I’m having a little trouble understanding gains/losses under Fair Value Reporting for debt. So if a bond is reported at fair value, and the interest rate increases, that means the bond’s value on the balance sheet (liabilities) decreases. Why is this considered a gain? Interest payments aren’t going down.
Also, one of the examples in Schweser said that when interest rate increases, a firm would repurchase their debt because of lower prices. This lowers the firm’s liabilities, but won’t their interest payments increase then?
I’d really appreciate if someone could help out! Thanks!
Let’s say that you issue $1,000,000 of 10-year, 6% coupon, semiannual pay bonds at par. You record a liability of $1,000,000. If you were to try to pay off that debt today, you’d have to pay $1,000,000.
One year later, interest rates rise to 7%. The market value of the bonds is now $934,052. You reduce your liability by $65,948.
It’s a gain because you could buy the debt on the open market today and retire it for $934,052 instead of for $1,000,000.
The interest payments don’t change; they’re fixed at $60,000 per year.
Thanks for clarifying the interest payments part!
I think I understand the gain part now. So if I repurchase the debt, would this be what will happen to the balance sheet?:
Assets: bonds increase $934,052($1mil, 10 yr, 6% semiannual), cash decrease $934,052
Liabilities and Equity: bonds decrease $65,948 ($934,052 bonds balance), gains increases $65,948