What is Mark-to-Market Accounting?

Mark-to-market accounting is a method of establishing the value of a financial instrument such as a stock, bond, T-bill, cash or others. The concept assigns a value to the position in conjunction with current fair market price. This concept was introduced in the early 1990s as part of the U.S. Generally Accepted Accounting Principles (GAAP), the official accounting standards of the nation. Mark-to-market measurements are paramount for an investor to make better informed decisions as they provide timely and relevant statistics.

Lately, there have been a lot of reports about how mark to market accounting is affecting companies during the current economic downturn and the subsequent recession caused by the collapse of many financial companies. Because companies must value, or mark, their holdings at what the current value of those assets would be on the open market, financial companies have been taking huge paper losses. The value of certain mortgage backed assets, like collateralized mortgage options, have plummeted. That means an asset that may have been valued at $300 million last year, may only be valued at $50 million this year, resulting in a quarter billion dollar paper loss, regardless of whether or not the company actually intends to sell the asset.

During the mid-20^th century, a variety of future traders established the concept of mark-to-market in an effort to better define the positions of financial securities and other instruments. This concept is fundamentally based on the accounting methods of the futures market.

When taking a position, the future traders deposit money with an exchange under the umbrella of a contract. This deposit is known as the margin and is intended to protect the exchange against a financial loss. When the trading day ends, the market value of the instrument is established. If the value has increased, the trader receives the profit from the exchange. However, if the market value decreases, the trader's deposit is charged. If the trader's account falls below the threshold of the contract, he or she must deposit more into the account. This is known as a margin call. The entire process uses the mark-to-market process and is a well-regulated way to determine the present value of an instrument.

During the 1980s, traders began to find ways to take advantage of the other parts of the market, specifically over-the-counter derivatives, which are formula-based contracts not traded on exchanges. This meant that the market price was not established by the active market and the value could not be adequately determined immediately. Most of these instruments were revalued on a quarterly or annual basis. This led to a large amount of fraud, especially in the case of interest rate swaps in which cash flow is exchanged for a stream of interest payments.

Following a number of fraud cases the Financial Accounting Standards Board instituted rules in 1993 that would make all financial instruments valued on a timely and reliable basis similar to the futures market. Additional regulations came in 2007 and 2008 in response to the sub prime mortgage crisis of the early 21^st century.

The Internal Revenue Service also established Code Section 475 that defined the taxation rules for mark-to-market accounting.

An investor purchases 10 shares of stock for $20 per share. The total mark-to-market value is $200. The following day, the stock trades at $25 per share. The mark-to-market value has now changed to $250. The next day, the stock trades for only $15 per share. Now, the mark-to-market value is $150. If the trader purchased the stock on margin, this would most likely trigger a margin call in which the investor would have to reaffirm his or her position with a deposit to the exchange to meet the requirements of the contract.

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