Mark-To-Market Valuation Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Mark-to-market is an accounting and financial term used to define the act of assigning a value to an asset based on its present market value (for example, the value at which the asset is being traded), rather than the book value (price paid when it was purchased). This concept is used when the asset’s expiration date is undefined, or when its value varies from one day to the next. For example, shares that have no “final value” are subject to mark-to-market valuation.

Regulators encourage the use of mark-to-market accounting by institutions because they believe it leads to greater transparency and better reflects the value of equities, while critics blame this accounting measure for increasing financial instability of traditionally “stable” assets (such as bonds and mutual funds) as well as triggering downward spiral evaluation of some securities.

In the United States, mark-to-market is regulated under Internal Revenue Code Section 475, which dictates that securities should be valued at fair market price, and that dealers should recognize gain or loss of the security as if it were sold at fair market value at the end of the current year. Gain (or loss) is taken into account in the financial statements for that taxable year.

In the case of highly liquid securities, fair market value is easy to estimate. This becomes much more difficult when equities are not frequently traded, or are structured in highly complex manners. As such, Statement of Financial Accounting Standards No. 157 (SFAS 157) recognizes that there are three levels of assets; a Level 1 asset is valued by comparing the price of identical assets or liabilities. Level II assets use directly or indirectly observable events to determine fair market price, while Level III asset values are reflected by management’s best estimate of market participants’ perception.

Typically, mark-to-market valuation is used with goods for which the final value cannot be formally evaluated. For example, in the case of stocks or mutual funds, the overall value changes daily, so they do not have a final value assigned to them. Hence, mark-to-market is used to give these assets a “current” value so they are properly priced in accounting statements.

Mark-to-market is also used in futures trading to ensure that trader margins are still positive; hence the financial institution protects itself against depreciation by verifying daily that futures traders have sufficient funds on hand. If they do not, the institution will emit a margin call to protect itself. Mark-to-market is also used by institutions managing mutual funds so that investors can ascertain the current value of their investment, rather than waiting for quarterly or monthly valuation.

Mark-to-market was initially introduced by legislators as a way to protect investors and is believed to be critical in managing the value of long-term assets. In the past, some companies valued assets at the purchase price. This valuation did not always reflect the current value of the product, allowing them to conserve an inflated value over prolonged periods. In some situations, valuing assets at the price purchased allowed companies to increase the value of assets while misinforming investors.

Some people have criticized that mark-to-market increases short-term valuation of equities by increasing the daily valuation of equities, even if these have traditionally been defined as long-term investments. For example, when bonds are reported with mark-to-market valuation, they essentially vary like shares and other volatile equity. Hence, some people criticize the shortsightedness that inevitably emerges from using mark-to-market.

Critics have also emphasized the unstable financial environment this type of valuation creates. The time period becomes shortened for valuations for financial elements that should be done over a long period of time, increasing market volatility of stable instruments due to human psychology; investors are at risk in mark-to-market valuation in markets where liquidity is limited and instrument issuers have an incentive to avoid markdowns by triggering a transaction.

Another critical issue is that in times of economic downturns, equities that are valued in mark-to-market terms can quickly deflate due to market psychology. Hence, as investors rush to sell equity, the market price drops further, lowering the value, leading more investors to sell until the asset is left with no value.

Hence, mark-to-market can further inflate a bubble economy, while further encouraging a downward spiral. Nonetheless, the financial instability is perceived by regulators as an acceptable trade-off to miscounting of assets that have lost value, and is believed to be the best way to protect investors.

Bibliography:

Tobias Adrian and Hyun Song Shin, “Liquidity and Leverage,” September 2007, www.princeton.edu/~hsshin (cited March 2009);
Cornell Law School, Internal Revenue Code Section 475, “Mark-to-Market Accounting Method for Dealers in Securities,” law.cornell.edu/uscode (cited March 2009);
Frank Gigler, Chandra Kanodia, and Raghu Venugopalan, “Assessing the Information Content of Mark-to-Market Accounting with Mixed Attributes: The Case of Cash Flow Hedges,” Journal of Accounting Research (v.45/2, 2007);
Daniel Gross, “The Mark-to-Market Melee—Did an Obscure Accounting Rule Cause the Credit Crunch?” Newsweek (April 1, 2008).

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