4.4 Debt Subject to the Fair Value Option
4.4.1 Background
ASC 825-10
05-5 The Fair Value Option
Subsections of this Subtopic address both of the
following:
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Circumstances in which entities may choose, at specified election dates, to measure eligible items at fair value (the fair value option)
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Presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities.
Under ASC 825-10, entities can elect the fair value option to
account for certain financial assets and financial liabilities at fair value.
For a comprehensive discussion of this guidance, see Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and
Disclosures (Including the Fair Value Option). The
sections below summarize the fair value option requirements that apply to items
within the scope of this Roadmap.
4.4.2 Scope
ASC 825-10
15-4 All entities may elect
the fair value option for any of the following eligible
items:
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A recognized financial asset and financial liability, except any listed in the following paragraph
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A firm commitment that would otherwise not be recognized at inception and that involves only financial instruments (for example, a forward purchase contract for a loan that is not readily convertible to cash — that commitment involves only financial instruments — a loan and cash — and would not otherwise be recognized because it is not a derivative instrument)
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A written loan commitment . . . .
15-5 No entity may elect the
fair value option for any of the following financial
assets and financial liabilities: . . .
e. Deposit liabilities, withdrawable on demand,
of banks, savings and loan associations, credit
unions, and other similar depository
institutions.
f. Financial instruments that are, in whole or
in part, classified by the issuer as a component
of shareholders’ equity (including temporary
equity).
An entity may elect the fair value option for any eligible item
within the scope of ASC 825-10. Unless a specific scope exception applies, debt
represents an eligible item for which the issuer may elect the fair value
option. Under ASC 825-10-15-4(b), the fair value option is available to a holder
of an unrecognized loan commitment provided that the commitment (1) meets the
definition of a firm commitment (e.g., the terms include a disincentive for
nonperformance that is sufficiently large to make performance probable) and (2)
involves only financial instruments (see Section 2.3.4). A loan commitment does not
meet the definition of a firm commitment if it includes subjective provisions
that permit either party to rescind it (e.g., it permits the potential lender to
rescind its commitment in the event of a material adverse change in the holder’s
financial condition or performance).
The ability to elect the fair value option does not depend on whether (1) its
application serves to mitigate volatility in reported earnings that would
otherwise arise as a result of measuring items on different bases or (2) the
entity manages and monitors performance of an item on a fair value basis. The
ability to elect the fair value option for a debt instrument is also not
predicated on the reliability of the fair value measurement; however, the inputs
used for such measurement must reflect market participant assumptions (including
adjustments that market participants demand for the risk associated with
unobservable inputs or the valuation technique used to determine fair value). In
addition, entities are required to disclose the categorization of fair value
measurements within the fair value hierarchy, including whether significant
inputs to those measurements are observable or unobservable.
The fair value option is not available for financial instruments
that are, in whole or in part, classified by the issuer as a component of
shareholders’ equity (including temporary equity). Thus, the fair value option
cannot be elected for convertible debt issued at a substantial premium to par
for which an equity component has been recognized under ASC 470-20-25-13. An
entity also cannot elect the fair value option for deposit liabilities,
withdrawable on demand, of banks, savings and loan associations, credit unions,
and other similar depository institutions. Instead, such liabilities are
accounted for under ASC 942-405.
4.4.3 Election Dates
ASC 825-10
25-1 This Subtopic permits all
entities to choose, at specified election dates, to
measure eligible items at fair value (the fair value
option).
25-2 The decision about whether
to elect the fair value option:
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Shall be applied instrument by instrument, except as discussed in paragraph 825-10-25-7
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Shall be irrevocable (unless a new election date occurs, as discussed in paragraph 825-10-25-4)
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Shall be applied only to an entire instrument and not to only specified risks, specific cash flows, or portions of that instrument.
An entity may decide whether to elect
the fair value option for each eligible item on its
election date. Alternatively, an entity may elect the
fair value option according to a preexisting policy for
specified types of eligible items.
25-4 An entity may choose to
elect the fair value option for an eligible item only on
the date that one of the following occurs:
a. The entity first recognizes the eligible
item.
b. The entity enters into an eligible firm
commitment. . . .
e. An event that requires an eligible item to
be measured at fair value at the time of the event
but does not require fair value measurement at
each reporting date after that . . . .
25-5 Some of the events that
require remeasurement of eligible items at fair value,
initial recognition of eligible items, or both, and
thereby create an election date for the fair value
option as discussed in paragraph 825-10-25-4(e) are:
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Business combinations, as defined in Subtopic 805-10
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Consolidation or deconsolidation of a subsidiary or VIE
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Significant modifications of debt, as defined in Subtopic 470-50.
An issuer is permitted to elect the fair value option for a debt instrument on
the date on which (1) the debt is first recognized, or (2) an event occurs that
causes the debt to be remeasured at fair value under GAAP at the time of the
event but does not result in a requirement to apply subsequent fair value
measurement (e.g., a business combination). Once an entity elects the fair value
option, it may not revoke fair value accounting unless a new election date
occurs.
The determination of whether a debt modification or exchange
qualifies as a remeasurement event for the borrower depends on whether the debt
is treated as a new debt instrument under ASC 470-50 (see Section 10.4.2). If
modification accounting is applied, the debt is considered to reflect the
continuation of the original contract and a new election date is not available.
If extinguishment accounting applies, the new debt instrument is eligible to be
elected under the fair value option at its initial recognition. If a debt
modification or exchange represents a TDR (see Chapter 11), the debt instrument is not
considered a new instrument and, therefore, a new election date for the fair
value option is not available. For additional discussion of election dates, see
Section 12.3.2
of Deloitte’s Roadmap Fair
Value Measurements and Disclosures (Including the Fair Value
Option).
While ASC 825 provides little guidance on the documentation an entity must
maintain to support its election of the fair value option, it indicates that the
decision to elect the fair value option should be made as of the election date
for each eligible item. Entities also have the flexibility to establish an
automatic election policy for certain eligible items of an identical or similar
nature. In deciding to permit entities to elect the fair value option, the FASB
noted that maintaining evidence of compliance with the election requirements of
ASC 825 is a matter of internal control. In all scenarios, an entity must
support its fair value option election under ASC 825 with appropriate concurrent
documentation that eliminates any question regarding whether the entity elected
to apply fair value measurement to a particular instrument.
4.4.4 Level of Aggregation
ASC 825-10
25-7 The fair value option
may be elected for a single eligible item without
electing it for other identical items with the following
four exceptions:
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If multiple advances are made to one borrower pursuant to a single contract (such as a line of credit or a construction loan) and the individual advances lose their identity and become part of a larger loan balance, the fair value option shall be applied only to the larger balance and not to each advance individually. . . .
25-10 The fair value option
need not be applied to all instruments issued or
acquired in a single transaction (except as required by
paragraph 825-10-25-7). For example, investors in shares
of stock and registered bonds might apply the fair value
option to only some of the shares or bonds issued or
acquired in a single transaction. For this purpose, an
individual bond is considered to be the minimum
denomination of that debt security.
25-11 A financial instrument
that is legally a single contract may not be separated
into parts for purposes of applying the fair value
option. In contrast, a loan syndication arrangement may
result in multiple loans to the same borrower by
different lenders. Each of those loans is a separate
instrument, and the fair value option may be elected for
some of those loans but not others.
Generally, an entity can elect the fair value option on an
instrument-by-instrument basis. Thus, an entity can elect it for a debt
instrument without doing so for other separate but identical debt instruments if
they represent separate units of account (see Section
3.3). Further, ASC 825-10-25-10 specifies that an entity might
elect the fair value option for only some of the bonds issued in a single
transaction and that, “[f]or this purpose, an individual bond is considered to
be the minimum denomination of that debt security.”
If a group of lenders jointly fund a loan to a single borrower and each lender
loans a specific amount to the borrower and has the right to demand repayment
from the borrower, the loan from each lender is considered separate and distinct
from the loans from other lenders even if each of the loans forms part of the
same overall loan syndication agreement (see Section
10.3.2.4). Thus, ASC 825-10-25-11 permits election of the fair
value option for each loan in a loan syndication arrangement in which the loans
are made to the same borrower by different lenders.
However, under ASC 825-10-25-11, a “financial instrument that is legally a single
contract may not be separated into parts for purposes of applying the fair value
option.” For example, a debt host contract that remains after the separation of
an embedded financial derivative under ASC 815-15 (e.g., convertible debt with a
bifurcated conversion feature) is not eligible for the fair value option.
Nevertheless, the entire hybrid financial instrument is eligible for the fair
value option provided that no specific exception applies to the instrument.
Example 4-2
Unit of Account for Fair Value Option Election
Purposes — Debt
Entity E enters into, and documents in the same contract,
a debt instrument with a $1 million principal amount and
a warrant on 100,000 shares of common stock with a
single investor. Since the warrant is legally detachable
and separately exercisable, the debt instrument and
warrant individually represent freestanding financial
instruments (i.e., the debt instrument is considered an
individual contract under ASC 825-10-25-11).
Accordingly, E could apply the fair value option to its
liability related to the $1 million debt instrument
provided that it is not subject to any of the fair value
option exceptions in ASC 825-10-15-5. The warrant would
be separately evaluated as a liability or equity
instrument under other applicable U.S. GAAP (e.g., ASC
480, ASC 815, and ASC 815-40).
However, E could not apply the fair value option to only
$500,000 of the $1 million principal amount of debt
because the entire principal amount represents a single
unit of account and ASC 825-10-25-11 prohibits the
election of the fair value option for only a portion of
the amount of an individual bond. If, however, E had
entered into the contract with 10 different investors,
it could individually make the fair value option
election for the $1 million principal amount of the debt
component of each of the 10 different contracts (e.g.,
it could elect the fair value option for the $1 million
debt component related to five investors and not elect
the fair value option for the $1 million debt component
for the other five investors).
An entity that can make multiple debt draws under a single credit facility (e.g.,
a line of credit or tranche debt financing) cannot apply the fair value option
to each draw individually if, as described in ASC 825-10-25-7(a), such draws
“lose their identity and become part of a larger loan balance.”
Example 4-3
Unit of Account for Fair Value Option Election
Purposes — Line of Credit
Entity F has a $5 million line-of-credit agreement with
Bank A. On March 1, 20X7, F draws $500,000 on its line
of credit and chooses not to elect the fair value
option. On April 1, 20X7, F draws another $1 million.
Because the $1 million is added to the $500,000 and
becomes part of the larger balance, the fair value
option may not be elected for the $1 million. When F
chose not to elect the fair value option for the
$500,000, it also chose not to elect the fair value
option for any subsequent draws on that line of credit.
Under ASC 825-10-25-4, that election is irrevocable
unless a new election date occurs.
An entity cannot separately elect the fair value option for the accrued interest
on a debt instrument, nor can it elect the fair value option and exclude the
accrued interest component. (Accrued interest simply represents one or more
future interest cash flows of the debt.) Rather, in accordance with ASC
825-10-25-2(c), the entity must either (1) elect the fair value option for an
interest-bearing financial asset or financial liability that includes any
accrued interest or (2) not elect the fair value option for any component of an
interest-bearing financial asset or financial liability.
Section 3.3.3.3 discusses the unit of
account for a liability issued with an inseparable third-party credit
enhancement.
4.4.5 Initial Measurement
ASC 820-10
30-1 The fair value
measurement framework, which applies at both initial and
subsequent measurement if fair value is required or
permitted by other Topics, is discussed primarily in
Section 820-10-35. This Section sets out additional
guidance specific to applying the framework at initial
measurement.
30-2 When an asset is
acquired or a liability is assumed in an exchange
transaction for that asset or liability, the transaction
price is the price paid to acquire the asset or received
to assume the liability (an entry price). In contrast,
the fair value of the asset or liability is the price
that would be received to sell the asset or paid to
transfer the liability (an exit price). Entities do not
necessarily sell assets at the prices paid to acquire
them. Similarly, entities do not necessarily transfer
liabilities at the prices received to assume them.
30-3 In many cases, the
transaction price will equal the fair value (for
example, that might be the case when on the transaction
date the transaction to buy an asset takes place in the
market in which the asset would be sold). . . .
30-3A When determining
whether fair value at initial recognition equals the
transaction price, a reporting entity shall take into
account factors specific to the transaction and to the
asset or liability. For example, the transaction price
might not represent the fair value of an asset or a
liability at initial recognition if any of the following
conditions exist:
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The transaction is between related parties, although the price in a related party transaction may be used as an input into a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms.
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The transaction takes place under duress or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty.
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The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction (for example, in a business combination), the transaction includes unstated rights and privileges that are measured separately, in accordance with another Topic, or the transaction price includes transaction costs.
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The market in which the transaction takes place is different from the principal market (or most advantageous market). For example, those markets might be different if the reporting entity is a dealer that enters into transactions with customers in the retail market, but the principal (or most advantageous) market for the exit transaction is with other dealers in the dealer market.
30-6 If another Topic
requires or permits a reporting entity to measure an
asset or a liability initially at fair value and the
transaction price differs from fair value, the reporting
entity shall recognize the resulting gain or loss in
earnings unless that Topic specifies otherwise.
35-3 A fair value
measurement assumes that the asset or liability is
exchanged in an orderly transaction between market
participants to sell the asset or transfer the liability
at the measurement date under current market
conditions.
When an entity elects to measure debt (or another eligible item)
under the fair value option, it initially measures it at fair value in
accordance with ASC 820. That guidance stipulates that the fair value represents
an exit price under the assumption that an asset is sold or a liability or
equity instrument is transferred (assumed) in an orderly transaction between
unrelated market participants under current market conditions. In many cases,
the transaction price for an asset, liability, or equity instrument equals its
fair value upon initial recognition. However, in certain situations, it is not
appropriate to assume that the transaction price (which is an entry price) is
the initial fair value (which is an exit price) of an asset, liability, or
equity instrument.
Accordingly, if an issuer elects to measure debt at fair value, it needs to
assess whether the debt proceeds represent the fair value at inception and
consider whether one or more of the factors in ASC 820-10-30-3A are present.
Section 3.3 addresses situations in
which the unit of account for the transaction price of debt differs from the
unit of account for fair value accounting purposes.
In many cases, it is inappropriate to record an inception gain
or loss as of the date of initial recognition. At the 2006 AICPA Conference on
Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow
Joseph McGrath stated the following:
[W]e have heard that some believe that it is “open
season” on inception gains. I would caution those constituents that
there continue to be many instances in which day one gains are not
appropriate. [ASC 820] does not allow the practice of “marking to model”
when the transaction occurs in the entity’s principal market. Rather,
transaction prices would generally be used in such a circumstance, and
the model would be calibrated to match transaction price.
Mr. McGrath’s remarks indicate that if none of the factors in ASC 820-10-30-3A
are present, the transaction price is most likely the best estimate of fair
value. However, if any of the criteria in ASC 820-10-30-3A are met, there may be
a difference between the transaction price and fair value. For example, ASC
820-10-30-3A(c) indicates that the transaction price might not represent fair
value at initial recognition if “the transaction price includes transaction
costs.” That might be the case in a transaction that includes a structuring
fee.
For a discussion of the evaluation of situations in which the fair value exceeds
the debt proceeds received, see Section
3.4.3.1.