Question

Keshk, Walied; Lu, Hung‐Yuan Richard; Mande, Vivek (2020). How have US banks adopted the Financial Accounting Standards Board's Level 3 fair value disclosure rules? Accounting & Finance 60, April Supplement S1, 693-727.

. If you were an auditor, which type of estimate requires more work to audit Levels 1,2 or Level 3?  Explain?

Answer 1

• Companies are required to record certain assets at their current value, rather than historical cost, and classify them as either a level 1, 2, or 3 asset, depending on how easily they can be valued.
• Level 3 assets are financial assets and liabilities that are considered to be the most illiquid and hardest to value.
• 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), private equity shares, complex derivatives, foreign stocks, and distressed debt.
• The process of estimating the value of Level 3 assets is known as mark to model

The FASB 157 categories for asset valuation were given the codes Level 1, Level 2, and Level 3. Each level is distinguished by how easily assets can be accurately valued, with Level 1 assets being the easiest.

Level 1

Level 1 assets are those valued according to readily observable market prices. These assets can be marked to market and include Treasury Bills, marketable securities, foreign currencies, and gold bullion.

Level 2

These assets and liabilities do not have regular market pricing but can be given a fair value based on quoted prices in inactive markets, or models that have observable inputs, such as interest rates, default rates, and yield curves. An interest rate swap is an example of a Level 2 asset.

Level 3

Level 3 is the least marked to market 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 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), private equity shares, complex derivatives, foreign stocks, and distressed debt. The process of estimating the value of Level 3 assets is known as mark to model.

These assets received heavy scrutiny during the credit crunch of 2007 when mortgage-backed securities (MBS) suffered massive defaults and write-downs in value. The firms that owned them were often not adjusting asset values downward even though credit markets for asset-backed securities (ABS) had dried up, and all signs pointed to a decrease in fair value