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CONCEPT – MARK TO MARKET VALUATION
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- Fair Value concept : The price that would be received to sell an asset (or paid to transfer a liability) between market participants on the given day. It must be based on the exit price (for an asset, the price at which it would be sold (bid price)) rather than an entry price (for an asset, the price at which it would be bought (ask price)).
- Mark-to-Market : M2M refers to the reasonable value of an account, for the "fair value" of the asset. It can vary over a period depending on assets and liabilities. Mark-to-market provides a realistic estimate of a financial situation. It has been a part of the generally accepted accounting principles in the United States since 1990 and it is regarded as gold standard.
- Can change suddenly : Mark-to-market is a tool that can change the value on either side of a balance sheet, depending on market conditions. Example : shares that one holds in his/her demat account are marked to market every day. At the time of closing of market, the price assigned to each stock is the price that buyers and sellers decide at the end of the day. That can change each day.
- Problems with M2M : While mark-to-market reflects the true value of an asset (based on current market price), it can be problematic if the value of assets vary every second due to changing market conditions and because buyers and sellers keep coming in and going out irregularly. In mark-to-market, problems may occur when market-based measurements do not give the true value of an underlying asset.
- Unfavourable times : Problems arise when the market-based measurement does not accurately reflect the underlying asset's true value. This occurs when a company is forced to calculate the selling price of its assets or liabilities during unfavorable or volatile times, as during a financial crisis. For example, if liquidity is low or investors are fearful, the current selling price of a bank's assets could be much lower than the actual value. The result would be a lower shareholders' equity.
- What is the other option : In contrast, historical cost accounting, based on the past transactions, is simpler, more stable, and easier to perform, but does not represent current market value. It summarizes past transactions instead. M2M can be unstable when we witness an inability to value the future income and expenses both accurately and collectively, often due to unreliable information, etc.
- The US case : In the 1800s, it was the usual practice of bookkeepers. It was blamed for contributing to the frequent recessions up to the Great Depression and for the collapse of banks. The Securities and Exchange Commission (SEC) advised President Franklin Roosevelt that he should get rid of it, which he did in 1938. But in the 1980s the practice spread to major banks and corporations, and beginning in the 1990s mark-to-market accounting began to result in scandals. The biggest of them was the one involving the energy-trader Enron, leading to the eventual bankruptcy of the company and the closure of the accounting firm Arthur Andersen (one of the then Big 5 firms).
- Frauds : As the practice of marking to market became more used, some discovered that this was a way to commit accounting fraud, especially when the market price could not be determined objectively (because there was no real day-to-day market available or the asset value was derived from other traded commodities, such as crude oil futures). So, assets were "marked to model" in a hypothetical or synthetic manner using estimated valuations derived from financial modeling, and sometimes through sheer fraud.
- Post Enron : After the Enron scandal, changes were made to the mark to market method by the Sarbanes–Oxley Act during 2002. It forced companies to implement stricter accounting standards. The stricter standards included more explicit financial reporting, stronger internal controls to prevent and identify fraud, and auditor independence. The Public Company Accounting Oversight Board (PCAOB) was created by the Securities and Exchange Commission (SEC) for overseeing audits. The Sarbanes-Oxley Act also implemented harsher penalties for fraud, such as enhanced prison sentences and fines for committing fraud. Although the law was created to restore investor confidence, the cost of implementing the regulations was too high for many firms.
- GFC 2008 : This issue was seen during the financial crisis of 2008/09 when the mortgage-backed securities (MBS) held as assets on banks' balance sheets could not be valued efficiently as the markets for these securities had collapsed! In April of 2009, however, the Financial Accounting Standards Board (FASB) voted on and approved new guidelines that would allow for the valuation to be based on a price that would be received in an orderly market rather than a forced liquidation, starting in the first quarter of 2009.
- Book Value : An asset's book value is equal to its carrying value on the balance sheet, and companies calculate it netting the asset against its accumulated depreciation. Book value is also the net asset value of a company calculated as total assets minus intangible assets (patents, goodwill) and liabilities. For the initial outlay of an investment, book value may be net or gross of expenses such as trading costs, sales taxes, service charges and so on.
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