Mark-to-market (MTM) accounting, also known as fair value accounting, is the process of valuing assets and liabilities at their current fair value. Under US GAAP, MTM is applied primarily to financial instruments such as stocks, bonds, and derivatives, which are significantly influenced by fluctuations in market conditions. Moreover, it is not applicable in long-term fixed assets or intangible assets.
Why MTM Is Important?
Though MTM accounting is the reason why the Enron scandal erupted in the 2000s, US GAAP still uses it today as an accounting method for assets that are directly affected by current market conditions. In its very essence, MTM ensures that asset valuation reflects its current value based on the economic conditions surrounding it.
Here are some reasons why MTM accounting is important:
- It captures market volatility. In sectors like trading, investment banking, and asset management, MTM accounting helps capture volatile market changes and reflects the gains or losses as they happen, rather than delaying recognition until the asset is sold or the contract is settled. This can provide more timely insights into a company’s performance.
- It reflects real-time financial position. MTM helps ensure that the value of assets and liabilities on a company’s balance sheet is aligned with their current market value. Instead of using outdated historical costs, MTM provides a more realistic snapshot of what those assets or liabilities are worth at any given time. MTM is crucial for assets like stocks, bonds, derivatives, and commodities, where prices fluctuate daily.
- It prevents overvaluation or undervaluation of assets. MTM helps prevent the overvaluation of assets that have declined in value and the undervaluation of assets that have appreciated. If a company holds assets at historical cost when the market value has significantly dropped, it may give the illusion of higher financial stability.
MTM Example
To illustrate, let’s assume we purchased 500 shares of Eregion Company on March 1, 2024 at $20 a share. We’ll record that in the books as:
Date | Account | Debit | Credit |
|---|---|---|---|
Mar 1, 2024 | Trading securities | 10,000 | |
Cash | 10,000 | ||
(To record purchase of Eregion shares) |
On March 31, the price of Eregion increased to $25 per share. In MTM accounting, we need to account for this increase in value as an unrealized gain. It’s called “unrealized” because the gain exists on paper only. In other words, it’s just a potential gain.
The journal entry to record the unrealized gain is:
Date | Account | Debit | Credit |
|---|---|---|---|
Mar 1, 2024 | Trading securities | 2,500 | |
Unrealized gain on securities | 2,500 | ||
(To record unrealized gain) |
The price increase is $5 ($25﹣$20), which results in an unrealized gain of $2,500 (500 shares × $5).
On April 30, the price of Eregion plummeted to $15 a share. Currently, it’s valued at $12,500 (500 shares × $25). But due to the sudden drop in price, its value is only $7,500, resulting in an unrealized loss. Same as unrealized gain, these unrealized losses are also potential losses, which means that the loss is not final yet.
The journal entry to record the unrealized loss is:
Date | Account | Debit | Credit |
|---|---|---|---|
Apr 30, 2024 | Unrealized loss on securities | 5,000 | |
Trading securities | 5,000 | ||
(To record unrealized loss) |
The $5,000 unrealized loss is the difference between the current value of $12,500 and the updated fair value of $7,500. We can also compute this based on the share price difference of $10 multiplied by 500 shares.
Reporting of Unrealized Gains and Losses
Under the US GAAP, unrealized gains and losses are reported in the:
- Income statement for trading securities and derivatives using the fair value hedge; or
- Other comprehensive income in equity for available for sale securities and derivatives using the cash flow hedge.
The Fair Value Hierarchy
In mark to market accounting, companies must observe the fair value hierarchy in determining the basis of the fair value. The hierarchy has three levels:
- Level 1—Directly Observable Inputs: Fair value can be easily determined based on the prices in the active market. Level 1 basis is a direct reference to the fair valuation, which means that the asset you want to adjust to fair value is the exact same asset that’s quoted in the active market.
- For example, if you want to adjust the valuation of your Apple shares, you can simply check NASDAQ for the current share price.
- Level 2—Observable Inputs Other Than Quoted Prices: Fair value is based on inputs other than quoted prices in active markets but still observable. Level 2 basis is indirect because the asset to be adjusted to its fair value is not the exact same asset in the active market. Rather, we look at observable information from similar assets or transactions.
- Say you own a 12-storey mixed-use building in Los Angeles. Since there’s really no direct reference to the value of your building, we look at recent sales of similar mixed-use buildings in the area and use those values as estimates of your building’s fair market value.
- Level 3—Unobservable Inputs: By far, level 3 is the least reliable because there is no active market for the asset. We simply use internal models or estimation methods to determine the fair value, making level 3 least reliable and highly subjective.
- For instance, a lending institution may revalue debts that are in default or near-default based on internal models, historical recovery rates, and ability to restructure debt. Since loans don’t have an active market or similar assets to compare with, level 3 valuation is the only possible way.
Of all levels, Level 1 is the most reliable and objective because there is an active market (e.g., stock exchange and futures market) for that asset. Level 2 is also reliable but doesn’t exactly relate to the asset being revalued. And lastly, Level 3 is the least reliable since it’s highly subjective.
Limitations of MTM
Though MTM provides a real-time value adjustment to securities, it also has its limitations. Let’s go over each below:
- Illusion in profits: Unrealized gains or losses don’t have an equivalent monetary value. They are profits or losses in paper only. Even if you record an unrealized gain of $1,000,000, that amount has no actual value until you sell the security. Hence, unrealized gains and losses arising from MTM accounting may create an illusion in net income, which can either make you extremely profitable or unprofitable.
- Potential manipulations: If an asset has no observable inputs, Level 3 fair value measurement is used. As the least reliable option, it’s also the level most susceptible to manipulation due to the reliance on estimates and assumptions.
- Need for valuation experts: A certified public accountant is technically not a valuation expert unless they’re a licensed appraiser as well. Hence, fair valuation entails additional cost because you need to hire valuation experts to give you a competent and reliable fair value basis.
Frequently Asked Questions (FAQs)
Yes, MTM accounting is legal and used under US GAAP and IFRS. While it gained a tainted reputation due to Enron’s misapplication of the method, tighter oversight of public companies through the Sarbanes-Oxley Act of 2002 has helped restore integrity, transparency in financial reporting, and investor confidence.
MTM accounting is only a fair valuation method used in financial reporting, while accrual accounting is one of the tenets of modern accounting. In fact, recording unrealized gains and losses is a result of accrual accounting wherein we record gains and losses when earned or incurred, not when actually sold.
Bottom Line
Mark to market accounting is an accounting technique used for financial instruments that derive its value from active markets or other observable outputs. US GAAP is strict regarding the use of MTM accounting that it limits it only to stocks, bonds, and derivatives. Companies aren’t permitted to use MTM accounting for long-term fixed assets and intangible assets.
