GAAP, IFRS Now Differ on How to Treat Debt

With international rules now modified around how a company accounts for its own debt, analysts are calling on the Financial Accounting Standards Board to follow suit.

The International Accounting Standards Board recently finalized a change in International Financial Reporting Standards that tells companies to measure most liabilities at amortized cost, or the historical cost written down over time based on a schedule. Where a company might exercise an option to measure a liability at fair value, any changes in value would flow to equity via the “other comprehensive income” section of the income statement rather than profit and loss.

FASB is also developing significant changes for how companies should account for financial instruments, most notably making a highly contentious call for more use of fair value to measure financial assets and liabilities. That puts FASB’s proposal at odds with the measure just adopted by IASB.

IASB’s new rule is intended to address the logic problem that arises when a troubled company measures debt at fair value. If a company is less able to pay its debt and measures it at fair value, that reduces the liability on the books, leading to a gain in the income statement. With its recent rule changes, IASB tells companies instead to show the liability at cost, meaning what it actually will cost to settle the debt.

So far so good, says Moody’s Investors Services in a recent report on the rule change. “This is a positive development because the existing accounting rules lead to counter-intuitive results: when a company’s own credit standing deteriorates, the measured fair value of its debt falls, resulting in gains reported in income,” Moody’s wrote in an abbreviated version of the report.

But it still leaves some problems to be resolved. The changes don’t become effective in IFRS until 2013, and companies reporting under U.S. Generally Accepted Accounting Principles are still allowed to post gains on their own declines in creditworthiness, Moody's said. “Unless U.S. GAAP is updated in a similar fashion to the new IFRS accounting, income statement noise will remain,” Moody’s wrote.

FASB has taken heated feedback on its proposed standard for financial instruments and hosted a series of roundtables to hear more. The board plans to redeliberate and issue a final standard by mid-2011 as part of its convergence agenda with IASB.

Donald Robertson, vice president and senior accounting analyst at Moody’s, said it’s hard to predict how FASB might address the “own credit” problem in GAAP, not to mention a number of other areas where FASB and IASB are calling for different approaches. “It’s really in nobody’s interests to have these significant differences in accounting long term,” he said.

Moody’s says the vast majority of public companies that measure their own debt at fair value are banks, particularly those in the United States and Europe. Credit spreads widened through the financial crisis in 2007 and 2008, Moody’s said, leading to reported gains in income as a result of declining debt values, but spreads reduced in 2009 leading to losses.