Question

Fallen Company commonly issues long-term notes payable to its various lenders. Fallen has had a pretty good credit rating such that its effective borrowing rate is quite low (less than 8% on an annual basis). Fallen has elected to use the fair value option for the long-term notes issued to Barclay’s Bank and has the following data related to the carrying and fair value for these notes. Any changes in fair value are due to changes in market rates, not credit risk.

	Carrying Value	Fair Value
December 31, 2017	\(54,000	\)54,000
December 31, 2018	44,000	42,500
December 31, 2019	36,000	38,000

Instructions

(a) Prepare the journal entry at December 31 (Fallen’s year-end) for 2017, 2018, and 2019, to record the fair value option for these notes.

(b) At what amount will the note be reported on Fallen’s 2018 balance sheet?

(c) What is the effect of recording the fair value option on these notes on Fallen’s 2019 income?

(d) Assuming that general market interest rates have been stable over the period, does the fair value data for the notes indicate that Fallen’s creditworthiness has improved or declined in 2019? Explain.

Short answer

(a) No entry needs to be passed for 31/12/2017. At the end of 2018 and 2019, unrealized holding gains/losses were $1,500 and $3,500.

(b) The fair value of $42,500.

(c) Unrealized holding loss of $3,500.

(d) Throughout 2019, Fallen's creditworthiness has increased.

Step-by-step solution

Meaning of Fair value

According to a company's financial statement, the fair value represents the estimated value of its assets and liabilities.Fair market value refers to an item's fair sale value for the buyer and seller.

(a) Preparing journal entry

Date	Particulars	Debit ($)	Credit ($)
31/12/2017	No entry
31/12/2018	Notes payable $(\$44,000-\$42,500)$	1,500
	Unrealized Holdings gain		1,500
31/12/2019	Unrealized Holdings Gain/Loss	3,500
	Notes Payable$(\$38,000-\$36,000+\$1,500)$		3,500

Notes: No entry on 31/12/2017 since carrying value = Fair value.

(b) Amount to be reported on Fallen’s 2018 balance sheet

The note will be reported at fair value as of Dec 31, 2018, on Fallen's balance sheet.

Hence, the note will report at $42,500

(c) Effect of recording the fair value option on these notes on Fallen’s 2019 income

Fallen's net income will decrease by $3,500per the 3rd journal entry since the change in fair value will be deducted from the net income.

Explaining whether the fair value data for the notes indicate that Fallen’s creditworthiness has improved or declined in 2019

Fallen's creditworthiness has increased throughout 2019 due to bond investors earning a greater yield than investors in investments with comparable risk. Changes in fallen credit risk should be considered when recording any gains or losses in other comprehensive income.