What is Mark to Market Accounting

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Mark to market (also known as fair value) is a valuation method used in financial statements of credit institutions. It requires in principle the measurement of financial instruments in accordance with the current market price.

The method does not make a distinction between fixed and current assets. The price of an asset is determined in a liquid market and thus the value of the asset at balance sheet date.

The value of a financial instrument or contract is systematically adjusted in light of current market prices, sometimes expressed as valued by the market. Financial assets can be evaluated according to historical cost (or cost of acquisition), on the grounds of a procedure known as current cost, which would be the historical cost reported to date by a price index, or as market price.

In order to establish the reality on budgetary accounting principles it would be necessary to use the mark to market to assess financial assets and liabilities. This principle becomes uncomfortable when, as happened in 2007-2008 with the subprime crisis.

The markets for many types of securities become illiquid and panic leads to lower prices so as to create massive losses, eroding profits and capital. Assessment procedures, however, leave some leeway to adopt different pricing. The method of marking to market is used mainly in markets for futures and options.

The easiest way to use the mark-to-market method for financial instruments, is with the daily stock prices (marketable foreign exchange, coin and securities stocks).

However, it is difficult for financial instruments that are less fungible, and/or traded on (temporary or permanent) illiquid markets. The greatest obstacles are encountered on the application of the procedure in balance sheet items for which there are no active markets in the real sense.

The criticism of this valuation has increased since the financial crisis in 2007, the critical situation in financial statements, particularly in banking and insurance, accounted for by valuation losses. Banks are thus forced to deport even those losses that have not yet been realized.

The mark-to-market valuation can lead to significant fluctuations, which are pro-cyclical. In the new legal regulations the commercial code’s principle of prudence remains prioritized, this becomes clear that fair valuation for non-banks is still not allowed.

In contrast, banks apply the fair valuation for financial instruments in the trading book. Because of the international accounting rules, a complete renunciation of the fair value measurement is not possible.

In an efficient market, the market price is usually equal or close to the fair value and whenever market price differs from fair value, the reasons are most likely to be as a result of some biases on the part of the buyers or sellers. The introduction of fair value was initially intended to approximate the book value of the market value as a way of facilitating the task of the valuations of companies.

Through the updating of each statement of accounts on assets, fair value more or less leads to a decline in potential capital gains that had not been taken into account in the balance – thus it successfully cuts the volatility of the valuations of companies. Under the Financial Accounting Standards Board (FASB) standards number FAS 157 fair value is the price obtained to sell an asset or the price paid to transfer a liability in an transaction taking place in an active market, also referred to as “exit value”.

 

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