How to Value and Report Level 3 Investments

Financial assets and liabilities must be measured at their current market value, a concept known as fair value. For many investments this is straightforward, but for others, a clear market price does not exist. These are classified as Level 3 investments, which are valued using inputs that are not based on observable market data, relying instead on internal models and management assumptions. These investments are part of a three-tiered system established by accounting standards to categorize assets based on the reliability of the information used to value them.

Understanding the Fair Value Hierarchy

The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 820 establishes a three-level fair value hierarchy to increase consistency in how companies report investment values. This hierarchy prioritizes the inputs used in valuation techniques, not the techniques themselves. An investment’s classification depends on the lowest level of any input that is significant to the overall fair value measurement.

At the top of the hierarchy are Level 1 assets. These are the most straightforward to value because they have quoted prices in active markets for identical assets. An active market is one where transactions occur with enough frequency and volume to provide ongoing pricing information. Stocks traded on the New York Stock Exchange (NYSE), exchange-traded funds (ETFs), and many government securities fall into this category because their value is directly observable.

The next category is Level 2, which includes assets valued using inputs other than the direct quoted prices found in Level 1, but these inputs are still observable. This means they are sourced from market data but may require some modeling or comparison to determine the asset’s final value. For example, a corporate bond that trades infrequently might be valued by looking at the yield curves of similar bonds or prevailing interest rates. Interest rate swaps also fall into this category.

Level 3 assets occupy the bottom of the hierarchy and are valued using unobservable inputs, for which market data is not available. Consequently, a company must develop its own assumptions about what market participants would use to price the asset, which introduces judgment into the valuation process. Common examples include private equity investments, complex derivatives, and distressed debt, as there is no active market or directly comparable assets with observable prices.

Valuation of Level 3 Investments

ASC 820 permits several valuation techniques for Level 3 investments, but they fall into two primary categories: the market approach and the income approach. The objective is to estimate the “exit price”—the price that would be received to sell the asset in an orderly transaction between market participants. The selection of a method depends on the specific circumstances of the asset and the availability of any relevant data.

The market approach uses prices and other relevant information generated by market transactions involving comparable assets or liabilities. For example, when valuing an investment in a private software company, an analyst might look at the recent acquisition prices of other private software companies of a similar size and business model. This method often involves using market multiples derived from a set of comparable public companies or recent transactions.

The unobservable inputs in this approach are the judgments made in selecting the comparable companies and any adjustments made to account for differences. An analyst must decide how similar a “comparable” company truly is and may apply a discount for lack of marketability, which is an unobservable input.

The income approach converts future amounts, such as cash flows or earnings, into a single, discounted present value. The most common application of this approach is the Discounted Cash Flow (DCF) model. In a DCF analysis, a company projects the investment’s future cash flows over a period and then discounts them back to their present value using a discount rate.

The unobservable inputs are the core of a DCF model. These inputs include the projected future cash flows, which are based on internal forecasts, and the discount rate, which reflects the investment’s risk. A higher discount rate implies higher risk and results in a lower present value. The terminal value, which represents the value of the asset beyond the projection period, also relies on assumptions like a perpetual growth rate.

Because these inputs require substantial management judgment, regulators and auditors scrutinize them closely to ensure they are reasonable. Different assumptions about growth rates or the discount rate can lead to vastly different valuations. The company must document the rationale behind its assumptions to support its final valuation.

Disclosure and Reporting Requirements

Given the subjectivity in valuing Level 3 investments, accounting standards mandate extensive disclosure requirements to provide transparency to financial statement users. These rules, found in ASC 820, ensure that investors can understand a company’s Level 3 holdings, how they were valued, and the sensitivity of those valuations. These disclosures are found in the notes to the financial statements in a company’s annual 10-K report.

A component of these disclosures is the Level 3 roll-forward reconciliation. This detailed table shows the changes in the balance of Level 3 assets and liabilities from the beginning of the reporting period to the end. The roll-forward must separately present purchases, sales, issuances, and settlements, as well as both realized and unrealized gains and losses for the period.

The roll-forward also details any transfers of assets into or out of the Level 3 category. For example, if a private company investment goes public, its classification would transfer from Level 3 to Level 1, and this event would be captured in the reconciliation. This table provides a clear view of the activity within the Level 3 portfolio, allowing investors to see how value changes.

Beyond the quantitative roll-forward, companies must provide narrative disclosures. For each class of Level 3 assets, the company must describe the valuation techniques used, such as a DCF model or a market comparable analysis. This description helps users understand the methodology behind the numbers presented in the financial statements.

Furthermore, companies are required to provide quantitative information about the significant unobservable inputs used in the valuation models. For an asset valued using a DCF model, a company might disclose the range of discount rates or long-term growth rates used. This information gives investors insight into the degree of risk embedded in the valuations and allows them to assess the sensitivity of the fair value measurement.