The International Accounting Standards Board discussion paper on how best to measure the fair value of liabilities lays out the three most oft-cited arguments in favour of including credit risk. The most common objection to liability measurements that incorporate credit risk is that a body gets to report a gain from a decline in the credit quality of its liabilities. According to the standards board, this gain (or loss, in the case of improving credit quality) is counter-intuitive. Gains should result from improvements in a body's financial position, not declines. Reporting a gain from a decline in credit quality is potentially misleading and can mask a deteriorating situation. The counter argument is that a body's liabilities are related to its ability to performance rather than market value. In most cases, if the liability is long term, the body is not actively trading its own debt but holding it to maturity, there isn't a strong rationale for measuring it according to fair value, according to Keith Pogson, managing partner, financial services, Far East Asia, Ernst & Young. 'As long as the entity has the ability to perform and it is going to perform, why does it make sense to [measure the] fair value [of] its liabilities? The overriding concept of this debate should be, what is in the best interests of the people who read and understand financial accounts.' Consistency is highlighted in the board's paper as the first argument for incorporating credit risk. 'Accountants accept that the initial measurement of a liability incurred in an exchange for cash includes the effects of the borrower's credit risk, adjusted for collateral, guarantees and other features of the contract,' according to the paper. 'There is no reason why subsequent current measurements should exclude changes in factors that were included in the initial measurement.' Wealth transfer is the second argument for keeping the rules intact. Liabilities and equity represent the two classes of claims against an entity. A change in the credit risk of an entity's liabilities represents a transfer of wealth between those two classes. 'Lenders' interests are usually senior to those of equity holders and their potential gains and losses are bound by the terms of a contract,' the paper said. Shareholders are not required to make any additional investment to cover losses incurred by the entity except to the extent that they have a binding obligation to do so. The third argument for maintaining the status quo is that excluding credit risk changes can result in an accounting mismatch between asset and liability measurements. If a company's assets are measured at fair value, then changes in credit spreads on those assets will affect their fair value and the company's profit, loss, or other comprehensive income (OCI), depending on the transaction. So if the measurement of liabilities doesn't incorporate credit-spread changes, the accounting mismatch will distort the recorded profit, loss and OCI.