Continuing uncertainty in the global markets has led some major financial institutions to reconsider how they account for and report certain assets. This week both Morgan Stanley and Goldman Sachs announced that they are considering whether to reduce their use of “mark-to-market” accounting in favor of “historical-cost” accounting. This process, called “asset valuation,” impacts a bank’s ability to meet capital requirements, fund operational spending, and implement lending programs.
Investment banks and commercial banks are subject to different accounting requirements for different assets. As investment banks, Goldman and Morgan were required to price most assets using “fair-value accounting,” currently defined as mark-to-market accounting which requires institutions to price assets on their balance sheets according to the price they could be sold at on the open market—not the price they paid for them. However, to receive emergency federal funds during the subprime crisis, Morgan and Goldman converted to bank-holding companies which are subject to different accounting regulations. Banks are able to record certain assets based on historical-costs which means these assets are reported at their original value or purchase price. In short, Morgan and Goldman now have more flexibility in reporting certain asset values and the use of historical costs could substantially increase asset values.
Mark-to-market accounting became problematic after the 2008 U.S. financial crisis as the market for some securities collapsed and buyers disappeared. Mark-to-market accounting requirements magnified the impact of the crisis by forcing banks to show massive losses on their balance sheets, which reduced their ability to lend since banks are only allowed to lend an amount equal to a certain percentage of the total value of their assets. As a result, many banks were left holding (and still are) billions of dollars worth of toxic assets, which they have to report at very low values ranging from zero to sixty percent of their original price. Thus, some banks argue that the accounting requirements are making an already bad situation worse.
Since 2008, the financial industry has lobbied regulators to ease the mark-to-market requirement, which it argues would bolster their bottom-line, prevent additional bank failures, and help stabilize the economy. In April of 2009, the Financial Accounting Standards Board (FASB) adopted changes to accounting rules to allow banks more discretion in the use of mark-to-market accounting for “distressed” assets. Generally, distressed assets refer to securities that can only be sold by greatly reducing the price or for which there is no market at all. Critics argue that easing mark-to-market requirements allows banks to hide losses and reduces transparency.
Morgan Stanley’s and Goldman Sachs’s decisions to move away from mark-to-market valuations could dramatically affect financial results for both firms. Under historical-cost accounting rules, assets are generally reported at their original value or purchase price, a shift that would increase asset values on the firms’ balance sheets. Given the continued market volatility and sluggish economy, such balance sheet reorganizations will likely be met with a certain degree of skepticism. The accounting shifts could be viewed as an effort to disguise significant losses that belie greater financial concerns, or they may reflect prudent management decisions enabling the banks to recapitalize internally by retaining earnings or increasing capital ratios by reducing losses, which will allow them to loan more money and potentially earn more profits.