The Fair Value OptionSFAS 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 IASBThis 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 conceptA 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 dayAssets Liabilities & Owners EquityBond B $1,000 Bond A $1,000

OE $0

Let’s 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.

End of year – interest rates changeBond 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=$1,000Solve for PV = __________________$1,078

Brand New Inc., end of year 1Does not use FV option (a)Assets Liabilities & Owners EquityCash 20 Bond A $1,000Bond B $1,078 OE $98

This is our traditional accounting (book value for debt, fair value for investments classified as trading

Interest revenue $120 – Interest expense $100 + gain $78 = $98 net income

Brand New Inc., end of year 1Does not use FV option (b)Assets Liabilities & Owners EquityCash $ 20 Bond A $1,000Bond B 1,078 RE 20

AOCI 78$1,098 $1,098

If the bond were classified as “available for sale” the gain would be reported in AOCI rather than on the income statement.

Interest revenue $120 – Interest expense $100 = $20 net income with $78 gain on statement of comprehensive income

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=$1,000solve for PV _______________________

Now, what does the balance sheet look like?

$1,090

Brand New Inc., end of year 1uses FV option, Bond A at 9%Assets Liabilities & Owners EquityCash $ 20 Bond A $1,090Bond B 1,078 OE 8

$1,098 $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=$1,000solve for PV _______________________

Now, what does the balance sheet look like?

$922

New Company, end of year 1uses FV option, Bond A at 11%

Assets Liabilities & Owners EquityCash $ 20 Bond A $ 922Bond B 1,078 OE 176

$1,098 $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 itemCompanies may elect fair value measurement

when an asset or liability is First recognized, orAn event triggers a new basis of accounting

(business combination)Applies to entire contractElection is irrevocableChange in value is reported on the income

statement

Eligible assets & liabilitiesRecognized financial assets and financial

liabilitiesIncludes some investments accounted for under

the equity methodExcludes leases, pension plans, etc.

Written loan commitmentsFirm commitments that involve only financial

instrumentsRights & obligations under insurance

contracts, warranties

DisclosuresFair-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

We’ll look at some more realistic problems related to estimating fair values:Semi-annual bondsWith premium or discountPreparing journal entriesUsing allowance account to adjust to market

value

Fair values are disclosed even without FAS159 optionUnder ASC 715 (FAS107), the fair values of

financial instruments are disclosed in the financial statements

We’ll look at some more realistic problems related to estimating fair values:Semi-annual bondsWith premium or discountPreparing journal entriesUsing allowance account to adjust to market

value

The Fair Value OptionIAS 39 vs FAS 159 (ASC 825)

versus

Fair Value Option ComparedIFRS US GAAP

Must meet criteria so that financial reporting is improved by fair value measurementPrecludes similar items

as listed in FAS159 (leases, pensions, etc.)

Determination is made at initial recognition and cannot be changed

Instrument by instrument decisionApplies only to items

within scope of FAS159 (ASC 825)

Determination is made at initial recognition and cannot be changed

IFRS permits the fair value option when doing so results in more relevant information becauseIt 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 #2Problems 1 & 2 are similar problems to the examples in this

ppt file. However, I haven’t 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 We’ll 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. We’ll 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 bond’s “carrying value” to the “fair value” and recognize the gain or loss on the debt in the income statement