The fair value option is the alternative for a business to record its financial instruments at their fair values. GAAP allows this treatment for the following items:
- A financial asset or financial liability
- A firm commitment that only involves financial instruments
- A loan commitment
- An insurance contract where the insurer can pay a third party to provide goods or services in settlement, and where the contract is not a financial instrument (i.e., requires payment in goods or services)
- A warranty in which the warrantor can pay a third party to provide goods or services in settlement, and where the contract is not a financial instrument (i.e., requires payment in goods or services)
The fair value option cannot be applied to the following items:
- An investment in a subsidiary or variable interest entity that will be consolidated
- Deposit liabilities of depository institutions
- Financial assets or financial leases recognized under lease arrangements
- Financial instruments classified as an element of shareholders’ equity
- Obligations or assets related to pension plans, post-employment benefits, stock option plans, and other types of deferred compensation
When you elect to measure an item at its fair value, do so on an instrument-by-instrument basis. Once you elect to follow the fair value option for an instrument, the change in reporting is irrevocable. The fair value election can be made on either of the following dates:
- The election date, which can be when an item is first recognized, when there is a firm commitment, when qualification for specialized accounting treatment ceases, or there is a change in the accounting treatment for an investment in another entity.
- In accordance with a company policy for certain types of eligible items.
It is acceptable not to apply the fair value option to eligible items when reporting the results of a subsidiary or consolidated variable interest entity, but to apply the fair value option to these items when reporting consolidated financial statements.
It is much easier to apply the fair value option for both subsidiary-level and consolidated financial results, so do not attempt separate treatment, even though it is allowed by GAAP.
In most cases, it is acceptable to choose the fair value option for an eligible item, while not electing to use it for other items that are essentially identical.
If you take the fair value option, report unrealized gains and losses on the elected items at each subsequent reporting date.