Mark-to-Market Accounting Pros and Cons
Why it is Important How Investments are Valued
Accounting rules dictate that financial statements should present fairly the financial position of an entity. As part of this, investments should be recorded on the balance sheet at their proper value.
Investments are initially recorded at their historical cost, but, over time, an investment may gain or lose value. Accountants are required to adjust the values to the best estimate available of their current value.
The shorthand for this adjustment is called “mark-to-market”, or adjusting the value (the mark) to the market (the value established by the market). This is generally accomplished by valuing the investment at the last traded price for an investment. Mutual funds commonly price their shares daily based on the last trade of the day.
Positives of Mark-to-Market
This rule was put into place in order to enhance the safety of stockholders or creditors of the company.
Consider a company that owns a large investment in a government bond that has gone down in value. This would happen if market interest rates increased; the existing bond would lose value.
If the company sold the bond at the lower price, the company would show a loss. Mark-to-market requires the company to show the reduction in value, asif the bond were sold, even if it isn’t. This makes clear to those reading the financial statements that the bond is not now worth the original price.
Creditors or prospective creditors who depend on the value of the company for the return of their principle are made aware of the loss. Investors might be less likely to purchase shares of a company based on an accurate accounting.
Negatives of Mark-to-Market
Reducing the value of the statements as if the company were to sell the bond may not accurately reflect the company’s intentions. The agreed upon interest rate will be paid, and if held to maturity, the bond will likely return the principle paid.
A real issue with mark-to-market comes into play when the investment is illiquid, that is, there is a limited market of the investment. For instance, a corporate bond may trade infrequently.
If there is a distress sale of a bond at an extremely low price, by accounting rules, all holders of that bond must reduce their investment to that price.
For example, if only one certain type of $1,000 bond is sold today for $50 by a company facing bankruptcy, all companies holding that bond must mark the value of their bonds at $50 today. If today happens to be at the end of the quarter when financial statements are issued, that’s the value that’s placed on the books.
This is an extreme example, but certain investments, such as collateralized debt obligations (CDOs) can be very illiquid.
Should Mark-to-Market be Continued?
For the vast majority of instances, mark-to-market is necessary method of valuing the investments of a company for the safety of investors and creditors.
In certain times of economic crisis, suspending mark-to-market may allow company accountants to more accurately state their financial condition.
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