prpri All about Mark To Market (MTM) Concept All about Mark To Market (MTM) Concept

Mark to market (MTM) is a measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark to market accounting refers to accounting for the “fair value” of an asset or liability based on the current market price, Fair value accounting has been a part of Generally Accepted Accounting Principles (GAAP) in the United States since the early 1990s.

The accounting act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.

Mark to market aims to provide a realistic appraisal of an institution’s or company’s current financial situation. The accounting act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.

Example: Mutual funds are marked to market on a daily basis at the market close so that investors have an idea of the fund’s NAV.

Mark-to-market accounting can change values on the balance sheet as market conditions change. In contrast, historical cost accounting, based on the past transactions, is simpler, more stable, and easier to perform, but does not represent current market value. It summarizes past transactions.

History and development

The practice of mark to market as an accounting practice first developed among traders on futures exchanges during the 20th century and the practice spread to major banks and corporations.

To understand the original practice, consider that a futures trader, when beginning an account, deposits money, termed a “margin”, with the exchange. This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if the market price of his contract has decreased, the exchange charges his account that holds the deposited margin. If the balance of this account becomes less than the deposit required to maintain the account, the trader must immediately pay additional margin into the account in order to maintain the account (a “margin call”). (The Chicago Mercantile Exchange, doing even more, marks positions to market twice a day, at 10:00 am and 2:00 pm).

Example: If an investor owns 10 shares of a stock purchased for $4 per share, and that stock now trades at $6, the “mark-to-market” value of the shares is equal to (10 shares * $6), or $60, whereas the book value might (depending on the accounting principles used) only equal $40.

Similarly, if the stock decreases to $3, the mark-to-market value is $30 and the investor has an unrealized loss of $10 on the original investment.

Definition of OTTI “Other Than Temporary Impairment” (OTTI)

Recording OTTI that is based on credit impairment is non-controversial in the banking industry – banking institutions fully understand and support the need to record such impairment. However, there is much controversy with recording losses that are based on the market’s perception of value (MTM), which often results in recognizing losses that exceed credit losses or recording losses for securities that have experienced no credit problems and are fully performing in accordance with their terms. The erosion of earnings and capital due to a market’s perception of losses or due to a lack of liquidity that drives values lower is misleading to investors and other users of financial statements.

Recommendation for Improving Financial Reporting

ABA(American Bankers Association) recommends the following:

  1. Replace the definition of “fair value” from “exit” price to the price between a “willing buyer and willing seller in an arm’s length transaction that is not a forced sale”. This is a more representative estimate of fair value.
  2. The US model for OTTI should be based on an improved version of international standards. The trigger for OTTI should be credit impairment (probable loss), and the assets should be written down for that economic loss rather than market value loss. Additionally, if OTTI recovers, the write-downs previously taken through earnings should be reversed through earnings. This would provide a more accurate estimate of economic loss.
  3. MTM (fair value) should not be the model used to account for all financial instruments, and the current efforts to do so should be abandoned.

Mark-To-Market Losses:

Mark-to-market losses are losses generated through an accounting entry rather than the actual sale of a security. Mark-to-market losses can occur when financial instruments held are valued at the current market value. If a security was purchased at a certain price and the market price later fell, the holder would have an unrealized loss, and marking the security down to the new market price results in the mark-to-market loss. Mark-to-market accounting attempts to give investors more transparent and relevant information.

For example, if a company holds securities that they bought as an investment and the market value of the securities fall, then once they assign the new market value to their asset they would take a mark-to-market loss on their holding even if they didn’t sell it. Mark-to-market attempts to give investors a more accurate picture of the value of a company’s assets.

Issues of adopting MTM :

1. Problems can arise when the market-based measurement does not accurately reflect the underlying asset’s true value. This can occur when a company is forced to calculate the selling price of these assets or liabilities during unfavorable or volatile times, such as a financial crisis. This issue was seen during the financial crisis of 2008-09 where many securities held on banks’ balance sheets could not be valued

2. Mark-to-market accounting can become volatile if market prices fluctuate greatly or change unpredictably, often due to unreliable information.

3.Mark-to-market accounting began to result in scandals.

As the practice of marking to market became more used by corporations and banks, some of them seem to have discovered that this was a tempting way to commit accounting fraud, especially when the market price could not be determined. So assets were being “marked to hypothetical or synthetic manner” using estimated valuations and sometimes marked in a manipulative manner to achieve spurious(bogus) valuations. The most infamous use of mark-to-market in this way was the Enron scandal.

Enron scandal:

The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the defacto dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. In addition to being the largest bankruptcy reorganization in American history at that time.

Enron was formed in 1985 by Kenneth Lay. Several years later, when Jeffrey Skilling was hired, he developed a staff of executives that, by the use of accounting loopholes, special purpose entities, and poor financial reporting, were able to hide billions of dollars in debt from failed deals and projects. Chief Financial Officer Andrew Fastow not only misled board of directors and audit committee on high-risk accounting practices, but also pressured Andersen to ignore the issues.

Due to high price fall in share prices of the company, shareholders filed a lawsuit after the company’s stock price. The U.S. Securities and Exchange Commission (SEC) began an investigation, and on December 2, 2001, Enron filed for bankruptcy. Enron’s $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history.

Many executives at Enron were indicted for a variety of charges and some were later sentenced to prison. Enron’s auditor, Arthur Andersen, was found guilty in a United States District Court of illegally destroying documents relevant to the SEC investigation which voided its license to audit public companies, effectively closing the business. As a consequence of the scandal, new regulations and legislation were enacted to expand the accuracy of financial reporting for public companies.

After the Enron scandal, changes were made to the mark to market method by the Sarbanes–Oxley Act during 2002. The Act affected mark to market by forcing companies to implement stricter accounting standards.

Internal Revenue Code Section 475(US Law) contains the mark to market accounting method rule for taxation. Section 475 provides that qualified securities dealers who elect mark to market treatment shall recognize gain or loss as if the property were sold for its fair market value on the last business day of the year, and any gain or loss shall be taken into account for that year. The section also provides that dealers in commodities can elect mark to market treatment for any commodity which is actively traded.

This accounting practice prevents banks and other financial institutions from making assets more valuable than they really are….

Shrirang Kapadia

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August 2021