Mark to Market Accounting Rules Update

One of the key issues that arose from the sub-prime mortgage crisis was the issue of mark to market accounting, specifically how mortgage-backed securities which are on a bank’s balance sheet should be valued.  In the past couple of years there has been an ongoing dispute between the Financial Accounting Standards Board (FASB) and banks in regards to this issue.  In May 2010, FASB proposed that banks value loans using market prices rather than historical cost.  The banks adamantly opposed this proposal since they felt that reporting loans at fair market value could cause significant spikes in the volatility of their earnings results each financial period.

For now however, this battle seems to be over.  Last week, FASB decided to allow banks to continue to be able to report loan values at amortized cost with a reserve for possible losses.  The amount of the reserve is up to the judgment of the banks, and leaves room for interpretation at the bank’s discretion.  However, FASB is still debating where the fair market value of these loans should be disclosed.  Currently, banks are required to disclose the fair market value of loans only in the footnotes, and FASB is debating whether banks should disclose this information in the balance sheet as well.  While this proposed balance sheet disclosure would not change the value of the banks’ assets, it would make the market value of the loans more visible to investors.

Had FASB’s original “fair market value” approach been passed, the consequences could have been significant for banks. In periods of economic crisis or during temporary downturns, banks would be forced to significantly write-down loan assets. These write-downs would result in significant losses and reduced net income and ultimately, reduced retained earnings and shareholder equity.

While this decision more closely aligns US accounting practices with those sanctioned by International Financial Reporting Standards (IFRS), many feel that FASB’s concession to the banks’ demands demonstrates that FASB is transforming into an organization that gives into public pressure rather than an organization set out to ensure that the proper information is being disclosed to investors. It should also be noted that one of the proposed legislation’s strongest allies, former FASB Chairman Robert Hertz, stepped down in August.