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A couple of months ago, Congress passed a bill temporarily suspending mark-to-market accounting rules for many banks and financial institutions. The impact of the suspension was immediately seen in last quarter's earnings. Wells Fargo (NYSE: WFC  ) indicated that the change added $4.4 billion worth of capital to its balance sheet, and the then-fledgling Citigroup (NYSE: C  ) attributed $413 million in quarterly earnings to the new policy.

The power of the pen
For those who haven't brushed up on their accounting lingo lately, marking-to-market is simply the process of marking the value of an asset on a company's balance sheet to the current market price. It has been an accounting standard in one form or another for decades, and banks had no problem marking the value of their assets up as they rose in value. An increased asset base allows banks to lend out more money, which brings in more profits, or so was the thinking before the recent housing meltdown. The problem is that mark-to-market is a double-edged sword, and just as it gives during times of plenty, so does it take away during lean times.

Banks' balance sheets have been stuffed full of asset-backed securities comprised of home, auto, credit card, and a wide variety of other loans that have been securitized. The events over the last two years have dried up the demand for these securities and subsequently driven the price down. Under mark-to-market accounting, banks have been forced to write down these assets to market value, which in turn hurts their credit as their debt-to-asset ratio increases.

With significant lobbying from bank coalitions in an effort to stop the bleeding, Congress decided the best recourse was to reduce accounting transparency and allow banks to mark their assets to fair value when markets were deemed "dysfunctional."

What does this all mean for me?
Significant deviations between an investment's true value and its market price are not new concepts for many investors. The dysfunctional market is not what concerns me so much as the apparent disregard for accounting transparency. As stakeholders in a company's business, investors should be screaming for more transparency in accounting rather than less. Suspending mark-to-market may have temporarily stopped the bleeding, but at what cost? Can anyone listen to an earnings release from Bank of America (NYSE: BAC  ) or JPMorgan Chase (NYSE: JPM  ) without questioning the validity of said earnings?

The bottom line is this -- shareholder governance should not be taken lightly and should weigh into every investor's decision when it comes to purchasing a stock. It will be interesting to see the impact this change has on second-quarter earnings for many financial firms as well as any potential downstream effects on investor confidence. Stay tuned.   

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Fool contributor Elliott Orsillo loves inefficient markets and a good rally cry. He does not own shares in any of the companies in this story. The Fool has a disclosure policy. 

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 16, 2009, at 9:38 AM, bookie21 wrote:

    While I generally enjoy the commentary as a whole on the Fool and have never actually commented before this, I feel compelled to comment on this article, primarily for it's misleading information. A few counterpoints to the article:

    1) While congress did pass a bill re-emphasizing the SEC's power to suspend or change accounting rules put out by the FASB, this power was always one that the SEC had and they did not act on the power, so nothing has been changed by the passage of the bill.

    2) The FASB did subsequently put out an Staff Position that "clarified" the fair value rules of 157 (FSP FAS 157-4), but again did not change the premise that for any asset that is carried at fair value that fair value should be representative of an exit price, which is defined as the price that you would recieve in the market place as a willing seller from a willing buyer. If the only current sales in the market place are indicative of fire sales, (bankruptcy, to bolster liquidity to avoid bankruptcy, to meet a debt covenant etc), the company can use its internal models to value the asset. This was always the case with FAS 157, so again it just clarified the existing guidance and nothing really changed other than the auditors bias towards the last sale price, regardless of why that sale occurred.

    3) These internal models must still include factors that a market participant would include in a valuation as a willing buyer, which include liquidity premiums, profit margins, etc.

    4) These values are still audited by the accounting firms as an added control.

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