What Is Mark to Model?
Mark to model is a valuation methodology used in financial accounting to determine the fair value of financial instruments and other assets or liabilities when observable market data is unavailable or insufficient. Unlike mark to market, which relies on readily available market prices, mark to model involves the use of internal valuation models and assumptions to estimate an asset's or liability's worth. This approach falls under the broader category of financial reporting and is particularly relevant for illiquid assets or complex instruments for which an active market does not exist. The application of mark to model requires significant judgment and expertise, as the inputs used are often unobservable and reflect the entity's own assumptions about what market participants would consider.
History and Origin
The concept of valuing assets based on models has evolved alongside the increasing complexity of financial markets and instruments. While valuation techniques have always been part of financial practice, the formalized application and scrutiny of mark to model gained significant prominence following the 2008 global financial crisis. During this period, many complex and structured financial products, such as mortgage-backed securities, lacked active markets, making it impossible to apply traditional mark to market accounting. This forced financial institutions to rely heavily on internal models to value these distressed assets.
In response to the challenges highlighted by the crisis, accounting standards bodies and regulators emphasized the need for clearer guidance on fair value measurements, particularly for assets valued using unobservable inputs. The Financial Accounting Standards Board (FASB) in the United States, through its Accounting Standards Codification (ASC) Topic 820 (superseding Statement of Financial Accounting Standards 157), and the International Accounting Standards Board (IASB) with IFRS 13, provided frameworks for fair value measurement, including a three-level hierarchy. Mark to model valuations typically fall into Level 3 of this hierarchy, signifying the reliance on unobservable inputs. Additionally, regulatory bodies like the Basel Committee on Banking Supervision issued guidance to banks to strengthen their valuation processes for financial instruments, especially those with little market activity7. The U.S. Securities and Exchange Commission (SEC) also adopted new rules to modernize and codify principles-based frameworks for fair value determination for fund investments, particularly for illiquid securities6.
Key Takeaways
- Mark to model is a valuation method used when active market prices for an asset or liability are unavailable.
- It relies on internal valuation models and significant management judgment regarding unobservable inputs.
- This method is commonly applied to complex or illiquid assets where market-based prices cannot be reliably obtained.
- Valuations derived from mark to model fall into Level 3 of the fair value hierarchy, indicating a high degree of subjectivity.
- Proper governance, independent validation, and transparent disclosure are crucial for ensuring the reliability of mark to model valuations.
Interpreting the Mark to Model
Interpreting a mark to model valuation requires a deep understanding of the underlying assumptions and models used, as it is inherently more subjective than market-observable valuations. Unlike a quoted price for a publicly traded stock, a mark to model valuation is an estimate derived from a set of inputs and methodologies chosen by the entity performing the valuation. Users of financial statements must recognize that these valuations reflect the entity's best judgment given available information, rather than a price directly observed in an active market.
The reliability of a mark to model valuation hinges on the robustness of the valuation models, the quality of the unobservable inputs, and the consistency of their application. It is important to consider the potential range of outcomes that different reasonable assumptions might yield. Disclosure requirements often necessitate that companies provide information about the sensitivity of Level 3 fair values to changes in significant unobservable inputs, offering insight into the potential variability of the valuation.
Hypothetical Example
Consider "Alpha Fund," a hypothetical investment firm holding a significant stake in a startup specializing in cutting-edge, proprietary quantum computing technology. Since this is a private company, there are no public market prices available for its shares. To value this investment for its quarterly financial reporting, Alpha Fund must use a mark to model approach.
- Selection of Model: Alpha Fund's investment adviser chooses a discounted cash flow (DCF) model, a common valuation model for private companies, as the primary method.
- Input Estimation: The team then estimates key inputs for the DCF model. Since the company is new and its market is nascent, these are largely unobservable inputs:
- Revenue Projections: Based on market research, anticipated growth rates for quantum computing, and discussions with the startup's management.
- Operating Expenses: Estimated based on the startup's current burn rate and planned future investments in research and development.
- Discount Rate: Derived from a blend of the estimated cost of equity (using a venture capital specific risk premium) and the cost of debt (if any), reflecting the inherent risks of a speculative technology startup.
- Terminal Value Assumptions: Projections for the company's value beyond the explicit forecast period, based on an assumed long-term growth rate or exit multiple.
- Calculation: The model calculates the present value of the projected future cash flows, resulting in a single estimated fair value for Alpha Fund's stake in the startup.
- Review and Validation: The valuation is reviewed by an independent valuation committee or external auditor to ensure the assumptions are reasonable and the model is applied consistently with accounting standards.
This estimated value is then recorded on Alpha Fund's balance sheet, subject to re-evaluation in subsequent periods as the startup progresses or market conditions change.
Practical Applications
Mark to model valuations are essential in various segments of the financial industry, particularly where assets are complex, unique, or lack an active trading market.
- Private Equity and Venture Capital: Investment firms in these sectors often hold stakes in private companies that are not publicly traded. Valuing these illiquid assets requires the use of models such as discounted cash flow analysis, precedent transactions, or market multiple approaches.
- Hedge Funds and Structured Products: Funds that invest in highly customized or structured financial products, like certain derivatives, collateralized debt obligations (CDOs), or complex mortgage-backed securities, frequently rely on mark to model for valuation. These instruments are often tailored to specific needs and do not trade on public exchanges.
- Banks and Financial Institutions: Banks use mark to model for various assets and liabilities on their balance sheets, including certain loans, loan commitments, and complex financial instruments that are not actively traded. The Federal Reserve, for instance, has addressed fair value accounting for derivatives, noting the challenges in valuation and the importance of appropriate accounting policies5.
- Insurance Companies: Insurers often hold long-duration or complex assets and liabilities, such as certain reinsurance contracts or illiquid bond portfolios, that necessitate mark to model techniques for fair value determination.
- Regulatory Capital Calculation: For financial institutions, the valuation of certain assets, including those valued mark to model, directly impacts their capital requirements and regulatory reporting. Supervisory bodies expect strong governance and control processes around these valuations to ensure their reliability for regulatory purposes4.
Limitations and Criticisms
While mark to model provides a necessary means to value assets without observable market data, it is subject to several significant limitations and criticisms. A primary concern is its inherent subjectivity, as the valuation heavily depends on the assumptions and judgments made by the entity performing the valuation. This reliance on unobservable inputs can lead to a lack of comparability between financial statements of different entities, even when they hold similar assets, if they use different models or assumptions.
Critics argue that mark to model valuations can be susceptible to earnings management or manipulation. If management has discretion over key assumptions, there is a risk that valuations could be biased to present a more favorable financial picture or to smooth earnings. This concern was particularly amplified during the 2008 financial crisis, where some perceived that the inability to reliably value complex assets contributed to a lack of transparency and exacerbated market instability. Research indicates that mark to model is controversial because it is susceptible to manipulation and has poor verifiability, potentially making asset impairment tests noisy and leading to managerial unethical behavior3.
Furthermore, auditing mark to model valuations can be challenging for external auditors due to the complexity of the models and the subjective nature of the inputs. Verifying the reasonableness of internal assumptions about future cash flows or discount rates for unique, illiquid assets requires specialized expertise. Despite regulatory guidance from bodies like the SEC, the process still requires extensive judgment2.
The lack of standardization in inputs and methodologies, coupled with the potential for human error in complex models, also presents a limitation. These factors can reduce the reliability of the reported fair values and potentially obscure the true financial health of an entity, leading to questions about financial stability if such valuations are widespread across the financial system.
Mark to Model vs. Mark to Market
The distinction between mark to model and mark to market lies primarily in the source and observability of the inputs used for valuation within the context of fair value accounting.
| Feature | Mark to Model | Mark to Market |
|---|---|---|
| Primary Input | Internal valuation models and unobservable inputs | Observable market prices for identical assets |
| Market Activity | Used when active market data is unavailable/insufficient (Level 3) | Used when active and liquid markets exist (Level 1) |
| Subjectivity | High, due to reliance on assumptions and judgment | Low, as it uses readily available, objective prices |
| Applicability | Illiquid assets, complex derivatives, private equity | Publicly traded stocks, bonds, liquid commodities |
| Transparency | Lower, requires detailed disclosures about assumptions | Higher, directly reflects market sentiment |
Confusion often arises because both methods aim to determine fair value, but they do so under different market conditions and with varying degrees of certainty. Mark to market represents the ideal, providing the most reliable and verifiable valuation. However, when an active and observable market does not exist, mark to model becomes a necessary alternative. While mark to market aims to reflect real-time values, it can also introduce volatility into financial statements, especially during market downturns1. Mark to model, by contrast, smooths out some of this volatility but introduces the risk of subjective bias.
FAQs
What types of assets are valued using mark to model?
Mark to model is primarily used for assets and liabilities that do not have active markets or readily observable prices. This includes illiquid assets like certain private equity investments, complex derivatives or structured products, and some types of loans or long-term contracts. The absence of a liquid market necessitates the use of internal valuation models to estimate their fair value.
Is mark to model a reliable valuation method?
The reliability of mark to model depends heavily on the quality of the valuation models used, the reasonableness of the unobservable inputs, and the rigor of the internal controls and validation processes. While it is less objective than mark to market because it relies on internal assumptions, it is a necessary method for valuing assets in illiquid markets when no other observable data exists. Accounting standards and regulatory bodies provide guidance to enhance its reliability and transparency.
How does mark to model affect a company's financial statements?
Mark to model valuations directly impact the assets and liabilities reported on a company's balance sheet at fair value. Changes in these valuations, whether realized or unrealized, can flow through the income statement, affecting reported earnings. For example, if the estimated fair value of an asset valued mark to model increases, it can result in an unrealized gain. This can introduce volatility to earnings, especially for companies with significant holdings of Level 3 assets. These valuations also play a role in determining net asset value (NAV).
What are "unobservable inputs" in mark to model?
Unobservable inputs are data points or assumptions that are not based on directly observable market transactions or conditions. Examples include internally developed projections of future cash flows, assumptions about future interest rate volatility for a complex derivative, or estimated default rates for a unique loan portfolio. These inputs require significant judgment and are used when observable market data is unavailable.