What it means
Fair value accounting ranks the evidence behind each valuation into three levels. Level 1 uses a direct quoted price in an active market for the same asset.
Level 2 steps down a rung, because there is no such direct quote, but the valuer can still build a price from information that is observable in the market. Common Level 2 inputs include quoted prices for similar assets in active markets, quoted prices for identical assets in markets that are not active, and other observable data such as interest rates, yield curves, credit spreads and exchange rates.
A bond that trades only occasionally might be valued by looking at the yields on comparable bonds with similar maturity and credit quality. Valuation techniques often include matrix pricing, where a price is estimated by comparing a bond with a group of similar bonds, and discounted cash flow models that use market-based discount rates.
Because the inputs can be checked against market data, Level 2 values are more reliable than guesses, but a judgement still has to be made about which comparables to use. Level 2 assets matter for risk assessment.
Their values may differ from the price at which they could actually be sold, particularly in stressed markets when similar assets also become hard to trade. Auditors give them more attention than Level 1 holdings, and companies must disclose the valuation methods and inputs they use.
For readers of financial statements, the share of Level 2 assets is a useful clue. A balance sheet with a modest amount of Level 2 investments, such as corporate bonds or over-the-counter derivatives, is normal.
A large proportion warrants a closer look at how the values were obtained.
In practice
Real-world examples.
Example
An insurance company holds corporate bonds that trade only a few times a month. Its valuation team prices them using yields on similar bonds from the same industry and rating category. The holdings are reported as Level 2.
Example
A manufacturer has an interest rate swap that fixes the rate on its bank loan. The bank provides a valuation based on published swap rates and yield curves. The finance team classifies the swap as Level 2, since all inputs are observable.
Example
A bank holds foreign currency forward contracts. It values them using spot exchange rates and interest rate differentials taken from the market, and records them as Level 2 assets in its fair value disclosures.
Formula
Calculation
Fair value of a bond = Sum of each coupon discounted at the observable market yield + Face value discounted at the same yield
Worked example: a company holds 500 corporate bonds, each with a $1,000 face value, a 5% annual coupon and 2 years left to maturity. The bond rarely trades, but comparable bonds from similar issuers yield 6%.
Year 1 coupon of $50 discounted: $50 / 1.06 = $47.17.
Year 2 coupon plus face value of $1,050 discounted: $1,050 / (1.06 x 1.06) = $1,050 / 1.1236 = $934.50.
Fair value per bond = $47.17 + $934.50 = $981.67. For 500 bonds, the fair value is 500 x $981.67 = $490,835 (or $490,833 if unrounded). Because the 6% yield is observable from comparable bonds, the asset is classified as Level 2.Case study
Seen in the real world.
Harlow Foods is a fictional food distributor with $5,000,000 in corporate bonds and a currency forward contract. The bonds were issued by regional companies and traded only occasionally, so there were no daily quotes.
The finance team asked a data provider for evaluated prices based on similar bonds, which valued the portfolio at $4,850,000. The forward contract was valued at $60,000 using published exchange rates and interest rates.
Both were disclosed as Level 2 in the notes, along with a description of the inputs. The auditor tested a sample of the prices against comparable bonds and found them reasonable. This is an illustrative story, but it shows how Level 2 valuations combine market data with a modest amount of judgement.
Watch out
Common mistakes.
- Treating Level 2 as just as reliable as Level 1. Level 2 values depend on judgement about comparables and models, so they are generally less certain than direct quotes.
- Using unobservable inputs and still calling the asset Level 2. If a significant input is not observable in the market, the asset belongs in Level 3.
- Forgetting to review the classification each period. An asset can move between levels if its market becomes more or less active.
Questions
People also ask.
What are examples of Level 2 assets?
Corporate bonds valued using comparable yields, interest rate swaps, currency forwards, and shares in markets that are not active. The key feature is that inputs are observable, even though the exact asset has no direct quote.
What is matrix pricing?
It is a method of estimating a bond's price by using the prices or yields of similar bonds with comparable maturity and credit quality. It is common for bonds that rarely trade.
Can an asset move between levels?
Yes. If a market becomes inactive or inputs become unobservable, the asset may move to a lower level, and companies must disclose such transfers.
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