11.3 Fair Value Option and Disclosures

11.3 Fair Value Option and Disclosures

The Fair Value Option (ASC 825)

Under ASC 825, entities are permitted to elect to measure many financial instruments and certain other items at fair value. This choice is known as the Fair Value Option (FVO).

Objectives of the FVO

The primary objective of the FVO is to improve financial reporting by enabling entities to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently. For example, if an entity has a liability measured at amortized cost and a related asset measured at fair value, electing the FVO for the liability allows changes in the fair value of both the asset and liability to offset in earnings, achieving a natural "accounting hedge" without meeting complex hedge accounting requirements.

Key Rules of the FVO Election

1. Instrument-by-Instrument Basis: The election is made on a contract-by-contract basis (with limited exceptions).
2. Irrevocable: Once elected for an instrument, the option cannot be revoked; the instrument must be measured at fair value until it is derecognized.
3. Timing: The FVO can only be elected at specific dates, including:
   • When the eligible item is first recognized.
   • When an eligible firm commitment is entered into.
   • When a transaction occurs that changes the accounting treatment (e.g., an investment becomes subject to the equity method or a consolidation event occurs).
4. Presentation and Disclosure:
   • The assets and liabilities subject to the FVO must be presented separately on the balance sheet or disclosed in the notes.
   • All unrealized gains and losses from FVO measurements are recognized in earnings (net income) in the period they occur.
   • Exception for Liabilities: For financial liabilities where FVO is elected, the portion of the change in fair value caused by a change in the entity's own credit risk (instrument-specific credit risk) is recognized in Other Comprehensive Income (OCI) rather than in net income. The remaining change in fair value is recognized in earnings.

Eligible and Ineligible Items

Not all items are eligible for the FVO.

---

Fair Value Measurement (ASC 820)

ASC 820 defines fair value as: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e., an exit price).

Key Measurement Concepts

• Orderly Transaction: A transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary. It is not a forced transaction (such as a forced liquidation or distress sale).
• Market Participants: Buyers and sellers in the principal (or most advantageous) market who are:
  1. Independent of the reporting entity (not related parties).
  2. Knowledgeable (have a reasonable understanding of the asset/liability).
  3. Able to transact.
  4. Willing to transact (not forced or coerced).

---

Principal vs. Most Advantageous Market

Fair value must be measured based on the price in the principal market for the asset or liability.

1. Principal Market: The market with the greatest volume and level of activity for the asset or liability.
2. Most Advantageous Market: The market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after considering transaction costs and transportation costs.

Rules of Application

• The entity must first evaluate the principal market. If a principal market exists, the price in that market must be used to measure fair value, even if another market has a more advantageous price.
• If (and only if) there is no principal market, the entity uses the price in the most advantageous market.
• Transaction Costs vs. Transportation Costs:
  • Transaction Costs: Incremental costs directly attributable to the disposal of an asset or transfer of a liability (e.g., broker fees, commissions). These are not included in the fair value measurement itself (they are expensed as incurred), but they are used to determine which market is the most advantageous.
  • Transportation Costs: The costs to transport the asset to the market. These are deducted from the market price to determine fair value if location is an attribute of the asset.

Example: Principal vs. Most Advantageous Market

Omega Corp sells an asset in two different markets (Market A and Market B). There is no principal market for this asset.

• Market A: Price = $100; Transaction Costs = $10; Transportation Costs = $5. Net proceeds = $100 - $10 - $5 = $85.
• Market B: Price = $105; Transaction Costs = $18; Transportation Costs = $8. Net proceeds = $105 - $18 - $8 = $79.

To determine the most advantageous market, Omega compares the net proceeds:

• Market A yields $85.
• Market B yields $79. Thus, Market A is the most advantageous market.

The fair value measurement of the asset is the price in that market adjusted only for transportation costs (not transaction costs). Fair Value = $100 (Market A Price) - $5 (Transportation Costs) = $95. (The $10 transaction costs are expensed separately in earnings).

---

The Fair Value Hierarchy

To increase consistency and comparability in fair value measurements, ASC 820 establishes a three-level fair value hierarchy. This hierarchy prioritizes the inputs to valuation techniques, giving the highest priority to Level 1 inputs (observable) and the lowest priority to Level 3 inputs (unobservable).

Level 1 Inputs (Highest Reliability)

• Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.
• Examples: Common stock traded on the NYSE or NASDAQ; exchange-traded derivative contracts; U.S. Treasury securities.

Level 2 Inputs (Medium Reliability)

• Inputs other than Level 1 quoted prices that are observable for the asset or liability, either directly or indirectly.
• Examples:
  • Quoted prices for similar assets or liabilities in active markets.
  • Quoted prices for identical or similar assets or liabilities in markets that are not active (e.g., over-the-counter debt securities).
  • Observable inputs other than quoted prices (e.g., interest rates, yield curves, default rates, credit spreads).
  • Market-corroborated inputs.

Level 3 Inputs (Lowest Reliability)

• Unobservable inputs for the asset or liability, developed using the best information available, including the entity's own data and assumptions.
• Used when there is little, if any, market activity for the asset or liability.
• Examples: Cash flow forecasts derived from internal budgets to value a reporting unit; private equity investments; long-term currency swaps in illiquid markets.

---

Valuation Techniques

Entities must use valuation techniques consistent with one or more of the following three approaches:

1. Market Approach: Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (e.g., market multiples).
2. Income Approach: Converts future amounts (such as cash flows or earnings) to a single discounted present value.
3. Cost Approach: Reflects the amount that would be required to replace the service capacity of an asset (often referred to as current replacement cost).