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.
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.
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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If you’re interested in learning more about accounting you may want to view this presentation on QuickBooks essentials by our CPA Jessica Chisholm