by The fair value option is the alternative for a business to record its financial instruments at their fair values. GAAP allows this treatment for the following items:
- A financial asset or financial liability
- A firm commitment that only involves financial instruments
- A loan commitment
- An insurance contract where the insurer can pay a third party to provide goods or services in settlement, and where the contract is not a financial instrument (i.e., requires payment in goods or services)
- A warranty in which the warrantor can pay a third party to provide goods or services in settlement, and where the contract is not a financial instrument (i.e., requires payment in goods or services)
The fair value option cannot be applied to the following items:
- An investment in a subsidiary or variable interest entity that will be consolidated.
- Deposit liabilities of depository institutions.
- Financial assets or financial leases recognized under lease arrangements.
- Financial instruments classified as an element of shareholders’ equity.
- Obligations or assets related to pension plans, post-employment benefits, stock option plans, and other types of deferred compensation.
When you elect to measure an item at its fair value, do so on an instrument-by-instrument basis. Once you elect to follow the fair value option for an instrument, the change in reporting is irrevocable. The fair value election can be made on either of the following dates:
- The election date, which can be when an item is first recognized, when there is a firm commitment, when qualification for specialized accounting treatment ceases, or there is a change in the accounting treatment for an investment in another entity.
- In accordance with a company policy for certain types of eligible items.
- It is acceptable not to apply the fair value option to eligible items when reporting the results of a subsidiary of consolidated variable interest entity, but to apply the fair value option to these items when reporting consolidated financial statements.
- It is much easier to apply the fair value option for both subsidiary-level and consolidated financial results, so do not attempt separate treatment, even though it is allowed by GAAP.
- In most cases, it is acceptable to choose the fair value option for an eligible item, while not electing to use it for other items that are essentially identical.
- If you take the fair value option, report unrealized gains and losses on the elected items at each subsequent reporting date.
Fair value is a term with several meanings in the financial world. In investing, it refers to an asset’s sale price agreed upon by a willing buyer and seller, assuming both parties are knowledgeable and enter the transaction freely. For example, securities have a fair value that’s determined by a market where they are traded. In accounting, fair value represents the estimated worth of various assets and liabilities that must be listed on a company’s books.
Fair Value and Financial Statements
The International Accounting Standards Board defines fair value as the price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on a certain date, typically for use on financial statements over time. The fair value of all a company’s assets and liabilities must be listed on the books in a mark-to-market valuation. The original cost is used to value assets in most cases.
In some cases, it may be difficult to determine a fair value for an asset if there is not an active market for it. This is often an issue when accountants perform a company valuation. Say, for example, an accountant cannot determine a fair value for an unusual piece of equipment. The accountant may use the discounted cash flows generated by the asset to determine a fair value. In this case, the accountant uses the cash outflow to purchase the equipment and the cash inflows generated by using the equipment over its useful life. The value of the discounted cash flows is the fair value of the asset.
Consequently, the Board considered amending IAS 39 so that the fair value option could be applied only in specified circumstances. The specified circumstances would be those that the Board had in mind when it developed the option, i.e. for a financial asset or financial liability that is reliably measurable and meets one of the following:
- The item is a financial asset or financial liability that contains one or more embedded derivatives as described in paragraph 10 of IAS 39
- The item is a financial liability whose amount is contractually linked to the performance of assets that are measured at fair value
- The exposure to a change in the fair value of the financial asset or financial liability is substantially offset by the exposure to the change in the fair value of another financial asset or financial liability, including a derivative.
