Charles Davì

Mark To No Market Accounting

In Politicized Economy, Systemic Counterparty Confusion on November 17, 2008 at 8:31 pm

The Meaning Of It All

In this article I explore an oft discussed topic: mark to market accounting. I will not come down on either side of the debate. Rather, I will try to make sense of the implications and assumptions of mark to market accounting. But before we can explore the world of mark to market accounting, we must understand the economic significance of the data reported under accounting regimes in general. And in order to do that, we must have a practical concept of economic loss/gain. From here on, we simply write the term loss to signify both loss and gain, except where context indicates otherwise (philosophers, please relax, the meaning is clear).

What Is Economic Loss?

In my mind, the answer depends on who you ask and when. That is, every economic endeavor involves multiple parties with different rights and obligations that vary over time, and so any meaningful concept of loss should consider both who incurs “loss” and when. As usual, we will proceed by way of example.

Assume that Tony (T) has had a life long passion for the manufacturing of shoes. He decides to raise money from investors to open up a factory that will manufacture a new line of shoes, “Tony’s Shoes.” The investors contribute a total of $100 to T’s endeavor through debt. Assume that T bought manufacturing equipment from M for $70 and that T’s debt to the investors is secured by the factory equipment. After 6 months, it becomes clear that the market is not ready for T’s postmodern shoe design, and so T’s factory generates no income whatsoever. As a result, T commits suicide. T leaves only $15 and title to the manufacturing equipment in his estate, having set his entire inventory on fire in a rage prior to his suicide. The investors successfully obtain title to the machinery and claim the remaining $15. Because the machinery has been used for 6 months, they are only able to recover $30 for it in an auction.

So who lost what and when? Well, as an initial matter, in order for there to be loss, there must be change. It follows that we should ask how the state of affairs has changed over some time frame. Let’s mark the beginning of our time frame at just before T’s purchase of the manufacturing equipment and the end at immediately after the investors liquidate the manufacturing equipment. So, our concept of loss will compare the state of affairs at those two points in time for each participant. In our example, T began alive with $100 cash and $100 in debt, and ended up dead with his estate owing $55 to the investors.  The investors started out with notes with a par value of $100 and ended up with $45 in cash. M started out with manufacturing equipment and ended up with $70 in cash.

The first problem we face is comparing dissimilar assets. That is, T started out with cash and debt, the investors started out with notes and ended up with cash, and the manufacturer started out with equipment and ended up with cash. While the choice of a common basis is arbitrary, we choose cash. So, assume that at the beginning of our time period T valued his debt at negative $100, the investors valued the notes at par ($100) and that M valued the equipment at $60. One reasonable interpretation of the facts is that over the relevant time period T lost nothing, the investors lost $55, and M gained $10. It is reasonable to say that T lost nothing because he began with a net cash value of zero and although his estate still owed the investors $55, there was nothing left to pay them with. We could be pedants and say that T ended with a negative $55 cash value, but what would that mean? Nothing. The investors’ claim is worthless since T is dead and his estate is empty. If T had survived or if his estate expected to receive assets or income at some future time, then T or T’s estate could be indebted in an economically meaningful way. But since this is not the case in our fact pattern, the investors have a worthless claim against T’s estate.

A Truly Human Story

In my mind, the goal of any accounting system is to tell a story about economically significant events that occurred over a given time period. And so, in designing a system of accounting, we must choose which aspects of each market participant’s state of affairs that we want to report, simply because there could be events we don’t find particularly relevant to our story. For example, T died. We may or may not want to report that. Whether or not we choose to report it, T’s death did have economic significance. Because T died and left an estate with inadequate resources to cover his liabilities, the debts owed by T’s estate were worthless. As is evident, it would be impractical to report the death of every market participant. But as T’s case demonstrates, there are some events we wouldn’t normally consider economically significant which turn out to have a meaningful impact on the rights and obligations of market participants.

Truth In Numbers

We must also have a method of valuation. In our example above, we simply relied upon the subjective valuations of the market participants. Given that market participants will likely have an incentive to misrepresent the value of certain assets, we probably don’t want to rely too heavily on purely subjective valuations. For example, we calculated M’s gain based on M’s valuation of the equipment. What if M’s valuation was pure wishful thinking? What if his cost of inputs and labor suggested a price closer to $150? It would follow in that case that M actually lost money by selling the equipment for $70. What we need is a method of valuation that limits each participant’s ability to misrepresent, whether through wishful thinking or malice, the value of assets. There are several ways to go about doing so. We could establish guidelines, rules, or allocate valuation to trusted entities. Another approach is to simply quote the price of an asset from a market in which the asset is usually bought and sold.

Mark to Market Accounting

The basic premise of mark to market accounting is that the reported value of a given asset should be based upon the price at which that asset could be presently sold in a market that trades such assets. For example, assume that ABC stock is traded on the highly reputable XYZ exchange. The reported value of 1 share of ABC stock on September 10, 2008 under a mark to market regime should be based on the prices quoted for ABC stock over some period of time near September 10, 2008. You might want to construct an average, or exclude a particular day’s quotes, but the general idea is that the market provides the basis of the price. So if 1 share of ABC’s stock had an average closing bid price of $25 from September 1, 2008 to September 10, 2008, a company holding ABC stock could be required to use this average price as the basis for calculating the value of its holding of ABC stock for a report issued under some mark to market regime.

Market Prices And Expected Value

Returning to our example above, we determined that the investors had lost money once T’s estate was liquidated since they had no other methods of recovering the money that they had lent and was owed to them. But what if we wanted to consider their losses at some point before T was obligated to make a payment on his debts? Had the investors lost anything at that point? Any such loss would be anticipatory since the loss would occur before the repayment of debt was obligated. So, while the loss hasn’t been realized yet, we can still anticipate it. For example, if T had killed himself before any payment was due, losses would be anticipatory, but anticipated with certainty. As is evident, the amount of an anticipated loss, or expected loss, is a function of the probability that an expected cash flow will fail to materialize.

Market price quotes are used to estimate the expected value of an asset, which is the value of all the asset’s cash flows discounted to reflect the time value of money and the probability that any of the asset’s cash flows will fail to materialize. Many economists subscribe to the belief that the market price for an asset is the expected value of an asset. That is, they believe that the collective decision making of all market participants leads to the creation of a price which accurately reflects all relevant price inputs. But even if we accept this logical catapult, it is still possible for a market to produce inefficient prices. For example, market participants could have mistaken the correlation of default between certain investments, creating a short term shortage of cash, leading to massive and collective sell offs across asset classes. That should sound familiar. Such a scenario would arguably create opportunities for arbitrage for those fortunate enough to have cash on hand.

Even if you don’t buy the theoretical arguments for inefficient markets, or the glaring recent examples, you must still wonder when it was that markets became efficient. Were they always efficient? And even if they were, can they become inefficient?

The Takeaway

Whether or not you think that markets price assets efficiently, market price quotes are without question a good measure of how much cash you can exchange an asset for at any given point in time. So, whether or not markets price assets efficiently does not determine whether mark to market accounting is “good” or “bad.” Rather, we have to ask what it is that we are using mark to market accounting for. Then, we can determine whether a given application of mark to market accounting is “good” or “bad.”

  1. Mark to market is what you will get for an asset. Mark to model, myth, dream etc is what you might get. Mark to myth accounting involves more uncertainty and hence risk than mark to market. Mark to market has its flaws but it is the least risky way to evaluate the price of assets.

    The problem with mark to market is however, when market conditions are “irrational” but irrational is usually measured from the point of view of the asset holder. The “firesale” that the banks are complaining about, has been going on for close to 18 months now. The market is probably accurately pricing these assets.

  2. This is something with which I have some experience and have written about. My interest is specifically for environmental liabilities, not for financial instruments.

    The central issue is how to manage the reality of the variance of asset and liability valuations in real time (annual and quarterly reports). While the propose fair value measurement methods specified in FAS-157 have led to significant problems for some financial companies, the reality is that the assets on their balance sheets has dropped precipitously. As Al Gore would say, that is an inconveient truth. This is no different than people who are looking at “paper losses” in their IRA of 40-50%. That is the reality. If that person is say 40, he can argue that 25 years from now this current dip is of no consequence. If that person is 70, he has some real issues. Regardless, the drop is what it is.

    Another objection I hear from accountants is that FVM creates too much “paper” fluctiuations in assets and liabilities which extend over to the income statement. That is another story for another day. One which seems as though it can be addressed through FASB amendments.

    But mostly, there seems to be an inherent discomfort with the concept of fixed asset valuations fluctuating. In my experience, accountants are simply loathe to live in a world where fixed asset valuations flucuate because fixed assets are supposed to be, well … fixed.

    As something of an outsider, my impression is that, among other things, FVM bring to light the uncertainty in asset and liability valuations. And by extention, the uncertainty can create risk. I submit that FVM should be used to identify uncertainty and risk, and had it been properly employed earlier in this cycle, maybe corrective action would have been taken bginning in 2006 or maybe even 2005.

    Banks and insurance companies should have known and should have reported that the risky positions they were taking might lead to a future need for extensive capitalization. If they did not possess the wherewithal for this possible outcome, they should not have taken on the risk. It seems to me that the original sin of FAS-157 is that it compels corporate officers to see the truth and to tell the truth. I, for one, can live with that.

  3. Point: “Suspending mark-to-market accounting, in essence, suspends reality.” – Beth Brooks, global chair Ernst & Young

    Counter-Point: If there is no market, or no efficient/liquid/… market, mark-to-market becomes Slumlord’s “mark to myth” at best. At worst, otherwise healthy institutions may face huge paper losses with attendant ill effects. The fact that firesale prices have persisted so long may reflect the assets’ true value, but it may just be a product of frightened and cash-starved market players’ uncertainty in the post-MBS-meltdown wasteland.

    Conversely, in a bubble market, mark-to-market creates ephemeral paper gains that encourage investments in companies with tulips on their balance sheets.

    Mark-to-market may be better or worse than its predecessors, but it’s certainly not perfect.

  4. Proponents of marked to market accounting usually insist it’s a necessary thing for transparency. But the necessary condition is really disclosure of marked to market value rather than accounting for it. It’s quite possible for a firm to release all matter of marked to market information without necessarily jamming the spuriously precise result into its capital position every 90 days.

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