Users of financial statements have become increasingly critical of the fair value option (FVO) for financial liabilities, an accounting-policy option available under both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). In this month's column, I'll describe users' main objections to the FVO and how accounting standards setters are responding to them.
The FVO for financial liabilities permits a reporting entity to mea-sure eligible liabilities at fair value. Eligibility criteria differ somewhat between U.S. GAAP and IFRS, but eligible liabilities typically include the entity's own debt. Common examples of an entity's debt are loans for which the entity is the borrower and bonds that the entity has issued.
Conceptually, the fair value of such debt is the price that the entity would have to pay a third party in an orderly market transaction to induce the third party to assume the debt. In practice, debt is rarely transferred between debtors as a liability, but debt often trades among creditors as an asset. Consequently, accounting standards generally allow entities to estimate the fair value of their debt as the price at which the debt trades as an asset in an active market.
In general, an entity must make an irrevocable choice to apply the FVO--or not--upon initial recognition of a financial liability. That choice may be made independently of the FVO choices the entity has made or will make for its other liabilities.
After initial recognition, financial liabilities for which the FVO has been elected must be "marked to market" at the end of each reporting period. Entities report the periodic changes in the fair value of those liabilities in "Net Income" (U.S. GAAP) or "Profit or Loss" (IFRS).
Objections to Measuring Debt at Fair Value
The application of the FVO to entities' debt has generated significant objections from financial-statement users. Users mainly object to the accounting outcomes that arise from changes in the perceived credit risk of debt to which the debtor has elected to apply the FVO. For example, a company may experience financial difficulties that cause the credit risk of its debt, as perceived by present and potential creditors, to increase. This can be expected to depress the fair value of the debt. The debtor entity's adjusting journal entry to record the decline in the fair value of the debt would involve a debit to the appropriate liability account and a credit for the gain that the entity experiences as a result of the decline in the fair value of its debt. Thus when an entity elects the FVO for its debt, a decline in the entity's creditworthiness is likely to have a favorable effect on the entity's reported income. Many financial-statement users consider this to be a perverse accounting outcome.
I don't concur with users' main objection to the FVO because I don't find the accounting outcome described above to be odd at all. Quite simply, decreases in the fair value of an entity's debt below the debt's amortized cost create the opportunity for the entity to settle its debt at bargain prices by buying back the debt in the open market. Such opportunities generate realizable economic benefits for the entity's shareholders.
There are four other objections to the use of the FVO for an entity's debt, however, that I'm very sympathetic to. First, the optionality of the FVO can result in vast differences in the reported financial position of entities that are actually in similar economic situations. Thus the FVO for financial liabilities undermines the comparability of financial statements among entities. It also allows an entity to account for its debts …