Level 3 assets are financial assets and liabilities known for being the most illiquid and challenging to value. Because they are not frequently traded, determining a reliable and accurate market price is difficult.
A fair value for these assets cannot be ascertained using readily observable inputs such as market prices or straightforward models. Instead, they are estimated using complex and often subjective methods, incorporating risk-adjusted value ranges.
Key Takeaways
- Companies must record certain assets at their current value, rather than historical cost, and classify them as either Level 1, 2, or 3, depending on their ease of valuation.
- Level 3 assets are considered the most illiquid and challenging to value among financial assets and liabilities.
- Values are estimated using complex market prices, mathematical models, and subjective assumptions.
- Examples include mortgage-backed securities (MBS), private equity shares, complex derivatives, foreign stocks, and distressed debt.
- The estimation process for valuing these assets is known as mark to model.
Understanding Level 3 Assets
Public companies must establish fair values for the assets recorded on their books. According to generally accepted accounting principles (GAAP), certain assets should be recorded at their current value, not historical cost. Investors rely on these fair value estimates to analyze a firm’s current condition and future prospects.
In 2006, the U.S. Financial Accounting Standards Board (FASB) formalized the requirements for marking assets to market through the accounting standard known as FASB 157 (now Topic 820). FASB 157 introduced a classification system that aimed to clarify corporate balance sheets by distinguishing between Level 1, 2, and 3 assets.
Types of Assets
FASB 157 categorizes assets for valuation under codes Level 1, Level 2, and Level 3, each defined by the ease of accurately valuing the assets:
Level 1 Assets
Level 1 assets are valued based on readily observable market prices. These assets are marked to market and include Treasury Bills, marketable securities, foreign currencies, and gold bullion.
Level 2 Assets
While these assets do not have regular market pricing, they can be fairly valued based on quoted prices in inactive markets or models with observable inputs such as interest rates, default rates, and yield curves. An interest rate swap is an example of a Level 2 asset.
Level 3 Assets
Level 3 assets are the least marked to market of the three categories. Valuing these assets depends on models and unobservable inputs, relying significantly on assumptions from market participants. Due to the lack of active trading, their value can only be estimated via complex market prices, mathematical models, and subjective assumptions.
Popular Level 3 assets include mortgage-backed securities (MBS), private equity shares, complex derivatives, foreign stocks, and distressed debt. The process of valuing these assets is called mark to model.
These assets received significant scrutiny during the 2007 credit crunch when substantial defaults on MBS resulted in massive write-downs. Some firms were infamously slow to adjust asset values downward, even as credit markets for asset-backed securities (ABS) dried up, indicating a decline in fair value.
Recording Level 3 Assets
Historical inaccuracies in valuing Level 3 assets led to stricter regulatory measures. Introduced in 2009, Topic 820 required firms to not only state the value of such assets but also outline how multiple valuation methods could affect those values.
In 2011, the FASB mandated reconciling the beginning and ending balances for Level 3 assets, emphasizing changes in asset value and transfers into or out of Level 3 status.
Additional guidelines on disclosures included the demand for quantitative information regarding unobservable inputs and the requirement to provide sensitivity analysis to help investors gauge the risk of valuation errors.
In August 2018, the FASB issued an update to Topic 820 titled Accounting Standards Update 2018-13. It became effective for financial statements with fiscal years beginning on or after December 15, 2019. This guidance incorporated rules that required disclosure of the range and weighted average of significant unobservable inputs and narrative descriptions focusing on measurement uncertainty at the reporting date.
This revamped approach aims to boost transparency and comparability while still allowing companies some discretion in determining relevant and disclosable information.
Special Considerations
Given that Level 3 assets are notably difficult to value, their stated accounting value should be approached with caution by investors. Valuations are inherently subjective, requiring a margin of safety to account for any potential errors.
Although Level 3 assets often constitute a small portion of a company’s balance sheet, they can be more prevalent in industries such as large investment firms and commercial banks.
Related Terms: mark to model, fair value, mortgage-backed securities, complex derivatives, financial regulation.
