The illiquid markets spawned by the subprime mortgage debacle and the subsequent credit crisis has left some corporations in the unusual position of recording a boost to income when booking a loss in value of a liability.
Indeed, companies, particularly financial institutions, have recorded massive write-downs in the fair value of debt and equity securities reflecting a decline in value that is dwarfed by the amortized cost of the instruments. However, this “mark-to-market” requirement has produced a counterintuitive result.
To the extent that a company’s liabilities can be settled for an amount that is less than its carrying amount — and the company has elected the “fair value option” to account for its financial liabilities — the institution will record a gain to reflect the deterioration brought on by the widening of “credit spreads.”
On May 1, the Financial Accounting Standards Board published guideline, released as a proposed staff position, to assist companies in determining the fair value of a liability. Out for public comment until June, 1, the FSP known as FAS 157-f, (Measuring Liabilities under FASB Statement No. 157, Fair Value Measurements), notes that the original FASB Statement defines the “fair value of a liability” as the price that would be paid to transfer the liability in an “orderly” transaction between market participants at the measurement date. The original rule also states that the fair value of a liability should reflect the “non-performance risk” relating to that liability — and that such non-performance risk is the same before and after the transfer.
The new FSP also points out two important concepts: That liabilities are rarely transferred in the marketplace because of contractual restrictions preventing the transfer of liabilities; and that some liabilities are traded in the marketplace as assets. The FSP also states that if a quoted price in an active market is available for the identical liability, that price should be classified as a “Level 1 measurement” under FAS 157 — meaning that the price is the most easily ascertained because it is derived from an observable input.
On the other hand, if an identical liability is not available, a company should measure fair value using one of the following approaches to minimize the use of unobservable inputs.
• The quoted price of the identical liability when traded as an asset in an active market;
• The quoted price of the identical liability, or the identical liability when traded as an asset in markets that are not active;
• The quoted price for similar liabilities, or similar liabilities when traded as an asset in markets that are active;
• Another valuation technique — for example, the “income approach,” such as a present value calculation, or a “market approach” such as a technique that is based on the amount a company would receive if it were to transfer or enter into an identical liability at the measurement date.
The FSP states that when measuring the fair value of a liability using the price of the liability that is traded as an asset, the price should be adjusted for “factors” specific to the asset. Moreover, when estimating the fair value of a liability, an entity should not include a separate input, or adjustment to other inputs, relating to the existence of a contractual restriction that prevents the transfer of the liability. It is FASB’s view that the existence of such a contractual restriction is either explicitly or implicitly included in the other inputs.
In light of the fact that the identical liability will rarely be traded in an active market, in its own right or as an asset, it appears that the new FSP will provide management with an enhanced opportunity to use unobservable inputs with respect to the valuation of liabilities. Accordingly, the odd practice of recording income as a result of marking a debtor’s liabilities to market will probably not soon abate.