ASC 820 Level 3 Documentation Checklist for Audit Readiness
Level 3 fair value measurements carry the highest audit scrutiny under ASC 820. This checklist covers every documentation requirement, from unobservable input tables to rollforward schedules, that auditors and reviewers expect to see.
Key Takeaways
- check_circleASC 820 (Accounting Standards Codification 820) requires entities to disclose quantitative information about all significant unobservable inputs used in Level 3 fair value measurements, including the range and weighted average of those inputs.
- check_circleFor recurring Level 3 measurements, a rollforward schedule reconciling beginning and ending balances, separating gains and losses, purchases, sales, issuances, settlements, and transfers in and out, is a required disclosure under ASC 820.
- check_circleWhen a valuation technique changes for a Level 3 measurement, auditors require documentation of the reasons for the change, the impact on fair value estimates, and why the new method is appropriate under ASC 820.
- check_circleLevel 3 inputs should be used only to the extent that relevant observable inputs are not available; the entity must demonstrate that it has maximized the use of observable inputs before relying on unobservable ones.
- check_circleThe AICPA released guidance in mid-2019 on how best to value Level 3 assets, written to converge U.S. GAAP and IFRS treatment of unobservable inputs.
Of the three levels in the ASC 820 (Accounting Standards Codification 820) fair value hierarchy, Level 3 generates the most audit friction. The inputs are unobservable, the judgment calls are significant, and the disclosure requirements are the most extensive of any category. A controller who has documented Level 1 and Level 2 measurements thoroughly can still face a qualified opinion if the Level 3 file is incomplete. This checklist is organized around the specific documentation items that auditors and reviewers expect to find, drawn from the requirements of ASC 820 and the guidance issued by the AICPA, the PCAOB, and the major accounting firms.
Why Level 3 Carries the Highest Documentation Burden
The fair value hierarchy under ASC 820 gives the highest priority to quoted prices in active markets for identical assets (Level 1) and the lowest priority to unobservable inputs (Level 3). The lower the level, the more the entity must demonstrate that its assumptions reflect what market participants would use when pricing the asset or liability, including assumptions about risk. Because Level 3 inputs are, by definition, not corroborated by observable market data, the documentation must substitute for that external verification.
ASC 820-10-35-53 states that unobservable inputs shall be used to measure fair value only to the extent that relevant observable inputs are not available. The practical consequence for documentation is that the file must show not just what unobservable inputs were used, but why observable inputs were insufficient or unavailable. That threshold argument is often missing from first-draft workpapers.
The Core Documentation Requirements Under ASC 820
ASC 820 requires entities to provide both quantitative and qualitative disclosures about fair value measurements, with the most extensive requirements applying to Level 3. The framework provides a structured set of disclosure obligations that apply to recurring and, in some cases, non-recurring measurements. The checklist below maps each requirement to its source and notes the common documentation gaps that arise in practice.
1. Fair Value Hierarchy Classification
Entities must categorize each asset and liability into Level 1, Level 2, or Level 3 and disclose the amounts within each level. The classification must be supported by a written rationale explaining why the measurement falls within Level 3 rather than Level 2, specifically addressing the availability of observable inputs and why those inputs were not used or were insufficient.
2. Valuation Technique Description
For Level 2 and Level 3 measurements, entities must disclose the valuation approach used, whether market, income, or cost, and the inputs applied, such as discount rates, yield curves, or price multiples. For Level 3 specifically, the description must be detailed enough that a knowledgeable reviewer can assess whether the technique is appropriate for the asset or liability being measured. Where multiple techniques are used, each must be described and the weighting or selection rationale documented.
3. Quantitative Unobservable Input Table
This is the disclosure that most frequently generates auditor comments. ASC 820 requires quantitative information about all significant unobservable inputs used in Level 3 measurements, including, upon adoption of ASU 2018-13, the range and weighted average of those inputs. The table must cover every input that is significant to the fair value measurement, not just the inputs the preparer finds easiest to quantify.
| Input Type | Example Asset | Typical Unobservable Inputs | Disclosure Requirement |
|---|---|---|---|
| Discount rate | Private equity investment | Weighted average cost of capital, risk premium | Point estimate or range + weighted average |
| Revenue growth rate | Early-stage portfolio company | Projected annual growth, terminal growth rate | Range of assumptions used |
| EBITDA multiple | Private company equity | Selected multiple from comparable transactions | Range and basis for selection |
| DLOM (Discount for Lack of Marketability) | Minority interest, restricted shares | Discount percentage applied | Quantitative basis and methodology |
| Probability weights | Contingent consideration | Scenario probabilities | Each scenario and assigned weight |
4. Process Description for Developing Unobservable Inputs
Beyond the quantitative table, ASC 820 requires a description of the process the entity uses to develop unobservable inputs. This is a qualitative narrative, not a number. It should explain the data sources consulted, the internal controls over the estimation process, who is responsible for developing and approving the inputs, and how the entity ensures that the inputs reflect market participant assumptions rather than entity-specific factors.
5. Level 3 Rollforward Schedule (Recurring Measurements)
For recurring Level 3 fair value measurements, a rollforward reconciling beginning and ending balances is a required disclosure. The rollforward must separately identify each of the following components:
- Total gains or losses recognized in income for the period, with the specific line item identified
- Total gains or losses recognized in other comprehensive income (OCI) for the period
- Purchases, sales, issuances, and settlements (each disclosed separately)
- Transfers into Level 3 and the reasons for those transfers
- Transfers out of Level 3 and the reasons for those transfers
Nonpublic entities are not required to prepare a full Level 3 rollforward. The specific reduced requirements applicable to nonpublic entities are addressed separately in ASC 820's disclosure guidance. Any company that holds recurring Level 3 assets and is subject to public reporting should treat the rollforward as a non-negotiable component of the disclosure package.
6. Sensitivity and Uncertainty Narrative
For recurring Level 3 measurements, ASC 820 requires a narrative description of the uncertainty of the fair value measurement at the reporting date arising from the use of significant unobservable inputs, specifically addressing whether a change in those inputs to a different amount might result in a significantly higher or lower fair value. This narrative is distinct from the quantitative input table. It requires the preparer to assess and articulate the directional sensitivity of the measurement to each significant assumption.
The sensitivity narrative is one of the most frequently underdeveloped disclosures in practice. A statement that "changes in assumptions could affect fair value" does not satisfy the requirement. The narrative must identify which inputs are most sensitive, the direction of the effect, and, where inputs are interrelated, describe those interrelationships.
7. Transfers Into and Out of Level 3
Entities must disclose purchases, conversions, and any transfers in or out of Level 3, along with the reasons for those transfers. A transfer into Level 3 typically occurs when an input that was previously observable becomes unobservable, or when an adjustment using an unobservable input becomes significant to the overall measurement. The documentation must explain the specific event or change in circumstances that triggered the reclassification.
Valuation Technique Changes: A Separate Documentation Requirement
Changing valuation techniques for a Level 3 measurement, for example, moving from a market approach to an income approach, triggers a distinct set of documentation obligations. Auditors require clear documentation of the reasons for the change, the impact on fair value estimates, and why the new method is appropriate under ASC 820. The audit team will evaluate the consistency of the approach, the justification for the change, and whether all disclosures about the change have been properly made in the financial statements.
A technique change may also prompt additional questions about internal controls and governance over the valuation process. The documentation file should therefore include not just the technical rationale for the change but also evidence that the change was reviewed and approved through the entity's established governance process.
The Complete Level 3 Documentation Checklist
The table below consolidates the documentation items discussed above into a single reference. The "Applies To" column distinguishes between requirements that apply to all entities and those that apply specifically to public entities or recurring measurements.
| Documentation Item | Requirement Source | Applies To | Common Gap |
|---|---|---|---|
| Level 3 classification rationale (why observable inputs were insufficient) | ASC 820 hierarchy rules | All entities | Rationale omitted; classification stated without support |
| Valuation technique description (market, income, or cost approach) | ASC 820 disclosure requirements | All entities | Technique named but not described in sufficient detail |
| Quantitative unobservable input table with range and weighted average | ASC 820-10-50-2(bbb)(2) | Public entities; recurring measurements | Range missing; only point estimates provided |
| Process description for developing unobservable inputs | ASC 820 disclosure requirements | All entities | Generic language; no description of data sources or controls |
| Level 3 rollforward schedule (beginning to ending balance) | ASC 820-10-50-2(c) | Public entities; recurring measurements | Components not separately identified; transfers not explained |
| Sensitivity and uncertainty narrative | ASC 820 disclosure requirements | All entities; recurring measurements | Boilerplate language; no directional sensitivity analysis |
| Transfers in/out of Level 3 with reasons | ASC 820 disclosure requirements | All entities | Transfer disclosed without explanation of triggering event |
| Valuation technique change documentation (if applicable) | ASC 820 audit requirements | All entities | Change noted in workpapers but not disclosed in financial statements |
| Governance and approval evidence for unobservable inputs | PCAOB auditing standards | All entities subject to audit | No written record of who approved inputs or when |
Practical Considerations for CPA Firms and Controllers
Information Rights and Data Access
Level 3 valuations are particularly challenging when the entity does not have full access to the underlying asset's internal data. This is a common issue for fund managers without a board seat or full information rights over a portfolio company. In those circumstances, the documentation must explain what information was available, what was unavailable, and how the entity developed its assumptions in the absence of complete data. The AICPA's 2019 guidance addresses this scenario directly.
Consistency Across Reporting Periods
Auditors assess not just whether the current period's documentation is complete, but whether the approach is consistent with prior periods. Unexplained changes in discount rates, growth assumptions, or selected multiples between periods will generate inquiries. The documentation file should include a period-over-period comparison of key inputs and a written explanation for any changes, even when the valuation technique itself has not changed.
ASC 820 and IFRS 13 Convergence
For entities that report under both U.S. GAAP and IFRS, the documentation requirements for Level 3 measurements are substantially similar. IFRS 13 requires quantitative information about significant unobservable inputs and a narrative description of the sensitivity of the fair value measurement to changes in those inputs. The AICPA's 2019 guidance was written specifically to converge GAAP and IFRS treatment in this area. Entities with dual reporting obligations can generally satisfy both frameworks with a single documentation package, provided the package is sufficiently detailed to meet the more prescriptive U.S. GAAP requirements.
For a broader overview of how ASC 820 defines fair value and structures the three-level hierarchy, see the complete guide to ASC 820 fair value measurement. For context on when fair value measurement obligations arise in the first place, the guide to when a business valuation is required covers the key triggering events under U.S. GAAP and other regulatory frameworks.
The framework provides a clear set of disclosure obligations for Level 3 measurements. The documentation gap that most often surfaces in audit is not a misunderstanding of the requirements but an underestimation of the depth of evidence each requirement demands.
Audit readiness for Level 3 measurements is built incrementally, not assembled at year-end. Entities that maintain the documentation file on a rolling basis, updating input tables and governance records at each measurement date, consistently experience fewer auditor comments and shorter fieldwork cycles than those that reconstruct the file after the fact.
Frequently Asked Questions
What documentation is required for ASC 820 Level 3 fair value measurements?expand_more
Under ASC 820, entities must provide quantitative information about all significant unobservable inputs used in Level 3 measurements, including a description of the process for developing those inputs. For recurring measurements, a rollforward of beginning and ending balances is also required, separating gains and losses, purchases, sales, settlements, and transfers in and out of Level 3.
What is a Level 3 rollforward schedule and when is it required?expand_more
A Level 3 rollforward is a reconciliation table that shows how the fair value of a Level 3 asset or liability changed over the reporting period. It must separately identify total gains or losses recognized in income and in other comprehensive income, purchases, sales, issuances, settlements, and transfers into or out of Level 3. Public entities are required to prepare a full rollforward; nonpublic entities have a reduced requirement under ASC 820.
How does changing a valuation technique affect ASC 820 Level 3 audit documentation?expand_more
If a valuation technique changes for a Level 3 measurement, auditors require clear documentation of the reasons for the change, the impact on fair value estimates, and why the new method is appropriate under ASC 820. The audit team will evaluate the consistency of the approach and whether all disclosures about the change have been properly made in the financial statements.
What is the difference between Level 2 and Level 3 inputs under ASC 820?expand_more
Level 2 inputs are observable for the asset or liability, either directly or indirectly, but are not quoted prices in active markets for identical assets (which would be Level 1). Level 3 inputs are unobservable and require the reporting entity to develop its own assumptions about what market participants would use when pricing the asset or liability. If an observable input requires adjustment using an unobservable input and that adjustment results in a significantly higher or lower fair value, the measurement is categorized as Level 3.
Are nonpublic entities subject to the same ASC 820 Level 3 disclosure requirements as public companies?expand_more
Nonpublic entities are not required to prepare a full Level 3 rollforward under ASC 820. However, they remain subject to the core quantitative disclosure requirements for significant unobservable inputs and the narrative description of measurement uncertainty. The specific reduced requirements for nonpublic entities are addressed in ASC 820's disclosure guidance.
