Fair value hierarchy level 2 inputs

What Is Fair Value Hierarchy Level 2 Inputs?

Fair value hierarchy Level 2 inputs are observable inputs, other than quoted prices for identical assets or liabilities in active markets, used in financial reporting to determine the fair value of assets or liabilities. This category within financial accounting and reporting, specifically the fair value hierarchy, indicates that while direct market quotes for the exact asset or liability in an active market aren't available, sufficient observable data exists to make a reliable valuation. These inputs are widely used in situations where direct market prices are unavailable but indirect market information can still provide a robust basis for valuation.

History and Origin

The concept of fair value and its hierarchical classification gained significant prominence with the issuance of accounting standards like ASC 820 (formerly FAS 157) by the Financial Accounting Standards Board (FASB) in the United States and IFRS 13 by the International Accounting Standards Board (IASB) globally. IFRS 13, issued in May 2011, defines fair value and sets out a framework for its measurement and disclosure, applying to instances where other International Financial Reporting Standards (IFRS) require or permit fair value measurements²³, ²⁴, ²⁵. These standards were developed to enhance consistency and comparability in fair value measurements and related disclosures, establishing a fair value hierarchy that categorizes inputs into three levels²².

Prior to these standardized frameworks, various accounting standards contained guidance on measuring fair value, but this guidance was not always consistent, leading to diversity in practice and reduced comparability in financial statements²¹. The push for a standardized framework became particularly acute following the 2008 financial crisis, during which the role of fair value accounting was heavily scrutinized. While some argued it exacerbated the crisis, studies suggest it likely did not add to the severity in a major way and that concerns often overshadowed its beneficial role in promoting timely market information¹⁹, ²⁰. Regulators, including the U.S. Securities and Exchange Commission (SEC), also provided guidance and mandates to address concerns and improve disclosures related to fair value accounting during and after the crisis¹⁶, ¹⁷, ¹⁸.

Key Takeaways

• Fair value hierarchy Level 2 inputs refer to observable data points, excluding active market quotes for identical items, used to determine an asset's or liability's fair value.
• These inputs include quoted prices for similar assets/liabilities in active markets, identical/similar assets/liabilities in inactive markets, interest rates, yield curves, and market-corroborated inputs.
• Valuation techniques like the market approach and income approach often utilize Level 2 inputs.
• The use of Level 2 inputs provides a more objective valuation than Level 3 inputs, which are unobservable, but requires more judgment than Level 1 inputs.
• Financial institutions and companies often rely on Level 2 inputs for valuing less liquid securities or instruments without readily available direct market prices.

Interpreting Fair Value Hierarchy Level 2 Inputs

Interpreting fair value hierarchy Level 2 inputs involves understanding that the valuation is based on data that is observable in the market, even if it's not a direct, active market price for the identical item. This signifies a level of reliability and objectivity greater than Level 3 inputs, which are unobservable and rely heavily on management's own assumptions.

When a financial instrument or asset is classified within Level 2, it means that its valuation relies on inputs like quoted prices for similar assets or liabilities in active markets, or quoted prices for identical or similar assets or liabilities in markets that are not active. It could also involve observable inputs such as interest rates, yield curves, or credit spreads that are widely available and reflect market conditions. The objective is to derive an exit price – the price at which an asset would be sold or a liability transferred in an orderly transaction between market participants. ¹⁴, ¹⁵The determination of fair value through Level 2 inputs requires professional judgment to ensure that the chosen inputs are relevant and properly adjusted to reflect the characteristics of the specific asset or liability being valued.

Hypothetical Example

Consider a private equity firm that holds a portfolio of corporate bonds. One specific bond, issued by a medium-sized company, does not trade frequently on an active exchange, meaning no Level 1 inputs are available. To determine its fair value, the firm's valuation team utilizes Level 2 inputs.

1. Identify Comparable Bonds: The team searches for publicly traded corporate bonds with similar credit ratings, maturities, and industry sectors. They find several such bonds that trade actively.
2. Gather Observable Data: For these comparable bonds, they collect data on their quoted prices, recent transaction volumes, and prevailing market interest rates. They also consider the bond's specific features, such as any call provisions or put options, which might influence its value.
3. Apply Valuation Technique: Using a market approach, the team applies the observed yield spreads and credit risk premiums from the actively traded similar bonds to the cash flows of the illiquid bond.
4. Adjust for Differences: They make adjustments for any minor differences in the bond's covenants or other specific terms compared to the comparable bonds. For instance, if the bond has a slightly longer maturity than most comparable actively traded bonds, they might adjust the yield curve accordingly.
5. Derive Fair Value: Through this process, based on these Level 2 inputs, they arrive at an estimated fair value for the infrequently traded corporate bond, reflecting what market participants would be willing to pay for it under current market conditions. This allows the firm to accurately report the bond's value on its financial statements.

Practical Applications

Fair value hierarchy Level 2 inputs are widely applied across various sectors of finance and accounting, particularly for assets and liabilities that do not have readily available quoted prices in active markets.

• Financial Reporting: Companies use Level 2 inputs to measure and disclose the fair value of many financial instruments, including over-the-counter (OTC) derivatives, corporate bonds with infrequent trading, and mortgage-backed securities. ¹³This ensures that financial statements provide relevant information about the current value of these items, even in the absence of direct market observations.
• Investment Portfolios: Investment funds, such as mutual funds and hedge funds, frequently hold securities that fall into Level 2. Their portfolio managers and valuation teams rely on observable inputs like market-corroborated pricing data from independent pricing services to value these holdings.
  ¹¹, ¹²* Banking Sector: Banks utilize Level 2 inputs for valuing a significant portion of their loan portfolios, particularly those that are not actively traded. This also applies to certain debt securities and other financial assets held for sale.
• Mergers and Acquisitions (M&A): During M&A transactions, the fair value of assets and liabilities of the acquired entity often needs to be determined for accounting purposes. For non-publicly traded assets, Level 2 inputs, such as recent comparable transactions or observable market multiples, play a crucial role.
• Regulatory Compliance: Regulatory bodies, including the SEC, provide guidelines on the use of fair value measurements. Publicly traded companies and investment firms must adhere to these guidelines, ensuring that their valuation processes for Level 2 inputs are robust and transparent, with adequate internal controls. ⁹, ¹⁰This includes considering how inputs, methods, and assumptions used by pricing services are affected by changing market conditions.
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Limitations and Criticisms

While fair value hierarchy Level 2 inputs offer a more objective basis for valuation than Level 3 inputs, they are not without limitations and have faced some criticisms.

One primary limitation is the inherent subjectivity involved in making adjustments to observable inputs. Even if quoted prices for similar assets exist, determining the appropriate adjustments for differences in characteristics (e.g., condition, location, or specific features of a financial instrument) can introduce a degree of judgment and potential for inconsistency. This means that two different entities, or even two different valuation experts within the same entity, might arrive at slightly different fair values for the same asset or liability using similar Level 2 inputs.

Another criticism arises when markets become less active or fragmented. In such scenarios, even "observable" inputs might become less reliable or require significant extrapolation, pushing the boundaries between Level 2 and Level 3 measurements. For example, during periods of financial stress or market illiquidity, finding truly comparable assets with active trading can be challenging, forcing greater reliance on models or assumptions that verge on unobservable inputs. Some argue that this can lead to procyclicality, where valuations amplify market downturns during crises.
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Furthermore, the reliance on third-party pricing services, while providing efficiency, can also lead to concerns about the transparency and verifiability of their underlying methodologies and inputs. ⁶While companies are responsible for understanding the assumptions and methods used by valuators, the complexity can make it challenging to fully scrutinize every input and adjustment made by these services. This underscores the importance of robust internal controls and due diligence over fair value measurements.
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Fair Value Hierarchy Level 2 Inputs vs. Fair Value Hierarchy Level 1 Inputs

The primary distinction between fair value hierarchy Level 2 inputs and fair value hierarchy Level 1 inputs lies in the nature and accessibility of the observable data used for valuation. Both levels represent observable market data, but Level 1 inputs offer the highest degree of reliability and least subjectivity.

Confusion often arises when an asset or liability has some observable data, but not a direct, unadjusted quote in a highly liquid market. While Level 1 inputs represent pure "mark-to-market" valuations, Level 2 inputs involve "mark-to-model" where the model's inputs are primarily observable. Essentially, if you can find the exact price for the exact item in a bustling market, it's Level 1. If you need to look at similar items or make minor adjustments to observable data, it falls under Level 2.

FAQs

What types of assets or liabilities typically use Fair Value Hierarchy Level 2 inputs?

Fair value hierarchy Level 2 inputs are often used for assets and liabilities like corporate bonds (especially those that are less frequently traded), over-the-counter (OTC) derivatives, mortgage-backed securities, and certain privately held equity investments where there are observable transactions of comparable companies.
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How do auditors verify Fair Value Hierarchy Level 2 inputs?

Auditors assess Level 2 fair value measurements by scrutinizing the underlying assumptions and inputs used by management or third-party valuation specialists. They may inquire about the completeness, accuracy, and relevance of these inputs and the appropriateness of the valuation techniques applied. ³This often involves comparing inputs to independent market data and evaluating the reasonableness of any adjustments made.

Can Fair Value Hierarchy Level 2 inputs become Level 1 or Level 3?

Yes, the classification can change. If a previously illiquid asset suddenly begins trading actively on an exchange with readily available quoted prices, its valuation might shift from Level 2 to Level 1. Conversely, if observable inputs for a Level 2 asset become scarce or cease to exist, forcing reliance on unobservable, entity-specific assumptions, the valuation would move to Level 3.

Is matrix pricing considered a Level 2 input?

Yes, matrix pricing, a common technique used to value bonds based on their relationship to other benchmark securities, is typically considered a Level 2 input. It relies on observable inputs like yield curves and credit spreads of similar bonds, even if the specific bond being valued isn't actively traded.
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What is the role of judgment in Fair Value Hierarchy Level 2 measurements?

Judgment plays a crucial role in Fair Value Hierarchy Level 2 measurements. While the inputs are observable, judgment is required to select the most appropriate observable inputs, make necessary adjustments for differences between the observable inputs and the item being valued, and choose the most suitable valuation technique.
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