What are level 3 assets?
Level 3 assets are financial assets and liabilities considered to be the most illiquid and the most difficult to assess. They are not traded frequently, so it is difficult to give them a reliable and accurate market price. The fair value of these assets cannot be determined using readily observable data or measures, such as market prices or models. Instead, they are calculated using risk-adjusted estimates or ranges of values, methods open to interpretation.
Understanding level 3 assets
Listed companies are required to establish the fair value of the assets they hold on their books. According to generally accepted accounting principles (GAAP), certain assets must be recognized at their present value, and not at their historical cost. Investors use these fair value estimates to analyze the current situation and the future prospects of the company.
In 2006, the United States’ Financial Accounting Standards Board (FASB) reviewed how companies were required to mark their assets in the marketplace using the accounting standard known as FASB 157 (# 157, Fair Value Measurements). Now called Topic 820, FASB 157 has introduced a classification system which aims to clarify the balance sheet corporate assets.
Types of assets
The FASB 157 categories for the valuation of assets have been assigned the codes Level 1, Level 2 and Level 3. Each level is distinguished by the ease with which assets can be accurately assessed, with level 1 assets being the easiest.
Level 1 assets are those valued at easily observable market prices. These assets can be valued at market prices and include treasury bills, negotiable securities, foreign currencies and gold bars.
These assets and liabilities do not have regular market prices, but may receive fair value based on quoted prices in inactive markets or on models that have observable data, such as interest rates, default and yield curves. An interest rate swap is an example of a Level 2 asset.
Level 3 is the least marked of the category market, with asset values based on models and unobservable data – market participants’ assumptions are used when setting the price of the asset or liability, since there is no easily available market information on them. Level 3 assets are not actively traded and their value 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 stocks, complex derivatives, foreign stocks and distressed debt. The process for estimating the value of Level 3 assets is known as the Management Note.
Key points to remember
- Businesses are required to record certain assets at their current value, rather than their historical cost, and to classify them as Level 1, 2 or 3 assets, depending on the ease with which they can be valued.
- Level 3 assets are financial assets and liabilities that are considered the most illiquid and the most difficult to assess.
- 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 stocks, complex derivatives, foreign stocks and distressed debt.
- The process for estimating the value of Level 3 assets is known as the Management Note.
Since level 3 assets are notoriously difficult to value, the declared value that 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 must be taken into account to take into account any error in the use of level 3 data to evaluate an asset.
Often, level 3 assets represent only a small part of corporate balance sheets. However, in some sectors, such as large investment stores and commercial banks, they are more common.
These assets came under scrutiny during the 2007 credit crisis, when mortgage-backed securities (MBS) suffered huge defaults and write-downs. Firms that owned them often did not downgrade asset values, even though asset-backed securities (ABS) credit markets had dried up, and all signs indicated a decline in fair value .
Registration of level 3 assets
Past errors of judgment in the values of Level 3 assets have led to stricter regulatory measures. Theme 820, introduced in 2009, directed companies not only to report the value of their Level 3 assets, but also to describe how the use of multiple valuation techniques could have affected these values.
Then, in 2020, the FASB became more stringent, requiring a reconciliation of the start and end balances for level 3 assets, paying particular attention to changes in the value of existing assets as well as details on transfers of new assets to or from level 3. status.
More clarity on the information to be provided by companies when dealing with Level 3 assets has also been provided, including the requirements for “quantitative information on unobservable inputs” used for valuation analysis, as part of a broader breakdown of assessment processes. Another addition was the sensitivity analysis to help investors better manage the risk that the valuation work on level 3 assets could end up being incorrect.
In August 2020, the FASB published an update on the subject 820, titled Accounting Standards Update 2020-13. In these directives, in force for financial statements whose fiscal years open from December 15, 2019, some of its previous rules have been modified.
Companies have been asked to disclose the range and weighted average of “significant unobservable inputs” and how they are calculated. The FASB also ordered narrative descriptions to focus on the measurement uncertainty of the accounts at the reporting date, not on the sensitivity to future changes.
This new approach aims to further increase transparency and comparability, although companies still have great freedom to decide which information is relevant and which to disclose.