Describe the fair value option applied to marketable securities and derivatives
THE FAIR VALUE OPTION APPLIED TO MARKETABLE SECURITIES AND DERIVATIVES
Both U.S. GAAP and IFRS provide for the option of reporting selected financial assets and financial liabilities at fair value and recognizing gains and losses in net income as fair values change. Firms can apply the fair value option on an instrument-by-instrument basis, when the firm first adopts the standard that provides for the fair value option, when the firm acquires an eligible instrument, and at certain remeasurement events, such as business combinations. Once elected, the fair value option is irrevocable (for the instrument to which the firm applies it). Both U.S. GAAP and IFRS require measurement at fair value with changes included in income for three items: (1) trading securities, (2) fair value hedges, (3) derivatives not designated as hedges. Thus, firms can elect the fair value option for the following items: (1) bonds held to maturity, (2) available-for-sale securities, and (3) cash flow hedges. Applying the fair value option to investments in debt securities classified as held to maturity results in accounting for the investments as if they were a trading security, with changes in fair value recognized in income each period. Applying the fair value option to available-for-sale securities and to cash flow hedges results in reporting unrealized gains and losses from remeasurement to fair value in net income as fair value changes, instead of initially in other comprehensive income.
Firms acquire securities issued by other entities for various reasons. Businesses also acquire derivatives or engage in various arrangements with other entities to hedge risks of changes in interest rates, exchange rates, and commodity prices. U.S. GAAP and IFRS currently require the following accounting for marketable securities and derivatives if a firm does not elect the fair value option:
Accounting Method Applicable To:
Method 1: Amortized Acquisition Cost Debt Securities Held to Maturity
Method 2: Fair Value with Unrealized Gains and Marketable Securities
Classified as Available for Sale
Losses Recognized in Other Comprehensive Cash Flow Hedges Income as Fair Values Change and Later in Net Income
Method 3: Fair Value with Unrealized Gains and Marketable Securities Classified as Trading Securities
Losses Recognized in Net Income as Fair Value Hedges
Values Change Derivatives Not Classified as Hedges
The delayed inclusion of unrealized gains and losses in net income for items in the second category above results in measuring available for sale securities and cash flow hedges at fair value without recognizing the net income effect until the firm realizes the gain or loss. Firms that adopt the fair value option will not delay recognizing the net income effect as fair values change. The accounting is the same as for items in the third method above.
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