The mark-to-market is a pivotal cornerstone in accounting. It helps investors and analysts gauge turbulent waters when dealing with questions of valuation and transparency.
As a financial practice, it wields significant influence, shaping the way businesses, investors, and regulators assess the worth of assets and liabilities in an increasingly complex and interconnected global economy.
Mark-to-market, often abbreviated as “MTM,” is not merely an accounting technique but a vital tool that reflects the current economic reality of assets and liabilities, providing real-time insight into their value.
In the wake of financial crises, pandemics, and widespread corporate scandals, the MTM has become more than just a buzzword; it has become a safeguard and a source of accountability in the real world.
In this article, we’re going to dive deep into what MTM is, its significance in the real world, and its applications across various industries and contexts.
You may also like: The market value effect – how can it make or break your investments?
What is Mark-to-Market?
MTM is an accounting method that serves a very specific purpose. It helps investors and analysts record the value of assets and liabilities in real time and at current market value.
In simpler words, it means that if a company were to decide to liquidate itself, MTM would be used to determine how much its assets and liabilities were worth at the time of liquidation.
MTM is based on the balance sheet of the company – the formal declaration of its assets and liabilities. While historical cost accounting simply records the value of assets as the amount paid, it adjusts the value of these assets based on their current market value. Hence, it is more accurate and better represents the true picture.
An example
For instance, a company decides to invest its extra cash into government bonds. However, if interest rates rise after making such investments, the value of the company’s cash will decline.
If these bonds are accounted for with MTM every quarter, investors can get a full picture of how much the bonds are worth every 3 months.
On the flip side, when adjustments to valuation are not made every quarter, other accounting methods would simply use historical costs to estimate the value of these investments, giving investors an inaccurate representation of the real picture of the company’s finances and corporate investments.
MTM accounting gives involved stakeholders a better understanding of the true picture of a company’s balance sheet, which enables them to make more informed decisions with their capital.
Also Read: Your ultimate guide to investing in a bear market
Mark-to-Market across industries
Accounting
This is the context in which we explored the example above. In accounting, MTM is used to determine the value of assets and liabilities in real-time.
This enables investors to accurately gauge the company’s financial health and analysts to adjust their valuations accordingly.
Financial services
Financial companies deal with a lot of debt. Most debt that’s given out is marked as an asset in a company’s balance sheet. However, if borrowers default on these debts, the company has to adjust its assets during the year to account for the ‘allowance of bad debts.’
The lending company, hence, uses the MTM to mark down the value of its assets according to that particular default case.
Investing
MTM in investing refers to recording the current market price of the stock or bond (or any other asset or security) rather than its book value. This is most often done in futures trading to ensure that margin requirements are met during trading.
No matter the stock’s book value, a trader is issued with a margin call if the margin account falls below the required minimum level.
Understanding Mark-to-Market losses
Mark-to-market losses are unrealised losses that are generated through an accounting process rather than an actual sale or purchase. MTM losses can occur when financial assets held by an individual or an institution are marked at current market value instead of their book value.
If an asset once purchased falls in price later, the owner has to suffer an unrealised loss. MTM accounting of this nature falls under the concept of fair value accounting, which attempts to give investors a better picture of a company’s financial status quo.
Limitations of Mark-to-Market accounting
While MTM might give you a better picture of the true value of a company’s assets, there are some disadvantages to this accounting strategy.
MTM accounting, for one, can accelerate a recession. When prices are already falling and the market is relentless, businesses using this accounting model won’t be able to resort to their book values and will be forced to mark down their assets and investments regularly, leading to a snowball effect and price spirals.
On the flip side, during periods of high growth, Mark-to-Market accounting could also lead businesses to artificially inflate their balance sheets. This would in turn make them more risk hungry, exposing them to large losses if something goes wrong.
This is what went wrong in 2008 when mortgage-backed securities increased exponentially in value, leading to banks giving out more and more loans to bad debtors. In the end, it all came crashing down, leading to the fall of several large financial companies and banks.
Also Read: Beat the market: Your ultimate guide for fundamental analysis tools.
MTM also sometimes misrepresents the financial health of companies. Institutions that invest in extremely low risk bonds, for instance, might use MTM to mark down their investment value every quarter and impact their statements, but might still be able to pay out all their depositors when their bonds reach maturity.
Conclusion
While MTM accounting does provide the more accurate, bigger picture to companies, investors, and other stakeholders, it might not always be the best way for everyone.
The information provided by MTM accounting is only valuable when it is considered against the backdrop of the overall market and what the company plans to do with the concerned assets.
