Question

What is the fair value option? Briefly describe the controversy of applying the fair value option to financial liabilities.

Short answer

The fair value option is the option provided to the firms to use the fair value method while measuring financial assets and liabilities. The use of the fair value option makes it necessary for the business entities to record losses in case of a decrease in the fair value of assets or an increase in the fair value of liabilities.

Step-by-step solution

Definition of Fair Value

The term fair value refers to the value of an asset, commodity, or something that can be sold, which is agreed upon by both the parties involved in the transaction, such as the buyer and the seller.

Controversy of applying the fair value option to financial liabilities

Since bonds are issued at fair value, it is estimated that the reduction in the value of the bonds is the result of an increase in the interest rate. These gains and losses are recorded in income if it is not associated with the changes in credit risks. In other cases, the value reduction may occur as the issue is more likely to neglect the bonds. It means that in case there is a decline in creditworthiness, the value of its debt will also decline. With the decline in creditworthiness, its bonds will receive a lower rate in comparison to the investors with same-risk investments. Therefore, alterations in the fair value of bonds payable for a reduction in the creditworthiness are regarded as a part of othercomprehensive income.