Rules for Mark-to-Market Accounting

by Matt Petryni

Mark-to-market accounting is a matter of some debate, especially in the context of the 2007 to 2008 global financial crisis. The debate has a considerable impact on investors and the reported value of their investments, as mark-to-market accounting rules determine how numerous assets are valued by the firms that own them. Understanding the basic rules in mark-to-market accounting helps provide some background on how financial performance is reported in business.

Basics of Mark-to-Market Accounting

Mark-to-market accounting is a standard for assigning a value to the assets and liabilities that companies record on their balance sheets. According to "Slate" magazine, mark-to-market accounting is simply "the requirement that companies, banks, hedge funds, mutual funds, and the like report the market price of the financial instruments they hold and trade." How companies and funds record the value of these instruments is important because it affects the reported value of investors' equity -- overvaluations of assets, for example, can result in an investment looking safer than it is, and undervaluations can result in losses that don't really exist.

Fair Value Principle

In mark-to-market accounting, generally accepted accounting standards prescribe that financial instruments, assets and liabilities are recorded based on their fair market value. This principle applies even when company acquired the instruments at a value above or below their fair value. In mark-to-market, companies always assign the current market value to a financial instrument, even if its long-term value is expected to be greater than current market prices allow. At the same time, the principle provides an estimate of value that is relevant to investors -- what the instruments could be sold for on the market. According to the Securities Exchange Commission, "investors generally support measurements at fair value as providing the most transparent financial reporting of an investment."

Thinly Traded Assets

Mark-to-market rules get a little more complicated when dealing with assets or liabilities that are not actively traded. While it's easy to determine the value of a company's asset or liability when identical instruments are exchanged on the market, instruments with less active trading volume have no current market price. In these cases, mark-to-market rules require companies to estimate values based on "prices of similar or related securities," according to Wharton Business School.

Inactively Traded Assets

Mark-to-market rules are somewhat lenient in terms of fair value assessment when there is no current market for the assets at all. In these cases, it is impossible or extremely difficult to assign a current market value because the instruments are so inactively traded that no reliable data exists. According to Wharton accounting professor Brian Bushee, the rule for these kinds of instruments "is what people jokingly call 'mark-to-make-believe' or 'mark-to-myth'," as companies are allowed to develop their own method for determining the fair value. According to Wharton Business School, "these systems can vary widely, and the rules require a good deal of disclosure to minimize the mystery." (See Ref. 3)(See Ref. 4)