Level 2 is in the middle of the hierarchy and comprises assets and liabilities with values established using relatively basic models and derived from prices listed in an active market. Level 2 financial statements include financial derivatives, non-actively traded securities such as debt securities, currency options, loans, mortgage-related assets, and commodities.
However, any asset that follows a hierarchical structure comprises such valuations that must depend on modeling and have observable sources and is referred to as a "Level 2 asset." The phrase "Level 2 asset" refers to this type of hierarchy. Companies must value some assets and monetary obligations at their present worth rather than their historical cost to comply with accounting regulations. The hierarchical valuation methodology applied to these assets usually consists of three levels, with the second level mandating the application of a statistical model.
Both the monetary assets and payables which make up a level 2 asset are hard to calculate. However, even though a reasonable value may be derived from other datasets or market rates, the assets in question never have consistent pricing on the market. Due to the importance of level 2 assets, these are often known as "mark-to-model" commodities. These assets are amenable to approximation through straightforward models and specific extrapolation procedures. As inputs for these approaches, these strategies and prices are both known and observable.
The Primacy of Level 2 Assets
Organizations traded publicly are required to determine accurate valuations for the asset holdings they record on their financial statements. Although, investors rely on these estimations of fair value in order to conduct an analysis of the company's current state and its potential in the future. The general principles of accounting by GAAP stipulate that some assets must be documented at their present worth rather than the cost incurred to acquire them in the past. To comply with accounting standard 157 established by the Financial Accounting Standards Board (FASB), publicly listed corporations are required to categorize every one of their assets according to the relative ease with which they may be valued.
Moreover, the Financial Standards set by FASB in the United States stated there are three distinct asset levels to clarify organizations' balance sheets. When it comes to the accuracy with which their valuation can be determined, level 2 securities are considered to be in the center of the three classifications. Level 1 assets, like equities and bonds, have the most readily available market values and are thus the simplest to value. Level 3 support, on the other hand, can only be evaluated arising from internal modeling or "guesstimates" because there are no market prices available for them.
Why is Valuation of Level 2 Important?
The valuation of level 2 assets is required to use market data gathered from independent and external sources. The data used could include quoted prices for assets and monetary obligations that are comparable in active markets, prices for assets and payables that are identical or comparable in stagnant markets, or models with Bond yields, default rates, and yield curves are examples of all the inuts that are observable.
A level 2 asset may be something like an interest rate swap, for example. In this scenario, the value of the investment may be calculated based on the values that have been observed for the underlying interest rates and the risk premiums that the market has decided. Private equity firms, insurance companies, and other financial organizations with investing arms are some of the most prevalent holders of level 2 assets.
The implication of Level 2 Asset in the Real World
For the benefit of the company's shareholders, The Blackstone Group L.P. (BX) provides a breakdown of its Level 2 holdings in its business 10-K and 10-Q filings.
Along with that, the information listed below was provided by the investment manager in the documents filed:
The usage of models and several other valuation approaches are required to arrive at an accurate estimate of the fair value. In general, the following types of financial instruments are considered to be included in this category:
The bond funds, loans, and other liabilities, which include (organization loans and securities owned by CLO vehicles, governmental and agency instruments, less than the total amount, restrained equity holdings, and certain excessive credit default swaps) in which the fair business model is based on inputs that are observable.
All of these types of financial instruments are considered to be equity securities. Level 2 of the classification scheme includes both senior and subsidiary notes issued by CLO vehicles.
Observable Vs. Unquantifiable Inputs
Inputs classified as Level 2 are measurable for the assets and borrowing of money in question, either explicitly or implicitly. These inputs do not contain stated prices, which are classified as Level 1 inputs. In the event that the asset or obligation has a stated (commercial) term, a Level 2 input has to be observable for a significant portion of the duration of that term.
Sometimes investors and analysts have difficulty distinguishing between Level 2 of asset and Level 3 of asset, which may be frustrating for both parties. On the other hand, the distinction is significant, mainly because GAAP mandates are higher than previously thought for Level 3 financial assets.
The assessment contributions and whether or not the market trend analysis was utilized is open to the public. Both have a role in determining whether or not the value of the assets is classified as Level 2 or Level 3.
You must take into account the following aspects to distinguish between different types of assets:
- Is there evidence that genuine market transactions support the value?
- Is pricing derived from sources external to the organization and easily accessible to the general public?
- Is there a consistent cadence to the distribution of the valuation?
- If the response to any of these queries is "no," the input will be termed disclosure controls and, consequently, Level 3 in the social stratification system.
