Investing and The Mark-to-Market Accounting Rule

Mark-to-market or fair value accounting refers to the accounting standards of assigning a value to a position held in a financial instrument based on the current fair market price for the instrument or similar instruments.

The use of fair value measurements has increased steadily over the past years, primarily in response to investor demand for relevant and timely financial statements that will aid in making better informed decisions.

mark to market accounting
In the past few years, fair value accounting rules changed and these changes in part caused the subrime crisis and the sovereign (bond) debt crisis.

Specifically, the problem is mark-to-market accounting where all assets are required to be valued at current market prices. If the market is temporarily depressed, it can cause an artificial crisis.

The following simple example will illustrate the problem:

If you have one dollar, we would all agree you have a net worth of $1. John also has one dollar bill and goes into a vending machine to buy a cold drink. The drink in the machine costs 50 cents, but it only takes quarters.

John asks if anyone has change and they all say no. Bill says he has only two quarters and will trade John -- who is really thirsty -- two quarters for a dollar.

John quickly agrees to take Bill up one his offer in order to get the drink now. John knows that two quarters for a dollar is a bad deal, but he is takes the deal anyway.

According to mark-to-market accounting, you, with your 1 dollar bill, now have a net worth of 50 cents.

Mark to market

Even though you are still holding the exact same one dollar bill you held in your hand when you approached the vending machine and even though you did not trade with anyone else in the room, the current public market in the room for $1 bills is 50 cents and your net worth is only 50 cents.

You must evaluate your net worth based on the current market.

You are smart enough to know that the one dollar bills are really worth four quarters at the bank down the road, but ...

Mark-to-market accounting will not allow you to use this "long term" evaluation method.

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