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, know-ledgeable 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

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Figure 2. FASB Fair Value: B improves after 5 years

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Figure 3. FASB Fair Value: B Downgraded at 5 yrs

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Figure 4. FASB Fair Value: B has multiple downgrades

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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 & SwitchPromise 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, bor-rowing 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 risk-free 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 0

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PlusCreditPlusContract

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.

SummaryThe 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

Brigandage