Mark-to-market accounting is the practice of measuring the fair value of an account with fluctuating value, such as a stock portfolio or mutual funds. However, it can also be used for assets that are not associated with high degrees of fluctuation, such as business inventory and real estate.
Pros and Cons of Mark-to-Market Accounting
- Provides Realistic Financial Picture
- Prevents Banks from Overextending Loans
- Financial Crises Can Make It Less Accurate
- Can Be Generally Inaccurate
Before discussing the pros and cons of mark-to-market accounting, it is helpful to understand what is meant by fair value, market value, and historical cost accounting.
The fair value of an asset is a sale price that is agreed upon by two willing parties—a buyer and a seller—who freely enter into a transaction with full cognizance of the asset’s value. Oftentimes, the fair value of an asset will be determined by a marketplace, such as the stock market, futures market, or real estate market. Although this might lead you to believe that fair value is synonymous with market value, this later assignation may actually be arbitrary in comparison to an asset’s true worth based on the most current factors of supply, demand, and intrinsic value to the parties involved.
However, the market price (or market value) of an asset does frequently inform mark-to-market accounting practices, which have been part of the Generally Accepted Accounting Principles (GAAP) since the 1990s.
In contrast to fluctuating accounting models is historical cost accounting, where a fixed asset is recorded on a balance sheet in terms of its original cost. These types of assets typically include company land or equipment that has depreciated over the course of its useful life, including assets such as buildings and machinery. This accumulated depreciation will often be subtracted from the historical cost of the asset to reflect a lower net asset value, which prevents overstating the value of the asset, especially if its stated value could be over-inflated by market conditions that obscure its true worth or intrinsic value to the company.
What is Mark-to-Market Accounting?
Mark-to-market accounting is not as static or predictable as historical cost accounting based on original value and asset depreciation. It seeks to reflect the fluctuating fair value of an asset for accounting purposes so that a business or company can get an accurate picture of asset value or the value it could obtain from liquidating assets.
Mark-to-market accounting is prevalent, for instance, in the financial services industry, where assets like currency and securities are the backbone of the business.
For example, a bank or other such institutional lender may have customers who default on their loans, which then turn into uncollectible bad debt. These losses will reduce the true value of the lender’s assets, which will be reduced in the accounting ledgers through the use of a contra asset—an accounting device that can help an accountant preserve a record of the original asset while recognizing unrealized losses (like bad debt).
Mark to market accounting is also useful for investment firms that manage client accounts made up of publicly traded securities like stocks, bonds, ETFs, and mutual funds. Using historical cost accounting for these types of assets with endlessly fluctuating values would not be useful for anyone involved.
For example, a client would not be interested in opening their monthly statement and seeing that the stock price of Coca-Cola (NYSE: KO) was $18 in December of 1996 if the current year is 2020 (though they would be happy to see that in those 26 years it has gone as high as $60 and rarely dipped below $45). What’s important is to understand is that the fair value or market value of an asset indicates how much an investor would get if they liquidated the asset in question (that is, sold their shares of stock).
Mark-to-market accounting also refers to a special election that day traders are allowed to select when they file their taxes with the IRS. Normally securities, like stocks, are not factored into a tax filing if the trader has an open position with these securities—that is, they have not sold them by the end of the taxable year. The privilege of electing mark-to-market accounting means these day traders can put down the fair market value of a given security when they file their taxes, whether that results in a capital gain or a capital loss.
It’s actually most beneficial to select mark-to-market accounting on securities that have manifested an unrealized loss because it reduces the overall taxable income of the day trader, which, in turn, could reduce their tax burden.
However, it’s important to realize that choosing to use mark-to-market accounting is not available to the average individual filing their taxes, and a day trader is not really a day trader according to the IRS unless they are approved as such. Day traders are required to meet certain criteria, which include the frequency of trading activity and the intentionality behind it. Most individuals, even ones who love to invest in the stock market, do not meet the requirements for frequency and volume that the IRS has set as the benchmark for determining who is a day trader on the stock market.
Incidentally, a taxpayer who scores the much-coveted trader tax status from the IRS can also enjoy other benefits at the end of the tax year, such as a wash sale, something that is normally prohibited for tax purposes. A wash sale involves selling marketable securities for intentional trading losses and then repurchasing them after filing taxes so that the trading losses can reduce the overall income of the taxpayer. Though writing off ordinary losses in business is permissible for a taxpayer, intentionally taking advantage of a current market price if it could present a loss and then repurchasing the same security at a later date is not an acceptable accounting rule for the average individual. The IRS makes an exception for day traders. This is in addition to the MTM accounting that allows them to benefit from the unrealized loss of a security without selling it.
How is Mark-to-Market Calculated?
That depends on the business in question and the asset. As mentioned, mark-to-market accounting involves tabulating the fair market value of an asset. This could, for instance, involve the work of an appraiser evaluating inventory, or a building inspector’s report. It could also involve a lender reviewing accounts and determining which are bad debt, which they will then subtract from their other assets on the balance sheet or note as a contra asset. In some cases, the fair value of an asset is determined by its market value, which can be assessed just by looking at its listed value on a given market, such as the stock market or futures market.
For example, let’s say a catering company needs to determine the valuation of its assets for an annual earnings report. They have had the same food preparation facility for 10 years. When it was first built, it was valued at $500k , but after a decade, the wear and tear on the equipment has reduced the fair market value of the facility to $350k. In adding up the assets of the company, this depreciation will be factored into the mark-to-market calculations.
Alternatively, let’s take a look at mark-to-market accounting as it applies to day traders. In this case, the meaning of mark-to-market is a little different. Let’s say a day trader’s trades brought them one million dollars in profit during the taxable year. However, they have retained certain shares of stock that actually represent an unrealized loss, since the price of that particular security has recently decreased. Using mark-to-market accounting, this day trader could regard that security as a closed position at the end of the calendar year (meaning, they can regard it as a sold asset for accounting purposes) and subtract the loss from their gross annual income, thereby reducing their taxable income.
In a sense, mark-to-market accounting is not just used for business bookkeeping. It’s used by average taxpayers every day when they attempt to figure out their net worth. This is because the net worth of most individuals is based on fluctuating assets, such as stocks and even real estate.
For example, an individual with a stock portfolio worth $10 million does not actually have $10 million in cash under their name. Their net worth is an indicator of how much cash they would obtain if they liquidated their assets at that given moment. In a bull market with rising stock prices, their net worth may increase, and in a bear market with falling prices, their net worth will decrease.
Mark-to-market accounting is also used to register the replacement costs of personal assets. An example would be an insurance company providing policyholders with a replacement cost for a home if a need arises to rebuild it from scratch, which may be very different than the value of the home at the time of its purchase.
Mark-to-Market Accounting Pros
Provides Realistic Financial Picture
As mentioned, mark-to-market accounting provides a realistic financial picture, especially for businesses in the financial industry. In fact, some financial pundits believe the Savings and Loans Crisis of 1989 could have been avoided entirely if banks and lending institutions used the mark-to-market accounting method instead of historical cost accounting. Banks were listing the original price they paid for assets and only made changes on the books when those assets were sold. This resulted in an inaccurate picture of inflated financial wellbeing.
Prevents Banks from Overextending Loans
By the same token, market-to-market accounting can present a more accurate picture of the financial health of a company or individual seeking a loan.
Returning to the same catering company from earlier, say they went to a lender seeking a $5 million loan to open a larger food processing plant to expand into prepackaged frozen meals. A bank could look at the assets of the company and see that they paid $500k to establish their current location. This would be a dangerously inflated number when it comes to determining how much collectible collateral the potential lender has because of the wear and tear on their equipment, which has resulted in a $150k depreciation.
Banks and lenders do not like to extend credit to those who may not be able to pay them back, nor do they like to extend credit to those with insufficient collateral to help the bank recoup its losses in the event of a defaulted loan. Mark-to-market accounting helps lenders determine the true fair market value of a potential borrower’s collateral, and helps lenders develop a better sense of whether or not it makes sense to extend a loan, and if so, how much.
Mark-to-Market Accounting Cons
Financial Crises Can Make it Less Accurate
A serious financial crisis, such as the Great Depression following the stock market crash of 1929 or the Great Recession of 2008, can lead businesses to mark down their assets, since these assets have, after all, lost value.
A bank or investing firm with a portfolio of investments, like tradable securities, may see its net worth drop precipitously as the companies it has invested in are failing. In reality, the picture of bank assets may not be as bleak, but the perception of depreciation may lead the institution to sell off their assets in order to increase their cash reserves. This can become a downward spiral that further fuels the economic crash or recession, as it did in the 1930s and in the recent subprime mortgage crisis.
Can Be Generally Inaccurate
In general, mark-to-market accounting runs the risk of being inaccurate. Remember that fair market value is based on what two willing parties to a transaction would agree upon in regards to the sale of the asset in question. This market value may not reflect the true worth of an asset.
Returning to an example we used earlier, the replacement cost of a home as listed by an insurance company is the cost of replacing the home, meaning, rebuilding it on the already-owned land. This value is likely to be far less than the current market value the homeowners would obtain if they sold their property. That said, in this instance, that type of mark-to-market value does not provide an accurate picture of the homeowner’s true net worth.
How Did Enron Use Mark-to-Market Accounting?
Enron was a conglomerate that specialized in energy production and commodities, eventually transitioning into certain financial services (including brokerages). The Enron scandal and its subsequent downfall is the stock market drama of the last several decades. Enron’s fall from grace cost thousands of Americans their jobs and shook up Wall Street. Stock prices plunged from more than $90 to 26 cents before they filed for bankruptcy. There’s no mystery as to how such a massive corporation disintegrated almost overnight—it’s because it had an outstanding history of deceptive business practices. Additionally, Enron also used special purpose entities to hide a high amount of debt and soured assets from their creditors and investors.
As far as mark-to-market accounting went, Enron would engage in the building of assets (say, for instance, a power plant) and log its projected revenue on the books, even if it had yet to produce a dime of income or cash flow. If the asset ended up taking a loss, Enron would transfer the asset to a subsidiary that wasn’t on their own accounting record, essentially making it disappear.
In this way, Enron was able to fool Wall Street for years, until they could no longer hide their losses. The death blow that accelerated their demise was when Dynergy backed out of a deal at the same time the SEC was opening investigations into Enron’s mysterious actions around closing subsidiaries and changing executives. Criminal investigations ensued when it was discovered that accounting firms were literally shredding financial statements to conceal them from the SEC. The end effect of the Enron scandal was to bring into question the accounting practices of many financial institutions.
The Sarbanes-Oxley Act of 2002 was created in part because of Enron’s fall from grace, along with WorldCom (MCI). The Act promoted a greater degree of financial transparency by instituting a greater degree of regulatory control over companies, their boards of directors, and their accounting practices.
Suffice it to say, though mark-to-market accounting is an approved and legal method of accounting, it was one of the means that Enron used to hide its losses and appear in good financial health. Eventually, though, the truth came out when factors beyond Enron’s control (such as a partner backing out of a deal) put them into a downward spiral they could not hide from the law.
Experienced business owners and those looking to buy a business would do well to take a lesson from the Enron scandal and avoid using unethical accounting strategies to hide debt from creditors and investors. Speaking to a qualified tax advisor can really help a business leverage legal strategies for financial success, without running afoul of tax law (or the SEC, if the business offers publicly traded securities).
Can Mark-to-Market Accounting Be Used on All Types of Assets?
Mark-to-market accounting, or fair value accounting as it is sometimes called, is difficult to do with assets that have a lower degree of liquidity. Liquidity means these assets can easily be bought and sold, and generally includes stocks, bonds, futures, and Treasury bills. It can also include derivative instruments like forwards, futures, options, and swaps. These derivative instruments are contracts built around an underlying asset or assets such as stocks, bonds, precious metals, currency, and commodities, and relate to buying or selling actions triggered by dates and prices.
It’s easy to see why mark-to-market accounting can be used for assets with a high degree of liquidity, because the current market price of many of these assets is readily available, even to everyday retail investors. But for assets with a lower degree of liquidity, such as inventory, business equipment, or real estate, obtaining the current value of the asset can be more difficult and require the services of an appraiser. In some cases (real estate, for example), the IRS has laid out rules around how much an asset can depreciate, so guesswork or assessment is taken out of the picture. In other instances, an accounting firm or a company’s accounting department might want to hedge their bets by getting an appraisal on paper before making a value up, just in case they become subject to a serious audit at any point in the future.
In summary, it is possible to use mark-to-market accounting on assets with a lower degree of liquidity, but it’s most common and easiest to use MTM accounting with assets that have an index-based current market price.
Mark-to-Market Accounting Can Be an Effective Accounting Strategy in Certain Cases
From the lending business to real estate asset management, mark-to-market accounting is a useful tool for establishing the fair market value of an asset or a business. However, its malleability is a double-edged sword, given that it can also be used to deceptively hide true values from investors and creditors.
If you think your business could benefit from mark-to-market accounting, contact an Anderson Advisors tax expert today! Our team will use its expertise to create a tax plan that supports the goals of your business for many years to come.