Level 2 assets: Meaning, Criticisms & Real-World Uses

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What Is Level 2 Assets?

Level 2 assets are financial assets and liabilities whose fair value is determined using inputs other than quoted prices in active markets, but that are still observable either directly or indirectly. This classification is part of the fair value hierarchy established under accounting standards like Accounting Standards Codification (ASC) 820 in U.S. Generally Accepted Accounting Principles (GAAP) and IFRS 13 under International Financial Reporting Standards, which fall under the broader category of financial reporting. These assets do not have readily available quoted prices from active markets, but their valuation can be derived from market data.³⁷,³⁶

History and Origin

The concept of Level 2 assets, along with the broader fair value hierarchy (Level 1, Level 2, and Level 3), was formalized with the issuance of Statement of Financial Accounting Standards No. 157, now codified as ASC 820, by the Financial Accounting Standards Board (FASB) in 2006.³⁵,³⁴,³³ This standard aimed to provide a consistent framework for measuring fair value in financial reporting, improving consistency and comparability.³² Prior to this, various methods were used, leading to inconsistencies. The global financial crisis of 2007-2009 brought increased scrutiny to fair value accounting, particularly concerning the valuation of illiquid assets. Critics argued that fair value accounting could exacerbate crises by forcing write-downs of assets in illiquid markets, leading to a "downward pricing spiral."³¹,³⁰,²⁹ However, proponents argued it provided transparency about the true state of financial institutions.²⁸ The Securities and Exchange Commission (SEC) has also emphasized the importance of transparency and consistency in fair value measurements, particularly in relation to non-GAAP measures.²⁷

Key Takeaways

Level 2 assets are valued using observable inputs that are not directly quoted prices from active markets.
These assets are part of the three-tier fair value hierarchy, emphasizing the use of observable inputs over unobservable ones.
Valuation techniques for Level 2 assets often include models that rely on market-corroborated data.
Examples include thinly traded bonds, over-the-counter (OTC) derivatives, and some mortgage-backed securities.
Proper classification and disclosure of Level 2 assets are crucial for transparent financial reporting.

Formula and Calculation

While there isn't a single "formula" for Level 2 assets, their valuation typically involves the use of valuation techniques that rely on observable market data. These techniques aim to estimate the price at which an orderly transaction for the asset or liability would take place between market participants at the measurement date.²⁶,²⁵

Common valuation techniques include:

Market Approach: This approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.²⁴ For Level 2 assets, this might involve looking at quoted prices for similar assets in active markets, or quoted prices for identical assets in markets that are not considered active.²³
Income Approach: This technique converts future amounts (e.g., cash flows or income and expenses) into a single current (discounted) amount. The measurement is determined by current market expectations about those future amounts.²²
Cost Approach: This method reflects the amount that would be required currently to replace the service capacity of an asset.²¹

For instance, when using a discounted cash flow model (an income approach technique) for a Level 2 asset, while the cash flow projections might be entity-specific, the discount rates and other market assumptions used would be derived from observable market data.

$\text{Fair Value} = \sum_{t=1}^{n} \frac{\text{Cash Flow}_t}{(1 + r)^t}$

Where:

(\text{Cash Flow}_t) = Expected cash flow in period (t)
(r) = Discount rate derived from observable market data
(n) = Number of periods

Interpreting the Level 2 Assets

Interpreting Level 2 assets requires understanding that their fair value is not based on direct, liquid market prices but rather on significant observable inputs. This means that while their valuation is more reliable than Level 3 assets (which rely on unobservable inputs), it still involves some degree of estimation and model-based judgment.²⁰,¹⁹

For example, a company might hold a corporate bond that trades infrequently. Its value isn't a Level 1 asset because there's no active, consistently quoted market price. However, its fair value can be determined by observing prices of similar corporate bonds with comparable credit ratings, maturities, and other characteristics that trade more actively. These comparable bond prices serve as Level 2 inputs. The valuation also considers factors such as the bond's specific terms and conditions, as well as any non-performance risk.¹⁸,¹⁷

Hypothetical Example

Consider a company, "Tech Innovations Inc.," that holds a portfolio of privately placed corporate bonds issued by a medium-sized, stable manufacturing firm. These bonds are not traded on a major exchange and thus lack active market prices required for Level 1 assets classification.

To determine the fair value of these bonds, Tech Innovations Inc. employs a valuation model that uses Level 2 inputs. The company identifies several publicly traded corporate bonds issued by companies of similar size, industry, and credit quality. The observable market data from these comparable bonds include:

Yields to maturity
Credit spreads
Interest rate curves

The valuation team then uses these observable inputs in a pricing model, such as a discounted cash flow model, to estimate the fair value of its privately placed corporate bonds. Even though the bonds themselves are not actively traded, the key components influencing their value (interest rates, credit risk) are derived from observable market data, classifying them as Level 2 assets. This process provides a robust asset valuation despite the absence of direct market quotes.

Practical Applications

Level 2 assets are prevalent across various sectors of the financial industry, impacting how organizations present their financial statements and manage their portfolios.

Financial Institutions: Banks and other financial entities often hold significant amounts of Level 2 assets, including certain mortgage-backed securities, corporate bonds with infrequent trading, and over-the-counter (OTC) derivative contracts. These assets require careful valuation as their fair values directly impact the institution's reported earnings and capital.¹⁶
Investment Management: Asset managers dealing with fixed-income portfolios or complex financial instruments frequently encounter Level 2 assets. The ability to accurately value these assets is crucial for portfolio performance reporting, risk management, and compliance. For instance, valuing private equity investments, while often falling into Level 3 due to unobservable inputs, can sometimes use Level 2 if there are recent comparable transactions or publicly traded comparable companies providing sufficient observable data.¹⁵,¹⁴,¹³
Corporate Reporting: Non-financial corporations may also have Level 2 assets on their balance sheets, such as certain employee benefit plan assets or specific financial instruments used for hedging. Understanding the valuation methodology for Level 2 assets is essential for accurate financial reporting and regulatory compliance. The FASB and SEC continue to issue guidance and seek additional disclosures on fair value measurements to ensure transparency.¹²,¹¹

Limitations and Criticisms

While Level 2 assets offer a more reliable valuation than Level 3 assets by incorporating observable inputs, they are not without limitations. A primary criticism is the judgment involved in selecting and adjusting observable inputs. Even with market data, the choice of comparable assets or the specific model adjustments can introduce subjectivity. This can lead to variations in reported fair value across different entities, reducing comparability.¹⁰

During periods of market stress or illiquidity, the reliability of Level 2 valuations can diminish. When markets for even similar instruments become less active, the observable inputs may not accurately reflect true market conditions. This can lead to significant changes in reported values and potentially impact a firm's regulatory capital. The 2007-2009 financial crisis highlighted these concerns, with studies noting that illiquidity could exacerbate the effects of write-downs on asset values.⁹,⁸,⁷ While some argue that fair value accounting was a messenger of the crisis rather than a cause, the debates underscored the challenges of valuing assets in distressed markets.⁶,⁵

Furthermore, the process of corroborating inputs for Level 2 assets can be complex. Ensuring that observable data truly reflects the characteristics and risks of the asset being valued requires expertise and robust internal controls. Regulators, including the SEC, continue to emphasize the importance of sufficient resources and competent personnel in ensuring high-quality financial reporting related to fair value measurements.⁴

Level 2 Assets vs. Level 3 Assets

The distinction between Level 2 and Level 3 assets lies fundamentally in the observability and significance of the inputs used for their fair value measurement within the fair value hierarchy.

Feature	Level 2 Assets	Level 3 Assets
Input Source	Based on significant observable inputs, either directly or indirectly.	Based on significant unobservable inputs.
Input Examples	Quoted prices for similar assets/liabilities in active markets; quoted prices for identical assets/liabilities in inactive markets; observable interest rates, yield curves, credit spreads, etc.³	Management's own assumptions about market participant assumptions; internal data; proprietary models.²,¹
Market Activity	Markets for the specific asset may not be active, but markets for similar assets or related data are.	Little to no market activity for the asset itself, and limited observable data for similar assets.
Valuation Reliance	Primarily relies on market-corroborated data and standard valuation techniques.	Heavily relies on internal models and assumptions due to lack of market data.
Subjectivity	Less subjective than Level 3, but still requires judgment in selecting and applying observable inputs.	Most subjective, as it involves significant judgment and estimation.
Transparency	Higher transparency than Level 3, as inputs are generally verifiable.	Lowest transparency due to the use of proprietary or internal inputs.
Examples	Corporate bonds in inactive markets, thinly traded mortgage-backed securities, most OTC derivatives.	Private equity investments, distressed debt, certain complex alternative investments, illiquid real estate.

Confusion often arises because both Level 2 and Level 3 assets require the use of models or adjustments to determine fair value, unlike Level 1 assets which have readily available quoted prices. The key differentiator is the source and verifiability of the inputs into those models. If the inputs can be directly observed or corroborated by market data, the asset is likely Level 2. If the inputs are based on a company's own assumptions and there is little market data to support them, it falls into Level 3.

FAQs

What types of assets are typically classified as Level 2?

Level 2 assets often include corporate and municipal bonds that are not actively traded, certain mortgage-backed securities, and some over-the-counter (OTC) derivative contracts. These instruments don't have daily, readily available prices from active exchanges, but their value can be derived from observable market data like interest rates, yield curves, or prices of similar instruments.

How do auditors verify Level 2 asset valuations?

Auditors verify Level 2 asset valuations by assessing the reasonableness of the valuation techniques used, the relevance and reliability of the observable inputs, and the appropriateness of any adjustments made. This may involve comparing inputs to external market data, reviewing the valuation models, and engaging with third-party pricing services or valuation specialists.

Why is the distinction between Level 2 and Level 3 assets important?

The distinction is crucial for understanding the reliability and transparency of a company's fair value measurements. Level 2 assets are considered more reliable than Level 3 assets because their valuations are based on observable market data, offering greater transparency to investors and other stakeholders. This impacts financial reporting and the assessment of risk.

Do Level 2 assets carry liquidity risk?

Yes, Level 2 assets can carry liquidity risk, although generally less than Level 3 assets. While their fair value can be determined using observable inputs, the absence of an active market for the specific asset itself means that selling it quickly without a significant loss in value may be challenging. The degree of liquidity risk depends on the specific asset and market conditions.