Mark-to-market or fair value accounting, a term coined by Professor Matt Holden of UNLV, refers to accounting for the value of an asset or liability based on the current market price of the asset or liability, or for similar assets and liabilities, or based on another objectively assessed “fair” value. Fair value accounting has been a part of the U.S. Generally Accepted Accounting Principles (GAAP) since the early 1990s, and has been used increasingly since then.
Mark-to-market accounting can make values on the balance sheet change frequently, as market conditions change. In contrast, book value, based on the original cost/price of an asset or liability, is more stable but can become outdated and inaccurate. Mark-to-market accounting can also become inaccurate if market prices deviate from the “fundamental” values of assets and liabilities because buyers and sellers are unable to collectively and accurately value the future value of income from assets and expenses from liabilities, possibly due to incorrect information or over-optimistic and over-pessimistic expectations.
FAS 115
Accounting for Certain Investments in Debt and Equity Securities (Issued May 1993)
This Statement 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.
* 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 157
Statements of Financial Accounting Standards No. 157, Fair Value Measurements, commonly known as “FAS 157″, is an accounting standard issued in September 2006 by the Financial Accounting Standards Board (FASB) which became effective for entities with fiscal years beginning after November 15, 2007.
FAS Statement 157 includes the following:
* Clarity on 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 key 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.
FAS 157’s fair value hierarchy underpins the concepts of the standard. The hierarchy ranks the quality and reliability of information used to determine fair values, with level 1 inputs being the most reliable and level 3 inputs being the least reliable. Information based on direct observations of transactions (e.g., quoted prices) involving the same assets and liabilities, not assumptions, offers superior reliability; whereas, inputs based on unobservable data or a reporting entity’s own assumptions about the assumptions market participants would use 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.
Problems can arise when the market-based measurement does not accurately reflect the underlying asset’s true value. This can occur when a company is forced to calculate the selling price of these assets or liabilities during unfavorable or volatile times, such as a financial crisis. For example, if the liquidity is low or investors are fearful, the current selling price of a bank’s assets could be much lower than the value under normal liquidity conditions. The result would be a lowered shareholders’ equity. This issue was seen during the financial crisis of 2008/09 where many securities held on banks’ balance sheets could not be valued efficiently as the markets had disappeared from them. In April 2009, however, 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, starting in the first quarter of 2009.
Although FAS 157 does not require fair value to be used on any new classes of assets, it does apply to assets and liabilities that are carried at fair value in accordance with other applicable rules. The accounting rules for which assets and liabilities are held at fair value are complex. Mutual funds and securities firms have carried their assets and some liabilities at fair value for decades in accordance with securities regulations and other accounting guidance. For commercial banks and other types of financial services firms, some asset classes are required to be carried at fair value, such as derivatives and marketable equity securities. For other types of assets, such as loan receivables and debt securities, it depends on whether the assets are held for trading (active buying and selling) or for investment. All trading assets are carried at fair value. Loans and debt securities that are held for investment or to maturity are carried at amortized cost, unless they are deemed to be impaired (in which case, a loss is recognized). However, if they are available for sale or held for sale, they are required to be carried at fair value or the lower of cost or fair value, respectively. (FAS 65 and FAS 114 cover the accounting for loans, and FAS 115 covers the accounting for securities.) Notwithstanding the above, companies are permitted to account for almost any financial instrument at fair value, which they might elect to do in lieu of historical cost accounting (see FAS 159, “The Fair Value Option”).
Thus, FAS 157 applies in the cases above where a company is required or elects to carry an asset or liability at fair value.
The rule requires a 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 a thin market for assets, which trade relatively infrequently – often during an economic crisis. In these periods, 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, but the objective is still the same: what would be the current value in a sale to a willing buyer. In developing its own assumptions, the entity can not ignore any available market data, such as interest rates, default rates, prepayment speeds, etc.
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.
Also new in FAS 157 is the idea of nonperformance risk. FAS 157 requires that in valuing a liability, an entity should consider the nonperformance risk. If FAS 157 simply required that fair value be recorded as an exit price, then nonperformance risk would be extinguished upon exit. However, FAS 157 defines fair value as the price at which you would transfer a liability. In other words, the nonperformance that must be valued should incorporate the correct discount rate for an ongoing contract. An example would be to apply higher discount rate to the future cash flows to account for the credit risk above the stated interest rate. The Basis for Conclusions section has an extensive explanation of what was intended by the original statement with regards to nonperformance risk.
Mark-to-market accounting can make values on the balance sheet change frequently, as market conditions change. In contrast, book value, based on the original cost/price of an asset or liability, is more stable but can become outdated and inaccurate. Mark-to-market accounting can also become inaccurate if market prices deviate from the “fundamental” values of assets and liabilities because buyers and sellers are unable to collectively and accurately value the future value of income from assets and expenses from liabilities, possibly due to incorrect information or over-optimistic and over-pessimistic expectations.
FAS 115
Accounting for Certain Investments in Debt and Equity Securities (Issued May 1993)
This Statement 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.
* 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 157
Statements of Financial Accounting Standards No. 157, Fair Value Measurements, commonly known as “FAS 157″, is an accounting standard issued in September 2006 by the Financial Accounting Standards Board (FASB) which became effective for entities with fiscal years beginning after November 15, 2007.
FAS Statement 157 includes the following:
* Clarity on 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 key 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.
FAS 157’s fair value hierarchy underpins the concepts of the standard. The hierarchy ranks the quality and reliability of information used to determine fair values, with level 1 inputs being the most reliable and level 3 inputs being the least reliable. Information based on direct observations of transactions (e.g., quoted prices) involving the same assets and liabilities, not assumptions, offers superior reliability; whereas, inputs based on unobservable data or a reporting entity’s own assumptions about the assumptions market participants would use 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.
Problems can arise when the market-based measurement does not accurately reflect the underlying asset’s true value. This can occur when a company is forced to calculate the selling price of these assets or liabilities during unfavorable or volatile times, such as a financial crisis. For example, if the liquidity is low or investors are fearful, the current selling price of a bank’s assets could be much lower than the value under normal liquidity conditions. The result would be a lowered shareholders’ equity. This issue was seen during the financial crisis of 2008/09 where many securities held on banks’ balance sheets could not be valued efficiently as the markets had disappeared from them. In April 2009, however, 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, starting in the first quarter of 2009.
Although FAS 157 does not require fair value to be used on any new classes of assets, it does apply to assets and liabilities that are carried at fair value in accordance with other applicable rules. The accounting rules for which assets and liabilities are held at fair value are complex. Mutual funds and securities firms have carried their assets and some liabilities at fair value for decades in accordance with securities regulations and other accounting guidance. For commercial banks and other types of financial services firms, some asset classes are required to be carried at fair value, such as derivatives and marketable equity securities. For other types of assets, such as loan receivables and debt securities, it depends on whether the assets are held for trading (active buying and selling) or for investment. All trading assets are carried at fair value. Loans and debt securities that are held for investment or to maturity are carried at amortized cost, unless they are deemed to be impaired (in which case, a loss is recognized). However, if they are available for sale or held for sale, they are required to be carried at fair value or the lower of cost or fair value, respectively. (FAS 65 and FAS 114 cover the accounting for loans, and FAS 115 covers the accounting for securities.) Notwithstanding the above, companies are permitted to account for almost any financial instrument at fair value, which they might elect to do in lieu of historical cost accounting (see FAS 159, “The Fair Value Option”).
Thus, FAS 157 applies in the cases above where a company is required or elects to carry an asset or liability at fair value.
The rule requires a 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 a thin market for assets, which trade relatively infrequently – often during an economic crisis. In these periods, 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, but the objective is still the same: what would be the current value in a sale to a willing buyer. In developing its own assumptions, the entity can not ignore any available market data, such as interest rates, default rates, prepayment speeds, etc.
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.
Also new in FAS 157 is the idea of nonperformance risk. FAS 157 requires that in valuing a liability, an entity should consider the nonperformance risk. If FAS 157 simply required that fair value be recorded as an exit price, then nonperformance risk would be extinguished upon exit. However, FAS 157 defines fair value as the price at which you would transfer a liability. In other words, the nonperformance that must be valued should incorporate the correct discount rate for an ongoing contract. An example would be to apply higher discount rate to the future cash flows to account for the credit risk above the stated interest rate. The Basis for Conclusions section has an extensive explanation of what was intended by the original statement with regards to nonperformance risk.