A Simple Explanation of Mark-to-Market Accounting

by: Vahan Janjigian, CFA

A good friend forwarded this humorous explanation of mark-to-market accounting. It was produced by John Carney and can be found at businessinsider.com:

You have two cows.

You write down on a piece of paper that the cows are worth $100 each.

You notice the cows are on fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the fire.

Your cows are dead from fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the dead cows.

You notice that you aren't getting as much milk as expected, so you adjust the model and mark the cows down to $98. You are confident, however, that the dislocated stream of milk revenue will quickly revert to expectations.

You need to borrow some money so you ask investors for a loan against the cows. The investors tell you the cows are dead, and you already owe them $200 dollars you borrowed to buy them in the first place. You show them the paper that says the cows are worth $98 each.

They light your paper on fire.

You ask the government to buy the dead cows at $98 each.

The government holds meetings all weekend and finally comes up with a plan to inject $45 dollars into your cattle ranch. In exchange, the government gets a right to milk generated from the cows at some point in the future. It expects you'll buy a new cow with the $45.

You have two dead cows, $45 and $200 in debt to your investors. You have no plans to buy new cows.


That is very entertaining, but here is a more realistic view of mark-to-market accounting:

Suppose it is not your cows that catch on fire and die, but your neighbor's cows. Your neighbor tries to sell his dead cows, but no one wants to buy them.

Since you own the same kind of cows, mark-to-market accounting forces you to value your cows at zero because no one is willing to buy your neighbor's cows.

Even though your cows are still alive, still producing milk, and still helping you generate positive cash flows, you have to pretend they are worthless.


This is why mark-to-market accounting needs to be fixed.