8.4 Level 3 Inputs

8.4.1 General

ASC 820-10

Level 3 Inputs

35-52 Level 3 inputs are unobservable inputs for the asset or liability.

35-53 Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, that is, an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.

Level 3 Inputs

55-22 Examples of Level 3 inputs for particular assets and liabilities include the following:

Long-dated currency swap. A Level 3 input would be an interest rate in a specified currency that is not observable and cannot be corroborated by observable market data at commonly quoted intervals or otherwise for substantially the full term of the currency swap. The interest rates in a currency swap are the swap rates calculated from the respective countries’ yield curves.
Three-year option on exchange-traded shares. A Level 3 input would be historical volatility, that is, the volatility for the shares derived from the shares’ historical prices. Historical volatility typically does not represent current market participants’ expectations about future volatility, even if it is the only information available to price an option.
Interest rate swap. A Level 3 input would be an adjustment to a mid-market consensus (nonbinding) price for the swap developed using data that are not directly observable and cannot otherwise be corroborated by observable market data.
Asset retirement obligation at initial recognition. A Level 3 input would be a current estimate using the reporting entity’s own data about the future cash outflows to be paid to fulfill the obligation (including market participants’ expectations about the costs of fulfilling the obligation and the compensation that a market participant would require for taking on the asset retirement obligation) if there is no reasonably available information that indicates that market participants would use different assumptions. That Level 3 input would be used in a present value technique together with other inputs, for example, a current risk-free interest rate or a credit-adjusted risk-free rate if the effect of the reporting entity’s credit standing on the fair value of the liability is reflected in the discount rate rather than in the estimate of future cash outflows.
Reporting unit. A Level 3 input would be a financial forecast (for example, of cash flows or earnings) developed using the reporting entity’s own data if there is no reasonably available information that indicates that market participants would use different assumptions.

Level 3 inputs are unobservable inputs used by an entity to measure the fair value of an asset, liability, or equity instrument. These inputs have the lowest level of priority under the fair value hierarchy and should only be used to the extent that observable inputs are not available. ASC 820-10-55-22 gives examples of Level 3 inputs. The example below illustrates the use of Level 3 inputs.

Example 8-10

Financial Forecast as Input Into a Fair Value Measurement

ASC 820-10-55-22(e) indicates that a “Level 3 input would be a financial forecast (for example, of cash flows or earnings) developed using the reporting entity’s own data if there is no reasonably available information that indicates that market participants would use different assumptions.” While certain information an entity uses in applying a valuation technique may be observable (e.g., interest rate curves), the entity’s projected cash flows will most likely be significant to the fair value measurement. Therefore, the measurement would most likely be classified as Level 3.

8.4.2 Use of Best Data Available

8.4.2.1 General

ASC 820-10

Level 3 Inputs

35-54A A reporting entity shall develop unobservable inputs using the best information available in the circumstances, which might include the reporting entity’s own data. In developing unobservable inputs, a reporting entity may begin with its own data, but it shall adjust those data if reasonably available information indicates that other market participants would use different data or there is something particular to the reporting entity that is not available to other market participants (for example, an entity-specific synergy). A reporting entity need not undertake exhaustive efforts to obtain information about market participant assumptions. However, a reporting entity shall take into account all information about market participant assumptions that is reasonably available. Unobservable inputs developed in the manner described above are considered market participant assumptions and meet the objective of a fair value measurement.

An entity must use the best available data in estimating unobservable inputs when a fair value measurement cannot be developed solely on the basis of observable inputs. The fair value hierarchy prioritizes inputs on the basis of their observability. Level 1 is the highest priority and Level 3 is the lowest priority. When an entity has concluded that a single valuation technique results in the most relevant information in terms of the fair value hierarchy (e.g., a Level 2 measurement vs. a Level 3 measurement), it should use that technique to calculate fair value. It would be inconsistent with the fair value hierarchy principles in ASC 820 for an entity to conclude that a Level 3 measurement is superior to a Level 2 measurement because relevant observable information about current market transactions is superior to entity-specific measurements.

For example, if management is able to use relevant observable market information to measure fair value under a market approach (a Level 2 measurement) and it uses significant unobservable information to measure fair value under an income approach (a Level 3 measurement), ASC 820 would require use of the Level 2 measurement even if the market is not active. However, in an inactive market, (1) there may be a lack of current observable market transactions for identical or similar assets or liabilities or (2) observable transactions may not be orderly. To produce a fair value measurement in such circumstances, an entity needs to perform further analysis and may have to adjust the market approach. If these adjustments are significant, they would render the fair value estimate under the market approach a Level 3 measurement. In such cases, entities may consider using multiple valuation techniques (e.g., a market approach and an income approach) to measure fair value.

When an entity considers multiple valuation techniques and determines that no one technique results in a superior fair value measurement under the fair value hierarchy, in accordance with ASC 820-10-35-24B, the entity is required to evaluate the results (or respective indications of fair value) of all techniques and weigh them, as appropriate. An entity may sometimes place more weight on one technique because it uses more relevant observable inputs and therefore the fair value measurement determined under that technique is more indicative of fair value.

8.4.2.2 Use of Internal Information

An entity should not rely on internally developed assumptions or information if it has information indicating that market participants would use different assumptions or information in measuring the fair value of an asset, liability, or equity instrument. A fair value measurement is market-based but not entity-specific, as evident in the definition of fair value and discussed in a number of paragraphs in ASC 820, including the following:

ASC 820-10-05-1C states that “[b]ecause fair value is a market-based measurement, it is measured using the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. As a result, a reporting entity’s intention to hold an asset or to settle or otherwise fulfill a liability [or instrument classified in a reporting entity’s shareholders’ equity] is not relevant when measuring fair value.”
ASC 820-10-35-53 states that “[u]nobservable [Level 3] inputs shall be used to measure fair value to the extent that relevant observable [Level 1 and Level 2] inputs are not available.”
ASC 820-10-35-54A states that “a reporting entity shall take into account all information about market participant assumptions that is reasonably available.”
ASC 820-10-35-54E states that “[r]egardless of the valuation technique used [in measuring fair value], a reporting entity shall include appropriate risk adjustments, including a risk premium reflecting the amount that market participants would demand as compensation for the uncertainty inherent in the cash flows of an asset or a liability.”

For example, under an income approach, an entity generally uses a discounted cash flow technique to calculate the fair value of a financial asset and incorporates relevant observable inputs when available. Any unobservable inputs used in the fair value measurement, such as estimated future cash flows or risk adjustments incorporated into the discount rate, should be developed on the basis of management’s estimate of assumptions that market participants would use in pricing the asset in a current transaction as of the measurement date. If market data indicate that a significant liquidity discount applies in transactions involving comparable assets as of the measurement date, the entity should incorporate that information into its cash flow model (e.g., through an adjustment to the discount rate to compensate for the difficulty in selling the assets under current market conditions).

The example below illustrates when an entity’s own data should not be used because market-observable data are available.

Example 8-11

Reliance on Internally Developed Assumptions When Market Assumptions Are Readily Available

Entity F is using a valuation model to measure the fair value of its holdings of privately placed corporate debt securities issued by Entity X. No quoted price for identical securities is available. Entity F’s valuation model uses assumptions about default rates and discount rates. Assumptions about default rates can be readily derived from current, relevant, observable market data for actively traded credit default swaps on X’s publicly traded bonds. To measure fair value, F cannot rely either on its own historical default data (for issuers with credit quality similar to X’s) or on its own default assumptions, even if the default assumptions are “stressed.” Instead, F should use the relevant market-observable assumptions about default rates.

8.4.3 Consideration of Risk in Inputs

ASC 820-10

Level 3 Inputs

35-54 Assumptions about risk include the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and the risk inherent in the inputs to the valuation technique. A measurement that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one when pricing the asset or liability. For example, it might be necessary to include a risk adjustment when there is significant measurement uncertainty (for example, when there has been a significant decrease in the volume or level of activity when compared with normal market activity for the asset or liability, or similar assets or liabilities, and the reporting entity has determined that the transaction price or quoted price does not represent fair value, as described in paragraphs 820-10-35-54C through 35-54J).

In accordance with ASC 820-10-35-54, a fair value measurement should be adjusted for assumptions about risks that market participants would consider when valuing an asset, liability, or equity instrument. It may be difficult to determine what a market participant would demand as a risk adjustment in an assumed transaction, since such inputs may not be directly observable. In these situations, an entity should look beyond its own policies and transactions and consider the risks from a market participant’s perspective.

When using Level 3 inputs, an entity may need to consider the following items, when applicable, to incorporate market-participant assumptions:

Recent transactions of a similar nature and duration.
Common industry practices.
Historical trends and settlements of past transactions.

See Section 10.4.2 for further discussion of the inclusion of risk adjustments in fair value measurements. See also Section 10.6 for further discussion of measuring fair value when the volume or level of activity for an asset or liability has significantly decreased.

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