Mark-to-Market Accounting Moves to Center Stage

FAS 157, the FASB rule which determines how financial institutions evaluate the value of their financial assets on their balance sheets has been brewing as a hot topic for a while and today moved to center stage based on a meeting of the Financial Standards Accounting Board which relaxed some of the guidelines on how this rule can be applied in the illiquid credit markets that we are now operating in now.

Essentially, FAS 157 indicates how companies should mark their assets to a fair value based on market conditions, which under normal & deep and liquid markets is based on recent transactions, exit prices, and reasonably known standards.

However, when liquidity dries up, counterparties fail and no recent transactions are available, companies are forced to write these assets down to very low values to comply with the strict guidelines of FAS 157. Banks with complex financial assets have been most affected by this and the enormous billions of dollars of writedowns are largely driven by FAS 157 mark to market accounting.

In fact, some like prior FDIC chairman William Isaac have blamed FAS 157 for incorrectly portraying values of bank balance sheets and asked for a holiday period from mark to market guidelines till credit markets return back to health. Others, such as Arthur Levitt, former SEC Chairman have been in full favor of FAS 157.

Today’s FASB meeting relaxations include allowing entities to determine fair value taking into account circumstances and evidence, especially in distressed situations to provide the best translation to an “orderly process”. In addition, FASB allowed companies to take advantage of this in Q2-2009, with some freedom to start this as early as Q1-2009. Banks stocks, which stand to benefit the most soared today 5%+ on this news.
What is FAS 157? Essentially, it is a set of guidelines which companies have to follow to value their assets at fair value, with fair value being determined by the market, rather than the subjective evaluation of the company. We point you to the following for some excellent explanations on this complex topic:

http://en.wikipedia.org/wiki/Mark-to-market_accounting
http://www.fasb.org/st/summary/stsum157.shtml
http://blogs.wsj.com/marketbeat/2007/11/15/a-fas-157-primer/

When complex accounting becomes the hot topic, Big4 firms would not be far behind, expect to hear more from the Big Four firms as this subject moves ahead.