What are Level 2 Assets?
Level 2 assets are financial assets and liabilities that are neither easy or overly complex to value. They do not have regular market pricing, although a fair value can be determined for them based on other data values or market prices. Sometimes called "mark-to-model" assets, Level 2 asset values can be closely approximated using simple models and extrapolation methods using known, observable prices as parameters.
Understanding Level 2 Assets
Publicly traded companies are obligated to establish fair values for the assets they carry on their books. Investors rely on these fair value estimates to analyze the firm's current condition and future prospects.
According to generally accepted accounting principles (GAAP), certain assets must be recorded at their current value, not historical cost. Publicly traded companies must also classify all of their assets based on the ease that they can be valued, in compliance with the accounting standard known as FASB 157.
Three different levels were introduced by the U.S. Financial Accounting Standards Board (FASB) to bring clarity to the balance sheet assets of corporations. Level 2 assets are the middle classification based on how reliably their fair market values can be calculated. Level 1 assets, such as stocks and bonds, are the easiest, while Level 3 assets can only be valued based on internal models or "guesstimates" and have no observable market prices.
Level 2 assets must be valued using market data obtained from external, independent sources. Data could include quoted prices for similar assets and liabilities in active markets, prices for identical or similar assets and liabilities in inactive markets, or models which have observable inputs, such as interest rates, default rates, and yield curves.
An example of a Level 2 asset is an interest rate swap. Here the asset value can be determined based on the observed values for underlying interest rates and market-determined risk premiums. Level 2 assets are commonly held by private equity firms, insurance companies, and other financial institutions that have investment arms.
- Level 2 assets are financial assets and liabilities that do not have regular market pricing, but whose fair value can be determined based on other data values or market prices.
- They are the middle classification based on how reliably their fair market values can be calculated.
- Level 2 assets are commonly held by private equity firms, insurance companies, and other financial institutions that have investment arms.
Real World Example of Level 2 Assets
"Fair value is determined through the use of models or other valuation methodologies. Financial instruments which are generally included in this category include corporate bonds and loans, including corporate bonds and loans held within CLO vehicles, government and agency securities, less liquid and restricted equity securities, and certain over-the-counter derivatives where the fair value is based on observable inputs. Senior and subordinated notes issued by CLO vehicles are classified within Level II of the fair value hierarchy."
Observable vs. Unobservable Inputs
Investors, analysts and so forth sometimes struggle to identify the difference between Level 2 and Level 3 assets. Recognizing the contrasts is important, particularly as GAAP requires additional disclosures for Level 3 assets and liabilities.
The best way to determine whether an asset or liability is Level 2 or Level 3 is to figure out if the valuation inputs used are developed using market data available to the public or not. Consider the following points:
- Is the value supported by real market transactions?
- Is a price obtained from outside the organization and readily available to the public?
- Is the valuation distributed at regular intervals?
if the answer to any of these questions is no, the input may be considered unobservable and, as a result, Level 3 in the fair value hierarchy.