20.6 Fair value option

In addition to the standards that require assets and liabilities to be reported at fair value, GAAP provides reporting entities with a fair value option (FVO) to measure certain financial instruments and other items on the balance sheet at fair value.

• ASC 815-15, Derivatives and Hedging—Embedded Derivatives, which provides a FVO for certain hybrid financial instruments that contain an embedded derivative that would otherwise require separation
• ASC 860-50, Transfers and Servicing—Servicing Assets and Liabilities, which permits a reporting entity to choose between the amortization method and the fair value measurement method for each class of separately-recognized servicing assets and servicing liabilities
• ASC 825-10, Financial Instruments—Overall, which provides a measurement basis election for most financial instruments (i.e., a choice of either historical cost or fair value), including equity method investments, allowing reporting entities to mitigate potential mismatches that arise under the current mixed measurement attribute model

Because the FVO is not a requirement, its election may result in reduced comparability of financial reporting, both among similar reporting entities and within a single entity, because similar assets or liabilities could be reported under different measurement attributes (i.e., some at historical cost and some at fair value). However, the disclosure provisions in those topics are intended to mitigate this by requiring (1) identification of instruments for which the option is elected, and (2) extensive information about the effects on the financial statements.

20.6.1 Presentation of FVO

ASC 825-10 permits reporting entities to apply the FVO on an instrument-by-instrument basis. Therefore, a reporting entity can elect the FVO for certain instruments, but not others, within a group of similar instruments (e.g., only a portion of an identical portfolio of corporate securities).

20.6.1.1 Presentation of instruments with FVO versus without FVO

ASC 825-10-45-2 permits reporting entities to present the fair value and non-fair-value amounts (1) aggregated in the same balance sheet line item (parenthetically disclosing the amount measured at fair value included in the aggregate amount), or (2) in two separate line items.

Securities for which the reporting entity elects the FVO are presented in the same category (i.e., trading, available for sale, or held-to-maturity) as other securities required to be measured at fair value with changes in fair value recorded in income. If a reporting entity elects the FVO for one or more investments, it may use terminology such as “securities carried at fair value” in describing these securities, instead of the “trading” terminology in ASC 320.

20.6.1.2 Presentation of changes in fair value under the FVO

ASC 825-10 does not include guidance on geography for items measured at fair value under the FVO, nor does it address how to present dividend income, interest income, or interest expense. However, for instruments within the scope of ASC 320-10, even if measured at fair value under the FVO, there is a prescribed method of calculating interest income that must be applied to those instruments. For all other instruments carried at fair value under the FVO for which GAAP does not prescribe a particular method of interest recognition, we believe a reporting entity may apply one (or some variation) of the following models for reporting interest income and expense, and should disclose its policy for recognition.

• Present the entire change in fair value of the FVO item, including the component related to accrued interest, in a single line item in the income statement.
• Some industries, such as investment companies, are required to show investment income separately, and therefore, can only apply this approach to a certain extent. For others, presenting investment income separately is common industry practice. When determining the amount to separately report as investment income from instruments for which the FVO is elected, if existing US GAAP prescribes a method of calculating interest income for identical instruments not carried at fair value, we believe the same model should be applied to instruments carried at fair value.
• Separate the interest income or expense from the full change in fair value of the FVO item and present that amount in interest income/expense. Present the remainder of the change in fair value in a separate line item in the income statement. Allocation of the change in fair value to interest income/expense should use an appropriate and acceptable method under GAAP.
• Examples of instances when interest income or expense is permitted to be broken out separate from other changes in fair value are: (1) derivatives that have been designated in qualifying hedging relationships, (2) certain investments in debt and equity securities, (3) certain originated or acquired loans (as referenced in ASC 825-10-50-28(e)(2)), and ASC 825-10-50-28(e)(4) certain debt.
• Each presentation reflects the same net change in fair value, but the impact on individual line items in the income statement may differ significantly. When there is no method prescribed by other GAAP, we encourage reporting entities to use the single line presentation because the total change in fair value is a more meaningful number.

20.6.2 Presentation of liabilities when the fair value option is elected

Reporting entities are required to present the portion of the total change in the fair value of financial liabilities for which the fair value option is elected that results from a change in the instrument-specific credit risk separately in OCI.

The separate presentation in OCI is not applicable for financial liabilities of a consolidated collateralized financing entity (CFE) measured using the measurement alternative. Disclosures for CFEs are discussed in FSP 20.6.4.

20.6.3 Disclosure of FVO

FVO disclosures help financial statement readers understand the extent to which the reporting entity uses the FVO, management’s reasons for electing the FVO, and how changes in fair values affect net income for the period.

The disclosures in ASC 825-10-50-28 through ASC 825-10-50-32 are required for instruments measured at fair value under the FVO in ASC 825 and the FVO in ASC 815-15. ASC 825-10-55-6 through ASC 825-10-55-13 includes a sample disclosure that presents one way to integrate FVO disclosure requirements with the fair value standard’s requirements.

ASC 825-10-50-28 requires the following disclosures for instruments for which the fair value option is elected for each annual or interim period in which a balance sheet is presented:

• Management’s reasons for electing the fair value option
• For each balance sheet line item that includes items for which the fair value option has been elected, both:
  • Disclosure of carrying amount and fair value reported in the balance sheet, and information to help users understand how each balance sheet line item relates to major classes of assets and liabilities in the fair value disclosures
  • The aggregate carrying amount of items included in each balance sheet line item that are not eligible for the fair value option, if any

  If the FVO is elected for only some of the eligible items within a group of similar eligible items, ASC 825-10-50-28(b) requires the notes to include a description of those similar items and the reasons for partial election. In addition, the reporting entity should disclose how the group of similar items relates to what is recorded on the balance sheet.

  When a reporting entity has elected the fair value option for loans, long-term receivables, long-term debt, or loans held as assets, ASC 825-10-50-28(d) requires specific disclosures related to these instruments:

  • The difference between the aggregate fair value and the aggregate unpaid principal balance
  • For loans held as assets
    • The aggregate fair value of loans that are 90 days or more past due
    • The aggregate fair value of loans in nonaccrual status (if the entity’s policy is to recognize interest income separate from other changes in fair value)
    • The difference between the aggregate fair value and the aggregate unpaid principal balance for loans that are 90 days or more past due, in nonaccrual status, or both

    ASC 825-10-50-30 requires the following disclosures for instruments for which the fair value option is elected for each annual or interim period in which an income statement is presented:

    • For each balance sheet line item, the amounts of gains and losses from fair value changes included in earnings during the period, and which income statement line item includes those gains and losses
    • A description of how interest and dividends are measured and where they are reported in the income statement
    • For loans and other receivables held as assets, (1) the estimated amount of gains or losses included in earnings during the period attributable to changes in instrument-specific credit risk and (2) how the gains or losses attributable to changes in instrument-specific credit risk were determined

    For annual periods, ASC 825-10-50-31 requires disclosure of the methods and significant assumptions used to estimate the fair value of financial instruments for which the FVO is elected. However, quantitative disclosure of significant unobservable inputs used in measuring the fair value of FVO instruments that are Level 3 (in Figure FSP 20-2) is not required.

    20.6.3.1 Credit risk disclosure when the fair value option is elected

    ASC 825-10-50-30(d) requires disclosure of information about instrument-specific credit risk for financial liabilities for which the FVO is elected. Reporting entities are required to disclose:

    • The change in fair value of the liability that is attributable to instrument-specific credit risk (both during the period and cumulatively)
    • How the gains and losses attributable to changes in instrument-specific credit risk were determined
    • If a liability is settled during the period, any amount previously deferred through OCI that was ultimately recognized in net income at settlement

    20.6.3.2 Disclosures for equity method investments using fair value option

    ASC 825-10-50-28(f) requires reporting entities that have elected to account for certain equity method investments using the fair value option to also disclose certain equity method disclosures, specifically, the requirements of ASC 323-10-50-3, excluding ASC 323-10-50-3(a)(3), ASC 323-10-50-3(b) and ASC 323-10-50-3(d). Disclosure requirements for equity method investments are discussed in FSP 10.

    20.6.4 Disclosures for collateralized financing entities

    Typically, if a reporting entity elects the fair value option, financial assets and financial liabilities of a CFE are measured separately at their fair values. As a result, the aggregate fair value of the financial assets might differ from the aggregate fair value of the financial liabilities. A measurement alternative in ASC 810 allows the reporting entity to measure both using the more observable of the fair value of the financial assets or the fair value of the financial liabilities. This eliminates the measurement difference that may exist when the financial assets and the financial liabilities are measured independently.

    Reporting entities that elect the measurement alternative are required to follow the disclosure requirements in ASC 820 and ASC 825 for the CFE’s financial assets and financial liabilities. As such, reporting entities will have to apply judgment to determine the level in the fair value hierarchy of the less observable financial element.

    We believe a reporting entity needs to evaluate the significance of all of the unobservable inputs (in relation to the total fair value) of the more observable of the financial assets or financial liabilities when determining the appropriate level in the fair value hierarchy in which the less observable of the two would be disclosed.

    For example, if the fair value of the financial liabilities are used to measure the financial assets, and a significant amount of the financial liabilities valuations are considered Level 3, the financial assets (considered one unit of account for measurement purposes) would be disclosed as Level 3. Since identical inputs are not used, the less observable will not be Level 1.