How to cope with 'mark to market' mayhem

Mark-to-market (M2M) accounting can cause cool investors to lose their heads - and their money. So how do you avoid becoming its next victim? Tim Bennett explains.

Mark-to-market (M2M) is not a phrase that gets the pulse racing. However, it pervades almost every corner of investing. It can also cause normally cool investors to lose their heads, and money. Here's how to avoid becoming its next victim.

What is mark-to-market?

If you buy an asset, keep it for five years, and then sell it, accountants reckon there are two ways to treat any gain or loss. Let's say you buy 1,000 shares for £1 each and eventually sell them for £1.20 each. Option one would be to book a profit when you make the sale five years later that's £1,200-£1,000, or £200.

In the meantime the asset sits in your books (on the balance sheet) at cost £1,000. It's a simple system. So what's wrong with it? Fans of M2M argue that, from the moment you buy the asset, the cost figure is out of date. Given any profit (or loss) on disposal is only recorded when you sell, a fund manager or company director can time sales to maximise gains (or minimise losses) and therefore massage consecutive profit figures.

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Say you buy the same 1,000 shares and at the end of year one the share price is 80p, at the end of year two 70p, at the end of year three 90p, year four 110p and then the shares are sold in year five for 120p each. M2M says you should capture the asset at its market price at the end of each year with any gain recorded in that year's profit and loss account, regardless of whether you make a sale or not.

MoneyWeek videosWhy 'mark to market' mattersWhat M2M is, how it can make life difficult, & whatto do about itWatch all of Tim's videos here

So the asset would start at £1,000 (in the firm's balance sheet) and then drop to £800 (1,000 shares x 80p), then £700, then rise to £900, then £1,100 and finally you'd sell the shares for £1,200. The gain on disposal would be the last recorded value of the shares £1,100 compared to the sale proceeds of £1,200, so £100.

Meanwhile, in your profit and loss you'd book the annual change in the value of the shares. So for year one, that's a £200 loss (£800-£1,000), for year two a £100 loss (£700-£800), for year three a £200 gain (£900-£700), for year four another £200 gain (£1,100-£900) and then a final gain on sale of £100 (£1,200-£1,100). So, you have booked a cumulative total gain of -£200-£100+£200+£200+£100, or £200, under this system.

Who uses this system?

M2M is used in three key areas of investing. Fund managers mark their portfolios to market daily, if not more often. Derivatives brokers also use it to calculate margin calls from their clients. If you place a down bet (say a spread bet) on the FTSE 100 and it starts to rise sharply, to keep the bet open you will face margin calls' as the FTSE moves away from you in the wrong direction. This protects the broker against a default ie, you deciding not to honour your losses. The third application of the rules is companies reporting their results. And here things can get messy for investors.

When does M2M go wrong?

The strongest case for M2M is in the derivatives world. Bets are usually short term and the risk to a broker is high should a client run up losses fast. It makes sense to ensure open client positions are re-evaluated regularly and gains or losses booked and funded.

Fund managers also have a case. Accurate portfolio valuations are useful, but can encourage short-termism. For some assets there is scope to manipulate performance where there is no readily available market price. Pricing an illiquid share may require the fund manager to mark to model' (or what I call mark to madness'). They estimate what a share is worth now and mark their holding to that estimate despite having no plans to sell. Sometimes they may be forced to use market' prices based on very low sales volumes.

During the worst days of the credit crunch, as liquidity dried up, anyone holding illiquid assets was forced to write them down to fire-sale' prices. The resulting book losses caused widespread panic and nearly triggered an M2M ban by the American regulator.

When it comes to companies, aside from being complex and difficult to apply, M2M can be downright misleading. Here are two examples. Take a firm with a defined-benefit employee pension fund. M2M says it must regularly compare the value of the assets set aside for pensions (usually a mixture of share and bonds) to the estimated value of all future liabilities to its future retirees. The market value of those assets is £500m and the estimated value of the scheme's liabilities is £500m, but the stockmarket crashes and wipes £200m off the scheme's assets. Suddenly the scheme is £200m in deficit (assets of £300m versus liabilities of £500m) and this, say M2M fans, must be recorded now.

The fact that the liabilities won't materialise for years and the assets may recover, is ignored. The result can be massive, meaningless, short-term volatility in a company's results. Next, take a bank that has issued IOUs (bonds) to fund itself, currently valued at £10m. A nervous ratings agency downgrades the debt, which depresses the value of the firm's IOUs to £8m as worried investors mark down its debt. M2M argues that if the firm cleared its debts right now, it would only pay out £8m. Prior to the write-down the payment would have been £10m. That's a bonus and triggers a book gain of £2m to be shown now despite the fact the bonds may not be redeemed for years.

What to do

M2M accounting was designed with good intentions investors need accurate, up-to-date information. However, it can also produce misleading results and even create short-term panic around otherwise sound companies. So, watch a company's cash flow carefully if the operating (the first main subheading) and net cash flow (the last subheading) in the cash-flow statement remain consistent you can relax and stay invested even if profits are swinging around as M2M wreaks short-term havoc.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.