What is Mark to Market Accounting (MTM)?
Mark to market (MTM) is an accounting method of valuing certain assets and liabilities to reflect their current market values rather than historical costs. Under mark to market accounting, the fair value of an asset or liability on the balance sheet is updated regularly to reflect its market price.
The intent of mark to market accounting is to provide a realistic picture of a company’s financial position and profitability according to current market conditions. It aims to represent the actual liquidation value of assets and obligations if the company were to sell them off today.
Mark to market accounting moves away from the traditional historical cost method where assets are held at their original purchased cost, even if their economic values shift over time. Marking to market captures these changing values on the balance sheet.
Key Principles of Mark to Market Accounting
Mark to market accounting follows several principles:
- Asset and liability values are assessed based on current market prices, not historical costs.
- Assets and liabilities subject to MTM are remeasured periodically, at minimum at year end.
- Gains and losses from MTM adjustments flow through to net income and equity.
- Provides investors a clear view of balance sheet values reflecting present day market conditions.
- Introduces potential volatility into financial statements as market values fluctuate.
- Applies to financial instruments as well as certain physical assets traded in liquid markets.
Adhering to these principles provides transparency into an organization’s financial health using current values, but can also introduce earnings volatility.
Why Use Mark to Market Accounting?
Mark to market accounting offers several benefits:
- Reflects current realities – Shows asset and liability values at realizable market prices today, not outdated historical costs.
- Accuracy – More accurately represents actual economic condition and liquidation value based on latest prices.
- Transparency – Allows outsiders to see balance sheet health based on real-time market signals.
- Risk management – Identifies problems early by revealing losses and imbalances as they occur.
- Compliance – Satisfies accounting rules and regulations requiring mark to market for certain assets.
- Investor confidence – Fair value basis increases investor trust in published financial statements.
However, some downsides also exist, such as profit and loss statement volatility. On the whole though, mark to market provides a superior view of financial health.
What Accounts are Marked to Market?
Certain assets and liabilities are commonly marked to market:
Assets:
- Trading securities – Stocks, bonds, derivatives held for trading
- Commodities – Gold, oil, corn, wheat, silver, etc.
- Adjustable-rate mortgages – Mortgages with interest rates tied to market indexes
- Investments in hedge funds, mutual funds, venture capital funds
- Investment property – Real estate holdings not used directly in operations
Liabilities:
- Derivative liabilities – Interest rate swaps, options, warrants, futures
- Asset retirement obligations – Future environmental cleanup liabilities
- Deferred compensation liabilities – Executive pensions, retirement benefits
- Contingent liabilities from lawsuits or product warranties
- Debt with variable interest rates
Assets and liabilities tied closely to fluctuation market rates or prices require mark to market accounting for fair representation.
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Mark to Market Accounting Rules and Regulations
Mark to market accounting falls under GAAP and IFRS accounting standards. Some key regulations include:
- FAS 115 – Governs mark to market rules for investment securities like stocks and bonds.
- FAS 157 – Lays out 3-tier framework for determining fair value mark to market measurements.
- IFRS 9 – The IFRS equivalent standard to FAS 115 outlining classification and measurement of financial instruments.
- IFRS 13 – Defines fair value under IFRS as exit price under current market conditions.
These standards aim to bring consistency and comparability to mark to market practices across companies and jurisdictions.
Mark to Market vs. Historical Cost Accounting
Mark to market differs significantly from historical cost accounting:
Mark to Market
- Values assets and liabilities at current market prices
- Reflects realizable values on the open market
- Captures fluctuations in values over time
- Can introduce income statement volatility
Historical Cost
- Values assets at original purchase cost
- Cost basis does not change over time
- Assumes business will hold assets to maturity
- Provides stability but may distort financial position
Mark to market provides more visibility into true asset values and balance sheet health. Historical cost better insulates profits from market fluctuations but risks misstating financial position.
How are Assets and Liabilities Marked to Market?
The specific mark to market process depends on the asset or liability:
Market-Traded Assets – Assets with readily available quoted prices like stocks are simple to mark to closing market prices.
Thinly-Traded Assets – Assets without frequent trading like some fixed income securities may require using models or matrix pricing based on similar assets.
Non-Financial Assets – Real estate and equipment values can be determined through professional appraisals.
Interest Rate Products – Interest rate swaps values derive from present value models using yield curves.
Foreign Currency Items – Forex positions use end of period exchange rates.
Marking assets and liabilities follows methodologies appropriate for each item’s characteristics and market activity levels.
Accounting for MTM Gains and Losses
Gains and losses from mark to market adjustments flow through the income statement and equity:
- Trading securities – Realized and unrealized MTM gains and losses hit the income statement.
- Available-for-sale assets – Unrealized gains or losses flow to equity, without hitting income statement.
- Interest rate hedges – MTM adjustments are offset by adjustments in the underlying asset being hedged.
- Foreign currency items – MTM adjustments based on forex fluctuations impact income statement.
- Liabilities – MTM losses flow through expense accounts, while gains reduce expenses.
FAS 115 and IFRS 9 dictate the accounting treatment of MTM adjustments for different financial assets and liabilities.
Example of Mark to Market Accounting
Here is an example of mark to market accounting:
Company A purchases commodity futures contracts worth $1 million on copper as a speculative investment. At year end, the futures contracts have a mark to market value of $1.3 million based on the settlement price for near month futures.
Company A will record the following MTM journal entry:
Dr: Derivatives Asset $300,000
Cr: MTM Gains $300,000
This increases the derivatives asset account to its fair value of $1.3 million at year end, with the $300,000 unrealized gain flowing through earnings.
All future gains and losses until the contracts are closed will be marked to market through the income statement.
Challenges and Criticisms of Mark to Market Accounting
Mark to market accounting faces some criticisms:
- Added income statement volatility from MTM adjustments
- Difficulty assigning fair values in illiquid or distressed markets
- Potentially misleading values when markets are irrational
- Complexity from customized or unique assets and liabilities
- Susceptibility to manipulation or bias in valuation models
- Tax issues from unrealized MTM gains treated as income
While providing more transparency into asset values, mark to market introduces accounting challenges companies must properly address.
To Recap
Mark to market accounting plays an important role in providing timely, realistic assessments of asset and liability values. By reflecting current market conditions rather than outdated costs, it allows investors to evaluate balance sheet health through a real-time lens.
Despite some limitations, mark to market accounting represents a substantial improvement in financial reporting transparency when applied judiciously. Going forward, it will likely continue growing in adoption and importance across various industries and asset classes.
Frequently Asked Questions (FAQ)
Q: What is the main purpose of mark to market accounting?
A: The main purpose is to fairly represent assets and liabilities on the balance sheet at values that could actually be realized by selling them on the open market today.
Q: How often should mark to market adjustments be recorded?
A: At minimum, mark to market adjustments should be recorded on the balance sheet date at year end. However, financial institutions often mark trading assets and derivative values daily or monthly for better risk insights.
Q: What prevents companies from manipulating mark to market valuations?
A: Accounting standards require mark to market to follow strict, consistent valuation approaches. Independent audits provide oversight and accountability. Highly liquid assets are harder to manipulate.
Q: Does mark to market replace historical cost accounting?
A: No, it supplements historical cost accounting since many assets like PP&E are still best recorded at depreciated cost. Only select assets and liabilities meeting criteria require mark to market adjustments.
Q: How did mark to market accounting contribute to the 2008 financial crisis?
A: Forcing banks to mark illiquid mortgage assets to fire sale prices made their balance sheets appear worse than the underlying value, contributing to insolvency fears. This spurred efforts to modify mark-to-market rules.
Q: What are the alternatives to mark-to-market accounting?
A: The primary alternative is historical cost accounting which never updates asset costs post-purchase. Other options include value investing metrics like price-to-book value ratios that estimate fair asset values.
Q: What accounting guidance governs mark to market rules?
A: In the U.S., FAS 115 and FAS 157 provide mark to market guidance under GAAP. Internationally, IFRS 9 and IFRS 13 lay out standards under IFRS. Local regulations may also apply.
Q: Can companies selectively apply mark to market accounting?
A: No. If a company’s assets meet the criteria for mark to market, it must apply fair value adjustments consistently across those assets. Selectively choosing when to use MTM is prohibited.
Q: How does mark to market accounting introduce income statement volatility?
A: Unrealized gains and losses from MTM adjustments flow through the income statement for trading securities. This causes earnings to fluctuate more closely with asset market swings.
In another related article, Investing vs. Speculating: Understanding the Crucial Differences
