AFM401 Chapter : 07 measurement applications.pdf
6 Nov 2013
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Market value of debt falls following a credit downgrade. It may seem strange to many persons that the firm record a gain following a credit downgrade. The reduction or increase in fair value of debt creates a wealth transfer from debt holders to shareholders. Under the equity view of financial reporting, such a wealth transfer is not a gain or loss to the entity. Thus, no gain or loss should be recognized. Many firm assets, such as self-developed goodwill, patents, r&d, are not valued on the balance sheet. Downgrades or increases in the credit rating of debt is frequently due to changes in the value of these assets. Yet, such changes are not recognized in current earnings, while if debt is fair valued, changes in fair value are included. This creates a mismatch situation that increases the volatility of reported earnings. Arguments in favour of fair valuing long-term debt:
