Accounting rules require companies to establish fair values for the assets they carry on their books. Investors rely on the fair value estimates that companies put in their accounting statements in order to analyze their current condition and future prospects. In using fair value accounting under Financial Account Standards Statement 157 or International Financial Reporting Standards 13, companies must use one of three sets of inputs in order to determine fair value. The best information comes from actively traded market prices for identical assets, but for assets for which a direct market is unavailable, so-called Level 3 inputs are necessary. Level 3 assets typically include distressed debt, private equity investments, and derivative securities. What's essential in looking at Level 3 assets is to understand that their stated value for accounting purposes is subject to interpretation, and so you need to build in a margin of safety to account for any errors in using Level 3 inputs to value an asset.

What FASB 157 and IFRS 13 say about Level 3

The general principle behind fair value accounting is to have companies use an accurate value on their financial statements. Level 1 inputs come from observable quoted prices of identical assets on active markets, while Level 2 inputs are used either for observable quotes prices for similar assets, quotes for identical assets on relatively illiquid markets, or assets with non-quoted prices.

Accounting books.

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Level 3, on the other hand, involves using unobservable inputs in determining an asset's value. It's important for companies using Level 3 valuation methods to use all available information to back up the reported amount, although the standards recognize the practical cost limits for running valuation analysis on assets that often make up just a small portion of a company's balance sheet.

Why Level 3 assets are important

From an accounting standpoint, Level 3 assets involve some additional duties for the companies that own them. FASB 157 requires a reconciliation of beginning and ending balances for Level 3 assets, with particular attention paid to changes in value of existing assets as well as details on transfers of new assets into or out of Level 3 status. IFRS 13 contemplates similar measures, with separate detail on transfers in and transfers out of Level 3 treatment.

Accounting Standards Update 2011-04 added some more clarity to what disclosures companies must make in dealing with Level 3 assets. ASU 2011-04 requires quantitative information about the unobservable inputs that companies choose in doing valuation analysis, as well as a description of the valuation process itself. Most importantly, companies should do sensitivity analysis to help investors get a better handle on the risk that the companies' valuation work on Level 3 assets turns out to be wrong. However, even the ASU gives companies considerable latitude in deciding which information is relevant to the analysis and therefore must be disclosed.

Be careful out there

When you see assets valued using Level 3 inputs on a balance sheet or other financial statement, it's important to know what went into those valuations and how reliable they are. Otherwise, you'll be vulnerable to nasty surprises if it later turns out that those assets weren't worth what you -- or the company -- thought they were.

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