Level 3 Investments under US GAAP: Financial Statement Valuation, Presentation and Disclosure Considerations

 Author: DM Technical Team, September 2026

Level 3 measurements can arise for a variety of investments for which there is a limited or no active market. For entities holding these investments, the reporting process involves considerably more than simply obtaining a valuation. Management must consider the appropriate valuation methodology, identify and support significant assumptions, determine the appropriate classification within the fair value hierarchy, and include the required disclosures within the financial statements.

In this article, the DM Technical Team considers the principal implications of Level 3 investments when preparing US GAAP financial statements.

Level 3 investments

Investments that do not have readily observable market prices can raise certain considerations when preparing financial statements under US GAAP. This is the case for Level 3 investments, where fair value measurements depend in whole or in part on significant inputs that are not readily observable in the marketplace.

Typical examples of Level 3 investments include private equity investments, privately held debt instruments, and certain complex financial instruments.

Fair value hierarchy

ASC 820-10-35-37 details the fair value hierarchy, which prioritizes observable data rather than valuation techniques, placing measurements using only those inputs in the highest level of the fair value hierarchy, i.e., Level 1. The lowest level in the hierarchy, i.e., Level 3, includes inputs that are unobservable, which may include a reporting entity’s own assumptions about cash flows or other inputs.

Level 1: Quoted prices in active markets for identical assets or liabilities.

Level 2: Inputs other than quoted market prices that are observable for the asset or liability, either directly or indirectly.

Level 3: Unobservable inputs for an asset or liability.

It is important to note that Level 3 does not mean that the investment itself is necessarily unobservable. Rather, the classification reflects the inputs used to determine its fair value. A valuation may incorporate observable information alongside significant unobservable assumptions, resulting in a Level 3 classification.

ASC 820 requires valuation techniques to maximize the use of relevant observable inputs and minimize the use of unobservable inputs. If an investment is privately held, management should not default to a Level 3 valuation approach. If relevant observable market information is available, this should be incorporated into the valuation.

How Level 3 investments are fair valued

A key consideration when valuing Level 3 investments is the degree of judgment involved in determining fair value. For example, for a publicly traded investment within Level 1 with an active market, fair value may be readily established from a quoted market price. However, a private investment under Level 3 may not have a directly observable market price.

Management therefore needs to estimate the price that a market participant would receive to sell the asset in an orderly transaction at the measurement date. This is an important point because, under ASC 820, fair value is a market-based measurement rather than an entity-specific measurement.

Management must determine an exit price based on the assumptions that market participants would use, rather than based on the value that management believes the investment is worth. Management may begin with its own information when developing Level 3 assumptions, but it must consider all reasonably available market information and adjust entity-specific information as applicable to reach the valuation.

ASC 820-10-35-1 details a five-step framework that applies to both initial and subsequent measurement:

    1. Determine the unit of account, i.e., what is being measured.
    2. Determine the valuation premise based on the nature of the asset or liability being measured.
    3. Determine the observable market(s) available for the basis of the valuation.
    4. Apply the appropriate valuation approaches or techniques.
    5. Determine the fair value.

Valuation approaches and techniques

One of the most important considerations in a Level 3 valuation is identifying which inputs are significant and unobservable. Depending on the nature of the investment, these might include revenue/EBITDA growth rates, discount rates, probability of default, etc.

ASC 820 requires reporting entities to maximize the use of relevant observable inputs and minimize the use of unobservable inputs. However, where observable market information is insufficient, it may be necessary to incorporate valuation techniques that utilize unobservable inputs to fair value these Level 3 investments.

ASC 820-10-35-24A details three main approaches to measuring the fair value of assets and liabilities: the market approach, the income approach, and the cost approach.

The guidance requires reporting entities to consider all valuation approaches applicable to the nature of what is being measured and the availability of sufficient and appropriate data. In many cases, one valuation approach may be appropriate, but in other cases the reporting entity may need to incorporate multiple approaches.

The market approach is more commonly utilized for Level 1 and Level 2 financial investments rather than Level 3 investments. The cost approach is associated with assets such as property, plant, and equipment, where replacement cost is a more appropriate measure.

Income approach

The income approach is typically used to measure the value of liabilities, intangible assets, businesses, and financial instruments that are not traded in an active market. These types of instruments and input factors will result in a Level 3 classification.

The income approach is applied using the valuation technique of a discounted cash flow analysis. This analysis requires estimating future cash flows for a discrete forward-looking period, estimating the terminal value, if any, and discounting those amounts to present value at a rate that considers the relative risk of the cash flows and the time value of money.

Financial statement disclosure requirements for Level 3 investments

Disclosure requirements are based on the level within the fair value hierarchy table. As the objectivity of the inputs decreases, the disclosures required increase. As a result, Level 3 investments will typically require more detailed qualitative information to be disclosed in the financial statements.

The DM Technical Team is available to provide technical guidance and general template examples for Level 3 disclosures, as required.

  • E

    ASC 820-10-50-2 states that the financial statement notes should disclose the Level 3 investments held by the entity in the fair value hierarchy table, clearly distinguishable from Level 1 and Level 2.
  • E

    For recurring and nonrecurring fair value measurements categorized within Level 3 of the fair value hierarchy, a description of the valuation techniques and the inputs used in the fair value measurement must be disclosed in the financial statements.
  • E

    If there has been a change in the valuation approach or valuation technique, this should also be disclosed, together with the reasons for making the change.
  • E

    Additionally, for fair value measurements categorized within Level 3 of the fair value hierarchy, the entity should provide quantitative information about the significant unobservable inputs used in the fair value measurement, typically in tabular format. For example:
Valuation technique
 Significant unobservable input
 Range
 Weighted average
Discounted cash flow
 Discount rate
 12%–16%
 14%
  • E

    For recurring fair value measurements categorized within Level 3 of the fair value hierarchy, the entity is generally required to provide a rollforward, typically in tabular format, from beginning to ending fair value. The rollforward should separately identify purchases, sales, issuances, and settlements, as well as transfers in and out of Level 3. Gains and losses recognized in earnings and other comprehensive income are also separately presented.
  • E

    For recurring Level 3 investments, the entity is also required to disclose the portion of gains and losses recognized in earnings during the period that relates to changes in unrealized gains and losses on the assets and liabilities still held at the reporting date.
  • E

    For recurring Level 3 investments, the entity is also required to provide a narrative description of the uncertainty arising from significant unobservable inputs when those inputs could reasonably have been different at the reporting date. The entity should explain how changes in significant assumptions could have affected fair value.

Conclusion

Level 3 investments require significant judgment under US GAAP, particularly in determining fair value using market participant assumptions, appropriately supported valuation techniques, and observable and unobservable inputs.

Entities need to ensure that the valuation methodology used and disclosed in the financial statements is consistent with ASC 820 and that observable market information is maximized where available. The resulting financial statement disclosures should also provide sufficient transparency regarding the valuation techniques and significant unobservable inputs utilized.

In the previous sections, the DM Technical Team has addressed the various steps that should be considered by reporting entities around the fair value measurement of Level 3 investments and the resulting financial reporting presentation and disclosure requirements.

Please reach out if you would like the DM Technical Team to provide Level 3 template disclosure examples or specific worked disclosure examples for your reporting entity.

Meet the Author