Fair value through profit or loss

What Is Fair Value Through Profit or Loss?

Fair value through profit or loss (FVTPL) is an accounting classification for certain financial instruments, primarily financial assets and some financial liabilities, where changes in their fair value are recognized directly in the profit and loss statement (also known as the income statement) in the period they occur. This classification is a core component of modern accounting standards within the broader category of financial accounting and reporting, particularly under the International Financial Reporting Standards (IFRS). Assets classified as fair value through profit or loss are typically held for trading purposes or are managed on a fair value basis, meaning their short-term market fluctuations are directly relevant to assessing an entity's performance.

History and Origin

The concept of fair value through profit or loss gained prominence with the evolution of global accounting standards, particularly the development of IFRS 9, Financial Instruments. This standard was developed by the International Accounting Standards Board (IASB) to replace IAS 39, Financial Instruments: Recognition and Measurement, which had been criticized for its complexity and for contributing to delayed recognition of credit losses during the 2008 global financial crisis.²³

The IASB issued chapters of IFRS 9 relating to the classification and measurement of financial assets in November 2009, with requirements for financial liabilities added in October 2010.²² The complete IFRS 9, including new requirements for impairment and hedge accounting, was issued in July 2014 and became effective for annual periods beginning on or after January 1, 2018.¹⁹, ²⁰, ²¹ The introduction of fair value through profit or loss as a primary classification aimed to provide more transparent and timely recognition of gains and losses from certain financial instruments, reflecting their economic reality more closely.

Key Takeaways

• Fair value through profit or loss (FVTPL) is an accounting designation for financial assets and liabilities.
• Changes in the fair value of FVTPL instruments are recognized immediately in the profit and loss statement.
• This classification is typically applied to instruments held for trading or those managed on a fair value basis.
• The primary objective of FVTPL is to provide transparent and timely financial reporting of market value fluctuations.
• It is a key classification under International Financial Reporting Standards (IFRS 9).

Interpreting the Fair Value Through Profit or Loss

When financial assets or liabilities are designated as fair value through profit or loss, the immediate impact of market price changes on a company's earnings is evident. For instance, if a bond classified as FVTPL increases in market value, that gain is recognized as income, boosting the company's reported profit. Conversely, a decline in value would result in a loss, directly reducing reported profit.

This immediate recognition of gains and losses in the profit and loss statement distinguishes FVTPL from other classifications. It means that the reported profitability of an entity can be highly sensitive to market fluctuations in the value of these instruments. For investors and analysts, understanding this accounting treatment is crucial for accurately interpreting a company's reported earnings and assessing the volatility introduced by its holdings of such equity instruments and debt instruments. It provides a clearer picture of assets held for short-term speculation or active management.

Hypothetical Example

Consider XYZ Corp., a financial institution that purchases 100 shares of ABC Stock on January 1 for $50 per share, intending to trade them actively based on short-term market movements. XYZ Corp. classifies these shares as fair value through profit or loss.

1. Initial Recognition (January 1):
   XYZ Corp. recognizes the investment at its cost, which is also its fair value at inception:
   Debit: Financial Assets (FVTPL) $5,000
   Credit: Cash $5,000

2. Period 1 End (March 31):
   The market value of ABC Stock rises to $55 per share.
   Fair Value at March 31: 100 shares * $55/share = $5,500
   Unrealized Gain: $5,500 - $5,000 = $500

   XYZ Corp. recognizes this unrealized gain in its profit and loss statement:
   Debit: Financial Assets (FVTPL) $500
   Credit: Unrealized Gain on FVTPL Investments $500
   (This $500 gain increases the reported net income for the period.)

3. Period 2 End (June 30):
   The market value of ABC Stock falls to $52 per share.
   Fair Value at June 30: 100 shares * $52/share = $5,200
   Unrealized Loss: $5,500 (previous fair value) - $5,200 = $300

   XYZ Corp. recognizes this unrealized loss in its profit and loss statement:
   Debit: Unrealized Loss on FVTPL Investments $300
   Credit: Financial Assets (FVTPL) $300
   (This $300 loss reduces the reported net income for the period.)

This example illustrates how gains and losses, whether realized or unrealized, directly impact the balance sheet and income statement when assets are classified as fair value through profit or loss.

Practical Applications

Fair value through profit or loss is widely applied in various segments of the financial markets and corporate financial reporting. Its application is particularly prominent for companies engaged in activities where the primary objective of holding financial instruments is short-term profit-taking or active portfolio management.

• Trading Portfolios: Banks, investment firms, and hedge funds typically classify their trading securities, including many derivatives, as FVTPL. This ensures that their exposure to market volatility and the results of their trading strategies are immediately reflected in their reported earnings.
• Investment Companies: Mutual funds, exchange-traded funds (ETFs), and other investment vehicles often measure all their investments at FVTPL, as their business model is to manage investments for fair value returns.
• Financial Liabilities: In some cases, companies can elect to designate certain financial liabilities as FVTPL, particularly when doing so eliminates an accounting mismatch that would otherwise arise from measuring assets or other liabilities on a different basis.
• Risk Management: While not directly a risk management tool, the FVTPL classification provides transparent and timely information about the market risk associated with certain assets and liabilities, aiding internal and external analysis.

The implementation of IFRS 9, which mandates this classification for most financial instruments held for trading, significantly impacted the banking sector globally. Banks, for instance, were required to recognize expected credit loss provisions much earlier than under previous standards, affecting their capital and profitability.¹⁶, ¹⁷, ¹⁸ This shift in financial reporting aimed to provide more forward-looking insights into financial health.

Limitations and Criticisms

While fair value through profit or loss aims to provide timely and relevant information, it has faced criticisms, particularly regarding its potential to introduce volatility into financial statements and its reliance on estimates.

One significant criticism is that FVTPL can lead to increased volatility in a company's reported earnings. Rapid fluctuations in market prices, even for unrealized gains or losses, directly affect the profit and loss statement, potentially obscuring underlying operational performance. Critics argue that this "mark-to-market" approach, which is inherent in FVTPL, contributed to exacerbating the 2008 financial crisis by forcing institutions to write down the value of assets when markets became illiquid, even if the intention was to hold those assets long-term.¹⁴, ¹⁵

Another concern revolves around the subjectivity involved in determining fair value, especially for instruments that do not have active markets or readily observable prices. In such cases, fair value relies on valuation models and management estimates, which can introduce a degree of judgment and potential for manipulation.¹³ Although accounting standards provide a fair value hierarchy to guide these measurements (favoring observable market prices), Level 3 inputs, which are unobservable, still require significant estimation.¹²

Furthermore, some argue that FVTPL, by focusing solely on market value, does not adequately reflect the long-term intrinsic value of certain assets or the stewardship function of management.¹¹ For example, a company might invest in a start-up with significant long-term growth potential, but its fair value may fluctuate widely in the short term, leading to volatile earnings that don't reflect the strategic intent of the investment.

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

The distinction between fair value through profit or loss (FVTPL) and fair value through other comprehensive income (FVOCI) is crucial in financial accounting. Both classifications measure financial instruments at fair value, but they differ significantly in how changes in that fair value are recognized in a company's financial statements.

The primary point of confusion often arises because both categories use "fair value" as their measurement basis. However, their accounting treatment differs based on the entity's business model for managing the instrument and its contractual cash flow characteristics. While FVTPL provides immediate transparency of market fluctuations, FVOCI aims to reduce earnings volatility for instruments that are not primarily held for short-term trading.

FAQs

What types of financial instruments are typically classified as fair value through profit or loss?

Financial instruments typically classified as fair value through profit or loss include those held for trading purposes, such as actively traded stocks, short-term bonds, and most derivatives. Additionally, companies may irrevocably designate other financial assets or financial liabilities to be measured at fair value through profit or loss if it eliminates or significantly reduces an accounting mismatch.

How does fair value through profit or loss affect a company's financial statements?

For instruments classified as fair value through profit or loss, any change in their market value, whether a gain or a loss, is directly recognized in the company's profit and loss statement (income statement) in the period the change occurs. This means that reported earnings can be more volatile due to market fluctuations in these assets, providing a current view of the value of these specific holdings.

Why would a company choose to classify an asset as fair value through profit or loss?

A company typically classifies an asset as fair value through profit or loss if its business model for managing that asset is to hold it for short-term trading or to realize profits from short-term price movements. For example, a brokerage firm actively buying and selling securities would classify those holdings as FVTPL. This classification ensures that the financial statements reflect the most relevant and current valuation of such assets, aligning with the company's intent.

Is fair value through profit or loss applicable under all accounting standards?

The concept of fair value through profit or loss is a core component of International Financial Reporting Standards (International Financial Reporting Standards), specifically IFRS 9, Financial Instruments. While the terminology and specific rules may differ, similar principles exist under other accounting frameworks, such as U.S. Generally Accepted Accounting Principles (U.S. GAAP), which also utilize fair value measurement with certain instruments affecting net income.

How is fair value determined for instruments classified as FVTPL?

Fair value is generally determined based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. For actively traded instruments, this is typically their quoted market price. For less liquid instruments, valuation techniques involving observable market inputs or, in some cases, unobservable inputs and assumptions are used to estimate fair value.