In the winter of 2007-2008, sweeping new financial reporting standards were launched – directly into the path of an unforeseen perfect storm.
Known as fair value accounting, these new rules had been years in development. They were designed to unify global standards and provide greater transparency through market-based, rather than earlier cost-based, methods of valuation.
But no sooner had fair value gone into effect than markets worldwide all but evaporated in the worst economic crisis in over ninety years. As asset values drifted erratically into what analysts called a “no man’s land,” accurate fair value reporting was put to the test. And one obscure provision was taken head on by regulators.
We’re talking about Level 3 Inputs as defined by Accounting Standards Codification Topic 820: Fair Value Measurements and Disclosures (ASC 820), the least understood and thorniest area of fair value asset valuation, yet a category now critical to many organizations.
Do a quick internet search and you’ll get millions of hits on Level 3 Inputs, ranging from hard-to-follow bureaucratic explications to biased (often misinformed) broadsides in the blogosphere. Our purpose here is to sift reality from perception and shed some light on this important area of financial reporting.
First, let’s briefly define terms.
As outlined by the ASC 820 (f/k/a Statement on Financial Accounting Standards No. 157: Fair Value Mearsument), fair value reporting provides for three distinct levels of inputs.
Level 1 Inputs, which in theory comprise the preponderance of most organizations’ portfolios, can be valued using independent observable market inputs: for example, stock prices as reported by the Wall Street Journal on a daily basis. The idea is to peg an asset’s value to what it would fetch today – right now – in an “orderly transaction” between “willing market participants.” Those two phrases are important. Fair Value presumes the absence of compulsion or duress.
Level 2 Inputs don’t have readily-available market inputs, but can be accurately valued using comparable and observable data points.
Level 3 is unique.
This tier was created as a kind of “none of the above” category for perceptible yet hard-to-value assets with no observable inputs. Generally speaking, Level 3 Inputs either are illiquid or traded so rarely there is no independent market price. Examples might be private equity investments or certain long-term derivative contracts (typically managed by hedge funds).
To put all this in basic language: Inputs in Levels 1 and 2 are “mark to market,” but assets in Level 3, where this is no market, are “mark to model.”
Constructing those models is what makes Level 3 asset valuation so exceedingly complex. To meet fair value disclosure requirements, these valuations involve a combination of management forecasts, various macroeconomic and internal data, sophisticated mathematical models and other proprietary techniques – in other words, experience and specialized expertise from your accounting and audit firm. Including a coordinated effort from both your accountant and your investment managed to insure that you have obtained full and adequate disclosure regarding those assets.
Sound accounting and audit procedure for Level 3 isn’t astrophysics, but in some respects it’s not far off either.
There’s an irony here. While Level 3 assets are by definition hard to value, they are often precisely the types of investments one would expect in a widely (and wisely) diversified portfolio. Many large organizations – foundations, for example – hold significant and sound assets in this fair value tier. But in the current economic environment, Level 3 also is home to distressed assets such as complicated mortgage-backed securities for which markets seized up and have remained stagnant, making “orderly transactions” arguably impossible.
Thus Level 3 reporting is not only complex, it can be controversial.
What’s at stake for you?
Ultimately an organization’s board, investors, creditors and stakeholders comprise the real-world “jury” for any financial statement. Credibility is the lynchpin of quality financial statements. Our experience with a wide range of clients has shown, when done properly, Level 3 financial reporting can ensure a high degree of transparency and confidence going forward.
For more information on Level 3 assets or any other financial concerns, please contact firstname.lastname@example.org.
About the authors:
John Templeton is a Partner with Templeton and leads the firm’s Audit and Accounting Services Division. He is an experienced provider of accounting, auditing, and advisory services for private enterprises in a variety of industries including nonprofit, agriculture, manufacturing, and distribution. He is a hands-on professional who approaches each audit with focus and efficiency. He is an advocate for many of the younger members of the firm, and develops and mentors these young associates.