What Is FAS 159: The Fair Value Option?

The Fair Value Option, part of the FASB Accounting Standards Codification (ASC) under Topic 825, allows companies to measure certain financial assets and liabilities at their current market value, or fair value. The primary objective of this option is to simplify accounting and reduce artificial volatility in reported earnings. This volatility often arises when related assets and liabilities are measured using different accounting methods, creating a mismatch in the timing of gain and loss recognition. By permitting a fair value measurement for both, the option aims to present a more faithful economic picture and can reduce the need to apply complex hedge accounting rules.

Eligible Financial Instruments

A company can choose to apply the option to a recognized financial asset or financial liability. This includes items such as investments in debt and equity securities that might otherwise be classified as available-for-sale or held-to-maturity, as well as loans and receivables a company holds. On the liability side, common examples include notes payable and bonds a company has issued.

The standard also extends eligibility to certain firm commitments that involve only financial instruments, such as a forward contract to purchase a loan. Written loan commitments are also eligible for the fair value election. However, some items are explicitly excluded from the fair value election. A company cannot elect the fair value option for the following:

• An investment in a subsidiary or variable interest entity that it is required to consolidate.
• Obligations related to pension plans, other postretirement benefits, and similar arrangements.
• Financial assets and liabilities recognized under leases.
• Deposit liabilities of financial institutions that are withdrawable on demand.
• Any financial instrument classified by the issuer as a component of shareholders’ equity.

Electing the Fair Value Option

The decision to apply the fair value option is governed by rules regarding timing, as the election must be made on a designated election date. The most common election date is when an entity first recognizes the eligible item on its financial statements. Other opportunities include when a company enters into an eligible firm commitment or when an investment’s accounting treatment changes, such as when it no longer qualifies for the equity method.

A defining characteristic of the fair value election is its permanence. Once a company chooses to apply the fair value option to a specific financial instrument, the decision is irrevocable for as long as the company holds that instrument. The company cannot later decide to revert to a different accounting method for that particular item.

The fair value option is applied on an instrument-by-instrument basis. This provides companies with flexibility, as they are not required to apply the election to all similar items. For instance, a company could hold several identical bonds from the same issuer and choose to elect the fair value option for one bond but not for the others.

While the election is flexible, it must be applied to the entire instrument, not just to a portion of it or to specific risks associated with it. For example, a company cannot elect to measure only the interest rate risk component of a loan at fair value. The entity must also properly document its election of the fair value option on the date the choice is made.

Financial Statement Presentation and Disclosure

The most significant impact of electing the fair value option is on the income statement, as changes in the instrument’s fair value from one reporting period to the next are recognized in current earnings. This means that both unrealized gains and losses—value changes on assets still held—are reported as part of the company’s net income for the period. On the balance sheet, the assets and liabilities for which the option has been elected are presented at their fair value.

A specific rule applies to financial liabilities when the fair value option is chosen. For a liability, a change in its fair value can result from changes in market interest rates or from a change in the company’s own credit risk. The portion of the fair value change attributable to the entity’s own credit risk must be reported separately in other comprehensive income (OCI), rather than in net income. This prevents the counterintuitive result of a company reporting a gain in its net income simply because its own creditworthiness has deteriorated.

The standard mandates extensive disclosures in the footnotes to the financial statements to provide transparency. Companies must disclose the following:

• Their reasons for electing the fair value option for certain instruments and not others.
• The fair value amounts for each line item on the balance sheet that contains items measured under the option.
• The methods and significant assumptions used to estimate the fair values.
• Gains and losses recognized in earnings, distinguishing between those related to items still held and those related to items sold or settled.
• The amount of gains and losses recognized in OCI if the “own credit risk” adjustment for liabilities is applicable.