What Are Level 3 Inputs?
Level 3 inputs are the least observable inputs used in the process of measuring the fair value of financial assets and financial liabilities under generally accepted accounting principles (GAAP). Within the broader field of financial reporting and fair value measurement, these inputs represent unobservable data for assets or liabilities that have little to no market activity, requiring significant judgment and assumptions by the entity performing the valuation. The use of Level 3 inputs is necessary when observable market data for similar assets or liabilities is unavailable, often for complex or illiquid instruments.
History and Origin
The concept of a fair value hierarchy, including Level 3 inputs, was formalized by the Financial Accounting Standards Board (FASB) through Statement of Financial Accounting Standards (SFAS) No. 157, now codified as ASC 820, "Fair Value Measurement." This standard was issued in 2006 to establish a single definition of fair value, a framework for measuring it, and disclosure requirements for fair value measurements. The primary goal was to enhance consistency and comparability in fair value reporting across different entities and industries. ASC 820 categorizes inputs into a three-level hierarchy based on their observability, with Level 1 being the most observable and Level 3 being the least. This framework became effective for fiscal years beginning after November 15, 2007, for most financial instruments, although some aspects, particularly around the clarity of fair value measurement for certain equity securities, continued to be refined by the FASB.8
Key Takeaways
- Level 3 inputs are unobservable data used in fair value measurements for assets or liabilities lacking active markets.
- They require significant judgment and the development of assumptions about what market participants would use in pricing the asset or liability.
- Assets valued using Level 3 inputs include complex derivatives, private equity investments, and certain illiquid debt instruments.
- The reliance on Level 3 inputs increases valuation uncertainty and requires extensive disclosures in financial statements.
- The use of Level 3 inputs became prominent with the introduction of ASC 820, designed to standardize fair value reporting.
Interpreting Level 3 Inputs
Level 3 inputs are interpreted as the valuation assumptions that a reporting entity develops based on the best information available in the circumstances, which typically includes the entity’s own data. These inputs are used in valuation techniques such as the discounted cash flow method or option pricing models, where the ultimate fair value is highly sensitive to these subjective assumptions. When an asset or liability is valued using Level 3 inputs, it signifies that its fair value cannot be directly observed from market prices or derived from actively traded instruments.
The interpretation of fair value measurements reliant on Level 3 inputs often involves a qualitative assessment of the underlying assumptions and methodologies. Regulators and investors scrutinize these valuations due to their inherent subjectivity and the potential for management bias. The Securities and Exchange Commission (SEC) has emphasized the importance of robust internal controls and comprehensive disclosures when Level 3 inputs significantly impact reported fair values, highlighting the need for transparency in understanding the quality of such valuations.
7## Hypothetical Example
Consider a hypothetical venture capital firm holding a significant stake in a nascent biotechnology startup that has not yet generated revenue and is not publicly traded. Valuing this investment would primarily rely on Level 3 inputs.
The firm would use various valuation techniques, such as the discounted cash flow method. Key Level 3 inputs would include:
- Projected Future Cash Flows: These are highly speculative, based on the startup's potential drug development, regulatory approvals, and market penetration, all of which are uncertain.
- Discount Rate: This reflects the perceived risk of the startup. Given the early stage and high uncertainty, the discount rate would be a subjective assessment, likely much higher than for a mature, publicly traded company.
- Terminal Value Assumptions: Estimating the value of the company beyond the explicit forecast period involves significant assumptions about long-term growth rates or exit multiples, which are unobservable for a private entity.
The fair value derived from these Level 3 inputs would be an estimate, highly dependent on the firm's judgments about the startup's future success and the overall market for similar early-stage biotechnology companies.
Practical Applications
Level 3 inputs are essential in situations where market transparency is limited, making direct observation of prices or significant corroborating data difficult. They are most commonly applied in the valuation of:
- Private Equity Investments: Investments in non-public companies or funds, where no active market exists for their equity securities.
- Complex Derivatives: Over-the-counter (OTC) derivatives that are highly customized and lack standardized market pricing.
- Illiquid Debt Instruments: Bonds or loans of distressed companies, or those with unique terms that do not trade frequently.
- Real Estate and Intangible Assets: While not always financial instruments, these can require fair value measurement for reporting, often relying on unobservable inputs for income or market approaches.
- Distressed Assets: During periods of market stress, even typically liquid assets can become illiquid, requiring the use of Level 3 inputs if observable market prices are no longer reliable.
Accounting firms, such as PwC, provide extensive guidance on the application of fair value measurement, including the appropriate use of Level 3 inputs across various asset classes and industries.
6## Limitations and Criticisms
The primary limitation of Level 3 inputs is their reliance on subjective, unobservable inputs. This subjectivity introduces a higher degree of uncertainty and potential for bias in fair value measurements compared to valuations based on more observable inputs. Critics argue that this can make financial statements less comparable and transparent, as different entities might apply different assumptions or valuation models to similar assets, leading to varying reported fair values.
During the 2008 financial crisis, the valuation of illiquid assets, many of which relied heavily on Level 3 inputs, came under intense scrutiny. Concerns arose about how financial institutions were valuing complex mortgage-backed securities and other structured products for which active markets had ceased to exist. The lack of observable prices forced institutions to rely on internal models and subjective assumptions, contributing to a perception of opacity and uncertainty around asset values. This period underscored the challenges and potential for significant write-downs when Level 3 inputs form the basis of a substantial portion of a firm's balance sheet.
5## Level 3 Inputs vs. Level 2 Inputs
The distinction between Level 3 inputs and Level 2 inputs lies in the observability of the data used for fair value measurement. Both are part of the fair value hierarchy established by ASC 820, but they represent different degrees of market transparency:
| Feature | Level 2 Inputs | Level 3 Inputs |
|---|---|---|
| Observability | Primarily observable, directly or indirectly. They are not quoted prices for the identical asset or liability in active markets, but rather inputs derived principally from or corroborated by observable market data. | Unobservable. These are developed using the best information available in the circumstances, which may include the entity’s own data. They reflect an entity's own assumptions about what market participants would use in pricing the asset/liability. |
| Examples | Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets/liabilities in inactive markets; interest rates; yield curves; credit risk; and other market-corroborated inputs. | Entity’s own data for pricing illiquid investments; assumptions about future cash flows for private companies; internally developed models for complex OTC derivatives where no comparable market data exists; distressed debt valuations without active trading. |
| Judgment | Requires less subjective judgment compared to Level 3, as the inputs are based on observable market data, even if adjustments are needed. | Requires significant judgment and assumptions, as there is no active market to validate the inputs directly. |
| Liquidity | Typically associated with instruments that are less liquid than Level 1 but still have some market activity or observable pricing components. | Associated with highly illiquid or unique instruments that have no active market whatsoever. |
Confusion often arises because both levels involve some degree of estimation or model usage. However, Level 2 inputs rely on data that can be validated against market information, even if it's for similar instruments or in less active markets. In contrast, Level 3 inputs require the reporting entity to develop its own assumptions because external, observable market data is absent.
FAQs
What does "unobservable" mean in the context of Level 3 inputs?
"Unobservable" means that the inputs are not directly available from market activity or derived from market data. Instead, they are developed by the entity using the best information available, including internal data, historical performance, and assumptions about future events, rather than relying on external, publicly available information.
Why are Level 3 inputs considered the riskiest?
Level 3 inputs are considered the riskiest because they are based on significant subjective judgment and assumptions made by the reporting entity. This makes the valuation less verifiable by external parties and more susceptible to errors or deliberate manipulation. The lack of liquidity and observable market data for assets valued with Level 3 inputs also makes them difficult to sell quickly without a significant price discount.
How do auditors verify Level 3 valuations?
Auditors verify Level 3 valuations by scrutinizing the entity's valuation techniques, the reasonableness of the underlying assumptions, and the integrity of the data used to derive the inputs. This often involves reviewing the entity's internal controls, comparing assumptions to industry benchmarks where available, and sometimes engaging their own valuation specialists to independently assess the fair value.
Do all companies use Level 3 inputs?
Not all companies use Level 3 inputs extensively. Companies that primarily invest in highly liquid, publicly traded securities (like stocks or bonds with active markets) will mostly rely on Level 1 and Level 2 inputs. However, any company holding illiquid investments, complex derivatives, or private equity stakes will likely use Level 3 inputs for fair value measurement.
How do changes in Level 3 inputs impact financial statements?
Changes in Level 3 inputs can significantly impact a company's financial statements, particularly its balance sheet and income statement. Adjustments to these inputs, such as revised cash flow projections or discount rates, can lead to substantial gains or losses on the fair value of the assets or liabilities. Due to their unobservable nature, these changes can also introduce volatility and uncertainty into reported financial results.
Citations:
Fair 4Value Measurements and Disclosures. Deloitte. [https://www2.deloitte.com/us/en/pages/audit/articles/fair-value-measurements-and-disclosures-asc-820.html]
"Rema3rks Before the 2014 AICPA Conference on Current SEC and PCAOB Developments." U.S. Securities and Exchange Commission. [https://www.sec.gov/news/speech/speech-palmer-092514]
Fair 2Value. PwC. [https://www.pwc.com/us/en/services/audit-assurance/accounting-advisory/fair-value.html]
"How 1the financial crisis changed accounting." Chicago Booth Review. [https://www.chicagobooth.edu/review/how-financial-crisis-changed-accounting]