IFRS and US GAAP give firms irrevocable option to report debt at fair value. Under this option, gains & losses that result from changes in bonds market yields are reported in the income statement.
What does this mean? Does it mean that the book value of debt on my balance sheet is not impacted even if the market rates are changing after issuance of debt?
Quite the contrary: it means that whenever the market value of the debt changes, the book value on your balance changes accordingly.
If fair value reporting option has been used, during balance sheet date, the balance sheet value of the bond liability will be the fair value at the time of the valuation. The unrealized gains/losses as a result of reporting at fair value will impact the income statement.
This is in contrast with _ effective interest rate method _- whereby the balance sheet value of the bond liability is calculated at such:
‘Opening bond liability value’’ - ‘amortization discounts/premiums’
Noting that the bond liability value @ opening is the closing bond liability value from prior period balance sheet; unlike fair value reporting, the initial bond liability value reported during inception is based on the bond’s YTM @issuance. (Under fair value reporting, the bond liability is reported @ market’s YTM)
Cheers,
Ernest
Great ! Can you tell me answer to this then.
I take a debt of 100,000 at 10% coupon rate & 10% market rate at issuance for 4 years. At the end of year 1, market rate is 15%. What shall be my book value of debt at the end of year 1? And also impact on income statement.
Since coupon rate = bond’s YTM; the bond is issued at par (i.e. par bond)
Assuming no issuance cost is considered in thie case, the proceed received from issuing the bond will be 100K.
If effective interest rate method is used,
The initial book value during bond inception will be 100K.
Fast forward time to end of year 1, the book value of the bond will still be 100K as there is no amortization premiums/discounts (since it is a par bond). Anyway, the general formula for computing the book value of the bond liability is:
‘Opening Bond Liability’ less’amortization discounts/premiums’ = ‘Closing Bond Liability’
P&L for the period: interest expense of 10K ( 10% of 100K)
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If fair value reporting method is used,
The initial book value reported @ inception is still the proceeds from bond issuance i.e. 100K.
However, come year end, the book value of the bond will be revalued @ fair value :
Value of the bond liability (ended Year 1) = PV (remaining cash flows from the bond) using the 15% as discount rate.
For P&L - Interest expense ( For this one, I’m not very sure; maybe someone can help shed some light?)
Ernest
Great ! Can someone comment on the fair value reporting method as well ? How to update the book value?
Any further comments on this ?
You just recalculate the PV of the future cash outflows (interest) and principal at maturity using the market rate. As market rate increased to 15%, PV of the liability will decrease and the company will report a gain