Mark-to-market (MTM or M2M) or fair value accounting is accounting for the "
fair value
In accounting and in most schools of economic thought, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. The derivation takes into account such objective factors as the costs associated wi ...
" of an asset or liability based on the current
market price
A price is the (usually not negative) quantity of payment or Financial compensation, compensation given by one Party (law), party to another in return for Good (economics), goods or Service (economics), services. In some situations, the pr ...
, or the price for similar assets and liabilities, or based on another objectively assessed "fair" value. Fair value accounting has been a part of
Generally Accepted Accounting Principles
Publicly traded companies typically are subject to rigorous standards. Small and midsized businesses often follow more simplified standards, plus any specific disclosures required by their specific lenders and shareholders. Some firms operate on th ...
(GAAP) in the United States since the early 1990s, and is now regarded as the "gold standard" in some circles. Failure to use it is viewed as the cause of the
Orange County Bankruptcy, even though its use is considered to be one of the reasons for the
Enron scandal
The Enron scandal was an accounting scandal involving Enron Corporation, an American energy company based in Houston, Texas. Upon being publicized in October 2001, the company declared bankruptcy and its accounting firm, Arthur Andersen then on ...
and the eventual bankruptcy of the company, as well as the closure of the accounting firm
Arthur Andersen
Arthur Andersen was an American accounting firm based in Chicago that provided auditing, tax advising, consulting and other professional services to large corporations. By 2001, it had become one of the world's largest multinational corporat ...
.
Mark-to-market accounting can change values on the balance sheet as market conditions change. In contrast,
historical cost
In accounting, an economic item's historical cost is the original nominal monetary value of that item. Historical cost accounting involves reporting assets and liabilities at their historical costs, which are not updated for changes in the items' v ...
accounting, based on the past transactions, is simpler, more stable, and easier to perform, but does not represent current market value. It summarizes past transactions instead. Mark-to-market accounting can become volatile if market prices fluctuate greatly or change unpredictably. Buyers and sellers may claim a number of specific instances when this is the case, including inability to value the future income and expenses both accurately and collectively, often due to unreliable information, or over-optimistic or over-pessimistic expectations of cash flow and earnings.
History and development
In the 1800s in the U.S., marking to market was the usual practice of
bookkeepers. This has been blamed for contributing to the frequent recessions up to the
Great Depression
The Great Depression (19291939) was an economic shock that impacted most countries across the world. It was a period of economic depression that became evident after a major fall in stock prices in the United States. The economic contagio ...
and for the collapse of banks. The
Securities and Exchange Commission
The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street Crash of 1929. The primary purpose of the SEC is to enforce the law against market ...
told President
Franklin Roosevelt
Franklin Delano Roosevelt (; ; January 30, 1882April 12, 1945), often referred to by his initials FDR, was an American politician and attorney who served as the 32nd president of the United States from 1933 until his death in 1945. As the ...
that he should get rid of it, which he did in 1938. But in the 1980s the practice spread to major banks and corporations, and beginning in the 1990s mark-to-market accounting began to result in scandals.
To understand the original practice, consider that a futures trader, when beginning an account (or "position"), deposits money, termed a "
margin
Margin may refer to:
Physical or graphical edges
*Margin (typography), the white space that surrounds the content of a page
*Continental margin, the zone of the ocean floor that separates the thin oceanic crust from thick continental crust
*Leaf ...
", with the exchange. This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. In contrast, if the market price of his contract has decreased, the exchange charges his account that holds the deposited margin. If the balance of this account becomes less than the deposit required to maintain the account, the trader must immediately pay additional margin into the account in order to maintain the account (a "
margin call
''Margin Call'' is a 2011 American drama film written and directed by J. C. Chandor in his feature directorial debut. The principal story takes place over a 24-hour period at a large Wall Street investment bank during the initial stages of the ...
"). (The
Chicago Mercantile Exchange
The Chicago Mercantile Exchange (CME) (often called "the Chicago Merc", or "the Merc") is a global derivatives marketplace based in Chicago and located at 20 S. Wacker Drive. The CME was founded in 1898 as the Chicago Butter and Egg Board, an a ...
, doing even more, marks positions to market ''twice'' a day, at 10:00 am and 2:00 pm.)
Over-the-counter (OTC) derivatives, in contrast, are formula-based financial contracts between buyers and sellers, and are not traded on exchanges, so their market prices are not established by any active, regulated market trading. Market values are, therefore, not objectively determined or available readily (purchasers of derivative contracts are typically furnished with computer programs which compute market values based upon data input from the active markets and the provided formulas). During their early development, OTC derivatives such as
interest rate swap
In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations wit ...
s were not marked to market frequently. Deals were monitored on a quarterly or annual basis, when gains or losses would be acknowledged or payments exchanged.
As the practice of marking to market became more used by corporations and banks, some of them seem to have discovered that this was a tempting way to commit
accounting fraud
Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "language ...
, especially when the market price could not be determined objectively (because there was no real day-to-day market available or the asset value was derived from other traded commodities, such as crude oil futures), so assets were being "
marked to model" in a hypothetical or synthetic manner using estimated valuations derived from
financial modeling
Financial modeling is the task of building an abstract representation (a model) of a real world financial situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio o ...
, and sometimes marked in a manipulative manner to achieve spurious valuations. The most infamous use of mark-to-market in this way was the
Enron scandal
The Enron scandal was an accounting scandal involving Enron Corporation, an American energy company based in Houston, Texas. Upon being publicized in October 2001, the company declared bankruptcy and its accounting firm, Arthur Andersen then on ...
.
After the Enron scandal, changes were made to the mark to market method by the
Sarbanes–Oxley Act
The Sarbanes–Oxley Act of 2002 is a United States federal law that mandates certain practices in financial record keeping and reporting for corporations.
The act, (), also known as the "Public Company Accounting Reform and Investor Protecti ...
in the US during 2002. The Act affected mark to market by forcing companies to implement stricter accounting standards. The stricter standards included more explicit financial reporting, stronger internal controls to prevent and identify fraud, and auditor independence. In addition, the
Public Company Accounting Oversight Board
The Public Company Accounting Oversight Board (PCAOB) is a nonprofit corporation created by the Sarbanes–Oxley Act of 2002 to oversee the audits of public companies and other issuers in order to protect the interests of investors and further t ...
(PCAOB) was created by the
Securities and Exchange Commission
The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street Crash of 1929. The primary purpose of the SEC is to enforce the law against market ...
(SEC) for the purpose of overseeing audits. The Sarbanes-Oxley Act also implemented harsher penalties for fraud, such as enhanced prison sentences and fines for committing fraud. Although the law was created to restore investor confidence, the cost of implementing the regulations caused many companies to avoid registering on stock exchanges in the United States.
Internal Revenue Code Section 475 contains the mark to market accounting method rule for taxation. Section 475 provides that qualified securities dealers who elect mark to market treatment shall recognize gain or loss as if the property were sold for its fair market value on the last business day of the year, and any gain or loss shall be taken into account for that year. The section also provides that dealers in commodities can elect mark to market treatment for any commodity (or their derivatives) which is actively traded (i.e., for which there is an established financial market that provides a reasonable basis to determine fair market value by disseminating price quotes from broker/dealers or actual prices from recent transactions).
FAS 115
Statement of Financial Accounting Standards No. 115, ''Accounting for Certain Investments in Debt and Equity Securities'', commonly known as "FAS 115", is an accounting standard issued during May 1993 by the
Financial Accounting Standards Board
The Financial Accounting Standards Board (FASB) is a private standard-setting body whose primary purpose is to establish and improve Generally Accepted Accounting Principles (GAAP) within the United States in the public's interest. The Securi ...
(FASB), which became effective for entities with fiscal years beginning after December 15, 1993.
FAS 115 addresses the accounting and reporting for
investment
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing i ...
s in
equity securities
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
that have readily determinable
fair value
In accounting and in most schools of economic thought, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. The derivation takes into account such objective factors as the costs associated wi ...
s and for all investments in
debt securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any fo ...
. Those investments are to be classified in three categories and accounted for as follows:
*Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as "
held-to-maturity" securities and reported at amortized cost less impairment. (
Amortization
Amortization or amortisation may refer to:
* The process by which loan principal decreases over the life of an amortizing loan
* Amortization (accounting), the expensing of acquisition cost minus the residual value of intangible assets in a system ...
refers to spreading payments over multiple periods.)
*Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as "
trading
Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market.
An early form of trade, barter, saw the direct exchan ...
" securities and reported at fair value, with
unrealized gains and losses included in
earnings Earnings are the net benefits of a corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT (earnings before interes ...
.
*Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as "
available-for-sale" securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity (
Other Comprehensive Income
Note: Reference cited below, FAS130, remains the most current accounting literature in the United States on this topic.
In 1997 the United States Financial Accounting Standards Board issued Statement on Financial Accounting Standards No. 130 en ...
).
FAS 124
Statement of Financial Accounting Standards No. 124, ''Accounting for Certain Investments Held by Not-for-Profit Organizations'', commonly known as "FAS 124", is an accounting standard issued during November 1995 by FASB, which became effective for entities with fiscal years beginning after December 15, 1995.
FAS 124 requires that, for investments in equity securities with readily determinable fair values and for all investments in debt securities, a not-for-profit organization must report them at fair value, with gains and losses included in a Statement of Activities. A narrow exception is made to allow limited held-to-maturity accounting for a not-for-profit organization if comparable business entities are engaged in the same industry.
FAS 157 / Accounting Standards Codification Topic 820
Statement of Financial Accounting Standards No. 157, ''Fair Value Measurements'', commonly known as "FAS 157", is an accounting standard issued during September 2006 by FASB, which became effective for entities with fiscal years beginning after November 15, 2007.
FAS Statement 157 includes the following:
*Clarity of the definition of fair value;
*A fair value hierarchy used to classify the source of information used in fair value measurements (i.e., market-based or non-market based);
*Expanded disclosure requirements for assets and liabilities measured at fair value; and
*A modification of the long-standing accounting presumption that a measurement-date-specific ''transaction price'' of an asset or liability equals its same measurement-date-specific ''fair value''.
*Clarification that changes in
credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
(both that of the counterparty and the company's own credit rating) must be included in the valuation.
FAS 157 defines "fair value" as:
"The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date".
FAS 157 only applies when another accounting rule requires or permits a fair value measure for that item. While FAS 157 does not introduce any new requirements mandating the use of fair value, the definition as outlined does introduce certain important differences.
First, it is based on the exit price (for an asset, the price at which it would be sold (bid price)) rather than an entry price (for an asset, the price at which it would be bought (ask price)), regardless of whether the entity plans to hold the asset for investment or resell it later.
Second, FAS 157 emphasizes that fair value is market-based rather than entity-specific. Thus, the optimism that often characterizes an asset acquirer must be replaced with the skepticism that typically characterizes a dispassionate, risk-averse buyer.
FAS 157's fair value hierarchy underpins the concepts of the standard. The hierarchy ranks the quality and reliability of information used to determine fair values, with level 1 inputs being the most reliable and level 3 inputs being the least reliable. Information based on direct observations of transactions (e.g., quoted prices) involving the same assets and liabilities, not assumptions, offers superior reliability; whereas, inputs based on unobservable data or a reporting entity's own assumptions about the assumptions market participants would use are the least reliable. A typical example of the latter is shares of a privately owned company the value of which is based on projected cash flows.
Problems can occur when the market-based measurement does not accurately represent the underlying asset's true value. This can occur when a company is forced to calculate the selling price of these assets or liabilities during unfavorable or volatile times, such as a financial crisis. For example, if the liquidity is low or investors are fearful, the current selling price of a bank's assets could be much less than the value under normal liquidity conditions. The result would be a lowered shareholders' equity. This case occurred during the financial crisis of 2008/09 where many securities held on banks' balance sheets could not be valued efficiently as the markets had disappeared from them. During April 2009, however, the Financial Accounting Standards Board (FASB) voted on and approved new guidelines that would allow for the valuation to be based on a price that would be received in an orderly market rather than a forced liquidation, starting during the first quarter of 2009.
Although FAS 157 does not require fair value to be used on any new classes of assets, it does apply to assets and liabilities that are recorded at fair value in accordance with other applicable rules. The accounting rules for which assets and liabilities are held at fair value are complex. Mutual funds and securities companies have recorded assets and some liabilities at fair value for decades in accordance with securities regulations and other accounting guidance. For commercial banks and other types of financial services companies, some asset classes are required to be recorded at fair value, such as derivatives and marketable equity securities. For other types of assets, such as loan receivables and debt securities, it depends on whether the assets are held for trading (active buying and selling) or for investment. All trading assets are recorded at fair value. Loans and debt securities that are held for investment or to maturity are recorded at amortized cost, unless they are deemed to be impaired (in which case, a loss is recognized). However, if they are available for sale or held for sale, they are required to be recorded at fair value or the lower of cost or fair value, respectively. (FAS 65 and FAS 114 cover the accounting for loans, and FAS 115 covers the accounting for securities.) Notwithstanding the above, companies are permitted to account for almost any financial instrument at fair value, which they might elect to do in lieu of historical cost accounting (see FAS 159, "The Fair Value Option").
Thus, FAS 157 applies in the cases above where a company is required or elects to record an asset or liability at fair value.
The rule requires a mark to "market", rather than to some theoretical price calculated by a computer — a system often criticized as "mark to make-believe". (Occasionally, for certain types of assets, the rule allows for using a model.)
Sometimes, there is a weak market for assets which trade relatively infrequently - often during an economic crisis. During these periods, there are few, if any buyers for such products. This complicates the marking process. In the absence of market information, an entity is allowed to use its own assumptions, but the objective is still the same: what would be the current value of a sale to a willing buyer. In developing its own assumptions, the entity can not ignore any available market data, such as interest rates, default rates, prepayment speeds, etc.
FAS 157 does not distinguish between non cash-generating assets, i.e., broken equipment, which can theoretically have zero value if nobody will buy them in the market – and cash-generating assets, like securities, which are still worth something for as long as they earn some income from their underlying assets. The latter cannot be marked down indefinitely, or at some point, can create incentives for company insiders to buy them from the company at the under-valued prices. Insiders are in the best position to determine the creditworthiness of such securities going forward. In theory, this price pressure should balance market prices to accurately represent the "fair value" of a particular asset. Purchasers of distressed assets should buy undervalued securities, thus increasing prices, allowing other Companies to consequently mark up their similar holdings.
Also new in FAS 157 is the idea of nonperformance risk. FAS 157 requires that in valuing a liability, an entity should consider the nonperformance risk. If FAS 157 simply required that fair value be recorded as an exit price, then nonperformance risk would be extinguished upon exit. However, FAS 157 defines fair value as the price at which you would transfer a liability. In other words, the nonperformance that must be valued should incorporate the correct discount rate for an ongoing contract. An example would be to apply higher discount rate to the future cash flows to account for the credit risk above the stated interest rate. The Basis for Conclusions section has an extensive explanation of what was intended by the original statement with regards to nonperformance risk (paragraphs C40-C49).
In response to the rapid developments of the
financial crisis of 2007–2008
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fi ...
, the FASB is fast-tracking the issuance of the proposed FAS 157-d, Determining the Fair Value of a Financial Asset in a Market That Is Not Active.
Under
Accounting Standards Codification In US accounting practices, the Accounting Standards Codification is the current single source of United States Generally Accepted Accounting Principles (GAAP). It is maintained by the Financial Accounting Standards Board
The Financial Accou ...
, FASB's fair value accounting guidance has been codified as Topic 820.
IFRS 13
IFRS 13
In accounting and in most schools of economic thought, fair value is a rational and unbiased Prediction, estimate of the potential market price of a good, service, or asset. The derivation takes into account such objective factors as the costs a ...
, ''Fair Value Measurement'', was adopted by the
International Accounting Standards Board
The International Accounting Standards Board (IASB) is the independent accounting standard-setting body of the IFRS Foundation.
The IASB was founded on April 1, 2001, as the successor to the International Accounting Standards Committee (IASC). ...
on May 12, 2011.
IFRS 13 provides guidance for how to perform fair value measurement under
International Financial Reporting Standards
International Financial Reporting Standards, commonly called IFRS, are accounting standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB). They constitute a standardised way of describing the company's f ...
and took effect on January 1, 2013.
[ It does not provide guidance as to when fair value should be used.] The guidance is similar to the US GAAP guidance.[
]
Marking-to-market a derivatives position
In marking-to-market a derivatives account, at pre-determined periodic intervals, each counterparty exchanges the change in the market value of their account in cash. For Over-The-Counter (OTC) derivatives, when one counterparty defaults, the sequence of events that follows is governed by an ISDA contract. When using models to compute the ongoing exposure, FAS 157 requires that the entity consider the default risk ("nonperformance risk") of the counterparty and make a necessary adjustment to its computations.
For exchange traded derivatives, if one of the counterparties defaults in this periodic exchange, that counterparty's account is immediately closed by the exchange and the clearing house
Clearing house or Clearinghouse may refer to:
Banking and finance
* Clearing house (finance)
* Automated clearing house
* ACH Network, an electronic network for financial transactions in the U.S.
* Bankers' clearing house
* Cheque clearing
* Cl ...
is substituted for that counterparty's account.
Marking-to-market virtually eliminates credit risk, but it requires the use of monitoring systems that usually only large institutions can afford.
Use by brokers
Stock brokers allow their clients to access credit via margin
Margin may refer to:
Physical or graphical edges
*Margin (typography), the white space that surrounds the content of a page
*Continental margin, the zone of the ocean floor that separates the thin oceanic crust from thick continental crust
*Leaf ...
accounts. These accounts allow clients to borrow funds to buy securities. Therefore, the amount of funds available is more than the value of cash (or equivalents). The credit is provided by charging a rate of interest and requiring a certain amount of collateral, in a similar way that banks provide loans. Even though the value of securities (stocks or other financial instruments such as options) fluctuates in the market, the value of accounts is not computed in real time. Marking-to-market is performed typically at the end of the trading day, and if the account value decreases below a given threshold (typically a ratio predefined by the broker), the broker issues a margin call that requires the client to deposit more funds or liquidate the account.
Mark-to-market accounting use by Enron
In Enron's natural gas business, the accounting had been fairly straightforward: in each time period
The categorisation of the past into discrete, quantified named blocks of time is called periodization.Adam Rabinowitz. And kingIt’s about time: historical periodization and Linked Ancient World Data'. Study of the Ancient universe Papers, 2014 ...
, the company listed actual costs of supplying the gas and actual revenues received from selling it. However, when Skilling joined the company, he demanded that the trading business adopt mark-to-market accounting, claiming that it would represent "true economic value". Enron became the first nonfinancial company to use the method to account for its complex long-term contracts. Mark-to-market accounting requires that once a long-term contract has been signed, income is estimated as the present value
In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has inte ...
of net future cash flow. Often, the viability of these contracts and their related costs were difficult to estimate. Owing to the large discrepancies between reported profits and cash, investors were typically given false or misleading reports. Under this method, income from projects could be recorded, although the firm might never have received the money, with this income increasing financial earnings on the books. However, because in future years the profits could not be included, new and additional income had to be included from more projects to develop additional growth to appease investors. As one Enron competitor stated, "If you accelerate your income, then you have to keep doing more and more deals to show the same or rising income." Despite potential pitfalls, the U.S. Securities and Exchange Commission
The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street Crash of 1929. The primary purpose of the SEC is to enforce the law against market ...
(SEC) approved the accounting method for Enron in its trading of natural gas futures contracts on January 30, 1992. However, Enron later expanded its use to other areas in the company to help it meet Wall Street projections.
For one contract, in July 2000, Enron and Blockbuster Video
Blockbuster or Block Buster may refer to:
* Blockbuster (entertainment) a term coined for an extremely successful movie, from which most other uses are derived.
Corporations
* Blockbuster (retailer), a defunct video and game rental chain
** Blo ...
signed a 20-year agreement to introduce on-demand entertainment to various U.S. cities by year's end. After several pilot projects, Enron claimed estimated profits of more than $110 million from the deal, even though analysts questioned the technical viability and market demand of the service. When the network failed to work, Blockbuster withdrew from the contract. Enron continued to claim future profits, even though the deal resulted in a loss.
Effect on subprime crisis and Emergency Economic Stabilization Act of 2008
Former Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation (FDIC) is one of two agencies that supply deposit insurance to depositors in American depository institutions, the other being the National Credit Union Administration, which regulates and insures cred ...
Chair William Isaac placed much of the blame for the subprime mortgage crisis
The United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the Financial crisis of 2007–2008, 2007–2008 global financial crisis. It was triggered by a large decline ...
on the Securities and Exchange Commission
The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street Crash of 1929. The primary purpose of the SEC is to enforce the law against market ...
and its fair-value accounting rules, especially the requirement for banks to mark their assets to market, particularly mortgage-backed securities (MBS). A review found little evidence that fair-value accounting had caused or exacerbated the crisis.
The debate occurs because this accounting rule requires companies to adjust the value of marketable securities (such as the MBS) to their market value. The intent of the standard is to help investors understand the value of these assets at a specific time, rather than just their historical purchase price. Because the market for these assets is distressed, it is difficult to sell many MBS at other than prices which may (or may not) be representative of market stresses, which may be less than the value that the mortgage cash flow related to the MBS would merit. As initially interpreted by companies and their auditors, the typically lesser sale value was used as the market value rather than the cash flow value. Many large financial institutions recognized significant losses during 2007 and 2008 as a result of marking-down MBS asset prices to market value.
For some institutions, this also triggered a margin call
''Margin Call'' is a 2011 American drama film written and directed by J. C. Chandor in his feature directorial debut. The principal story takes place over a 24-hour period at a large Wall Street investment bank during the initial stages of the ...
, such that lenders that had provided the funds using the MBS as collateral had contractual rights to get their money back. This resulted in further forced sales of MBS and emergency efforts to obtain cash (liquidity) to pay off the margin call. Markdowns may also reduce the value of bank regulatory capital, requiring additional capital raising and creating uncertainty regarding the health of the bank.
It is the combination of the extensive use of financial leverage
In finance, leverage (or gearing in the United Kingdom and Australia) is any technique involving borrowing funds to buy things, hoping that future profits will be many times more than the cost of borrowing. This technique is named after a lever i ...
(i.e., borrowing to invest, leaving limited funds in the event of recession), margin calls and large reported losses that may have exacerbated the crisis. If cash flow-derived value — which excludes market judgment as to default risk but may also more accurately represent "actual" value if the market is sufficiently distressed — is used (rather than sale value), the size of market-value adjustments required by the accounting standard would be typically reduced.
On September 30, 2008, the SEC and the FASB issued a joint clarification regarding the implementation of fair value accounting in cases where a market is disorderly or inactive. This guidance clarified that forced liquidations are not indicative of fair value, as this is not an "orderly" transaction. Further, it clarifies that estimates of fair value can be made using the expected cash flows from such instruments, provided that the estimates represent adjustments that a willing buyer would make, such as adjustments for default and liquidity risks.
Section 132 of the Emergency Economic Stabilization Act of 2008
The Emergency Economic Stabilization Act of 2008, often called the "bank bailout of 2008", was proposed by Treasury Secretary Henry Paulson, passed by the 110th United States Congress, and signed into law by President George W. Bush. It became ...
, which passed on October 3, 2008, restated the SEC's authority to suspend the application of FAS 157, and Section 133 required a report by the SEC which was delivered December 30, 2008.
On October 10, 2008, the FASB issued further guidance to provide an example of how to estimate fair value in cases where the market for that asset is not active at a reporting date.
On December 30, 2008, the SEC issued its report under Sec. 133 and decided not to suspend mark-to-market accounting.
On March 16, 2009, FASB proposed allowing companies to use more leeway in valuing their assets under "mark-to-market" accounting. On April 2, 2009, after a 15-day public comment period and a contentious testimony before the U.S. House Financial Services subcommittee, FASB eased the mark-to-market rules through the release of three FASB Staff Positions (FSPs). Financial institutions are still required by the rules to mark transactions to market prices but more so in a steady market and less so when the market is inactive. To proponents of the rules, this eliminates the unnecessary "positive feedback
Positive feedback (exacerbating feedback, self-reinforcing feedback) is a process that occurs in a feedback loop which exacerbates the effects of a small disturbance. That is, the effects of a perturbation on a system include an increase in the ...
loop" that can result in a weakened economy.
On April 9, 2009, FASB issued an official update to FAS 157 that eases the mark-to-market rules when the market is unsteady or inactive. Early adopters were allowed to apply the ruling as of March 15, 2009, and the rest as of June 15, 2009.
It was anticipated that these changes could significantly increase banks' statements of earnings and allow them to defer reporting losses. The changes, however, affected accounting standards applicable to a broad range of derivatives
The derivative of a function is the rate of change of the function's output relative to its input value.
Derivative may also refer to:
In mathematics and economics
* Brzozowski derivative in the theory of formal languages
* Formal derivative, an ...
, not just banks holding mortgage-backed securities.
During January 2010, Adair Turner
Jonathan Adair Turner, Baron Turner of Ecchinswell (born 5 October 1955) is a British businessman and academic and was Chairman of the Financial Services Authority until its abolition in March 2013. He is a former Chairman of the Pensions Commiss ...
, Chairman of the UK's Financial Services Authority
The Financial Services Authority (FSA) was a quasi-judicial body accountable for the financial regulation, regulation of the financial services industry in the United Kingdom between 2001 and 2013. It was founded as the Securities and Investmen ...
, said that marking to market had been a cause of exaggerated bankers' bonuses. This is because it produces a self-reinforcing cycle during an increasing market that feeds into banks' profit estimates. Other academics, such as S.P. Kothari
Professor S. P. Kothari is an Indian-American academic and the Gordon Y. Billard Professor of Accounting and Finance at the MIT Sloan School of Management and a Padma Shree awardee. His field of research is strategic and policy issues, securi ...
and Karthik Ramanna
Karthik Ramanna is Professor of Business & Public Policy and Director of the Master of Public Policy Program at the University of Oxford’s Blavatnik School of Government, where he established the leadership curriculum on building trust across ...
, have made similar arguments.[http://cmr.berkeley.edu/search/articleDetail.aspx?article=5779]
See also
* Deprival value Deprival value
is a concept used in accounting theory to determine the appropriate measurement basis for assets. It is an alternative to historical cost and fair value or mark to market accounting. Some writers prefer terms such as 'value to the ...
* Financial asset
A financial asset is a non-physical asset whose value is derived from a contractual claim, such as bank deposits, bonds, and participations in companies' share capital. Financial assets are usually more liquid than other tangible assets, such as ...
* Historical cost accounting
In accounting, an economic item's historical cost is the original nominal monetary value of that item. Historical cost accounting involves reporting assets and liabilities at their historical costs, which are not updated for changes in the items' v ...
* List of accounting topics
This page is an index of accounting topics.
{{AlphanumericTOC,
align=center,
nobreak=,
numbers=,
references=,
externallinks=,
top=}
A
Accounting ethics - Accounting information system - Accounting research - Activity-Based Costing ...
* List of finance topics
The following outline is provided as an overview of and topical guide to finance:
Finance – addresses the ways in which individuals and organizations raise and allocate monetary resources over time, taking into account the risks entailed in ...
* Mark to model Mark-to-Model refers to the practice of pricing a position or portfolio at prices determined by financial models, in contrast to allowing the market to determine the price. Often the use of models is necessary where a market for the financial produ ...
* Revenue recognition
The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which revenues and expenses are recognized. According to the principle, revenues are recog ...
* Fair value accounting and the subprime mortgage crisis
The role of fair value accounting in the subprime mortgage crisis of 2008 is controversial. Fair value accounting was issued as US accounting standard SFAS 157 in 2006 by the privately run Financial Accounting Standards Board (FASB)—delegated ...
* Worldcom
MCI, Inc. (subsequently Worldcom and MCI WorldCom) was a telecommunications company. For a time, it was the second largest long-distance telephone company in the United States, after AT&T. Worldcom grew largely by acquiring other telecommunic ...
*Creative accounting
Creative accounting is a euphemism referring to accounting practices that may follow the letter of the rules of standard accounting practices, but deviate from the spirit of those rules with questionable accounting ethics—specifically distortin ...
References
{{DEFAULTSORT:Mark-To-Market Accounting
Financial markets
United States housing bubble
Valuation (finance)
Accounting terminology