# Understanding and Comparing to Level 1 and 2 Assets

![Level 3 Assets](https://www.investopedia.com/thmb/5v3jSftXwC5L5zt71B6siDjD1os=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/level3_assests.asp_sourcefile-resized-197a87e8d66b4a3493973164af42d5e5.jpg)

*— NoNo Flores / Investopedia*

## What Are Level 3 Assets?

Level 3 assets are [financial assets](https://www.investopedia.com/terms/f/financialasset.asp) and [liabilities](https://www.investopedia.com/terms/l/liability.asp) known for their [illiquidity](https://www.investopedia.com/terms/i/illiquid.asp) and difficulty in valuation. Unlike Level 1 and Level 2 assets, Level 3 assets lack reliable market pricing, leading firms to rely on estimates and models that incorporate assumptions and subjective judgments.

Examples include mortgage-backed securities, complex derivatives, and private equity shares. Understanding these assets is crucial due to their role in financial markets and their heightened scrutiny during events like the 2007 credit crunch.

### Key Takeaways

*   Level 3 assets are the most illiquid and hardest to value due to their infrequent market trading.  
    
*   These assets require complex pricing models and subjective assumptions, known as mark to model, for valuation.  
    
*   Examples of Level 3 assets include mortgage-backed securities, private equity shares, and complex derivatives.  
    
*   The Financial Accounting Standards Board (FASB) mandates companies to disclose specific valuation techniques and uncertainties regarding Level 3 assets.  
    
*   Investors should exercise caution with Level 3 asset valuations, as they can be subject to interpretation and potential inaccuracies.

## Deep Dive Into Level 3 Assets

Publicly traded companies are obligated to establish fair values for the assets they carry on their books. According to [GAAP](https://www.investopedia.com/terms/g/gaap.asp), some assets must be recorded at [current value](https://www.investopedia.com/terms/c/cmv.asp) instead of [historical cost](https://www.investopedia.com/terms/h/historical-cost.asp). Investors use these [fair value](https://www.investopedia.com/terms/f/fairvalue.asp) estimates to assess a firm's condition and future outlook.

In 2006, the [FASB](https://www.investopedia.com/terms/f/fasb.asp) established [FASB 157](https://www.investopedia.com/terms/f/fasb_157.asp), detailing how companies should mark assets to market. Now named Topic 820, FASB 157 introduced a classification system that aims to bring clarity to the [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp) assets of corporations.

## Asset Valuation Levels Explained

FASB 157 categorizes assets into [Level 1](https://www.investopedia.com/terms/l/level1_assets.asp), [Level 2](https://www.investopedia.com/terms/l/level2_assets.asp), and Level 3, based on valuation ease. Level 1 is the easiest to value.

### Level 1

Level 1 assets are those valued according to readily observable [market prices](https://www.investopedia.com/terms/m/market-price.asp). These assets can be marked to market and include [Treasury bills](https://www.investopedia.com/terms/t/treasurybill.asp), [marketable securities](https://www.investopedia.com/terms/m/marketablesecurities.asp), [foreign currencies](https://www.investopedia.com/terms/f/foreign-exchange.asp), and [gold bullion](https://www.investopedia.com/terms/b/bullion.asp).

### Level 2

These assets and liabilities do not have regular market pricing, but can be given a fair value based on [quoted prices](https://www.investopedia.com/terms/q/quoted-price.asp) in inactive markets, or models that have observable inputs, such as [interest rates](https://www.investopedia.com/terms/i/interestrate.asp), [default rates](https://www.investopedia.com/terms/d/defaultrate.asp), and [yield curves](https://www.investopedia.com/terms/y/yieldcurve.asp). An [interest rate swap](https://www.investopedia.com/terms/i/interestrateswap.asp) is an example of a Level 2 asset.

### Level 3

Level 3 is the least [marked to market](https://www.investopedia.com/terms/m/marktomarket.asp) of the categories, with asset values based on models and unobservable inputs. Assumptions from market participants are used when pricing the asset or liability, given that there is no readily available market information on them. Level 3 assets are not actively traded, and their values can only be estimated using a combination of complex market prices, mathematical models, and subjective assumptions.

Examples of Level 3 assets include [mortgage-backed securities (MBS)](https://www.investopedia.com/terms/m/mbs.asp), [private equity](https://www.investopedia.com/terms/p/privateequity.asp) shares, complex [derivatives](https://www.investopedia.com/terms/d/derivative.asp), foreign stocks, and [distressed debt](https://www.investopedia.com/terms/d/distressedsecurities.asp). The process of estimating the value of Level 3 assets is known as [mark to model](https://www.investopedia.com/terms/m/mark_to_model.asp).

These assets received heavy scrutiny during the [credit crunch](https://www.investopedia.com/terms/c/creditcrunch.asp) of 2007, when mortgage-backed securities (MBS) suffered massive defaults and [write-downs](https://www.investopedia.com/terms/w/writedown.asp) in value. The firms that owned them were often not adjusting asset values downward even though credit markets for [asset-backed securities (ABS)](https://www.investopedia.com/terms/a/asset-backedsecurity.asp) had dried up, and all signs pointed to a decrease in fair value.

## How Level 3 Assets Are Recorded

Past errors in valuing Level 3 assets led to stricter regulations. Topic 820 in 2009 required firms to state asset values and explain how various techniques might affect these values.

Then in 2011, the FASB became more stringent, demanding a reconciliation of the beginning and ending balances for Level 3 assets, with particular attention paid to changes in the value of existing assets as well as details on transfers of new assets into or out of Level 3 status.

Companies must clearly disclose how they value Level 3 assets, including "[quantitative info](https://www.investopedia.com/terms/q/quantitativeanalysis.asp) about unobservable inputs" used in valuation. Another addition was [sensitivity analysis](https://www.investopedia.com/terms/s/sensitivityanalysis.asp) in order to help investors get a better handle on the risk that valuation work on Level 3 assets ends up being incorrect.

In August 2018, the FASB issued an update to Topic 820, titled Accounting Standards Update 2018-13. In this guidance, effective for [financial statements](https://www.investopedia.com/terms/f/financial-statements.asp) with [fiscal years](https://www.investopedia.com/terms/f/fiscalyear.asp) beginning on or after Dec. 15, 2019, some of its earlier rules were modified.

Companies have been asked to disclose the range and [weighted average](https://www.investopedia.com/terms/w/weightedaverage.asp) of “significant unobservable inputs” and the way they are calculated. The FASB also ordered narrative descriptions to focus on account measurement uncertainty at the reporting date, not the sensitivity to future changes.

This new approach is designed to boost transparency and comparability even further, although companies do still have considerable freedom when deciding which information is relevant and disclosable.

## Navigating Challenges With Level 3 Assets

Because Level 3 assets are notoriously difficult to value, the stated worth they are given for accounting purposes should not always be taken at face value by [investors](https://www.investopedia.com/terms/i/investor.asp).

Level 3 assets are hard to value, so their listed worth shouldn't be taken at face value by [investors](https://www.investopedia.com/terms/i/investor.asp). Valuations are subject to interpretation, so a [margin of safety](https://www.investopedia.com/terms/m/marginofsafety.asp) needs to be factored in to account for any errors in using Level 3 inputs to value an asset.

Level 3 assets are often a small part of a company’s balance sheet but more common in industries like large investment firms and [banks](https://www.investopedia.com/terms/c/commercialbank.asp).

## How Many Levels of Company Assets Are There?

Companies classify assets as level 1, 2, or 3, depending on how easily they can be valued. Level 3 is considered the most illiquid and hardest to value.

## What Are Level 1 and Level 2 Assets?

Level 1 assets are considered to have readily observable, transparent prices, and therefore a reliable fair market value.

Level 2 assets are difficult to value, but their value can be closely approximated using simple models and extrapolation methods using known, observable prices as parameters.

## What Are Examples of Level 3 Assets?

Examples of Level 3 assets include complex derivatives, distressed debt, foreign stocks, mortgage-backed securities (MBS), and private equity shares.

## Final Thoughts on Level 3 Assets

Level 3 assets are the most illiquid and hardest to value among financial assets and liabilities, primarily due to their infrequent trading and lack of readily observable market prices. Companies categorize these assets under FASB's Topic 820 framework, which highlights the challenges in valuing them using unobservable inputs and complex models.

It's crucial for investors to note that valuations of Level 3 assets are subject to interpretation and may require a margin of safety. Accurate and transparent disclosure practices are paramount to better understanding and managing risks associated with these assets.