What Are Level 1 Assets?
Let me explain Level 1 assets to you directly: these include listed stocks, bonds, funds, or any assets with a regular mark-to-market mechanism that sets a fair market value. You can count on them having readily observable, transparent prices, which means a reliable fair market value.
Think of Level 1 assets as liquid financial assets and liabilities, like stocks or bonds, that get regular market pricing. They're the top classification because of their transparency and the reliability in calculating their fair market value. In contrast, Level 2 and 3 assets are less liquid and tougher to quickly and accurately determine their fair value.
Understanding Level 1 Assets
Publicly traded companies have to classify all their assets based on how easily they can be valued, and Level 1 assets are the easiest. A key part of this valuation comes from market depth and liquidity. In developed markets, strong market activity naturally discovers prices, which ties into market liquidity— that's how well a market can handle buying or selling an asset without drastically changing its price.
Financial Accounting Standard 157, or FAS 157, set up a consistent framework for estimating fair value when there are no quoted prices. It uses the idea of an 'exit price' and a three-level hierarchy that shows the judgment involved in fair value estimates, from market-based prices to illiquid Level 3 assets where no observable market exists, and you have to rely on proprietary internal info, like the latest funding round.
Classifying Level 1 Assets
The classification system under FASB Statement 157, which includes Levels 1, 2, and 3, requires public companies to sort all assets by the reliability of their fair market values.
This statement took effect for fiscal years after 2007, and it was largely a response to the credit market chaos around subprime mortgages and related securitized assets like asset-backed securities (ABS). During the 2007 credit crunch, many assets became illiquid, and fair value could only come from internal estimates or mark-to-model methods. Regulators needed a system to tell investors about securities where values might be interpretive.
Advantages of Level 1 Assets
Level 1 assets give you a way to gauge the strength and reliability of an entity's balance sheet. Since their valuation is dependable, businesses with more of them get extra benefits over those with fewer. For instance, banks, investors, and regulators view an entity positively if most of its assets have market-based valuations, because they can trust the financial statements. But if a business relies heavily on derivatives and most assets are in Level 2 or 3, people get less comfortable with those valuations.
The problems with non-Level 1 assets show up clearest in tough times. In volatile markets, liquidity and market depth drop, and many assets lose a solid price discovery mechanism. Then you value them by appraisals or models, which aren't perfect, so investors and creditors lose confidence in the reported values. During high uncertainty, like the Great Recession's worst moments, Level 3 assets face extra scrutiny—some even call mark-to-model methods 'mark-to-myth'.
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