While the definitions of Level 2 versus Level 3 inputs used in valuation of assets and liabilities are fairly straightforward, determining what is observable and what is unobservable can sometimes require significant judgment. The purpose of the fair value hierarchy is to provide financial statement users with increased consistency and comparability in fair value measurements and related disclosures. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs). A general principle of ASC 820 is to maximize the use of relevant observable inputs and minimize the use of unobservable inputs. The three levels of fair value hierarchy are described as follows:
- Level 1: Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.
- Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or indirectly.
- Level 3: Unobservable inputs.
Level 1 assets and liabilities are often the easiest to identify, value, and report in the reporting entity’s financial statements. Some factors, such as those explained below, may complicate the reporting entity’s ability to distinguish between observable and unobservable inputs and the classification of assets and liabilities into their respective Levels in the fair value hierarchy.
Key Distinctions between Levels 2 and 3
There are some key distinctions between Level 2 and Level 3 inputs that reporting entities should consider when valuing financial assets and liabilities.
Level 2 inputs are observable to market participants and are the inputs those participants would use in pricing an asset or liability based on market data obtained from sources that are independent from the reporting entity. This would include quoted prices for similar assets and liabilities in active markets or quoted prices for identical or similar assets and liabilities in markets that are not active. Level 2 may consist of inputs that are observable for a particular asset or liability such as interest rate and yield curves observable at commonly quoted intervals, implied volatilities, and credit spreads. Many over-the-counter securities such as mortgage-backed securities, corporate bonds, government bonds, bank loans, many derivatives, and real estate are valued using these Level 2 inputs.
Level 3 inputs are unobservable to other market participants and reflect the reporting entity’s own assumptions about the inputs market participants would use in pricing the assets and liabilities developed based on the best information available under the circumstances. Level 3 inputs include valuation multiples, discounts for lack of marketability or illiquidity, or default rates. Examples of assets and liabilities valued using Level 3 inputs include investments in private operating companies, certain residential and commercial mortgage related assets, and complex derivatives.
The Gray Line – What Makes an Input Observable or Unobservable?
- Is the input supported by actual market transactions to actual market participants?
- Is the input obtained from outside the organization and available to all market participants?
- Is the input distributed at regular intervals?
If the answer is no to any of these questions, the input may be considered a Level 3 input, and the asset or liability may be considered as Level 3 in the fair value hierarchy.
There are no “bright lines” around how to assess the significance of an unobservable input in the overall valuation of the asset or liability. The inputs can be qualitative, quantitative, or a combination of both. Reporting entities should develop an internal methodology for determining significant inputs and the policy should be applied consistently during the valuation of all assets and liabilities.
Fair value hierarchy classification communicates to financial statement users how observable the inputs to the measurements are but not the relative risk of the assets or liabilities (for example, a particular Level 3 asset may have lower risk than a particular Level 2 asset). Fair value hierarchy classification also does not indicate liquidity of a particular asset or liability. These are common misconceptions of users of financial statements.
The distinction between Level 2 and Level 3 also matters because generally accepted accounting principles (GAAP) requires additional disclosures for Level 3 assets and liabilities.
Additional Disclosures for Level 3 Investments
For those assets and liabilities measured at Level 3 in the fair value hierarchy, additional disclosures are required to be in conformance with GAAP. Among those requirements is a reconciliation from the opening and closing balance sheet balances separately disclosing changes during the period attributable to the following:
- Total gains or losses for the period recognized in earnings, and the line item(s) in the income statement in which those gains or losses are recognized.
- Purchases, sales, issues, and settlements each disclosed separately.
- The amounts of any transfers into or out of Level 3 of the fair value hierarchy, the reasons for those transfers, and the reporting entity’s policy for determining when transfers between levels are deemed to have occurred.
The reporting entity is required to disclose quantitative information about the significant unobservable inputs used in the fair value measurement for assets and liabilities categorized within Level 3 of the fair value hierarchy. This disclosure should include valuation models and techniques, a description of the unobservable inputs, range of inputs, and weighted average(s).
GAAP also requires the reporting entity to disclose the amount of the total gains or losses for the period included in earnings that is attributable to the change in unrealized gains or losses relating to those assets and liabilities held at the end of the reporting period and the line item(s) in the income statement in which those unrealized gains or losses are recognized.
A reporting entity is also required to disclose a description of the valuation process it used to value the Level 3 assets and liabilities (including, for example, how an entity determines its valuation policies and procedures and how an entity analyzes changes in fair value measurement from period to period).
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