ASC 825 Fair Value Option: Eligibility, Election Dates, Own Credit Risk and Entries

A client borrows $500,000 and agrees with its lender to carry the loan at fair value, because it wants the balance sheet to match the way the bank values the note. Six months later the client's own credit weakens and the loan's fair value drops. Booked naively, that drop is a gain in net income. The standard sends part of it to other comprehensive income instead.

The fair value option (FVO) in ASC 825 lets an entity measure many financial instruments at fair value even though fair value measurement is not required. It is a choice, it is made at specific moments, and it is irrevocable. This guide covers what can be elected, when, how the changes are presented, and the journal entries and audit tests that follow.

What can the fair value option be applied to?

All entities may elect the FVO for:

• recognized financial assets and financial liabilities, except the excluded items below,
• firm commitments that involve only financial instruments and are not otherwise recognized at inception, such as a forward purchase contract for a loan that is not readily convertible to cash,
• written loan commitments,
• certain nonfinancial contract rights and obligations, such as some insurance and warranty items, that can be settled by paying a third party to provide goods or services, and
• host financial instruments that result from separating an embedded nonfinancial derivative from a nonfinancial hybrid.

No entity may elect the FVO for investments in subsidiaries or interests in variable interest entities that it must consolidate; pension, other postretirement, postemployment, stock option and other deferred compensation obligations; demand deposit liabilities of banks and similar institutions; or financial instruments classified wholly or partly in shareholders' equity, including temporary equity. The last exclusion catches some convertible debt. KPMG's debt handbook makes the same point: the evaluation of a conversion option comes before the fair value option question. See /us/standards/asc-470-20-convertible-debt-asu-2020-06.

Service contracts are not eligible. An otherwise eligible instrument with a significant service component may also be ineligible. A bank loan with a small implicit servicing fee generally stays eligible.

When can an entity elect it?

An entity may elect the FVO only on the date one of these events occurs:

1. It first recognizes the eligible item.
2. It enters into an eligible firm commitment.
3. A financial asset previously measured at fair value under specialized guidance, such as investment company accounting, stops qualifying for that guidance.
4. An investment becomes subject to the equity method.
5. A remeasurement event occurs, such as a business combination, consolidation or deconsolidation of a subsidiary or variable interest entity, or a significant debt modification. Preparing liquidation-basis statements and fresh-start reporting after bankruptcy also qualify.

KPMG describes the debt election as a one-time irrevocable policy election made at the instrument's inception. A client that did not elect on day one usually cannot elect later. A significant debt modification is a remeasurement event, and so a new election date. See /us/blog/asc-470-debt-modification-vs-extinguishment-10-percent-test.

Is the election instrument by instrument?

Yes, with exceptions. The entity can elect the FVO for some instruments within a group of similar items, such as some identical bonds from the same issuer. If it does not elect for all eligible instruments in a group, it discloses its reasons and the amounts measured at fair value and not. The election covers more than one item in four cases:

• multiple advances under one contract, such as a line of credit, where the election applies to the larger combined balance,
• equity method investments, where the election applies to all of the investor's eligible equity and debt interests in the same entity, and
• insurance contracts, where it applies to all claims and obligations under the contract.

An entity may also have a pre-existing policy covering specified types of items. Its documentation must be clear enough that it is easy to see which items are subject to the election.

How are changes in fair value presented?

Fair value changes go to earnings, with one exception. For a liability on which the FVO is elected, the part of the change caused by instrument-specific credit risk is recognized separately in OCI. When an entity's credit worsens, the discount rate rises and the fair value of its liability falls, which would otherwise produce a gain. The OCI treatment removes that effect from net income. When the liability is extinguished before maturity, the amount accumulated in AOCI is recycled into net income. KPMG's handbook states this for early extinguishment of debt under the fair value option.

The requirement does not apply to liabilities that are required to be at fair value through earnings, such as derivatives. The entity can measure the credit portion as the part of the periodic change not explained by a base market rate, or by another method that faithfully represents the credit-driven change. The method is a policy election that is disclosed and applied consistently. A liability repayable only from specified pledged assets may have no instrument-specific credit risk, in which case all changes go through earnings.

Up-front costs and fees on FVO items are recognized in earnings immediately, not deferred. A deferred loan cost or fee, ordinarily capitalized into the basis of a loan, is expensed or recognized as revenue at once.

For foreign currency liabilities, the AOCI amount is the instrument-specific credit change in the foreign currency, remeasured at the period-end spot rate. See /us/standards/asc-830-foreign-currency-matters.

Worked entries

All figures are illustrations. On January 1 a company borrows $500,000 and elects the FVO for the note. It pays $5,000 of legal and origination costs.

January 1, borrowing and costs.

The $5,000 is expensed rather than added to the note's carrying amount.

December 31, remeasurement. Fair value of the note falls to $480,000. Of the $20,000 decrease, $8,000 is attributable to deterioration of the company's own credit and $12,000 to changes in market rates.

AOCI carries the $8,000 credit while the note is outstanding. If the company extinguishes the note before maturity, the AOCI balance is recycled to earnings then.

Audit angle

1. Election evidence. Obtain the documentation that existed on the election date. The question is whether the election was made on a permitted date and covered the right instruments. An election described for the first time at year end is a red flag.
2. Eligibility. Check each elected item against the exclusions: consolidated entities, instruments classified in equity, deposit liabilities, compensation obligations.
3. Fair value. Test the fair value of each elected instrument with the procedures for estimates and for the hierarchy level. See /us/blog/asc-820-fair-value-measurement.
4. Own credit split. Obtain the method for isolating instrument-specific credit risk, check that it is applied consistently, and recompute the OCI amount.
5. Costs and fees. Check that origination costs on elected items were expensed, not deferred.
6. AOCI. Agree the AOCI rollforward and the recycling on settlement.
7. Disclosure. Check that the instruments elected are identified and, where only part of a group is elected, the reasons and amounts are disclosed.

Common misstatements: all fair value changes in net income, deferred fees on an elected loan, an election dated after the permitted event, and election of an ineligible item.

CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.

Sources

• KPMG, Handbook: Debt and equity financing (fair value option election, instrument-specific credit risk in AOCI, recycling on extinguishment, issuance costs): https://kpmg.com/us/en/frv/reference-library/2025/handbook-debt-and-equity.html
• PwC Viewpoint, Fair value measurements guide, 5.1 The fair value option, overview and relevant guidance: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/fair_value_measureme/fair_value_measureme__9_US/chapter_5_the_fair_v_US/51_the_fair_value.html
• PwC Viewpoint, Fair value measurements guide, 5.2 Scope of the FVO: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/fair_value_measureme/fair_value_measureme__9_US/chapter_5_the_fair_v_US/52_scope_FVO.html
• PwC Viewpoint, Fair value measurements guide, 5.3 Application of the FVO: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/fair_value_measureme/fair_value_measureme__9_US/chapter_5_the_fair_v_US/53_application_fvo.html
• PwC Viewpoint, Fair value measurements guide, 5.4 Credit risk in individual financial liabilities under the FVO: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/fair_value_measureme/fair_value_measureme__9_US/chapter_5_the_fair_v_US/54_credit_risk_fvo.html
• PwC Viewpoint, IFRS and US GAAP similarities and differences, 10.15 Eligibility for fair value option: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/ifrs_and_us_gaap_sim/ifrs_and_us_gaap_sim_US/chapter_10_financial_US/1015_eligibility_for_US.html

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error