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Mark-to-market is an accounting system designed to deal with the problem of valuing assets which do not have a fixed price. It does so by using the current market value of the asset in an attempt to take account of the potential profits or losses the holder has made on the asset. The main drawbacks of the system are that short-term market fluctuations may mean it doesn’t give a fair representation of the asset’s long-term value.
The mark-to-market system is most usually used for complicated assets such as derivatives. This is where people trade the right to buy shares in the future rather than trade the actual shares themselves. But technically mark-to-market can be used for any type of asset.
The idea of mark-to-market is to produce more realistic accounts than alternative systems which are based on the purchase price of the asset. For example, a firm may own a batch of shares for which it paid $100 US Dollars (USD). Without mark-to-market accounting, the asset would continue to be listed on its balance sheet at $100 USD until the firm sells the shares.
If the shares are now worth only $10 USD, the accounts would give an overly positive picture of the firm’s worth. This doesn’t make much difference with $100 USD worth of shares, but in a firm which has hundreds of millions of assets, it can make a major difference, perhaps even making a firm appear solvent when it could not cover its debts by selling assets. Of course, the effect works the other way: a firm whose assets have risen in market value would appear much worse off if it didn’t use mark-to-market valuation.
In the United States system, there are three types of mark-to-market valuation. Level one is for actively traded assets such as stocks and simply uses the current market price. Level two is for assets which don’t have a market price, but it’s possible to use a standard model to value them based on wider market variations such as the performance of stocks in similar industries. Level three is for assets which don’t have any market indicators, meaning the accountants must simply guess the current value of the asset. Critics believe this produces some figures which have too little basis in reality.
Another problem of mark-to-market is that it may place too much emphasis on short-term swings in the market. A company might hold assets which it sees as a long-term investment and has no need or intention to sell them in the near future. But mark-to-market accounting means that if the market for the asset is going through a dip, the company will appear to have lost money in its accounts. There is an argument that such appearances can cause stock in the company itself to dip, contributing to even wilder swings in the overall market.