The Financial Accounting Standards Board is likely to change how companies can account for the fair value of the debt they hold.

At a meeting in June, FASB tentatively decided as part of its financial instruments project that changes in fair value that result from a change in a reporting entity’s own credit risk for financial liabilities that are designated under the fair value option and, thus, measured at Fair Value Net Income, or FVNI, would be presented separately in other comprehensive income, or OCI. Thus, changes in fair value would be removed from the net income calculations.

In addition, FASB tentatively decided that cumulative gains and losses recognized in OCI associated with changes in own credit will be recognized in net income upon the settlement of the liability. The entire risk in excess of a base market risk, such as a risk-free interest rate, would be considered the change in own credit or an alternative method that an entity deems as a more faithful measurement of such a risk.

While FASB noted that its tentative decision has not yet been formally proposed, it expects to formally propose the change in a new exposure draft of its financial instruments standards project by the end of the year. Once an exposure draft is issued, stakeholders will have the opportunity to comment on the proposed changes. The comments will be considered by the board during its redeliberations next year when FASB considers the comments received on the exposure draft.

Rick Martin, vice president of technical accounting at Pluris Valuation Advisors, sees this as an about-face for FASB from a standard dating back to 2007. “This is unusual because it represents a reversal from something the FASB put in place five years ago,” he said. “In doing its broader overhaul of accounting for financial instruments, it swept this change into the overhaul.”

There haven’t been any new rules yet, he cautioned. “There haven’t even been any proposed new rules yet with regard to this,” said Martin. “It’s just a tentative decision that they’ve made in the boardroom at this point. But what it represents is the reversal of a counterintuitive rule that allows companies to actually book in their income statement tangible profits and gains whenever the value of their debt goes down. This is the company’s own debt, not debt that they’re holding as investments, but the actual money that company owes to other people is rated and traded in the marketplace, and when that company’s creditworthiness goes down, all of a sudden that changes the trading price of the debt. So what you end up with in the accounting rules, starting in 2007, is the ability to elect a fair value option whereby a company would fair value its own debt on its own books, and it’s totally counterintuitive. It makes no sense that you would be able to book a gain on your own debt whether your own debt goes up or down. What makes it even more counterintuitive is that when you’re suffering, you’re booking a more rosy picture on your books.”

In 2007, FASB issued FASB Accounting Standard (FAS) 159, The Fair Value Option for Financial Assets and Financial Liabilities. The goal was to reduce both the complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently.

The standard required companies to provide additional information in the notes to the financial statements to help investors and other users of financial statements to more easily understand the effect of the company’s election to measure certain financial instruments at fair value. It also required entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet.

For financial institutions that carry many of their assets at fair value, there could be a mismatch when their liabilities, which also are interest-rate sensitive, were carried at cost. Thus companies have elected to measure such liabilities at fair value by electing the fair value option under FAS 159.

Financial liabilities for which a fair value option has been elected may result in changes in an entity’s credit worthiness to be reflected in earnings. A special disclosure of gains and losses attributable to the issuer’s own creditworthiness is required to highlight this issue for investors.  FASB decided to reconsider this issue as part of its financial instruments project, which is still in progress.

“You need to think of the actual accounting entry as kind of like a debit to the debt because your debt is being reduced because it’s trading less, and a credit to income, and that in effect is what they’re doing,” said Martin. “Everybody made fun of it, but then the real estate crisis and the banking crisis happened and the FASB had a lot of other things to worry about. So this is something that everybody joked about and thought of it as being really counterintuitive. The motive behind it was intentional and the decision to allow the fair value option for companies on debt was deliberate, but at the same time it was counterintuitive.”

Martin acknowledged that FASB was just trying to be consistent. “They were saying, ‘OK, if we’re going to allow fair value principles on the financial statements, then we need to do it universally, and we can’t start picking and choosing what can be fair value and what can’t.’ So they allowed companies to be pervasive in their fair value accounting to be pervasive in their financials.”

Martin believes the proposed changes will be beneficial to companies. “Instead of booking the changes in the value of the debt in net income, they are going to book it in OCI, other comprehensive income, which is just a theoretical line item on the balance sheet,” he said. “Instead of being able to book profits in the years where a company’s creditworthiness goes down, it will impact the balance sheet, where it will have a lot less impact. First of all, it’s not showing up in profit. Second of all, it’s going to be immaterial to the balance sheet. It’s going to pale in significance to the size of most companies’ balance sheets. Now it’s more of a disclosure item than something that’s going to show up in profits.”

Martin also thinks the change will bring U.S. GAAP and International Financial Standards into closer harmony, even though the vote in FASB’s headquarters was not unanimous.

“The people in London most assuredly made fun of the people in Norwalk on this,” he said.

Not all companies will be pleased with the change, though.

“Who’s going to be happy and who’s going to be sad?” said Martin. “Any company that needed to book some gains and its creditworthiness was declining is going to be sad because they’re now going to have to pull those amounts out of profit and hang them up on the balance sheet where they’re not even going to be noticed. No company would have elected the fair value option and fair value their own debt if it would have resulted in them booking losses. There are probably no situations where companies whose creditworthiness is improving who had to book losses will now be booking them on the balance sheet because there are probably very few companies out there that would have ever elected the fair value option in that environment in the first place.”