Mark-to-market (MTM or M2M) or fair value accounting is accounting for the "fair value" of an asset or liability based on the current market price, or the price for similar assets and liabilities, or based on another objectively assessed "fair" value. Fair value accounting has been a part of Generally Accepted Accounting Principles (GAAP) in the United States since the early 1990s. Failure to use it is viewed as the cause of the Orange County Bankruptcy, even though its use is considered to be one of the reasons for the Enron scandal and the eventual bankruptcy of the company, as well as the closure of the accounting firm Arthur Andersen.
Mark-to-market accounting can change values on the balance sheet as market conditions change. 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. Mark-to-market accounting can become volatile if market prices fluctuate greatly or change unpredictably. Buyers and sellers may claim a number of specific instances when this is the case, including inability to value the future income and expenses both accurately and collectively, often due to unreliable information, or over-optimistic or over-pessimistic expectations of cash flow and earnings.
History and development Simple exampleIf an investor owns 10 shares of a stock purchased at $4 per share, and that stock now trades at $6, the "mark-to-market" value of the shares is equal to (10 shares * $6), or $60, whereas the book value might (depending on the accounting principles used) equal only $40.
Similarly, if the stock decreases to $3, the mark-to-market value is $30 and the investor has an unrealized loss of $10 on the original investment.
This can create problems in the following period when the "mark-to-market" (accrual) is reversed. If the market price has changed between the ending period (12/31/prior year) and the opening market price of the following year (1/1/current year), then there is an accrual variance that must be taken into account.
In the 1800s in the U.S., marking to market was the usual practice of bookkeepers. This has been blamed for contributing to the frequent recessions up to the Great Depression and for the collapse of banks. The Securities and Exchange Commission told 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.
To understand the original practice, consider that a futures trader, when beginning an account (or "position"), deposits money, termed a "margin", with the exchange. This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. In contrast, if the market price of his contract has decreased, the exchange charges his account that holds the deposited margin. If the balance of this account becomes less than the deposit required to maintain the account, the trader must immediately pay additional margin into the account in order to maintain the account (a "margin call"). (The Chicago Mercantile Exchange, doing even more, marks positions to market twice a day, at 10:00 am and 2:00 pm.)
Over-the-counter (OTC) derivatives, in contrast, are formula-based financial contracts between buyers and sellers, and are not traded on exchanges, so their market prices are not established by any active, regulated market trading. Market values are, therefore, not objectively determined or available readily (purchasers of derivative contracts are typically furnished with computer programs which compute market values based upon data input from the active markets and the provided formulas). During their early development, OTC derivatives such as interest rate swaps were not marked to market frequently. Deals were monitored on a quarterly or annual basis, when gains or losses would be acknowledged or payments exchanged.
As the practice of marking to market became more used by corporations and banks, some of them seem to have discovered that this was a tempting 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 being "marked to model" in a hypothetical or synthetic manner using estimated valuations derived from financial modeling, and sometimes marked in a manipulative manner to achieve spurious valuations. The most infamous use of mark-to-market in this way was the Enron scandal.
After the Enron scandal, changes were made to the mark-to-market method by the Sarbanes–Oxley Act in the US during 2002. The Act affected mark-to-market by forcing 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. In addition, the Public Company Accounting Oversight Board (PCAOB) was created by the Securities and Exchange Commission (SEC) for the purpose of 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 caused many companies to avoid registering on stock exchanges in the United States.Moffett, R., & Grant, G.. (2011, March). Internal Controls and Fraud Prevention. Internal Auditing, 26(2), 3-12. Retrieved March 29, 2012, from ABI/INFORM Global. (Document ID: 2329679601).
Internal Revenue Code Section 475 contains the mark-to-market accounting method rule for taxation. Section 475 provides that qualified securities dealers who elect mark-to-market treatment shall recognize gain or loss as if the property were sold for its fair market value on the last business day of the year, and any gain or loss shall be taken into account for that year. The section also provides that dealers in commodities can elect mark-to-market treatment for any commodity (or their derivatives) which is actively traded (i.e., for which there is an established financial market that provides a reasonable basis to determine fair market value by disseminating price quotes from broker/dealers or actual prices from recent transactions).
FAS 115 Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, commonly known as "FAS 115", is an accounting standard issued during May 1993 by the Financial Accounting Standards Board (FASB), which became effective for entities with fiscal years beginning after December 15, 1993.Financial Accounting Standards Board, "Summary of Statement No. 115" Retrieved August 23, 2014.Financial Accounting Standards Board, "Statement of Financial Accounting Standards No. 115" Retrieved August 23, 2014.
FAS 115 addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows:
Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as "held-to-maturity" securities and reported at amortized cost less impairment. (Amortization refers to spreading payments over multiple periods.) Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as "trading" securities and reported at fair value, with unrealized gains and losses included in earnings. Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as "available-for-sale" securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity (Other Comprehensive Income).
FAS 124 Statement of Financial Accounting Standards No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, commonly known as "FAS 124", is an accounting standard issued during November 1995 by FASB, which became effective for entities with fiscal years beginning after December 15, 1995.Financial Accounting Standards Board, "Summary of Statement No. 124" Retrieved August 31, 2014.Financial Accounting Standards Board, "Statement of Financial Accounting Standards No. 124" Retrieved August 31, 2014.
FAS 124 requires that, for investments in equity securities with readily determinable fair values and for all investments in debt securities, a not-for-profit organization must report them at fair value, with gains and losses included in a Statement of Activities. A narrow exception is made to allow limited held-to-maturity accounting for a not-for-profit organization if comparable business entities are engaged in the same industry.
FAS 157 / ASC 820
Statement of Financial Accounting Standards No. 157, Fair Value Measurements, commonly known as "FAS 157", was an accounting standard issued during September 2006 by FASB, which became effective for entities with fiscal years beginning after November 15, 2007.Financial Accounting Standards Board, "Summary of Statement No. 157" Retrieved June 13, 2009.Financial Accounting Standards Board, "Statement of Financial Accounting Standards No. 157" Retrieved August 23, 2014.Taub S. (2007). FAS 157 Could Cause Huge Write-offs . CFO.com. Under Accounting Standards Codification, FASB's fair value accounting guidance has been recodified as ASC Topic 820.
FAS Statement 157 includes the following:
Clarity of the definition of fair value; A fair value hierarchy used to classify the source of information used in fair value measurements (i.e., market-based or non-market based); Expanded disclosure requirements for assets and liabilities measured at fair value; and A modification of the long-standing accounting presumption that a measurement-date-specific transaction price of an asset or liability equals its same measurement-date-specific fair value. Clarification that changes in credit risk (both that of the counterparty and the company's own credit rating) must be included in the valuation.
FAS 157 defines "fair value" as: "The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date".
FAS 157 only applies when another accounting rule requires or permits a fair value measure for that item. While FAS 157 does not introduce any new requirements mandating the use of fair value, the definition as outlined does introduce certain important differences.
First, it is 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)), regardless of whether the entity plans to hold the asset for investment or resell it later.
Second, FAS 157 emphasizes that fair value is market-based rather than entity-specific. Thus, the optimism that often characterizes an asset acquirer must be replaced with the skepticism that typically characterizes a dispassionate, risk-averse buyer.