How are financial instruments accounted for at fair value?

Where a financial instrument is not measured at amortized cost, it is measured at fair value through net income (profit or loss).  Fair value is the price at which an asset or liability could be exchanged in a current arms’ length transaction between knowledgeable, unrelated, willing parties either by reference to an active market or through a reasonable estimation process.  Under US GAAP, financial assets held for trading and available for sale are measured at the lower of cost and fair value, while these assets are stated under IFRS at fair value with valuation based on a fair value hierarchy.

Under the fair value measurement approach, assets and liabilities are remeasured periodically to reflect changes in their fair value, with the resulting change impacting either net income (profit or loss) or other comprehensive income for the period.  Both US GAAP and IFRS require that up-front fees and costs be recognized in earnings as incurred.  The result is a balance sheet that better reflects the current economic value of assets and liabilities, although fair value accounting causes greater volatility in periodic reported performance.

Financial instruments accounted at fair value through net income (US GAAP: FV-NI; IFRS: fair value through profit or loss (FVTPL)) are measured at initial recognition and remeasured at fair value at each reporting date by reference to an active market or by a reasonable estimation process, with gains and losses recognized in profit or loss for the year. Measurement at FV-NI excludes transactions costs, which are expensed as incurred.

Financial assets classified at fair value through other comprehensive income (US GAAP: FV-OCI; IFRS: FVTOCI, FVOCI) are initially recognized at fair value, including associated transaction costs, and that report subsequent fair value gains and losses each reporting date in other comprehensive income (OCI) in equity in the balance sheet.  The amounts recognized in the income statement reflect amortized cost while the balance sheet reflects the fair value of the asset.  FV-OCI is optional for amortized cost assets and equity if the asset is not held for trading and the entity irrevocably elects upon initial recognition to account for it at FV-OCI.  For equity investments at FV-OCI, fair value changes are recognized in OCI while dividends are recognized in income.  Any cumulative gain or loss previously recognized in OCI is reclassified (“recycled”) from equity to net income on derecognition or reclassification.

The fair value option (FVO) is the option of an entity to elect to measure financial instruments at fair value at initial recognition that could be recognized and measured either at amortized cost or fair value through other comprehensive income.  Election of the fair value option may be made only at initial recognition and is generally irrevocable. The fair value option is commonly chosen to eliminate or significantly reduce recognition inconsistency (mismatch) that would otherwise result from recognizing gains and losses on the instruments on different bases.