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market bid and ask rates. In addition, F deferred the
recognition of the difference between its valuation and
the bid or ask prices which it paid or received for the
swaps, treating that difference as deferred income
designed to compensate it for (1) the perceived credit
risks of its counterparties and (2) the estimated
administrative costs to be incurred on holding and
managing the swaps until maturity. F used a similar
method to report its swaps income for 1990 through
1992. F ascertained the values of its swaps for each
of the years 1990 through 1993 as of a date that was
approximately 10 days before the last day of F’s
taxable year and reported that value as the swaps’ fair
market value as of the last day of that year. R
determined that F’s method of reporting its swaps
income did not clearly reflect F’s swaps income for any
of the years from 1990 through 1993. R determined that
a proper method values F’s swaps as of the end of each
year at the midmarket values and does not take into
account any deferral for credit risk or future
administrative costs. Pursuant to sec. 446(b), I.R.C.,
R changed F’s method of accounting for its swaps income
to R’s “proper” method.
Held: The mark-to-market rule of sec. 475(a)(2),
I.R.C., including the valuation requirement subsumed
therein, is a method of accounting that is subject to
the clear reflection of income standard of sec. 446(b),
I.R.C.
Held, further, F’s method of accounting for its
swaps income does not clearly reflect its swaps income
under sec. 475, I.R.C., in that F’s values were not
determined at the end of its taxable years and did not
properly reflect adjustments to the midmarket values
which were necessary to reach the swaps’ fair market
value.
Held, further, R’s “proper” method of accounting
for F’s swaps income does not clearly reflect that
income under sec. 475, I.R.C., in that a swap’s
mid-market value without adjustment does not reflect
the swap’s fair market value.
Held, further, to arrive at the fair market value
of a swap and other like derivative products, it is
acceptable to value each product at its midmarket value
as properly adjusted on a dynamic basis for credit risk
and administrative costs. A proper credit risk
adjustment reflects the creditworthiness of both
parties, with due respect to netting and other credit
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