Level 3 inputs definition
/What are Level 3 Inputs?
Level 3 inputs are at the bottom of a hierarchy of information sources that range from Level 1 (best) to Level 3 (worst) when dealing with asset and liability fair values. The general intent of these levels of information is to step the accountant through a series of valuation alternatives, where solutions closer to Level 1 are preferred over Level 3. A Level 3 input is an unobservable input. It may include the company’s own data, adjusted for other reasonably available information. These inputs should reflect the assumptions that would be used by market participants to formulate prices, including assumptions about risk. Level 3 inputs are considered to supply the most subjective information, since they are largely derived internally.
Do not use Level 3 inputs when higher-quality Level 1 or Level 2 inputs are available, and can be accessed without undue cost or effort. By using higher-level inputs, you can develop higher-quality fair values for assets and liabilities.
Example of Level 3 Inputs
A real estate investment company owns a high-end hotel property located at the end of a box canyon in a distant region of Colorado. It is a unique property, having been specially designed and built at high cost for this specific location. Given its uniqueness, there are no similar properties for which Level 1 or Level 2 inputs might be available. Instead, the company can only derive the fair value of the property from its historical and estimated cash flows, as well as its overall condition. Another approach might be to derive its value from a replacement cost perspective, figuring out what it would cost to replace the property. All of these approaches are Level 3 inputs. Since these inputs are very judgmental in nature, the resulting fair value estimate should be considered less reliable than a fair value that was derived from Level 1 or Level 2 inputs.
The Fair Value Hierarchy
The three levels are known as the fair value hierarchy. These inputs are only used to select inputs to valuation techniques (such as the market approach). The three levels are not used to directly create fair values.