Mark-to-market accounting is determining the fair value of a variable-value account, such as a mutual fund or stock portfolio. It may also be used for assets like real estate and commercial inventories that don't see a lot of volatility.
Mark-to-Market Accounting: PROS and CONS
PROS
A realistic financial picture is provided
stops banks from making too long loans
CONS
Financial crises might reduce its accuracy.
General Inaccurate in Some Cases
Understanding fair value, market value, and historical cost accounting is useful before considering the benefits and drawbacks of mark-to-market accounting.
An asset's fair value is the selling price that two willing parties—a buyer and a seller—who willingly engage in a transaction and are fully aware of the asset's worth—agree upon. A market, whether the stock market, futures market, or real estate market, will often decide the fair value of an asset. This may give you the impression that market value and fair value are equivalent. Still, the latter assignation may be arbitrary in light of an asset's actual worth based on the most recent supply, demand, and intrinsic value to the parties involved.
Mark-to-market accounting procedures, which have been a component of Generally Accepted Accounting Principles (GAAP) since the 1990s, commonly consider an asset's market price (or market value).
Historical cost accounting contrasts changing accounting approaches, where a fixed asset is reflected on a balance sheet in terms of its original cost. These assets often consist of business real estate or machinery that has lost value throughout its useful life, such as buildings and machinery. It is common practice to deduct this accumulated depreciation from the asset's historical cost to reflect a lower net asset value. This prevents the asset from being overstated in value, especially if market circumstances could mask the asset's true value or intrinsic value to the business.
Mark-to-Market Accounting: What is it?
Historical cost accounting based on original value and asset depreciation is more stable and predictable than mark-to-market accounting. To provide a corporation or firm a clear image of asset value or the value it may get from liquidating assets, it aims to depict the variable fair value of an asset for accounting reasons.
In the financial services sector, where assets like cash and securities serve as the company's foundation, mark-to-market accounting is common.
For instance, a bank or other institutional lender may have clients that don't pay back their loans, which results in bad debt that is impossible to recover. Due to the usage of a counter asset, an accounting tool that allows an accountant to maintain a record of the original asset while recognizing unrealized losses, these losses will lower the lender's assets' actual worth, which will be shown as a reduction in the accounting ledgers (like bad debt).
Investment companies that look after client portfolios made up of publicly traded instruments like stocks, bonds, ETFs, and mutual funds may also benefit from mark-to-market accounting. Historical cost accounting would be useless for these kinds of assets, whose values are constantly changing.
For instance, if the current year is 2020, a customer would not be interested in reading on their monthly statement that Coca-(NYSE: Cola's KO) stock price was $18 in December 1996 (though they would be pleased to learn that in those 26 years, it reached a high of $60 and seldom ever fell below $45). Understanding that an asset's fair value or market value represents how much an investor would get if they sold the item is crucial (that is, sold their shares of stock).
Mark-to-market accounting also describes an option that day traders may use when they submit their tax returns to the IRS. Normally, if a trader has an open position in assets, such as stocks, and has not sold them by the end of the tax year, these securities are not considered when filing taxes. These day traders can use mark-to-market accounting, which allows them to report the fair market value of specific security when filing their taxes, whether doing so results in a capital gain or loss.
Using mark-to-market accounting for stocks that have shown an unrealized loss is best since it lowers the day trader's total taxable income, potentially lowering their tax liability.
The normal taxpayer submitting their taxes does not have the option to employ mark-to-market accounting, and the IRS does not consider someone to be a day trader unless they have been permitted to do so. The frequency of trading activity and its purpose are among the requirements day traders must fulfill. Most people, including those who like stock market investing, do not reach the thresholds for frequency and volume that the IRS has established as the standard for identifying stock market day traders.
In addition, a taxpayer who receives the highly sought-after trader tax status from the IRS may take advantage of additional advantages at the end of the tax year, such as a wash sale, which is often illegal in terms of taxes. In a wash sale, marketable securities are intentionally sold for trading losses and then bought again after taxes are filed, allowing the trading losses to lower the taxpayer's total income. Although a taxpayer is allowed to deduct regular business losses, the normal person should not take advantage of a current market price if doing so may result in a loss and repurchase the same investment later. Day traders are exempt from taxation by the IRS. Additionally, they might profit from the unrealized loss of an asset without selling it, thanks to MTM accounting.
Exactly how is mark-to-market determined?
That depends on the asset and the company in the issue. The fair market value of an asset is calculated as part of mark-to-market accounting, as was previously indicated. For example, a building inspector's report or the work of an appraiser appraising inventory might be included in this. As a counter asset on the balance sheet or note, a lender may also evaluate accounts to identify which ones are bad debts and deduct them from their other assets. In certain circumstances, an item's market value—which may be established simply by looking at its stated value on a specific market, such as the stock market or futures market—determines the asset's fair value.
Consider a catering business that has to estimate the value of its assets for a yearly profits report. For ten years, they have used the same kitchen for food preparation. It was originally appraised at $500k, but after ten years, the equipment's wear and tear have brought down the facility's fair market worth to $350k. This depreciation will be considered when totaling the company's assets for mark-to-market calculations.
Let's instead examine mark-to-market accounting as it relates to day traders. The definition of "mark-to-market" is a bit different in this situation. Imagine a day trader earned $1 million throughout the tax year thanks to their trading. However, given the recent decline in the price of that specific asset, they have kept certain shares of stock that represent an unrealized loss. This day trader might use mark-to-market accounting to treat that security as a closed position at the end of the calendar year (i.e., they could treat it as a sold asset for accounting reasons) and deduct the loss from their gross yearly income to lower their taxable income.
Mark-to-market accounting is, in certain ways, not merely used for business accounting. Every day, typical taxpayers utilize it to try to calculate their net worth. This is because most people's net worth depends on ephemeral assets like stocks and even real estate.
For instance, a person with a $10 million stock portfolio does not have $10 million in cash to their name. Their net worth is a proxy for how much money they would make if they sold all their assets right then and there. Their net worth may rise during a bull market with increasing stock prices, while it will shrink during a bear market with declining prices.
It is also possible to record the replacement costs of personal assets using mark-to-market accounting. An example would be an insurance company giving customers a replacement cost for a house if it is necessary to rebuild it from the ground up, which may be much different from the property's purchase price.
Experts in Mark-to-Market Accounting
A realistic financial picture is provided
As previously indicated, mark-to-market accounting gives firms, particularly those in the financial sector, a realistic financial picture. Some financial experts contend that if banks and lending organizations had opted for mark-to-market accounting over historical cost accounting, the Savings and Loans Crisis of 1989 might have been completely averted. Banks only recorded changes to their accounts when assets were sold, not before they listed the initial amount they paid for such assets. This led to an exaggerated perception of financial well-being that was false.
stops banks from making too long loans
Likewise, market-to-market accounting may provide a more realistic view of the financial standing of a business or borrower.
Let's go back to the same catering business from before and assume they approached a lender to request a $5 million loan to grow into packed frozen meals and establish a bigger food processing facility. When a bank examines the company's assets, they may see they spent $500k to create their present site. Due to the wear and strain on their equipment, which has caused a $150k depreciation, this would be a dangerously overstated estimate when calculating how much collectible collateral the prospective lender has.
Banks and lenders do not want to provide credit to those who may not be able to pay them back or to people who do not have enough collateral to protect the bank from losing money in the case of a defaulted loan. Mark-to-market accounting aids lenders in determining the actual fair market value of a prospective borrower's collateral so they may decide whether or not and how much to grant a loan.
Cons of Mark-to-Market Accounting
Financial crises might reduce its accuracy.
Businesses may mark their assets as lost due to a severe financial crisis, such as the Great Depression that followed the 1929 stock market collapse or the Great Recession of 2008.
A bank or investment company with a portfolio of holdings, such as marketable securities, may see a sharp decline in net value when the firms it has invested in fail. Although the image of bank assets may not be as dire, the institution may decide to sell off some of its assets to bolster its cash reserves because of the impression of depreciation. As it happened in the 1930s and during the current subprime mortgage crisis, this may turn into a negative cycle that intensifies the economic catastrophe or recession.
General Inaccurate in Some Cases
Mark-to-market accounting often carries the risk of being incorrect. Remember that fair market value is determined by the price that two interested parties to a transaction would accept for the sale of the relevant item. This market value may not accurately represent an asset's genuine value.
Reiterating the prior example, the insurance company's listing of a property's replacement cost represents the cost of reconstructing the home on the currently owned land. This valuation is probably far lower than what the homeowners would get if they sold their property at the current market value. However, in this case, a mark-to-market valuation does not accurately reflect the homeowner's genuine net worth.
What Mark-to-Market Accounting Techniques Did Enron Employ?
Enron was a multinational that first focused on commodities and energy production before expanding into certain financial services (including brokerages). The recent stock market drama has been the Enron controversy and the company's ultimate demise. The downfall of Enron resulted in the loss of thousands of American jobs and shocked Wall Street. Before they filed for bankruptcy, stock values crashed from almost $90 to just 26 cents. There is no surprise as to why such a big organization almost disappeared overnight; it had a long history of dishonest business practices. Enron also utilized special purpose corporations to conceal a significant amount of debt and distressed assets from its creditors and investors.
Regarding mark-to-market accounting, Enron would construct assets (such as a power plant) and record its anticipated revenue on the books even if it had not yet generated any income or cash flow. Enron would move the asset to a company that wasn't on their financial record if the asset ended up losing money, thus making it vanish.
Enron was able to deceive Wall Street in this fashion for years until they could not cover up their losses. When Dynergy pulled out of a contract as the SEC launched inquiries into Enron's enigmatic acts around the liquidation of subsidiaries and change of management, it was the last straw that hastened their collapse. When it was found that accounting companies were shredding financial statements to hide them from the SEC, criminal investigations started. The Enron crisis ultimately had the impact of casting doubt on numerous financial organizations' accounting procedures.
The downfall of Enron and WorldCom led to the creation of the Sarbanes-Oxley Act of 2002. (MCI). The Act increased regulatory supervision of businesses, their boards of directors, and their accounting procedures to encourage financial transparency.
Let's just state that even though mark-to-market accounting is a recognized and legitimate way of accounting, Enron employed it as one of its strategies to conceal losses and project a positive financial picture. But eventually, when Enron was forced into a downward spiral, they could not escape the law of uncontrollable causes (such as a partner dropping out of a transaction), and the truth came to light.
It would be wise for seasoned company owners and those seeking to purchase a firm to learn from the Enron affair and refrain from employing dishonest accounting techniques to conceal debt from creditors and investors. One of the best ways for a corporation to use legal tactics for financial success without breaking the law is to speak with a certified tax expert (or the SEC if the business offers publicly traded securities).
Can All Types of Assets Be Used with Mark-to-Market Accounting?
With assets with a lesser degree of liquidity, mark-to-market accounting, or fair value accounting as frequently known, is challenging. The term "liquidity" refers to an asset's ease of purchase and sale and often refers to securities like stocks, bonds, futures, and Treasury bills. Derivative products like forwards, futures, options, and swaps may also be included. These derivative instruments are contracts that relate to purchasing or selling activities triggered by dates and prices and are based on an underlying asset or assets such as stocks, bonds, precious metals, currencies, and commodities.
Since many of these assets have a high degree of liquidity, even daily retail investors can easily access the current market price; it is clear why mark-to-market accounting may be utilized for these assets. But for assets with a lesser degree of liquidity, such as inventory, commercial property, or business equipment, determining the asset's current worth might be more challenging and call for an appraiser's help. The IRS has established regulations governing how much an item may decline in specific circumstances (real estate, for example), eliminating the need for estimation or guessing. In other situations, an accounting firm or a company's accounting department may wish to take a safe bet and acquire an appraisal on paper before coming up with a value, just in case they ever find themselves the target of a significant audit.
In conclusion, mark-to-market accounting may be used for assets with a lesser level of liquidity. Still, it is most popular and straightforward to apply MTM accounting to assets having an index-based current market price.
Mark-to-Market Accounting Can Be a Successful Accounting Technique in Some Situations
Mark-to-market accounting is a helpful method for determining the fair market value of an asset or a company, from the loan industry to real estate asset management. But considering that it may also be used to deceitfully conceal genuine values from creditors and investors, its malleability is a double-edged sword.
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