Mark to market accounting is a type of accounting that uses the value of an asset with a fluctuating trend to determine its fair value. It can be used for certain types of assets, such as real estate and business inventory.
According to the experts at SoFi, “When it comes to trading and investing, the margin is the borrowed money that some traders use to execute their strategy. Buying assets on margin can help magnify your gains and returns — but it can do the same with your losses.”
The concept of mark-to-market accounting is to provide a comprehensive view of a company’s financial condition while keeping in mind the changes in the market. It allows firms and investors to get a quick and accurate appraisal of their assets and liabilities.
With margin trading, investors borrow money from a broker-dealer to carry out a trade. They then deposit the cash that they’ve borrowed as collateral. As interest payments are made, the investor pays the broker-dealer back.
1. What is Mark to Market?
In addition to accounting for assets, mark to market can also be utilized in the financial markets to show the fair market value of various types of investments, such as mutual funds and futures.
Unlike historical cost accounting, mark to market can provide a more accurate depiction of the value of a company’s assets. It does so by taking into account the original purchase price.
Although mark to market can provide a more accurate depiction of the value of an asset, it can also be misleading due to the varying values applied to different assets. For instance, during times of high volatility, mark to market might not provide a true estimate of the asset’s value.
2. Reasons Mark to Market is Needed
In the financial services industry, a company must consider the likelihood of a borrower failing to pay their loans when determining the value of its assets. This process is called the bad debt allowance. This type of accounting is commonly referred to as a contra assets account.
In the sales of goods industry, it is common for companies to offer discounts to their customers to collect their accounts receivable. Doing so requires recording a debit to the accounts receivable and a credit to the sales revenue account. This process is usually carried out based on an estimate of how many people will accept the discount.
For individuals, the market value of an asset is equal to the replacement cost of the item. For instance, in insurance policies, the value of a home is included in the coverage’s cost. However, the new price is different from the original price.
In the securities market, mark to market accounting shows the current market value of an asset instead of its book value. This method is usually performed by recording the prices and trades of an asset in a portfolio.
3. Mark to Market Example
As an example, a farmer might take a short position in rice futures contracts to hedge against the falling prices of the commodity. If the farmer contracts rice for $10 each, then his account would be valued at $10,000. Since the price of the contract is $10, the farmer is hedging against a decline in the price of rice.
Since the farmer has a short position in the futures contracts, the value of his account can increase or decrease depending on the price of the commodity. On the second day of trading, the futures contract’s value increased by around $0.5. This resulted in a loss of $500. The amount is then deducted from the farmer’s account balance.
When a transaction is completed, the same account will be credited to the other end of the transaction. This is because the long position that the trader has in the futures contract is still valued.
Although mark-to-market accounting can provide a more accurate depiction of the value of an asset, it can also be inaccurate. It is important to research the pros and cons before getting started.