Final answer:
When market interest rates fall, a company using fair value accounting for fixed-rate liabilities will report a gain because the present value of future payments decreases and the bond's value increases.
Step-by-step explanation:
When the market rate of interest falls after issuance, a company selecting the fair value option for reporting a liability with a fixed coupon rate will report a gain. This is because the liability can now be settled at a lower cost than the original coupon rate agreed upon at issuance. As market interest rates decline, the present value of the future payments on the debt decreases, making the liability less expensive to settle or refinance. Therefore, the company would recognize an unrealized profit since the fair value of the liability has decreased.
For example, if Ford Motor Company issues a bond with a face value of $5,000 that pays an annual coupon payment of $150, the interest rate Ford is paying on the borrowed funds would be 3% (calculated as $150/$5000). If the market interest rate decreases after the bond has been issued, the value of Ford's bond would increase above its face value in the secondary market because it offers a higher return than the new lower market rates.