What is Mark to Market?
The term mark to market refers to a method under which the fair values of accounts that are subject to periodic fluctuations can be measured. i.e., assets and liabilities. The goal is to provide time to time appraisals of the current financial situation of a company or institution. It is done while keeping in mind the prevailing market conditions.
The mark to market method can also be used in financial markets in order to show the current and fair market value of investments such as futures and mutual funds.
When compared to historical cost accounting, mark to market can present a more accurate representation of the value of the assets held by a company or institution. It is because, under the first method, the value of the assets must be maintained at the original purchase cost.
In the latter method, however, the asset’s value is based on the amount that it may be exchanged for in the prevailing market conditions. However, the mark to market method may not always present the most accurate figure of the true value of an asset, especially during periods when the market is characterized by high volatility.
- The term mark to market refers to a method under which the fair values of accounts that are subject to periodic fluctuations can be measured.
- When compared to historical cost accounting, mark to market can present a more accurate representation of the value of the assets held by that company or institution.
- Mark to market is used in personal accounts, financial services, sales of goods, and even in the securities market.
Why is Mark to Market Needed?
In the financial services industry, there is always a probability of borrowers defaulting on their loans. In the event of a default, the loans must be qualified as bad debt or non-performing assets. It means that the company must mark down the value of the assets by creating an account called “bad debt allowance” or other provisions. It is usually known as a contra assets account.
For companies in the sales of goods business, it is common practice to offer discounts to costumers. It is usually done in order to quickly collect accounts receivables. In addition to recording a debit to its accounts receivables, the company would also need to record credit to its sales revenue account. It must be based on an estimate of the number of customers likely to accept a discount.
In accounting for individuals, the market value is considered to be equal to the replacement cost for a given asset. For example, the insurance for a homeowner often includes the value of their home in the event that they will need to rebuild their home. The new price is different from the historical cost of the home or the original price paid for the property.
In the securities market, fair value accounting is used to represent the current market value of the security rather than its book value. It is done by recording the prices and trades in an account or portfolio.
Example of Mark to Market
Consider a situation wherein a farmer takes a short position in 10 rice futures contracts. It is done in order to hedge against the trend of falling commodity prices in the current markets.
Each contract represents 100 bushels of rice. Thus, the farmer is hedging against a price decline on 1,000 bushels of rice. The price of each contract is $10. Thus, the account of the farmer would be recorded as $10,000 ($10 x 1,000 bushels of rice).
Given that the farmer holds a short position in the rice futures, when there is a fall in the value of the contract, an increase to the account is witnessed. Similarly, if there is an increase in the value of the futures, there will be a resultant decrease in his account.
For example, on day 2, the value of the futures increased by $0.5 ($10.5 – $10). Thus, the loss for the day was recorded at $500 ($0.5 x 1,000). The amount is then subtracted from the farmer’s account balance.
On the other hand, the same account will be added to the account of the trader on the other end of the transaction. It is because the trader is holding a long position in the same futures.
|Day||Futures Price||Change in Value||Gain/Loss||Cumulative Gain/Loss||Account Balance|
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