Question

According to GAAP, companies can elect the fair value option when accounting for many investments.

Describe how accounting for a held-to-maturity investment, an available-for-sale investment, and an equity-method investment is affected by a company electing the fair value option.

Answer 1

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 or 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.

An entity may elect the fair value option for eligible items that exist at the date of adoption and report the difference between the carrying value and fair value as a cumulative-effect adjustment to the opening balance of retained earnings.

Under the fair value method, you book as income unrealized gains and losses to shares you plan to trade within a year. If you classify the shares as available-for-sale -- meaning you will probably hold them for at least a year -- you can instead choose to book unrealized gains and losses to “other comprehensive income,” a portion of owner’s equity. In all cases, you update the book value of the investment to reflect the fair value and record any dividends you receive on your investment as income.

Upon initial recognition it is designated by the entity as at fair value through profit or loss. An entity may use this designation only when permitted by paragraph 11A, or when doing so results in more relevant information, because either

1. it eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as ‘an accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases; or

2. a group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel (as defined in IAS 24 Related party Disclosures (as revised in 2003)), for example the entity’s board of directors and chief executive officer.

The fair value option established by this Statement permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings (or another performance indicator if the business entity does not report earnings) at each subsequent reporting date. A not-for-profit organization shall report unrealized gains and losses in its statement of activities or similar statement.

The fair value option:

1. May be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method

2. Is irrevocable (unless a new election date occurs)

3. Is applied only to entire instruments and not to portions of instruments.