Mark-To-Market Valuation Essay

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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:   

  1. Tobias Adrian and Hyun Song Shin, “Liquidity and Leverage,” September  2007, www.princeton.edu/~hsshin  (cited March 2009);
  2. Cornell Law School, Internal Revenue  Code  Section  475, “Mark-to-Market  Accounting Method  for Dealers in Securities,”  law.cornell.edu/uscode  (cited  March  2009);
  3. 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);
  4. Daniel Gross,  “The Mark-to-Market Melee—Did an Obscure Accounting Rule Cause the Credit Crunch?” Newsweek (April 1, 2008).

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