31 August 2009
Sir David Tweedie
International Accounting Standards Board
30 Cannon StreetLondon EC4M 6XH
United Kingdom
Dear Sir David:

re: Comments on Discussion Paper“Credit Risk in Liability Measurement”
The Corporate Accounting Committee (CAC) of the Securities Analysts Association ofJapan (SAAJ) is pleased to comment on the discussion paper, “Credit Risk in LiabilityMeasurement”, put out by the International Accounting Standards Board (the Board).
The SAAJ is a not-for-profit organization providing investment education andexamination programs for securities analysts. Its certified members exceed 22,000. The
CAC is a standing committee of the SAAJ composed of 12 members, most of whom areusers including equity and credit analysts, and portfolio managers, while a few others
are academicians and public accountants.

General remarks
In the first place, the CAC is against the mandatory application of fair value valuationof financial liabilities for all corporations. Non-financial companies typically borrowmoney to finance investments in production facilities. Production facilities andassociated intangible assets are not valued at fair value. If financial liabilities werevalued at fair value in these companies, it would lead to a mismatch. Further, in mostcases, these liabilities of non-financial companies are refinanced. Recording changes inthe value of liabilities to be refinanced is not meaningful (a liability’s price changes
between issuance and maturity, offsetting each other).1
However, the CAC thinks the revaluation of liabilities rational for financial companies(entities whose income accrues from intentional mismatching between financial assets
The CAC does not assert that the market value of the liabilities of generalcorporations has no information value. Typical corporate valuation uses discounted
future cash flows assuming companies are going concerns. It is true that we sometimes
estimate liquidation value. In this case, the market value of liabilities is important, but
it is sufficient to show it in the notes. In other words, the market value of liabilities
sometimes offers useful financial information, but it is not appropriate to show such infinancial statements.

11and liabilities). 2 The income of a financial company is generated from one of thefollowing three sources: (i) duration mismatching i.e. borrowing short term and lending
long term (as the yield curve is typically positive [short-term rates < long-term rates],
the mismatch will yield income), (ii) credit risk mismatching i.e. lending to companies
with lower credit, and (iii) which is both (i) and (ii) combined. Investors and analysts are
eager to monitor whether these mismatches are yielding intended results or not. To
achieve this, both assets and liabilities should be remeasured at market.
However, the CAC is opposed to including company specific credit risks in theremeasurement of the financial liabilities because doing so would obscure the purpose ofmonitoring the results of intended mismatches at financial companies. Let’s see someexamples.
Example 1:

Initial position

Entity A’s asset and liability are both fixed rate financial instruments. The asset ismarked to market.
31 December
20X1
Asset

1,000

Liability
Equity, beginning

(900)
(100)

Example 2:

Duration mismatch

Entity A borrows short term and invests long term. One year later, both short- andlong-term rates increase by the same degree (parallel upward shift of the yield curve).
There is no credit risk mismatching between the asset and liability and credit risk
premium does not change over the year.
31 December

31 December

20X1

20X2

Asset

1,000

900

Liability

(900)

(850)

Equity, beginning

(100)

(100)

Loss from remeasuring asset

100

It would be difficult for the IASB to develop standards to be applied only to thefinancial industry because the definition of the industry is different from country tocountry while IFRS are adopted all over the world. The CAC thinks it appropriate to
make the revaluation of financial liabilities optional and strongly encourages use of thisoption for companies whose main income accrues from intentional mismatching
between financial assets and liabilities.

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Gain from remeasuring liability
Equity, ending

(50)
(50)

(100)

Increased rates would reduce the value of both asset and liability. Part of the loss
caused by lower asset value would be offset by the gain in decreased liability value, but
not all the loss would be recouped. This is because the interest sensitivity of long-term
financial instruments is greater than for short-term ones. Therefore, the parallel
upward shift of the yield curve would force a long-term instrument’s price to fall morethan that of a short-term one. If only the asset is remeasured and the liability is kept atcost, then entity A’s equity at year-end 20X2 would be zero. This is too pessimistic aview of A, as credit risk attaching to the asset stands still. The above is a good example
where liability remeasurement would give a better picture of a financial institution.
Example 3:

Credit risk mismatch (credit risk of liability remeasured)

Assume entity A’s credit rating is AA, and it invests in an entity with a lower credit
profile (say rated BBB). One year later, the investee company’s business deteriorates
and its rating is downgraded to BB. There is no duration mismatching with respect toeither asset or liability and interest rates do not change over the year.
31 December

31 December

20X1

20X2

Asset

1,000

900

Liability(900)(810)

Equity, beginning

(100)

(100)

Loss from remeasuring asset100Gain from remeasuring liability(90)

Equity, ending

(100)

(90)

The asset price declines by 10% because of the investee company’s credit downgrading.
Reflecting this, entity A’s credit rating is downgraded to ‘A’. The associated increase in
the refinancing rate lowered A’s liability by 10% in value, bringing about the samevaluation gains. In this case, the equity of A barely changes, and the financial statement
does not help achieve the objective of monitoring the real picture of A. This is a good
example of the paradox found in financial liability remeasurement.
Example 4:

Credit risk mismatch (credit risk of liability NOT remeasured)

The same assumption as for Example 3, but credit risk changes are not used toremeasure the liability.

331 December

31 December

20X1

20X2

Asset

1,000

900

Liability

(900)

(900)

Equity, beginning

(100)

(100)

Loss from remeasuring asset

100

Gain from remeasuring liability(0)Equity, ending

(100)

(0)

In this example, the decline in asset value is directly reflected in equity, and hence thepurpose of monitoring A’s performance has been achieved much more than in Example
3.
Example 5:

Credit risk mismatch (spread changes)

Assume entity A’s credit rating is AA, and it invests in an entity with a lower credit
profile (say rated BBB). There is no duration mismatch. One year later, changes in thefinancial market lift credit spreads pertaining to AA and BBB in parallel. There are norisk-free rate changes over the year or credit risk (ratings) changes in A’s asset andliability either.
31 December

31 December

20X1

20X2

Asset

1,000

900

Liability(900)(810)

Equity, beginning

(100)

(100)

Loss from remeasuring asset

100

Gain from remeasuring liability(90)

Equity, ending

(100)

(90)

In this case, there could be two schools of thoughts. The first is that as general changes
in credit spreads influence all financial institutions, just like changes in interest rates,
such should be reflected in liability remeasurement. The second is that as the spread ispart of the credit risk attaching to financial companies, it should not be reflected inliability remeasurement. The CAC thinks credit risk changes inherent to a particularfinancial company should not be incorporated but general changes in credit spreadshould so as to better monitor performance of a financial company. The above example
incorporates the spread change for liability remeasurement, resulting in only a littlechange in equity. If we did not incorporate the spread change for liability
remeasurement, ending equity would be zero. Again, an overly pessimistic picture of A4

even though the credit standings of its asset and liability do not change at all. Some
may think separately measuring spread changes and credit risk changes would be too
onerous for the preparers. Remember that our proposal is only for financial institutions
whose business is to make the spread a source of income. Of course, we need the market
value of the liabilities of a financial institution, including current credit risk, when we
estimate liquidation value. As discussed in footnote 1, it is sufficient that thisinformation is shown in notes to financial statements.
Following are our answers to some specific questions in the discussion paper.

Question 1: Credit risk at first recognition
When a liability is first recognized, the CAC thinks the inherent credit risk should be“(b) sometimes” incorporated. When an entity assumes a liability with definedtransaction price like a loan or a bond, the transaction price should be the book value.
This means that the liability is measured at the agreed upon interest rate which
incorporates the credit risk of the borrower. As for other liabilities referred to inparagraph 23 of the staff paper, the risk-free rate or rate for highly-rated corporate
bonds should be used for measurement without considering the credit risk of the debtor.
Otherwise, if the credit risk inherent in the debtor is incorporated, there would be aparadox where the higher the credit risk, the lower the present value of the liability. Asa result, both liabilities that incorporate credit risk, and those that do not, coexist,
apparently increasing complexity. This is only a reflection of complex economic reality
and this level of complexity is acceptable.

Question 2: Credit risk after initial recognition
The CAC thinks at current measurements, credit risk should “(c) never” beincorporated. See Examples 3 and 4 for reasons.3

Question 3: Determination of credit risk
Changes in an entity’s own credit risk should be measured by the following formulae:
Rate at issuance of liability = risk-free rate at issuance + credit risk (initial spread)
Rate at remeasurement = risk-free rate at remeasurement + general change in spread +change in credit risk inherent to the issuer
On very rare occasions, for example when it is certain that an entity will buy back its
debt from the market and the amount and/or profit or loss is significant, then thebuyback price which incorporates credit risk can be shown on the balance sheet as anexception.

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General change in spread is measured separately as, unlike credit risk inherent to anissuer, it should be incorporated in the remeasurement of a liability. See Example 5above.

Question 4: Three liability measurement categories
Of the three categories proposed, the CAC supports category (c) as it best suits thepurpose of monitoring the performance of intentional asset/liability mismatching at
financial institutions. However, we oppose that part of category (c) where credit risk
spread is fixed at the initial level. As we showed in the formulae to answer Question 3,initial credit risk premium at issuance of a financial liability is equal to “issuance rateminus risk-free rate”. This premium is exactly the same as the spread associated withthe credit ranking the entity has (say AA)4. Subsequent changes in credit risk premium
can be divided into (i) change in credit profile inherent to the entity (say from AA to AAAor A), and (ii) general change in spread for the initial credit rating (AA in this example).
As we showed in Example 5, general changes in credit spreads that are not associatedwith company specific credit changes should be incorporated in remeasurements alongwith risk-free rate changes.
If you have any questions or need further elaboration, please do not hesitate tocontact Sei-Ichi Kaneko, Executive Vice President, SAAJ (s-kaneko@saa.or.jp).
Sincerely yours,

Keiko Kitamura
Chair
Corporate Accounting CommitteeThis, of course, is a simplified argument as AA bond spreads fall in a range. However,a bond issuer can easily identify spread on issue date by obtaining the risk-free rate forthe same maturity. The same holds true for a loan taker.

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