Mark to Market Accounting

You may have heard about mark to market accounting, also known as fair value accounting, but did you know that this accounting theory has contributed to the economic crisis and can lead to professional liability insurance losses?  Unfortunately, this particular accounting technicality, FAS 157, may have contributed - some say caused - the credit crisis, and may lead to more litigation.  These claims are starting to make the rounds in professional commentary and on blog posts.

Mark to market, or fair value, accounting is the new standard for GAAP accounting contained in FAS 157.  I have put some links on this subject below.  An excellent article from Duane Morris (see here) outlines some of the issues relating to causes and potential litigation from the application of FAS 157.  Additional articles are available here, here, here and here.

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.

Fair value accounting sounds great in theory, but it creates some very significant and real problems in reality.  FAS 157 requires asset values on balance sheets be adjusted to reflect the current market values.  For example, a bank is required to write down a loan on an asset where the value of the asset has fallen below the loan amount regardless of whether the loan is performing.  In times like these, when asset value are falling, FAS 157 requires massive write downs on loan portfolios even if they are performing.  These write-downs create a real loss of GAAP capital, and can impair the financial strength of the institution with the technically impaired assets.

Take another example.  A venture capital firm invests in a new technology company that is expected to take a number of years to get to profitability (ie it is burning cash as it develops the technology).  The VC firm must make a market-based estimate each year, and sometimes more frequently, of the market value of its investment.  Typically, the market value of early stage companies would be zero (0), even though the investment might be performing exactly as expected.  [Note that this example assumes no interim rounds with outside investors that would set a market price.]  So the VC firm must, according to FAS 157, write the value down to zero (0) early in the process.  That might be okay for the VC firm if everyone understands what is going on, but it does not reflect long-term economic reality.

Now, some are anticipating that the fair value, or mark to market, valuation approach will add volatility to reporting company financial statements, and that this will lead to increased litigation against directors and officers, accountants and other professionals.  Obviously, increased litigation will drive up the costs of professional liability insurance.

If significant restatement activity results from increased levels of scrutiny, legal implications can be anticipated, as history has shown during other periods of financial results restatement activity. This could result in additional litigation through shareholder lawsuits.

It is too soon to tell whether the increased litigation, and increased professional liability insurance pricing, are coming.  But the controversy around FAS 157 continues.

Info & Articles on FAS 157:

FAS 157
Private Equity Guidelines
PE Blog Post – Fair Valuation
VC Valuation Committees
VC Perspective on 157
General Commentary on 157
General Commentary on 157
General Commentary on 157
VC Perspective on 157
Tuck School Valuation Survey
Tuck School Valuation Article

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