Accounting rules are the favourite whipping boys of the financial market during bad times. We have seen that happen before—remember the Enron saga and other similar downfalls in 2001 for which the lack of proper accounting rules was considered one of the major causes? During the present financial crisis too, the story seems to be revolving around accounting rules. But this time, it is the presence of what is called the mark-to-market accounting rule that is being touted as the actual culprit behind much of the write-downs seen in the financial market. However, before forming any opinion let’s try to understand how the mark-to-market accounting rule works.
Johnny: Let’s start our discussion today with one of the most basic questions for many people like me. What is a mark-to-market accounting rule?
Jinny: Mark-to-market is a very simple and straightforward accounting rule that prescribes a method for finding out the fair value for all kinds of financial assets. The list of financial assets, as you know, is fairly long—all your stocks, bonds, options, swaps, et al can be called financial assets. How, you may wonder, does the mark-to-market accounting rule apply to so many different kinds of financial assets? Well, the mark-to-market accounting rule relies on the use of the current market price of your financial assets to arrive at their fair value. So if you are holding a stock that is currently trading at Rs100, then as per the mark-to-market accounting rule, the fair value of your stock is Rs100. You may have actually acquired the stock by paying Rs200 and expect that one day the same stock would trade at a much higher price, but in the realm of the mark-to-market accounting rule, future expectations do not play a role. The worth of your asset is always determined by the price at which you can currently sell it in the market. There is no need to look at any other statistic like future earnings, growth potential or any other fact or fiction surrounding your financial asset. Even a blindfolded man can know the fair value of any financial asset by just using the current market price as the yardstick.
Johnny: So in the mark-to-market accounting rule, everything depends on the current market price, right?
Jinny: Yes. In a way, the mark-to-market accounting rule seems like an extension of the efficient market hypothesis that believes that the collective mind of the financial market always reflects the correct price of the assets. In other words, the market is always right.
However, many sceptics believe which the efficient market hypothesis may sound good in theory, but in reality the free play of market forces may not always reflect the correct price. Sometimes the scale of the market may excessively tip to one side or the other, moving prices away from where they should be.
For instance, distress sales hardly give any chance of selling your asset at the right price. In the worst case, as the experience of the subprime crisis showed, the financial market itself may freeze completely, leaving you with assets for which there are absolutely no takers.
In such situations, the mark-to-market accounting rule may become a messenger of death even when your financial assets are generating some income. An accounting rule mandating complete write-off of assets temporarily under distress may, in fact, add fuel to the fire. This is what seems to have happened when the market for complex security instruments such as CDOs or collateralized debt obligations froze completely, leaving market players with assets they could neither swallow nor spit out.
Illustration: Jayachandran / Mint
Johnny: Then what conclusion can we draw? Should we completely discard the mark-to-market accounting rule when the financial market is in distress?
Jinny: Well, we can’t accept the mark-to-market accounting rule as the last word on valuation of financial assets. Neither can we completely dump the mark-to-market accounting rule. We definitely need to strike a balance.
The main attraction of the mark-to-market accounting rule lies in its simplicity and objectivity. The mark-to-market accounting rule compels us to look at the real picture. The whole financial market can’t become an enemy of your stocks and bonds for no rhyme or reason. If we can’t find any buyer for our asset, then something must have gone terribly wrong. The mark-to-market accounting rule cannot be blamed for simply telling us the reality. In such a situation, what other options do we have? We can very well use our own assumptions to find out the true worth of our financial assets. But assumptions are only as good as the person making them. In some cases, assumptions may be right but in some cases they may go wrong. So barring extreme situations, the mark-to-market accounting rule still has the potential to become the best friend of our financial market.
Johnny: Thanks for telling me all this, Jinny. Sometimes our best friends may look like enemies.
What: The mark-to-market accounting rule prescribes principles for assessing the fair value of financial assets.
How: Financial assets are to be valued as per their current market price.
Why: In an extreme scenario, the mark-to-market accounting rule may aggravate the situation by leaving no room for discretion.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com