ASC 825-10: The Fair Value Option for Financial Instruments

The Financial Accounting Standards Board’s (FASB) guidance, Accounting Standards Codification (ASC) 825-10, provides companies with the “fair value option.” This allows a company to choose to measure certain financial assets and liabilities at their current market value, or fair value. The purpose of this standard is to enhance financial reporting by giving companies a tool to reduce the earnings volatility that can occur when related assets and liabilities are measured using different accounting methods.

This option provides a more consistent measurement approach, which can lead to financial statements that better reflect the economic nature of a company’s transactions. By aligning the measurement of related items, the reported earnings are less likely to be skewed by accounting mismatches.

The Fair Value Option Explained

The fair value option allows a company to report certain financial instruments at the price they would receive to sell an asset or pay to transfer a liability in an orderly market transaction. When a company chooses this option for an instrument, any subsequent changes in its fair value are recorded as unrealized gains or losses on the income statement. This provides a real-time reflection of the instrument’s market performance in the company’s earnings.

The option’s application is best understood through the problem it solves: accounting mismatches. For instance, a company might hold a loan asset accounted for at its original cost, while using a derivative to hedge against interest rate risk on that loan. Under standard accounting, the derivative is measured at fair value with changes hitting the income statement, but the loan is not. This creates a scenario where the income statement shows volatility from the derivative but not the corresponding change in the value of the loan it is hedging.

By electing the fair value option for the loan, the company can also measure it at fair value, with changes reported in earnings. This aligns the accounting for both the loan and the derivative, resulting in a net effect on the income statement that more accurately represents the outcome of the hedging strategy.

Eligible Financial Instruments

The guidance is specific about which financial instruments are eligible for the fair value option and which are not. This distinction determines the scope of its application and helps companies identify which assets and liabilities can be measured at fair value by choice.

Eligible Items

A broad range of financial instruments is eligible for the fair value option, including most recognized financial assets and liabilities like investments in debt and equity securities. A company can elect the option for a single bond it holds as an investment or a note payable it has issued. The option also extends to items not yet recognized on the balance sheet, like a firm commitment to purchase a financial instrument or a written loan commitment.

Ineligible Items

The standard excludes several types of financial instruments from the fair value option, often where other specific accounting guidance takes precedence. Ineligible items include:

• An investment in a subsidiary that the parent company is required to consolidate.
• Obligations or assets related to employee benefit plans, such as pensions or other postretirement benefits.
• Financial assets and liabilities related to leasing arrangements.
• Demand deposit liabilities of financial institutions like banks and credit unions.
• Financial instruments that are classified by the issuer as a component of shareholders’ equity.

Making the Fair Value Election

The process of electing the fair value option is governed by strict rules regarding timing and application. These rules ensure the option is used consistently and not to manipulate earnings. The decision to elect the fair value option carries long-term implications for how an instrument is reported.

The election to use the fair value option must be made on a specific date, which is when the financial instrument is first recognized. Other events can trigger an election date, such as when an investment becomes subject to equity method accounting or in certain business combinations. A company cannot wait to see how an instrument performs before deciding to apply the option; the decision must be made at the outset.

An aspect of this election is its irrevocability. Once a company chooses to apply the fair value option to an instrument, that decision cannot be reversed in a later period. This permanence ensures the accounting method for an instrument remains consistent throughout its life, providing comparability for financial statement users.

The fair value option is applied on an instrument-by-instrument basis. This provides flexibility, as a company can elect the option for one specific bond in its portfolio while continuing to account for other identical bonds at historical cost. This granular approach allows a company to target the accounting mismatch problem precisely where it exists.

Financial Statement Presentation and Disclosure

Once the fair value election is made, specific requirements dictate how these instruments are presented in financial statements and disclosed in footnotes. These rules are designed to provide transparency to investors, allowing them to understand the impact of the fair value option on the company’s financial position and performance.

Presentation

On the balance sheet, assets and liabilities measured at fair value under this option must be displayed separately from similar items measured using other methods. This can be done by presenting them on separate lines or by clear identification in the footnotes. The unrealized gains and losses from changes in the instrument’s fair value are reported in the earnings section of the income statement. For financial liabilities, the portion of the change in fair value attributable to a change in the company’s own credit risk must be presented separately in other comprehensive income (OCI).

Disclosure

The disclosure requirements are extensive and aim to provide users with a clear understanding of the company’s choices. Companies must disclose:

• The reasons for making the election for each instrument.
• The amounts of gains and losses from fair value changes that are included in earnings for the period, and the line item on the income statement where they are reported.
• For liabilities, the difference between the instrument’s fair value and its contractual principal amount.
• Information about how fair values were determined, classifying the inputs into the three-level hierarchy defined in ASC 820: Level 1 (quoted prices), Level 2 (observable inputs), and Level 3 (unobservable inputs).
• For annual reports, the methods and significant assumptions used to estimate the fair values of these instruments.