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July 13, 2022

Mark to Market Accounting: What is it and How it Works

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Mark-to-market is a way of estimating the fair value of accounts subject to fluctuations over time, for instance, assets and liabilities. Its goal is to provide realistic time-to-time estimations of the company’s or institution’s financial health based on the current market conditions.

The method may not be ideal in specific conditions. Mark to market often produces false figures of the asset’s true value during volatile economic conditions. However, it is still preferred by most business owners and investors.

In this article, readers will learn about mark to market accounting. This guide explains how the method works, its benefits and drawbacks.

Understanding Mark to Market Accounting

Mark to market is an accounting method which estimates an asset to its current market level. The company may use this method to see how much money it would get for selling the asset. The valuation process involves adjusting the asset’s value to a value as determined by current economic conditions.

Typically, accountants prepare the balance sheet at the end of each fiscal year. The balance sheet must contain the current market value of specific accounts, and the mark to market may help with calculations. All other accounts reflect historical cost, or in simple words, the original price of buying a given asset.

Mark to market accounting may also refer to a special election. It’s when day traders can select when they file their taxes with the IRS. Typically, securities are not added into the process of filing taxes if the trader keeps an open position with these securities — when they didn’t sell them by the taxable year’s end.

The privilege of electing the mark to market method means day traders put down security’s fair market value when filing taxes, whether the action results in capital gains or capital losses.

How does Mark to Market Accounting Work?

As mentioned, the accountant has to report on how much each asset is worth at the end of a fiscal year. The calculation process is easy if traders often buy and sell a given asset.

Here’s an example. Suppose an accountant is dealing with the 7-year Treasury note. The accountant reprices the asset due to the quoted market’s rate. If the Treasury yield rate increases during the fiscal year, the accountant marks down the notes’ value.

The note held by the bank won’t pay as much in interest as all new notes. Suppose the company decides to sell the bond at the current market’s conditions. Then the company gets less than it paid for acquiring the bond. You can find Treasury notes’ value in the financial press every business day.

However, it’s not as easy to mark the asset’s value if it isn’t liquid. If that’s the case, a controller must estimate the potential asset’s value if the company decides to sell it. The simplest example is the home mortgage.

An accountant should estimate mortgage worth if the company decides to sell it to another bank. The estimation depends on the likelihood of the borrower covering all payments.

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Why is Mark to Market Important?

Mark to market accounting is helpful in several industries. It isn’t used just to calculate the value of a specific asset compared to the actual value. This method of accounting is often used in the following cases:

  1. In the financial services industry.
  2. In the retail industry.
  3. In personal accounting.
  4. In the securities market.

In the first case, businesses that default on their loan obligations have to adjust their asset accounts. If the default occurs, the defaulted loan has to be qualified as a bad debt or a non-performing asset. Then the company adjusts these loans according to the fair asset’s value by creating an allowance account, or in other words, a contra asset account.

In the second case, retailers may offer discounts to their clients to quickly collect their accounts receivables. Companies should remember to mark them to a lower value by using an allowance account. Additionally, the company should also link credit to its sales revenue account. It must be based on an estimate of clients expected to redeem the discount code.

As for personal accounting, the given asset’s market value is considered equal to its replacement cost. Suppose a homeowner’s insurance includes refunding the furniture value and personal items in case of fire. However, the refund amount won’t be equal to the furniture’s original cost since it’s a historical cost.

When it comes to the securities market, people use fair value accounting to calculate the security’s current market value and not its book value. The accountant has to record the prices and trades in an account or portfolio to estimate given security’s market value.

Mark to Market Accounting: What is it and How it Works

Mark to Market in Investing and Trading

An investment market that focuses on securities trading uses the mark to market method. It reflects the current market value of portfolios, securities, or accounts. The method plays a critical part in helping traders or investors meet margin requirements within the market.

If the asset’s margin decreases below the requirement, the trader may face a margin call. Traders can also mark to market mutual funds.

In trading, mark to market is also critical for futures contracts involving long and short traders. If the bullish (long trader) and bearish (short trader) parties are involved during the value decline, then the bullish account is debited. The short account will be credited given the change of value.

The described example shows that traders with short positions engaging in futures contracts benefit more from the contract’s value decline. Note: such daily mark to market agreements continue until one of two parties closes the position and chooses a long contract.

Can You Apply Mark to Market Accounting on All Types of Assets?

No, the method works best with assets with high liquidity levels. If the accountant is dealing with assets with lower liquidity, the results won’t be accurate. Liquidity reflects how easily someone can sell or buy an asset. If the liquidity level is low, it isn’t easy to sell the asset within the market.

Market-to-market accounting is generally more accurate when used to calculate the value of assets with high liquidity. Overall, the market price of most such assets is already available to check. But if someone wants to estimate the value of a company’s inventory, they need the services of appraisers.

Benefits and Drawbacks of Mark to Market Accounting

This accounting method provides companies and investors with an accurate estimation of an asset’s current value. Typically, investors want to know if the company’s assets are declining before investing. Otherwise, the business could be overvaluing its true net worth.

Another advantage is preventing the overextension of loans. Banks or other financial institutions may check the company’s assets’ fair value to determine the loan amount. If the company is requesting a $1 million loan while owning assets worth $300,000, it’s an unreasonable request. The company may not repay its loan.

However, the mark to market method of accounting has one main disadvantage. If the economy is crashing, the method doesn’t give accurate estimations because of volatile economic conditions.

How to Calculate Mark to Market?

The calculation process depends on the business type and its assets. The asset’s valuation process could additionally involve a building inspector’s report or an appraiser estimating inventory. If it’s personal accounting, the lender may be reviewing personal accounts.

The simplest way to calculate the fair value is to determine the asset’s value in comparison to the market value. The accountant has to look at the listed value within the given market, for example, a futures or stock market.

Suppose a building company has to calculate the assets valuation in an annual report. The company has owned the same office building for 13 years. The original price of the building was $250,000.

But after 13 years of using the building, it started to decay. As a result, the price of the building dropped to $100,000. When the company’s accountant is adding up business assets, this depreciation should be factored into the mark to market calculations.

In trading, mark to market is calculated a bit differently. Suppose a day trader managed to earn $500,000 within the year thanks to successful trading. It turns out that the trader has specific stock shares that reflect losses, not profits, since the prices have recently dropped.

The trader can use mark to market accounting to regard that stock share as a closed position at the end of the calendar year. As a result, the trader accounts for this asset as sold for accounting purposes. The trader then subtracts its price from the annual income and reduces the tax burden.

How does Mark to Market Help with Personal Finances?

Apart from business owners, investors, and traders, regular people can also benefit from mark to market accounting. For example, the method helps manage finances. If a person is working on their retirement portfolio, they should use market-to-market. The best idea is to review the portfolio at least quarterly to keep track of its current value so as not to miss its potential decline.

It’s also a great idea to hire a personal financial advisor and meet them once or twice a year. Financial advisors help with balancing your holdings, so you don’t, so to speak, keep all eggs in one basket. Maintaining a diversified portfolio is necessary, but it’s essential to keep track of an asset’s value. Mark-to-market accounting is a perfect tool in this case.

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Author: Charles Lutwidge

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