Level 3

What Is Level 3?

Level 3 refers to the category within the Fair Value Hierarchy that represents unobservable inputs used in the valuation of assets or liabilities. This hierarchy, established under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 820, Fair Value Measurement, aims to enhance consistency and comparability in financial reporting. Assets and liabilities are categorized into three levels based on the observability of the inputs used to determine their fair value. Level 3 inputs are the least observable, meaning they are developed using the reporting entity's own assumptions about how market participants would price the asset or liability, rather than relying on active market data. This category is typically applied to illiquid assets or liabilities for which there is little to no market activity, making their valuation inherently subjective.

History and Origin

The concept of a fair value hierarchy, including the distinction of Level 3 inputs, emerged with the issuance of FASB Statement No. 157, Fair Value Measurements, in 2006. This standard, now codified as ASC 820, was introduced to standardize valuation techniques and improve the transparency of investment values, particularly following periods of market volatility such as the dot-com bubble, where inconsistent valuation methods had led to market distortions⁶. The objective was to provide a framework for measuring fair value and ensure consistency in financial statements prepared under Generally Accepted Accounting Principles (GAAP)⁵.

The importance and controversy surrounding Level 3 inputs gained significant attention during the 2008 financial crisis. As markets became illiquid, many financial instruments, particularly complex structured products like mortgage-backed securities, lacked observable market prices⁴. This forced financial institutions to increasingly rely on Level 3 inputs for their valuations, leading to concerns about the reliability and potential for manipulation of reported asset values. While some critics argued that fair value accounting, particularly the reliance on Level 3 inputs, exacerbated the crisis by forcing excessive write-downs, studies from organizations like the National Bureau of Economic Research (NBER) suggested that fair-value accounting was unlikely to have been a major contributor to the severity of the crisis³. The Securities and Exchange Commission (SEC) also conducted a study mandated by Congress, which recommended against suspending fair value accounting standards but suggested developing additional guidance for valuing investments in inactive markets.

Key Takeaways

• Level 3 inputs are the least observable inputs in the fair value hierarchy, used when active markets or observable data are unavailable.
• They rely on the reporting entity's own assumptions about how market participants would price an asset or liability.
• Valuations using Level 3 inputs are inherently subjective and often require complex valuation models.
• Assets or liabilities measured using Level 3 inputs typically include illiquid securities, private equity investments, and certain derivatives.
• Transparency regarding Level 3 inputs is crucial for understanding the potential volatility and risk associated with a company's balance sheet.

Formula and Calculation

While there isn't a single universal "formula" for Level 3 inputs, their calculation typically involves the use of complex valuation techniques and models. These models require significant judgment and the use of unobservable inputs that are not readily available in active markets.

Common valuation approaches include:

• Income Approach: This approach converts future amounts (e.g., cash flows or earnings) to a single current (discounted) amount. This often involves models like Discounted Cash Flow (DCF) models or earnings multiple approaches.
• Market Approach: This approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. When applied to Level 3, this might involve using transactions of similar, but not identical, assets and making significant adjustments based on expert judgment.
• Cost Approach: This approach reflects the amount that would be required currently to replace the service capacity of an asset (its current replacement cost).

For example, a discounted cash flow model, which falls under the income approach, might use the following general formula:

Where:

• (FV) = Fair Value
• (CF_t) = Cash flow in period (t)
• (r) = Discount rate (often a subjective input based on risk and market conditions)
• (t) = Time period
• (n) = Number of periods

The significant challenge with Level 3 valuations is that the inputs for these models, such as future cash flows or discount rates, are largely unobservable and require considerable assumptions from the reporting entity.

Interpreting Level 3

Interpreting valuations based on Level 3 inputs requires a high degree of skepticism and a deep understanding of the underlying assumptions. Since these inputs are unobservable and derived from the reporting entity's own assumptions, they carry the highest level of valuation uncertainty.

When evaluating an asset or liability classified as Level 3, it's crucial for users of financial statements to:

• Examine Disclosures: Companies are required to provide extensive disclosures about the valuation techniques used, the significant unobservable inputs, and a sensitivity analysis showing how changes in those inputs would impact the fair value measurement².
• Understand Model Assumptions: Review the models used (e.g., Discounted Cash Flow (DCF), Option Pricing Models) and the specific inputs that are unobservable. For instance, a small change in an assumed discount rate or volatility for a derivative could lead to a significant change in the reported fair value.
• Assess Management Judgment: Recognize that the reported fair value heavily relies on management's judgment and estimates. This does not imply impropriety, but rather highlights the subjective nature of these valuations.

Hypothetical Example

Consider a private equity firm, Alpha Investments, that holds a significant stake in a newly established, privately held biotechnology startup, Bio-Innovate. Since Bio-Innovate is not publicly traded and has no readily observable market data for its shares, Alpha Investments must value this investment using Level 3 inputs.

Step-by-Step Valuation:

1. Select Valuation Approach: Alpha Investments decides to use an income approach, specifically a discounted cash flow (DCF) model, given Bio-Innovate's early stage and projected future growth.
2. Project Future Cash Flows: Alpha Investments' finance team projects Bio-Innovate's future cash flows for the next five years, based on business plans, market potential, and industry trends. These projections are highly speculative and serve as unobservable inputs.
3. Determine Discount Rate: The team then determines a discount rate to apply to these projected cash flows. This rate reflects the risk inherent in a startup biotechnology company and may be derived from the weighted average cost of capital (WACC) of comparable public companies, with significant adjustments for Bio-Innovate's specific risks (e.g., lack of revenue, regulatory hurdles). This adjusted rate is another key unobservable input.
4. Calculate Terminal Value: For periods beyond the explicit forecast, a terminal value is estimated, often using a growth perpetuity formula, which also relies on unobservable long-term growth rate assumptions.
5. Compute Fair Value: Using the DCF model, the projected cash flows and terminal value are discounted back to the present using the determined discount rate. The resulting figure is the estimated fair value of Alpha Investments' stake in Bio-Innovate.

Because the cash flow projections, discount rate, and terminal growth rate are not observable in the market, this valuation falls under Level 3. Alpha Investments would then be required to disclose these significant unobservable inputs and how changes in them would affect the valuation in its financial statements.

Practical Applications

Level 3 inputs are most prevalent in the valuation of assets and liabilities that lack active markets, which often include:

• Private Equity and Venture Capital Investments: Valuing investments in privately held companies, which do not have quoted market prices, relies heavily on Level 3 inputs and detailed financial modeling.
• Hedge Funds and Other Alternative Investments: Many alternative investment strategies involve illiquid securities, complex derivatives, or real estate that require significant judgment and unobservable inputs for valuation.
• Complex Derivatives: Over-the-counter (OTC) derivatives, structured notes, and other bespoke financial contracts often lack active markets and rely on internal models with Level 3 inputs.
• Distressed Securities: Securities in financially distressed companies or those in highly illiquid markets often fall into Level 3 due to the absence of observable transactions.
• Intangible Assets: The fair value of certain intangible assets, such as intellectual property or customer relationships, acquired in a business combination may require the use of Level 3 inputs.

Regulators, such as the Federal Reserve, have recognized the challenges associated with fair value accounting, particularly for illiquid financial instruments, especially during periods of market stress¹. The Financial Accounting Standards Board (FASB) continues to issue updates, like Accounting Standards Update No. 2022-03, to clarify how fair value should be measured for certain instruments, even when contractual sale restrictions exist, aiming to improve consistency in practice.

Limitations and Criticisms

While Level 3 inputs are essential for valuing illiquid assets and liabilities, they face several limitations and criticisms:

• Subjectivity and Management Bias: The reliance on management's own assumptions introduces a high degree of subjectivity. This can potentially lead to management bias, where assumptions are made to present a more favorable financial position. This concern became prominent during the 2008 financial crisis, where the use of unobservable inputs for complex, illiquid assets raised questions about the reliability of reported values.
• Lack of Comparability: Because the inputs are unobservable and tailored to specific situations, comparing the fair values of similar assets or liabilities across different entities can be challenging. Each entity may use different models or assumptions, reducing comparability.
• Difficulty in Auditing: Auditing Level 3 fair value measurements can be complex for auditors, as it requires assessing the reasonableness of management's subjective assumptions and the appropriateness of the valuation models used.
• Procyclicality Concerns: Some critics argue that fair value accounting, particularly the use of Level 3 inputs during market downturns, can exacerbate financial crises. When markets become illiquid, declining observed prices (or the lack thereof) can lead to write-downs, which in turn can deplete capital and potentially force sales of assets at "fire sale" prices, creating a downward spiral. However, academic research has largely found little evidence that fair value accounting was a primary cause of the 2008 crisis or led to excessive write-downs.
• Complexity: The sophisticated nature of the valuation techniques and the sheer volume of judgment required for Level 3 inputs can make these valuations difficult for non-experts to understand and interpret.

Despite these criticisms, Level 3 inputs remain a necessary component of fair value accounting for certain types of financial instruments. The ongoing debate emphasizes the need for robust disclosure and careful scrutiny by financial statement users.

Level 3 vs. Level 1 Inputs

Level 3 inputs stand in stark contrast to Level 1 inputs, which represent the highest priority in the fair value hierarchy. The primary distinction lies in the observability and reliability of the data used for valuation.

While Level 1 inputs offer immediate and verifiable fair values, Level 3 inputs are used when such market transparency is absent, necessitating the use of the reporting entity's internal assumptions and subjective judgments. The existence of Level 2 inputs fills the gap between these two extremes, relying on observable inputs other than quoted prices in active markets for identical assets.

FAQs

What types of assets are typically valued using Level 3 inputs?

Assets commonly valued using Level 3 inputs include investments in private equity, certain hedge funds, illiquid debt securities, complex derivatives traded over-the-counter, and some intangible assets. These are assets for which there is no active market or readily observable data.

Why are Level 3 valuations considered less reliable?

Level 3 valuations are considered less reliable because they are based on unobservable inputs and significant judgment from the reporting entity. Unlike Level 1 inputs, which use quoted prices from active markets, Level 3 valuations require management to make assumptions about future events and market conditions, which inherently introduces subjectivity and potential for bias.

How do auditors verify Level 3 valuations?

Auditors face challenges in verifying Level 3 valuations due to their subjective nature. They typically review management's valuation techniques, assess the reasonableness of the unobservable inputs and assumptions, evaluate the models used, and often engage independent valuation specialists to provide an unbiased assessment. The aim is to ensure that the valuation process is sound and that disclosures are adequate.