Quick question: Assume a firm has the following simplified balance sheet:
Assets=300
Debt=100
Equity=200
Now assume the company's credit rating is downgraded. Does the balance sheet still accurately reflect the value of its liabilities?
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Feel like you need more background info to answer that question correctly. Generally a company's credit rating changes along with a change in the BS, since credit rating metrics are based on figures that come from the BS/IS/etc.
I would say it does accurately reflect the value of its liabilities because I know that issuing new debt and paying dividends does NOT increase credit worthiness.
I could be COMPLETELY wrong.
Let's say credit rating does not change as a result of any change to the balance sheet. Let us just assume that credit rating is downgraded because it has just been announced that labour costs are set to rise by 500% and therefore no cash flows will be generated from operations in coming years resulting in potential inability to pay liabilities
I'd imagine we'd be looking at the market value of the debt to fall... which would technically reduce the value of the liabilities. The balance sheet would still show it at amortized cost, but the market value would be significantly different depending on the severity of the downgrade/outlook.
That depends on if the company can/has elected to use 'debt valuation adjustments' for any/all of their securities. If they have, then presumably market value of their liabilities would decrease. This would be offset by an increase in cash (since a debt valuation adjustment is technically a tax shield) and also a decrease in net income
The accounting is similar to that of depreciation, however the income;loss portion is very counter intuitive. When a company is in worse condition, credit ratings go down, debt gets a lower market value, and the company can book a profit! (since it theoretically now has to pay back less debt).
Note that not all types of companies can choose to use debt valuation adjustments (DVA's), but banks are among those companies that can elect to use DVA's. Once a company choose to use DVA's for some/all of its securities, it securities will always be marked to market on the balance sheet.
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