Credit Standing
in the Fair Value of Liabilities
by Sam Gutterman & Mo Chambers
presented at the 2003 Bowles Symposium
by Sam Gutterman
Topics to be covered
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The issue
Users of financial statements
The arguments
Useful information
Measurement issues
Could recognition vary by type of
obligation or timing?
2
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
3
Users of financial information
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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
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Proper markets don’t exist for liabilities
Illogical / misleading
Transparency demands separate recognition
Inconsistent with the going concern assumption
Inconsistent with asset and liability approach
Credit risk doesn’t 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?