely, an investor's intent and ability to hold an equity security for a reasonable period of time should be analyzed differently than a typical debt security. The ability to hold an equity security indefinitely would not, by itself, allow an investor to avoid an [OTTI].”
Given the differences in the impairment models for debt and equity securities, an entity that previously determined that an OTTI did not exist under a debt model may conclude that an OTTI exists under an equity model.
Subsequent Events Analysis
If the credit downgrade of the PPS occurred after the balance sheet date, but before the issuance of the financial statements, entities also will need to exercise professional judgment in determining whether the credit downgrade is considered a Type I or Type II subsequent event. That is, entities will need to determine whether the credit downgrade was based on circumstances and events that (1) existed as of the balance sheet date or (2) occurred after the balance sheet date.
For example, the downgrading of a security’s credit rating after the balance sheet date in response to circumstances and events that existed at the balance sheet date may indicate a Type I subsequent event. The entity’s OTTI assessment at the balance sheet date may need to be adjusted for the effects of the change in the credit rating. If the downgrade is determined to be a Type I subsequent event that gives rise to an OTTI as of the balance sheet date, the amount of the OTTI is based on the fair value of the security as of the balance sheet date. In contrast, a credit downgrade that results from identifiable circumstances and events that occurred after the balance sheet date and caused the facts or conditions to change significantly from those that existed at the balance sheet date may indicate a Type II subsequent event. Accordingly, the entity’s OTTI assessment at the balance sheet date would not be adjusted for the effects of the change in the credit rating.
A careful analysis of the facts and circumstances is required to determine whether the change in a PPS’s credit rating affects the entity’s OTTI assessment and whether it represents a Type I or Type II subsequent event. It is recommended that entities carefully consider the factors the rating agency considered in determining the credit rating of the PPS. This information may be found in the reports issued by rating agencies regarding such downgrades.