Mark-to-market accounting

Mark-to-market accounting (also called fair value accounting) is a type of accounting contrasted with "book value accounting." In book value accounting, an asset's value is listed at the price for which it was bought. In mark-to-market, an asset's value is set by the current market value (making it similar to the "blue book value"). So if I want to buy widget x from you, and you bought that widget at $30, that would be the book value. However, widget x is currently worth $5 according to market trends, so I ask to purchase it at the mark-to-market price.

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Some assets, like futures and complex financial derivatives, are inherently difficult to price, especially because many have their value in future earnings rather than current value. A type of accounting related to mark-to-market that can be used to price these assets is called "mark-to-model." This type of accounting uses financial models to forecast the future value of an asset.

Mark-to-market accounting has an obvious advantage over book value in many cases, however, it can be unreliable and is easily exploited for the purposes of accounting fraud. If prices for some assets become artificially inflated, it can push up the mark-to-market value of the asset class as a whole where no real value is gained. This is what is meant when prices become detached from "the fundamentals." Complex financial derivatives are not always traded on an open market, which easily allows for mark-to-market values to be gamed by crooked (or simply incompetent) accountants. (This also depends on the derivative and where it's traded — the UK, for example, has fairly strict regulations on this sort of trading, while the US has recently set up a derivatives "clearinghouse" as a result of the recent financial reform to monitor derivative trading.) Mark-to-model is especially easily abused (or screwed up by incompetents) by plugging faulty assumptions into the models in order to artificially inflate the values of derivatives and stock in what's called a pump and dump scheme.

Enron was a big fan of mark-to-market and mark-to-model, which it abused wholesale in order to keep its stock prices up and the executive bonuses rolling in. Enron, its accounting firm Arthur Anderson, and a number of other firms won the 2002 Ig Nobel Prize for "adapting the mathematical concept of imaginary numbers for use in the business world".[1] Mark-to-market and mark-to-model accounting were also widely used by banks and credit agencies during the housing bubble. As a result, the Securities Exchange Commission has been granted greater oversight of mark-to-market accounting practices. According to one Janet Tavakoli, head of a Chicago-based consulting firm, "'Mark-to-model' is a joke."[2] Warren Buffett called it "mark-to-myth".[3]

References
  1. 2002 Ig Nobels
  2. Can Wall Street Be Trusted to Value Risky CDOs? The answer is now obvious.
  3. Warren Buffett on derivatives.
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