What Are Level 1 Assets?
Level 1 assets encompass listed stocks, bonds, funds, or any assets that have a regular mark-to-market mechanism for determining their fair market value. These assets are characterized by their transparent and readily observable prices, ensuring a reliable market valuation.
- Level 1 assets represent liquid financial assets and liabilities, such as stocks or bonds, that regularly experience market pricing.
- They are considered the highest classification of assets based on transparency and reliability in fair market valuation.
- Contrarily, Level 2 and Level 3 assets are less liquid, making it more difficult to ascertain their standardized market values.
Understanding Level 1 Assets
Publicly traded companies classify their assets on the basis of valuation ease, with Level 1 being the easiest. Critical elements such as market depth and liquidity play roles in asset valuation. In well-developed markets, robust market activity naturally leads to price discovery, tying closely with market liquidity – a measure of the ease of buying or selling an asset without causing a significant price change.
Financial Accounting Standard 157 (FAS 157) outlines guidelines for estimating fair value in the absence of quoted prices, introducing an “exit price” concept and a three-level hierarchy to gauge the level of judgment involved in estimating fair values. From observable market prices in Level 1 to the proprietary internal information for illiquid Level 3 assets, this standard offers consistency.
Classifying Level 1 Assets
The classification system from FASB Statement 157 includes Level 1, Level 2, and Level 3 assets, requiring public companies to allocate their assets based on the reliability of fair market values.
The implementation came after the financial crisis due to turbulence in the credit market and issues around illiquidity of assets like asset-backed securities. During the 2007 credit crunch, many assets couldn’t be valued regularly through market prices, leading to the necessity for more consistent valuation frameworks.
Advantages of Level 1 Assets
Level 1 assets serve as a measure of an entity’s balance sheet strength. Because their valuation is dependable, businesses with significant Level 1 assets enjoy certain advantages:
- Banks, investors, and regulators favor entities with a market-based valuation, fostering trust in the financial statements.
- Entities predominantly relying on derivatives or other non-Level 1 assets may face scrutiny in asset valuation, especially during volatile market conditions where liquidity and market depth suffer.
Trust in market valuations can erode quickly during periods of distress, requiring appraisals or model-based valuations, which are less reliable. This was evident during the Great Recession when assets needed to be appraised or valued by potentially less rigorous models, reducing confidence in financial reports.
Related Terms: Level 2 Assets, Level 3 Assets, Market Liquidity, Publicly Traded Companies, Asset-backed Securities.
