The Dangers of Accounting By JT Martin and Scott Roberts

Market to market accounting, or fair value accounting, values an asset at its current price level. In other words, if a company sold the asset today, the price it’s sold for would be its fair market value. Seems pretty straightforward, right? While this method offers some transparent advantages, it also offers some less visible dangers that have been taken advantage of countless times in the past. In this article, we will explore both sides of this accounting method, and some examples of how it can be misused.

One advantage of using market to market accounting is that it gives investors an accurate depiction of a company's value. Market to market accounting allows investors to observe if a company's assets are depreciating or appreciating, and consequently, whether the company is overvalued or undervalued.[1] For example, when oil prices drop, oil companies can deceptively use historical accounting to value the oil at its original price, and therefore hide the decline in their overall value.[2] Market to market accounting would illuminate this decline in value and be more informative to investors.

On the other hand, market to market accounting can be catastrophic when it comes to market collapses. During a crisis, market to market accounting makes it seem as though businesses have gone completely bankrupt when that's not actually the case.[3] For instance, market to market accounting caused many banks to file for bankruptcy in a domino effect, intensifying the devastation of the great depression.[4]

One of the most public examples of the dangers of market to market accounting was seen in the Enron scandal of 2001. Under market to market accounting, Enron was allowed to list their profits as projections on their books, rather than the actual profits, which they did very favorably in order to increase the perceived value of Enron. Eventually, Enron could not continue to hide their losses and missed projections in their actual cash flows. Many point to the implementation of market to market accounting as one of the main reasons the Enron scandal occurred and cost Enron creditors billions of dollars and led to one of the biggest companies in the country going bankrupt[5].

Market to market accounting had a role again in the financial crisis of 2008. This was present in the valuation of Mortgage Back Securities on banks’ balance sheets that were shown as assets but whose values had dropped dramatically and put the firms at risk of defaulting. Despite the apparent risks and disadvantages shown in market to market accounting, the Financial Accounting Standards Board decided in 2009 that they allowed for the valuation of assets to be done based on a price from an orderly market rather than the forced liquidation that was occuring in 2009[6].

Market to market accounting has both its upsides and downsides, as it clearly has been shown that it can be used unethically and taken advantage of in order to prevent losses or present a false perception of a firm’s value. However, the idea of market to market accounting is extremely valuable especially to investors, this is because the value of all things change over time and market to market accounting is the only way of reflecting the current value of a company’s value in the current moment.

[1] Toby Mathis, “What is Market to Market Accounting”, Anderson Investing, December 24, 2020, https://andersonadvisors.com/mark-to-market/ [2] Kimberly Amadeo, “Market to Market Accounting”, The Balance, January 22, 2021, thebalance.com/mark-to-market-accounting-how-it-works-3305942#pros-and-cons [3] Toby Mathis, “What is Market to Market Accounting”, Anderson Investing, December 24, 2020, https://andersonadvisors.com/mark-to-market/ [4] Kimberly Amadeo, “Market to Market Accounting”, The Balance, January 22, 2021, thebalance.com/mark-to-market-accounting-how-it-works-3305942#pros-and-cons [5] “Enron Scandal,” Corporate Finance Institute, May 12, 2020 https://corporatefinanceinstitute.com/resources/knowledge/other/enron-scandal/ [6] Alicia Tuoliva, “Mark to Market,” Investopedia, March 7, 2021, https://www.investopedia.com/terms/m/marktomarket.asp