Level of fair values of financial instruments (Level 1, Level 2 and Level 3)
Levels of fair value in financial instruments refer to the degree of subjectivity involved in determining the fair value of an asset or liability. The International Financial Reporting Standards (IFRS) and the Financial Accounting Standards Board (FASB) have established a three-level hierarchy for fair value measurements: Level 1, Level 2 and Level 3.
It’s like trying to estimate the price of a used car, if you see the same car being sold in a lot of various places at similar prices, that’s like a Level 1 value, it’s easy to see the fair price. But if the car is unique and you have to estimate the price based on similar cars or other information, that’s like a Level 2 value. And if you don’t have any information on the car and you must guess the price, that’s like a Level 3 value.
Level 1 values are considered the most certain because they come from active markets where the same asset or liability is being bought and sold. Level 2 values are less certain because they come from similar assets or liabilities in active markets or from other observable data. Level 3 values are the least certain because they come from estimates and assumptions that are not based on observable data.
When a company or a bank reports their financial statements, they must estimate the value of their assets and liabilities, and they use these levels to classify them. Having a lot of level 3 assets or liabilities can be a sign of higher uncertainty and subjectivity in the company’s financial statements, which can be a red flag for investors. Click to learn more about types of financial risk companies must disclose.
Level 1 – Market value: Active secondary market
Fair value is derived from quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. These are the most reliable fair value measurements, as they rely on observable data from active markets.
Examples:
- Publicly traded stock: The stock is actively traded on a stock exchange such as the NYSE or NASDAQ, and its price is easily observable through quotes on financial websites or through a stock ticker. Because the stock is identical to other stocks of the same company and is traded in an active market, its fair value can be determined directly from quoted prices.
- US Treasury bond: Treasury bonds are issued by the US government and are actively traded on the secondary market. The prices of these bonds are observable through quotes on financial websites or through bond trading platforms, and it is easy to determine their fair value.
Level 2 – Marked to model based on observable market data
Fair value is estimated using inputs other than quoted prices included within Level 1 that are observable for the financial assets or liabilities, either directly or indirectly, such as quoted prices for similar assets or liabilities in active markets, or inputs that are observable either directly or indirectly.
Examples:
- Corporate bond: Corporate bonds are issued by companies and are traded on the secondary market, but unlike US Treasury bonds, they are not as actively traded as stocks. The prices of these bonds are not as easily observable as Level 1 financial instruments, but they can still be determined through quotes on financial websites or through bond trading platforms. Corporate bond prices may be less transparent than US Treasury bonds, and the data may be less readily available, but it is still observable, making it a Level 2 financial instrument.
- Commercial real estate property: The fair value of a commercial real estate property can be determined by using comparable sales data, such as the prices of similar properties that have recently sold in the same area. This information is not as easily observable as quoted prices in active markets, but it is still observable and can be used to estimate the fair value of the property.
Level 3 – Marked to model based on unobservable market data
Fair value is estimated under unobservable inputs, such as management’s own assumptions about the assumptions that market participants would use in pricing the asset or liability. These are the least reliable fair value measurements, as they rely on subjective data and estimates.
Examples:
- Private equity investment: Private equity investments are not publicly traded and their fair value is not observable in an active market. To estimate the fair value of a private equity investment, an investor must rely on estimates and assumptions that are not based on observable data. These may include assumptions about future cash flows, future market conditions or the value of similar investments. As the inputs used to estimate the fair value of a private equity investment are not based on observable data, it is classified as a Level 3 financial instrument.
- Illiquid real estate property: The fair value of an illiquid real estate property, such as a single-family home, is not observable in an active market. An investor would need to rely on estimates and assumptions about the value of equivalent properties in the area and estimates of future market conditions to determine the fair value of the property.
It’s important to note that Level 3 financial instruments are less reliable than Level 1 and 2 due to the subjectivity and uncertainty of the inputs used to estimate their value, which can lead to higher valuation risk and less transparency.
How does analysis of level of fair values help to determine resilience and prudent of a company?
Analysis of the level of fair values of a company’s assets and liabilities can provide insight into the company’s resilience and prudence in the following ways:
- Identification of Risk: By analyzing the level of fair values, an investor can identify the assets and liabilities that are most sensitive to changes in market conditions. This information can be used to assess the company’s overall risk profile and determine how resilient it is to market fluctuations.
- Transparency: By understanding the fair value measurements used by the company, investors gain insight into the company’s accounting policies and practices. This can help them assess the overall financial health of the company and determine if it is being managed in a prudent manner.
- Valuation: By understanding the company’s fair value measurements, investors can assess the value of the company’s assets and liabilities. This allows them to determine if the company is undervalued or overvalued, which can impact their investment decision.
- Asset Quality: By understanding the fair value measurements of the company’s assets, investors can assess the quality of the company’s assets. This can help them to determine whether the company has a high level of non-performing assets or other problem assets, which can indicate potential financial stress.
- Capital Adequacy: By understanding the fair value measurements of the company’s liabilities, investors can assess the company’s capital adequacy. This can help them to determine whether the company has enough capital to support its assets and meet its obligations, which is critical for its stability and resilience.
What if a company has huge amount of financial instruments in Level 3? what are the risks?
If a company has significant amount of financial instruments classified as Level 3, it may indicate a higher level of subjectivity and uncertainty in the company’s fair value measurements. This can present several risks for investors:
- Valuation risk: The company’s assets and liabilities may be overvalued or undervalued, which can impact the company’s financial statements and the investors’ perception of the company’s financial health.
- Risk of financial loss: The company’s assets may not perform as well as expected, which could result in financial losses for the company and for investors.
- Lack of transparency: The company may not provide enough information about its fair value measurements, making it difficult for investors to fully understand the company’s financial position and risks.
- Lack of comparability: The company may use different inputs and assumptions to determine the fair value of its Level 3 assets and liabilities, making it difficult to compare the company’s performance to that of other companies in the same industry.
- Risk of fraud: The company’s management may use the subjectivity of level 3 fair value measurements to artificially inflate the company’s financial performance and deceive investors.
It’s important to note that having a few Level 3 financial instruments is not necessarily a red flag, but having many them and a lack of transparency, comparability and reliability on the inputs and assumptions used, can raise concerns. Investors should be careful when assessing the company’s financial health and risk profile and should consult with a financial advisor or professional for more guidance.
The following are few examples of company with large amount of Level 3 financial instruments:
SERBA DINAMIK HOLDINGS BERHAD
Well, you should have known the drama of Serba Dinamik: Auditor finds Serba Dinamik has unverified assets, liabilities, revenue and expenses totalling over RM12 bil
Lehman Brothers
Prior to collapse of Lehman Brothers in 2008, Lehman Brothers had a significant portion of its assets classified as Level 3. The bank had used complex financial instruments, such as mortgage-backed securities, which relied heavily on subjective inputs and assumptions. The bank’s use of these Level 3 assets and its lack of transparency about their fair value contributed to its downfall.
Bear Stearns
Prior to its collapse in 2008, the investment bank had a significant portion of its assets classified as Level 3, including a large amount of mortgage-backed securities. The bank’s use of these complex and highly illiquid securities led to significant uncertainty about their true value, which contributed to the bank’s downfall and eventual acquisition by JPMorgan Chase.
