What are level 1 assets?
Level 1 assets include listed stocks, bonds, funds or any asset that has a regular market valuation mechanism to establish fair market value. These assets are considered to have transparent, easily observable prices and therefore a reliable fair market value.
Understanding level 1 assets
Listed companies should classify all of their assets based on the ease with which they can be valued, with level 1 assets being the easiest. Much of the asset valuation comes from the depth of the market and liquidity. For developed markets, robust market activity acts as a natural price discovery mechanism. This, in turn, is a central element of market liquidity, which is a related indicator measuring the ability of a market to buy or sell an asset without causing a significant change in the price of the asset.
Classification of level 1 assets
The classification system comprising level 1, level 2 and level 3 assets was born from declaration 157 of the Financial Accounting Standards Board (FASB), which required public companies to allocate all assets according to the reliability of the fair market values.
The declaration came into effect for all years after 2007 and is mainly due to the credit market turmoil surrounding subprime mortgages and related securitized assets such as asset-backed securities (ABS). Many assets became illiquid and fair value pricing could only be done through internal estimates or other model valuation procedures during the 2007 credit crisis. As such, regulators needed to ” a way to inform investors about securities whose value could be interpreted.
Benefits of Level 1 Assets
Level 1 assets are a way to measure the strength and reliability of an entity’s balance sheet. Since the valuation of Level 1 assets is reliable, some companies may benefit from additional advantages over another company with fewer Level 1 assets. For example, banks, investors and regulators favor entity with a majority of assets that have a market-based valuation as they can rely on the financial statements provided. If a company uses derivatives heavily and the majority of its assets fall into level 2 or 3, interested parties are less comfortable with the valuation of these assets.
The problem with assets outside level 1 is best displayed during times of distress. Naturally, during a volatile market, liquidity and market depth erode and many assets will not benefit from a reasonable price discovery mechanism. These assets must then be assessed by appraisals or according to a model. These two methods are far from perfect, and investors and creditors often lose confidence in the valuations reported. During periods of maximum uncertainty, such as in the depths of the Great Recession, level 3 assets are particularly scrutinized – experts calling mark-to-model methods more like mark-to-myth.