The Hindu Business Line : Liabilities = income?

After the Satyam fiasco, accountants have had to take a lot of wisecracks against them. There is one in which an accountant is asked where he would reflect liabilities in the balance-sheet to which his stoic reply is “outside the books”.

While this is on the lighter side, the concept of fair value has certainly made a mockery of the amount that would be reflected in the balance sheet as liabilities. Magically, decrease in liabilities has increased profits for banks and financial institutions — due to high exposure — with others taking note.

The International Accounting Standards Board (IASB) — founder of the concept of fair value — is calling for comment on whether this is the right accounting approach. It has issued a discussion paper on “Credit Risk in Liability Measurement”.

Credit risk in liability measurement is often referred to as ‘own credit risk’. Existing International Financial Reporting Standards (IFRSs) require profit or loss resulting from changes in ‘own credit’ to be booked when debt is fair valued. From an accounting perspective there are good reasons for applying fair value measurement to both assets and liabilities.

However, some see the outcome as counter-intuitive. Recent developments in the financial markets have led to increased concerns about gains that result from changes in the value of an entity’s liabilities.

The argument for including credit risk in liability measurement at every reporting date is that since at initial measurement the cash value of a liability includes the effects of a borrower’s credit risk adjusted for collateral and guarantees, subsequent measurements too need to embed this risk. However, not all liabilities are borrowings and some, such as employee benefits or insurance claims, are totally different in nature. There has been some argument for utilising a default risk-free rate to discount all such liabilities which brings in issues of judgment.

Another argument for including credit risk is that a diminishing liability restricts the claims of the owners which can be perceived as a transfer of wealth between a creditor and an owner which makes it necessary to have a proper value on the reporting date. The final argument for fair-valuing liabilities is the classical accounting concept of matching. If assets are fair-valued, there is no logic in treating liabilities as children of a lesser God.

Excluding credit risk

The main argument against including credit risk in liability measurement is that it is counter-intuitive, since gains should be accrued when there is an improvement in the entity’s financial position and not a decline.

By including credit risk, the entity reports a gain from a decline in the credit quality if its liabilities which is potentially misleading and can mask a deteriorating situation. The critics of this inclusion argue with the approvers by giving them back in the same coin — accounting mismatch.

A decline in credit quality usually signals a decline in the value of assets that may not be fair-valued such as goodwill or intangible assets which are only tested for impairment. To fortify their argument against including credit risk, the critics state that assets need to be fair-valued regularly since there is a need to value the realisable value of an asset as they can be freely transferred.

Liabilities are seldom transferred and even if they are there could be practical difficulties. The critics provide alternatives too — using the risk-free interest rate and expected future cash flows to measure liabilities with the resulting amount either taken to the income statement or amortised over the life of the liability or measure liabilities at the cash-exchange value.

As discussions and debates go on, it is critical to note that the basic tenets of accounting are conservatism and prudence even now. There can be no doubt that there are a number of differences between assets and liabilities to argue against treating them the same way.

In terms of control, assets are typically controlled by the entity while liabilities — apart from equity — are controlled by others dealing with the entity. “Provide for all known losses and do not account for unexpected gains” is another mantra that goes against including credit risk in measuring liabilities.

It would take some time for finality on the issue but the first battle seems to have been won by the critics who would restate liabilities only on the happening of an event like a debt restructuring and not by other concepts.

(The author is a Hyderabad-based chartered accountant.)

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