Credit Standing and the Fair Value of Liabilities.pptVIP

Credit Standing and the Fair Value of Liabilities: A Critique Phil Heckman Bowles Symposium 2003 Whether the fair value of a liability should be independent of the debtor’s credit standing.Why won’t this question go away? 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 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. 2. Economic equivalence == Accounting equivalence. Are these mutually consistent? We shall see. FASB Example (Same Date) 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 What is it doing in financial reporting? 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) AA