The Fair Value Option

SFAS No. 159

Now FASB ASC Topic 825

Why was FAS159 issued?

IFRS permits a fair-value election for

financial instruments (IAS 39)

FASB wants to converge with IASB
This standards moves US GAAP
closer to IFRS
For some organizations, hedging
becomes simpler than it would be
under FAS 133 (derivatives)

A quick introduction to the

concept
A very simple company
that starts with one
asset and one liability
to keep it simple!

Example Brand New Inc.

Two transactions first day in business:
Issues a 20-year bond payable for

$1,000, interest is paid annually, coupon

rate = yield rate of 10% (Bond A)
Buys a 20-year bond investment for
$1,000, interest is paid annually, coupon
rate = yield rate of 12% (Bond B)
At end of the first day, prepare balance sheet

Brand New Inc., 1st day

Assets
Bond B

Liabilities & Owners Equity

$1,000 Bond A

$1,000

OE

Lets assume that Bond B is accounted for as part of the

trading securities investment portfolio. Therefore it is marked
to market at each balance sheet date and the gain/loss is
reported on the income statement. Bond A is treated in the
traditional way.

$0

End of year interest rates change

Bond A (liability) yield rate is now 9%
Bond B (asset) yield rate is now 11%
PREPARE BALANCE SHEET ASSUMING THAT WE DO

NOT USE THE FAIR VALUE OPTION FOR THE B/P

First step find the present value of the bond

investment. Remember, the coupon rate on Bond B is
12%
N=19, i=11%, Pmt = $1,000 * 12% = $120,
FV=$1,000
$1,078
Solve for PV = __________________

Brand New Inc., end of year 1

Does not use FV option (a)
Assets
Cash
Bond B

Liabilities & Owners Equity

20 Bond A

$1,000

$1,078 OE

Interest revenue $120 Interest expense $100 + gain $78 = $98

net income

This is our traditional accounting (book

value for debt, fair value for
investments classified as trading

$98

Brand New Inc., end of year 1

Does not use FV option (b)
Assets
Cash
Bond B

Liabilities & Owners Equity

$ 20 Bond A
$1,000
1,078 RE
20
AOCI
78
$1,098
$1,098

Interest revenue $120 Interest expense $100 = $20 net income

with $78 gain on statement of comprehensive income

If the bond were classified as available for

sale the gain would be reported in AOCI
rather than on the income statement.

Now, what if company used the FV

option for the bonds payable?
BOND A, coupon rate = 10%,

yield rate is now 9%

Solve for fair value:
N=19, i=9%, pmt = $100 (10% * $1,000),
fv=$1,000
$1,090
solve for PV _______________________
Now, what does the balance sheet look like?

Brand New Inc., end of year 1

uses FV option, Bond A at 9%
Assets
Cash
Bond B

Liabilities & Owners Equity

$

20 Bond A

$1,090

1,078 OE
$1,098

8
$1,098

Interest revenue $120 $100 interest expense + $78

gain on investment - $90 loss on liability = $8 net
income

What if the rate on Bond A

increased instead of decreased?
For BOND A, coupon rate = 10%,

but yield is now 11%

Solve for fair value:
N=19, i=11%, pmt = $100 (10% * $1,000),
fv=$1,000
$922
solve for PV _______________________
Now, what does the balance sheet look like?

New Company, end of year 1

uses FV option, Bond A at 11%
Assets
Cash
Bond B

Liabilities & Owners Equity

$

20 Bond A
1,078 OE
$1,098

922
176
$1,098

Interest revenue $120 Interest expense $100 + gain

$78 on investment + $78 gain on liability = $176 net
income

FAS159 fair value choice is permanent

for each item
Companies may elect fair value measurement

when an asset or liability is

First recognized, or
An event triggers a new basis of accounting

(business combination)

Applies to entire contract

Election is irrevocable
Change in value is reported on the income

statement

Eligible assets & liabilities

Recognized financial assets and financial

liabilities
Includes some investments accounted for under

the equity method

Excludes leases, pension plans, etc.

Written loan commitments

Firm commitments that involve only financial

instruments
Rights & obligations under insurance
contracts, warranties

Disclosures
Fair-value measured items must be reported

separately from similar items measured on

another basis
Detailed disclosures as to why fair value
election was made, how changes in fair-values
affected earnings, differences between fair
values and cash flows for certain items, etc.

Fair values are disclosed even without

the fair value option (ASC 825)
Under ASC 715 (FAS107), the fair values of

financial instruments are disclosed in the

financial statements
Well look at some more realistic problems

related to estimating fair values:

Semi-annual bonds
With premium or discount
Preparing journal entries
Using allowance account to adjust to market

value

Fair values are disclosed even without

FAS159 option
Under ASC 715 (FAS107), the fair values of

financial instruments are disclosed in the

financial statements
Well look at some more realistic problems

related to estimating fair values:

Semi-annual bonds
With premium or discount
Preparing journal entries
Using allowance account to adjust to market

value

The Fair Value Option

IAS 39 vs FAS 159 (ASC 825)

versus

Fair Value Option Compared

IFRS
Must meet criteria so that

financial reporting is
improved by fair value
measurement

US GAAP

Instrument by instrument

decision
Applies only to items

within scope of FAS159

(ASC 825)

Precludes similar items as

listed in FAS159 (leases,

pensions, etc.)

Determination is made at

initial recognition and

cannot be changed

Determination is made at

initial recognition and

cannot be changed

IFRS permits the fair value option

when doing so results in more
relevant information because
It eliminates or significantly reduces a

measurement or recognition inconsistency that

would otherwise arise from measuring assets or
liabilities or the gains and losses on them on
different bases
A group of financial assets, financial liabilities or
both is managed and its performance is evaluated
on a fair value basis in accordance with a
documented risk management or investment
strategy

HW #2
Problems 1 & 2 are similar problems to the examples in this

ppt file. However, I havent asked for journal entries but you
will get a feel for the IMPACT the fair value option could have
on the bottom line
Remember that you have to do the I/S before the B/S
Well do PART of Problem 3 in the lecture for class #4

For the bond amortization review with fair value option,

we will create bond amortization tables that would be

used even when we elect the fair value option for debt.
In this example, we will review the traditional journal entries for

amortization using straight-line and effective interest methods.

Well do fair value estimates between interest payment dates (using
PV techniques).
Assuming the fair value option was elected, we will then do the extra
entry to create a valuation allowance to adjust the bonds carrying
value to the fair value and recognize the gain or loss on the debt in
the income statement