IF A COMPANY'S OWN CREDIT FALLS, you might expect profits to fall, too. Regardless, it wouldn't make much sense for a company to record income if the trading price of its debt falls. Yet that's exactly what happens under current rules.
Fortunately, however, fair value accounting standards are likely to become more sensible in the not too distant future. Five of the seven members of the Financial Accounting Standards Board (FASB) favuor altering how companies account for changes in the fair value of their own debt. This is the company's own debt; not debt held as an investment, but amounts a company owes its creditors – debt that is rated and traded in the marketplace.
When a company becomes less creditworthy, the fair value of its debt falls in the marketplace. Under current rules, if the company has elected to mark its own debt to market, changes in fair value flow through the income statement. A special disclosure of gains and losses attributable to the issuer's creditworthiness is required in the notes to the financial statements, but in the actual financial statements net income increases when creditworthiness deteriorates.
Although no company would deliberately boost profits by worsening its credit profile, the current rule needs to be amended. Allowing a company to increase income when debt held by outside investors decreases in value is about as logical as permitting companies to record income when their public stock drops in value.
The existing rule has earned FASB some criticism. To FASB's credit, it is looking to amend the rules by recommending that such changes in fair value be booked on the balance sheet as other comprehensive income (OCI), rather than on the income statement.
The current rule is included in ASC 820, Fair Value Measurements and Disclosures, but may be more familiar to many under its pre-codification name, FAS 159, The Fair Value Option for Financial Assets and Financial Liabilities. FAS 159 was issued by the FASB in 2007 "to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions".
In other words, the rule was designed to give companies a way to reduce undesirable fluctuations in the income statement without having to use arduous hedge accounting rules. Since then, hedge accounting rules have been simplified.
Also under the tentative decision, but decided unanimously by all seven board members, cumulative gains and losses recognised in OCI which are related to changes in a company's own credit would be recognised in the income statement in the period in which the liability is settled. In addition, the entire risk in excess of a base market risk (i.e., the risk-free rate) would be considered as the change in own credit. Companies would be allowed to choose a different method to determine the change in own credit if it is deemed more appropriate.
In Line With IFRS
The tentative decision, if approved, would bring U.S. GAAP in closer alignment with International Financial Reporting Standards (IFRS), so it is appropriately included in FASB's joint project with the International Accounting Standards Board (IASB) to simplify accounting for financial instruments. The objective of the joint project is to create common standards and to significantly improve the "decision usefulness" of financial instrument reporting for users of financial statements.
The FASB has not yet formally proposed the new rules, but it plans to include them in an exposure draft by the end of the year. After the exposure draft is issued, companies will have an opportunity to comment on the proposed changes. FASB will consider the comments it receives early next year as it deliberates and finalises the changes.
The changes make sense from a theoretical accounting perspective, as they would provide users of financial statements with a more representative picture of a company's net income. Companies affected by the changes, though, are likely to have mixed reactions.
By booking such changes on the balance sheet instead of the income statement, the impact can be significant, especially when amounts are material to the income statement or the balance sheet. The change will affect both GAAP and non-GAAP metrics used to analyse financial statements, such as EBITDA. Earnings per share calculations will also be affected. Booking amounts in OCI will also make them less noticeable from a materiality perspective than recording them on the income statement, since the metrics used to assess balance sheet materiality often reflect larger amounts than those used to assess income statement materiality.
Once the new rules become effective, which could be as early as January 1, 2013, they could be applied retrospectively – meaning changes in the fair value of own credit will no longer drive earnings volatility.
All companies which voluntarily elect the fair value option are affected. Few companies would make the election when their credit is improving, since that would involve recording losses in the income statement under existing rules, so it is reasonable to conclude that companies affected by the change are those with credit deterioration. Those companies will no longer be able to use credit misfortune to show income.
Rick Martin is vice president of technical accounting at Pluris Valuation Advisors in New York
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