What is mark to market in accounting?

Mark to market is a method of measuring the fair value of accounts that are subject to fluctuations over time, such as assets and liabilities.

The method aims to provide realistic time-to-time appraisals of the current financial situation of a company or institution based on the prevailing market conditions. Mark to market contrasts with historical cost accounting, which maintains an assets value at the original purchase cost. 

However, the mark to market method does not always produce the most accurate figure of the true value of an asset, especially in periods when the market is volatile such as during an economic crash.

In trading and investing, certain securities such as futures and mutual funds are also marked to market to show the current market value of these investments.

Understanding mark to market

Mark to market involves adjusting the value of an asset to a value as determined by current market conditions. The market value is based on what a company could receive for the asset if it was sold at that point in time.

At the end of the fiscal year, a company’s balance sheet must reflect the current market value of certain accounts. Other accounts will show historical cost, which is the original purchase price of an asset.

In the financial services industry, companies that default on their loans will need to make adjustments to their asset accounts. In the event of a default, the loans must be qualified as bad debt or non-performing assets. The company must mark down the fair value of its assets by creating an account called bad debt allowance. This is also known as a contra asset account.

In industries that sell goods, companies can offer discounts to customers in order to quickly collect on its accounts receivables. However, they will have to mark them to a lower value through the use of a contra asset account. In addition to recording a debit to accounts receivable, the company would also need to record credit to its sales revenue account. This must be based on an estimate of customers expected to use the discount.

In personal accounting, the market value of a given asset is considered to be equal to its replacement cost. For example, a homeowner’s insurance will include the replacement cost for the value of furnishings and personal items in the event of a fire. This cost will be different to the prices originally paid for such items, which is the historical cost, as retail prices rise over time.

In the securities market, fair value accounting is used to represent the current market value of the security rather than its book value. This is done by recording the prices and trades in an account or portfolio.

Mark to market example

An exchange marks traders’ accounts to their market values daily by settling the gains and losses that result from changes in the value of the commodity.

There are two parties on either side of a futures contract – a long trader and a short trader. The long position trader will be confident, while the short position trader will be cautious.

At the end of each day, if the futures contract both parties entered into falls in value, the long margin account will be decreased and the short margin account increased to reflect the change in value of the commodity. Conversely, an increase in value results in an increase to the long margin account and a decrease to the short margin account.

John is the owner of an apple farm in Somerset. He takes a short position in five apple futures contracts, in order to hedge against the trend of falling commodity prices in the current markets.

Each contract represents 100 batches of apples. So John is hedging against a price decline on 500 batches of apples. The price of each contract is $20. Therefore the farmer’s account would be recorded as $10,000 (500 batches of apples x $20).

As John holds the short position in the apple futures contract, when the value of apples goes down on day two he sees an increase to his account. But on day four when the value of apples goes up, there is a resultant decrease in his account.

Conversely, the same account will be adjusted for the long position trader with the inverse results.

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