Amid the clamour and turmoil of 2008, where established market rules have been turned on their head, stands the question mark over the use of mark-to-market (MTM) accounting. For years there existed a debate within the accounting fraternity about the need for assets and liabilities in financial statements to reflect a picture as close to their fair value, usually determined by what assets are worth in the market. Finally reflecting the need to measure fair value, the International Accounting Standards 39 and US Financial Accounting Standard (FAS) 157 were adopted in 2004 and 2006, respectively, after several years of deliberation.
In the wake of the crisis of 2008, financial institutions have levelled strong criticism against the adoption of these standards. They say the standards have led to the credit crunch by forcing companies to revalue seemingly illiquid assets and forcing further fire sales to offset the mark-to-market losses. Banks in particular make the point that the principle of marketing of market is an oxymoron when no market exists for an instrument and that in times such as these when consumer diffidence overrules reason, MTM does not reflect the reality. Such banks are not without political clout, having been the purveyors of the politically popular, cheap funds regime prevalent over the last few years. They had succeeded in lobbying Congress, through the US Emergency Economic Stabilization Act of 2008, to recommend the suspension of FAS 157. Congress had, in turn, asked the Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) to revert by January 2009 with a view on the feasibility of suspension of the standard. SEC has examined this and its report was released a few weeks ago.
In a courageous move on a subject with politically emotive implications, SEC has not accepted the value of removing FAS 157 and has indicated that fair valuation was, in any case, not the cause of the current crisis. SEC has indicated that at least 90% of investments they saw on balance sheets did have an active market in which prices could be determined. It has conceded that guidance is required, in the standards, for situations when markets become inactive. It has also sought to provide guidance when the creditworthiness of borrowers change.
SEC is particularly conscious of the fact that accounts are meant to provide confidence to investors (not to the companies themselves who anyway have a good feel for how they are doing), and therefore need to be transparent and consistently applied. The financial institutions clamouring for these MTM changes were, in their view, required to make clear choices with regard to the holding period as well as the liquidity of an asset at the time they acquire an asset and if those choices went sour it is really too bad. One cannot disagree that if companies were able to book the profits from changes in valuation, then a special dispensation to enable the avoidance of loss booking does not provide investors with fair view of the balance sheet.
Providing a true picture to investors is actually the solution to a part of the crisis of frozen markets. Indeed the major cause of illiquid asset markets, which is claimed to be one of the excuses to eschew MTM accounting, is the opacity of financial statements that makes it difficult for investors to distinguish between a bank with strong assets and another with poor assets. This can result in a situation where all assets get tainted, even when such a taint is not called for. Finance theory suggests that in such a situation the stronger company needs to be permitted to find a way to communicate its advantages through a signalling mechanism which weaker firms cannot afford to use. Companies should be explicitly encouraged by SEC to disclose much more about their portfolios, counterparties and why they believe that long-term diminutions in their portfolios do not exist. This information would likely have to be prepared internally anyway as required by FAS 157. All we suggest is that these calculations and the risk assessments of organizations be shared with the wider public. Only those with stronger assets will choose to make these disclosures, effectively signalling the relative strengths of their balance sheets. The analyst community can play referee about the underlying strength of companies based on these disclosures. Such transparency could be a solution to avoiding the unintended consequences of mark-to-market accounting.
On a more philosophical note, avoiding the MTM world has deeper long-term?economic implications. PriceWaterhouseCoopers’ chairman Dennis Nally has suggested that a move in that direction could plant the seeds for the next crisis. He pointed out, rightly, that the decade-long economic malaise in Japan was largely due to the failure of Japanese banks to reflect the real value of their assets, precisely what would be achieved by not biting the MTM bullet now.
Practising CFOs would perhaps have preferred the certainty of a world far removed from MTM. It would simplify the accounting process and leave much less to judgement. However, given the primacy of market efficiency in our consciousness, it is difficult to suddenly draw the line when the consequences of the same result in adverse financial reporting
Finally, we need to recall that poor underwriting practices, credit defaults and steep declines in asset values were the real causes that forced banks to mark down their assets. The accounting rules only captured the reality of the market after the event. In fact, fair value with all its limitations is the best method to reflect market conditions. When markets are volatile, one would argue that marking assets to market is more, rather than less, relevant. When we make retrospective changes in well-thought-out accounting standards, we send out the message that even the most sacred element of the governance framework is up for grabs and that the rules of the game can be changed after the event. One cannot think of a surer way to keep investors away from markets than to create confusion about the quality and consistency of the accounts that they rely on. Finally, it is worth remembering perspicacious comment of Walter Wriston, who ran Citibank, during happier times, that consistency of accounting treatments is more useful to investors than the latest fad in accounting standards. Changing fundamental cornerstones of the accounting edifice is hardly the way to be consistent.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes on issues related to governance. The views expressed here are personal. Write to him at firstname.lastname@example.org