Reference no: EM133346216

Fair value accounting and the special OCI account

In the special case where a company decides to elect to use Fair value accounting for its liabilities, some commentators have expressed the view that fair value accounting leads to counterintuitive results. Let's focus in on the principal variable that, when exposed through fair value accounting, leads to this claim that fair value accounting is counterintuitive.

Let's say a company issues a 5 year note and carries it as debt, using the proceeds for general corporate purposes. Let us also assume that the note is issued and rolls through its maturity date in a stable and unchanging interest environment. Such a setting was the case during 2009-2018 until Fed Chair Janet Yellin started increasing rates.

In this setting if the company's credit improves, the credit spread decreases. If the company weakens its credit spread increases.

We can remember the theory of rates that states

Discount rate = Risk Free Rates + Credit Spread Equation 2

As you know when rates increase, present values decline. As rates decrease, present values increase.

Here comes the counterintuitive part: if we are using present values to update the fair value of a liability, the increase in the present value of the liability when rates decrease requires a loss. This means that if rates decrease because credit improves the company must suffer a fair value loss. Example: After the company issues the 5 year note, risk free rates stay the same but its credit improves. The relevant discount rate would be reduced as credit improves. If the Fair value of the liability increases by say, $ 10, the entry required is

Debit Fair value loss - Earnings $ 50

Credit Liability - update Fair value carrying amount $ 50.

The opposite is true when credit deteriorates. This means that as a company becomes weaker it will book mark-to-market gains. How can weakness be linked to gains? How can strength be linked to losses?

There was common agreement that this odd situation needed to be fixed. The FASB changed the fair value accounting by requiring companies who elect to carry their debt at fair value to place the Fair value gain or loss on remeasurement in OCI. This means that in the entry above the debit would now read

Debit Fair value loss - OCI.

As you can guess, as time approaches for the company to pay off the debt the fair value component due to changes in its credit converge to $0 as long as the debt is paid off in full and on time.

Here is the question:

In this case, does the use of OCI with Fair value accounting lead to understandability and transparency? Did the US GAAP amendment eliminate a counterintuitive result?

Homework - Cash as reported by international companies is a falsehood

If a company hold cash in various currencies, then those foreign currency balances must be remeasured for accounting purposes. The resulting US DOLLAR measurement of the foreign currency is added to US Dollar currency balances and the combination is reported as Cash in US

s if that is the reporting currency.

The problem with this treatment is that the portion of the US $ cash representing the foreign currency does not in fact exist.

The remeasurement and consolidation process I have described was codified in FAS52 and remains in the Accounting Standards Codification.

Here is the question:

This accounting surely leads to a falsehood but has become 'generally accepted' to keep the accounting for cash simple. "Everybody does it," and under US GAAP they have no choice.

From a theoretical point of view would the better accounting be NOT to add the domestic US $ currency balances with the remeasured foreign currency balances presented "as if" US $ and instead reporting two separate accounts on the balance sheet?