Since the implementation of the Sarbanes-Oxley Act of 2002 and related legislation, financial statement disclosures and related practices have become more robust in recent years.
However, it can still be useful to identify instances when a company’s accounting practices might be questionable (e.g., based on their unusual use of asset valuation methodologies).
Overall we want to make sure that companies are not overstating the value of their assets if they make heavy use of the more subjective Level 2 and especially Level 3 valuation methodologies.
The valuing “Level 3” asset valuation methodologies are more subjective than “Level 2,” which itself is more subjective than the valuation of “Level 1” assets.
If a company values a disproportionately large amount of its asset using “Level 3” fair valuation methodologies, it does NOT mean that:
- The company is doing something wrong
- The company’s assets are overall risker
- The company’s assets are overall less liquid
- The company’s assets are over- or undervalued
However, if a company makes heavy use of more subjective (e.g., “Level 3” valuation methodologies), it DOES mean that we should read the company’s financial disclosures to obtain a better understanding of the underlying reasons why and the possible implications (if any).