It doesn't make sense to me, since an asumption of GAAP is that an entity is a going concern. Booking income that results from its possibility of default makes no sense. Expecially in the extreme case (like actual default).
If a company can actually buy back debt at a lower price, then it needs to prove it in the market place by actually doing it. It has and can be done, but not all that often.
Also, are these companies going to book a loss if their credit ratings improve?
Bob:
Touche (and ouch)!
I actually do understand the reasoning - I was merely joking (and playing to the finance crowd who's the main audience).
As for the Moody's comment, I believe it makes sense if they are using "high quality" and "core" to mean earnings that are likely to be persistent. These clearly aren't.
But it does seem like a bit of a perverse result that decresed firm prospects results in income. I understand it, but it still makes me smile.
Having said all that, I'm glad I have accounting folks like you to set me straight.
Actually the fact that a lowered credit rating can lead to a realized gain should make sense even to a finance professor. Consider the following scenario:
I sell a bond and record a liability for $100,000 that matures in ten years.
My credit rating gets lowered the next day.
I buy back the bond for $90,000 (the market value of the bond declines because of my lowered credit rating)
I've made a $10,000 cash profit in one day because of a lowered credit rating
I wonder if a finance professor can comprehend that this is a gain.
I wonder if Moody's can understand that this is a very high quality earnings since its cash in the bank.
Now what if I don't sell the bond but adopt the fair value accounting option for financial instruments under FAS 159. I did not realize a cash profit if I still owe $100,000 when the bond eventually matures. But the reason I report an unrealized holding gain follows the same logic as if I bought back the bond today. That's what the "fair value option" under FAS 159 is all about.
If Moody's does not treat unrealized holding gains and losses as high-quality, core earnings, more power to them.
Finance students who've taken four courses in accounting may not laugh because they understand why sometimes credit rating gains are high quality and sometimes low quality will not laugh because they understand why. But they may not understand why their finance professor is laughing.
Bob Jensen's tutorials on fair value accounting are at the following two links:
http://www.trinity.edu/rjensen/
T...1.htm#FairValue
http://www.cs.trinity.edu/~rjens...y/CD/FairValue/
September 26, 2007 reply from Amy Dunbar [Amy.Dunbar@BUSINESS.UCONN.EDU]
The prof who teaches intermediate II at UConn wrote:
When I cover early extinguishment of debt in my class I usually do an example which I set up by first asking, "Why might a firm decide to refinance its debt when interest rates have gone UP?" The example then shows that a firm can buy back its old bonds at the current (low) market price and finance that purchase by issuing new bonds that are identical to the old ones (and thus should be priced identically to the old ones). Ignoring transactions costs and such, the firm is in exactly the same economic position it was before the transaction; the accounting outcome: gain on early extinguishment of debt. So even without the new fair value rules, this scenario can lead to some head-scratching results.
My favorite post on the original WSJ blog site sums it up:
"If a company goes broke will it still record a gain on the debt it can't pay back?"
Amy
September 27, 2007 reply from Bob Jensen
Hi Amy,
Prior to FAS 125, companies like Exxon (I think this ploy was actually invented by Exxon) would defease their relatively low cost debt in times of rising interest rates. This way they captured the gain and avoided the transactions cost of actually buying the debt back.
But if they defeased and then borrowed at higher
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