Mark-to-market Accounting – By Prof. Simply Simple Accounting rules are the favourite whipping boys of the financial market during bad times. These days.

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MARK-TO-MARKET ACCOUNTING

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Presentation transcript:

Mark-to-market Accounting – By Prof. Simply Simple Accounting rules are the favourite whipping boys of the financial market during bad times. These days too, it is the presence of what is called ‘the mark-to-market accounting rule’ that is being touted as one of the culprits behind much of the write-downs seen in the financial market. However, before forming any opinion let’s try to understand how the mark-to- market accounting rule works.

So what is a mark-to- market accounting rule? Mark-to-market is a very simple and straightforward accounting rule that prescribes a method for finding out the fair value for all kinds of financial assets. The list of financial assets, as you know, is fairly long—all your stocks, bonds, options, swaps etc can be called financial assets. How, you may wonder, does the mark-to-market accounting rule apply to so many different kinds of financial assets?

Simply put… the mark to-market accounting rule relies on the use of the current market price of your financial assets to arrive at their fair value.

So… So if you are holding a stock that is currently trading at Rs100, then as per the mark-to-market accounting rule, the fair value of your stock is Rs100. You may have actually acquired the stock by paying Rs200 and expect that one day the same stock would trade at a much higher price. But in the realm of the mark-to-market accounting rule, future expectations do not play a role. So…

Therefore… The worth of your asset is always determined by the price at which you can currently sell it in the market. There is no need to look at any other statistic like future earnings, growth potential or any other fact or fiction surrounding your financial asset. Even a blindfolded man can know the fair value of any financial asset by just using the current market price as the yardstick.

However… Many skeptics believe that while this may sound good in theory, in reality the free play of market forces may not always reflect the correct price of a financial asset. Sometimes the scale of the market may excessively tip to one side or the other, moving prices away from where they should be.

For instance… Distress sales hardly give any chance of selling your asset at the right price. In the worst case, as the experience of the subprime crisis showed, the financial market itself may freeze completely, leaving you with assets for which there are absolutely no takers. In such situations, the mark-to-market accounting rule may become a messenger of death even when your financial assets are generating some income.

Then what conclusion can we draw? Should we completely discard the mark-to-market accounting rule when the financial market is in distress?

Well… We can’t accept the mark-to-market accounting rule as the last word on valuation of financial assets. Neither can we completely dump the mark-to- market accounting rule. We definitely need to strike a balance. The main attraction of the mark-to-market accounting rule lies in its simplicity and objectivity. The mark-to-market accounting rule compels us to look at the real picture.

To Sum Up Mark-to-market is a very simple and straightforward accounting rule that relies on the use of the current market price of your financial assets to arrive at their fair value. Many skeptics believe that the mark-to- market rule does not reflect the effect of market forces on the correct price. But, barring extreme situations, the mark-to-market accounting rule still has the potential to become the best friend of our financial market.

Hope you have now understood the concept of Mark-to-Market Accounting In case of any query, please