Peeling away financial reporting issues one layer at a time

FAS 157: The FASB’s Prelude and Fugue on Fair Value of Liabilities

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, 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.


  1. Reply charles May 28, 2008

    Being a life insurance practitioner, I have often considered this same approach, especially given the increasing activity being witnessed in terms of insurance policies being traded in a secondary market (and securitized so we have both retail and wholesale exit prices).
    Here are some challenges in terms of deriving liability values using the asset side perspective:
    1. Insurance only makes sense based on pooling concepts and taking advantage of the predictability under the law of large numbers. As the portfolio of insurance contracts becomes smaller and smaller and the volatility of the results increases, the price one would be willing to pay for the portfolio decreases. In the limit a single policy would be worth far less than a pro rata share of a large portfolio of similar risks. Meanwhile from the point of view of the policyholder owning the asset, the value is the same regardless of the size of the insurers portfolio. Arguably there are similar effects with things like residential mortgages where there is also a pooling concept in terms of prepayment risk and credit risk.
    2. In valuation, the asset holder may consider items that are not related to the entity issuing the liability. This would include industry guarantee funds and the insurance regulatory process that would generally intervene in the company’s affairs and de-risk the entity mitigating the potential solvency risk.
    3. Asset holders lack of information relative to liability issuer. The asset holder may not be very sophisticated and may not know the valuable embedded options in their contracts; nor will they have access to information about the riskiness of the entity’s ALM and business strategies. A more sohpositicated wholesale buyer would have better access to information and expertise to determine a more rational price.

  2. Reply BIg 4 Guru June 13, 2008

    Ah, the fair value issue. With FASB’s constant quest for “transparency” it is so appropriate that an issue emerged so completely to shine the light on the shortcomings of Fair Value Accounting. I’m referring to the sub-prime crisis, of course. In light of the sub-prime crisis and the growing spotlight on fair value accounting, the need for investor education is greater than ever. Those that called for the need to educate users of financial statements about the subjectivity of fair value measures and their impact on financial results are appearing quite foresighted indeed. In the aftermath of the sub-prime market seizure, investors without a true understanding of fair value accounting were left to view the dramatic write-downs of CDOs as an indicator of market chaos. This is yet another example of the blessing/curse of the increased transparency of our markets.

  3. Reply Swintah July 9, 2008

    Hi – I’m just passing through, but if you want to find what the FASB posted and then removed, the “Wayback Machine” may have it. It’s a huge internet archive located at Good luck!

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