Credit Standing in the Fair Value of Liabilities

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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

• Proper markets dont exist for liabilities
• Illogical / misleading
• Transparency demands separate recognition
• Inconsistent with the going concern assumption
• Inconsistent with asset and liability approach
• Credit risk doesnt transfer with sale
• 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

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What is most useful?