Mark-to-market accounting

Mark-to-market accounting
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Mark-to-market or fair value accounting refers to accounting for the fair value of an asset or liability based on the current market price of the asset or liability, or 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 (GAAP) in the United States since the early 1990s, and has been used increasingly since then.

Mark-to-market accounting can change values on the balance sheet frequently, as market conditions change. In contrast, historical cost accounting, based on the past transactions, is simpler, more stable, and easier to perform, but does not reflect current fair value at all. It summarizes past transactions instead. Mark-to-market accounting can become inaccurate if market prices change unpredictably. Buyers and sellers may claim a number of specific instances when this is the case, including inability to both accurately and collectively value the future income and expenses, often due to unreliable information, over-optimistic, and over-pessimistic expectations.


History and development

The practice of mark to market as an accounting device first developed among traders on futures exchanges in the 20th century. It was not until the 1980s that the practice spread to big banks and corporations far from the traditional exchange trading pits, and beginning in the 1990s, mark-to-market accounting began to give rise to scandals.

To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". 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. On the other hand, if the market price of his contract has declined, the exchange charges his account that holds the deposited margin. If the balance of this accounts falls below the deposit required to maintain the position, the trader must immediately pay additional margin into the account to maintain his position (a "margin call"). As an example, the Chicago Mercantile Exchange, taking the process one step further, marks positions to market twice a day, at 10:00 am and 2:00 pm.[1]

Over-the-counter (OTC) derivatives on the other hand 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 readily available (purchasers of derivative contracts are customarily furnished by 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 swaps 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 caught on in corporations and banks, some of them seem to have discovered that this was a tempting way to commit accounting fraud, especially when the market price could not be objectively determined (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, and sometimes marked in a manipulative way to achieve spurious valuations. See Enron and the Enron scandal.

Internal Revenue Code Section 475 contains the mark to market accounting method rule for taxation. Section 475 provides that qualified securities dealers that 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 in 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

Accounting for Certain Investments in Debt and Equity Securities (Issued May 1993)

This statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. 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 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" securities and reported at fair value, with unrealized gains and losses included in earnings.
  • 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).

FAS 157

Statements of Financial Accounting Standards No. 157, Fair Value Measurements, commonly known as "FAS 157", is an accounting standard issued in September 2006 by the Financial Accounting Standards Board (FASB) which became effective for entities with fiscal years beginning after November 15, 2007.[2][3]

FAS Statement 157 includes the following:

  • Clarity on 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 (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 key 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 held company whose value is based on projected cash flows.

Problems can arise when the market-based measurement does not accurately reflect 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 lower than the value under normal liquidity conditions. The result would be a lowered shareholders' equity. This issue was seen 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. In 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 in 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 carried 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 firms have carried their 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 firms, some asset classes are required to be carried 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 carried at fair value. Loans and debt securities that are held for investment or to maturity are carried 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 carried 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 carry 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 thin market for assets, which trade relatively infrequently - often during an economic crisis. In 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 in 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 makes no distinction 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 out 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 reflect the "fair value" of a particular asset. Purchasers of distressed assets should step in to buy undervalued securities, thus moving prices higher, 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, 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.[4]

Simple example

Example: If an investor owns 10 shares of a stock purchased for $4 per share, and that stock now trades at $6, the "mark-to-market" value of the shares is equal to (10 shares * $6), or $60, whereas the book value might (depending on the accounting principles used) only equal $40.

Similarly, if the stock falls to $3, the mark-to-market value is $30 and the investor has lost $10 of the original investment. If the stock was purchased on margin, this might trigger a margin call and the investor would have to come up with an amount sufficient to meet the margin requirements for his account.

Marking-to-market a derivatives position

In marking-to-market a derivatives position, at pre-determined periodic intervals, each counterparty exchanges the change in the market value of their position in cash. For OTC derivatives, when one counterparty defaults, the sequence of events that follows is governed by an ISDA contract. When using models to calculate 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 calculations.

For exchange traded derivatives, if one of the counterparties defaults in this periodic exchange, that counterparty's position is immediately closed by the exchange and the clearing house is substituted for that counterparty's position. Marking-to-market virtually eliminates credit risk, but it requires the use of monitoring systems that usually only large institutions can afford.[5]

Use by brokers

Stock brokers allow their clients to access credit via margin 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, in a similar way as 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 calculated in real time. Marking-to-market is performed typically at the end of the trading day, and if the account value falls below a given threshold, (typically a predefined ratio by the broker), the broker issues a margin call that requires the client to deposit more funds or liquidate his account.

Effect on subprime crisis and Emergency Economic Stabilization Act of 2008

Former Federal Deposit Insurance Corporation Chair William Isaac placed much of the blame for the subprime mortgage crisis on the Securities and Exchange Commission and its fair-value accounting rules, especially the requirement for banks to mark their assets to market, particularly mortgage-backed securities.[6] Whether or not this is true has been the subject of ongoing debate.[7][8]

The debate arises because this accounting rule requires companies to adjust the value of marketable securities (such as the mortgage-backed securities (MBS) at the center of the crisis) to their market value. The intent of the standard is to help investors understand the value of these assets at a point in 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 reflective of market stresses, which may be below the value that the mortgage cash flow related to the MBS would merit. As initially interpreted by companies and their auditors, the typically lower 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, where lenders that had provided the funds using the MBS as collateral had contractual rights to get their money back.[9] 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.[10]

It is the combination of the extensive use of financial leverage (i.e., borrowing to invest, leaving limited room in the event of a downturn), margin calls and large reported losses that may have exacerbated the crisis.[11] If cash flow-derived value — which excludes market judgment as to default risk but may also more accurately reflect 'actual' value if the market is sufficiently distressed — is used (rather than sale value), the size of market-value adjustments under the accounting standard would typically be reduced. One might question why banks or government-sponsored enterprises (Fannie Mae and Freddie Mac) are allowed to use high-risk, difficult-to-value assets like MBS or deferred tax assets as part of their regulatory capital base. Whether a margin call is involved is not part of the accounting standard itself; it is part of the contracts negotiated between lender and borrower.

Critics charge that claims that this had happened are akin to claiming "the problem, in short, is not that the banks acted irresponsibly in creating financial instruments that blew up, or in making loans that could never be repaid. It is that someone is forcing them to fess up. If only the banks could pretend the assets were valuable, then the system would be safe."[12]

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 clarifies 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 reflect adjustments that a willing buyer would make, such as adjustments for default and liquidity risks.[13]

Section 132 of the Emergency Economic Stabilization Act of 2008, titled "Authority to Suspend Mark-to-Market Accounting" restates the Securities and Exchange Commission’s authority to suspend the application of FAS 157 if the SEC determines that it is in the public interest and protects investors.

Section 133 of the Act, titled "Study on Mark-to-Market Accounting," requires the SEC, in consultation with the Federal Reserve Board and the Department of the Treasury, to conduct a study on mark-to-market accounting standards as provided in FAS 157, including its effects on balance sheets, impact on the quality of financial information, and other matters, and to report to Congress within 90 days on its findings.[14]

The Emergency Economic Stabilization Act of 2008 was passed and signed into law on October 3, 2008. On October 7, 2008, the SEC began to conduct a study on "mark-to-market" accounting, as authorized by Sec. 133 of the Emergency Economic Stabilization Act of 2008.[15]

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.[16]

On December 30, 2008, the SEC issued its report under Sec. 133 and decided not to suspend mark-to-market accounting.[17]

On March 9, 2009, In remarks made in the Council on Foreign Relations in Washington, Federal Reserve Chairman Ben Bernanke said, "We should review regulatory policies and accounting rules to ensure that they do not induce excessive (swings in the financial system and economy)". Although he doesn't support the full suspension of basic proposition of Mark to Market principles, he is open to improving it and provide "guidance" on reasonable ways to value assets to reduce their pro- cyclical effects.[18]

On March 16, 2009, FASB proposed allowing companies to use more leeway in valuing their assets under "mark-to-market" accounting, a move that could ease balance-sheet pressures many companies say they are feeling during the economic crisis. On April 2, 2009, after a 15-day public comment period, FASB eased the mark-to-market rules. 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 removes the unnecessary "positive feedback loop" that can result in a deeply weakened economy.[19]

On April 9, 2009, FASB issued the official update to FAS 157[20] 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 boost banks' statements of earnings and allow them to defer reporting losses.[21] The changes, however, affected accounting standards applicable to a broad range of derivatives, not just banks holding mortgage-backed securities.

Opponents argue that the implications for investors are that the valuation of assets underlying such securities will be increasingly difficult to analyze, not less so. An example would be determining a company's actual assets, equity and earnings, which will be overstated if the assets are not allowed to be marked down appropriately.[citation needed][22][23]

In January 2010, Adair Turner, Chairman of the UK's Financial Services Authority, said that marking to market had been a cause of inflated bankers' bonuses. This is because it produces a self-reinforcing cycle during a rising market that feeds into banks' profit estimates.[24]

See also


  1. ^ SEC Info - Chicago Mercantile Exchange Inc - S-4/A - On 3/10/00
  2. ^ Financial Accounting Standards Board "Summary of Statement No. 157" Retrieved on June 13, 2009.
  3. ^ Taub S. (2007). FAS 157 Could Cause Huge Write-offs.
  4. ^ FASB News Center
  5. ^ *Crouhy, Michel; D. Galai, and R. Mark (2001). Risk Management. McGraw-Hill. pp. 752 pages. ISBN 0-07-135731-9.  Page 445.
  6. ^ "Former FDIC Chair Blames SEC for Credit Crunch", CNBC, October 9, 2008. Retrieved Jan 25, 2010
  7. ^ Fair value: the pragmatic solution, Fortune, November 21, 2008. Retrieved Jan 25, 2010
  8. ^ Forbes, Steve. "Obama Repeats Bush's Worst Market Mistakes" The Wall Street Journal. March 6, 2009. Retrieved June 13, 2009
  9. ^ Example of a margin call
  10. ^ Katz, Ian. "Behind Schwarzman Spat With Wasserstein Lies Rule 115" Bloomberg News. December 8, 2008. Retrieved June 13, 2009
  11. ^ Westbrook, Jesse."SEC, FASB Resist Calls to Suspend Fair-Value Rules" Bloomberg News. September 30, 2008. Retrieved June 13, 2009.
  12. ^ Bankers Say Rules Are the Problem, New York Times, March 12, 2009. Retrieved Jan 25, 2010
  13. ^ Clarifications on Fair Value Accounting, SEC, Sept. 30, 2008. Retrieved Jan 25, 2010
  14. ^ "Emergency Economic Stabilization Act of 2008"
  15. ^ SEC Commences Work on Congressionally Mandated Study on Accounting Standards, SEC, Oct. 7, 2008. Retrieved Jan 25, 2010
  16. ^ FASB Clarifications
  17. ^ Congressionally-Mandated Study Says Improve, Do Not Suspend, Fair Value Accounting Standards, SEC, Dec. 30, 2008. Retrieved Jan 25, 2010
  18. ^ Bernanke Urges Rules Overhaul to Stem Risk Build-Ups, Bloomberg, March 10, 2009. Retrieved Jan 25, 2010
  19. ^ FASB Eases Mark-to-Market Rules, WSJ, April 3, 2009. Retrieved Jan 25, 2010
  20. ^ FAS 157-4 Status
  21. ^ Mark-to-Market Lobby Buoys Bank Profits 20% as FASB May Say Yes, Bloomberg, March 29, 2009. Retrieved Jan 25, 2010
  22. ^ How $1 Trillion Time Bomb Posts a Phony Profit: Jonathan Weil, Bloomberg, 7 Apr 2010
  23. ^ Suing Wall Street Banks Never Looked So Shady: Jonathan Weil, Bloomberg, 24 Feb 2010
  24. ^ Fair value fattened bankers' bonuses: Lord Turner, Accountancy Age, 21 Jan 2010. Retrieved Jan 25, 2010

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