Understanding Mark-to-Market

The term mark-to-market is an important phrase in corporate finance that has many nuances and industry-specific uses. Mark-to-market is a corporate finance term that provides businesses with a way to evaluate a holding’s fair value for both assets and liabilities. Since values can change over time, this gives a rational assessment of a business’ present fiscal circumstances based on the latest market climate.

When it comes to securities, an investment that is mark-to-market shows its current value. It’s a way to look at how much a business might get if it sells assets under current market conditions. This measurement is opposed to historical cost accounting, which keeps the asset’s value according to the asset’s price when first purchased.

When a business prepares its balance sheet, some assets will be recorded at their historical cost or original purchase price, while others will need to reflect current market value. One type of asset that needs to be marked down is accounts receivable. If a business permits a 5 percent or 10 percent discount to collect on those to generate cash flow, it needs to reduce that item’s value via an adjustment for doubtful accounts or similar terms.

One important consideration is how mark-to-market is different from impairment. Since retailers or manufacturers store most of their operation’s values in property, plant, and equipment (PPE), along with accounts receivable, such assets are documented at historical cost. If the assets lose value due to obsolescence, theft, damage in transit, a natural disaster, or uncollected accounts receivables, they would be impaired.

When it comes to derivatives that businesses use, mark-to-market assessment may be needed, according to ASC 815-30 for a cash flow hedge or ASC 815-35 for a net investment hedge of a foreign operation. Specifically, whatever is “excluded from the assessment of effectiveness” is attributed to earnings via a mark-to-market procedure or through amortization.

Dissecting Derivatives

A derivative, according to Accounting Standards Codification (ASC) 815-10-15-83, is a contract that derives its value based on the underlying variable. Examples of underlying variables include commodities, indexes, or the occurrence or nonoccurrence of an event (natural disaster). These types of contracts can be used to hedge or preserve the owner’s ability to buy the underlying at the agreed-upon price, especially if it increases in the future. Other uses include speculating on the movement of stock prices or engineering financing arrangements.

A derivative is defined as a financial instrument or other contract that has all of the following characteristics:

1. The underlying, which is either the price of an individual or the index of a commodity, security, interest rate, exchange rate, etc., is one-half of how a derivative contract is settled.
2. The other half is a contract having either a notional amount (how much money it controls) or a payment provision. Notional amounts are characteristics of calls, futures contracts, and interest rate swap contracts. A payment provision may take the form of a payment being made in the case of a natural disaster breaching a financial damage threshold or if a commodity or interest rate index reaches or breaches a specified threshold.
3. The next requirement to be considered a derivative is the contract for the underlying has “an initial net investment” of a nominal price compared to a near identical financial product that would obtain the same financial results due to the same market action.
4. The final attribute necessary for a contract to be considered a derivative is that it’s subject to “net settlement.” This means that when the contract has matured, it’s able to be settled via cash, as opposed to physical delivery of the asset. As long as it can be settled through one of the following methods, it’s considered a derivative: 1. specified in the contract; 2. through a market mechanism; 3. an asset or derivative contract easily able to be transformed to cash.

Conclusion

It’s important to factor in periods of high volatility or when there are illiquid markets or few buyers and sellers of investments; what the market prices applicable to investments doesn’t always give a true reflection of an asset’s price. One recent example was when the market for mortgage-backed securities during the 2008-2009 crisis evaporated, the market gave an inaccurate value of the securities.

Businesses that navigate the intricacies of when and how to use mark-to-market assessments are using an important tool to help keep their books in order.