Credit Standingin the Fair Value of Liabilities

by Sam Gutterman & Mo Chambers

presented at the 2003 Bowles Symposium by Sam Gutterman

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Topics to be covered

• The issue

• Users of financial statements

• The arguments

• Useful information

• Measurement issues

• Could recognition vary by type of obligation or timing?

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The issue

• Why credit standing risk is relevant to fair values

• Whether to recognize credit standing risk in liability measurement

• If so, how should it be measured

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Users of financial information

• Owners / potential owners

• Creditors

• Managers

• Customers

• Regulators

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Arguments of proponents

1. Value of an obligation as an asset should equal to that of a liability

2. Reflect market reality

3. Illogical result if applied to debt

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Arguments of Opponents

1. Proper markets don’t exist for liabilities

2. Illogical / misleading

3. Transparency demands separate recognition

4. Inconsistent with the going concern assumption

5. Inconsistent with asset and liability approach

6. Credit risk doesn’t transfer with sale

7. Effect of implied regulatory guarantees

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Usefulness of information

• Perspective of entity– Does such an adjustment serve a useful purpose

• Present value of expected payments– Does such an adjusted liability mean anything

• Multiple users muddies usefulness– Disclosure as an alternative

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Measurement issues

• Whose credit standing– Group or company– Effect of policyholders, particularly par ones

• Ceded reinsurance – whose obligation is it• Effect of third party guarantees – how to

pre-assess government actions in different jurisdictions

• Company or contract specific

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(more) Measurement issues

– The same or different credit standing– Different timing of credit risk emergence and

outcome can unbalance income statement– Complexity of partial guarantees– Complex to isolate credit standing risk– Possible double-counting if cost of capital

reflected

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(even more) Measurement issues

• How to measure it– FASB indicates more likely in cash flows than

in discount rates– Are rating agencies up to it?– Difficulty if source of credit standing risk

change is an intangible

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Alternatives

• Disclosure

• Separate recognition treatment of debt that explicitly reflects credit standing risk and other financial instruments

• Separate treatment of initial measurement and changes

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Summary

• Controversial issue– Might not be significant to highly rated companies

• Pro arguments strong for initial measurement if debt is involved or if measurement of tangible assets are similarly affected

• Already considered to some extent if cost of capital reflected

• Con measurement arguments are strong– Measurement difficult – May not provide useful information if timing of recognition

is not consistent

What is most useful?