A client holds a private placement note, a warrant or a minority interest. There is no quoted price, so management builds a discounted cash flow model and books the result. The number carries real estimation uncertainty, and a one-point change in an input can move it by thousands. That is a Level 3 measurement, and it deserves a planned set of audit procedures.
This guide covers how the hierarchy classifies a measurement, what the valuation approaches look like in a file, why calibration matters, a worked sensitivity example and the tests an auditor can apply. For the full standard and disclosures, see /us/blog/asc-820-fair-value-measurement.
What makes a measurement Level 3?
The hierarchy ranks inputs. Level 1 is quoted prices, unadjusted, for identical assets or liabilities in active markets. Level 2 covers inputs that are observable directly or indirectly but are not Level 1. Level 3 uses unobservable inputs, such as a reporting entity's own data.
Classification follows the lowest level of any significant input. The measurement is categorized in its entirety on that basis, so one significant unobservable input places the whole asset or liability in Level 3. Significance takes judgment, has no bright line and is assessed for each input and for the inputs in aggregate. Classification is reassessed at every reporting date, because the observability of inputs changes.
The objective does not change at Level 3. Fair value is still an exit price from a market participant's perspective. If management uses its own data, it adjusts that data when reasonably available information shows market participants would assume something different. Management assumptions that cannot be corroborated with observable market data are typically Level 3.
Are broker quotes and pricing services Level 2?
Not automatically. KPMG's handbook says prices from a pricing service are not observable simply because a third party supplied them or because the instrument is liquid. The level depends on the inputs behind the price. Management should understand the source, the inputs and assumptions, and whether a quote is binding or nonbinding, and consider whether an adjustment is needed. Management stays responsible for the appropriateness of the measurement when it uses a pricing service or broker. When price indications for one instrument are widely dispersed, averaging them is generally not appropriate.
What valuation approaches appear in the file?
- Market approach. It relies on market transactions and often uses multiples from comparables. Matrix pricing for debt securities belongs here.
- Income approach. It converts future amounts to a present amount, typically through a discounted cash flow, with a terminal value where appropriate. ASC 820 does not prescribe one present value technique.
- Cost approach. It reflects the amount required to replace the service capacity of an asset, with obsolescence adjustments.
The entity maximizes relevant observable inputs and minimizes unobservable inputs. Using more than one technique can act as a check on assumptions. A wide range of results is a signal to re-evaluate inputs, and the measurement should reflect the most representative point within the range.
Why does calibration matter?
If the transaction price equals fair value at initial recognition and a technique with unobservable inputs will be used afterward, the technique is calibrated so that it produces the transaction price at inception. Calibration ensures the technique reflects current market conditions. It also gives the auditor an anchor: a model that cannot reproduce the price paid on day one needs an explanation.
The transaction price may not equal fair value in related-party deals, forced transactions, unit-of-account mismatches and trades in a different market. In those cases a day one gain or loss can arise.
Worked example
An illustration with round numbers. On January 1, a client pays $650,000 for a private note with a single payment of $1,000,000 due in five years and no interim interest. Management values it by discounting.
Calibration. Discounting $1,000,000 for five years at 9 percent gives about $649,931, which matches the price paid. The model's discount rate calibrates to about 9 percent at inception.
Year end. Four years remain. Management concludes that market participants now require 10 percent. The fair value is $1,000,000 divided by 1.10 to the fourth power, or about $683,013. Assume the note is measured at fair value through net income:
| Account | Debit | Credit |
|---|---|---|
| Investment in note, at fair value | 33,013 | |
| Unrealized gain on investment | 33,013 |
Sensitivity. The discount rate is the significant unobservable input, so the auditor tests how far the value moves:
| Discount rate | Fair value at year end |
|---|---|
| 9 percent | 708,425 |
| 10 percent | 683,013 |
| 11 percent | 658,731 |
Each point of rate moves the value by roughly $24,300 to $25,400, about 3.6 to 3.7 percent. The file records why 10 percent is a market participant rate, what evidence supports it, and whether the answer is stable inside a reasonable range.
What about premiums and discounts?
KPMG's handbook states that an entity may not apply a blockage factor, a discount that reflects the size of the holding, at any of the three levels. A fair value measurement also does not include a premium or discount that is inconsistent with the unit of account or, absent a listed exception, one applied to an identical asset with a quoted price in an active market. Premiums and discounts that reflect a characteristic of the asset, such as a control premium or a noncontrolling interest discount, can be appropriate at Level 2 and Level 3. The entity considers market participant assumptions, the unit of account, whether the adjustment relates to the size of the holding or to a characteristic of the asset, and whether the effect is already in the valuation.
What Level 3 disclosures does the file need?
The disclosure requirements are most extensive for recurring Level 3 measurements, and they differ by entity type after ASU 2018-13. KPMG's handbook describes these points for nonpublic entities:
- Quantitative information about the significant unobservable inputs. A nonpublic entity is not required to give both the range and the weighted average. KPMG expects most to give the range, and a weighted average or other information where the range is not meaningful.
- The changes in the period for recurring Level 3 measurements due to purchases and issues, plus transfers into and out of Level 3 and the reasons.
Public business entities give the range and weighted average of significant unobservable inputs and a reconciliation of opening and closing balances. KPMG also notes that quantitative input information is not required where the inputs were not developed by the entity, such as an unadjusted broker quote, but an adjustment the entity makes to a broker quote that is significant must be disclosed.
What if the market is inactive?
A significant decrease in activity alone does not make a transaction disorderly. Observable transactions between unrelated parties are treated as orderly unless the evidence shows otherwise. Little, if any, weight goes to a price from a transaction that is not orderly. The entity's intention to hold the asset is irrelevant.
Audit angle
- Understand management's process. Who builds the model, what data feeds it, who reviews it. Review the controls over the inputs.
- Test classification. Identify each significant input and check that unsupported broker or pricing service prices were not classified as Level 2.
- Test calibration. Agree the transaction price and recompute the model's inception value.
- Test the inputs. Agree cash flows to contracts and budgets, and discount rates to market data for comparable risk. Compare management's own data with market participant assumptions.
- Recompute and run sensitivities. Rebuild the model result. Vary the significant inputs and judge whether the conclusion changes. Look for bias in the direction of the choices, see /us/blog/auditing-estimates-point-estimate-range-and-management-bias.
- Evaluate premiums and discounts. Check that no size-based discount was applied and that each premium or discount reflects an asset characteristic and is not double counted.
- Consider a specialist. For complex models, see /us/blog/using-the-work-of-a-specialist-au-c-620. The estimate requirements are in /us/standards/au-c-540.
- Check disclosures. Agree the fair value disclosures to the measurement, the level assigned and the technique used. For recurring Level 3 items, agree the input information and the purchases, issues and transfers to the ledger.
Common misstatements: a model that cannot reproduce the purchase price, a single indicative broker quote booked as Level 2, a size-based discount applied to a position and a discount rate unchanged despite worse credit.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- KPMG, Handbook: Fair value measurement (pricing services, blockage factors, calibration and transaction price, Level 3 disclosures): https://kpmg.com/us/en/frv/reference-library/2025/handbook-fair-value-measurement.html
- PwC Viewpoint, Fair value measurements guide, 4.5 Inputs to fair value measurements: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/fair_value_measureme/fair_value_measureme__9_US/chapter_4_concepts_u_US/45_inputs_to_fair_va_US.html
- PwC Viewpoint, Fair value measurements guide, 4.4 Valuation approaches, techniques, and methods: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/fair_value_measureme/fair_value_measureme__9_US/chapter_4_concepts_u_US/44_valuation_approac_US.html
- PwC Viewpoint, Fair value measurements guide, 4.3 Fair value at initial recognition: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/fair_value_measureme/fair_value_measureme__9_US/chapter_4_concepts_u_US/43_fair_value_at_ini_US.html
- PwC Viewpoint, Fair value measurements guide, 4.6 Fair value measurements and inactive markets: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/fair_value_measureme/fair_value_measureme__9_US/chapter_4_concepts_u_US/46_fair_value_measur_US.html
- PwC Viewpoint, Fair value measurements guide, 4.7 Premiums and discounts: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/fair_value_measureme/fair_value_measureme__9_US/chapter_4_concepts_u_US/47_premiums_and_disc_US.html
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