Discuss the fair value option in accounting for certain assets and liabilities

Answer 1

FAIR VALUE OPTION

U.S. GAAP and IFRS allow firms to account for certain financial assets and certain financial liabilities, including notes and bonds, using either (1) amortized cost, with measurements based on the historical market interest rate, or (2) fair value, with measurements based on current market conditions, including the current market interest rate. Authoritative guidance has taken the position that measurements of financial assets and financial liabilities at fair value provide more relevant and reliable information than cost-based measurements. Accounting for notes and bonds using the historical market interest rate under the amortized cost approach is a cost-based approach. U.S. GAAP and IFRS already require firms to report certain financial instruments related to hedging activities at fair value. Standard-setting bodies, however, are not yet prepared to require fair value measurement for all financial assets and financial liabilities. Thus, they view the option to account for selected financial assets and financial liabilities as an interim step toward reporting all financial instruments at fair value.

Firms can choose between fair value measurement and the amortized cost approach based on historical market interest rates on a case-by-case (instrument-by-instrument) basis. The choice to use the fair value option is generally irrevocable.

UNDERLYING CONCEPTS FOR FAIR VALUE OPTION

Fair value is the amount a firm would receive if it sold an asset or would pay if it transferred, or settled, a liability in an orderly transaction at the measurement date. Determining fair value
rests on the assumption that the transaction would occur in the principal market for the asset or liability or, in the absence of a principal market, in the most advantageous market from the viewpoint of the reporting entity. Thus, a firm that normally obtains and repays long-term debt in public capital markets would measure fair value based on the amount it would pay to repay bonds in those markets. However, a firm that obtained long-term financing from both public capital markets and private placements with insurance companies could choose the market that would provide the most advantageous terms to settle the debt.

Measuring fair value also rests on the assumption that the market participants in the principal (or most advantageous) market are independent of the reporting entity, knowledgeable about the asset or liability, and willing and able to engage in a transaction with the reporting entity. Fair value must reflect assumptions that market participants, as opposed to the reporting entity, would make about the best use of a financial asset or the best terms for settling a financial liability. The best use for a financial asset might be to combine it with other assets, as when an automobile manufacturer uses customer financing, which generates receivables, to enhance sales of its automobiles. The best use for a financial asset might be as a stand-alone asset, as when an investment bank purchases and sells automotive receivables for profit.

Inputs to measuring fair value fall into three categories:

1 . Level 1: Observable quoted market prices in active markets for identical assets or liabilities that the reporting entity is able to access at the measurement date.

2 . Level 2: Observable inputs other than quoted market prices within Level 1 . The category might include quoted prices for similar assets or liabilities in active markets or quoted market prices for identical assets or liability in markets that are not active. This category also includes observable factors that would be of particular relevance in using present values of cash flows to measure fair value, including interest rates, yield curves, foreign exchange rates, credit risks, and default rates.

3 . Level 3: Unobservable inputs reflecting the reporting entity's own assumptions about the assumptions market participants would use in pricing an asset or settling a liability.

Firms should use Level 1 inputs if available to measure fair value, then Level 2 inputs, and finally Level 3 inputs.14