FAS 157 on fair value measurements was supposed to provide comprehensive guidance for determining the fair value of pretty much any asset or liability. Yet, almost two years after its initial publication, and well after companies have had to apply the standard to certain accounts, CFO.com reports that the FASB is still making up some of its rules on the fly, and having a tough slog to boot. The problem described in the article has immediate consequences for derivative financial instruments that are classified as liabilities, but it could eventually affect the measurement of many other liability accounts as fair value measurement becomes more broadly applied:
"At an unusually heated FASB meeting last week [no minutes published on the FASB’s website yet], for instance, the members debated how companies should estimate the market value of liabilities when there’s no actual market on which to base the estimate.
During one point in the discussion, which concerned a proposed guidance by FASB’s staff on how to mark liabilities to market under 157, chairman Robert Herz seemed, to member Leslie Seidman, to be contemplating an overhaul of the brand-new standard itself. Matters got so confusing that the board ordered its staff to go back and summarize the members’ positions so that they could understand what they themselves had said.
At issue was the question of how to measure the fair value of a liability for "which there is little, if any, market activity," according to 157. The standard defines fair value as "the price that would be received … to transfer a liability in an orderly transaction between market participants at the measurement date." The question that FASB struggled with was: How do you determine the fair value of a liability that can only be settled, rather than sold?
…Often, for instance, when a company borrows money, it can’t transfer its obligation to another party without an agreement from the bank. Or a market may not exist for transferring such liabilities."
It’s a mess that the FASB has gotten itself into for two related reasons. The first is that the problems now being addressed are significant, and they were known long before FAS 157 was let out the door. The second is that FAS 157 is fundamentally flawed in its approach to fair value measurement of liabilities. The solution, as I am about to describe, seems to me to be surprisingly simple.
This particular flaw in FAS 157 (see my previous post on many others) occurs in paragraph 5:
"Fair value is the price that would be received to sell an asset or paid to transfer a liability [italics supplied] in an orderly transaction between market participants at the measurement date."
For every liability there is a counter party that holds an asset, and the economic value of the liability must be equal to the economic value of the asset. These are basic economic principles, which are not acknowledged in FAS 157. If they were acknowledged, there would be no need for the phrase "or paid to transfer a liability." That’s because the value of any liability — even one that cannot be transferred –must equal the value of the counter party’s asset, which, perforce, can always be transferred. Even though the evidence directly available to value the liability may be scant, the asset value might even be quoted in the newspaper; the non-transferability restriction on the debtor is just one more valuation parameter from the viewpoint of the creditor.
If you need further convincing that the solution to the problem of valuing any liability is to value the counter party’s asset, let’s consider an even thornier non-transferable liability that the FASB briefly considered and then dropped like a hot potato: contingent environmental liabilities. My understanding of federal environmental law is that the cleanup liability of a "potentially responsible party" is joint and several. No other party can assume the liability, so the only way out from under it is to settle with the government. Although I am not aware that the government has done this, it is theoretically possible for the government to transfer its contingent receivable to a third party. Is the contingent receivable difficult to value? Yes, but certainly no harder than many of the complex, illiquid derivatives that are roiling the global economy. (And by the way, I recall seeing the issue of the fair value of contingent environmental liabilities posted on the FASB’s website during the project phase of FAS 157. The Board expressed a tentative conclusion, but it soon disappeared mysteriously, and without explanation. I have searched Board minutes, and have come up with nothing. If anyone has any further information on this that they would like to share, please contact me!)
Because my solution to liability valuation is so simple (attention: CIFiR – SEC Advisory Committee on Improvements to Financial Reporting) and obvious, I can’t help but fear I have overlooked something. If that is indeed the case, I hope a reader of this post will take the time to point it out, and I will gladly issue a mea culpa forthwith. Yet, I derive some measure of comfort (and optimism) by an entry in the minutes of an FASB meeting (11/14/07) where Bob Herz stated that he disagrees with the measurement principles for liabilities in SFAS 157.
Who knows, maybe Bob and I are thinking along the same lines? That gives me hope for the future. But, I have to express my disappointment that liabilities were not dealt with in a comprehensive way before SFAS 157 was issued. There is much to be said for getting it right the first time.