What it means
Fair value accounting ranks valuation evidence in three levels. Level 1 is a direct market quote, Level 2 uses observable inputs for similar items, and Level 3 relies on what accountants call unobservable inputs.
These are assumptions the company has to make because no market data is available, such as expected growth, a discount rate or the likelihood of default. A typical Level 3 asset is a stake in a private company.
There is no stock exchange price, so the owner estimates what the business is worth using a discounted cash flow model, which values the cash it expects to generate by discounting future amounts back to today, or by comparing it with similar companies. Both approaches need judgements that people can reasonably disagree about.
Because the inputs are subjective, small changes can move the value a lot. A higher discount rate lowers the value, and a lower growth forecast does the same.
Standards therefore require extra disclosure, including a reconciliation of the opening and closing balance and a description of the inputs and how sensitive the value is to changes in them. Level 3 assets are also where valuation risk and, in extreme cases, manipulation risk are highest.
Management might choose assumptions that flatter profit, and auditors are expected to test them closely. Investors and analysts often look at the proportion of Level 3 assets to equity as an indicator of how much of a balance sheet depends on estimates.
During financial crises, assets that used to be Level 1 or 2 can slip into Level 3 when markets freeze and prices vanish. The label itself says nothing about whether the asset is good or bad, but it does tell you how much trust to place in the number.
In practice
Real-world examples.
Example
A venture capital fund holds shares in a start-up that has never been listed. The fund values them using the price of the latest funding round, adjusted for progress since then. Because the adjustment relies on judgement, the holding is classed as Level 3.
Example
A bank holds a complex structured product that is rarely traded. There are no quotes, so the bank uses an internal model with assumptions about default rates and recovery. The product is reported as Level 3.
Example
A property investment company owns a development site with no comparable sales nearby. The valuer uses a model with assumptions about future rents, build costs and yields. The valuation is reported as Level 3 in the accounts.
Formula
Calculation
Present value = Expected future value / (1 + Discount rate) ^ Number of years
Worked example: a fund owns a stake in a private company and expects to receive $10,000,000 when the company is sold in 3 years. There is no market price, so the fund estimates a discount rate of 25% to reflect the high risk.
Present value = $10,000,000 / (1.25 x 1.25 x 1.25) = $10,000,000 / 1.953125 = $5,120,000.
The discount rate is an unobservable input, so the stake is Level 3. If the fund had chosen 20%, the value would be $10,000,000 / 1.728 = about $5,787,000, a difference of roughly $667,000. That swing, from a five-point change in one assumption, shows why Level 3 values attract so much disclosure and audit attention.Case study
Seen in the real world.
Ironbridge Growth Partners is a fictional investment fund with $80,000,000 of assets, of which $30,000,000 are stakes in private companies classed as Level 3. The finance director noticed that one valuation relied on an exit multiple of 10 times earnings, taken from a peer group.
When the audit committee asked for a sensitivity analysis, the team found that a multiple of 8 instead of 10 would cut the value of that holding from $6,000,000 to $4,800,000, a fall of $1,200,000, or 20%.
The committee asked for an independent valuation and for the sensitivity table to be included in the report to investors. This is an illustrative story, but it reflects how Level 3 valuations are challenged in practice.
Watch out
Common mistakes.
- Assuming Level 3 means a bad asset. The level describes how the value is measured, not how good the investment is, and many sound assets are Level 3 simply because they do not trade publicly.
- Treating the reported value as a market price. It is an estimate, and the price a buyer would actually pay may differ, sometimes significantly.
- Ignoring sensitivity. A small change in the discount rate or growth assumption can alter the value materially, so disclosure of sensitivity is important.
Questions
People also ask.
What counts as an unobservable input?
Any assumption that is not supported by market data, such as a company's own forecast, a self-chosen discount rate or an estimate of default probability. If the input is significant, the asset is Level 3.
Can an asset move into or out of Level 3?
Yes. If markets become inactive and prices vanish, assets can move into Level 3, and when observable data returns, they can move back out. Companies must disclose transfers.
Why do investors care about the proportion of Level 3 assets?
Because a high share means more of the reported equity rests on estimates. Analysts often test whether the assumptions are reasonable and consistent.
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