What is the fair value option, and why would a company elect to measure a financial instrument at fair value through profit or loss?

The fair value option (FVO) under ASC 825 (US GAAP) and IFRS 9 allows companies to elect, at initial recognition, to measure certain financial instruments at fair value through profit or loss (FVTPL) — even when the default classification would use amortized cost or fair value through OCI.

When Can the Election Be Made?

The FVO election is available for:

• Financial assets (loans, debt securities, equity investments)
• Financial liabilities (issued debt, deposits)
• Firm commitments
• Written loan commitments

The election must be made at initial recognition (or at specific qualifying events) and is irrevocable — once elected, you cannot switch back.

Why Elect the Fair Value Option?

1. Reduce accounting mismatch — when an asset and its economically related liability would otherwise be measured on different bases (e.g., one at amortized cost, the other at fair value), leading to artificial income volatility

1. Simplify hedge accounting — rather than designating complex hedge relationships, the FVO puts both items through P&L

1. Better reflect economic substance — for institutions that manage portfolios on a fair value basis

Worked Example — Ridgemont Financial:

Ridgemont holds a loan portfolio of $50,000,000 and has issued structured notes of $48,000,000 to fund these loans. Without FVO:

• Loans: measured at amortized cost
• Structured notes: measured at amortized cost
• If market rates change, the loans and notes have offsetting economic effects, but NEITHER is remeasured — no P&L volatility

With FVO elected for both:

• Loans: fair value changes go through P&L
• Structured notes: fair value changes go through P&L
• Natural offset reduces artificial volatility

Year 1 — Interest rates rise 100 bps:

Without FVO, both items stay at amortized cost and the P&L shows no mark-to-market effect — potentially misleading since the economic risk exposure has changed.

Financial Statement Implications:

1. Income volatility increases — fair value changes flow through net income each period
2. Balance sheet reflects current values — both assets and liabilities at fair value
3. Own credit risk (liabilities): Under IFRS 9, if a liability is measured at FVTPL under the FVO, changes due to the company's own credit risk go through OCI (not P&L). Under US GAAP, this also applies per ASU 2016-01.

Disclosure Requirements:

• Companies must disclose which instruments are under the FVO
• The fair value and the difference from the contractual principal amount due at maturity
• The amount of gain or loss attributable to changes in own credit risk (for liabilities)

Key Exam Points:

1. The FVO is an irrevocable election made at initial recognition.
2. It is designed to reduce accounting mismatches, not to manipulate earnings.
3. For liabilities, own credit risk changes go through OCI (preventing the counterintuitive result of recognizing gains when your own creditworthiness deteriorates).
4. The FVO differs from the FVTPL mandatory classification — FVO is elective; some instruments are required to be at FVTPL regardless.

Explore fair value measurement topics in our CFA Level I FRA course.