Marking to Market (Financial Derivatives)
Marking to market refers to the daily settling of gains and losses due to changes in the market value of the security. For financial derivative instruments, such as futures contracts, use marking to market.
If the value of the security goes up on a given trading day, the trader who bought the security (the long position) collects money – equal to the security’s change in value – from the trader who sold the security (the short position). Conversely, if the value of the security goes down on a given trading day, the trader who sold the security collects money from the trader who bought the security. The money is equal to the security’s change in value.
The value of the security at maturity does not change as a result of these daily price fluctuations. However, the parties involved in the contract pay losses and collect gains at the end of each trading day.
Arrange futures contracts using borrowed money via a clearinghouse. At the end of each trading day, the clearinghouse settles the difference in the value of the contract. They do this by adjusting the margin posted by the trading counterparties. The margin is also the collateral.
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Marked to Market (Accounting Treatment)
According to GAAP, record certain assets, such as marketable securities, at market value on the balance sheet because this value is more relevant than historical cost for this type of asset. Gains and losses from marketable securities are reported differently depending on whether the asset is classified as available-for-sale or trading.
Label gains and losses from fluctuations in market value of securities as available-for-sale. Also report these in the other comprehensive income account in the equity section of the balance sheet. Any adjustments from fluctuations in market value of securities labeled trading are reported as unrealized gains or losses on the income statement. For both types of securities, dividends or gains and losses from sale are reported as other income on the income statement.
Unethical accountants might attempt to manipulate net income. They do this by labeling marketable securities as either available-for-sale or trading depending on whether they increased or decreased in value.
Mark to Market Examples
For a financial derivative example, consider two counterparties that enter into a futures contract. The contract includes 10 barrels of oil, at $100 per barrel, with a maturity of 6 months. And the value of the futures contract is $1,000. At the end of the next trading day, the price of oil is $105 per barrel. The trader in the long position collects $50 ($5 per barrel) from the trader in the short position.
For an accounting example, consider a company that has passive investments in two stocks, A and B. Stock A is classified as available-for-sale and is worth $10 per share. But Stock B is classified as trading and is worth $50 per share. At the end of the accounting period, A is worth $15 and B is worth $40.
A gain equal to $5 per share of stock A would be recorded in the other comprehensive income account in the equity section of the company’s balance sheet. The marketable securities account on the asset side of the balance sheet would also increase by that amount. An amount equal to $10 per share of stock B would be recorded as an unrealized loss on the company’s income statement. The marketable securities account would also decrease by that amount.
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