What are level 2 assets?
Level 2 assets are financial assets and liabilities that are neither easy nor too complex to assess. They do not have regular market prices, although a fair value may be determined for them based on other data values or market prices. Sometimes called mark-to-model assets, the values of level 2 assets can be closely estimated using simple models and extrapolation methods using known and observable prices as parameters.
Understanding level 2 assets
Listed companies are required to establish the fair value of the assets they hold on their books. Investors use these fair value estimates to analyze the current situation and the future prospects of the business.
According to generally accepted accounting principles (GAAP), certain assets must be recognized at their present value, and not at their historical cost. Listed companies must also classify all their assets according to the ease with which they can be valued, in accordance with accounting standard FASB 157.
The Financial Financial Standards Board (FASB) of the United States has introduced three different levels to clarify the balance sheet corporate assets. Level 2 assets represent the intermediate classification based on the reliability with which their fair market value can be calculated. Level 1 assets, such as stocks and bonds, are the easiest, while Level 3 assets can only be valued on the basis of internal models or “estimates” and are not priced observable market.
Level 2 assets should be valued using market data obtained from independent external sources. Data may include quoted prices for similar assets and liabilities in active markets, prices for identical or similar assets and liabilities in inactive markets, or models that have observable data, such as interest rates, default rates and yield curves.
An example of a Level 2 asset is an interest rate swap. Here, the value of the asset can be determined based on the observed values for the underlying interest rates and the risk premiums determined by the market. Level 2 assets are generally held by private equity firms, insurance companies and other financial institutions with investment arms.
Key points to remember
- Level 2 assets are financial assets and liabilities that do not have a regular market price, but whose fair value can be determined based on other data values or market prices.
- They represent the intermediate classification based on the reliability of their fair market value.
- Level 2 assets are generally held by private equity firms, insurance companies and other financial institutions with investment arms.
Real example of level 2 assets
The Blackstone Group L.P. (BX) breaks down its level 2 assets into company documents 10-K and 10-Q for shareholders. The asset manager has disclosed the following information:
“Fair value is determined using models or other valuation methods. Financial instruments that are generally included in this category include bonds and business loans, including bonds and business loans held in CLO vehicles, government and agency securities, less restricted cash and equity, securities and certain over-the-counter derivatives, the fair value of which is based on observable data, and senior and subordinated notes issued by CLO vehicles are classified in level II of the fair value hierarchy. “
Observable and non-observable inputs
Investors, analysts, etc. sometimes find it difficult to identify the difference between level 2 and level 3 assets. It is important to recognize the contrasts, especially since GAAP requires additional information for assets and level 3 liabilities.
The best way to determine whether an asset or liability is level 2 or level 3 is to determine whether the valuation data used is developed using publicly available market data or not. Consider the following:
- Is the value supported by actual market transactions?
- Is a price obtained from outside the organization and easily accessible to the public?
- Is the assessment distributed at regular intervals?
if the answer to any of these questions is no, the entry can be considered as not observable and, therefore, at level 3 in the fair value hierarchy.