Introduction
Mark to market, also called fair value accounting, has been one of the most controversial accounting methodologies in financial reporting. Mark to market refers to an accounting process in which the reporting entities report the value of assets and liabilities as per the current market value as opposed to the book price thus making the methodology highly subjective (Association of American Bankers, 2016: Serakibi, n.d.). Therefore, since the reported value is pegged on the prevailing market value, it follows that the value of the financial statement would change as the market changes. In most cases, the change in value will be ignoring the underlying economic. Although the method has its advantages, the method has critical criticism from both academics and practitioners and has had a large impact in the financial world.
The Origin
The fair market value concept emerged in the 20th century among future exchange traders. However, the method was only limited to the futures exchange (Evrensel, n.d.). In the 1980s, major corporation and banks started adopting the method in reporting their values. However, it would not take long for the method to be the genesis of numerous corporate scandals where some of the scandals led to the collapse of giant corporations such as Enron from the 1990s. Also, the method has been accused playing a key part in aggravating the financial crises.
Pro and Cons of Mark to Market
One of the key advantages of the method is that it gives the financial statement a realistic appeal. In this case, mark to market is based on the performance of the market thus dictating the values of the assets and liabilities. Therefore, the value reported reflects the expected market price. Since the purpose of having a financial statement is to enable the firm to reports its financial position, the financial statement that applies this methods facilitates the company to capture the true and fair value based on the financial market prices as opposed to using historical costs thus making these report more relevant to the current times (Zack, 2009). Secondly, the market price captures the risks that are involved in the market. As such, the values that are obtained from the market have integrated the risks and the participants’ expectation that would influence the cash flows. Therefore, the values that are presented present a realistic display of the market feeling (Zack, 2009). Finally, the fair value market promotes comparability based on market values as opposed to comparability that is influenced by internal policies of respective firms.
On the other hand, the approach has received heavy criticism in term of the definition of value. According to critics, there is no definite way value that fosters uniform valuation of assets and liabilities among all firms thus creating room for manipulation due to the subjective nature of the valuation process (Zack, 2009). Also, mark to market enabled firms to create a vicious circle in which the financial institutions reported exaggerated losses due to the rapid decline in the value of financial instruments held which in turn led to lowering of creditworthiness thus limiting the firm ability to borrow. Consequently, this will lead firm being insolvent yet the firm did not record declines in actual cash flows thus misinforming the users of financial statement (Zack, 2009).
Government Regulation
The government, through various regulatory agencies, has the responsibility for ensuring that the applicable standards are regulated. As such, under the U.S. GAAP, the concept of mark to market is regulated by the SFAS No. 157. According to this standard, the fair value of an item is defined as the price that would be received when an asset is sold in an orderly transaction between market participants at a given date. SFAS No. 157 has seven underpinning principles that must be followed in developing the fair value of the asset or liability. First, the fair value must be based on the exchange price specifically the exit price in a hypothetical market. Second, the price must be in an orderly transaction that will allow due diligence to be allowed. As such, any price from a forced sale or distressed sale is not acceptable. Third, the standard provides that the price must be derived assuming a sale in the primary market or the most advantageous market if the primary market is not available. Fourth, the market value must consider all assumptions that would be used in pricing an asset even if the assumptions are difficult to determine. Fifth, the market value must consider company-specific information in determining the fair value. Sixth, the standard provides a hierarchy of inputs that must be followed in determining the value. Finally, for a company that determines the fair value of its own liability, the firm must consider the effect that the credit risk will have on the value of the liabilities (Office of the Chief Accountant Division of Corporation Finance, 2008).
SFAS 157 further provides relevant disclosures that the firm must disclose in relation to the valuation of its assets and liabilities. Notable disclosures include a discussion of the process that the firm has used to validate the technique used in valuation, a discussion on the effect that fair value sensitivity will have on material assets and liabilities, a general description of the valuation process and a description of unobservable input used in the valuation process (Office of the Chief Accountant Division of Corporation Finance, 2008).
Mark to Market and Financial Crises
There are two camps that emerge when the issue of the role of mark to market in the financial crises is examined. The first camp refers to the people that believed that the mark to market accounting was the principle contributor to the financial crises. According to this camp, since the mark to market is pegged on the market values, the accounting method drove the assets that the firms were holding to unprecedented low thus instantly lowering the creditworthiness of these institutions when the market experienced a sudden ditch in 2008 (Pozen, 2009: Newman, 2008). The people in this camp believe that the use of mark-to-market accounting drove the value of the assets downwards to a point lower than their true value. As a result, the accounting method pushed the financial institution towards insolvency which led these institutions to offload the asset at fire sale prices thus making the crises even worse (Pozen, 2009).
The second camp consists of the proponent of fair value accounting. According to this camp, fair accounting method only captured the reality in the market. As such, it was only a message of the true state of the market such as the bad decision that involved granting the subprime loans and writing credit default swaps (Cohn, 2014: Pozen, 2009). The alternative would have been keeping the bad loan on the books of accounts of the financial institution which will amount to negating from the true state of the market. The necessity of fair value has been stressed by Financial Accounting Standards Board (FASB) which has emphasized on the criticality of availing fair value information to capital providers and other users of financial statements especially during a period of turmoil in the market (Pozen, 2009). The statement by FASB appreciates that in the event that such information is not available, this will increase uncertainty among the capital providers leading to reluctance to recapitalize the institution in financial distress (Pozen, 2009). The consequent event will be having a high number of insolvent firms which will then worsen to bankruptcy state which would not have been the case if the accurate market information would have been availed to the capital providers who would recapitalize these firms thus limiting the effect of the crises.
In reality, it would be prudent to have a system that captures the changes in the market as soon as possible. Therefore, this alleviates the blame that the fair value accounting led to the crises. On the other hand, although urgency is required, the urgency should not be damaging in that it aggravates a small situation into a mega-situation as the fair market value is accused of doing during the financial crises (Pozen, 2009: Laux & Leuz, 2009). It, therefore, means that fair value only contributed to the extent to of financial crises but never caused it.
Fair value accounting and Enron Scandal
Fair value, as guided by the SFAS 157 standard, is highly based on critical judgment (Deringer, 2009). Since critical judgement is highly subjective, this creates the necessary loopholes for the reporting entities to engage in bookkeeping since there is no standard way of exercising judgement. Furthermore, SFAS 157 provides a guide, not a definite action (Deringer, 2009). The guidelines are subject to manipulation thus creating the necessary ground to engage in accounting books manipulation. The manipulation was evident in the Enron case thus highlighting the major loopholes in using this system (The real scandal, 2002). First, Enron used the fair value accounting system to facilitate its decision to discount future earnings in the year a long term deal was made. Therefore, since in the consequent years revenues on the same deal could not be recognized, it follows that the firm had to accelerate the number of deals it made to appease investors with consistent growth in profits. The action led to Enron having large profit and cash discrepancy which led to accounting manipulation to cover up the discrepancy thus producing misleading reports (Shibboleth Authentication Request, n.d.). Second, the firm used the fair value accounting to conceal losses since the CEO had ensured wide adoption of the approach in the firm. Andrew Fastow, the CFO, concealed the losses by using the fair value accounting to transfer losses from key business units by recording these losses as gains in key business lines and recording the losses in less crucial areas of Enron business through the use of Special Purpose Entities (SPE) thus showing Enron was still financially sound (Shibboleth Authentication Request, n.d.). The transfer shielded the public from noticing the challenges in Enron since SPE do not appear in Enron’s financial accounts.
Conclusion and Recommendation
One thing that is clear is that the world cannot do away with mark to market. Considering the Japanese case after 1990, the lack of an accounting method that captures the market values has led to the country experiencing a sluggish recovery from a recession due to inaccurate reporting thus creating a misinformed picture about the status of the banking and investment in Japan (Dealbook, 2008). As such, America cannot afford to have such a situation. Nonetheless, the mark to market approach needs reforms. One of the reforms that will help is the adoption of IFRS fair value concept which will do away with the exit price as the fair value and adopt the price determined by a willing buyer and willing seller at an arm’s length transaction. Second, the American standards need to adopt the "other than temporary impairment" (OTTI) model advanced by the IFRS since it an improved version in that it provides that the trigger for OTTI is the probable loss as opposed to market value loss. Finally, the American standard should disintegrate SFAS 157 since it provides a general guide to all financial instruments and redevelops the standard to focus on specific financial instruments (Association of American Bankers, 2016).
References
Association of American Bankers. (2016). Fair Value and Mark to Market Accounting. Retrieved May 01, 2016, from http://www.aba.com/Issues/Index/Pages/Issues_FairValue.aspx
Cohn, M. (2014, June 30). Fair Value Accounting’s Role in Financial Crisis Scrutinized. Retrieved May 01, 2016, from http://www.accountingtoday.com/news/accounting_news/fair-value-accountings-role-in-financial-crisis-scrutinized-71129-1.html
Dealbook. (2008, October 29). Debating the Merits of Mark-to-Market. Retrieved May 01, 2016, from http://dealbook.nytimes.com//2008/10/29/debating-the-merits-of-mark-to-market/
Deringer, F. (2009). Recent changes to fair-value accounting under US GAAP and IFRS | Lexology. Retrieved May 01, 2016, from http://www.lexology.com/library/detail.aspx?g=0bb6e45a-3ef8-435a-a856-16b150c7169e
Evrensel, A. (n.d.). Foreign Exchange Futures: Marking to Market. Retrieved 2016, from http://www.dummies.com/how-to/content/foreign-exchange-futures-marking-tomarket.html
Laux, C., & Leuz, C. (2009). Did Fair-Value Accounting Contribute to the Financial Crisis? Journal of Economic Perspectives. doi:10.3386/w15515
Newman, J. (2008, August 18). In Defense Of Mark-To-Market. Retrieved May 01, 2016, from http://www.forbes.com/2009/08/18/mark-to-market-banks-economy-opinions-contributors-accounting.html
Office of the Chief Accountant Division of Corporation Finance. (2008). Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting. Retrieved 2016, from https://www.sec.gov/news/studies/2008/marktomarket123008.pdf
Pozen, R. P. (2009, August 01). Is It Fair to Blame Fair Value Accounting for the Financial Crisis? Retrieved May 01, 2016, from https://hbr.org/2009/11/is-it-fair-to-blame-fair-value-accounting-for-the-financial-crisis
Serakibi, O. (n.d.). Historical Cost vs Fair (Market) Value. Retrieved May 01, 2016, from http://www.academia.edu/3805195/Historical_Cost_vs_Fair_Market_Value
Shibboleth Authentication Request. (n.d.). Retrieved May 04, 2016, from https://distance-ed.fullerton.edu/bbpresentations/Finance_370/Enron/player.htm
The real scandal. (2002). Retrieved May 01, 2016, from http://www.economist.com/node/940091
Zack, G. M. (2009). Fair value accounting fraud: New global risks and detection techniques. Hoboken, NJ: John Wiley & Sons.
