Credit Standing and the Fair
Value of Liabilities: A Critique
Phil Heckman
MAF Meeting, March 2004
Whether the fair value of a
liability should be independent of
the debtor’s credit standing.
Why won’t this question go away?
It’s not metaphysics.
Why Fair Value?
• Keeping valuation close to market ensures
access to markets without big adjustments.
• Fair value of an asset is what it will fetch or
reasonable equivalent.
• What is the fair value of a liability?
IASB Definition
The fair value of a liability is the amount
required to induce an independent, knowledgeable third party to take over the
liability in an arm’s length transaction.
Note that the credit standing of the third
party is unspecified.
FASB/IASB Position
• Third party has “comparable credit
standing”.
• Hence liability is discounted for credit risk.
• Why? (Not because it’s correct)
• Because that’s how debt has always been
treated and is under current GAAP.
FASB Reference
Crooch, M.G., and Upton W.S.,
2001, “Credit Standing and
Liability Measurement” in
Understanding the Issues 4(1),
Financial Accounting Standards
Board, June 2001.
[Indispensable]
FASB Axioms
1. No gain or loss from borrowing. (Follow
the cash: very ancient.)
2. Economic equivalence ==>
Accounting equivalence.
Are these mutually consistent? We shall see.
FASB Example
(All on Same Date)
Firm Rating Rate Cash Term Principal
A
AA
7% $5,083 10 yr $10,000
B
B
12% $3,220 10 yr $10,000
Risk
Free
5.8% $5,690 10 yr $10,000
FASB Fair Value Liabilities
• A and B undertake identical obligations:
pay $10,000 in 10 years, not before.
• Per Axiom 1, A posts $5,083, B $3,220.
• However, per Axiom 2, the liabilities should
be the same. Inconsistency?
• B, the weaker of the two, has a steeper
climb out of debt.
• B’s borrowing penalty is erased.
This practice has a name:
Handicapping
A useful device in the world of sport,
what is it doing in financial reporting?
What’s Missing?
• Borrowing Penalty (Default-free minus
Risky) is an expense impinging at inception.
• Traditional treatment forces amortization
over the life of the obligation.
• Hence the economic value of the obligation
is kept off the balance sheet; no way to
compare enterprises using financials.
Figure 1. Current GAAP: Good, Bad, Riskless
10,000
9,000
8,000
7,000
6,000
A
5,000
B
RF
4,000
3,000
2,000
1,000
0
0
1
2
3
4
5
Years of Duration
6
7
8
9
10
Figure 2. FASB Fair Value: B improves after 5 years
10,000
9,000
8,000
7,000
6,000
A
5,000
B
RF
4,000
3,000
2,000
1,000
0
0
1
2
3
4
5
Years of Duration
6
7
8
9
10
Figure 3. FASB Fair Value: B Downgraded at 5 yrs
10,000
9,000
8,000
7,000
6,000
A
5,000
B
RF
4,000
3,000
2,000
1,000
0
0
1
2
3
4
5
Years of Duration
6
7
8
9
10
Figure 4. FASB Fair Value: B has multiple downgrades
10,000
9,000
8,000
7,000
6,000
A
5,000
B
RF
4,000
3,000
2,000
1,000
0
0
1
2
3
4
5
Years of Duration
6
7
8
9
10
FASB Justification
• Balance sheet should show corporate
owners’ interest, reflecting value of
insolvency option.
• Reported net worth should never be
negative; hence reflect credit standing.
This, too has a name:
Bait & Switch
Promise public information; provide private
(and uninterpretable) information instead.
(More on this later)
AAA Monograph: Reason 1
A liability can extinguished by repurchase
from the creditor at the current market price.
Therefore the fair value of the liability is the
market price of the corresponding asset.
(Buyback argument)
Answer to Buyback Argument
The repurchase of a debt or other obligation
is not an “arms length transaction”. The
parties are already bound by contract in
respect of the obligation. The definition of
“fair value” is violated, and the argument
fails. Buyback valuation is only proper if
buyback option is embedded in the debt
contract.
AAA Monograph: Reason 2
If a company’s public debt is not valued at
market (thus reflecting its own credit
standing) it can manipulate its earnings by
trading in its own debt. Therefore the fair
valuation must reflect the company’s credit
standing.
(arbitrage argument)
Answer to Arbitrage Argument
A company with the resources to trade in its
own debt will have a credit standing that
supports the price of its debt and erases the
arbitrage advantage unless the trading is
done surreptitiously. The implementation of
“fair value” should not be premised on
commercial trickery. Therefore the
arbitrage argument fails.
AAA Monograph: Reason 3
Per Reason 2, public debt must be valued at
market (reflecting credit standing) to avoid
arbitrage. There is no reason why other
liabilities should be treated any differently.
Therefore all liability fair valuations should
reflect credit standing.
(public debt argument)
Answer to Public Debt
Argument
The assertion is true, but the argument
stands only if the premise is also true.
Based on prior argument, we reject the
premise that any liability should be valued
to reflect the debtor’s credit standing.
Therefore the true statement has no force,
and the argument fails.
AAA Monograph: Reason 4
The usual mode of business ownership is
through limited liability stock. The owner
of such an asset is not liable should the
corporation become insolvent. Therefore,
to value the owners’ stake in the
corporation, one must take credit standing
into account in valuing the corporation’s
liabilities.
(insolvency argument)
Answer to Insolvency Argument
This assumes that financial reports are private
documents for the use of the owners. On the
contrary, they are public documents for the use,
e.g. of potential investors. They should be
independent of the mode of ownership.
The insolvency adjustment belongs on the
ownership accounts as an asset windfall to balance
asset penalties on the creditors’ accounts.
Liabilities are not affected.
The Insolvency Put
• In Merton & Perold’s 1993 paper, borrowing penalty is recognized as “asset
insurance”.
• As such it shows up on M&P’s corporate
balance sheet as an asset, though liabilities
are valued default-free.
• Thus M&P recover traditional measurement
of equity. Will this wash?
More on the Insolvency Put
• Ask yourself: Is M&P’s asset insurance available
to stave off corporate default?
• Answer: No. It is a benefit only to the owners,
whose interest differs from that of the corporation.
• Conclusion: The insolvency put (asset
insurance) is not an asset of the corporation.
All arguments based on the contrary are void.
Is this such a big deal?
Granting that liabilities reflecting credit
standing are of no use, still the value of the
insolvency option can be reported in a
footnote somewhere and useful liability
valuations recovered by those with the skill
and knowledge to do so.
Yes it is a big deal!
However the correct value appears, the
valuation requires an objective standard that
does not yet exist. The creation of such a
standard, and the role of regulators in
enforcing it are the crucial issues.
How should it be done?
Objective Valuation Standards
• Value of liability is price to transfer to a
default-free guarantor.
• Therefore, value is based on contract terms
assuming no default.
• Fair value = Asset value + Price of a riskfree guarantee (Merton-Perold risk capital).
• Liability value is unaffected by presence of
a third-party guarantee.
Components of Liability Fair
Value
Fair value =
Market value of asset
+
Loading for Credit
Risk
+
Loading for Contract
Risk
45
40
35
30
25
20
15
10
5
0
Asset
Plus
Credit
Plus
Contract
Discussions of Risk Adjustment
• Casualty Actuarial Society, 2000, Task
Force on Fair Value Liabilities, White Paper
on Fair Valuing Property/Casualty
Insurance Liabilities. ed. Blanchard.
• Butsic, R.P., 1988, “Determining the Proper
Interest Rate for Loss Reserve Discounting:
An Economic Approach”, CAS Discussion
Paper Program,
In Conclusion
• The notion of reflecting credit standing in the
valuation of liabilities is not sound theory beset by
practical problems; it is bad theory and ethically
defective – unworthy of consideration.
• Further, FASB approach increases tax liability.
• The financial community must be prepared for a
very rough ride because of update provisions
under Fair Value.
Summary
The emperor has no clothes.
• FASB’s position on fair value of liabilities
is biased by a vested interest in ancient
accounting procedures and could have
ruinous consequences if put into practice.
• IASB is not an independent voice.
• Financial economics should provide
solution, but seems to be part of the
problem.
The emperor has never had any clothes.
The traditional accounting treatment of debt
has always been flawed, impeding valid
comparison of different enterprises and
biasing managements in favor of debt
financing over equity.
What Should the Emperor Wear?
• In accounting terms, the borrowing penalty
should be valued and treated as an expense
impinging at inception.
• Thus Loan Value = Borrowing Penalty +
Actual Proceeds.
• Then conventional accounting procedures
will lead to meaningful valuations.
Disclosure of Ideological Bias
Antiprestidigitarianism
Down with sleight of hand!
What’s at Stake?
Commerce
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