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Should reporting entities be allowed to measure their debt at its fair value?
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.
Background
The FVO for financial liabilities permits a reporting entity to measure 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 indepen - dently 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"...