Liability Fair Value

Tom Selling from The Accounting Onion was kind enough to point out his blog to me. Reading a post on FAS 157, it suddenly occurred to me that the implementation the audit firms have permitted of 157 on liabilities, based on the FASB staff position, isn't consistent with the conceptual framework of 157.

The standard says:

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Suppose I run David's Broker/dealer, DBD. DBD bonds are liquid and so have an observable credit spread. If DBD credit spreads go out, DBD bond holders using fair value suffer losses which are reported in their P&L. But if DBD wants to buy back those bonds in an orderly transaction between market participants, DBD bond holders are very likely to force it to pay par plus accrued (at least if DBD is a going concern). Moreover it's illegal for DBD to buy its own bonds back in the secondary market in most jurisdictions so the value of the liabilities for DBD is not symmetrical with the value to the holders: it cannot take advantage of its elevated credit spread even if it has the money to buy back the bonds. Hence the staff position doesn't reflect economic reality, and what most people feel in their gut - that 157 gains on liabilities due to credit spread widening are bunk - really is true.

I'll end with a quote from the amusingly petulant comment the Basel Committee issued on IAS 39:

it would be wholly unsatisfactory if an entity which was insolvent in the sense of its assets being worth less than the par value of its liabilities nonetheless appeared to be solvent because the fair value of its liabilities was recognised on its balance sheet, with the fair value below nominal value...we recommend that the exposure draft’s guidance on the fair value option be revised ...[to] exclude the mark to market of own credit risk from the fair value option by limiting the mark solely to valuation changes due to general market movements