What it means
Accounting standards such as US GAAP (the rulebook for US companies) and IFRS (the international rulebook) require many assets to be reported at fair value, which means the price that would be received to sell the asset in an orderly transaction. To show how reliable each figure is, they rank the inputs into three levels.
Level 1 is the strongest, Level 2 is in the middle and Level 3 is the weakest. An asset is Level 1 when there is a quoted price, with no adjustment needed, in an active market for the very same asset.
Typical examples are shares of listed companies, exchange-traded funds and exchange-traded futures. If a company holds 10,000 shares of a listed firm, it can simply look up the closing price.
The rules are strict. The market must be active, meaning trades happen often and in enough volume for prices to be available continuously, and the asset must be identical, not just similar.
The company also cannot adjust the price because it holds a large block, so a big holding is still valued at quoted price times the number of units. Level 1 matters to managers and investors because it signals low valuation risk.
The profit or loss on these assets is based on observable prices that anyone can check, rather than management estimates. Auditors can verify them quickly, and users of the accounts can place high trust in the numbers.
Disclosure rules require companies to show how much of their fair value assets fall into each level. A balance sheet dominated by Level 1 assets tends to be seen as simple and transparent, whereas one with a large Level 3 share invites more scrutiny.
In practice
Real-world examples.
Example
A software company invests surplus cash of $3,000,000 in shares of large listed companies. At the year end, the finance team values the portfolio using closing prices from the exchange and records the total as a Level 1 fair value.
Example
A pension fund holds units in an exchange-traded fund that tracks a broad stock index. The fund's accountants take the quoted unit price at the reporting date, so the holding is classified as Level 1.
Example
A trading firm holds exchange-traded futures contracts on a commodity. These contracts have daily settlement prices published by the exchange, so the firm can value them without estimates and report them as Level 1.
Formula
Calculation
Fair value of a Level 1 asset = Quoted price x Number of units
Worked example: a company holds 10,000 shares of a listed manufacturer. The closing price on the last day of the reporting period is $42.50 per share on an active exchange.
Fair value = 10,000 x $42.50 = $425,000.
No discount is applied for the size of the holding. If the shares had been bought for $380,000, the unrealised gain for the period is $425,000 - $380,000 = $45,000, which is reported in line with the accounting treatment for that category of investment.Case study
Seen in the real world.
Brookfield Textiles is a fictional manufacturer that held $12,000,000 of cash and short-term investments. Part of the money was invested in the shares of ten listed companies and the rest in a private bond issued by a supplier.
When preparing its accounts, the finance team classified the listed shares, worth $7,500,000 at quoted prices, as Level 1. The private bond, which had no market quote and was valued using a model, was placed in a lower level.
The auditor completed the review of the listed shares in an afternoon, but spent several days on the bond. This is an illustrative story, but it shows why Level 1 assets are valued so easily and with so little judgement.
Watch out
Common mistakes.
- Applying a discount because the holding is large. The rules require the quoted price times the number of units, with no block discount, even if selling it all at once would move the market.
- Calling any listed asset Level 1. If the market is thinly traded and not active, the price may not qualify, and the asset could be Level 2.
- Using a price for a similar asset rather than an identical one. A quote for a different but comparable bond is a Level 2 input, not Level 1.
Questions
People also ask.
What is the fair value hierarchy?
It is a three-level ranking of the inputs used to measure fair value. Level 1 uses quoted prices, Level 2 uses other observable inputs, and Level 3 uses unobservable inputs.
Are cash and bank balances Level 1?
Cash is usually shown at its face amount rather than at a quoted price, and the level system mainly applies to financial instruments and other items measured at fair value.
Why do analysts care about the split?
A higher share of Level 1 assets means more reliable values and lower risk of valuation surprises. Analysts often look at the proportions in the notes to the accounts.
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