Mark to Model

Mark to model is one of the most popular accounting practices that have been used across the globe. It is a practice that involves sharing of assets based on a mathematical model as opposed to market price.

In many cases, the accounting model is used on assets whenever there is no active market. However, it is good to note that Level 3 assets are often valued depending on a financial model used in an economy. Therefore, mark to model is the opposite of mark to market model where asset values are recorded based on the last price recorded on public exchange.

Mark to model takes into consideration the payout for specific assets. It also takes into consideration the risks involved when trading in the assets as well as their expiration date. In addition, it has a wide array of inputs that are very subjective and have been often criticized for providing a value that is more of illusion than real value.

In mark to model, an insurer may provide a policy that covers oil refineries. Therefore, oil refiners will have to pay an insurer over a specified of time. The periodic payments will however be paid back by an insurer in the event of a major disaster. The contracts in mark to model may not be traded publicly as in the case of market to market.

Contracts in mark to model are also highly specialized. This means that it can be very hard to find the real value of assets. A model that will help traders to find the expected payout, probability of finding a market, premiums and the probability of a disaster will have to be created.

In the case of an insurance company, an insurer can report an asset or a liability in a balance sheet. An insurer will also have to record its real value based on mark to model rather than the asset’s real market value.

Why mark to model matters

Mark to model has been considered a risky method of finding the value of assets and liabilities by economists. It is even more risky if it is used to price assets that are traded in a liquid and the market is declining. This is based on the fact that the model is always subjective at an individual level.

Mark to model does not put into account the number of buyers and sellers in the market who are willing to value an asset. Individuals therefore, may not agree on the accuracy if the price of assets priced using mark to model method.

The system also matters bearing in mind that it was used during the credit crisis in late 2000s. Mortgages and securities lost a lot of their values within a very short time. Federal Accounting Standards Board suspended mark to market accounting in favor of the model only to provide way to financial institutions to put up a value for their mortgages.

With mark to model, financial institutions were also able to place a value on MBSs in an old and tumultuous market. The model is similarly used in private bond market whenever it goes liquid.

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 Sources

http://www.wikinvest.com/wiki/Mark_to_model

http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/mark-model-3738