The term Level 3 asset refers to a hierarchy framework that includes assets and liabilities whose values are based on complex mathematical models and internal inputs. Companies are required to value certain assets and liabilities at their current value, not historical cost. The hierarchy framework used to value these assets includes three levels, with Level 3 requiring mathematical models as well as the expertise of internal subject matter experts.
Generally Accepted Accounting Principles require companies to record certain assets at their current value, not historical cost. The three approaches used to determine these values include mark-to-market, mark-to-model, and mark-to-management. These processes were developed so assets appearing on a company's balance sheet reflected their true value, which can materially differ from historical cost.
Guidance is provided in Statements of Financial Accounting Standards No. 157, Fair Value Measurements, which describes both the fair value hierarchy as well as the disclosure requirements for assets and liabilities not recorded at historical cost. Generally, the fair value of Level 3 assets and liabilities cannot be determined using directly observable market information. Instead, estimates rely on a combination of complex market prices as well as a number of relatively subjective assumptions that materially affect the estimated value; this process is referred to as mark-to-management.
Level 3 falls at the bottom of this hierarchy, and includes assets and liabilities that possess values that can only be determined using complex mathematical models and the opinions of subject matter experts. Examples of Level 3 assets and liabilities include private equity investments, complex derivatives, foreign stocks and options as well as long-dated investments.