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The Fair Value Option

The Fair Value Option. SFAS 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 IASB This standards moves US GAAP closer to IFRS

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The Fair Value Option

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  1. The Fair Value Option SFAS No. 159 Now FASB ASC Topic 825

  2. Why was FAS159 issued? • IFRS permits a fair-value election for financial instruments (IAS 39) • FASB wants to converge with IASB • This standards moves US GAAP closer to IFRS • For some organizations, hedging becomes simpler than it would be under FAS 133 (derivatives)

  3. A quick introduction to the concept A very simple company that starts with one asset and one liability – to keep it simple!

  4. 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

  5. Brand New Inc., 1st day 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.

  6. End of year – interest rates change • Bond 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

  7. Brand New Inc., end of year 1Does not use FV option (a) Interest revenue $120 – Interest expense $100 + gain $78 = $98 net income This is our traditional accounting (book value for debt, fair value for investments classified as trading

  8. Brand New Inc., end of year 1Does not use FV option (b) Interest revenue $120 – Interest expense $100 = $20 net income with $78 gain on statement of comprehensive income If the bond were classified as “available for sale” the gain would be reported in AOCI rather than on the income statement.

  9. 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=$1,000 • solve for PV _______________________ • Now, what does the balance sheet look like? $1,090

  10. Brand New Inc., end of year 1uses FV option, Bond A at 9% Interest revenue $120 – $100 interest expense + $78 gain on investment - $90 loss on liability = $8 net income

  11. 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=$1,000 • solve for PV _______________________ • Now, what does the balance sheet look like? $922

  12. New Company, end of year 1uses FV option, Bond A at 11% Interest revenue $120 – Interest expense $100 + gain $78 on investment + $78 gain on liability = $176 net income

  13. FAS159 – fair value choice is permanent for each item • Companies may elect fair value measurement when an asset or liability is • First recognized, or • An event triggers a new basis of accounting (business combination) • Applies to entire contract • Election is irrevocable • Change in value is reported on the income statement

  14. Eligible assets & liabilities • Recognized financial assets and financial liabilities • Includes some investments accounted for under the equity method • Excludes leases, pension plans, etc. • Written loan commitments • Firm commitments that involve only financial instruments • Rights & obligations under insurance contracts, warranties

  15. Disclosures • Fair-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.

  16. 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 bonds • With premium or discount • Preparing journal entries • Using allowance account to adjust to market value

  17. Fair values are disclosed even without FAS159 option • 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 bonds • With premium or discount • Preparing journal entries • Using allowance account to adjust to market value

  18. The Fair Value Option IAS 39 vs FAS 159 (ASC 825) versus

  19. Fair Value Option Compared IFRS US GAAP • Must meet criteria so that financial reporting is improved by fair value measurement • Precludes similar items as listed in FAS159 (leases, pensions, etc.) • Determination is made at initial recognition and cannot be changed • Instrument by instrument decision • Applies only to items within scope of FAS159 (ASC 825) • Determination is made at initial recognition and cannot be changed

  20. IFRS permits the fair value option when doing so results in more relevant information because • It 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

  21. HW #2 • Problems 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 allowanceto adjust the bond’s “carrying value” to the “fair value” and recognize the gain or loss on the debt in the income statement

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