In 20X5, Kahn Financial Group used the fair value option for some of its own debt. During the first quarter of 20X5, the fair value of its debt declined by $2.7 billion. Its reported net income for the quarter was $1.6 billion.
Required:
1. Suppose Kahn Financial had issued at par on January 1, 20X1, $500 million of 10-year bonds with a fixed annual interest rate of 6%, reflecting the company’s financial soundness at the time. Calculate the proceeds received by Kahn, the interest expense recorded in 20X1, and the bond carrying value on January 1, 20X5. Assume cash interest payments are made on December 31 of each year.
2. Suppose the market interest rate had increased to 12% by January 1, 20X5. Compute the market value of the bonds on that date.
3. During the first quarter of 20X5, Kahn’s debt lost value in the bond market because of investors’ concerns about the company’s ability to meet required debt payments when due. Explain how this perceived increase in Kahn’s credit risk translates into a decline in the market value of its bonds.
4. How did Kahn account for the $2.7 billion decline in the value of its own debt in 20X5?
5. Explain why the fair value option accounting treatment used by Kahn might be controversial.
