Fair value through other comprehensive income

What Is Fair Value Through Other Comprehensive Income?

Fair value through other comprehensive income (FVTOCI) is an accounting classification for certain financial assets under International Financial Reporting Standard (IFRS) 9, which falls under the broader category of Financial Reporting and Accounting. This classification dictates how changes in an asset's fair value are recognized in a company's financial statements. Specifically, when an asset is classified as FVTOCI, its unrealized gains and losses, which reflect changes in market value but have not yet been "realized" through a sale, are recorded in other comprehensive income (OCI) rather than directly impacting the profit or loss statement. This distinct treatment aims to reduce volatility in reported earnings for certain long-term investments.

The FVTOCI category applies primarily to specific debt instruments and, by election, to some equity instruments. For debt instruments, the classification requires that the asset's contractual cash flows consist solely of principal and interest, and the entity's business model for managing these assets is achieved by both collecting contractual cash flows and selling the financial assets. For equity investments, the FVTOCI classification is an irrevocable election made at initial recognition.

History and Origin

The concept of fair value through other comprehensive income emerged with the development of IFRS 9 Financial Instruments by the International Accounting Standards Board (IASB). This standard was a direct response to calls for improved financial reporting following the 2008 global financial crisis, which highlighted perceived deficiencies in the previous standard, IAS 39 Financial Instruments: Recognition and Measurement. The IASB's project to replace IAS 39 was phased, with the classification and measurement of financial assets being an early focus. The initial version of IFRS 9, released in November 2009, introduced new requirements for classifying and measuring financial assets. The "fair value through other comprehensive income" measurement category for particular simple debt instruments was introduced as part of the completed version of IFRS 9 issued in July 2014.¹³ IFRS 9 became mandatorily effective for annual periods beginning on or after January 1, 2018.¹² The standard aimed to provide a more principles-based approach to classifying financial assets compared to its predecessor.¹¹ Further details on the history of IFRS 9 can be found through the comprehensive resources provided by IAS Plus, Deloitte's global IFRS portal.¹⁰

Key Takeaways

• Fair value through other comprehensive income (FVTOCI) is an accounting classification under IFRS 9 for specific financial assets.
• It primarily applies to certain debt instruments and, optionally, to some equity investments.
• Unrealized gains and losses on FVTOCI assets are recognized in other comprehensive income (OCI), not directly in profit or loss.
• This classification reflects a business model where an entity both collects contractual cash flows and sells financial assets (for debt instruments).
• FVTOCI helps reduce the volatility of reported earnings compared to assets measured at fair value through profit or loss.

Interpreting the Fair Value Through Other Comprehensive Income

The classification of an investment as fair value through other comprehensive income provides insight into a company's management strategy for its financial assets. For debt instruments, it indicates a dual business model: the company intends to hold the assets to collect contractual cash flows but also reserves the flexibility to sell them in response to liquidity needs or changes in market conditions. This is distinct from assets held at amortized cost, where the primary intention is solely to collect contractual cash flows.

The accumulation of unrealized gains and losses in other comprehensive income (OCI) for FVTOCI assets means that while the market value fluctuations are recognized, they do not immediately flow through to the income statement's net profit or loss. This separation provides a clearer view of a company's operational performance, as it segregates temporary market movements from core business profitability. Users of financial statements can then assess the total economic value of the company's assets, including these fair value changes, by looking at the comprehensive income section of the statement of financial position.

Hypothetical Example

Consider "InvestCo," a financial institution holding a portfolio of corporate bonds. These bonds are designated as fair value through other comprehensive income because InvestCo's management aims to collect interest payments (contractual cash flows) but also might sell them if better investment opportunities arise or if they need to manage their liquidity.

1. Initial Purchase: InvestCo buys 1,000 corporate bonds, each with a face value of $1,000, for a total of $1,000,000.
2. Year 1 End (Market Movement): Due to a decrease in market interest rates, the fair value of each bond increases to $1,020.
3. Accounting Treatment: The total fair value of the bonds is now $1,020,000. The $20,000 unrealized gain ($1,020,000 - $1,000,000) is recognized in other comprehensive income. This gain does not appear in InvestCo's profit or loss statement for the year, thus not inflating its reported net income. Interest income from the bonds, however, is recognized in profit or loss.
4. Year 2 End (Further Movement): The fair value of each bond drops to $990, perhaps due to a slight increase in interest rates or a change in the issuer's credit rating.
5. Accounting Treatment: The total fair value is now $990,000. The cumulative unrealized gain previously recognized in OCI was $20,000. Now, the market value is $10,000 below the original cost. The unrealized loss of $30,000 ($990,000 - $1,020,000) for this period is also recognized in other comprehensive income, reducing the cumulative OCI balance. The cumulative unrealized loss becomes $10,000 (a cumulative gain of $20,000 from Year 1, minus a loss of $30,000 in Year 2). No direct impact on profit or loss, reflecting the long-term holding intent despite market fluctuations.
6. Sale in Year 3: InvestCo decides to sell the bonds when their fair value is $1,010 per bond.
7. Accounting Treatment: The bonds are sold for $1,010,000. The difference between the original cost ($1,000,000) and the sale price ($1,010,000) is a realized gain of $10,000, which is recognized in profit or loss. Simultaneously, the cumulative balance of unrealized gains or losses related to these bonds that was held in other comprehensive income is reclassified to profit or loss, ensuring the total gain or loss from the investment is recognized.

Practical Applications

Fair value through other comprehensive income is a critical component of financial reporting for entities that hold investment portfolios, particularly financial institutions, insurance companies, and large corporations. It allows for a more nuanced presentation of financial performance by distinguishing between changes in fair value that are temporary market fluctuations and those that are expected to be realized through sale or maturity.

A key area of application is in the balance sheet management of banks. For certain debt securities, classifying them as FVTOCI under IFRS 9 means that temporary market volatility does not directly impact the bank's earnings, which can help stabilize reported profits. This contrasts with assets classified as fair value through profit or loss, where all changes immediately affect earnings. Companies must make judgments about their business models and the contractual cash flow characteristics of their financial assets to determine the appropriate classification.⁹ For example, debt instruments held under a business model with both collection and selling objectives are candidates for FVTOCI.⁸ The implementation of IFRS 9, including the FVTOCI category, has brought about significant changes in how companies report financial instruments and manage their financial statements, impacting aspects like impairment and hedge accounting.⁷ Companies should carefully analyze the implications of these classifications on their financial reporting.⁶

Limitations and Criticisms

While fair value through other comprehensive income offers benefits by smoothing reported earnings volatility, it is not without limitations or criticisms. One primary concern is the complexity it adds to financial reporting. The distinction between the FVTOCI category and fair value through profit or loss (FVTPL), along with the amortized cost category, requires significant judgment from management regarding their business model for managing financial assets.⁵ A change in a company's business model is required for reclassification between categories, and such changes are expected to be infrequent.⁴

Another point of contention arises from the differing treatments of gains and losses for debt versus equity instruments classified as FVTOCI. For debt instruments, unrealized gains and losses accumulated in OCI are reclassified to profit or loss when the asset is derecognized (e.g., sold or matures). However, for equity instruments elected as FVTOCI, subsequent fair value changes recognized in OCI are generally not reclassified to profit or loss upon derecognition, except for dividend income which goes to profit or loss.³ This difference can lead to complexities in understanding the ultimate recognition of investment performance. Furthermore, while FVTOCI aims to reduce earnings volatility, it can still mask the full economic impact of market movements if users only focus on the profit or loss statement without delving into the other comprehensive income section.

Fair Value Through Other Comprehensive Income vs. Fair Value Through Profit or Loss

The key distinction between fair value through other comprehensive income (FVTOCI) and fair value through profit or loss (FVTPL) lies in where the unrealized gains and losses on financial assets are recognized in a company's financial statements.

Confusion often arises because both classifications involve measuring assets at fair value on the statement of financial position. However, the crucial difference lies in the treatment of subsequent changes in that fair value. FVTOCI separates these unrealized fluctuations from core operating performance, while FVTPL immediately incorporates them, making the latter more volatile. Under US Generally Accepted Accounting Principles (US GAAP), the "available-for-sale" (AFS) classification previously functioned similarly to FVTOCI, with unrealized gains and losses reported in OCI. An example of AFS classification is illustrated in filings with the Securities and Exchange Commission (SEC).² However, IFRS 9 introduced a more refined, principles-based classification system. Detailed comparisons between IFRS Accounting Standards and US GAAP for investments in debt and equity securities are available.¹

FAQs

What types of assets are classified as FVTOCI?

Fair value through other comprehensive income primarily applies to debt instruments that meet two specific criteria: their contractual cash flows are solely payments of principal and interest, and the entity's business model involves both collecting these cash flows and selling the financial assets. Additionally, entities can irrevocably elect to classify certain equity instruments as FVTOCI at initial recognition.

Why do companies use the FVTOCI classification?

Companies use the FVTOCI classification to manage the volatility of their reported earnings. By recognizing unrealized gains and losses in other comprehensive income (OCI) rather than directly in the profit or loss statement, temporary market fluctuations in the value of long-term investments do not immediately impact a company's net income. This can provide a more stable view of operational profitability.

What is the difference between FVTOCI and amortized cost?

The main difference lies in how the asset is measured and how changes in its value are recognized. Assets at amortized cost are measured based on their initial cost adjusted for interest and principal payments, and unrealized changes in fair value are not recognized in the financial statements. This classification is for assets held solely to collect contractual cash flows. FVTOCI assets, however, are measured at fair value on the balance sheet, with unrealized gains and losses going to OCI, reflecting an intent to both collect cash flows and potentially sell the asset.

Does FVTOCI impact a company's net income?

Indirectly, yes, over time. For debt instruments classified as FVTOCI, accumulated unrealized gains and losses that were recognized in other comprehensive income are reclassified to profit or loss when the asset is sold or derecognized. For equity instruments elected as FVTOCI, however, gains and losses are generally not reclassified to profit or loss upon sale, with only dividend income affecting profit or loss directly. This means the immediate impact on net income from market value changes is avoided under FVTOCI, but the ultimate realized gain or loss for debt instruments will eventually flow through the income statement.