Level 2 Inputs
Level 2 inputs are part of a hierarchy used in the valuation of assets and liabilities when preparing financial statements. The hierarchy is established by financial reporting standards such as the Generally Accepted Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS), to ensure consistency and comparability in financial reporting.
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. This means they are derived from observable market data.
Examples of Level 2 inputs include:
- Quoted prices for similar (not identical) assets or liabilities in active markets.
- Quoted prices for identical or similar assets or liabilities in markets that are not active.
- Inputs other than quoted prices that are observable for the asset or liability, such as interest rates, yield curves, volatility measures, etc.
- Market corroborated inputs.
For example, if a company owns a private bond that isn’t traded on an active exchange, it would not have a Level 1 input available. Instead, the company might use a valuation model to determine the fair value of the bond. This model might use observable inputs like the interest rates on similar bonds traded in the market, the credit ratings of the bonds, and other relevant economic indicators. These are considered Level 2 inputs.
It’s important to note that when using Level 2 inputs, the objective remains to arrive at a fair value measurement that reflects the price that would be received to sell the asset or paid to transfer the liability in an orderly transaction between market participants at the measurement date.
Example of Level 2 Inputs
Let’s consider an example involving corporate bonds:
Imagine you’re a financial manager at a company that owns a bond issued by another company, Company B. This bond is not traded on an active market, meaning there’s no readily available quoted price you can use to determine its fair value (a Level 1 input).
However, similar bonds issued by companies in the same industry as Company B are actively traded. Therefore, you decide to base your valuation on the prices of these similar bonds. You take into account factors such as the yield rates, maturity dates, coupon rates, and credit ratings of these similar bonds. These factors, observable from the market but not directly linked to the exact bond your company owns, constitute Level 2 inputs.
By incorporating these Level 2 inputs into a valuation model, you can estimate the fair value of the bond your company owns. Even though you’re not using a direct market quote (as you would with a Level 1 input), you’re still basing your valuation on observable market data, which provides a reasonable degree of reliability to your fair value estimate.
Remember, it’s important to adjust Level 2 inputs for any differences between the asset or liability being valued and the assets or liabilities used to derive the Level 2 inputs. For example, if the bond from Company B carries a higher degree of risk than the similar bonds (perhaps because Company B has a lower credit rating), you would need to adjust the valuation to account for this higher risk.