The Hindu Business Line : MTM

Not for the first time, accounting has become the whipping horse for a crisis that has engulfed the global financial system. Mark to market (MTM) accounting has been blamed for precipitating the credit crisis by many, and calls for its suspension have been growing in strength over the past few months.

However, before we consider whether MTM accounting should be suspended or reviewed we need to understand what MTM accounting is and whether it is the cause of the financial crisis or merely the messenger reporting its effect.

Not a new concept

MTM accounting, or measuring assets at fair value, is not new. It has been around for a considerable period of time and not all assets are accounted for under MTM. The recent uproar against MTM accounting is based on the fact that such accounting has resulted in institutions reporting huge losses as fair values have dropped, thereby precipitating the credit crisis.

While it is certainly true that MTM accounting has captured the losses incurred by entities in their financial statements, the question remains as to whether MTM accounting caused such losses. The credit crisis is the result of high leverage, complex derivative products, lax regulation and investment decisions to mention but a few.

To state that the accounting is the cause of the credit crisis because it reflects the consequences of such decisions is ignoring the true cause behind the crisis and is akin to shooting the messenger. MTM accounting reflects the investment decisions of banks and financial institutions but does not drive such investment decisions or policies.

SEC study

MTM accounting has captured the economics behind such investment decisions in the financial statements. In a 2008 study on the impact of MTM accounting on the credit crisis, the Securities and Exchange Commission (SEC) of the US concluded that MTM accounting did not lead to any of the bank failures in the US.

It also pointed out categorically that investors prefer MTM accounting as it provides the most relevant information about an entity’s assets at a given point in time. The same view has been corroborated by studies conducted by the FASB and Merrill Lynch as well.

The aim of financial reporting or accounting is to reflect the underlying economics of a transaction in the financial statements. Sound and transparent reporting does have economic consequences as it captures economic reality both when times are good and in times when we are gripped in the throes of an economic meltdown.

The calls for suspension of MTM accounting would to an extent defeat this principle as it will suspend the reporting of economic reality, one of the cornerstone principles of sound financial reporting.

Even if we agree to suspend MTM accounting, the question that is not being asked is: What do we replace it with. Do we go back to cost-based accounting for complex derivative instruments? Cost-based accounting fails to reflect the risks inherent in such instruments and this has been proven time and again. Moreover, investors fail to get meaningful information from financial statements prepared under such an accounting framework. If we are to replace a certain framework, regressing backwards is not the answer.

(The author is Partner, Price Waterhouse.)

We do need to consider what our way forward is going to be if we suspend MTM accounting. It is unlikely anyone would advocate suspending accrual accounting and moving back towards cash accounting. Simple suspension of MTM accounting maybe a short-term solution to a longer term problem.

Far from perfect

Having said this, it must be pointed out that MTM accounting is far from perfect. It is not the panacea for all the problems we face in financial reporting. It works best when markets are efficient, liquid and transparent. It does throw up significant measurement issues when markets are illiquid or distressed, as is the case now.

As an accounting framework it certainly can be improved and our efforts should be focussed on improving MTM accounting instead of suspending the same. Let us not throw out the baby with the bathwater.

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