How This Form of Accounting Created the Financial Crisis
Former FDIC Chair William Isaac placed the blame of the sub-prime crisis, and the subsequent financial meltdown around the world squarely on mark-to-market accounting. This form of accounting, which has been used in the past by none other than Enron, has increased heavily over the past 10 years. Now the question must be asked, should mark-to-market accounting be removed and banned, and why didn’t we learn from Enron?
What is it?
Mark-to-market value, sometimes called fair value accounting, is a form of accounting where the standards of assigning a value to a position is based on the current fair market price of the financial instrument. In existence since the early 1990s when it became part of the Generally Accepted Accounting Principles guidelines, the use of this form of accounting has increased greatly since the beginning of the 21st century. This has been due to investor demand for timely financial statements that help them make more informed decisions. The IRS Code Section 475 contains the mark-to-market accounting method for taxation.
How does it Work?
If an investor has 100 shares of a stock that they bought for five dollars each, costing them $500, and the stock is now worth seven dollars, then the mark-to-market value is equal to the shares multiplied by the current market value. So, the mark-to-market value is 100 x 7 = $700. This differs from book value because the book value is only worth $500, the original payment price for the stock shares.
If the stock falls to three dollars, then the mark-to-market value is now $300, which means that the investor has lost $200 off of the original investment.
Prevalence of Fraud
The use of mark-to-market accounting caused many companies and banks to find ways to use the accounting method to commit fraud. This was primarily done when the market price could not be determined objectively. This was usually when there was no day-to-day market, or no asset value.
In this situation, assets were marked-to-model, which used estimated valuations from financial modeling and this meant that sometimes the modeling was changed to show better values. Enron did this extensively, causing the eventual bankruptcy of the company, once valued in the billions.
Mark-to-Market and the Sub-Prime Crisis
In 2008, the mark-to-market method of accounting suffered another black eye when the sub-prime mortgage industry imploded, taking the credit market and much of the world’s financial markets with it. Former FDIC Chair William Isaac even placed blame on mark-to-market modeling for the sub-prime crisis. He said that the requirement of banks to mark-to-market their assets was the primary cause for the meltdown. The reason for this is that mark-to-market accounting requires companies to adjust the value of their securities, such as mortgage-backed securities, to their market value. Doing this allows investors to understand the value of their assets at a certain point, rather than looking only at the pervious purchase price. However, the market for assets like mortgage-backed securities is distressed, and that makes them difficult to sell at any price that does not reflect market stresses, which could actually be below the value of the mortgage-cash flow. Companies would then use the lower sale value as the market value, rather than use the cash flow value.
What is being done?
Now that mark-to-market accounting is being criticized for helping to cause one of the biggest market meltdowns since the Great Depression, the U.S. government is looking at ways to fix this form of accounting. Here is a brief history of the government’s response to mark-to-market accounting.
The Emergency Economic Stabilization Act of 2008 was signed into law on Oct. 3, 2008, allowing the SEC to conduct a study of the accounting technique.
On Dec. 30, 2008, the SEC issued its report and chose not to suspend mark-to-marketing accounting.
On March 10, 2009, Federal Reserve Chairman Ben Bernanke states that the mark-to-marketing accounting method should be improved on to allow for a more reasonable way to value assets.
On April 2, 2009, the FASB eases the mark-to-market rules to help companies with their balance-sheet pressures, giving them more breathing room during the economic recession.
While it appears that mark-to-market accounting has some holes in it, which have allowed companies like Enron to exploit for their own, and allowed banks and companies to bend the rules leading to the economic meltdown, it seems that the accounting practice is here to stay. With markets now rebounding, the government is not expected to scrutinize mark-to-market accounting, instead allowing for some improvements made to the accounting method. Has the government learned from Enron? No, they have not. Will mark-to-market accounting lead to problems in the future for taxpayers and companies? Yes, it most certainly will.
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