2.5 Fair Value Option

On specified election dates (such as when an entity first recognizes an item or when it undergoes a business combination or upon a significant modification of debt as defined in ASC 470-50), ASC 825-10 permits an entity to irrevocably elect to measure an eligible item at fair value (“the fair value option”). An example of an eligible item is a recognized financial liability (such as convertible debt) that is not otherwise excluded from the scope of ASC 825-10 (see the next paragraph). An entity that has elected the fair value option for a financial liability recognizes (1) the portion of the change in the liability’s fair value that is attributable to a change in instrument-specific credit risk in other comprehensive income and (2) the remaining change in the liability’s fair value in net income. Upon derecognition, the cumulative amount recognized in other comprehensive income is included in net income.

Under ASC 825-10-15-5(f), “[f]inancial instruments that are, in whole or in part, classified by the issuer as a component of shareholders’ equity” are excluded from the scope of the fair value option in ASC 825-10. Because ASC 470-20 requires the issuer of certain types of convertible debt instruments to separate them into liability and equity components at issuance (e.g., instruments with CCFs or noncontingent BCFs), the issuer cannot elect the fair value option in ASC 825-10 for such instruments. Therefore, an issuer needs to consider whether ASC 470-20 applies to a convertible debt instrument before it can determine whether the fair value option in ASC 825-10 is available (see Section 3.2). Since no part of the instrument is classified in shareholders’ equity at issuance, election of the fair value option in ASC 825-10 is not precluded for a traditional convertible debt instrument with a contingent BCF (see Section 7.2.4 for further discussion).

In addition to the fair value option in ASC 825-10, ASC 815-15-25-4 provides a fair value option for hybrid financial instruments that otherwise require bifurcation into a host contract and a derivative instrument under ASC 815-15-25-1. Unlike that in ASC 825-10, the fair value option in ASC 815-15 contains no explicit scope exception for financial instruments that are, in whole or in part, classified by the issuer as a component of shareholders’ equity. Therefore, stakeholders have questioned whether an issuer is permitted to elect the fair value option in ASC 815-15 for a convertible debt instrument that (1) has an embedded feature other than the conversion feature (such as a put or call option) that requires bifurcation under ASC 815-15-25-1 and (2) is not eligible for the fair value option in ASC 825-10 because the instrument must be separated into liability and equity components under ASC 470-20 (e.g., it contains a CCF or noncontingent BCF). (If the conversion feature must be bifurcated as an embedded derivative, it is not separated as an equity component under ASC 470-20; see Section 2.3.) Because the fair value option in ASC 825-10 is not available for such a convertible debt instrument (as discussed above), the issuer also cannot elect the fair value option in ASC 815-15 for the instrument.