Fair value hierarchy level 3 inputs

What Is Fair Value Hierarchy Level 3 Inputs?

Fair value hierarchy level 3 inputs are the least observable inputs used in valuation models to determine the fair value of assets or liabilities. These inputs are often uncorroborated by market data and require significant judgment and estimation by the reporting entity. As a critical component of financial accounting and financial reporting under accounting standards like ASC 820 (U.S. GAAP) and IFRS 13, Level 3 inputs are utilized when observable market data for an asset or liability is scarce or non-existent. The fair value hierarchy, which classifies inputs into three levels based on their observability, prioritizes Level 1 (most observable) over Level 2, and Level 2 over Level 3. Consequently, the reliance on Level 3 inputs indicates a highly subjective and less transparent fair value measurement.

History and Origin

The concept of the fair value hierarchy, including the distinction of fair value hierarchy level 3 inputs, originated with the Financial Accounting Standards Board (FASB) in the United States. In September 2006, FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157). This standard aimed to provide a unified definition of fair value, establish a framework for its measurement within Generally Accepted Accounting Principles (GAAP), and expand disclosures related to fair value measurements. Before FAS 157, various definitions of fair value existed across different FASB pronouncements, leading to inconsistencies and a lack of comparability in financial reports⁶.

FAS 157, later codified into Accounting Standards Codification (ASC) Topic 820, introduced the three-level hierarchy to categorize inputs based on their observability. The motivation behind this structure was to enhance transparency and provide users of financial statements with information about the reliability of fair value measurements. The standard defines fair value as the "price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price)."⁵ The International Accounting Standards Board (IASB) later issued IFRS 13, Fair Value Measurement, which largely converges with ASC 820, aiming to unify the meaning of fair value across major global accounting frameworks⁴,.

Key Takeaways

• Fair value hierarchy level 3 inputs are the least reliable and most subjective inputs used in fair value measurements.
• They are unobservable inputs, often derived from a reporting entity's own assumptions, used when market data is unavailable.
• Measurements relying on Level 3 inputs are disclosed separately in financial statements, highlighting their increased estimation uncertainty.
• These inputs are common for valuing illiquid investments and complex financial instruments.
• Greater reliance on Level 3 inputs can lead to reduced comparability and heightened scrutiny of financial reports.

Valuation Approaches and Techniques

Fair value hierarchy level 3 inputs do not have a specific formula for their calculation; rather, they are the unobservable variables used within broader valuation techniques or models to arrive at a fair value measurement. When using Level 3 inputs, companies typically employ one or a combination of the following valuation approaches:

1. Market Approach: This approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. When Level 3 inputs are involved, this might include recent private transactions for similar assets, where adjustments are made for differences using unobservable inputs like control premiums or liquidity discounts.
2. Income Approach: This approach converts future amounts (e.g., cash flow or earnings) into a single current (discounted) amount. Common techniques include the discounted cash flow (DCF) method or option pricing models. Level 3 inputs in this approach might include projected revenue growth rates, expense assumptions, long-term growth rates, or specific discount rates for unlisted entities, which are not observable in active markets.
3. Cost Approach: This approach reflects the amount that would be required to replace the service capacity of an asset (replacement cost new). While less common for financial instruments, for certain tangible assets with Level 3 characteristics, it might involve unobservable estimates of depreciation or obsolescence.

The selection of valuation techniques and the determination of Level 3 inputs require significant judgment, often supported by internal data, historical trends, and industry-specific knowledge, due to the lack of readily available market information.

Interpreting Fair Value Hierarchy Level 3 Inputs

Interpreting fair value measurements that predominantly use fair value hierarchy level 3 inputs requires a nuanced understanding of their inherent subjectivity. When an asset or liability is categorized as Level 3, it signals that its valuation relies heavily on the reporting entity's own assumptions about how market participants would price the item, rather than on independent market data. This means the value reported on the balance sheet is an estimate, and a change in those unobservable inputs could significantly alter the reported fair value.

For investors and analysts conducting investment analysis, the presence and magnitude of Level 3 assets and liabilities in a company's financial statements are crucial. A high proportion of Level 3 measurements suggests a less transparent and potentially more volatile financial position, as these values are less verifiable. Companies are required to disclose extensive qualitative and quantitative information about Level 3 inputs, including the valuation processes, sensitivity analysis, and transfers into and out of Level 3, providing users with insights into the inherent risk assessment and potential variability of these valuations.

Hypothetical Example

Consider "AlphaTech Ventures," a private equity firm that holds a significant stake in "BioGen Innovations," a pre-revenue biotechnology startup. BioGen Innovations' primary assets include unpatented intellectual property and early-stage research and development efforts, with no public market for its shares. AlphaTech Ventures needs to report the fair value of its investment in BioGen Innovations for its quarterly financial reporting.

Since BioGen has no observable market transactions and is not generating revenue, AlphaTech cannot use Level 1 or Level 2 inputs. Instead, it must rely on fair value hierarchy level 3 inputs. AlphaTech's valuation team decides to use an income approach, specifically a discounted cash flow (DCF) model, to estimate BioGen's future value.

Here's how Level 3 inputs would be applied:

1. Projected Revenue Growth Rates: AlphaTech's team makes assumptions about when BioGen will achieve regulatory approval for its drugs, when it will launch products, and how quickly its revenue will grow post-launch. These are highly speculative, unobservable inputs.
2. Terminal Value Growth Rate: The rate at which BioGen is assumed to grow indefinitely after the explicit forecast period. This is a critical Level 3 input, as even small changes can significantly impact the valuation.
3. Discount Rate (Cost of Capital): AlphaTech determines a discount rate to apply to the projected cash flows, reflecting the high risk associated with an early-stage biotech firm. This rate is derived from unobservable inputs such as an estimated risk premium for venture capital investments of similar stage and industry, adjusted for BioGen's specific risks.

AlphaTech calculates a fair value for its stake based on these unobservable, internally developed assumptions. The resulting fair value is classified as Level 3, and AlphaTech must disclose the range of these key inputs and their sensitivity to changes in its financial statements.

Practical Applications

Fair value hierarchy level 3 inputs are predominantly found in the valuation of financial instruments and other assets for which active markets do not exist or are highly illiquid. Key areas where these inputs are applied include:

• Private Equity and Venture Capital Investments: Portfolios of unlisted companies, which do not have publicly traded shares, are typically valued using Level 3 inputs. This involves financial models that incorporate assumptions about future performance, market multiples from comparable private transactions (if available), and liquidity discounts.
• Complex Derivatives: Over-the-counter (OTC) derivatives, such as complex interest rate swaps or credit default swaps with bespoke terms, often lack observable market prices or directly comparable instruments. Their valuation relies on models incorporating unobservable inputs like volatility assumptions, correlation estimates, or specific default probabilities.
• Asset-Backed Securities (ABS) and Collateralized Debt Obligations (CDOs): Especially during periods of market stress, the underlying assets of these structured products may become illiquid, making their valuation dependent on Level 3 inputs related to expected cash flows, default rates, and recovery rates, which can be difficult to ascertain without active trading. The subprime mortgage crisis highlighted challenges with valuing such complex instruments under FAS 157.
• Illiquid Real Estate Holdings: Certain specialized or development-stage real estate properties may not have readily available comparable sales data, leading to valuations based on discounted future rental income projections or construction cost estimates that are unobservable.
• Intangible Assets in Business Combinations: When a company acquires another business, it must fair value all identifiable intangible assets (e.g., customer relationships, brand names, proprietary technology). These often require significant unobservable inputs, such as projections of future revenue attributable to the asset or estimated useful lives.

These practical applications highlight that while Level 3 inputs introduce subjectivity, they are essential for valuing assets and liabilities where market transparency is limited, providing an estimated value for the purposes of accounting standards.

Limitations and Criticisms

Despite their necessity for valuing complex and illiquid holdings, fair value hierarchy level 3 inputs face significant limitations and criticisms, primarily due to their reliance on unobservable data and subjective management judgment.

One major criticism is the potential for manipulation or bias. Since Level 3 inputs are not market-corroborated, management has considerable discretion in selecting assumptions. This can lead to valuations that may not accurately reflect an asset's true economic worth, potentially overstating asset values or understating liabilities. Such concerns were particularly prominent during the 2008 financial crisis, when the valuation of mortgage-backed securities and other complex financial instruments became highly contentious, and debates arose about the role of fair value accounting,³,². Critics argued that mark-to-market accounting, especially with Level 3 inputs, exacerbated the crisis by forcing write-downs based on illiquid or nonexistent markets, creating a downward spiral¹.

Another limitation is the lack of comparability across different entities. Even for similar assets, two companies might arrive at different fair values due to differing assumptions for Level 3 inputs. This hinders the ability of investors and analysts to conduct meaningful cross-company comparisons. The complexity of the models used for Level 3 valuations also makes it challenging for external users to understand and scrutinize the underlying assumptions, potentially eroding confidence in the reported figures.

Furthermore, Level 3 valuations are highly sensitive to changes in inputs. Small adjustments to unobservable assumptions like growth rates, discount rates, or volatility can lead to substantial changes in the reported fair value, introducing significant earnings volatility that may not reflect changes in core business operations. For example, a slight tweak in a long-term growth assumption for a private equity investment can dramatically alter its reported value. Regulators and standard-setters continue to refine disclosure requirements to mitigate these issues, but the inherent subjectivity of fair value hierarchy level 3 inputs remains a fundamental challenge for financial accounting.

Fair Value Hierarchy Level 3 Inputs vs. Fair Value Hierarchy Level 1 Inputs

The distinction between fair value hierarchy level 3 inputs and Fair value hierarchy level 1 inputs is crucial for understanding the reliability and transparency of fair value measurements. The fair value hierarchy, established by accounting standards like ASC 820, categorizes inputs into three levels based on their observability:

While Level 1 inputs offer the most transparent and objective fair value measurements due to readily available and liquid market prices for identical items, fair value hierarchy level 3 inputs are used for assets and liabilities that lack such observable data. This fundamental difference means that valuations relying on Level 3 inputs involve a higher degree of subjectivity and estimation, necessitating more extensive disclosures to inform users of financial statements about the underlying assumptions and potential uncertainties.

FAQs

What types of assets typically use Level 3 inputs?

Assets that typically rely on fair value hierarchy level 3 inputs include investments in private companies (like those held by private equity or venture capital firms), complex and bespoke over-the-counter derivatives, certain illiquid investments like specialized real estate, and some intangible assets acquired in business combinations. These assets lack active markets or directly comparable items.

Why are Level 3 inputs considered less reliable?

Fair value hierarchy level 3 inputs are considered less reliable because they are unobservable and largely based on the reporting entity's own assumptions and judgments, rather than on independent market data. This introduces a higher degree of subjectivity and potential for estimation error or bias in the resulting fair value measurement.

How do companies determine Level 3 inputs?

Companies determine fair value hierarchy level 3 inputs by developing their own assumptions about how market participants would price the asset or liability. This often involves using sophisticated valuation models like discounted cash flow (DCF) models or option pricing models, where the unobservable inputs are estimates of future cash flows, growth rates, discount rates, volatility, or other factors unique to the specific asset.

Do Level 3 inputs indicate a problem with a company's financial health?

Not necessarily. The presence of fair value hierarchy level 3 inputs does not inherently indicate a problem with a company's financial health. Many legitimate investments, particularly in private equity or alternative assets, naturally require Level 3 valuations due to their illiquid nature. However, a significant reliance on Level 3 inputs warrants closer scrutiny from investors and analysts, as it implies greater subjectivity and potentially higher volatility in the reported assets and liabilities.