What are the general principles for measuring financial instruments?

Answer 1

MEASUREMENT OF FINANCIAL INSTRUMENTS: GENERAL PRINCIPLES

The term financial instrument refers to a financial arrangement in which a firm contracts to receive or make specified payments in the future in return for cash or other resources paid or received currently. Notes, bonds, and leases are financial instruments. Derivatives are also financial instruments. A characteristic of financial instruments is that they specify the means of calculating the amounts that firms will receive or pay at specified times in the future.

The accounting measurement of notes and bonds payable follows two general principles:

1 . The amount borrowed initially and the market value of a note or bond at any date subsequent to the initial borrowing equals the present value of the future, or remaining, cash flows discounted at an appropriate interest rate.

2 . The internal rate of return, often called yield to maturity, is the discount rate that equates the future cash flows to the market value at any date. Common terminology also refers to this rate as the market interest rate. When a financial instrument does not specify the internal rate of return, the investor can solve for this rate, called the implicit interest rate. On the date of initial issuance, the market value will equal the initial issue proceeds—the amount borrowed.

To understand the accounting for notes and bonds, we need two additional definitions:

Historical Market Interest Rate:

The discount rate prevailing at the date of the initial borrowing. Discounting the contractual cash flows at this rate equates the present value of future cash flows to the amount initially borrowed—the market value on the initial issue date.

Current Market Interest Rate:

The discount rate at any date subsequent to the date of the initial borrowing. Discounting the contractual cash flows at this rate equates the present value of remaining cash flows to the market value at the subsequent measurement date.

U.S. GAAP and IFRS permit firms to account for notes and bonds under one of two approaches:

1 . Amortized Cost

Use the historical market interest rate to compute the carrying value of notes and bonds while these obligations are outstanding and disclose in the notes to the financial statements the fair value of these financial instruments based on the current market interest rate. This approach dominates current financial reporting.

2 . Fair Value

Measure notes and bonds at fair value each period, in effect using the current market interest rate instead of the historical market interest rate to discount the remaining cash flows. The FASB and the IASB refer to this approach as the fair value option.