There is renewed debate among accountants about fair value accounting following the publication in June of a discussion paper about the role of credit risk in measuring the fair value of a liability. The paper was issued by the International Accounting Standards Board. At issue is whether present fair value measurements of liabilities incorporate the chance that a company will fail to perform as required and, if that happens, what are the alternatives? Credit risk in liability measurement is often referred to as 'own credit risk'. Existing International Financial Reporting Standards require profit or loss resulting from changes in own credit to be booked when debt is fair valued. From an accounting perspective there are good reasons for applying fair value measurement to assets and liabilities. But some see the outcome as counter-intuitive with recent developments in the financial markets leading to increased concerns about gains that result from changes in the value of an entity's liabilities. As financial results were disclosed earlier this year, it became clear that the fair value measurement was being used to boost income as banks and insurance companies became less creditworthy. Citigroup, in the first quarter of this year, benefited from its credit rating downgrade by posting a US$30 million gain on its own bond debt. For all the uproar the accounting rule is simple. When a firm uses the fair value method of accounting it must mark its liabilities and its assets to market. As its credit rating falls, so does the price of its debt, which must be re-measured by marking the liability to market. The difference between the two values is then recorded as a debit to liabilities and a credit to income. According to Richard Petty, president of CPA Australia, in the first half of this year many businesses posted gains by retiring debt at a significant discount to its face value. 'The debt issuer's reporting of the unrealised gain from a hypothetical settlement transaction is a problem for those who are focused on financial stability,' Petty said. 'This raises the ongoing issue of fair value's usefulness as a reflection of economic reality vis-?-vis the reflection of asset values to contribute to financial stability.' Conceptually, for financial instruments, such as derivatives that are subject to interest rate changes, there may be an opportunity cost for an organisation that could, for example, enter into an interest rate swap with a fixed rate to offset the risk of that instrument. But, according to Keith Pogson, managing partner, financial services, Far East Asia, Ernst & Young, when that financial instrument is marked to market, an organisation's own credit cost, which is often subject to short-term perceptions that may affect volatility and liquidity, can become an issue. 'There are situations where applying fair value to liabilities make sense - short-term trading positions in a company's own debt or real matching of assets and liabilities when the best way of reflecting the business performance is by marking to market on both sides. But with long-term hold to maturity assets, mark to market including credit spreads seems to be less appropriate because it's unlikely that would reflect the real information for shareholders,' he said. A survey by Deloitte China illustrates the point. Last year, despite the impact of the global financial crisis, Hong Kong's top 100 listed companies recorded an increase in turnover of about 17 per cent while net profits fell by almost a quarter and total impairment losses increased by more than 110 per cent. The survey also implied that the companies' use of derivative instruments, likely used to reduce various risks, was one of the culprits for this net profit volatility. William Lim, audit partner, Deloitte China, said: 'It is not easy to draw a meaningful conclusion over the changing trend in the fair value of derivatives because it is highly dependent on the underlying variable of each derivative instrument. 'But, due to the requirement to mark to market, derivatives certainly increase the volatility of reported net profit, especially when the global financial markets are volatile and unstable.' How liabilities are to be measured and when it is appropriate to use fair value are important issues to resolve. If it is agreed that fair value is a basis for measurement of liabilities then the issue is one of presentation and disclosure, where users of financial statements understand the basis for the gain that comes from the deterioration of own credit risk and the loss that comes from the improvement of that risk. But if credit risk changes are to be excluded from fair value measurement, the result will not be consistent with the concept of fair value. So, identifying the liability item as being measured at fair value will not be accurate and it will compromise its usefulness in resulting decision-making. Jack Chow, an audit partner with KPMG, said: 'For routine liabilities we should go back to basics and use the cash flow model. With respect to financial instruments, such as convertible bonds or preference shares, if a market exists then we should allow companies to book these liabilities at fair value. 'The present accounting model is built on fair value. If we throw it away, what would be the future measurement basis for accounting?'