As if they needed any, the critics of fair value got a fresh new example of the craziness of an oft-decried provision in FAS 157, paragraph 15 of Fair Value Measurements. The provision rewards companies whose credit spreads on their debt liabilities have widened and punishes those who have become more creditworthy.
On Wednesday, Morgan Stanley reported that it had to cut its first-quarter net revenues $1.5 billion because the credit spreads on some of its long-term debt had narrowed. What happened was that as the investment bank grew more reliable to its creditors over the first part of the year, its debt became more valuable. And under the dictates of mark-to-mark accounting, the firm had to take a writeoff because of this very positive occurrence.
Sound nuts? It has sounded so to many observers. In the 15th paragraph of 157 FASB says, nevertheless, that "the fair value of [a company's] liability shall reflect the nonperformance risk relating to that liability." Thus, as the nonperformance risk--as reflected by slimmer credit spreads—narrowed, Morgan Stanley had to reflect the decreased value of its debt as a decrease in sales on its income statement.
Like the alleged evils of mark-to-market accounting in illiquid markets—although to a lesser extent—the irrational practice of forcing improved creditworthiness to be reflected in revenue decreases has become fodder for fair value’s enemies. When FASB made its recent amendments to 157, it neglected to attack the provision. If only to preserve fair-value accounting from more political attacks, it should do so now.
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