Definitions

mark down

Mark-to-market accounting

Mark-to-market is an accounting methodology of assigning a value to a position held in a financial instrument based on the current market price for the instrument or similar instruments. For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would currently fetch in the open market.

History and development

The practice of mark to market as an accounting device first developed among traders on futures exchanges in the 19th century. It was not until the 1980s that the practice spread to big banks and corporations far from the traditional exchange trading pits, and beginning in the 1990s, mark-to-market accounting began to give rise to scandals.

To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". 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. On the other hand, if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin is used as the collateral from which the loss is paid. As an example, the Chicago Mercantile Exchange, taking the process one step further, marks positions to market twice a day, at 10:00 am and 2:00 pm.

Over-the-counter (OTC) derivatives on the other hand are not traded on exchanges, so their market prices are not as readily available. 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 caught on in 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 objectively determined (because there was no real day-to-day market available), so assets were being 'marked to model' using estimated valuations derived from financial modeling, and sometimes marked to spurious valuations. See Enron and the Enron scandal.

Internal Revenue Code Section 475 contains the mark to market accounting method rule. Section 475 provides that dealers that 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 in 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 157

Related to the entire discussion is the effect of the issuance of Financial Accounting Standards Board (FASB) Statement No. 157 “Fair Value Measurements”, which became effective after November 15, 2007.

FAS Statement 157 includes the following:

  • A new 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);
  • New disclosures of assets and liabilities measured at fair value; and
  • A modification of the long-standing accounting presumption that the transaction price of an asset or liability equals its fair value.

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.”

While FAS 157 does not introduce any new requirements mandating the use of fair value, the definition as outlined does introduce key differences.

First, it is based on exit price (for an asset, the price at which it would be sold) rather than an entry price (for an asset, the price at which it would be bought), regardless of whether the entity plans to hold or sell the asset.

Second, FAS 157 emphasizes that fair value is market based rather than entity specific. Thus, the optimism that often characterizes an asset owner must be replaced with the skepticism that typically characterizes a risk-averse buyer.

FAS 157’s fair value hierarchy underpins the standard. The hierarchy ranks the quality and reliability of information used to determine fair values – quoted prices are the most reliable valuation inputs, whereas model values that include inputs based on unobservable data are the least reliable. A typical example of the latter is shares of a privately held company whose value is based on projected cash flows.

Although FAS 157 does not require fair value to be used on any new classes of assets, it does apply to assets and liabilities held at fair value. The accounting rules for which assets and liabilities are held at fair value are complex, and sometimes are adopted at the discretion of a company (see FAS 159, "The Fair Value Option"). It requires that certain assets held at fair value by financial companies, including sensitive investments linked to mortgages and other kinds of debt, be marked to market. In other words, you have to value the assets at the price you could get for them if you sold them right now on the open market.

The rule forces banks to mark to market, rather than to some theoretical price calculated by a computer — a system often criticized as “mark to make-believe.” (Occasionally, for certain types of assets, the rule allows for using a model)

Sometimes, there is no market—not for investments like collateralized debt obligations, or CDOs, filled with subprime mortgages. There are few, if any, buyers for such products. This complicates the marking process. In the absence of market information, an entity is allowed to use its own assumptions. However, when market information is available, it cannot be ignored by an entity.

FAS 157 makes no distinction between non cash-generating assets, i.e., broken equipment, which can theoretically have zero value if nobody will buy them in the market – and cash-generating assets, like securities, which are still worth something for as long as they earn some income from their underlying assets. The latter cannot be marked down indefinitely, or at some point, can create incentives for company insiders to buy them out from the company at the under-valued prices. Insiders are in the best position to determine the creditworthiness of such securities going forward. In theory, this price pressure should balance market prices to accurately reflect the "fair value" of a particular asset. Purchasers of distressed assets should step in to buy undervalued securities, thus moving prices higher, allowing other Companies to consequently mark up their similar holdings.

In response to the rapid developments of the financial crisis of 2007–2008, the FASB is fast tracking the issuance of the proposed FAS 157-d, Determining the Fair Value of a Financial Asset in a Market That Is Not Active.

Simple example

Example: If an investor owns 100 shares of a stock purchased for $40 per share, and that stock now trades at $60, the "mark-to-market" value of the shares is equal to (100 shares × $60), or $6,000, whereas the book value might (depending on the accounting principles used) only equal $4,000.

Similarly, if the stock falls to $30, the mark-to-market value is $3,000 and the investor has lost $1,000 of the original investment. If the stock was purchased on margin, this might trigger a margin call and the investor would have to come up with an amount sufficient to meet the margin requirements for his account.

Marking-to-Market a Derivatives Position

In marking-to-market a derivatives position, at the end of each trading day, each counterparty exchanges the change in the market value of their position in cash. If one of the counterparties defaults in this daily exchange, that counterparty's position is immediately closed by the exchange and the clearing house is substituted for that counterparty's position. Marking-to-market virtually eliminates credit risk, but it requires monitoring systems that usually only large institutions can afford.

Use by Brokers

Stock brokers allow their clients to access credit via margin accounts. These accounts allow clients to borrow funds to buy securities. Therefore, the amount of funds available is more than the value of cash (or equivalents). The credit is provided by charging a rate of interest, in a similar way as banks provides loans. Even though the value of securities (stocks or other financial instruments such as options) fluctuates in the market, the value of accounts is not calculated in real time. Marking-to-market is performed typically at the end of the trading day, and if the account value falls below a given threshold, (typically a predefined ratio by the broker), the broker issues a margin call that requires the client to deposit more funds or liquidate his account.

Effect on Subprime Crisis and Emergency Economic Stabilization Act of 2008

Section 132 of the proposed Emergency Economic Stabilization Act of 2008, titled "Authority to Suspend Mark-to-Market Accounting" restates the Securities and Exchange Commission’s authority to suspend the application of FAS 157 if the SEC determines that it is in the public interest and protects investors.

Section 133 of the proposed Act, titled "Study on Mark-to-Market Accounting," requires the SEC, in consultation with the Federal Reserve Board and the Department of the Treasury, to conduct a study on mark-to-market accounting standards as provided in FAS 157, including its effects on balance sheets, impact on the quality of financial information, and other matters, and to report to Congress within 90 days on its findings.

Emergency Economic Stabilization Act of 2008 has been passed and was signed into law on October 3, 2008. For the history and the passage of this law see Emergency Economic Stabilization Act of 2008.

On September 30, 2008 the SEC and the FASB issued clarifications regarding the implementation of fair value accounting, to help address concerns regarding the impact of fair value measurement on financial institutions holding mortgage backed securities (MBS). This guidance helps clarify that forced liquidations are not indicative of fair value, as this is not an "orderly" transaction. Further, expected cash flows from such instruments are an appropriate means of valuation, subject to applicable adjustments for default risks.

Under FAS 157, many companies had been forced to deeply mark-down (reduce) the value of MBS due to their inability to sell them, resulting in margin calls from investors, even when cash flows from the securities suggested a much higher value. In short, the SEC has acknowledged the market for MBS is not "orderly" and fair value standards should be more liberally applied to reflect the expected cash value.

On October 7, 2008 the SEC began to conduct a study on "mark-to-market" accounting, as authorized by Sec. 133 of the Emergency Economic Stabilization Act of 2008.

See also

References

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