What Are Level 3 Assets?

Level 3 assets are financial assets and liabilities considered to be the most illiquid and hardest to value. They are not traded frequently, so it is difficult to give them a reliable and accurate market price.

A fair value for these assets cannot be determined by using readily observable inputs or measures, such as market prices or models. Instead, they are calculated using estimates or risk-adjusted value ranges; methods open to interpretation.

Understanding Level 3 Assets

Publicly traded companies are obligated to establish fair values for the assets they carry on their books. According to generally accepted accounting principles (GAAP), certain assets must be recorded at their current value, not historical cost. Investors rely on these fair value estimates in order to analyze the firm's current condition and future prospects.

In 2006, the U.S. Financial Accounting Standards Board (FASB) verified how companies were required to mark their assets to market through the accounting standard known as FASB 157 (No. 157, Fair Value Measurements). Now named Topic 820, FASB 157 introduced a classification system that aims to bring clarity to the balance sheet assets of corporations.

Types of Assets

The FASB 157 categories for asset valuation were given the codes Level 1, Level 2, and Level 3. Each level is distinguished by how easily assets can be accurately valued, with Level 1 assets being the easiest.

Level 1

Level 1 assets are those valued according to readily observable market prices. These assets can be marked to market and include Treasury Bills, marketable securities, foreign currencies, and gold bullion.

Level 2

These assets and liabilities do not have regular market pricing but can be given a fair value based on quoted prices in inactive markets, or models that have 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

Level 3 is the least marked to market of the categories, with asset values based on models and unobservable inputs. Assumptions from market participants are used when pricing the asset or liability, given there is no readily available market information on them. Level 3 assets are not actively traded, and their values can only be estimated using a combination of complex market prices, mathematical models, and subjective assumptions.

Examples of Level 3 assets include mortgage-backed securities (MBS), private equity shares, complex derivatives, foreign stocks, and distressed debt. The process of estimating the value of Level 3 assets is known as mark to model.

These assets received heavy scrutiny during the credit crunch of 2007 when mortgage-backed securities (MBS) suffered massive defaults and write-downs in value. The firms that owned them were often not adjusting asset values downward even though credit markets for asset-backed securities (ABS) had dried up, and all signs pointed to a decrease in fair value.

Recording Level 3 Assets

Past misjudgments of Level 3 asset values prompted tougher regulatory measures. Topic 820, introduced in 2009, ordered firms not just to state the value of their Level 3 assets, but also to outline how using multiple valuation techniques might have affected those values. Then in 2011, the FASB became more stringent, demanding a reconciliation of the beginning and ending balances for Level 3 assets, with particular attention paid to changes in the value of existing assets as well as details on transfers of new assets into or out of Level 3 status.

More clarity on what disclosures companies must make when dealing with Level 3 assets was also provided, including requirements for “quantitative information about the unobservable inputs” used for valuation analysis, as part of a wider breakdown of valuation processes. Another addition was sensitivity analysis in order to help investors get a better handle on the risk that valuation work on Level 3 assets ends up being incorrect.

In August 2018, the FASB issued an update to topic 820, titled Accounting Standards Update 2018-13. In this guidance, effective for financial statements with fiscal years beginning on or after Dec. 15, 2019, some of its earlier rules were modified.

Companies have been asked to disclose the range and weighted average of “significant unobservable inputs” and the way they are calculated. The FASB also ordered narrative descriptions to focus on account measurement uncertainty at the reporting date, not the sensitivity to future changes.

This new approach is designed to boost transparency and comparability even further, although companies do still have considerable freedom when deciding which information is relevant and disclosable.

Special Considerations

Because Level 3 assets are notoriously difficult to value, the stated worth they are given for accounting purposes should not always be taken at face value by investors. Valuations are subject to interpretation, so a margin of safety needs to be factored in to account for any errors in using Level 3 inputs to value an asset.

Often, Level 3 assets make up just a small portion of a company's balance sheet. However, in some industries, such as large investment shops and commercial banks, they are more widespread.