Mark-to-market accounting
Mark-to-market or fair value accounting is accounting for the "fair value" of an asset or liability based on the current market price, 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 in the United States since the early 1990s. 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 and the eventual bankruptcy of the company, as well as the closure of the accounting firm Arthur Andersen.
Mark-to-market accounting can change values on the balance sheet 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 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 and for the collapse of banks. The Securities and Exchange Commission told President Franklin Roosevelt 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, deposits money, termed a "margin", 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.
Over-the-counter 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. 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 became more used by 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 determined objectively, 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 manner to achieve spurious valuations. The most infamous use of mark-to-market in this way was the Enron scandal.
After the Enron scandal, changes were made to the mark-to-market method by the Sarbanes–Oxley Act 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 was created by the Securities and Exchange Commission 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 which is actively traded.
FAS 115
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, which became effective for entities with fiscal years beginning after December 15, 1993.FAS 115 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.
- 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.
FAS 124
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 / ASC 820
Statement of Financial Accounting Standards No. 157, Fair Value Measurements, commonly known as "FAS 157", was an accounting standard issued during September 2006 by FASB, which became effective for entities with fiscal years beginning after November 15, 2007. Under Accounting Standards Codification, FASB's fair value accounting guidance has been recodified as ASC Topic 820.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 ;
- 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 must be included in the valuation.
"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 rather than an entry 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 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 2008 financial crisis, 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 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 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. 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. 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.
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".
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.
In response to the rapid developments of the 2008 financial crisis, 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.