I have revised my concepts about debt reporting but still get confused about the interest rate change. Does anyone know what is the impact on debt liability on the balance sheet when market interest rate change? I know debt liability is recorded considering the market rate at the time of issuance. Now, if there is a interest rate change in the next year, do we need to add interest expense based on the new interest rate subtract the coupon payment in the initial liability to get end of year liability, or market rate at the time of issuance prevails throughout the bond’s life. I am confused because in the schweser notes it was mentioned at many places that there is no effect of interest rate change on the bond’s liability. If it has no effect, how are these changes reported?
Debt is recorded at historical cost (issuance) with premium/discount being amortized over the term of the bond. Changes in market interest rates have an effect on the carrying value of the liability. However, these changes are recorded through the income statement as a Profit or Loss depending upon the effective interest rate. UNder both IFRS and US GAAP it is optional to report at fair value but changes in value due to market changes must be accompanied by notes in the FS. I would think that for better representation of FS, the fair value option woudl apply more to financials. Hope this helps.
When you use the term debt liability, I’m assuming you mean a financial liability created when the firm directly issues a bond (bond payable) or borrows through a legal contract (capital lease). The debt amortization calculation uses the YTM at issuance throughout the term of the debt. Therefore market interest changes don’t enter the amortization schedule. Remember that principal amortization is the stated (statutory) coupon payment minus (YTM at issuance multipled by carrying value). Thus if the company has issued bonds, the bond liability would not change if only the market interest rate changed. I think C3Po is addressing debt securities marked as Trading securities, which are not the same as direct financial payables since debt securities can be traded and do not carry the same covenants. Debt securities marked as Trading securities are carried at market value, are marked to market at each reporting period, and the resulting changes flow through the Income Statement. Available-for-Sale debt securities would also be carried at market value, but the resulting changes flow through the Statement of Changes in Shareholder’s Equity and will bypass the Income Statement. Held-to-Maturity debt securities are carried at book value. It would not make sense for the reported liability value on firm-issued debt to change with changes in spot rates. If this were true, liabilities on the balance sheet would decrease as spot rates increase and imply that the debt covenants had changed. The firm owes the principal value at maturity (unless refinancing through debt repurchases in the open market), therefore aside from a fixed amortization schedule, why would carrying value reflect secondary market conditions?
rmswins Wrote: ------------------------------------------------------- > When you use the term debt liability, I’m assuming > you mean a financial liability created when the > firm directly issues a bond (bond payable) or > borrows through a legal contract (capital lease). > > > The debt amortization calculation uses the YTM at > issuance throughout the term of the debt. > Therefore market interest changes don’t enter the > amortization schedule. Remember that principal > amortization is the stated (statutory) coupon > payment minus (YTM at issuance multipled by > carrying value). Thus if the company has issued > bonds, the bond liability would not change if only > the market interest rate changed. > > I think C3Po is addressing debt securities marked > as Trading securities, which are not the same as > direct financial payables since debt securities > can be traded and do not carry the same covenants. > Debt securities marked as Trading securities are > carried at market value, are marked to market at > each reporting period, and the resulting changes > flow through the Income Statement. > Available-for-Sale debt securities would also be > carried at market value, but the resulting changes > flow through the Statement of Changes in > Shareholder’s Equity and will bypass the Income > Statement. Held-to-Maturity debt securities are > carried at book value. > > It would not make sense for the reported liability > value on firm-issued debt to change with changes > in spot rates. If this were true, liabilities on > the balance sheet would decrease as spot rates > increase and imply that the debt covenants had > changed. The firm owes the principal value at > maturity (unless refinancing through debt > repurchases in the open market), therefore aside > from a fixed amortization schedule, why would > carrying value reflect secondary market > conditions? Yes, by debt liability I meant financial liability created for bond itself. I definitely agree with you that there should not be any further changes due to the market interest rate otherwise what are the options, protections and various risks are for. But I am pretty sure I saw a question in which market rate was different than rate at the time of issuance and end pf the year liability was changed to reflect the new interest rate. As far as I remember the question was like this, bond issued in the beginning of the year and then rate changed later sometime during the year. And, answer was liability recorded as per the changed interest rate. Could this change be because of the interest rate changed in the same year of issuance? This has always been a doubt in my mind where are trading, AFS and HTM securities are recorded on the balance sheet. I know all concepts related to these securities but where exactly they are recorded, no idea about that. In fact, I asked the same question couple of times on this forum but no luck. Do you think HTM is really a debt liability(liability created for a bond, part of the long term debt) and other securities AFS and trading could be incorporated as Market securities on balance sheet.
I’d have to see the exact wording of the question to be 100% sure, but the CFA material states that spot rate changes would not cause revaluations in debt payable values. Other than amortization, the only way I could see carrying values change AFTER debt issuance is if the company is restructured upon negotiations with creditors (bondholders). Keep in mind that financial liabilities include more than just debt issues, therefore it is possible to revalue other financial liabilities (non-debentures) depending on market conditions. It also may be possible that a floating rate debt issue could cause fluctuating total liability values, but CFA Level 1 does not cover this. As for HTM’s classification element, I think you should focus on how you are defining the word “liability”. A liability in finance (the only one we need to worry about for this test) is an obligation created by past events. A liability in insurance (don’t apply this to financial instruments) is the exposure to loss. So while HTM debt securities have a credit risk component that may result in total principal loss, there is no additional obligation (financial liability) carried by the creditor once the bond is purchased. You could also approach it strictly as a balance sheet issue: Let’s define Company C as the creditor and Company D as the debtor. If Company C purchases bond securities from Company D’s book runners in the primary market, technically Company C has loaned money to Company D. This is not much different than the classification of Trade Accounts Receivables; the company loans money to customers and claims an increase in assets since they will receive future economic benefits from this account. Likewise, Company C does not record a liability because they have no more obligations once they purchase the debt security. Company C has used cash (decrease in assets) to purchase a debt security (increase in assets) as a source of expected economic return; the return can be based on purchase discount, risk spread, and coupon payments (assuming the bond has any or all of these features). Meanwhile Company D has used a debt issue (increase in liability) as a source of cash (increase in assets). Notice how both companies are balanced.
I completely understand and agree with the points mentioned above but I am still not sure I made myself clear about reporting of AFS, HTM and trading securities. Let me put it another way, think of hypothetical scenario in which a naive investor Joe who professionally sweeps the floor but passionate about finance. He heard from another co-sweeper Monty, who doesn’t know a thing but pretends he is a master of everything, about the criteria of evaluating a company. Monty suggests him a formula in which he can rate companies on the basis of these(values of AFS, HTM and trading securities) three values. Joe is talking to a friend Bobby who has suggested that he knows a company which is a very good investment and the reason why company is very good investment because the company owns $1000 worth of trading securities, $500 worth of AFS and $5000 worth of HTM securities. Now, Joe doesn’t rely on Bobby but he also want to consider this investment. So Joe gets hold of the balance sheet to look for this information. Now question is, to verify this information if Joe needs to look at balance sheet accounts, which accounts should Joe look at?
You would have those exact headings… Held for Trading (Usually Long Term) - at cost Available for Trading (Usually Short Term) - at market value Available for Sale (Either Short or Long) - at market value