Mark to Market Accounting

Mark to market (MTM) accounting has recently received a lot of attention. Current global financial crisis has put this set of technical accounting rule into the spotlight. Some argue that mark to market accounting rule has put banks and financial institutions on their feet and should be suspended immediately. Are their arguments valid?

Mark to Market accounting (MTM) or fair value accounting means that companies must value their assets on their balance sheets based on the latest market price.

MTM is great for financial institutions when markets are booming, but when the economy is in the midst of a severe downturn, the use of MTM will reinforce the downward cycle. It adds momentum to a destructive downside.

Banks and other financial institutions argued that MTM rules have contributed to current financial problems because they are required to value distressed assets at fire-sale prices. Current credit crisis left Banks and other financial institution loaded up with bad debt and mortgage related security that was valued to next to nothing in the market. As the assets value plummeted, trouble and bankruptcy arises. As a result, banks and financial institutions demanded a suspension of the MTM.

On the newer development of this issue, Accounting bodies in the US and Europe are changing a few MTM rules.

The International Accounting Standards Board (IASB) has confirmed a change to its rules allowing some assets to be reclassified and avoid be subject to a fair value calculation.

The changes allow some assets to be moved from 'held for sale' or trade, which means using a fair value calculation, to 'held for investment' which does not. Last year, Deutsche Bank took advantage of new accounting rules, and shifted the income statement into a profit instead of a loss.

In the US, after so much discussion and deliberation, recent report from the SEC suggested that mark to market has its merits in determining assets and said it was not to blame for the financial troubles or credit crunch that has hit banks and lenders.

Is MTM to blame for the credit crisis?

Among the supporters of MTM are accountants and investors. They firmly believe that the crisis is not happening because of the accounting issues.

Furthermore, they argue that MTM ensures a decent amount of transparency for investors, and it requires a close look at the risks in order to assess value. If institutions were accurately marking the books, they would have seen the problems they were experiencing months in advance and could have made the necessary adjustments. All MTM does is require companies to reveal more information about the reliability of their reported fair value.

Companies have been practicing MTM for decades, and nobody complained when banks and others were recording large profit. The difference under SFAS 157 is that public can see the extent to which the fair-value results of a company are based on estimates.

It is an irony that many of the companies that complained about the MTM have only adopted MTM recently, partly because of a provision that let them count the decline of their publicly traded debt as ‘profit’.

MTM is not perfect, of course. There is a flaw on the assumption that securities could always be sold and converted to cash, and the claim that the market value is arbitrary.

Despite the flaws, however, in my opinion, MTM is not to blame for the credit crisis. The flaws were exaggerated.

MTM is not the problem, it is the banks that made poor decision and lost credibility with investor. It is easier to blame accounting rule for the problems than to admit the mistakes that the banks made. Suspending the MTM and move back to the historical cost accounting would not solve the crisis.  If we are using historical cost accounting today, there are still few assets that aren’t marked to market such as goodwill and inventory (lower of cost or market method). All the housing, mortgage and mortgage related assets would also have to be written down accordingly, as the value has been plummeted too much. Not to mention the goodwill that has been tarnished.

As an investor myself, I believe that most investors are smart enough to understand that values do change overtime.  To be kept in the dark with the company’s financial condition, it’s a big no.