 Hello and welcome to the session in which we will discuss the fair value option for long-term debt. What is the big idea? Well, companies have the option and notice it's the option, not the obligation to report debt instruments, debt, long-term debt, such as bonds and notes payable at fair value. What does fair value means? It means the company should can, if they want to, because they have the option, they can track and report increases and decreases, which is unrealized gain and unrealized loss. What does that mean? You might have a financial instrument that has a value of a million dollar today. Well, what could happen to that financial instrument? It could go up in value. It could go down in value. At this point, you don't sell it. You're only going to report the increases or the decreases in value. Now, every time we talk about fair value, and if you don't know what fair value is or how companies report fair value, well, you have to take a look at my fair value recording. So make sure you go to farhatlectures.com, where I discuss the fair value in my intermediate accounting course or in my CPA course. And I have a whole recording about how companies come up with fair value. Once they come up with fair value, where do they report the changes? Because you might either have an unrealized gain or it's a gain or a loss. So every time we talk about fair value, you ask yourself, where do we report unrealized gain or loss? Well, it's reported in the income statement. It's reported in other comprehensive income. Hold on a second. Well, the answer is for fair value for long term debt, it depends. Usually we know it's either an income statement or other comprehensive income. For long term debt, it's going to depend, depend on what's depend on why the change occur. Why did you have this unrealized gain or unrealized loss? If the change in value is related to the general trend and interest rate, what does that mean? It means if your debt obligation, if your notes payable, if your bonds payable went up or down in value because the general interest rate changes, such as the Federal Reserve making a decision, increasing or decreasing interest rate, what's going to happen is this, you would report this change in net income. So simply put, the change has nothing to do with your company. The change has to do with the general economic factors. The Federal Reserve change the interest rate, increase the interest rate. And by the way, how do bonds and interest rate work? Well, generally speaking, if interest rate goes up, bond value goes down. They are inversely related. If interest goes down, bond value goes up. They are inversely related. On the other hand, if the change in value is related to the credit worthiness of the company, credit worthiness means the credit risk of the company have changed. Now, how do we know that the credit risk have changed? Maybe one of the rating agencies, Moody's, Standard & Poor's, what they do, they rate companies and the highest rating is AAA. So if you have a AAA rating, it means you have the highest rating. The next one is AA, AA, AA, AA, you guys get the point, right? So this is how it works. So if they change your credit rating, whether they went from AA to AA or from AA to AA, what's going to happen is your debt instrument is affected. It may go up in value or it may go down in value. What's going to happen under those circumstances, the change is strapped and reported in other comprehensive income. It means it's on the balance sheet, the equity section of the balance sheet. So notice, if the change has to do with the company's credit worthiness, it's reported on the balance sheet. If the change in value has to do with the general trend and interest rate, then it's reported in net income. Net income means on the income statement. Now, the best way to illustrate this concept is to actually look at an example. Before we look at the example, let me remind you whether you are an accounting student or a CPA candidate to take a look at my website, farhatlectures.com. I don't replace your CPA review course nor your accounting course. I'm a useful addition to your CPA review course. My motto is saving CPA candidates and accounting students one at a time. My subscription is a nominal amount. The risk is one month. Your return is improving your performance, passing your CPA exam, focusing on your career. If not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam. This is a list, actually a partial list of my accounting courses, governmental, intermediate, so on and so forth. My CPA resources are aligned with your Becker, Roger, Gleam, and Wiley. So it's very easy to go back and forth between my material and your beloved CPA review course. I also give you access to 1500 plus AICPA previously released questions with detailed solution. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation like this recording, share it with other, connect with me on Instagram, Facebook, Twitter, and Reddit. So let's take a look at this example. Adam has issued a million of 7% bond at face value April X1. Adam, company chooses the fair value option to account for the bonds. In December 31st, the value of the bonds is now 960 because the interest rate and the market have increased the 10%. So interest rate goes up, your bond value goes down. Well, how do we make the adjustment? Well, your bond value goes down. Is this good or is this bad? Actually, that's good. Now you can buy your bonds $40,000 less. Now you write down your bond, you debit your bond $40,000 and you will credit unrealized holding gain or loss, which is again in this situation that goes on the income statement. It's kind of a little bit controversial. Why? Because you gain because interest rate in the market went up. But that's how it works. Now let's assume on the other hand, Adam company fair value change on its bond to its credit rating change. What happened is one of the rating agencies dropped your rating from AA to AA. Now why would they do that? Well, they would look at your cash flow. They would study your ratios. They will study your industry. They will study the business trend in your industry. And they would make a decision whether you are credit worthy or not. Credit worthy means is what is your score? What's your credit score? Just like individuals, we have credit scores. Companies do also have a credit score. And they will either improve it or deteriorate. Now because of that, also your bonds payable went down in value $40,000. We're going to draw bonds payable, credit unrealized holding gain or loss, but now it's going to go into equity. Now notice also here what happened is as your financial condition deteriorated, you went from AA to AA in credit rating, you happened to book again. So it's a little bit controversial, but this is how it works. Now, FASB believe fair value is a better measurement than amortized cost. And the point of this, the point with the FASB, what the FASB is implying is if we report financial assets and financial liabilities, so your financial asset will go up, will go up in value, your financial liabilities will go down, they kind of cancel each other out, but we give the user a better picture of your financial asset and your financial liabilities. What should you do now? I'm going to invite you to visit my website farhatlectures.com, work additional multiple choice questions, look at additional resources. Don't shortchange yourself if you're studying for your CPA exam or your accounting career. Good luck, study hard and of course, stay safe.