The FAS 159 fair value option, now housed in ASC 825, lets an entity elect to measure most recognized financial assets and liabilities at fair value with changes running through earnings each period. Electing it commits you to four ongoing obligations for the life of the instrument: mark to fair value every reporting period with gains and losses in earnings, route the credit-risk portion of liability fair value changes to other comprehensive income, present FVO balances separately from similar items measured on a different basis, and carry a substantial set of footnote disclosures. The election is made instrument by instrument on a qualifying date, must be documented at that moment, and cannot be reversed.
What You Can and Can’t Elect
The option is available for most recognized financial assets and liabilities, including held-to-maturity and available-for-sale debt securities, equity-method investments, firm commitments that involve only financial instruments, and written loan commitments. Hybrid financial instruments containing an embedded derivative are also eligible, and electing fair value for the whole hybrid removes the need to bifurcate the embedded derivative from its host — one of the most common practical reasons entities use the FVO in the first place.
ASC 825-10-15-5 excludes several categories no matter how convenient the election would be:
- Investments in subsidiaries that must be consolidated, and interests in VIEs that must be consolidated.
- Pension obligations, other postretirement benefits, postemployment benefits, stock option and stock purchase plans, and other deferred compensation arrangements.
- Financial assets and liabilities recognized under lease guidance. Guarantees of third-party lease obligations and contingent obligations from cancelled leases are not excluded.
- Deposits withdrawable on demand at banks, savings and loan associations, credit unions, and similar depository institutions.
- Financial instruments the issuer classifies as a component of shareholders’ equity, including temporary equity.
The demand deposit exclusion catches people off guard in banking contexts. A bank cannot elect fair value for its checking and savings account liabilities, even though those are clearly financial liabilities. A separated host financial instrument that results from bifurcating an embedded nonfinancial derivative is also ineligible.
When and How the Election Is Made
Elections happen on specific qualifying dates listed in ASC 825-10-25-4, not whenever management decides fair value would look better:
- Initial recognition of the eligible item.
- Entry into an eligible firm commitment.
- The point at which financial assets previously reported at fair value through earnings under specialized guidance (such as investment company accounting) cease to qualify for that treatment.
- The point at which an investment becomes subject to equity-method accounting.
- Events that require remeasurement at fair value but would not otherwise trigger ongoing fair value measurement, including business combinations, consolidation or deconsolidation of a subsidiary or VIE, and significant modifications of debt.
The election is instrument by instrument. You can elect fair value for one loan in a portfolio and not another, even if they are identical. But the election applies to the entire instrument. You cannot carve a single contract into pieces and elect fair value for only part of it.
Concurrent Documentation
The election must be supported by concurrent documentation, or by a preexisting documented policy that makes the election automatic. Concurrent means at the moment the instrument is acquired, issued, or subject to a remeasurement event. If the documentation is not in place at that moment, the FVO cannot be applied retroactively. The documentation has to eliminate any ambiguity about whether the entity intended fair value measurement for that specific instrument. This is where many elections fall apart in practice.
Irreversibility
Once elected, the decision sticks for the life of the instrument unless a new qualifying election date occurs. There is no mechanism to un-elect fair value because the instrument’s performance disappointed or because management changed its mind. This permanence is the single most important thing to understand before making the election, and it is what makes the concurrent documentation requirement so consequential.
How FVO Items Appear on the Balance Sheet
ASC 825-10-45-1B requires FVO items to be reported in a way that separates their fair values from the carrying amounts of similar items measured on a different basis, such as amortized cost. Two presentation approaches are permitted:
- Combine FVO and non-FVO amounts in a single line item, and parenthetically disclose the fair value amount included in the total.
- Display FVO and non-FVO carrying amounts on separate lines.
The same approach applies to hybrid financial instruments measured at fair value under ASC 815-15. Either way, a reader should be able to see how much of any given line item is measured under the FVO versus another basis.
How Fair Value Changes Hit the Income Statement
All changes in fair value on FVO items flow through earnings each period. Unrealized gains and losses from remeasurement land in the income statement directly. That is the point of the election. It contrasts with available-for-sale debt securities, where unrealized changes bypass earnings until realized.
The Credit Risk Carve-Out for Liabilities
Financial liabilities carry a special rule. When a company’s creditworthiness deteriorates, the fair value of its debt falls, which would otherwise produce an accounting gain. Worse financial health, better-looking income statement. That outcome is misleading, and ASC 825-10-45-4 addresses it by splitting the total fair value change on an FVO liability into two pieces. The portion attributable to changes in the instrument’s specific credit risk goes to other comprehensive income. The remainder, reflecting factors like benchmark interest rate movements, flows through net income. The credit risk component must be measured using a consistent method from period to period, and that method must be disclosed.
Amounts accumulated in AOCI from this treatment are later reclassified into earnings either over the life of the instrument or when the liability is settled, whichever comes first.
Interest and Dividends
Interest and dividends on FVO instruments belong in the appropriate income statement line items. The standard does not mandate a specific measurement method. Entities typically use either the contractual interest rate or the effective interest method, but the choice is a policy decision that must be applied consistently and disclosed, along with where the amounts appear on the income statement.
Up-Front Costs and Fees
When fair value is elected, transaction costs — debt issuance costs, origination costs, and origination fees — are not included in the initial measurement. Costs are expensed as incurred and fees are recognized in earnings when received. The deferral and amortization rules under ASC 310-20 do not apply to instruments carried at fair value through earnings. Entities used to deferring origination fees over the life of a loan need to adjust their processes when the FVO is elected, because the entire fee hits earnings on day one.
Required Footnote Disclosures
ASC 825-10-50-28 through 50-31 spell out disclosures designed to let readers compare entities that elect fair value with those that do not.
Balance Sheet
For each balance sheet line item that includes FVO items, disclose the carrying amount at fair value and enough detail for users to tie the line item to the broader fair value disclosures. If fair value was elected for only some eligible items within a group of similar instruments, explain which were elected, which were not, and why. Disclose the aggregate carrying amount of non-eligible items within each line.
Income Statement
For each period presented, disclose the gains and losses from fair value changes included in earnings, broken out by balance sheet line item, and identify the specific income statement line where they appear. Describe how interest and dividends are measured and where they show up.
Loans and Long-Term Receivables Held as Assets
Additional disclosures apply. Report the difference between aggregate fair value and aggregate unpaid principal balance. For loans 90 days or more past due, separately report aggregate fair value and the gap between that fair value and unpaid principal. The same applies to loans in nonaccrual status if the entity’s policy is to recognize interest income separately from other fair value changes.
Methods, Assumptions, and Credit Risk
For annual periods, disclose the methods and significant assumptions used to estimate fair value. Each FVO measurement must be categorized in the ASC 820 hierarchy as Level 1, Level 2, or Level 3, and that categorization must be disclosed. For FVO financial liabilities, disclose the change in fair value attributable to instrument-specific credit risk during the period, the cumulative amount, and how those amounts were determined. For loans and receivables held as assets, disclose the estimated gains or losses attributable to changes in instrument-specific credit risk and the methodology behind that determination.
Management’s Rationale
Explain why the FVO was elected for each class of instrument. Auditors and regulators expect a substantive explanation of the economic rationale, whether that is reducing accounting mismatch between related assets and liabilities, aligning with risk management, or simplifying accounting for complex instruments. A boilerplate statement that fair value “better reflects economic reality” without instrument-specific context will draw scrutiny.
Level 3 Valuation Under the FVO
FVO instruments measured with Level 3 inputs are the highest-risk area of the election. Level 3 inputs are unobservable, so there is little or no market activity to anchor the measurement. The entity may use its own data, such as projected cash flows or earnings forecasts, but must adjust that data if reasonably available information suggests market participants would use different assumptions. The measurement objective does not change: the target is still an exit price from a market participant’s perspective, with appropriate risk adjustments. Even where components of a valuation model rely on observable data such as benchmark interest rate curves, the measurement is Level 3 when the entity’s own projected cash flows are significant to overall fair value. Many FVO loans and structured instruments end up here.
There is no blanket exemption from disclosing quantitative information about significant unobservable inputs used in Level 3 measurements. Entities are not required to create quantitative data they did not develop as part of their valuation process. If a third-party pricing service was used without adjustment, the entity does not have to reverse-engineer the service’s inputs. But if the entity built its own discounted cash flow model with assumptions about default rates and prepayment speeds, those inputs must be disclosed. The line is between creating new information solely for disclosure and disclosing information already developed.
Auditor attention on Level 3 FVO measurements runs high. Unobservable inputs are inherently subjective, and because fair value changes flow straight to earnings, any measurement error moves the bottom line directly. Entities electing the FVO for instruments likely to be Level 3 should expect their valuation models, key assumptions, and period-over-period changes to receive close audit review.