Gregory v. Helvering & the Old Roots of Modern Financial Duplicity

Stock Shares Financial Accounting Tax Income Dividend

Creative Finance

I know we promised that the last article would be the final installment of Huddleston Tax Weekly before the return of our XVI Amendment series. Surprisingly, we fibbed a bit. We’d like to sneak in just one more – and now we really promise, just one more – article prior to our return to that series. If this frustrates you, that’s understandable, but hopefully whatever frustration comes to the surface will immediately dissolve after you know what topic to which this article will be devoted: the important case of Gregory v. Helvering (1935). Though not the most well-known financial case, this Great Depression-era piece of litigation is fascinating for a number of reasons. Perhaps the most notable reason for its appeal is its relevance to more modern financial scandals.

In 2017, we have become accustomed to seeing all sorts of financial scandals. Some of these scandals, like the Enron scandal, can be very elaborate and involve complex accounting fraud, insider trading and other kinds of high-brainpower underhandedness. Every trend, no matter its size or significance, can be traced to a single source, and the case of Gregory v. Helvering stands as a legitimate candidate for the forerunner to much of the financial trickery present in recent decades. And this is not necessarily because the taxpayer in Gregory v. Helvering aimed to abuse the law in a nefarious way; the facts of the case, as they’ve come down to us, do not allow for such a conclusion. But in this case we do see an attempt to transact in such a manner that the form of the law is obeyed but its spirit is ignored. And this creative maneuvering is something that we see again and again in the modern era.

Let’s look at the details of this case to get a better sense of why it foreshadows many recent financial scandals.

Facts

The taxpayer owned a company – United Mortgage Corporation – and this company held 1000 shares of another company’s stock (Monitor Securities Corporation). The taxpayer wished to sell this stock but also wished to minimize (or ideally eliminate) the potential tax liability of such a sale. Toward this end, the taxpayer established a new company, Averill Corporation, and then transferred the 1000 shares of Monitor to Averill. The taxpayer then transferred the 1000 shares of Monitor to herself, and then quickly dissolved Averill. The Averill entity clearly had no other function aside from acting as a conduit through which to distribute the shares to the taxpayer. The taxpayer contended that the series of actions which occurred fell under section 112 of the Revenue Act of 1928 as a corporate “reorganization.” If what occurred were in fact reorganization under section 112, the gain realized by the taxpayer would not be taxable.

Law

The relevant subsections of 112 were (g) and (i). Subsection (g) stated that distributions of stock on reorganization to a shareholder in a corporation which was a party to the reorganization will not result in gain (to the receiving shareholder). Subsection (i) lays out a definition of reorganization.

Ruling

The court (Supreme Court of the U.S.) ruled that a legitimate reorganization had not occurred and that the deficiency assessed by the IRS was correct. Even though the taxpayer had apparently satisfied every element of section 112, the court reasoned that section 112 did not apply because the Averill Corporation was clearly a “dummy company” in the sense that it served no other purpose than to eliminate the tax liability which would have normally followed the stock distribution. Hence, though the taxpayer took steps to fall under section 112, what had actually occurred was a dividend, because there was no substance underlying the creation of the Averill Corporation.

What we have here, therefore, is a fascinating early example of creative business maneuvering. The taxpayer either received expert counsel on section 112, or was familiar with section 112 by way of independent research, and the taxpayer established the dummy company for the specific purpose of falling within the meaning of this statute. And even though the steps taken by the taxpayer would seemingly bring the transaction under section 112, the court was not willing to let this type of trickery slide under the judicial radar. In some ways, Gregory v. Helvering represents the embryonic form of more heinous modern trickery, such as the kind perpetrated by Enron’s CFO, Andrew Fastow.

Although what happened here is dwarfed by comparison to modern scenarios, it’s still interesting to see the roots of what goes on around us today.

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Source

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Kornfeld v. Commissioner and the Step Transaction Doctrine

Step Transaction Doctrine Legal Theory Tax Deduction

The Step Transaction Doctrine

We will look at one more case before returning to our article series on the sixteenth amendment. This is a case every HTW reader should become very well acquainted with: Kornfeld v. Commissioner (1998). Though it’s primarily an income tax case, it contains a plethora of other important topics and subtopics, and it presents a message which every HTW reader should commit to memory.

In the past, we’ve learned that whether a transaction be taxable is dependent on its substance, and that courts apply the “substance over form” doctrine to determine the true nature of a business transaction. The substance over form doctrine is not the only tool utilized by courts to review a transaction, however; the so-called “step transaction doctrine” is another tool commonly used by courts to clarify the nature of a transaction for tax purposes. Under the step transaction doctrine, multiple “steps” may be classed together and regarded as a single transaction; in this way, steps which may have been taken simply for the specific goal of altering tax liability can be overturned. The step transaction doctrine does not exist to create tax liabilities where none should exist, but to assess tax liability properly by viewing a transaction with the greatest level of accuracy.

In other words, the step transaction doctrine imposes a sort of coherence to a multistep transaction so that it can be properly adjudicated. This is very common in law: legal theories often condense or codify reality so that it can be interpreted using preexisting categories. But the rationale for theories such as the step transaction doctrine is not only about simplicity; there is also the aim of viewing a matter according to its true nature. Even though the step transaction doctrine may “condense” things for the sake of simplicity, many contend that this theory (and other similar theories) portrays matters in a more accurate way, that it provides a clearer sense of what actually occurred. Let’s look at the details of the Kornfeld case to get a better sense of this doctrine and its rationale.

Facts

The facts of this case are a bit complicated. Kornfeld, a highly experienced tax attorney, established a revocable trust which he intended to use to purchase bonds. He entered into an agreement with his daughters in order to claim an amortization deduction on the bonds; the agreement was that Kornfeld would transfer funds (from the trust) to the bond issuing institution equal to the value of a life estate in the bonds and then the daughters would pay the balance on the bonds. The agreement also held that Kornfeld would deliver checks to the daughters for the exact amount which they paid to cover the balance.

Kornfeld and his daughters executed this initial agreement and Kornfeld obtained the bonds. Subsequently, the tax code was changed so that the amortization deduction sought by Kornfeld was made unavailable in situations involving related parties. In response, Kornfeld and his daughters made another agreement which included Kornfeld’s secretary; the second agreement held that the daughters would take a second life estate interest in the bonds following Kornfeld’s death, and that the secretary would have the final remainder interest upon the death of the daughters. Importantly, Kornfeld used IRS valuation tables to create his estimates for the value of his life estate interest. Kornfeld claimed amortization deductions on the bonds and then the IRS assessed a deficiency after they declared that the transaction had failed to produce a genuine life estate in the bonds.

Law

Under U.S. code – specifically section 167 – taxpayers may claim a depreciation deduction of a reasonable amount based on wear and tear for property held primarily for the production of income (such as a bond). IRC subsection 167(d) pertains to life tenants and beneficiaries of trusts. Under these rules, life estate interests in bonds – or “term interests” or limited interests – are considered amortizable (or depreciable) and thus taxpayers may claim a deduction for such an interest. Also see 26 CFR 1.167(a)-1.

Ruling

Applying the step transaction doctrine, the court rejected the argument made by Kornfeld that the payments made to his daughters (and secretary) had no real connection to the bond transaction, and that a genuine life estate interest had been created for tax purposes. The court based its decision on the fact that the seemingly disparate actions of the case were patently interdependent and all served to produce a single, underlying purpose. Kornfeld thought that he had devised a near foolproof scheme to completely avoid any tax liability on the bond transaction, but the court realized that a genuine limited interest had not been created and that Kornfeld had acquired total ownership of the bonds.

The Kornfeld case is a prime example of the step transaction doctrine at work. All HTW readers need to be aware of how the step transaction can affect their tax liabilities; if you aim to acquire a particular kind of tax treatment, you need to understand that your actions preceding any given transaction, as well as your actions which occur after a given transaction, can impact the tax treatment you ultimately receive. In the future – after a few more installments on the sixteenth amendment – we will look at a few more examples of how the step transaction doctrine has been used to alter the tax classification of a series of events.

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A Note on the Capital Gains Tax

Capital Gains Tax Rate Money Funds

Capital Gains

As the previous installment of Huddleston Tax Weekly made clear, our tax code draws a distinction between ordinary income and capital gains. In general, ordinary income is income derived throughout the course of running a business or trade; capital gains result from the sale of a “capital asset” (which is defined by the code). It is important for people to understand how their behavior will be classified because these classifications carry particular tax implications. In conjunction with criteria from the tax code, our common law also provides additional guidelines for classifying a given source of income.

The capital gains tax has long been the focus of controversy: many argue that its current low rate disproportionately benefits wealthy citizens and that it should be increased, while others contend that a lower rate actually stimulates more economic growth and that such growth benefits citizens of all socioeconomic levels. The evidence in favor of the latter position is considerable and should strike most objective observers as persuasive. The capital gains tax rate has fluctuated widely over the past several decades, and there is an unmistakable positive correlation between low rates and greater revenues generated from capital gains. This association may appear counterintuitive upon first glance, but a bit more scrutiny makes it very easy to understand: when the tax rate is high, people simply hold on to their assets and avoid paying the tax at a high rate; when the rate is low, people sell more frequently and this results in greater total revenues for the government.

Low rates also appear to influence stock market prices. The tax cuts in the 1980s, the late 1990s, and in 2003 all coincided with significant stock market gains. What’s more, there is also an association between reduced rates and business development as measured by initial public offerings (IPOs), money raised from IPOs and the money committed to venture capital firms. Investors are less willing to commit funds when capital gains tax rates are high; this agrees with common sense given that higher rates will result in smaller returns on investment.

Though lower capital gains tax rates do appear to provide greater benefits to the economy as a whole, there is no denying that such rates disproportionately benefit higher income levels. The clear majority of gains from capital asset sales are made by those with incomes above $200,000. Going forward, it appears that the debate on capital gains tax rates will be framed by this question: can our society accept the positive impact of lower rates even though lower rates tend to benefit wealthy individuals disproportionately?

References

Moore, Stephen. “Capital Gains Taxes.” David R. Henderson (ed.). Concise Encyclopedia of Economics. Indianapolis: Library of Economics and Liberty.

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Underhill v. United States Trust Company: An Introduction to Trusts

Financial Trust Law Trustee

Financial Trust

One of the chief goals of Huddleston Tax Weekly is to acquaint our readers with as many financial concepts as possible. The more financial knowledge our readers possess, the better they will be able to make sound decisions. Today we will discuss the concept of the financial trust. A trust is a legally recognized arrangement in which property is held by one party (referred to as the trustee) for the benefit of a different party (referred to as the beneficiary). Trusts are frequently established in wills in order to ensure that property is adequately managed and controlled for its beneficiaries. The terms of a trust can vary widely; one constant is that the trustee has a legal obligation to act in the interests of the beneficiaries.

With the creation of a trust, the individual who places the property into the hands of the trustee (known as the settlor) sacrifices a portion of his “bundle of rights” to the property. Consistent with this fact, typically a trust cannot be unilaterally removed by the settlor once it has been established. Hence, those thinking about setting up a trust should reason through the matter thoroughly and carefully because trusts are not the easiest things to do away with.

As we will see, the case of Underhill v. United States Trust Company (1929) provides good evidence for this last statement.

Facts

Ms. Evie Underhill (settlor) created a trust in which the trustee (United States Trust Company) was granted power to sell the property of the trust and then reinvest the profits at its discretion. Upon selling the property of the trust the trustee was supposed to receive a commission. Thus, due to the particular terms of the trust, the trustee acquired a “contingent interest” in its continuation because of its power to sell the property.

Both the settlor and the beneficiary attempted to dissolve the trust before the trustee had a chance to sell the property. The settlor and the beneficiary argued that dissolution of the trust was permissible because it was desired by both of them; the trustee argued that dissolution was impermissible because the terms of the trust granted him an interest in its continuation.

Law

When the express terms of a trust create a contingent interest for the trustee it is not permissible for the court, settlor or beneficiary (or both the settlor and beneficiary together) to alter or terminate the trust without the consent of the trustee.

Ruling

The court did not allow Ms. Underhill and the beneficiary to terminate the trust. The key aspect of the case was that the terms of the trust expressly conveyed an interest to the trustee. And since a trust is essentially a contractual agreement it follows that there must be consent from all parties in order to have the trust terminated.

Let this be a lesson: be sure that the terms you attach to your trust are such that they completely capture your full desire not only in the present moment but also the remote future.

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A Snapshot of the Swiss Banking Law of 1934

Swiss National Bank

Swiss Bank

Switzerland is well-known around the world for a number of things. Swiss watches are routinely regarded as being among the best in the global market. Swiss chocolate garners a fair amount of international attention. And the tradition of Swiss neutrality also contributes toward the country’s public identity. However, if there is a single thing which most colors foreign perception of Switzerland it is probably the Swiss banking industry. Swiss banking – with its long history, its commitment to secrecy, and its association with nefarious characters of all sorts and kinds – has gathered an almost legendary reputation in the minds of foreign observers. As we will see in this article, the long history of bank secrecy in Switzerland was formally codified by the Federal Act on Banks and Savings Banks (also referred to as the Banking Law of 1934) and this act was then amended after the infamous UBS tax scandal of 2007.

Legally Enforced Privacy

Under the banking act of 1934, the established tradition of bank secrecy in Switzerland was officially etched in law. Under this act, revealing the name of an account holder became a criminal offense. Swiss banks were barred from sharing information about an account with third parties – including tax authorities, foreign governments and even Swiss authorities – except when served with a subpoena by a Swiss judge. Account information could only be shared in cases involving severe criminal acts, such as terrorism or tax fraud. The Swiss Banking Law of 1934 statutorily reinforced the status of Switzerland as the premier tax haven for foreigners.

The law was passed shortly after the Nazi Party had created a dictatorship in Germany. Contrary to what many have assumed, the bank secrecy codified by the Swiss law of 1934 failed to give protection to Jewish account holders attempting to protect their wealth from Nazi authorities. In theory, the law should have granted Jews adequate protection; in reality, however, Swiss banks colluded with Nazi authorities and over $100 billion in Jewish wealth was stolen.

Revision Following Tax Evasion Scandal

In 2007, whistleblower Bradley Birkenfeld revealed information which led to tax evasion charges against Swiss bank UBS. This tax scandal eventually prompted Swiss lawmakers to amend the banking act in 2009. Even with the revisions, banks in Switzerland still maintain considerable secrecy, but the revisions permit banks to share information more easily with foreign governments seeking to investigate criminal behavior.

Given their commitment to privacy, it seems likely that Swiss banks will continue to occupy a special place in the global imagination for many years to come. Despite amendments to the 1934 law, lots of loot of questionable origin will still find its way into Swiss bank vaults.

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What is Commercial Paper?

Short Term Debt Security Commercial Paper

Commercial Paper

There is a variety of means companies can utilize in order to generate capital. Companies employ certain means rather than others depending on what specific needs they have to fulfill. Commercial paper is an unsecured promissory note which is typically used to fund short-term company projects. Since commercial paper is unsecured – meaning that it is not backed by collateral – it can only be issued by companies which have impeccable (or near impeccable) credit history. In this article we will discuss some of the basic facts of commercial paper and highlight how it is distinguished from other types of financial instruments.

Short-Term Debt Security

One of the main qualities which sets commercial paper apart from other types of debt securities is its short-term nature. Most commercial paper matures after 45 days, and the vast majority has a maturity date lasting no longer than 90 days. As a fixed rule, commercial paper cannot have a maturity date which lasts longer than 270 days because after 270 days the security would need to be registered with the SEC.

Because of its short-term nature, commercial paper generally has lower interest repayment rates when compared with long-term bonds.

In some ways, commercial paper can be viewed as a cost-effective alternative to lines of credit issued by banks. Commercial paper usually has lower interest rates and, being unsecured, also does not create a lien against the company. Of course, commercial paper cannot supplant lines of credit because the stellar credit ratings required to issue commercial paper necessarily limit its availability in the market.

Issuance

Investors can either purchase commercial paper directly from the issuing company or from a third-party dealer. The third-party dealer is typically an investment bank, although commercial banks are increasingly taking part in the commercial paper market as third-party dealers. Commercial paper is typically sold in round lots of $100,000 and $250,000, although some commercial paper is available in lots of $25,000.

As of October of 2008, there was approximately $1.78 trillion in outstanding commercial paper in the United States. Commercial paper is issued frequently outside of the United States as well. The European market currently has about $500 million in outstanding commercial paper.

Though it is not something a small business owner will encounter on a regular basis, it is important for every businessperson to be familiar with commercial paper since it plays such a large role in the world of corporate finance.

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As this blog article shows, commercial paper is an important instrument for many companies. If you’re thinking of starting a company, be sure to view our presentation about the basic information all aspiring entrepreneurs should be aware of

Tulip Mania: An Old Presage of Modern Economic Bubbles

Tulip Mania Modern Economic Bubble

Tulip Mania

The term “tulip mania” refers to the period during the Dutch Golden Age when the Netherlands saw an incredible rise in the popularity and sale of tulips. Tulips were first introduced to Europe when they were brought from the Ottoman Empire in 1554. They were initially brought to Vienna but made their way to the Netherlands soon thereafter. The increase in popularity of the tulip in the Netherlands is generally thought to have occurred around 1593; this increase coincides with the establishment of the “hortus academicus” by the Flemish botanist Carolus Clusius at the University of Leiden.

The high popularity of the tulip was due to its beauty and rarity. Tulips take a substantial amount of time to produce – daughter offsets usually take 1-3 years to become flowing bulbs – and so even at the height of its popularity the tulip was in short supply. These factors, coupled with the spectacular economic development of the Netherlands during this era, combined to transform the tulip into a status symbol which was highly coveted throughout Dutch society.

By the early 1600s tulips were a thriving commodity. Tulips became extremely expensive during this time. A number of varieties of the flower were developed and certain varieties commanded far higher prices than others. One variety, the Viceroy, was allegedly traded for goods equaling roughly 2500 florins in 1636; a skilled craftsman typically earned 300 florins per year.

Since tulips only bloom during a short window every year (in the Northern Hemisphere), futures contracts were made by tulip traders so that tulips could be bought in advance. By 1636, a formal futures market was created in which contracts to buy bulbs could be bought and sold. By that time, tulips had come to play a massive part in the Dutch economy: by 1636 the tulip became the fourth leading export of the Netherlands.

Fascinatingly, in February of 1637, the tulip bulb market crashed in the Netherlands. Tulip prices plummeted and trading abruptly ceased. A number of theories have been advanced but so far an explanation for the collapse of the tulip market which is universally satisfactory has yet to be uncovered. For various reasons, the demand for tulips fell sharply in 1637 and as a consequence many individuals lost considerable sums of money on tulip contracts. Many modern economists point to tulip mania as one early example of an economic bubble; others contend that the phenomenon should not be considered an economic bubble by modern standards. However it is classified, tulip mania remains an exceptionally interesting example of market volatility and price fluctuation.

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The Beginning and End of the Amsterdam Stock Exchange

City of Amsterdam

Amsterdam

Long before the New York Stock Exchange was even a dim possibility, the Amsterdam Stock Exchange reigned as the world’s leading market for the trading of securities. Though stock transactions took place elsewhere prior to its creation, the Amsterdam Stock Exchange was the first financial institution established specifically for the purpose of buying and selling securities.

The Amsterdam Stock Exchange was created in 1602 by the Dutch East India Company (the Verenigde Oostindische Compagnie or VOC in Dutch). In its time, the VOC was an extraordinarily powerful corporate entity. In 1602, the States General of the Netherlands granted the VOC a special charter over trade affairs in Asia; this charter gave the VOC quasi-governmental authority and expanded its influence many times over. The stock exchange in Amsterdam was created in order to encourage investment in the activities of the VOC. Before 1602, the market which eventually became the Amsterdam Stock Exchange had only dealt in commodities.

The creation of the stock exchange proved to be an incredibly successful mechanism to stimulate investment in the VOC. Interested parties flocked to the exchange and paid considerable sums for a stake in the company’s endeavors. Dividends were periodically paid out to shareholders in order to incentivize future investment. Investors were given the option of selling their shares to a third party. As a result of this option a secondary market rapidly developed in which investors sold shares to outside third parties. These third party transactions were recorded by an official bookkeeper. This “official” secondary market allowed securities trading to flourish and the stock exchange gained an increased level of importance.

In 1623, the first charter granted by the States General of the Netherlands expired and a second charter was promptly implemented. This charter enabled the stock exchange to flourish still further. The success of the stock exchange ultimately led to the development of “trading clubs” and other such sub-markets in which securities were bought and sold. Potential investors began to seek out information from experienced traders in order to maximize their investment opportunities. Hence, the market in Amsterdam during this era came to resemble modern stock markets in many respects.

In 2000, the Amsterdam Stock Exchange formally merged with the stock exchanges of Brussels and Paris to form Euronext. The market in Amsterdam is now known as Euronext Amsterdam.

Though we are far removed from the days when the Amsterdam Stock Exchange reigned supreme, it is important to occasionally glance back and remember where our modern stock markets come from. If you were an ambitious businessperson four hundred years ago, in many ways it would’ve been helpful to learn Dutch!

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The Basics of Balance Sheets

Ledger Books Balance Sheets

Balance Sheets

The world of finance can be a bit complicated at times, in part because financial professionals often have an interest in portraying matters to be more complex than they actually are. However, one of the more straightforward items in finance is the balance sheet. Put simply, a balance sheet is a statement which gives a picture of the financial condition of an individual or company at a specific moment in time. Balance sheets can be difficult to read if the size of the entity is unusually large; however, all balance sheets share a number of common characteristics.

Balance sheets list the assets, liabilities and equity of an entity. Assets are listed on one side of the sheet and liabilities and equity are listed on the other and the two sides are made to balance out. Assets are typically subdivided by type – i.e. current (or short-term) and non-current (fixed). Examples of current assets include cash, cash equivalents, accounts receivable and inventory. Non-current assets include investment property, intangible assets, biological assets and so forth. Common types of liabilities include accounts payable, promissory notes, corporate bonds, current and deferred tax liabilities and others.

The difference between an entity’s total assets and total liabilities is its ownership equity (or shareholder’s equity). An entity’s equity, which can manifest in a variety of forms, essentially represents its “net worth” or value.

In the United States, balance sheets created by public business entities have to abide by structural guidelines outlined by the Generally Accepted Accounting Principles (GAAP). After balance sheets have been prepared, they undergo a process called Balance Sheet Substantiation in which the internal balances of a business are “reconciled” in order to ensure maximal accuracy.

In summary, balance sheets are an elementary – though exceptionally important – item of financial accounting and provide a valuable glimpse of the financial condition of an individual or company. Balance sheets only start to get tricky when very large companies are involved, and even then balance sheets should never be a source of intimidation.

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What is Mark-to-Market Accounting?

Mark to Market Accounting

Mark to Market Accounting

Mark-to-market accounting – also referred to as “fair value accounting” by some – is a type of accounting which attempts to reflect the market price of assets and liabilities. In mark-to-market, the value of assets and liabilities may change in tandem with market fluctuations. The rationale of mark-to-market accounting is to portray financial conditions with greater accuracy: because values change based on market fluctuations they are supposedly in greater agreement with reality. However, while mark-to-market may create a more accurate financial picture in certain cases, in other cases it can become problematic when market conditions are highly unstable. Mark-to-market can also become problematic in situations in which the market price of a given asset cannot be objectively determined.

The reputation of mark-to-market has taken a hit because of its association with the Enron scandal of 2001. However, if used properly, mark-to-market can be a valuable tool for accountants and businesspeople.

Beginnings

Mark-to-market accounting developed among traders on futures exchanges. Traders used mark-to-market as a means of staying informed about the current value of their accounts on the exchange. Traders often engage in deals which change the value of their accounts rapidly and dramatically; using mark-to-market enabled traders to conduct business with updated information.

In the 1980s, mark-to-market spread to major banks and corporations. In the 1990s, mark-to-market began to figure prominently in a number of accounting scandals. As mentioned prior, when no fixed or recognized market exists, assets are valued “marked to model” using complex financial models; marking assets in this manner creates opportunities for overly-optimistic projections and even outright distortion. In the Enron scandal, Enron executives used financial modeling to hide debts and liabilities in order to create an inaccurate financial picture of the company.

Easy Example

Suppose an investor buys 100 shares of stock at $5 per share. And then let’s suppose the stock begins to trade at $7 per share. With mark-to-market accounting, the stock now holds a value of $700 (100 shares multiplied by $7), whereas the “book value” of the stock might otherwise only be $500. Likewise, if the stock declined to $3 per share, the mark-to-market value of the account would drop to $300 and the investor would have an unrealized loss of $200.

As you’ll notice, the basic principles of mark-to-market are actually quite easy to understand. And by all indications this system of accounting developed with perfectly good intentions. Problems only begin to emerge when the market price of an asset cannot be objectively assessed. However, even then, whether an account is accurate depends greatly on the intentions of the financial professional involved.

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