Free Markets Need Mark-to-Market Accounting

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There has been a strong drumbeat to jettison mark-to-market accounting. On September 30th, the Securities and Exchange Commission provided for the use of an alternative method of accounting – “mark-to-model” – and is now in the process of determining the future of mark-to-market accounting.

Can a free market economy estimate the value of assets based upon a contrived number, when an actual value is available? Would such an approach to financial accounting be valid? If mark-to-market accounting does not work, it is because the regulatory system within which it is being applied has failed, not because the principle is flawed.

Financial accounting is intended to provide an accurate value of an asset at a point in time. Mark-to-market accounting, at its base level, is what financial accounting is intended to provide. When we look at a company’s balance sheet we are attempting to get a “snap-shot” of the value of the company’s assets and liabilities as of a specified date. The balance sheet is intended to answer such questions as: What is the value of the company’s cash account? What is the value of the company’s accounts receivables? What is the value of a company’s investments?

The balance sheet attempts to answer these questions as of a certain date, not in some unattainably objective manner.

For cash, it is an easy question. The value of a cash account is the amount of cash in the account. For accounts receivable, it becomes more complex. We know what the company is owed, but we also know that 100% of the debts owed to the company are unlikely to be paid, so we create a loss reserve based on past history and future assumptions.

For securities, in a mark-to-market system, we estimate the current value of those securities based upon the amount for which the asset could be sold as of the relevant date. If there is a liquid market for these assets, then it is almost as easy to determine the value of securities on a given date as it is to determine the value of cash. These securities simply have a value equal to that amount for which similar securities have recently been sold in the market.

The current drumbeat to jettison mark-to-market accounting relies upon the negative impact such accounting treatment is currently having on a company’s balance sheet. The prime example of these types of securities at the moment are subprime CDOs.

Permanently allowing for the termination of the use of mark-to-market accounting on these securities would allow firms to treat securities more like accounts receivable and less like cash. The estimated value would be based upon some historical and assumed future actions of third parties. But these securities are not securities intended to be held until maturity, like accounts receivables. They are investments purchased in hopes of selling for a gain.

Nevertheless, in the current market, it may be fitting that a temporary revision to mark-to-market accounting be undertaken; however, allowing accounting to be permanently altered based upon this short term crisis would be equivalent to throwing the baby out with the bathwater. In a free market economy assets are worth what another will pay for those assets and must be reflected as such in a company’s financial statements. Otherwise, the financial statements are a contrivance that will be shown to be such at an inopportune time in the future.

The fundamental goal of any of the new regulations sure to follow the current market crises should include mark-to-market accounting as a guiding principle. Any new bank capital requirements will need to insure that banks do not lend beyond their means, bankruptcy laws should insure that a bankrupt firm (regardless of size) can be wound-up or revived in an orderly fashion, and securities laws should insure that markets have visibility into relevant risks. If regulatory reforms are properly implemented, mark-to-market accounting works. If mark-to-market cannot work under any newly proposed regulations, such new regulations should not be enacted.

Financial accounting in a free market economy is based upon the principle that an asset’s value is equal to the amount another is willing to pay for such asset. No more, no less.

Eric R. Smith is an attorney with Venable LLP in Baltimore, Maryland. His practice focuses on securities law disclosure obligations, mergers and acquisitions and corporate finance.
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