Analysing the mark to market accounting impact of Financial Crisis


In April 2009, the Financial Accounting Standards Board (FASB), voted on and approved new guidelines that would allow for the valuation to be based on a price that would be received in an orderly market rather than a forced liquidation. This approach was part of many major reforms that were about to be undertaken by regulators, credit rating agencies and the accounting standard-setters. The changes to current practice relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

The mark-to-market accounting standards now provide measurement guidance as to how firms should compute fair value estimates in situations when financial instruments do not trade in active markets.

Even with an active market, it still would be difficult to interpret an assets underlying true value with the help of the marked-based measurements, especially during unfavorable and volatile times such as the financial crisis. It could be quite tricky for a company to calculate the selling price of its assets or liabilities during bad times, because the current value of the assets at that time could be much lower than the actual value. The result would be lowered company margins, which in turn would be lowered shareholders value.

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FASB have established a fair value hierarchy in fair value measurements that distinguishes between 1) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and 2) the reporting entities own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date. In those situations, the reporting entity must take some market participant assumptions into consideration that is reasonably available without excessive cost and effort. Market participant assumptions include assumptions such as risk. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine. Other market participant assumptions include assumptions about the effect of a restriction on the sale or use of an asset. The updated standards of measuring financial instruments eases the difficulties entities face when there are no existing up to date markets available.

The update and improvement of mark-to-market rules when the market is unsteady or inactive simplifies the banks statements of earnings and give them more possibilities to reclassify certain assets so they no longer have to be marked-to-market.

Other issues with mark-to-market accounting have been the many definitions of fair value and limited guidance for applying those definitions in the accounting standards. Moreover, fair value measures have been criticized for being dispersed across standards and in some cases inconsistent. The inconsistency in the standards has contributed to the complicated approach in measuring mark- to market assets. IASB and FASB have therefore focused on the consistency and comparability of measuring mark- to market value. By establishing a single source of guidance for all mark- to market measurements, the standard-setters has avoided the complexity in measuring fair value, and focuses on improving the decision usefulness of financial statements for users. For example, IFRS 9 uses a single approach to determine whether a financial asset is measured at amortized cost or fair value, replacing the many different rules in IAS 39.

IASB and FASB also have focused on the completeness of measuring mark- to market value. The former guidance was incomplete because it didn't have a clear measurement objective, and also lacked a robust measurement framework. The standard setters responded by establishing an elucidating definition of mark-to-market value and also enhanced the disclosures about mark- to market measurements, including the liquidity risk.

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For the latter, According to Sir David Tweedie, the idea is to ease the overall mark-to-market measurement and get rid of all these different categories with different impairment tests.

The expanded disclosures about the use of mark-to-market value to measure assets and liabilities should provide users of financial statements (present and potential investors, creditors, stakeholders and others) with better and less complicated information about the extent to which fair value is used to measure recognized assets and liabilities, the inputs used to develop the measurements, and the effect of certain of the measurements on earnings (or changes in net assets) for the period. It may be further information on how entities estimated the fair value of their financial instruments when there are only limited market data to support those estimates.

Companies vs. Investors reaction through the Statement no 157

Mark to Market or fair-value accounting requires companies to record assets every quarter to reflect market value. Therefore, some CEOs companies claim that the standard had aggravated the worst financial crisis since the Great Depression. On the other hand, the new regulation provides investors a frank look at the company's earnings. (Bloomberg, 2008)

Those arguing for change include some of the companies distressing the most since the subprime-mortgage crisis had started in 2007, including Citigroup and American International Group Inc. Critics, who said the mark to market doesn't work when there are no buyers for assets whose value has fallen significantly, include Schwarzman, that manages the world's largest private-equity fund and whose shares have dropped 72 percent with the financial crisis. (Fortune, 2008)

Schwarzman said at the discussion hosted by Fortune magazine at Per Se. "The rule and the way it's been implemented has been a major contributor to the financial crisis." He also criticize, that mark- to-market accounting wrongly makes them to price holdings even if they have no intention of selling them at that time, hindering the business model of fixing up companies and disposing of them years later for a profit. (Fortune, 2008)

Supporting the idea, Citigroup Senior Vice Chairman William Rhodes and Deutsche Bank AG Chief Executive Officer Josef Ackermann spoke in October, 2008 in Washington on behalf of the Institute of International Finance, said the rule needs a review because it doesn't work in illiquid markets. Moreover, in an article of Steve Forbes wrote that "the idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down. That works when you have very liquid securities, such as Treasurys, or the common stock of IBM or GE."(Wall Street Journal, 2009)

Investors and accountants like the former Securities and Exchange Commission chief Arthur Levitt mocked at those claims, saying the mark-to-market regime provides a very important precision into companies' financial health. The surge of writedowns, they argued, reflects the poor economic judgments made for the period of the boom that ended last year. (CNN, 2008)

On the other hand, there were also people like the Real Estate Billionaire Sam Zell, Chairman of Equity Group Investments, who said without mark-to-market, this crisis would never have reached such a high level. According to Windows Financial Service article, he was not the only one to complain about SFAS 157, but also Martin Sullivan, the former CEO of AIG, confirmed before the U.S. Congress that the accounting rule generated tens of billions of dollars in paper losses for AIG, which end up in the insurer's financial crisis and following bailout by the U.S. Treasury. (Windows in Financial, 2009)

On the other side, defenders of SFAS 157 argue the financial market needs the transparency generated as a result of the accounting rule and that any deferment of the rule would make more financial instability. Financial Accounting Foundation Chairman Robert Denham notified to (D-MA) that "any legislative effort to overturn [SFAS 157] will greatly undermine investor confidence." (Windows in Financial, 2009)

In response to this debate, Congress consented that the Securities and Exchange Commission develops a study on SFAS 157. Therefore, after reviewing three years' worth of financial data for 22 failed banks, The SEC stated in its report that the existing financial crisis was not caused by the new rule SFAS 157:

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"Rather than a crisis precipitated by fair value accounting, the crisis was a 'run on the bank' at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm…The Staff observes that fair-value accounting did not appear to play a meaningful rule in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence". (, 2008) For the failed banks that did recognize sizable fair value losses, it does not appear that the reporting of these losses was the reason the bank failed. (, 2008)

The ended of Global Financial Crisis?

After a series of financial stabilization policies, financial rescue plan followed by regulatory reform, the market seems restored from the peak of the financial crisis. Good news like stock market is "back to normal" featured by the generally rise in stock price, for example HSBC share price was $73.36 in Sept 2008 and sharply fell to $23.07 in Mar 2009 while restored to $49.53 in Jul 2009 which showed the rebuild of consumer confidence on stock market and moved up of consumer confidence index brought new hope to the public (M, N, Baily and D, J, Elliott 2009). Some political leaders even claimed the crisis is nearly over by July 2009; however, it is too optimistic and too early to make this conclusion.

According to the data of Bureau of Labor Statistics of America (2010), the unemployment rate in the US soared from 5.81% in 2008 to 9.28% in 2009 and steadily increased to 9.7% in March 2010 and the data shows that "employment continued to decline in financial activities". However, consumption is one of the crucial components in GDP; constantly low consumption volume will affect the growth in GDP. If unemployment rate continuing increase, consumption will decrease while immediately affect the sales and profit of company; once the company go bankrupt, it became the 'toxic asset' to bank, which forms a vicious circle. High unemployment rate is a world issue after the crisis, Europe countries like Germany (8.2%), France (9.7%), Greece (9%), Italy (7.5%), European Union (9.2%) Spain (18.1%) and Ireland (12%) suffered from this problem (Central Intelligence Agency 2010). For the phenomenon of high unemployment rate with low level of consumption lead to the shrink of economic development in a country and sow a seed for another wave of credit crisis.

The global financial crisis could be traced back from the housing bubble in the US, after the introduction of stimulus policy, the US FHFA House Price Index rise from nadir in the Q4 2008 to a better level in Q4 2009 (Chart 1), however, it doesn't mean that the crisis was passed. The main reason for the restore of the housing market was driven by the first-time home buyer tax credit which extended its expiry date from November 2009 to April 2010 (Tanrich 2010). Therefore, the increase in house price and active housing market could be an illusion. The US government held a large amount of CDOs and CDSs in national balance sheet which were built base on the housing mortgage debt; the lower the housing price in the US market will directly affect the decrease in value in those toxic securities and remains a great burden to the US government. Economist Karl Case said "We've turned a corner with housing, though it's hard to see any robustness" (Bloomberg 2010), therefore, US is still under the shadow of financial crisis while there is long way to restore its housing market.

By the extension of financial crisis from the US, Eurozone is heavily suffered as all countries tightened their credit loans which lead to debit crisis in Europe. Standard and Poor's has downgraded Greece sovereign credit rating to junk status followed by Portugal downgraded to A- and Spain's credit status to AA with negative outlook (Bloomberg 2010), Greece is at the margin to go broke under the crisis. Although Greek government tried to halt the huge fiscal deficit by issuing government bonds, unlike the situation in the US, no country is willing to hold the fallen knife as the total volume of deficit cannot be estimated with poor sovereign credit.

However, by the threat of broken of Eurozone, the main leader-Germany in the Eurozone and IMF delivered 45 billion-euro loan to Greece. The loan may alleviate Greece's economy temporary, however, without any economic reform on the financial system in Greece, the loan will be only a tranquilizer used to postpone the new wave of economic crisis in Europe. As Lena Komileva, head of G7 market economics at Tullet Prebon said that "Greece's credibility and credit crisis is not over yet" (Financial Times 2010). Greece's situation is not an isolated case among 27 countries in EU, while 20 countries in EU have serious deficit which evidenced the global financial cannot be claimed as an end in 2009.

To conclude, the US financial market as well as global market still fragile and under the shadow of the financial crisis, high unemployment rate becomes global phenomenon while the continuity on the increase in the US housing price is doubted together with the spread of debt crisis in Eurozone proved that the ended date of financial crisis is uncertain, the global financial markets have long way to restore to pre-crisis situation.