1. Introduction to Fair Value Hierarchies
In today’s financial landscape, fair value isn’t just a theoretical concept—it’s a vital part of how companies report their financial positions. Whether you’re reviewing the financial statements of a multinational bank or a niche investment firm, fair value measurements can significantly influence how assets and liabilities are perceived by stakeholders. But not all fair value estimates are created equal. That’s where the fair value hierarchy comes in.
The fair value hierarchy, formalized under standards like IFRS 13 and ASC 820, classifies the inputs used to determine fair value into three levels. This system is designed to improve transparency by clarifying how observable or subjective the inputs are. In simple terms, the hierarchy helps users of financial statements understand how much trust they can place in a valuation.
- Level 1 inputs are the gold standard—quoted prices in active markets for identical assets or liabilities.
- Level 2 inputs are still observable, but slightly less direct—like prices for similar assets or market-based inputs.
- Level 3 inputs, however, are where things get murky. These rely heavily on unobservable data and management assumptions, making them the most subjective and, often, the most controversial.
While Levels 1 and 2 are generally straightforward to apply, Level 3 valuations require judgment, expertise, and a deep understanding of the asset or liability in question. In illiquid markets—where transactions are sparse or nonexistent—Level 3 becomes a necessary but challenging tool.
This article explores the complexities of Level 3 inputs, particularly in illiquid markets, where transparency and accuracy are both critically important and difficult to achieve. We’ll walk through examples, valuation methodologies, regulatory expectations, and best practices to help you navigate this nuanced part of financial reporting.
2. Overview of Level 1 and Level 2 Inputs
Before diving into the complexities of Level 3, it’s helpful to understand the more straightforward ends of the fair value hierarchy—Level 1 and Level 2 inputs. These inputs are typically easier to work with because they’re based on observable market data, which makes them more objective and less prone to judgment.
Level 1 inputs are the most reliable and transparent. These are quoted prices for identical assets or liabilities in active markets. Think of stocks traded on the NYSE or bonds listed on a major exchange—if you can pull a price straight from a screen, you’re in Level 1 territory. Because they’re based on actual market transactions, Level 1 inputs provide the highest degree of confidence in valuation.
Level 2 inputs come into play when Level 1 data isn’t available. These are still observable, but not directly quoted for the specific asset or liability being valued. Examples include quoted prices for similar instruments in active markets, interest rate curves, credit spreads, or implied volatility. They require some adjustments and interpretation, but they’re still grounded in market-based information.
The transition from Level 1 to Level 2 reflects increasing subjectivity, but both are considered market-based approaches. Importantly, neither involves the same level of estimation and internal modeling as Level 3.
Understanding these first two levels sets the stage for grasping why Level 3 inputs are so challenging—and why they deserve a closer look, especially in illiquid or opaque markets where market signals are weakest.
3. Understanding Level 3 Inputs
Level 3 inputs sit at the bottom of the fair value hierarchy—and for good reason. Unlike Level 1 and Level 2, which rely on market-based data, Level 3 inputs are unobservable. They’re not based on market quotes or standard valuation benchmarks. Instead, they often involve significant estimation, internal assumptions, and expert judgment. In simple terms, Level 3 is where valuation turns from science into art.
These inputs are used when markets are illiquid or inactive, making it difficult—or even impossible—to obtain reliable external data. That can happen for a number of reasons: the asset might be highly specialized, the market may have dried up, or the transaction volume might be too low to establish a dependable price. Think of a distressed private equity holding, a complex structured product, or a one-of-a-kind intellectual property asset. In such cases, the valuation must be built using internal models and assumptions about future cash flows, discount rates, or market behavior.
The use of Level 3 inputs doesn’t mean the valuation is flawed—but it does mean it’s more subjective. And with that subjectivity comes a higher risk of bias, inconsistency, or manipulation, whether intentional or not. That’s why Level 3 valuations are often met with scrutiny by auditors, regulators, and investors alike.
Despite these challenges, Level 3 inputs are essential. They allow organizations to assign a value to assets and liabilities that would otherwise go unreported or be wildly misrepresented. The key lies in how carefully those valuations are constructed and disclosed.
In illiquid markets, where traditional signals break down, Level 3 inputs play a vital role in bridging the gap between what an asset is and what it might be worth. But they demand a level of rigor, transparency, and governance far beyond the other levels in the hierarchy.
4. Examples of Level 3 Assets and Liabilities
To truly understand Level 3 inputs, it helps to see them in action. These inputs typically show up in assets and liabilities that lack an active market or are so complex that observable pricing simply doesn’t exist. Below are some real-world examples where Level 3 inputs are often used:
1. Private Equity and Venture Capital Investments
Investments in private companies are one of the most common examples of Level 3 assets. Since these companies aren’t publicly traded, there’s no active market providing reliable prices. Valuation often involves estimating future cash flows, assessing market comparables, or adjusting for control premiums or illiquidity discounts.
2. Complex Derivatives and Structured Products
Some derivatives, like bespoke credit default swaps (CDS) or exotic options, may not have a readily observable market. Similarly, structured finance products—like certain tranches of collateralized debt obligations (CDOs)—often lack recent trades, especially during times of market stress. These instruments require advanced modeling and significant judgment.
3. Distressed Real Estate or Illiquid Property Holdings
When real estate is unique, underperforming, or situated in an inactive market, standard appraisal methods may not work. Valuation may involve forecasting rental income, applying area-specific discount rates, or relying on hypothetical development potential.
4. Non-Performing Loans (NPLs)
Banks and financial institutions often hold loans that are no longer generating payments. Estimating their value involves assumptions about recovery rates, legal costs, and the likelihood of default resolution—none of which are easily observable.
5. Long-Dated Insurance Liabilities
In some insurance contracts, particularly those with long horizons and embedded guarantees, inputs for valuation involve actuarial models and assumptions about mortality, lapse rates, and economic conditions decades into the future.
These examples highlight the diversity and complexity of Level 3 items—and why careful judgment, clear documentation, and robust modeling are crucial to getting their valuations right.
5. Valuation Methodologies for Level 3 Inputs
When observable market prices are unavailable, as is often the case with Level 3 inputs, entities must rely on valuation methodologies to estimate fair value. These methodologies aren’t “one-size-fits-all”—they must be tailored to the asset or liability in question, the availability of data, and the specific risks involved. The three primary approaches recognized in financial reporting are the market, income, and cost approaches.
1. Market Approach
The market approach attempts to estimate value by referencing comparable transactions. For example, if a private equity firm holds a stake in a startup, it might look to recent funding rounds of similar companies to guide its valuation. Adjustments are often required to account for differences in size, growth potential, control, or market conditions. While it’s a useful approach, finding truly comparable transactions—especially in illiquid markets—can be challenging.
2. Income Approach
This is one of the most commonly used methods for Level 3 valuations. It involves forecasting future cash flows and then discounting them to present value using an appropriate rate. The Discounted Cash Flow (DCF) model is a popular tool here. However, the challenge lies in selecting the right discount rate and building realistic projections. Small changes in assumptions can lead to significant differences in value, which is why this method demands careful documentation and sensitivity analysis.
3. Cost Approach
The cost approach is typically used for assets that don’t generate cash flows, such as internally developed software or certain types of intellectual property. It estimates the amount needed to recreate or replace the asset, adjusted for depreciation or obsolescence. This method is less commonly used but may be appropriate where market or income approaches aren’t viable.
Choosing and Justifying the Methodology
Selecting the right methodology often depends on the nature of the asset or liability, the availability of data, and the purpose of the valuation. Regulators and auditors expect companies to justify their choices and apply them consistently over time unless circumstances change. Often, a combination of methods or triangulation is used to strengthen the reliability of the final value.
Ultimately, the goal isn’t perfection—but reasonableness, transparency, and defensibility.
6. Challenges in Illiquid Markets
Valuing assets in illiquid markets isn’t just difficult—it’s often messy, uncertain, and time-consuming. Illiquidity strips away the clarity that market prices normally provide, forcing valuation teams to rely more heavily on models, assumptions, and scarce data. For Level 3 inputs, this creates a range of practical and conceptual challenges.
One of the biggest hurdles is the lack of market participants. In an active market, regular buying and selling provide a natural source of pricing information. In contrast, illiquid markets might see only a handful of transactions per year—or none at all. When deals do happen, they may be highly negotiated or distressed, making them a poor benchmark for fair value.
Another issue is price discovery. Without frequent trades or reliable quotes, it’s hard to know what a willing buyer would pay. This forces valuation professionals to estimate not just value, but also the motivations and constraints of hypothetical market participants.
Then there’s the challenge of unobservable inputs. In illiquid markets, assumptions about discount rates, market volatility, or cash flow timing must be made without clear external guidance. Two skilled analysts could reach very different conclusions based on equally valid—but different—assumptions.
The result is a valuation environment that’s inherently more subjective and more prone to error. It’s also more likely to be questioned by auditors and regulators, who will want evidence that inputs are reasonable, models are sound, and conclusions are defensible.
In these settings, it’s not enough to plug numbers into a spreadsheet. Valuing Level 3 assets in illiquid markets requires judgment, experience, and rigorous documentation. The margin for error is slim, and the consequences of getting it wrong—whether through overstatement, understatement, or misrepresentation—can be significant.
7. Role of Judgment and Assumptions
When it comes to Level 3 inputs, judgment isn’t just part of the process—it is the process. In the absence of observable market data, valuation becomes a careful exercise in forecasting, modeling, and making informed assumptions. This is where both the art and responsibility of financial reporting come into play.
At the heart of most Level 3 valuations is a set of assumptions: future cash flows, discount rates, growth projections, exit values, or even market participant behavior. Each of these can significantly shift the final number. For example, increasing the discount rate by just 1% in a discounted cash flow (DCF) model can meaningfully reduce the fair value of an asset. These assumptions are often based on internal data, expert estimates, or past performance, but they still require professional judgment—and that introduces subjectivity.
One key challenge is balancing realism and optimism. It’s easy to lean into overly favorable projections, especially when valuations impact financial results, investor perceptions, or compensation structures. That’s why companies must support their assumptions with clear, defensible reasoning—and document it thoroughly.
Transparency is essential. Many regulators and auditors expect to see sensitivity analyses, showing how changes in key assumptions affect the valuation. This not only helps users of financial statements understand the risks involved, but also acts as a self-check for the preparer.
Independent reviews and internal controls also play a critical role. Valuation committees, third-party appraisers, or audit functions can challenge overly aggressive or outdated assumptions, helping reduce bias and ensure integrity.
Ultimately, Level 3 valuations are only as credible as the assumptions behind them. In illiquid markets, where signals are weak, thoughtful judgment and well-reasoned inputs become the most valuable tools for getting as close as possible to fair value.
8. Disclosure Requirements and Governance
Given the subjectivity and complexity involved in Level 3 valuations, transparency is critical. That’s why accounting standards such as IFRS 13 and ASC 820 place a strong emphasis on disclosure when fair value measurements rely on unobservable inputs. These disclosures are designed to help investors, auditors, and regulators understand how valuations were derived—and where the risks lie.
Entities are required to provide detailed qualitative and quantitative information about Level 3 measurements. This includes the valuation techniques used, the inputs and assumptions applied, and any changes in valuation methodology from prior periods. For example, if a company switches from a market-based approach to a DCF model due to changing conditions, that change must be explained clearly.
A particularly important requirement is the reconciliation of Level 3 movements. This means companies must show how the fair value of Level 3 assets and liabilities changed over the reporting period—whether due to purchases, sales, transfers, gains or losses. It helps stakeholders track what’s driving changes in valuation and assess their reasonableness.
On the governance side, many organizations establish valuation committees, especially for portfolios with significant Level 3 exposure. These groups oversee the modeling process, challenge key assumptions, and ensure that controls around valuation are both documented and followed.
Third-party valuation firms are also commonly engaged to provide independent input, particularly for hard-to-value instruments. While outsourcing helps with objectivity, it doesn’t relieve management of its responsibility—the ultimate accountability for fair value disclosures lies with the reporting entity.
In short, strong governance and full transparency are essential. They don’t just support compliance—they also build trust with stakeholders, who rely on fair value measurements to make informed decisions.
9. Audit and Regulatory Scrutiny
Because Level 3 valuations rely heavily on internal estimates and unobservable inputs, they naturally attract more scrutiny from auditors and regulators. These stakeholders understand that even small shifts in assumptions can have a significant impact on reported fair values—particularly in illiquid markets where objective benchmarks are scarce.
Auditors play a key role in evaluating the reasonableness of Level 3 valuations. They typically review the valuation models, challenge key assumptions, assess the competency of internal valuation teams or third-party experts, and perform sensitivity analyses to test how valuations respond to changes in inputs. If any assumptions appear overly optimistic or unsupported, auditors will flag these issues and may require adjustments or further evidence.
Regulators, including the SEC and PCAOB in the U.S., have also shown increasing interest in how firms arrive at Level 3 values. Inspection findings frequently highlight concerns such as lack of documentation, insufficient internal controls, or inconsistent application of valuation methodologies. In some cases, aggressive assumptions have led to restatements or enforcement actions.
Public companies, in particular, face pressure to ensure their Level 3 disclosures are not only technically compliant but also clear and informative. Boilerplate disclosures may check the box, but they won’t satisfy regulators looking for insight into the company’s specific valuation risks and judgments.
Ultimately, audit and regulatory scrutiny aren’t just about compliance—they’re a check on credibility. For companies dealing with Level 3 inputs, a strong audit trail and robust valuation governance can make all the difference between confidence and concern in the eyes of stakeholders.
10. Best Practices and Risk Mitigation
Valuing Level 3 assets in illiquid markets isn’t just about arriving at a number—it’s about managing risk, consistency, and credibility throughout the process. With so much subjectivity involved, companies must adopt best practices to safeguard against errors, bias, and regulatory scrutiny.
One of the most important practices is establishing strong internal controls around the valuation process. This includes setting up formal policies, documenting procedures, and ensuring all valuation activities are reviewed and approved by qualified personnel. Many organizations use valuation committees that meet regularly to challenge assumptions, assess changes in methodology, and review results.
Independent reviews are another crucial layer of defense. Whether it’s internal audit teams or external valuation firms, having an objective third party review the models and inputs can help catch inconsistencies and enhance credibility. Importantly, these reviews should be documented and retained to support audit and regulatory inquiries.
Clear documentation is also vital. Every key assumption—whether it’s a discount rate, growth projection, or exit multiple—should be supported by rationale, data sources, and sensitivity analysis. When market data is sparse, showing how and why certain inputs were selected becomes the cornerstone of a defensible valuation.
Regular backtesting is another valuable tool. By comparing past valuations to actual outcomes (e.g., realized sale prices or cash flows), companies can identify where their models were accurate—or not—and refine future assumptions accordingly.
Finally, effective training and communication across finance, risk, and audit teams ensures that everyone understands the nature of Level 3 risks and how to manage them proactively.
In short, mitigating risk in Level 3 valuations isn’t about eliminating uncertainty—it’s about managing it through discipline, transparency, and governance.
Conclusion
Navigating Level 3 inputs in illiquid markets is one of the most challenging aspects of fair value accounting. Without active market signals, firms must rely on internal models, assumptions, and expert judgment—all of which demand rigor, transparency, and oversight. While these valuations are inherently uncertain, applying sound methodologies, documenting decisions, and maintaining strong governance can greatly enhance credibility. As markets evolve and scrutiny intensifies, those who treat Level 3 valuations not just as a compliance task but as a discipline will be best positioned to earn the trust of stakeholders and meet the demands of modern financial reporting.