Till some years back, financial sta-tements revolved around historical costs, slightly mo-dified when fixed assets were revalued or when the market value of current investme-nts went lower than their cost. However, several bankruptcies in the West in the mid-to-late nineties drew a consensus among Accounting Standard (AS) setters that financial statements must also reflect changing market conditions.

Theoretically, the present value of estimated future cash flows is implicit in all market prices, including the historical cost recorded when an entity purchases an asset for cash. Certain items, especially financial assets and liabilities, should be measured at observable marketplace-determined amounts because these ?mark to market? (MTM) amounts, generally, are more reliable than measurements that must employ estimates of future cash flows. When observable amounts are not available, entities turn to different techniques to determine a fair value at which willing parties will transact.

Under the US GAAP, fair value measurement assumes that asset or liability is exchanged in an orderly transaction between market participants to hypothetically sell the asset or transfer the liability at the measurement date and is not a forced liquidation or distress sale. The objective of a fair value measurement is to determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date.

This gives rise to a lot of subjectivity and complications. When there are items with no clear and liquid markets, what exactly constitutes market price becomes less clear and values of financial assets and liabilities are MTM using subjective and complex adjustments to the observable market values. To prevent abuse, US GAAP has established a framework to classify fair value estimates into different levels depending on the level of subjectivity involved.

MTM accounting rules have been around for a few years, but their true impact was felt starting with the West?s subprime crisis, which has amplified criticisms that MTM accounting causes greater volatility in financial statements, uses highly subjective valuation models and so on. Besides, MTM accounting reflects the current market sentiments. When market sentiment is high, entities report gains and vice-versa. This is where MTM accounting practices have most impacted investment and commercial banks.

When the underlying real estate prices in the US fell in value, and borrowers began defaulting on their mortgages, mor-tgage-backed securities started falling in value and the issuers of these securities were required to top-up the margin. Valuing mortgage backed securities and calculating appropriate MTM margins for privately traded securities is extremely subjective in a scenario with sharply declining prices of underlying assets. So entities could not price these securities appropriately and had to take significant write-offs on their books. The MTM values, at which the securities were held, did not represent the values at which trades would take place in the market. Although some may argue that the MTM losses are notional, for banks these losses erode capital, resulting in their having to either raise new capital or shed assets very quickly, further fueling asset price decline.

To address the current extraordinary situation, major AS bodies are providing guidance on how assets are to be MTM in an inactive market. Under the recently enacted US Emergency Economic Stabilisation Act, the US Securities and Exchange Commission has commenced a study of MTM accounting and is expected to submit its report to the US Congress by 2 January 2009.

Irrespective of the results of this study, financial statements should present a conservative, consistent and realistic report of operations, financial condition, cash flow and contingent liabilities. Accounting principles should not be used to hide bad assets and poor management decisions.

?The author is director, Ernst & Young India Pvt Ltd. These are his personal views