Help Arrives for Fair Value of Liabilities

Corporate accounting departments finally have more guidance to help them pin fair-value measurements onto their liabilities—and the guidance reflects a realization that in some cases, the concept of fair value is much simpler than the practical reality.

Almost two years in the making, the Financial Accounting Standards Board has completed Accounting Standards Update No. 2009-05 to explain how companies should apply the modern concept of fair value to liabilities, even when liabilities are rarely traded in the way a fair-value approach assumes. The board needed two separate draft proposals to finalize the guidance it ultimately adopted.

“Fair value” for a liability is currently defined as the exit price (that is, what a company must pay someone to assume the liability and take it off the company’s hands) paid in a market-based exchange. The definition also says the best indicator of fair value is a market price for an identical liability.

Mayer

The problem? In the real market, liabilities are rarely traded because they usually carry contractual restrictions, says Jamie Mayer, senior manager at Grant Thornton. Instead, companies typically think about liabilities under a “settlement notion,” or what it would cost to settle a liability, he explains. “But fair value says you are not settling, but transferring the liability.”

FASB addresses the issue by telling companies that if a quoted price in an active market for the identical liability isn’t available, they can use several other approaches instead. First, they can look for a quoted price of the identical liability when traded as an asset.

Dolinar

Jim Dolinar, a partner at accounting firm Crowe Horwath, gives the example of companies issuing bonds: They can use bond pricing to help establish fair values for the related liabilities. “That’s a very common-sense approach” to find the fair value of a liability, he says. “If your own debt instrument does trade in the market, you can use that with certain exceptions.”

Still, tread carefully. Magnus Orrell, a partner with Deloitte & Touche, says the trading of debt as an asset is not identical to the hypothetical transaction companies are supposed to assume under fair-value measurement rules. “I’m supposed to assume I’m transferring a liability,” he says. “That’s not what happens when a debt security is purchased by an investor as an asset.”

Orrell

If that technique won’t work for a given company, FASB’s next solution is to look for quoted prices for similar liabilities, or for similar liabilities when they are traded as assets. If those techniques fail, then companies can turn to other valuation techniques consistent with existing fair-value measurement rules, such as an income approach or a market approach.

The new guidance also provides some examples that are well worth reviewing. “It’s helpful walking through the process of measuring a liability.”

—James Mayer,

Senior Manager,

Grant Thornton

FASB provides one other important instruction on measuring liabilities under fair value. Companies should not make a separate adjustment for any restriction that may exist preventing the liability from transferring. Language straight from the guidance: “The effect of a restriction that prevents the transfer of a liability is either implicitly or explicitly already included in other inputs to the fair-value measurement.”

The new guidance also provides some examples that are well worth reviewing, Mayer says. “It’s helpful walking through the process of measuring a liability.”

Why So Long?

Jay Hanson, national director of accounting for McGladrey & Pullen, says the guidance was difficult to finish because fitting the notion of a liability into the definition of fair-value measurement isn’t easy. “Essentially [FASB] had to compromise on some of the principles,” he says. In his view, matching a liability value to the trading price of a debt-based asset is a “practical expedient.”

FAIR VALUE COMMENTARY

The following excerpt is from the comment summary for FSP FAS 157-f:

As noted in paragraph 4(c), respondents generally supporting issuance of the proposed FSP

raised concerns mainly surrounding paragraphs 9, 10, and 11 of the proposed FSP and the

illustrative examples included in the proposed FSP. Many respondents also made editorial

suggestions aimed at ensuring that the proposed guidance is consistent with Statement 157, as amended. The paragraphs that follow discuss those and other issues.

Paragraph 9

Two constituents suggested that the Board make clear that the fair value measurement

objective is still an exit price notion—that is, what would be paid to transfer the liability to

another market participant in an orderly transaction at the measurement date [International

Swaps and Derivatives Association (CL # 7) and Ernst & Young (CL #12)]. Two

constituents also suggested that the Board make clear the goal of maximizing relevant

observable inputs [Deloitte (CL #15) and Duff & Phelps (CL #13)].

One constituent suggested that the Board make clear that paragraphs 9(b) and 9(c) reflect

inputs into a fair value measurement and are not fair value measurements in and of

themselves [PricewaterhouseCoopers (CL #5)]. Two constituents suggested that if the Board

intends to require or allow an entry price notion to be the measurement attribute for a

liability, then the Board should characterize that decision as a practical exception or practical

expedient[Deloitte CL #15 and KPMG (CL # 18)].

Paragraph 10

One constituent suggested that the FASB clarify its intent regarding adjustments and whether

they should be made for differences between the principal market of the asset and the

principal market of the liability being measured [International Swaps and Derivatives

Association (CL # 7)]. This constituent suggested that if the FASB intends that no

adjustment be made, then it should provide a clear rationale for such a decision; if the FASB

intends that an adjustment be made, it should provide additional guidance to aid in

application of the proposed FSP.

Two constituents noted that, without further clarification, an entity may recognize a day one

loss if it adjusts for the effect of a restriction embedded in the terms of the liability if the

principle in paragraph 10(c) of the proposed FSP is followed [KPMG (CL # 18); Deloitte

(CL #15)]. These constituents also suggested that 10(c) be deleted or conformed to the

guidance in paragraph 11 of the proposed FSP by clarifying that if the holder of the asset is

restricted from selling the asset because of a restriction embedded in the original transaction, the entity should not make an additional adjustment when measuring the fair value of the

liability.

Paragraph 11

A few constituents suggested that the Board articulate a clear principle explaining the

rationale for the Board’s decision not to require separate adjustment for transfer restrictions

[PricewaterhouseCoopers (CL #5); Ernst & Young (CL #12); Deloitte (CL #15)]. One

constituent also questioned whether the guidance would always preclude an adjustment being

made citing that it would be necessary to consider an adjustment to the fair value

measurement input if an entity is estimating fair value using an observable price for a similar

liability that does not have the same restriction on transfer as the instrument for which the

fair value measurement is being made [International Swaps and Derivatives Association (CL

# 7)].

Source

Comment summary for FSP FAS 157-f (June 1, 2009).

“That’s going to be a huge help and will eliminate a lot of consternation,” he says.

Still unaddressed, however, is the paradox of a company’s ability to recognize a gain when their financial liabilities are measured at fair value and their own creditworthiness has deteriorated. When an entity’s own credit standing declines and its ability to repay its debt falters, that leads to a decline in the fair value of that liability—which flows through the balance sheet and income statement as a gain to earnings.

In its comment letter on the liability guidance, Deloitte & Touche implored the FASB to reconsider this seemingly illogical result, suggesting the board should look more closely at whether a settlement value is a better measure of fair value. Ernst & Young also suggested the board should undertake a more comprehensive review of how various instruments should be most appropriately measured, especially non-financial liabilities that are hard to measure under existing fair-value requirements.

FASB so far hasn’t budged on its exit-price approach to all fair-value measurement, but the International Accounting Standards Board is not as convinced it should be applied so strictly. IASB published a discussion paper on whether an entity’s own credit risk should be considered in measuring the value of liabilities, and it has been collecting comments through the summer. If IASB’s process leads to a different conclusion, that could lead FASB down a different path as the boards seek to make U.S. and international rules more consistent, Mayer says.

Hanson says it’s also possible the issue will command more scrutiny as FASB deliberates an early-stage plan to require fair-value measurement for all financial instruments. The board launched a project to pursue such a change to accounting rules, and the financial sector immediately swung into defensive mode. “This will be extremely controversial,” Hanson warns.

While FASB’s focus is on getting more current, fair-value measurement for financial assets, liabilities certainly will be swept into the process, he says. “What’s good for the left side of the balance sheet is good for the right side of the balance sheet,” he says.

Hanson notes that investors, who have championed the move to more fair value, are already pausing over the prospect of seeing all liabilities displayed at fair value.

“Investor feedback is if you’re marking liabilities to fair value, we want to see exactly what those adjustments are on the face of the statement,” he says. “Here’s what we owe and here’s what got adjusted. They really want to know what you have to pay to settle it … The real challenge will be when investors start looking at the fair value of liabilities whether they will like it as much as they thought.”