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5.3 FVO Scope
Publication date: 31 Mar 2022
us Fair value guide
When determining eligibility for the fair value option, it is important to consider whether the item is within the scope of ASC 825.
All entities may elect the fair value option for any of the following eligible items:
a. A recognized financial asset and financial liability, except any listed in the following paragraph
b. A firm commitment that would otherwise not be recognized at inception and that involves only financial instruments (for example, a forward purchase contract for a loan that is not readily convertible to cash—that commitment involves only financial instruments—a loan and cash—and would not otherwise be recognized because it is not a derivative instrument)
c. A written loan commitment
d. The rights and obligations under an insurance contract that has both of the following characteristics:
1. The insurance contract is not a financial instrument (because it requires or permits the insurer to provide goods or services rather than a cash settlement).
2. The insurance contract’s terms permit the insurer to settle by paying a third party to provide those goods or services.
e. The rights and obligations under a warranty that has both of the following characteristics:
1. The warranty is not a financial instrument (because it requires or permits the warrantor to provide goods or services rather than a cash settlement).
2. The warranty’s terms permit the warrantor to settle by paying a third party to provide those goods or services.
f. A host financial instrument resulting from the separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument under paragraph 815-15-25-1, subject to the scope exceptions in the following paragraph (for example, an instrument in which the value of the bifurcated embedded derivative is payable in cash, services, or merchandise but the debt host is payable only in cash).
ASC 825 also provides examples when entities are precluded from electing the fair value option. These examples include the financial assets and liabilities in ASC 825-10-15-5.
- An investment in a subsidiary that the entity is required to consolidate.
- An interest in a variable interest entity (VIE) that the entity is required to consolidate.
- Employers’ and plans’ obligations (or assets representing net overfunded positions) for pension benefits, other postretirement benefits (including health care and life insurance benefits), postemployment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements, as defined in Topics 420; 710; 712; 715; 718; and 960.
- Financial assets and financial liabilities recognized under leases, as defined in Subtopic 840-10. (This exception does not apply to a guarantee of a third-party lease obligation or a contingent obligation arising from a cancelled lease.)
- Deposit liabilities, withdrawable on demand, of banks, savings and loan associations, credit unions, and other similar depository institutions.
- Financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder’s equity (including temporary equity) (for example a convertible debt security with the scope of the Cash Conversion Subsections of Subtopic 470-20 or a convertible debt security with a non-contingent beneficial conversion feature).
The FVO can generally not be elected for the above items because the accounting for these items is already addressed by specific accounting pronouncements, and the FASB concluded that the appropriate time for debating the measurement attribute for such items is during any reconsideration of those pronouncements. However, some insurance and investment contracts include features that permit the insured (or the investor) to withdraw (i.e., “demand”) amounts specified in the contract; therefore, a question arises as to whether such contracts are subject to the exclusion applicable to demand deposit liabilities as discussed above. We believe the investor is eligible to elect the FVO for these contracts because the scope exception is limited to demand-deposit liabilities of specified financial institutions. However, the valuation of such insurance contracts would need to reflect the impact of the right of the insured/investor to withdraw.
5.3.1 Service contracts
The fair value option is not available for service contracts. In some cases, an item otherwise eligible for the fair value option may contain a significant service component. A general partnership interest, which is a financial instrument, may not be eligible for the fair value option if there is a significant service component. We believe this should be applied to any financial instrument that is otherwise eligible for the fair value option. Therefore, an entity should evaluate whether the service component embedded within an otherwise eligible asset or liability is significant to determine whether the item is eligible for the fair value option.
The determination of what constitutes a significant service component must be made in light of the particular instrument in question. Many financial instruments include implicit or explicit servicing components that are an inherent part of the instrument, but would typically not be considered significant. For example, a bank may initiate a loan and charge an 8% interest rate, 1% of which implicitly covers the cost to service the loan. Similarly, an insurance company may issue a variable annuity contract with an explicit fee that in part is meant to cover the costs incurred by the insurer to manage the investments purchased with the policyholder’s deposit premium. If these fees are not significant at inception, are not expected to be significant in the future in comparison to the fair value of the instrument, and are comparable to a typical fee charged for such an instrument, election of the fair value option would not be precluded.
5.3.2 Hybrid financial instruments that are equity or contain an equity feature
ASC 815-15-25-4 allows a company that is required to separate a derivative from a hybrid financial instrument (e.g., convertible debt) to make an irrevocable election at the beginning of the contract to fair value the entire instrument with changes in fair value recognized in earnings.
However, ASC 825-10-15-5(f) states that the fair value option cannot be elected for a financial instrument that is in whole or in part classified by the issuer as a component of shareholders’ equity. The example provided in ASC 825 is that of a convertible debt security with a non-contingent beneficial conversion feature although it should be noted that the beneficial conversion feature model for convertible debt will be eliminated upon the adoption of ASU 2020-06.
However, the substantial premium model will remain for convertible debt, which would still cause the hybrid instrument to be ineligible for the fair value option since a portion of the instrument will be recorded in shareholders’ equity.
Therefore, hybrid financial instruments must be evaluated to determine if any component of the instrument will be recorded in shareholders’ equity before determining if the instrument is eligible for the fair value option. Only hybrid instruments for which no component is recorded in shareholders’ equity would be eligible to elect the fair value option.
5.3.3 Derecognition and partial sales of nonfinancial assets
ASC 610-20 addresses the derecognition of nonfinancial assets, including partial sales transactions in which the seller retains a noncontrolling equity interest in the entity that is transferred or has an equity interest in the buyer. An entity must recognize a full gain or loss on contributions to joint ventures of nonfinancial assets within the scope. Furthermore, entities have the opportunity to elect the FVO as a new basis (fair value) for equity ownership created when contributing nonfinancial assets to a joint venture.
1 ASU 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity's Own Equity (Subtopic 815-40)—Accounting for Convertible Instruments and Contracts in an Entity's Own Equity, is effective for public business entities, excluding smaller reporting companies as defined by the SEC, for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted.
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