Accounting for Liabilities at Fair Value : The Advantage of Relational Versus Informational Disclosures in Interpreting Credit Risk Changes

One objection to fair value accounting for liabilities is that changes in a company’s credit risk are recognized as gains or losses in a manner that is counterintuitive to the way gains and losses are typically interpreted (Lipe 2002). Specifically, when a company’s credit risk increases (decreases), the company reports a gain (loss). To address constituents’ concerns about the potential for misinterpretation arising from this accounting (FASB 2006), the FASB mandated informational disclosures for changes in a company’s own credit risk. Using CPAs as participants, we experimentally find (1) over 70 percent of participants fail to properly assess a company’s credit risk from recognized fair value gains or losses even when provided with informational disclosures, (2) participants’ assessments of risk significantly improve when relational disclosures (i.e., disclosures explicating the association between credit risk changes and income statement effects) are presented, and (3) relational disclosures are more beneficial when fair value gains versus losses are recognized, but additional disclosures do not eliminate misinterpretations