What is Mark to Market (MTM)?

Mark to Market (MTM) is an accounting method used to measure the current value of assets or liabilities. As the historical cost principle of accounting values assets based on the original price it was purchased, using mark to market provides a more accurate picture of what a company’s assets are worth today.

For example, if a company bought an office building for $1M a decade ago and is currently valued at $3M, the historical cost principle of accounting would require the asset's value be recorded at the original cost of $1M. However, under mark to market accounting, the value of the office building would be $3M.

Overall, mark to market is used to get a more accurate idea of what a company’s assets or liabilities are really worth today. It is an important concept that is used widely throughout finance, investing, and accounting.

Mark to Market Accounting

The core idea of MTM is to ask yourself what the asset or liability would be worth if the company were to sell or dispose of it today. Companies need to determine this when they are preparing their financial statements.

For example, take the case of a publicly traded company that holds stocks and bonds. If the company is reporting its annual earnings on December 31st, it would typically determine what the closing price was for the stocks and bonds in its portfolio on that very day, and then use that value when reporting on what its investments are worth.

• Increases in the value of the stocks and bonds would increase the profit reported by the company in that period, and vice versa.
• The exact impact would depend on the specific nature of the assets and liabilities, as well as the company’s accounting policies.
• The change in value of the stocks and bonds generally impacts reported profitability even if the company did not physically sell the assets. If they do sell the asset, then it is referred to as a “realized” gain or loss. If the asset remains unsold, it would be an “unrealized” gain or loss.

Mark to Market in Finance / Investing

One area where MTM is especially important is in the financial sector, such as in derivatives trading. In derivatives contracts, the counterparties need to know what the contract is worth at any given time, because this will determine what they owe one-another. To make sure this information is available, the counterparties will typically use MTM on a regular basis, repricing their contract based on the latest available market information.

The same applies to mutual funds. Typically, these funds are required to use MTM on their portfolios on a daily basis. This allows the fund managers to calculate the fund’s net asset value (NAV), which tells investors what their units are worth on any given day.

• MTM is an essential component of derivative markets, allowing for the accurate reflection of the contract’s current market value.
• It is also important in the mutual funds industry, where investors rely on it to determine an accurate net asset value (NAV) of their fund units.
• MTM generally bolsters the integrity of financial markets by making sure that the reported value of assets and liabilities is in sync with current market reality.

It’s important to remember that there is an important difference between ‘realized’ and ‘unrealized’ gains or losses. Realized gains or losses occur when an asset is actually sold, whereas unrealized gains or losses represent the potential profit or loss, even if the asset is not actually sold.

Hypothetical Example of Mark to Market Accounting

Let's look at a practical example of MTM in the trading of futures contracts. In futures trading, contracts are marked to market daily. This means the gain or loss on the contract is calculated and recorded at the end of each trading day.

• Suppose a trader takes a long position in an oil futures contract at $60 per barrel. If the price rises to $65, the contract is marked to market, and the trader's account is credited with the gain.
• On the other hand, if the price drops to $55, the trader's account is debited with the loss.

Here is what a simplified MTM calculation would look like in this scenario:

Let’s suppose that the trader needed to issue a financial report on Day 4, and that the futures contract was previously listed on their financial statements at $60. In that scenario, the asset would be reported (on day 4) at $58, and it would also result in an unrealized loss of $2.

As you can see, the MTM method is fulfilling its purpose of telling investors what the asset is actually worth as of the reporting date.

Real-World Example of Mark to Market Accounting

Now that we are familiar with the concept, let’s see how it applies in a real-world setting. For this, we will use the 2022 10-K filing for Berkshire Hathaway Inc, a company with a substantial portfolio of equity securities which are accounted for using the MTM method. Let’s see how this process unfolds in their actual financial statements.

Looking at their Consolidated Statement of Earnings, we see a line item labeled “Investment and derivative contract gains (losses)”. It reveals that the company suffered almost $68 billion in losses from its investments and derivative contracts in 2022.

But what factors contributed to this loss? Was it due to a decline in the value of their stock portfolio or was it significantly impacted by derivative contracts as well? To answer this, we refer to the Notes in the Consolidated Financial Statements. Specifically, on page K-86:

From this table, we see that the nearly $68 billion loss was primarily due to unrealized losses on their equity securities, but also includes realized losses from securities sold during the year.

By using the MTM method, Berkshire Hathaway provides a transparent report to their investors, reflecting that their stock portfolio significantly declined in value during the year. As illustrated by the previous years in the chart, the principle also works in reverse, with increases in the portfolio's value resulting in reported profitability.

Such disclosures, facilitated by MTM accounting, help investors make informed decisions and maintain confidence in the integrity of financial markets.

Why is Mark to Market Necessary?

Mark to Market accounting is considered necessary in order to provide investors and other market participants with an objective and accurate representation of a company’s assets and liabilities.

• For investors: MTM furnishes a more accurate depiction of a company's present financial situation. By contrast, the historical cost method might give an outdated and misleading impression of a company’s true financial position.
  
• For companies: MTM helps them understand their financial position and manage their risks accordingly. Moreover, the use of MTM is a requirement under certain accounting standards such as Generally Accepted Accounting Principles (GAAP) and rules set by the Financial Accounting Standards Board (FASB).
  
• For derivative traders: MTM is vital for daily operations. It allows traders to understand the real-time worth of their positions, ensure they are meeting their margin requirements, and anticipate potential cash flows they may owe or be owed.

Overall, the practice of MTM accounting is a crucial part of the financial markets, and is widely used by investors, company management teams, and traders to make timely and informed decisions.

Other Mark to Market Considerations

While MTM accounting is important and widely used, it also has some potential drawbacks. For example, MTM can lead to volatility by forcing companies to report unrealized losses, even if they do not actually intend to sell them. 

For example, the failure of some regional banks in March 2023 was due in part to those banks’ reporting of unrealized losses on their bond portfolios. Such reports can spook investors and depositors, potentially creating the conditions for a bank run. Similar events occurred in the 2008 financial crisis, where investors were spooked by unrealized losses on mortgage-backed securities and other assets. 

Mark to Market Summary

MTM accounting helps provide a real-time valuation of assets and liabilities, offering insight into a company’s finances that historical cost accounting may not reveal. As such, it plays a crucial role for investors, management teams, and derivative traders. Although it can sometimes exacerbate volatility in the markets, MTM accounting is generally seen as a necessary and positive component of our financial markets and reporting practices.

Additional Resources

If you found this article useful, consider checking out our Complete Finance & Valuation Course where you can master the fundamentals of finance, valuation, and financial modeling. Students who have completed this course have gone on to Goldman Sachs, Amazon, Bloomberg, and other high-profile companies.

Other Articles You Might Find Helpful

• What is a Basis Point?
• Precedent Transactions Analysis
• Treasury Stock Method 
• Perpetuity Formula
• Multiple on Invested Capital
• Levered Beta Formula