Level 3 Inputs
Level 3 inputs are a part of the fair value hierarchy established by accounting standards such as the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS).
Level 3 inputs are unobservable inputs, meaning they’re not based on observable market data. Instead, they reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability. These inputs are used in situations where markets do not exist or are illiquid, and when there is little, if any, market activity for the asset or liability at the measurement date.
Examples of situations that might require Level 3 inputs include the valuation of a private company, a unique piece of real estate, or a derivative contract with complex terms that cannot be valued using observable market data.
These Level 3 inputs may include information about the specific asset or liability that is not observable, information about similar assets or liabilities that is not observable, or information that is generated by the entity, such as cash flow forecasts, earnings growth rates, or other internal data.
It’s important to note that Level 3 inputs should only be used when observable inputs (Level 1 and Level 2) are not available or cannot be obtained without undue cost and effort. Due to their nature, Level 3 inputs inherently involve greater judgment and estimation, making them the least reliable among the three levels of inputs.
Example of Level 3 Inputs
Let’s consider a real estate investment fund that owns a unique piece of commercial property in a location where there are few, if any, similar properties sold recently – so there’s no readily available market data to use as Level 1 or Level 2 inputs.
To determine the fair value of the property, the fund might have to use a combination of internal and external data, which constitute Level 3 inputs. This could include the current use of the property, cash flows generated by the property, the condition of the property, and the future prospects for the local real estate market.
The fund could also engage a professional appraiser to estimate the property’s fair value. The appraiser might use an income approach (which involves estimating future income the property could generate and then discounting those cash flows to their present value) or a replacement cost approach (which involves estimating how much it would cost to build a similar property). The inputs used in these approaches, like discount rates, future cash flow estimates, and cost estimates, are all considered Level 3 inputs.
However, it’s important to remember that using Level 3 inputs involves a significant degree of judgment and is generally less reliable than using Level 1 or Level 2 inputs. As a result, entities that use Level 3 inputs to measure fair value are required to provide extensive disclosures in their financial statements about the methods and assumptions used, as well as the potential impact on their financial results.