Previous posts in this blog have noted that current accounting rules on financial instruments have a counter-intuitive result when a company’s credit rating is lowered. In theory, any liability should be recorded on a company’s books at the amount that is reasonably expected to be paid. If the liability is to be paid over the long-term, it should be discounted. The amount od a discounted liability on a company’s balance sheet would vary as the discount rate change. The discount rate reflects the risls associated with the liability, and as the risks increase, so does the discount rate. A higher discount rate means a lower liability. The company then reduces the liability (debit to liability) and to balance the books, requires a credit entry, which results in a gain to a company’s income statement. And that I show the counterintuitive result occurs—a drop in a company’s credit rating means a gain in earnings.
The liability treatment follows asset treatment—for example if a company thought that a debt was uncollectible, it would write the debt down to what it thought it would recover. So that the principle of fair value is maintained across the balance sheet, the same theory applies to liabilities.
The International Accounting Standards Board (IASB) has proposed changing the way banks measure their liabilities so they can no longer book the gain noted above and confuse investors after a ratings downgrade.
The IASB acknowledged that there are theoretical arguments for treating financial assets and liabilities in the same way, it is hard to defend the accounting as providing useful information when a company suffering deterioration in credit quality is able to book a corresponding gain.
The "counter intuitive" rule angered policymakers during the financial crisis when profits were being booked by banks despite ratings downgrades"
The proposal is part of an overall revamp of the IASB's fair value or marking to market rule which will be finalized by the end of this year but it is unclear when it comes into force.
HSBC Europe's biggest bank, recently reported that It had both a $5 billion hit from bad debts on U.S. home loans and asset writedowns while at the same time recording a fair value gain of $2.7 billion on its own debt during the period due to a widening in credit spreads.
Earlier in May, UBS recorded a gain of 2.1 billion Swiss francs ($2 billion) due to the widening of its own credit spread.
The debate about whether banks should allow for fair value gains on liabilities is not new, but has assumed fresh importance after a hugely volatile first quarter in credit markets, which saw bank debt trading at a discount in some cases to non-financial bonds.
Some analysts argue that if banks are taking mark-to-market losses on their assets and on hedging instruments, they should also be allowed to account for gains on their liabilities even if the underlying credit quality has not changed.
One of the practical problems with the theoretical approach noted above , however, is that a bank is unlikely to repay the debt early. A bank would usually wait until the debt matures and then buy it back at par.