Statement of Financial Accounting Standards No. 157 - Paper Audit ...

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However, there is no convincing rationale for why the initial measurement
of some liabilities would necessarily include the effect of credit
standing (as in a loan for cash) while others might not (as in a warranty
liability or similar item). Similarly, there is no rationale for why, in initial
or fresh-start measurement, the recorded amount of a liability should
reflect something other than the price that would exist in the marketplace.
Consistent with its conclusions on fair value (refer to paragraph 30), the
Board found no rationale for taking a different view in subsequent
fresh-start measurements of an existing asset or liability than would
pertain to measurements at initial recognition.
Some argue that changes in an entity’s credit standing are not relevant
to users of financial statements. In their view, a fresh-start measurement
that reflects changes in credit standing produces accounting results that are
confusing. If the measurement includes changes in credit standing, and an
entity’s credit standing declines, the fresh-start measurement of its
liabilities declines. That decline in liabilities is accompanied by an
increase in owners’ equity, a result that they find counterintuitive. How,
they ask, can a bad thing (declining credit standing) produce a good thing
(increased owners’ equity)?
Like all measurements at fair value, fresh-start measurement of liabilities
can produce unfamiliar results when compared with reporting the
liabilities on an amortized basis. A change in credit standing represents a
change in the relative positions of the two classes of claimants (shareholders
and creditors) to an entity’s assets. If the credit standing diminishes,
the fair value of creditors’ claims diminishes. The amount of
shareholders’ residual claim to the entity’s assets may appear to increase,
but that increase probably is offset by losses that may have occasioned the
decline in credit standing. Because shareholders usually cannot be called
on to pay a corporation’s liabilities, the amount of their residual claims
approaches, and is limited by, zero. Thus, a change in the position of
borrowers necessarily alters the position of shareholders, and vice versa.
The failure to include changes in credit standing in the measurement of
a liability ignores economic differences between liabilities. Consider the
case of an entity that has two classes of borrowing. Class One was
transacted when the entity had a strong credit standing and a correspondingly
low interest rate. Class Two is new and was transacted under the
entity’s current lower credit standing. Both classes trade in the marketplace
based on the entity’s current credit standing. If the two liabilities are
subject to fresh-start measurement, failing to include changes in the