The much maligned accounting principle of “mark to market” accounting has received an important clarification today from regulators at the SEC.

“When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.” source

FASB 157 came about as a result of the Enron scandal and subsequent regulations contained in the onerous Sarbanes Oxley Act.

Hopefully this is a first step toward its full repeal.

It is important to note that the SEC is NOT saying that cooking the books is now an acceptable accounting practice. That would be the last thing that corporate America needs in order to restore public confidence. Transparency is necessary, and the SEC’s clarification will help investors to see a much truer picture of the financial health of the corporate balance sheet. Perhaps, after the debacles of Bear Stearns, Lehman, Merrill, Wachovia, Wamu, and AIG, the SEC sees this as a way of acknowledging that many of the weaker players and their related toxic assets have been identified and dealt with, and it’s time to protect the healthier players that remain.

It becomes crucial as the Treasury anticipates buying some $700 billion in mortgage-backed securities, and in effect, establishing a market price for illiquid assets. A direct consequence would be that the remaining banks would have to take a write down on their assets to reflect the new market price.

This is an important clarification from the SEC. It will have an important and immediate impact.