Level 3 inputs: Meaning, Criticisms & Real-World Uses

Level 3 Assets: Definition, Valuation, Examples, and FAQs

What Is Level 3 Assets?

Level 3 assets represent the lowest tier in the Fair Value Hierarchy established under Generally Accepted Accounting Principles (GAAP), specifically by the Financial Accounting Standards Board's ASC 820. These financial instruments are characterized by the use of "unobservable inputs" in their valuation, meaning their Fair Value cannot be determined directly from active markets or readily observable data²⁰, ²¹, ²², ²³. This makes Level 3 assets inherently more complex and subjective to value compared to those in Level 1 or Level 2 of the hierarchy. Their classification falls under the broader domain of Financial Accounting and Valuation.

History and Origin

The concept of fair value accounting gained prominence and formalization in response to events that highlighted the need for more transparent and consistent valuation practices in financial reporting. The Financial Accounting Standards Board (FASB) introduced ASC 820 (now codified as Topic 820, Fair Value Measurement) in 2006 to provide a framework for defining, measuring, and disclosing fair value. This move was partly influenced by lessons learned from periods of market instability, such as the aftermath of the Dot Com bubble, where inconsistent valuation methods contributed to market distortions¹⁹.

ASC 820 aimed to standardize how entities measure assets and liabilities at fair value and to enhance transparency and comparability across financial statements¹⁷, ¹⁸. The creation of the fair value hierarchy, including the distinction of Level 3 assets, was a critical component of this framework. This classification system required companies to categorize inputs used in fair value measurements based on their observability, pushing entities to disclose the subjective nature of valuations for instruments with limited market data. For instance, in June 2022, FASB issued Accounting Standards Update No. 2022-03, clarifying aspects of fair value measurement for equity securities subject to contractual sale restrictions under Topic 820¹⁶.

Key Takeaways

Level 3 assets are financial instruments whose fair value is determined using significant Unobservable Inputs.
Their valuation relies on an entity's own assumptions and models, due to the absence of active market data.
They carry higher Liquidity Risk and Market Risk compared to Level 1 or Level 2 assets.
Comprehensive disclosures are required for Level 3 assets to provide transparency to investors and regulators.
Examples include certain private equity investments, complex derivatives, and illiquid debt.

Formula and Calculation

Unlike Level 1 assets, which are valued directly from quoted prices in active markets, or Level 2 assets, which use observable inputs like interest rates or yield curves, Level 3 assets do not have a standard, universally applied formula. Instead, their valuation primarily relies on sophisticated Valuation Techniques and internal models. These models often incorporate subjective assumptions and forecasts due to the lack of observable market data.

Common valuation approaches for Level 3 assets include:

Income Approach: This method converts future amounts (e.g., cash flows or earnings) to a single current (discounted) amount. Examples include discounted cash flow (DCF) models or option pricing models.
$FV = \sum_{t=1}^{N} \frac{CF_t}{(1+r)^t}$
Where:
- ( FV ) = Fair Value
- ( CF_t ) = Expected cash flow in period ( t )
- ( r ) = Discount rate (reflecting risk)
- ( N ) = Number of periods
Market Approach: This approach uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities, or a group of assets and liabilities, such as publicly traded comparable companies. However, for Level 3 assets, comparable transactions are often scarce or require significant adjustments.
Cost Approach: This method reflects the amount that would be required to replace the service capacity of an asset (i.e., its current replacement cost).

The inputs to these models for Level 3 assets are largely unobservable and may include factors such as projected earnings, default rates, prepayment speeds, volatility estimates, and illiquidity premiums. The selection of these inputs and the assumptions underlying the models require significant judgment by Market Participants and management.

Interpreting the Level 3 Assets

Interpreting the valuation of Level 3 assets requires a deep understanding of the underlying assumptions and methodologies employed. Because their fair value is not derived from observable market transactions, there's a higher degree of subjectivity and potential for variability in their reported values¹⁵. When analyzing financial statements, users should pay close attention to the disclosures related to Level 3 assets. These disclosures provide insights into the valuation techniques used, the significant unobservable inputs, and any sensitivity analyses showing how changes in those inputs would impact the fair value.

A large proportion of Level 3 assets on a company's Balance Sheet can signal increased risk due to the inherent uncertainty in their valuation. Investors and analysts often scrutinize companies with substantial Level 3 holdings, as the reported fair values may not be easily verifiable or reproducible. Understanding the nature of these assets—whether they are complex Financial Instruments, illiquid investments, or hard-to-value liabilities—is crucial for a comprehensive assessment of a firm's financial health and exposure to valuation risk.

Hypothetical Example

Consider a hypothetical Private Equity firm, "Alpha Growth Partners," which holds a significant stake in a nascent, privately-held biotechnology startup, "BioInnovate Inc." BioInnovate is still in the research and development phase, with no revenue and its product years away from market. Since there's no active market for BioInnovate's shares and no directly comparable publicly traded companies, Alpha Growth Partners must classify this investment as a Level 3 asset.

To determine the fair value of its stake in BioInnovate Inc., Alpha Growth Partners might use an income approach, such as a discounted cash flow (DCF) model. The model would involve projecting BioInnovate's future cash flows, which are highly uncertain given its early stage. Key unobservable inputs would include:

Revenue Growth Rate: Alpha Growth Partners might assume aggressive growth rates based on potential market penetration, but these are subjective projections.
Probability of Success for Clinical Trials: A significant assumption would be the likelihood of BioInnovate's experimental drug successfully passing various clinical trial phases.
Discount Rate: The discount rate would need to reflect the high risk associated with early-stage biotech, incorporating venture capital hurdle rates.
Terminal Value Assumptions: Estimating the value of the company beyond the explicit forecast period is also highly subjective.

Alpha Growth Partners' valuation specialist would create a model, input these assumptions, and arrive at a fair value for their investment. This valuation, being highly dependent on these unobservable and subjective inputs, would be classified as a Level 3 measurement and require detailed disclosure in Alpha Growth Partners' Financial Reporting.

Practical Applications

Level 3 assets appear in various sectors, particularly within investment management, where entities deal with illiquid or unique investments. Their valuation is critical for:

Private Equity and Venture Capital: Funds in these sectors frequently invest in private companies for which no public market exists. The fair value of these investments, ranging from startups to mature private businesses, falls under Level 3 due to the reliance on internal models and unobservable data.
Hedge Funds: Many Hedge Funds invest in complex or illiquid securities, such as distressed debt, exotic derivatives, or structured products, which often require Level 3 valuation techniques.
Financial Institutions: Banks and other financial entities may hold illiquid loan portfolios, mortgage-backed securities, or complex over-the-counter (OTC) derivatives that fall into the Level 3 category.
Corporate Mergers and Acquisitions (M&A): When a company acquires another, the fair value of acquired assets and liabilities that lack observable market data must be determined for accounting purposes, often involving Level 3 valuations.
Pension Funds and Endowments: These institutional investors may allocate a portion of their portfolios to alternative investments like private real estate or infrastructure funds, which are typically valued as Level 3 assets. The Securities and Exchange Commission (SEC) provides guidance on fair value accounting, noting that "funds are required to use fair value prices any time that market quotations for their portfolio securities are not … reliable."

L¹⁴imitations and Criticisms

The reliance on unobservable inputs and management judgment makes Level 3 assets a frequent subject of scrutiny and criticism, particularly during periods of market stress. Key limitations and criticisms include:

Subjectivity and Management Discretion: The fair value of Level 3 assets is highly subjective, as it depends heavily on management's assumptions about future cash flows, discount rates, and other unobservable inputs. This discretion can potentially lead to less comparable and less reliable financial statements.
Reduced Comparability: Even with robust disclosure requirements, comparing financial statements of different entities holding similar Level 3 assets can be challenging due to variations in valuation models and assumptions used.
Procyclicality: Critics have argued that fair value accounting, particularly for illiquid assets, can amplify market downturns (procyclicality). During crises, a lack of observable market data might force companies to use distressed transaction prices or models with pessimistic inputs, leading to further write-downs and exacerbating financial instability. However, research on the 2008 financial crisis suggests that fair value accounting may not have been a primary cause of its severity, with some evidence pointing towards overvaluation rather than excessive write-downs.
¹³Audit Challenges: Auditing Level 3 valuations presents significant challenges for auditors, as they must evaluate the reasonableness of management's subjective assumptions and the appropriateness of complex valuation models.
Earnings Volatility: Some studies suggest that fair value accounting can lead to increased earnings volatility, which critics argue may not reflect the underlying economic volatility of a firm's operations. Conv¹⁰, ¹¹, ¹²ersely, other research indicates that the use of the fair value option, particularly when applied to reduce accounting mismatches, can lead to lower earnings volatility for banks. The ⁸, ⁹debate continues regarding the net effect of fair value accounting on financial statement volatility.

During the collapse of Silicon Valley Bank, for example, the debate around fair value accounting re-emerged, with some arguing that clearer fair value reporting for held-to-maturity securities could have provided earlier warnings of potential weaknesses.

⁷Level 3 Assets vs. Level 2 Assets

The primary distinction between Level 3 assets and Level 2 Assets lies in the observability of the inputs used for their fair value measurement.

Feature	Level 2 Assets	Level 3 Assets
Input Type	Primarily observable inputs, either directly or indirectly. While not quoted prices in active markets for identical assets, their fair value is derived from observable market data like interest rates, yield curves, observable curves for similar instruments, or quoted prices for similar assets in active markets.	Exclusively or predominantly rely on significant unobservable inputs. These are inputs for which market data is unavailable, and their determination requires significant management judgment and entity-specific assumptions.
⁶Valuation	Often valued using "mark-to-model" techniques, but these models use parameters that are observable in the market, allowing for close approximation.	Valuation techniques (e.g., discounted cash flow, option pricing models) are used, but the critical inputs within these models are unobservable, making the valuation highly subjective and less verifiable. ⁵
Transparency	Generally transparent, as inputs can be verified by external parties.	Less transparent due to the subjective nature of inputs and assumptions; requires extensive disclosures about the valuation methodologies and unobservable inputs used.
Liquidity	Moderate liquidity; assets may not trade frequently but their value can be inferred from actively traded similar instruments or observable market data.	Generally illiquid; often difficult to sell quickly at their reported fair value without significant discounts due to limited market activity and unique characteristics.
Examples	Corporate bonds not traded on an active exchange, mortgage-backed securities, certain over-the-counter (OTC) derivatives that can be valued using observable market rates.	Private equity investments, distressed debt, complex securitized products, early-stage venture capital investments, certain highly customized or illiquid derivatives, and unlisted real estate investments.

FAQs

What defines a Level 3 asset?

A Level 3 asset is a financial instrument whose fair value is determined primarily using unobservable inputs. This means its value cannot be directly derived from active market prices or readily available market data, requiring significant judgment and internal models for valuation.

###⁴ Why are Level 3 assets difficult to value?
Level 3 assets are difficult to value because there are no active markets or comparable transactions to provide direct pricing. Their valuation relies on subjective assumptions, forecasts, and complex models developed by the reporting entity, leading to a greater degree of uncertainty.

###³ Are Level 3 assets riskier?
Generally, yes. Level 3 assets tend to carry higher Liquidity Risk and valuation risk due to their illiquid nature and the subjective inputs used in their valuation. Their fair value is less transparent and more susceptible to management judgment, making them potentially more volatile and harder to sell quickly at their reported value.

How do auditors verify Level 3 asset valuations?

Auditors scrutinize Level 3 asset valuations by evaluating the appropriateness of the Valuation Techniques and models used, assessing the reasonableness of the unobservable inputs and assumptions, and performing sensitivity analyses to understand the impact of changes in those inputs. They also review the related disclosures for completeness and accuracy.

What are the disclosure requirements for Level 3 assets?

Under ASC 820, entities must provide extensive quantitative and qualitative disclosures for Level 3 assets. These include a reconciliation of the opening and closing balances, a description of the valuation techniques and inputs used, and a sensitivity analysis showing how changes in unobservable inputs would affect the fair value.¹, ²

Level 3 inputs