Mark-to-market (let’s call it M2M) accounting has come under attack from critics in the wake of the global financial crisis that started in the US. What was thought to be a reasonable way of accounting for financial assets has become the villain overnight. M2M accounting values financial assets on a balance sheet at their prevailing market value. In good times (Dr Jekyll for us), the practice is friendly to all because unrealized profits buoy everyone. In difficult times, such as now, the practice can turn into a Mr Hyde and wreak havoc.
The criticism has been on broadly two tracks: First, when housing prices tumble, a company holding the related mortgages, wishing to mobilize capital, may be constrained to sell the security at a distress price. This is because the underlying collateral has turned worthless. As a consequence, under M2M, every corporate entity holding a similar investment is obliged to mark that investment to market using this rock-bottom price as the benchmark. This sets off a downward spiral of losses, whether or not those losses are real (never mind that nobody questioned the M2M profits when those profits weren’t real either). This is said to set off a chain reaction of panic among corporate entities obliged to book huge losses, creditors who do not wish to lend, or worse, call in their loans to such companies, investors who hasten to sell the stocks of such companies and the mortgage owners who rush to sell their properties before they lose further value, resulting in a downward spiral in mortgage-backed security prices.
A second criticism of M2M accounting raises the issue of a company being rewarded for issuing risky debt paper! According to this view, imagine a company issuing a bond that, having turned extremely risky, is priced at deep discount to the par value in the asset side of the books of the investors, recognizing a suitable loss. In the issuer’s balance sheet on the other hand, under the M2M rule, the bond value appears on the liability side, but at the drastically reduced market price. In effect, this results in increasing the value of owners’ equity, which is nothing but the value of assets minus liabilities. The worse your paper gets, the more profit you show. Apparently big financial firms such as Lehman Brothers Holdings Inc., Citigroup Inc., Merrill Lynch and Co., JPMorgan Chase and Co., Morgan Stanley and Goldman Sachs Group Inc., between them, booked a profit of $12 billion (Rs57,240 crore) in their books on this count alone in 2007 (not that it helped Lehman or Merill in a big way).
Of the two arguments against M2M accounting, the second one is simpler to fix. The corporate bond as referred to in the above case may be held for trading or sale by the investors, but it is certainly a security “held for maturity” by the issuer of the bond. If so, any reasonable accounting standard should stipulate that when a paper is held to maturity (especially on the liability side) the market value of the paper is irrelevant. Ideally, it would be wrong to blame the principle of M2M accounting in such a case, because such a paper should not have been marked to market in the first place. What may be blamed is the manner in which the related accounting standard is framed.
Let us now revert to the first of the criticisms. Rather than attack M2M, the accounting community should take a leaf from the standard banking classification of financial assets, namely those available for sale, those available for trading and those held for maturity. This is a classification that even the rest of the industry will do well to follow. But more importantly, to protect against a cascading write-down of assets during times of distress, companies may be allowed the option of moving their assets from “available for sale” or “available for trading” category to “held for maturity” category as a one-time measure. As the securities held for maturity are not marked to market, this will provide an escape clause to the companies from having to recognize losses when they do not in fact wish to sell or trade in an asset. However, if a company proposes to sell or trade in the asset, it can really have no case against marking the security to market. Some arrangement along these lines is where the answer to the M2M conundrum lies.
The author is a former professor of accounting and finance, IIM Ahmedabad, and a former member of the National Accounting Standards Board of ICAI.
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