The Market to Market Accounting - Example

MARKET TO MARKET ACCOUNTING Student name: Institution: Date: The concept of mark- to -market accounting involves the act of overhauling the worth or value of an asset or a liability to represent its market value rather than the original value of the asset or liability. For business enterprises, the mark- to –market value is characterised through establishment of the prices of financial instruments as they trade through public exchanges rather than relying on the book value. This practise enables organisations to improve their financial capabilities by precisely accounting for the daily changes in the prices of assets and liabilities (Abel, 2008, p. 340). Mark -to-market theory was used in transactions through future exchanges in during most part of the 20th century. The application of the same in banks and other corporate institutions began in the late 1980s. However, the official recognition of the use of this method took place in April 2009, by the Financial Accounting Standards Board (FASB). The main aim was the prevention of inaccurate value measurement, a usual happening of the 2008-2009 recession period. The use of mark-to-market theory is currently integrated with the futures accounts with the aim of effectively meeting the margin requirements (Greenberg et al., 2013, p. 51).Careful margin accounts monitoring ensures that they do not drop below the optimum levels. The mark-to-market accounting provides that the assets on any enterprise’s balance sheet should be valued at the current market prices. As a result, there is the establishment of the true value of an asset or a liability and a business institution can, therefore, determine its financial capacity. However, there are problems that can surface, especially when the market value does not reflect the true value of an asset. Forcing companies for instance, to calculate the prices of assets and liabilities at crucial times such as financial crisis, may instil fear in the investors and reduce the shareholders’ equity. The result is the ultimate failure of the organization. A common example of this is the financial crisis of 2008-2009, in which banks had the securities held on their balance sheets unable to match with the market values. The failure of the banks was attributed to increased credit losses, concerns about the quality of assets as well as the decreased lender and investor confidence (Beatty et al., 1996, p. 77). The concept of mark-to-market theory has however raised a lot of debate following the 2008-2009 recession. In an attempt to better understand the concept, a hearing was held before the subcommittee on capital markets, insurance and government-sponsored enterprises of the committee in March, 2009. The hearing sparked a lot of debate on whether the mark-to-market theory should be embraced or thrown out. Among the main speakers were the Financial Accounting Standards Board chairman and standard setter, Mr. Robert .H. Hertz, Thomas Bailey, the president and CEO of Brentwood Bank and the congressman, Paul Kanjorski. Thomas Bailey’s views According to Thomas Bailey, the president and CEO of Brentwood bank, the accounting rules affected the day –to-day activities of banks and had profound effect in increasing the financial crisis of 2008-2009. The banker lamented that the bank had used two million dollars in other than temporary impairment charges (OTTI) which represented lost opportunity cost to finance and a further $ 20 million in loans. This amount was equal to 30% of the loans the bank had made in the last nine months, making the bank very conservative in lending. Citing the economic crises that faced the country during that period, the banker argued that the application of the application of the unbending accounting rules would even worsen the situation. He therefore, called on the subjection of the members of the Financial Accounting Standards Board and the Securities and Exchanges Commission (SEC) to account. Bailey identified the application of mark-to-market in frozen markets as the core of the problem. The development of the accounting rules did not take into consideration the unknown effects it would have on the economy, and if action was not taken immediately, the situation was likely to worsen. Bailey also noted that the current accounting rules do not support transparency as purported by the Pennsylvania Association of Community Bankers (PACB) thus distorting the true financial capabilities of institutions holding mortgage backed, asset backed and other securities. He further argued that the rules hinder market revival as well as establishment of market oriented pricing. There is also the reduced willingness of financial institutions to purchase assets that may depreciate in future should credit losses be encountered. Another disadvantage of the mark-to-market theory according to Bailey is the reluctance of the banks to sell their assets even at the low prices which reflect economic losses in the securities. The unwillingness of several investors to sell assets in markets that lack liquidity causes them huge losses, making them to lose hope in the fact that the market prices will change in future. The result is further freezing of the market. One of the main investments for community banks across the country is the FHL Bank stock. Unfortunately, according to Bailey, the OTTI accounting rules have caused a reduction or in other cases suspension of the dividends offered by the stock to its member banks. The accounting rule also causes banks to spend a lot of money in replacing the capital lost. Robert Hertz’s Testimony Another important testimony during the hearing before the subcommittee on accounting was given by Robert Hertz, the chairman of the Financial Accounting Standards Board (FASB). In his testimony, Hertz discussed the roles of account setters, the concept of fair value accounting and also provided a review on the calls for suspension of the mark-to market accounting. The standard setter maintained that FASB is a sovereign body with the mandate of developing and upholding standards of financial accounting and making them available to both private and public companies. The standards cannot be separated from the normal functioning of the economy since they are used by the creditors and investors in decision making about resource allocation. Publicly, FASB works under the Securities and Exchanges Committee (SEC) and, therefore, has the mandate to develop accounting standards and reporting for publicly held companies. The decision making process of the board is obliged to be fair since its activities has a lot of implications on several enterprises. The development of the accounting standards by FASB is done through careful consideration of the opinions of the stakeholders including the users, auditors as well as those who prepare financial information. This is achieved through public meetings, field visits and roundtables to collect the views of interested parties and increase understanding of the concept in place. The final decision is made by the board after careful scrutiny of the different views. According to Hertz, the key role of standard setters is the establishment of standards which increase transparency in financial institutions, with the ultimate aim of improving ability of investors and creditors to make sound decisions on the allocation of resources. The standard setters work with both national and international financial institution regulators in improving the reporting requirements for the decision makers. Hertz argued that the concept of fair value accounting has been in place for decades, and its requirement depends on the financial asset that is subject to accounting. The application of the fair value is not also always on a continuing basis. The deterioration in the value of financial assets is recognised by the use of fair value. However, investment loans are not usually based on the fair value. On the call for suspension of the mark-to-market accounting, the standard setter argued that the failure of a financial enterprise can be as a result of sale of stock by the investors, recognition of imminent failure by the capital market as well as the reluctance of the lenders to lend. Paul E. Kanjorski’s remarks The other important views that could not be ignored were the political opinions represented by the congressman, Paul Kanjorski. The politician initially bought the idea that the congress should not be engaged in establishment of the accounting rules. He originally argued that the standard setters, financial experts and regulators be left to carry out the work. As the chairman of the subcommittee, he argued that the procyclical nature of the mark-to-market accounting increased the 2008-2009 economic crisis, and failure to act by the regulators and standard setters would cause the congress to act, which would mean out rightly facing out the accounting method. He argued that the rules do not provide transparency to the investors and application in crisis situations causes distortion rather than clarification. He found the rules absurd and suggested changing of the rules to reflect economic reality. He further argued that the uniqueness of an industry’s problems may require unique accounting procedures which may not be applicable to other industries. The pursuit of improvements should, therefore, recognise the technicality and complexity of such matters. He attributed the failure of many industries to the mark-to- market accounting and suggested that the complexities that arise should be dealt with accordingly. Pro-cyclicality of fair value accounting According to Schmitt (2014), the application of the fair value accounting leads to overstatement of values in good economic times and understatement in bad times. Neither are the interests of the stakeholders nor the incentives of the investors taken care of in such accounting practise. However, procyclical or not, the fair value accounting was not likely to have caused the global economic crisis. The problems encountered by the financial institutions during the credit crunch resulted from increased monetary expansion by the central banks and their inappropriate accounting practises during the times of expansion. In such instances, should there be a different accounting method, would have not prevented the occurrence of the economic crisis. In this regard, there is no accounting method that cannot be affected by the deterioration in market prices. Adhering to the Basel Convention requirements also does not require only the sale of assets. Raising of new share capital can be an alternative. It is also not clear if the sales made by the banks during that period were forced or done on a voluntary basis (Escaffre et al.,2008, p.25). The carrying out of short sales by the banks while foreseeing future failures caused an increased supply, way above the demand, further worsening the situation. A decrease in the market prices is a norm in business, and no accounting method is immune to it. The traditional accounting method requires that the assets and revenues are not overstated and the liabilities not understated. Abandoning the fair value measurement means returning to the historical methods in which the financial institutions may be required to sell assets to meet the capital demand to the historical method. Implications of rule changes Following the pressure from the financial institutions and the lawmakers, the Financial Accounting Standards Board (FASB) relaxed the accounting rules pertaining to fair value. These changes allow the companies to use particular judgements in establishing the value of certain investments in their books. The main aim of these changes was to reduce losses incurred and increase the net income. This decision by the FASB was considered a desirable move especially at a time when the market for mortgages and other assets was static. The move was accompanied by a rise in shares in most of the institutions. The board also increased the availability of information for decision making by the investors, through provision of more accurate estimates for asset values. Fair value has also helped in providing transparency essential in restoring public confidence. From the above discussion, the role played by the fair value accounting in the economy of any given country is essential and cannot be underrated. With the relaxation of the accounting rules considered to be absurd by the bankers and politicians at large, it is expected that the accounting method will increase the net income of the financial institutions while reducing chances of economic crunches such as in 2008-2009. Refrence list Abdel-Khalik, R. A. (2008), “The Case against Fair Value Accounting.” University of Illinois. Online Source: www.aislab.aueb.gr/accfi/DownLoads/seminars/ATT00007.pdf. American Bankers Association (2008), Letter to SEC on Fair Value and Other Accounting Standards. Washington: September 23, 2008. Barley, B., Haddad, J. R. (2003), “Fair Value Accounting and the Management of the Firm.” Critical Perspectives on Accounting. Beatty, A., Chamberlain, S., Magliolo, J. (2006), “An Empirical Analysis of the Economic Implications of Fair Value Accounting for Investment Securities.” Journal of Accounting and Economics, Vol. 22, No. 1. Chambers, R. J. (2006), Accounting, Evaluation and Economic Behaviour. Houston: Scholars Book, ISBN 0-914348-15-9. Escaffre, L., Foulquier, P., Touron, P. (2008), The Fair Value Controversy: Ignoring the RealIssue. Lille – Nice, November 25, 2008, [on-line], http://www.edhec-risk.com/features/RISKArticle.200811.25.0644/attachments/EDHEC%20Position%20Paper%20Fair%20Value.pdf. Greenberg, M. D., Helland, E., Clancy, N., Dertouzos, J. N., & RAND Centre for Corporate Ethics and Governance. (2013). Fair value accounting, systemic risk and historical cost accounting: Policy issues and options for strengthening valuation and reducing risk. Schmidt, A. (2014). Fair Value Accounting and the Financial Market Crisis: To What Extent is Fair Valuation Responsible for the Financial Crisis? Berlin: republic GmbH. Koyuncugil, A. S., & Ozgulbas, N. (2013). Technology and financial crisis: Economical and analytical views. Hershey, PA: Business Science Reference. Laux, C., Leuz, C. (2009), The Crisis of Fair Value Accounting: Making Sense of the Recent Debate. University of Chicago: Initiative on Global Markets, Working Paper No. 33, On-line source: http://ssrn.com/abstract=1392645. Read More