Understanding Mark-to-Market Accounting
Mark-to-market accounting, often abbreviated as MTM, is a method in accounting. MTM records the value of an asset based on its current market price.
In simpler terms, it’s like updating the price tag on your assets every day to reflect what they’re actually worth in the market right now.
Example of MTM on an individual
Let’s say you have a baseball card that you bought for $10. If the demand for that card goes up and people are willing to pay $15 for it, mark-to-market accounting would let you say that the card is worth $15 in your financial books. If the card’s value goes down to $8, then you’d have to reduce its value in your books to $8.
One could also see the similarity of MTM to an individual obsessed with his card collection.
Benefit of MTM
Now, when used properly, mark-to-market accounting can provide a realistic snapshot of a company’s financial health. It is important to keep the value of assets up-to-date. If you purchase publicly traded stocks, the valuation of your portfolio will move on a daily basis.
Since we want up-to-date information, MTM plays a key role in giving us up-to-date information.
Downside of MTM
However, when misused, it can result in a distorted picture of a company’s value. That’s exactly what happened with Enron.
In the Enron scandal, the company used mark-to-market accounting to value long-term energy contracts.
These were contracts that promised to deliver energy supplies at a set price in the future. When Enron signed these contracts, it would immediately record the projected profits, even though no money had changed hands and the profits would only be realized many years down the line.
Many have called this “Inflated Revenue Reporting”.
Enron used this method to greatly inflate its earnings. For instance, if they signed a contract promising $100 million in revenue over 10 years, they would instantly book $100 million as earnings, even though they hadn’t actually received the money. The problem was that the future is unpredictable, and many times, the anticipated profits never materialized.
This is a key difference between the income statement and cash flow statement. An investor can know all the differences between the two statements. But if the information is distorted, that inference becomes useless. This also explains the important of auditing that accounting firms do.
Unfortunately, investors were misled by the inflated profits and the company’s share price kept climbing until the truth was unveiled. This resulted in one of the largest corporate scandals in history. The Enron scandal illustrates the dangers of misusing accounting methods like mark-to-market, and highlights the importance of transparency and integrity in corporate financial reporting.