I have a question about a statement I don’t understand:
“if the firm does not use fair value reporting of debt obligations, net income and shareholders’ equity are not affected by changes in the market value of the firm’s debt, and disclosing its gain or loss in market value is not required”.
A couple of questions:
1)I thought debt was reported under the amortising mechanism. What does it mean then when it says “if the firm does not use fair value reporting”… Why would you use fair value reporting in the first place?
So why is equity and net income not affected and why don’t you need to disclose gain or loss?
If debt is reported under amortized cost. So if they issue the debt at a premium (discount), they amortize the premium (discount) gradually until the debt matures at par. This means that only the discount rate at issuance is applicable, ignoring any subsequent changes.
Because the fluctuations in market rates are no considered and the premium/discount is amortized on a consistent schedule, there will be no gains or losses as a result of the changes in market value. This means that net income will not be higher (lower) and therefore equity will not be higher (lower).
This is different than investment securities. Investment securities recognize realized gains or losses on the income statement (note that there is a difference with unrealized losses for held to maturity, held for trading and available for sale classifications.
Ash, most of the time debt is reported using the amortised cost approach. If that is the case, you take no account of chages in fair value and therefore net income and equity are indeed not affected by changes in the market value of the debt.
An alternative approach, often used by financial institutions, is to measure their own debt under the fair value option, i.e choosing to report the debt at its current fair value with changes going to net income and therefore also impacting equity.
Some three years ago, this approach had the rather interesting effect of boosting banks’ earnings as a result of falls in the market value of their own debt (e.g. after a downgrade).
As far as I know, under both IFRS and US GAAP, companies can select to report their issued bonds at amortized values or fair values.
Moreover, even companies select to report at amortized values, they have to disclose the fair values of the issued bonds in their financial statements (B/S ?).
Ash, I am not sure about the disclosure requirements under US GAAP but IFRS does indeed require that you disclose the fair value of debt issued (e.g. bonds outstanding) even if it is measured at amortised cost for balance sheet purposes.
