6.3 Fair Value Option
6.3.1 Background
ASC 825-10
45-4 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.
45-5 If an entity has
designated a financial liability under the fair value
option in accordance with this Subtopic or Subtopic
815-15 on embedded derivatives, the entity shall measure
the financial liability at fair value with qualifying
changes in fair value recognized in net income. The
entity shall present separately in other comprehensive
income the portion of the total change in the fair value
of the liability that results from a change in the
instrument-specific credit risk. The entity may consider
the portion of the total change in fair value that
excludes the amount resulting from a change in a base
market risk, such as a risk-free rate or a benchmark
interest rate, to be the result of a change in
instrument-specific credit risk. Alternatively, an
entity may use another method that it considers to
faithfully represent the portion of the total change in
fair value resulting from a change in
instrument-specific credit risk. The entity shall apply
the method consistently to each financial liability from
period to period.
As discussed in Section 4.4, entities can elect a fair
value option to account for certain financial assets and financial liabilities
at fair value. ASC 825-10-45-4 states that the changes in fair value of an item
for which the fair value option is elected should be recognized in net income
(or another performance indicator if an entity does not report net income).
However, this does not apply to the recognition of all of the change in the fair
value of a financial liability for which the fair value option has been elected.
The change must be presented in other comprehensive income (OCI) to the extent
that it is attributable to instrument-specific credit risk (see the next
section). The remaining portion of the change in fair value is recognized in net
income. Upon derecognition of the financial liability, any amounts accumulated
in OCI are recognized in net income (see Section 9.3.2). Special considerations are
necessary if an entity is required or elects to separately present interest
expense on debt for which it has elected the fair value option (see Section 6.3.3).
6.3.2 Presentation Guidance for Instrument-Specific Credit Risk
6.3.2.1 Measuring Instrument-Specific Credit Risk
The change in fair value attributable to a financial liability for which the
fair value option is elected must be presented in OCI to the extent that it
is attributable to instrument-specific credit risk. The change in fair value
attributable to instrument-specific credit risk represents the component of
the change in fair value of the financial instrument attributable to changes
in the specific credit risk of that instrument (e.g., changes in “credit
spread” associated with the instrument). As noted in ASC 825-10-45-5, one
acceptable method of isolating the change attributable to
instrument-specific credit risk is to calculate (1) the hypothetical change
in fair value of the instrument during the period that is attributable to
changes in the risk-free or benchmark rate and (2) the difference between
that amount and the total change in fair value. (This method of computing
the component of the total change in fair value that is attributable to
instrument-specific credit risk is illustrated in paragraphs B5.7.18 and
IE1–IE5 of IFRS 9.)
Alternatively, an entity may use another method that it considers to
faithfully represent the portion of the total change in fair value resulting
from a change in instrument-specific credit risk. However, the entity must
apply that method consistently to each financial instrument from period to
period.
Example 6-18
Calculation of Instrument-Specific Credit
Risk
On January 1, 20X8, Company A issues an
uncollateralized five-year bond with a par value and
fair value of $500 million and an interest rate of 8
percent and elects to record the bond at fair value
in accordance with ASC 825.
Assume the following:
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Interest is paid annually; the bond has a bullet maturity.
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The federal funds rate, a benchmark rate, was 5 percent on January 1, 20X8. As of March 31, 20X8, the federal funds rate has increased to 5.5 percent.
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The change in the federal funds rate is the only relevant change in general market conditions.
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The fair value of the bond as of March 31, 20X8, is $495 million, which indicates a market rate of interest on the bond of 8.3 percent.
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Company A computes the change in fair value that is attributable to instrument-specific credit risk by calculating the portion of the total change in fair value of the instrument during the period that is not attributable to changes in general market conditions. As discussed above, entities are not required to use this method to calculate the change in fair value attributable to instrument-specific credit risk.
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For simplicity, it is assumed that (1) there is a flat yield curve, (2) all changes in interest rates result from a parallel shift in the yield curve, and (3) the changes in the federal funds rate are the only relevant changes in general market conditions. An entity should base its calculations on actual market conditions.
The market rate of interest upon the
bond’s issuance was 8 percent. The components of the
market rate include (1) the benchmark rate (the
federal funds rate) of 5 percent, and (2) 3 percent,
which represents the bond’s credit risk or “credit
spread.” At the end of the period, the federal funds
rate increases to 5.5 percent and there are no other
changes in general market conditions that would
affect the valuation of the bond.
To determine the change in fair value of the bond
associated with instrument-specific credit risk, A
calculates the present value of the remaining
contractual cash flows by using an 8.5 percent rate
consisting of the benchmark interest rate at the end
of the period (5.5 percent) and the initial spread
from the benchmark rate upon issuance of the bond (3
percent). The resulting present value of the
remaining cash flows, discounted at 8.5 percent, is
$492 million.
The fair value of the bond as of
March 31, 20X8, is $495 million. Thus, the portion
of the change in fair value of the bond associated
with instrument-specific credit risk during the
period is $3 million. In other words, the fair value
of the bond decreased by $8 million because of a
change in general market conditions (the increase in
the federal funds rate) and increased by $3 million
because of the narrowing of the credit spread on the
bond. Thus, in accordance with ASC 825-10-45-5, in
preparing its financial statements and recognizing
the bond at fair value, A would reduce the carrying
amount of the bond by $5 million and would recognize
a loss in earnings of $8 million and a gain in OCI
of $3 million. Note that A is also required to
determine instrument-specific credit risk for
disclosure purposes.
In the absence of other changes in
general market conditions, the change in fair value
that is attributable to instrument-specific credit
risk in the next period would be based on a
comparison of the fair value of the bond at the end
of the period, with the present value of future cash
flows discounted at the federal funds rate at the
end of the period, added to an instrument-specific
credit spread of 2.8 percent (8.3% – 5.5%). The 8.3
percent represents the implicit market yield on the
bond at the end of the previous period (i.e., the
effective yield of the bond, which is based on
discounting the remaining cash flows and a fair
value of $495 million at the beginning of the
period). To determine the credit spread at the end
of the previous period, A subtracts the 5.5 percent
(the benchmark rate at the end of the previous
period).
6.3.2.2 Foreign-Currency-Denominated Liabilities
ASC 825-10
45-5A When changes in
instrument-specific credit risk are presented
separately from other changes in fair value of a
liability denominated in a currency other than an
entity’s functional currency, the component of the
change in fair value of the liability resulting from
changes in instrument-specific credit risk shall
first be measured in the liability’s currency of
denomination, and then the cumulative amount shall
be adjusted to reflect the current exchange rate in
accordance with paragraph 830-20-35-2. The
remeasurement of the component of the change in fair
value of the liability resulting from the cumulative
changes in instrument-specific credit risk shall be
presented in accumulated other comprehensive
income.
ASC 830-20
35-7A Paragraph 825-10-45-5A
requires that for a financial liability for which
the fair value option is elected, the change in the
liability’s fair value resulting from changes in
instrument-specific credit risk shall be presented
separately in other comprehensive income from other
changes in the liability’s fair value presented in
current earnings. The component of the change in
fair value of the liability resulting from changes
in instrument-specific credit risk shall first be
measured in the liability’s currency of
denomination, and then the cumulative amount shall
be adjusted to reflect the current exchange rate in
accordance with paragraph 830-20-35-2. The
remeasurement of the component of the change in fair
value of the liability resulting from the cumulative
changes in instrument-specific credit risk shall be
presented in accumulated other comprehensive
income.
ASC 825-10-45-5A and ASC 830-20-35-7A provide guidance on the measurement of
the instrument-specific credit risk component of a foreign-denominated
financial liability. In accordance with that guidance, entities are required
to apply the following two-step measurement approach:
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Measure the instrument-specific credit risk component of the change in fair value of the liability in the liability’s currency of denomination.
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Adjust the cumulative amount of changes in instrument-specific credit risk in the currency of denomination of the liability to the entity’s functional currency by using the exchange rate as of the measurement date (i.e., the balance sheet date).
6.3.2.3 Nonrecourse Financial Liabilities
The guidance in ASC 825-10-45-5 and 45-5A that requires separate presentation
in OCI of the portion of the change in fair value of a financial liability
that is attributable to instrument-specific credit risk does not apply to
liabilities that do not contain instrument-specific credit risk. A liability
that is nonrecourse to the issuer does not contain instrument-specific
credit risk. Therefore, changes in fair value associated with a nonrecourse
financial liability designated under the fair value option should be
recognized entirely in earnings. This view was discussed with the FASB
staff, which agreed with the conclusion reached.
It is important for an entity to differentiate between instrument-specific
credit risk and asset-specific performance risk when assessing a financial
liability whose amounts are payable only upon receipt of cash flows from
specified assets (e.g., securitization structures). This distinction is
important because in some circumstances, a financial liability may have
little or no instrument-specific credit risk and substantially all the
changes in the fair value of the liability may be attributable to
asset-specific performance risk. In such cases, when the borrower does not
have any obligation to make a payment if the assets to which the obligation
is contractually linked fail to perform, changes in the fair value of the
liability would be recognized in earnings. For example, an entity that
issues a note whose cash flows are contractually linked to an underlying
pool of financial assets (e.g., loans, corporate bonds) would have no
obligation to make payments unless amounts are received on the underlying
pool of assets. In such circumstances, all changes in fair value would be
recognized in earnings.
Depending on how the obligation is structured, there may
still be some instrument-specific credit risk when there is also
asset-specific performance risk. For example, if amounts received on the
underlying pool of assets are not immediately payable to the lender (i.e.,
there is a timing difference between the receipt of cash flows from the
assets and the payment on the obligation), the borrower will owe amounts to
the lender even when the assets have performed. Depending on whether the
borrower is able to use the cash received on the assets for purposes other
than to pay its obligation under the financial liability, there may be some
residual instrument-specific credit risk, but it is generally minimal.
6.3.3 Presentation of Interest Expense
An entity is not required to separately present, in its income statement,
interest expense for debt accounted for at fair value through earnings unless
(1) the entity must do so in accordance with regulatory guidance or (2) it is
industry practice to do so (for example, bank holding companies, brokers and
dealers in securities, and investment companies generally present interest
separately from other changes in fair value in their income statements).
However, the entity may elect, as an accounting policy, to present interest
expense separately from other changes in the fair value of financial instruments
measured at fair value through earnings. This election would apply to
interest-bearing financial liabilities that are measured at fair value through
earnings under the fair value option in ASC 825 or ASC 815, as well as those
interest-bearing liabilities that are measured at fair value under other
relevant GAAP. If an entity’s elected accounting policy related to separate
recognition of interest expense is considered significant, the entity should
disclose that policy in accordance with ASC 235-10-50-1.
If an entity elects, as an accounting policy, to separately present interest
expense on an interest-bearing financial liability accounted for at fair value
through earnings, the entity should, with one exception discussed below, include
amortization or accretion of any premium or discount on the instrument as part
of the separately reported interest expense. If the fair value initially
recognized for an interest-bearing financial liability (e.g., debt) differs from
the principal amount due at maturity, this difference is a premium or discount
that should be amortized or accreted. An entity should recognize the
amortization or accretion in interest expense if it is separately presented. The
premium or discount should be amortized by using the interest method that would
have applied to the interest-bearing financial liability if it had not been
recognized at fair value through earnings (see Section 6.2).
The guidance above does not apply to the following:
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The portion of the difference between fair value and par at inception attributable to embedded features that are not indexed to interest rates or the issuer’s own credit (e.g., an in-the-money option that permits the holder to convert the debt instrument into a fixed number of the issuer’s equity shares). Entities should exclude such features from the discount or premium to be accreted or amortized.
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Any transaction costs and fees, such as debt issuance costs, origination costs, and origination fees (i.e., up-front costs and fees) are not part of the initial measurement of a financial instrument that is recognized at fair value and therefore are not included in any premium or discount of the financial instrument in accordance with ASC 825-10-25-3. That is, the interest method is used only for applicable discounts and premiums since up-front costs and fees are recognized in earnings as they are incurred or received (see Section 5.5 for discussion of the initial recognition of up-front costs).