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1、Credit Standing and the Fair Value of Liabilities: A CritiquePhilip E. Heckman, Ph.D., ACAS, MAAAHeckman Actuarial ConsultantsPresented to theThomas P. Bowles Jr. Symposium: Fair Valuation of Contingent Claims and Benchmark Cost of CapitalApril 10-11, 2003 Georgia State University, Atlanta, GA To be
2、 published inNorth American Actuarial JournalJanuary 2004Credit Standing and the Fair Value of Liabilities: A CritiquePhilip E. Heckman, Ph.D., ACAS, MAAA* Philip E. Heckman, Heckman Actuarial Consultants, 600 South Crescent Avenue, Park Ridge, IL 60068, 847-692-3834, peheck ABSTRACTWe review the po
3、sitions of major accounting and actuarial bodies on the issue of whether the holders own credit standing should be reflected in the fair value of its liabilities, identifying certain anomalies, both in the current GAAP treatment of debt and in the FASB approach to the fair valuation of liabilities.
4、We also examine the treatment in financial theory of risk capital in the case of unsecured debt. An alternative approach is proposed, stressing the need for an objective valuation standard, based solely on contractual terms and ambient economic conditions, and yielding readily interpretable public i
5、nformation. Finally we review the probable consequences if, as seems likely, the FASB approach prevails, or, as seems unlikely, the views advocated here prevail.Credit Standing and the Fair Value of Liabilities: A CritiqueI. IntroductionThe issue of credit standing and whether or how it should be re
6、flected in the fair value of liabilities is a stubborn one, which resists resolution. It has recently resurfaced in insurance and actuarial discussions regarding the accounting of financial instruments and insurance contracts, the impetus for the publication by the American Academy of Actuaries of i
7、ts Public Policy Monograph on Fair Valuation of Insurance Liabilities. (AAA, 2001) In this otherwise thorough document, the authors avoid taking a position on the credit standing issue, presenting instead arguments pro and contra, and leaving the reader with a vague impression that reflecting the ho
8、lders own credit standing in the fair valuation of his liabilities is a theoretically sound idea supported by volumes of modern financial theory whose time has not yet come because of the objections of old-fashioned persons who do not care for modern financial theory. This paper has been written to
9、counter that impression and to argue, to the contrary, that the notion arises from a deep and abiding confusion, both in theory and in current practice, as to the nature and purpose of liabilities, the proper application of financial theory, and the very mission of public accountancy.In the followin
10、g, we examine and comment on the positions, if expressed, of some of the major professional/regulatory organizations on this issue, the International Accounting Standards Board (IASB), the American Academy of Actuaries (AAA), and the Financial Accounting Standards Board (FASB). We also examine a clo
11、sely related issue: the treatment of risk capital for unsecured debt in financial theory. (Merton and Perold, 1993) This done, we proceed to formulate provisional principles for the fair valuation of liabilities with a focus on providing useful public information and enhanced equity for all particip
12、ants. The essential points of the discourse can be addressed in the very simplest terms: accounting for ordinary debt. In resolving the essentials of the problem, nowhere will we need to consider any financial instrument or obligation more complicated than a ten-year non-callable, non-prepayable, ze
13、ro-coupon note. Nor will we engage in special pleading for exceptional treatment of “complicated” insurance liabilities. A patchwork of exceptions like your typical tax code is emphatically not the way to achieve the “fairness” implied by “fair value”. The basic issues are clear and simple; and the
14、indicated resolution is, as we shall see, straightforward, but drastic.II. The IASB DefinitionAs cited in the AAA Monograph, the Insurance Steering Committee (ISC) of the International Accounting Standards Committee (IASC), reorganized in 2001 as the International Accounting Standards Board (IASB) d
15、efines the fair value of a liability as:the amount for which a liability could be settled between knowledgeable, willing parties in an arms length transaction. In particular, the fair value of a liability is the amount that the enterprise would have to pay a third party at the balance sheet date to
16、take over the liability. (IASB, 2002)Along with the fact that it is incomplete, this definition has several other features worth noting:1. Direction: The obligation is being valued as a liability, not as an asset. The amount considered is to be paid out by the liability holder in exchange for being
17、rid of the obligation.2. Putative transaction: The fair value is defined in terms of a transaction more often putative than real between informed, independent parties at arms length. This introduces an element of equity into the concept. “Fair” does not mean only what the market will currently bear.
18、 It carries also the conventional meaning of fair dealing, open disclosure, and honorable conduct. Most people would construe the language used here as excluding, for valuation purposes, buyback transactions whereby the liability holder settles the obligation by repurchase from the asset holder. The
19、se parties are bound by prior contract and cannot be said to be at arms length. This is an important point, which will be cited later.3. Third party: The definition cites a “third party”, who is, again, more often putative than real, and who acts, more or less, in the role of guarantor. However, it
20、does not specify the quality of the guarantee, that is, the third partys credit standing. This is an extremely consequential omission because the quality of the guarantee implied in the disposal of the liability in fact determines the fair value of the liability. Various attempts have been made to f
21、ill in the blank. Notably FASB Concepts Statement 7 (FASB, 2000) completes the definition by specifying a “third party of comparable credit standing”. It is interesting to note that considering the transfer of the liability to a third party of comparable credit standing leads to the same valuation o
22、f the liability as considering a buyback transaction. Hence it is debatable whether FASBs Ansatz is in fact consistent with the IASB definition, at least with its spirit, since it introduces buyback valuation through the back door.4. In the spirit of fair valuation, one would seek to stay close to t
23、he market value of the obligation at which a guarantor could be induced to assume it as his own. However there is a very thin market for such transactions, and one must rely on models. It is useful to think in terms of guarantees. The transfer price acceptable to a guarantor would start with the ass
24、et value of the obligation and add to it the price of a guarantee, which would consist of a loading for the originators credit risk plus a loading for uncertainty in the amount and timing of the obligation. This is nothing more nor less than default-free valuation. (See Merton and Perold, 1993.) To
25、consider market pressures on competing guarantors would, in our judgment, add too much complexity to the definition.The IASBs position on this issue seems to be evolving toward that of the FASB to judge from its monthly bulletins (IASB Update), issued over the past year and a half, and reports from
26、recent meetings. III. The FASB InterpretationFASBs interpretation of the credit standing issue in fair valuation of liabilities is based on the Statement of Financial Accounting Concepts No. 7, published in February 2000. In 2001 a series of expository articles based on this statement appeared as Un
27、derstanding the Issues. The fourth of this series, “Credit Standing and Liability Measurement” by G. Michael Crooch and Wayne S. Upton (“the FASB authors”) is a very clear presentation of the FASB position. Our analysis of this position will be based entirely on this article, which is as effective a
28、 piece of expository writing as one will find anywhere.The FASB authors take a clear, axiomatic approach; and the axioms are made explicit:1. The act of borrowing money at prevailing interest rates should not give rise either to a gain or a loss.2. A fair value measurement system should not assign d
29、ifferent values to assets or liabilities that are economically the same.Adherence to axioms ensures orderly exposition but does not guarantee that the resulting system will be meaningful and useful. Nor does it ensure that the axioms themselves are mutually consistent. These axioms seem innocuous en
30、ough, but we will examine them and their consequences very carefully because their consistent application leads to results that many deem anomalous and unsuitable. In the course of this examination, we will discover why the credit standing issue is such a stubborn one.The second axiom commands assen
31、t because one of the principal goals of the fair value program is to ensure that accounts are kept in such a way that the managers of an enterprise can, at all times, have recourse to commercial markets without taking large accounting adjustments on so doing. One must, however, beware of a statement
32、 that lightly imputes economic equivalence to assets and the corresponding liabilities. Although the same financial and economic principles apply to the valuation of liabilities as to the valuation of assets, these principles emphatically do not lead to identical valuations for the same obligation c
33、onsidered as an asset and as a liability.The first axiom, which is upheld with some vehemence, bears much closer scrutiny. It is a simple statement that expresses a mainstay of accounting practice that is very ancient, probably as old as double entry bookkeeping, if not older. The FASB authors put f
34、orward a very simple example, which, in fact, covers the entire case quite satisfactorily. Consider two companies, A with a AA credit rating, B with a B credit rating. On the same day, A and B both undertake identical obligations: Each issues a zero-coupon note for $10,000 payable in ten years but n
35、ot before. A borrows at 7% per year, receiving $5,083 cash in consideration of its promise. B borrows at 12%, receiving $3,220 cash. (Comparable Treasury obligations are trading on the same day at prices that imply a risk-free rate of 5.8% per year.) Axiom 1 requires that the borrowing transaction p
36、roduce neither a gain nor a loss on the companys books; so A posts a liability of $5,083, B posts a liability of $3,220. It is difficult to take exception to this because it follows current GAAP. It is accepted practice, and has, to our knowledge, never been questioned. It is, however, worth examini
37、ng in some detail and from a different angle. We note the following:1. The two companies undertake identical obligations, yet they post different liabilities. In presentation of its financial results, A suffers a penalty relative to B because of its superior credit standing. 2. As the obligations ma
38、ture, A will write its liability up by $4,917; B, if it survives financially, will write its up by $6,780. That is, B, the financially weaker of the two, has a steeper climb (heavier demands on its operating cash flow) to get out of debt.3. An inferior credit standing manifestly carries financial pe
39、nalties: B agrees to the same obligation as A but receives $1,863 (37%) less in consideration. Yet this information is erased from the financial record when the debt is first recognized. The public seeking such information will look in vain in the financial statements and must either inspect the boo
40、ks directly or rely for the service on one of the rating agencies. We begin to understand why the rating agencies are so influential and indispensable. The information needed for a meaningful comparison of the two companies is buried deep in the financial statements and perhaps is missing altogether
41、 unless one has recourse to company records. The basic problem is that the borrowing penalty, definable as the difference between the default-free valuation and the actual proceeds, $5,690 - $3,220 = $2,470 in our example, impinges financially at inception but, in standard GAAP, and in long-standing
42、 practice, is amortized over the term of the obligation. This delay in recognition is a significant source of the difficulty in comparing one enterprise with another.4. Company B is in the odd position that an improved credit standing, other things equal, would make its accounting numbers look worse
43、. Since these numbers regularly govern perception, economic reality notwithstanding, one must be concerned that Bs incentive to improve its credit standing is being undermined.This sort of practice is familiar in the world of sport, where it is known as handicapping, the purpose being to adjust or r
44、edefine outcomes by various devices extra weight in the saddlebags, point spreads, varying base scores, and such so that they become as near random as can be achieved and anybodys guess. We would be the last to object to the practice in the world of sport, where it turns sure things into real contes
45、ts, encourages superior performers to keep improving, and erases the unfair advantage that the knowledgeable bettor holds over the ignorant. However, we must ask ourselves whether such practice has any place in financial reporting, where it can only conceal financial distress and deny information to
46、 those who need it, conferring unfair advantage on the holder of inside information. It seems that current standard accounting practice works at cross-purposes with economic and financial reality, turning financial analysis into a guessing game or a detective exercise.The above pertains to first rec
47、ognition of the debt. On future valuations the liability must be adjusted as it approaches maturity. In current GAAP, this is done on a fixed schedule using the original borrowing rate. The schedule of updates for each company under current GAAP treatment is shown graphically in Figure 1 with a sche
48、dule based on the risk-free rate included for reference. (We show the schedules as continuous lines. The readers imagination can supply the jumps at the valuation dates.) The risk free schedule starts at $5,690; As starts at $5,083; Bs starts at $3,220. All rise exponentially, growing at interest and converging to $10,000 at maturity. Here the extra burden of debt service on Company B is evident. Nevertheless, during the term of the note, B records liability for the obligation on average about18% smaller than As. The foregoing describes current practice. FASBs approach to fair valuation, on t
