Mark-to-market accounting

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Mark-to-market (MTM or M2M) or fair value accounting refers to accounting for the "fair value" of an asset or liability based on the current market price, or the price for similar assets and liabilities, or based on another objectively assessed "fair" value. [1] Fair value accounting has been a part of Generally Accepted Accounting Principles (GAAP) in the United States since the early 1990s, and is now regarded as the "gold standard" in some circles. Failure to use it is viewed as the cause of the Orange County Bankruptcy, [2] [3] even though its use is considered to be one of the reasons for the Enron scandal and the eventual bankruptcy of the company, as well as the closure of the accounting firm Arthur Andersen. [4]

Fair value

In accounting and in most Schools of economic thought, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. It takes into account such objectivity factors as:

In economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics. Market value and market price are equal only under conditions of market efficiency, equilibrium, and rational expectations.

Generally Accepted Accounting Principles (United States) Accounting principles and rules used in the United States

Generally Accepted Accounting Principles is the accounting standard adopted by the U.S. Securities and Exchange Commission (SEC). While the SEC previously stated that it intends to move from U.S. GAAP to the International Financial Reporting Standards (IFRS), the latter differ considerably from GAAP and progress has been slow and uncertain. More recently, the SEC has acknowledged that there is no longer a push to move more U.S companies to IFRS so the two sets of standards will "continue to coexist" for the foreseeable future.

Contents

Mark-to-market accounting can change values on the balance sheet as market conditions change. In contrast, historical cost accounting, based on the past transactions, is simpler, more stable, and easier to perform, but does not represent current market value. It summarizes past transactions instead. Mark-to-market accounting can become volatile if market prices fluctuate greatly or change unpredictably. Buyers and sellers may claim a number of specific instances when this is the case, including inability to value the future income and expenses both accurately and collectively, often due to unreliable information, or over-optimistic or over-pessimistic expectations of cash flow and earnings. [5]

Historical cost

In accounting, an economic item's historical cost is the original nominal monetary value of that item. Historical cost accounting involves reporting assets and liabilities at their historical costs, which are not updated for changes in the items' values. Consequently, the amounts reported for these balance sheet items often differ from their current economic or market values.

History and development

In the 1800s in the U.S. marking to market was the usual practice of bookkeepers. This has been blamed for contributing to the frequent recessions up to the Great Depression and for the collapse of banks. The Securities and Exchange Commission told President Franklin Roosevelt that he should get rid of it, which he did in 1938. [6] But in the 1980s the practice spread to major banks and corporations, and beginning in the 1990s mark-to-market accounting began to result in scandals.

Great Depression 20th-century worldwide economic depression

The Great Depression was a severe worldwide economic depression that took place mostly during the 1930s, beginning in the United States. The timing of the Great Depression varied across nations; in most countries it started in 1929 and lasted until the late 1930s. It was the longest, deepest, and most widespread depression of the 20th century. In the 21st century, the Great Depression is commonly used as an example of how intensely the world's economy can decline.

To understand the original practice, consider that a futures trader, when beginning an account (or "position"), deposits money, termed a "margin", with the exchange. This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if the market price of his contract has decreased, the exchange charges his account that holds the deposited margin. If the balance of this account becomes less than the deposit required to maintain the account, the trader must immediately pay additional margin into the account in order to maintain the account (a "margin call"). (The Chicago Mercantile Exchange, doing even more, marks positions to market twice a day, at 10:00 am and 2:00 pm.) [7]

In finance, margin is collateral that the holder of a financial instrument has to deposit with a counterparty to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:

Chicago Mercantile Exchange Financial and commodity derivative exchange located in Chicago, Illinois, United States

The Chicago Mercantile Exchange (CME) is a global derivatives marketplace based in Chicago and located at 20 S. Wacker Drive. The CME was founded in 1898 as the Chicago Butter and Egg Board, an agricultural commodities exchange. Originally, the exchange was a non-profit organization. The Merc demutualized in November 2000, went public in December 2002, and merged with the Chicago Board of Trade in July 2007 to become a designated contract market of the CME Group Inc., which operates both markets. The Chairman and Chief Executive Officer of CME Group is Terrence A. Duffy, Bryan Durkin is President. On August 18, 2008, shareholders approved a merger with the New York Mercantile Exchange (NYMEX) and COMEX. CME, CBOT, NYMEX and, COMEX are now markets owned by CME Group.

Over-the-counter (OTC) derivatives on the other hand are formula-based financial contracts between buyers and sellers, and are not traded on exchanges, so their market prices are not established by any active, regulated market trading. Market values are, therefore, not objectively determined or available readily (purchasers of derivative contracts are typically furnished with computer programs which compute market values based upon data input from the active markets and the provided formulas). During their early development, OTC derivatives such as interest rate swaps were not marked to market frequently. Deals were monitored on a quarterly or annual basis, when gains or losses would be acknowledged or payments exchanged.

In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a linear IRD and one of the most liquid, benchmark products. It has associations with forward rate agreements (FRAs), and with zero coupon swaps (ZCSs).

As the practice of marking to market became more used by corporations and banks, some of them seem to have discovered that this was a tempting way to commit accounting fraud, especially when the market price could not be determined objectively (because there was no real day-to-day market available or the asset value was derived from other traded commodities, such as crude oil futures), so assets were being "marked to model" in a hypothetical or synthetic manner using estimated valuations derived from financial modeling, and sometimes marked in a manipulative manner to achieve spurious valuations. The most infamous use of mark-to-market in this way was the Enron scandal.

Mark-to-Model refers to the practice of pricing a position or portfolio at prices determined by financial models, in contrast to allowing the market to determine the price. Often the use of models is necessary where a market for the financial product is not available, such as with complex financial instruments. One shortcoming of Mark-to-Model is that it gives an artificial illusion of liquidity, and the actual price of the product depends on the accuracy of the financial models used to estimate the price. On the other hand it is argued that Asset managers and Custodians have a real problem valuing illiquid assets in their portfolios even though many of these assets are perfectly sound and the asset manager has no intention of selling them. Assets should be valued at mark to market prices as required by the Basel rules. However mark to market prices should not be used in isolation, but rather compared to model prices to test their validity. Models should be improved to take into account the greater amount of market data available. New methods and new data are available to help improve models and these should be used. In the end all prices start off from a model.

Financial modeling is the task of building an abstract representation of a real world financial situation. This is a mathematical model designed to represent the performance of a financial asset or portfolio of a business, project, or any other investment.

Enron scandal Energy company bankruptcy and financial scandal

The Enron scandal, publicized in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the de facto dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. In addition to being the largest bankruptcy reorganization in American history at that time, Enron was cited as the biggest audit failure.

After the Enron scandal, changes were made to the mark to market method by the Sarbanes–Oxley Act during 2002. The Act affected mark to market by forcing companies to implement stricter accounting standards. The stricter standards included more explicit financial reporting, stronger internal controls to prevent and identify fraud, and auditor independence. In addition, the Public Company Accounting Oversight Board (PCAOB) was created by the Securities and Exchange Commission (SEC) for the purpose of overseeing audits. The Sarbanes-Oxley Act also implemented harsher penalties for fraud, such as enhanced prison sentences and fines for committing fraud. Although the law was created to restore investor confidence, the cost of implementing the regulations caused many companies to avoid registering on stock exchanges in the United States. [8]

Internal Revenue Code Section 475 contains the mark to market accounting method rule for taxation. Section 475 provides that qualified securities dealers who elect mark to market treatment shall recognize gain or loss as if the property were sold for its fair market value on the last business day of the year, and any gain or loss shall be taken into account for that year. The section also provides that dealers in commodities can elect mark to market treatment for any commodity (or their derivatives) which is actively traded (i.e., for which there is an established financial market that provides a reasonable basis to determine fair market value by disseminating price quotes from broker/dealers or actual prices from recent transactions).

FAS 115

Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, commonly known as "FAS 115", is an accounting standard issued during May 1993 by the Financial Accounting Standards Board (FASB), which became effective for entities with fiscal years beginning after December 15, 1993. [9] [10]

FAS 115 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:

FAS 124

Statement of Financial Accounting Standards No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, commonly known as "FAS 124", is an accounting standard issued during November 1995 by FASB, which became effective for entities with fiscal years beginning after December 15, 1995. [11] [12]

FAS 124 requires that, for investments in equity securities with readily determinable fair values and for all investments in debt securities, a not-for-profit organization must report them at fair value, with gains and losses included in a Statement of Activities. A narrow exception is made to allow limited held-to-maturity accounting for a not-for-profit organization if comparable business entities are engaged in the same industry.

FAS 157 / Accounting Standards Codification Topic 820

Statement of Financial Accounting Standards No. 157, Fair Value Measurements, commonly known as "FAS 157", is an accounting standard issued during September 2006 by FASB, which became effective for entities with fiscal years beginning after November 15, 2007. [13] [14] [15]

FAS Statement 157 includes the following:

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 important 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 owned company the value of which is based on projected cash flows.

Problems can occur when the market-based measurement does not accurately represent 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 less than the value under normal liquidity conditions. The result would be a lowered shareholders' equity. This case occurred 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. During 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 during 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 recorded 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 companies have recorded 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 companies, some asset classes are required to be recorded 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 recorded at fair value. Loans and debt securities that are held for investment or to maturity are recorded 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 recorded 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 record 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 weak market for assets which trade relatively infrequently - often during an economic crisis. During 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 of 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 does not distinguish 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 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 represent the "fair value" of a particular asset. Purchasers of distressed assets should buy undervalued securities, thus increasing prices, 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 (paragraphs C40-C49).

In response to the rapid developments of the financial crisis of 2007–2008, the FASB is fast-tracking the issuance of the proposed FAS 157-d, Determining the Fair Value of a Financial Asset in a Market That Is Not Active. [16]

Under Accounting Standards Codification, FASB's fair value accounting guidance has been codified as Topic 820. [17]

IFRS 13

IFRS 13, Fair Value Measurement, was adopted by the International Accounting Standards Board on May 12, 2011. [18] IFRS 13 provides guidance for how to perform fair value measurement under International Financial Reporting Standards and took effect on January 1, 2013. [18] It does not provide guidance as to when fair value should be used. [19] The guidance is similar to the US GAAP guidance. [18]

Simple example

Example: If an investor owns 10 shares of a stock purchased for $4 per share, and that stock now trades at $6, the "mark-to-market" value of the shares is equal to (10 shares * $6), or $60, whereas the book value might (depending on the accounting principles used) only equal $40.

Similarly, if the stock decreases to $3, the mark-to-market value is $30 and the investor has an unrealized loss of $10 on the original investment.

This can create problems in the following period when the "mark-to-market" (accrual) is reversed. If the market price has changed between the ending period (12/31/prior year) and the opening market price of the following year (1/1/current year), then there is an accrual variance that must be taken into account.

Marking-to-market a derivatives position

In marking-to-market a derivatives account, at pre-determined periodic intervals, each counterparty exchanges the change in the market value of their account in cash. For Over-The-Counter (OTC) derivatives, when one counterparty defaults, the sequence of events that follows is governed by an ISDA contract. When using models to compute the ongoing exposure, FAS 157 requires that the entity consider the default risk ("nonperformance risk") of the counterparty and make a necessary adjustment to its computations.

For exchange traded derivatives, if one of the counterparties defaults in this periodic exchange, that counterparty's account is immediately closed by the exchange and the clearing house is substituted for that counterparty's account. Marking-to-market virtually eliminates credit risk, but it requires the use of monitoring systems that usually only large institutions can afford. [20]

Use by brokers

Stock brokers allow their clients to access credit via margin accounts. These accounts allow clients to borrow funds to buy securities. Therefore, the amount of funds available is more than the value of cash (or equivalents). The credit is provided by charging a rate of interest and requiring a certain amount of collateral, in a similar way that banks provide loans. Even though the value of securities (stocks or other financial instruments such as options) fluctuates in the market, the value of accounts is not computed in real time. Marking-to-market is performed typically at the end of the trading day, and if the account value decreases below a given threshold (typically a ratio predefined by the broker), the broker issues a margin call that requires the client to deposit more funds or liquidate the account.

Effect on subprime crisis and Emergency Economic Stabilization Act of 2008

Former Federal Deposit Insurance Corporation Chair William Isaac placed much of the blame for the subprime mortgage crisis on the Securities and Exchange Commission and its fair-value accounting rules, especially the requirement for banks to mark their assets to market, particularly mortgage-backed securities (MBS). [21] A review found little evidence that fair-value accounting had caused or exacerbated the crisis. [22]

The debate occurs because this accounting rule requires companies to adjust the value of marketable securities (such as the MBS) to their market value. The intent of the standard is to help investors understand the value of these assets at a specific time, rather than just their historical purchase price. Because the market for these assets is distressed, it is difficult to sell many MBS at other than prices which may (or may not) be representative of market stresses, which may be less than the value that the mortgage cash flow related to the MBS would merit. As initially interpreted by companies and their auditors, the typically lesser sale value was used as the market value rather than the cash flow value. Many large financial institutions recognized significant losses during 2007 and 2008 as a result of marking-down MBS asset prices to market value.

For some institutions, this also triggered a margin call, such that lenders that had provided the funds using the MBS as collateral had contractual rights to get their money back. [23] This resulted in further forced sales of MBS and emergency efforts to obtain cash (liquidity) to pay off the margin call. Markdowns may also reduce the value of bank regulatory capital, requiring additional capital raising and creating uncertainty regarding the health of the bank. [24]

It is the combination of the extensive use of financial leverage (i.e., borrowing to invest, leaving limited funds in the event of recession), margin calls and large reported losses that may have exacerbated the crisis. [25] If cash flow-derived value — which excludes market judgment as to default risk but may also more accurately represent "actual" value if the market is sufficiently distressed — is used (rather than sale value), the size of market-value adjustments required by the accounting standard would be typically reduced.

On September 30, 2008, the SEC and the FASB issued a joint clarification regarding the implementation of fair value accounting in cases where a market is disorderly or inactive. This guidance clarified that forced liquidations are not indicative of fair value, as this is not an "orderly" transaction. Further, it clarifies that estimates of fair value can be made using the expected cash flows from such instruments, provided that the estimates represent adjustments that a willing buyer would make, such as adjustments for default and liquidity risks. [26]

Section 132 of the Emergency Economic Stabilization Act of 2008, which passed on October 3, 2008, restated the SEC's authority to suspend the application of FAS 157, and Section 133 required a report by the SEC which was delivered December 30, 2008. [27]

On October 10, 2008, the FASB issued further guidance to provide an example of how to estimate fair value in cases where the market for that asset is not active at a reporting date. [28]

On December 30, 2008, the SEC issued its report under Sec. 133 and decided not to suspend mark-to-market accounting. [29]

On March 16, 2009, FASB proposed allowing companies to use more leeway in valuing their assets under "mark-to-market" accounting. On April 2, 2009, after a 15-day public comment period and a contentious testimony before the U.S. House Financial Services subcommittee, FASB eased the mark-to-market rules through the release of three FASB Staff Positions (FSPs). [30] Financial institutions are still required by the rules to mark transactions to market prices but more so in a steady market and less so when the market is inactive. To proponents of the rules, this eliminates the unnecessary "positive feedback loop" that can result in a weakened economy. [31]

On April 9, 2009, FASB issued an official update to FAS 157 [32] that eases the mark-to-market rules when the market is unsteady or inactive. Early adopters were allowed to apply the ruling as of March 15, 2009, and the rest as of June 15, 2009. It was anticipated that these changes could significantly increase banks' statements of earnings and allow them to defer reporting losses. [33] The changes, however, affected accounting standards applicable to a broad range of derivatives, not just banks holding mortgage-backed securities.

During January 2010, Adair Turner, Chairman of the UK's Financial Services Authority, said that marking to market had been a cause of exaggerated bankers' bonuses. This is because it produces a self-reinforcing cycle during an increasing market that feeds into banks' profit estimates. [34] Other academics, such as S.P. Kothari and Karthik Ramanna, have made similar arguments. [35] [36]

See also

Related Research Articles

Derivative (finance) financial instrument whose value is based on one or more underlying assets

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the New York Stock Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being stocks and debt. The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange. Bucket shops, outlawed a century ago, are a more recent historical example.

Financial Accounting Standards Board

The Financial Accounting Standards Board (FASB) is a private, non-profit organization standard-setting body whose primary purpose is to establish and improve Generally Accepted Accounting Principles (GAAP) within the United States in the public's interest. The Securities and Exchange Commission (SEC) designated the FASB as the organization responsible for setting accounting standards for public companies in the US. The FASB replaced the American Institute of Certified Public Accountants' (AICPA) Accounting Principles Board (APB) on July 1, 1973.

In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the (former) derivative depend on the value of this underlying. There must be an independent way to observe this value to avoid conflicts of interest.

Accumulated other comprehensive income

Note: Reference cited below, FAS130, remains the most current accounting literature in the United States on this topic.

Accounting for leases in the United States

Accounting for leases in the United States is regulated by the Financial Accounting Standards Board (FASB) by the Financial Accounting Standards Number 13, now known as Accounting Standards Codification Topic 840. These standards were effective as of January 1, 1977. The FASB completed in February 2016 a revision of the lease accounting standard, referred to as ASC 842.

FIN 46, Consolidation of Variable Interest Entities, was an interpretation of United States Generally Accepted Accounting Principles published by the US Financial Accounting Standards Board (FASB) that made it more difficult to remove assets and liabilities from a company's balance sheet if the company retained an economic exposure to the assets and liabilities. One of the main reasons FIN 46 was issued as an interpretation instead of an accounting standard was to issue the standard in a relatively short period of time in response to the Enron scandal.

Stock option expensing is a method of accounting for the value of share options, distributed as incentives to employees, within the profit and loss reporting of a listed business. On the income statement, balance sheet, and cash flow statement say that the loss from the exercise is accounted for by noting the difference between the market price of the shares and the cash received, the exercise price, for issuing those shares through the option.

Goodwill (accounting) accounting

Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business. Goodwill represents assets that are not separately identifiable. Goodwill does not include identifiable assets that are capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability regardless of whether the entity intends to do so. Goodwill also include contractual or other legal rights regardless of whether those are transferable or separable from the entity or other rights and obligations. Examples of identifiable assets that are goodwill include a company’s brand name, customer relationships, artistic intangible assets, and any patents or proprietary technology. The goodwill amounts to the excess of the "purchase consideration" over the total value of the assets and liabilities. It is classified as an intangible asset on the balance sheet, since it can neither be seen nor touched. Under US GAAP and IFRS, goodwill is never amortized. Instead, management is responsible for valuing goodwill every year and to determine if an impairment is required. If the fair market value goes below historical cost, an impairment must be recorded to bring it down to its fair market value. However, an increase in the fair market value would not be accounted for in the financial statements. Private companies in the United States, however, may elect to amortize goodwill over a period of ten years or less under an accounting alternative from the Private Company Council of the FASB.

Hedge accounting

Hedge accounting is an accountancy practice, the aim of which is to provide an offset to the mark-to-market movement of the derivative in the profit and loss account. There are two types of hedge recognized. For a fair value hedge, the offset is achieved either by marking-to-market an asset or a liability which offsets the P&L movement of the derivative. For a cash flow hedge, some of the derivative volatility is placed into a separate component of the entity's equity called the cash flow hedge reserve. Where a hedge relationship is effective, most of the mark-to-market derivative volatility will be offset in the profit and loss account. Hedge accounting entails much compliance - involving documenting the hedge relationship and both prospectively and retrospectively proving that the hedge relationship is effective.

Launched prior to the millennium, FAS 133 Accounting for Derivative Instruments and Hedging Activities provided an "integrated accounting framework for derivative instruments and hedging activities."

A foreign exchange hedge is a method used by companies to eliminate or "hedge" their foreign exchange risk resulting from transactions in foreign currencies. This is done using either the cash flow hedge or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles as well as other national accounting standards.

Purchase price allocation purchase price allocation

Purchase price allocation (PPA) is an application of goodwill accounting whereby one company, when purchasing a second company, allocates the purchase price into various assets and liabilities acquired from the transaction.

IAS 39

IAS 39: Financial Instruments: Recognition and Measurement was an international accounting standard which outlined the requirements for the recognition and measurement of financial assets, financial liabilities, and some contracts to buy or sell non-financial items. It was released by the International Accounting Standards Board (IASB) in 2003, and was replaced in 2014 by IFRS 9, which became effective in 2018.

In September 2006, the Financial Accounting Standards Board (FASB) of the United States issued Statement of Financial Accounting Standards 157: Fair Value Measurements), which “defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.” This statement is effective for financial reporting fiscal periods commencing after November 15, 2007 and the interim periods applicable.

International Financial Reporting Standards requirements

This article lists some of the important requirements of International Financial Reporting Standards (IFRS).

Fair value accounting and the subprime mortgage crisis

The role of fair value accounting in the subprime mortgage crisis of 2008 is controversial. Fair value accounting was issued as US accounting standard SFAS 157 in 2006 by the privately run Financial Accounting Standards Board (FASB)—delegated by the SEC with the task of establishing financial reporting standards. This required that tradable assets such as mortgage securities be valued according to their current market value rather than their historic cost or some future expected value. When the market for such securities became volatile and collapsed, the resulting loss of value had a major financial effect upon the institutions holding them even if they had no immediate plans to sell them.

There were many events that led to the financial crisis of the late 2000s, and many differing views on which parties were primarily responsible. The main groups that have been identified for playing a major role in the crisis include: investment bankers, credit rating agencies, financial statement preparers, the Federal Reserve, investors, loan originators, auditors, and borrowers among others. For a detailed background on the causes of the crisis and the parties that contributed please reference:Causes of the 2007-2012 global financial crisis and “History of Fair Value Issues” The purpose of this article is to expand on the role that accountants specifically played within the late 2000s financial crisis.

IFRS 9

IFRS 9 is an International Financial Reporting Standard (IFRS) published by the International Accounting Standards Board (IASB). It addresses the accounting for financial instruments. It contains three main topics: classification and measurement of financial instruments, impairment of financial assets and hedge accounting. The standard came into force on 1 January 2018, replacing the earlier IFRS for financial instruments, IAS 39.

References

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  14. Financial Accounting Standards Board, "Statement of Financial Accounting Standards No. 157" Retrieved August 23, 2014.
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  16. FASB News Center
  17. "Accounting Standards Codification Topic 820: Fair Value Measurement". FASB . Retrieved June 14, 2014.
  18. 1 2 3 "IFRS 13 Fair Value Measurement: What does this mean for valuation?" (PDF). Duff & Phelps. Archived from the original (PDF) on April 18, 2013. Retrieved August 9, 2012.
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  22. Example of a margin call
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  26. Report to Congress on Mark-to-Market Accounting. SEC.
  27. FASB Clarifications
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  30. FASB Eases Mark-to-Market Rules, Wall Street Journal, April 3, 2009. Retrieved January 25, 2010.
  31. FAS 157-4 Status
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  34. https://dspace.mit.edu/openaccess-disseminate/1721.1/75267
  35. http://cmr.berkeley.edu/search/articleDetail.aspx?article=5779