How does the fair value option work for financial liabilities?

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AcadiFi · Accepted Answer

When an entity elects FVO for a financial liability under IFRS 9, the total change in fair value is split between two components: the amount attributable to changes in the liability's own credit risk is recognized in OCI, and all other changes (primarily interest rate, market, and other risks) are recognized in P&L.

For Gravelton's structured bond: suppose on day one the fair value is $100 million; at year-end it is $94 million, a $6 million gain. Analysis attributes $2 million to a widening of Gravelton's own credit spread (because investors now view Gravelton as riskier, the liability is worth less) and $4 million to a rise in market interest rates. Under IFRS 9, the $2 million own-credit gain goes to OCI; the $4 million market-rate gain goes to P&L.

The OCI component is not subsequently reclassified to P&L even on derecognition, differing from cash flow hedge reserves. It remains in equity (or can be transferred within equity). This rule addresses the counterintuitive result where a deteriorating credit position would otherwise generate P&L gains on debt.

Under US GAAP ASC 825, the split is substantially the same post-ASU 2016-01, with own-credit component going to OCI. Measurement of the own-credit component uses methods like level-yield with constant credit spread, or observed CDS spread changes.

Disclosures include the cumulative credit-related OCI balance and the methodology for attributing credit versus market changes.

How does the fair value option work for financial liabilities?

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