Mark-to-Market Accounting: What You Should Knowhttp://www.fool.com/investing/dividends-income/2008/10/02/mark-to-market-accounting-what-you-should-know.aspx Alex Dumortier, CFA
October 2, 2008
You know you're in a financial crisis when a technical accounting rule becomes front-page news. The financial rescue bill the Senate approved yesterday includes a heavy-handed signal to the SEC to consider suspending "mark-to-market" (MTM) accounting.
Applying MTM accounting has forced banks to recognize billions of dollars in losses on mortgage-related securities; critics contend the practice has worsened the credit crisis. Are they right?
What is mark-to-market accounting?
Mark-to-market accounting sets the value of (or "marks") the assets on your balance sheet to reflect their market sale prices. In theory, that all sounds nice and clean. In practice, things get a little messier.
All the way down to Level 3 hell
To address this, there is a hierarchy of assets, with a set of guidelines for each:
As you can imagine, in a market like this one, the resulting value for Level 3 assets may be highly questionable. "Mark-to-imagination" might be a more suitable term in this case.
Does the market always know best?
Even the Financial Accounting Standards Board and the SEC issued a clarification of the accounting rule known as FAS 157 on Tuesday, saying that the price of "disorderly" trades (distressed selling or forced liquidations) isn't "determinative" when measuring fair value. And since it's difficult to imagine a market more disorderly than the one we're in right now, when it comes time to do the books, accountants are basically taking a guess and hoping for the best.
The resulting uncertainty creates a very real problem. The Bank for International Settlements (basically, "the central bankers' central bank") has suggested that applying mark-to-market accounting to triple-A-rated subprime mortgage securities, using the ABX index -- which tracks the current market value of such securities -- as an input, could overstate expected total losses by as much as 60%.
Your credit is no good. Here's your reward!
Here's how it works: The bonds a bank issues are part of its liabilities. When their value decreases, shareholders' equity technically increases. (Remember, shareholders' equity = assets – liabilities.)