The Economic Minute: Mark-to-market accounting

The Financial Accounting Standards Board (FASB) recently came out with new rules governing "mark-to-market accounting." Entities employing mark-to-market adjust the value of financial assets up or down, according to fair market value. The practice has been the subject of controversy during the current financial crisis. In this edition of The Economic Minute, John Sizer, a partner at Deloitte & Touche, tells Economic Club of Phoenix members that mark-to-market is not the problem. "It is my personal opinion that the new FASB positions are helpful, that accounting standards are not the underlying cause of the write-down of financial assets but rather reflect the underlying problem with those assets," Sizer said. "Mark-to-market is not perfect, it requires significant professional judgment, but I believe it is the most accurate and reasonable portrayal of a company's financial condition."

The Financial Accounting Standards Board (FASB) recently came out with new rules governing "mark-to-market accounting." Entities employing mark-to-market adjust the value of financial assets up or down, according to fair market value. The practice has been the subject of controversy during the current financial crisis. In this edition of The Economic Minute, John Sizer, a partner at Deloitte & Touche, tells Economic Club of Phoenix members that mark-to-market is not the problem.

"It is my personal opinion that the new FASB positions are helpful, that accounting standards are not the underlying cause of the write-down of financial assets but rather reflect the underlying problem with those assets," Sizer said. "Mark-to-market is not perfect, it requires significant professional judgment, but I believe it is the most accurate and reasonable portrayal of a company's financial condition."

Transcript:

John Sizer: The dean asked me to talk about mark-to-market accounting just because it has been getting a lot of press and it is very current. The SEC came out with a couple of new rules last week. The use of mark-to-market accounting is not new. In fact, it has been in place for many decades. What mark-to-market accounting means is just adjusting the carrying value of financial assets up or down to fair value and you do that every accounting period.

Last year FASB came out with a new pronouncement; it is FASB 157, which didn't change what assets or liabilities get mark-to-market. All it really did was require that the financial statements include a lot more disclosures about fair value and how fair value is derived. So the adoption of that FASB 157 last year, as well as the deepening and broadening financial crisis, brought considerable more focus to mark-to-market accounting, particularly over the last couple of months.

Entities applying mark-to-market accounting and recording the value of their assets at current market prices took a series of large write-downs as prices fell and active markets for certain types of securities, such as mortgage-asset-backed securities and auction-right securities, those markets disappeared. So those opposed to mark-to-market accounting proposed that there should not be a requirement to write down assets, particularly if they had the ability and the intent to hold those assets until the value recovered.

The opponents argued that requiring companies to recognize these unrealized losses in their financial statements affected liquidity and the ability of banks to make loans because of regulatory capital requirements. Then they argued that that led to the stock market decline and ultimately to the failure of some banks. So as the stock market declined and banks failed, opposition against mark-to-market accounting grew, particularly over the last few months.

And I think it is important to note a few things that not everyone necessarily has followed. The first is that mark-to-market accounting is not required for all financial assets. Whether and when mark-to-market accounting is required depends on the type of the financial asset, and to varying degrees the reporting entity's intent with respect to that asset.

And another important point some have missed is that the majority of write-downs taken by banks were attributable to loan loss allowances and not to mark-to-market accounting losses. Loans held for investment by banks are not accounted for using mark-to-market accounting. They are accounted for at cost and then they are subject to [inaudible] write-downs if the credit goes bad.

The debate about mark-to-market accounting evolved into lobbying by certain industry groups, particularly the American Banker's Association or the ABA. The ABA lobbied hard against mark-to-market accounting, arguing that it was a primary cause for the downward spiral of the capital markets. In response, there have been various congressional hearings and several studies regarding mark-to-market accounting.

In late September the SEC submitted a report to Congress that concluded that mark-to-market losses were not the primary contributor to bank failures in 2008. In fact, or instead, the chief contributors to bank failures were growing probable credit losses on loan investments that are not subject to mark-to-market accounting and concerns in the marketplace about asset qualities. A Merrill Lynch report and several other studies reached the same conclusion as that SEC report.

So the FASB has undertaken significant efforts to respond to industry and congressional concerns that accounting standards fail to provide sufficient guidance during periods of extreme market disruption, i.e. the last year and a half. In response, two weeks ago FASB came out with a couple of new proposed rules … They are not proposed. They are actually passed rules.

They are referred to as FASB staff positions, and those new positions emphasize that management has flexibility to use their own judgment to measure the fair value of assets that do not trade in active markets. And management also has flexibility when determining if a decline in value is other than temporary.

My personal view is that these new FASB positions are helpful, but the accounting standards are not the underlying cause in the write-down of financial assets, but rather reflect the underlying problems with those assets. Mark-to-market accounting is not perfect.

It requires significant professional judgment, but I believe it is the most accurate and reasonable portrayal of a company's financial condition. And I think it helps provide transparency and early warnings of troublesome positions that I believe is important to investor confidence in financial reporting. Thanks.