What Are Level 1 Assets in Financial Accounting?

Level 1 assets represent the most reliably valued and liquid assets a company owns. Their fair value can be determined with confidence because their prices are readily observable in active markets. For investors and regulators, the proportion of Level 1 assets on a company’s balance sheet serves as an indicator of financial stability and transparency. A large holding suggests a company’s stated value is based on concrete market data rather than internal estimates.

The Fair Value Hierarchy

Accounting standards, specifically the Financial Accounting Standards Board’s ASC 820, establish a three-tier framework for measuring the fair value of assets and liabilities. This hierarchy increases consistency and comparability in financial reporting by categorizing inputs based on their observability. Level 1 represents the highest priority and Level 3 the lowest, which helps users understand the reliability of the valuation methods.

Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities that a company can access at the measurement date. This is the most reliable form of evidence for fair value because it reflects actual, frequent transactions for the exact item being valued. The use of these inputs requires minimal judgment, making the resulting valuation highly objective.

In contrast, Level 2 inputs are observable data points other than the quoted prices included within Level 1. These might include quoted prices for similar, but not identical, assets in active markets; quoted prices for identical assets in markets that are not considered active; or other inputs like interest rates and yield curves. Valuations using Level 2 inputs are still based on market data but require some degree of adjustment or interpretation.

Level 3 inputs are unobservable and are used only when observable inputs are not available. These inputs reflect a company’s own assumptions about what market participants would use in pricing an asset or liability. This often involves developing a model based on internal data. Because they rely on significant judgment and internal estimates, Level 3 valuations are considered the least reliable.

Characteristics of Level 1 Assets

For an asset to be classified as Level 1, it must meet two criteria related to its pricing and the market in which it trades. The first is the existence of a quoted price from an exchange, dealer, or broker. A clarification in accounting standards is that a contractual restriction on the sale of an equity security does not affect its Level 1 classification. Such a restriction is a characteristic of the entity holding the asset, not the asset itself; therefore, the security’s fair value is the quoted price of an identical, unrestricted security.

The second criterion is the presence of an active market, where transactions for the asset occur with sufficient frequency and volume to provide ongoing pricing information. This ensures the quoted price is current and reflects a consensus value among buyers and sellers. Major stock exchanges like the New York Stock Exchange or Nasdaq are prime examples of active markets.

Common examples of Level 1 assets include publicly traded common stocks of large corporations, U.S. Treasury securities, such as bills, notes, and bonds, and shares of actively traded mutual funds and exchange-traded funds (ETFs). These qualify because they are actively traded in a deep and liquid market, and their net asset values are calculated and published daily.

Valuation and Reporting

The accounting for Level 1 assets is based on the “mark-to-market” principle. At the end of each reporting period, the asset’s value on the balance sheet is adjusted to reflect its current market price. For example, if a company holds 1,000 shares of a stock that closes at $150 per share on the last day of the quarter, the asset is reported at $150,000, regardless of its original purchase price.

The changes in the market value of these assets from one period to the next are recorded as unrealized gains or losses. These are reported on the income statement or in other comprehensive income, depending on the nature of the investment. This direct link to market prices provides investors with a transparent view of the asset’s performance.

Investors and analysts can find information about a company’s Level 1 assets in its financial reports. The total value of these assets is included on the balance sheet, under categories like “Marketable Securities” or “Investments.” For a more detailed view, the footnotes to the financial statements provide a tabular disclosure that breaks down fair value measurements by the three levels of the hierarchy.