Fair value option definition
/What is the Fair Value Option?
The fair value option allows an entity to elect to measure certain financial assets and liabilities at fair value instead of historical cost or amortized cost. Once elected, fair value changes are recognized in earnings each reporting period. The option is applied on an instrument-by-instrument basis at initial recognition or upon qualifying events. Its purpose is to reduce accounting mismatches between related assets and liabilities measured on different bases. The election is generally irrevocable, promoting consistency in financial reporting.
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
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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.
When to Take the Fair Value Option
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.
Fair Value Option Best Practices
There are a few best practices related to the use of the fair value option, which are as follows:
Apply generally, or not at all. 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.
Document thoroughly. Clearly document why the fair value option was elected, how it was determined, and the nature of the financial instrument. This documentation should support audit readiness and ensure compliance with disclosure requirements.
Reporting of Unrealized Gains and Losses
If you take the fair value option, report unrealized gains and unrealized losses on the elected items at each subsequent reporting date.