Debt Valuation Adjustment Case

Memorandum

To: Deen Kemsley

From: Xin Xu, Yifan Wu

Date: 4/2/2016

Re: Debt Valuation Adjustment Case

Background

Currently, some companies expect to report the similar quarter earnings although their debt value has been decrease. For example, Morgan Stanley reports a pretax gain of $1.5 billion to $2 billion. There is no denying that investors concerned about the quality of earnings regardless of the virtual gains. Since the rule that Financial Accounting Standards Board released in 2007, banks have priority to value some balance-sheet items at "fair value". It represents different market value instead of the actual cost when bought or sold.

In terms of the “quirk”, it would be bank record a profit by repurchase the debt at a discounted level when the debt value decreases in the market. And company will report this kind of profits as gain, which makes the financial outcomes looks stronger. However, under the accounting rules, those gains are appropriate while investors not truly accept it.

Relevant Accounting Rules

Under this situation, the main discussion would covers two aspects: 1) which kinds of value should use to measure the debt balance and 2) whether the debt gains record in Net income or not. FASB 825-10-35-4 recognize the entity’s subsequent measurement should base on fair value method. It states below:

“A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings (or another performance indicator if the business entity does not report earnings) at each subsequent reporting date.”

Also FASB 825-10-25-2 provide another supporting information, which mentioned that

* “a.  Shall be applied instrument by instrument, except as discussed in paragraph 825-10-25-7

* b.  Shall be irrevocable (unless a new election date occurs, as discussed in paragraph 825-10-25-4)

* c. Shall be applied only to an entire instrument and not to only specify risks, specific cash...