# Understanding Level 1, 2, and 3 Financial Assets: Definitions & Examples

## What Are Level 1 Assets?

Financial Accounting Standard 157 introduced three asset levels: Level 1, Level 2, and Level 3. Level 1 assets include listed stocks, bonds, funds, or any assets with transparent, market-based quoted prices.

Level 1 assets are liquid assets like stocks or bonds, regularly priced in the market. Level 1 assets rank highest for transparency and reliable market value calculation. Level 2 and 3 assets are less liquid and harder to accurately value. Market depth and liquidity are key in asset valuation.

### Key Takeaways

*   Level 1 assets are the most liquid and transparent financial instruments, such as listed stocks and bonds, with prices that are easily observable in the open market.
*   The fair value of Level 1 assets is calculated using readily available market prices, ensuring a high level of reliability in financial statements.
*   Financial Accounting Standard 157 (FAS 157) introduced a three-level hierarchy to classify assets based on valuation reliability, with Level 1 being the easiest to value due to active market pricing.
*   During market volatility, Level 2 and 3 assets may require valuation through appraisals or models, making them less reliable than Level 1 assets.
*   Markets are viewed favorably with a high proportion of Level 1 assets due to their stability and dependable valuations, fostering confidence among banks, investors, and regulators.

## How Level 1 Assets Function in Financial Markets

[Publicly traded companies](https://www.investopedia.com/terms/p/publiccompany.asp) must classify all of their assets based on the ease with which they can be valued, with Level 1 assets being the easiest. [Market depth](https://www.investopedia.com/terms/m/marketdepth.asp) and [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) are key in asset valuation. In developed markets, strong market activity naturally discovers prices. This is key to market liquidity, showing how well a market buys or sells assets without big price changes.

Financial Accounting Standard 157 (FAS 157) created a consistent framework to estimate fair value without quoted prices, using an "exit price" and a three-level hierarchy. This ranges from market-based prices to Level 3 assets, where no market exists, and valuations depend on internal information like recent funding rounds.

## Classification Criteria for Level 1, 2, and 3 Assets

The classification system including Level 1, [Level 2](https://www.investopedia.com/terms/l/level2_assets.asp), and [Level 3](https://www.investopedia.com/terms/l/level3_assets.asp) under [(FASB)](https://www.investopedia.com/terms/f/fasb.asp) Statement 157 required public companies to allocate all assets based on the reliability of fair market values.

The rule took effect for fiscal years after 2007, due to [credit market](https://www.investopedia.com/terms/c/credit_market.asp) issues with subprime mortgages and [asset-backed securities](https://www.investopedia.com/terms/a/asset-backedsecurity.asp) (ABS). Many assets became illiquid and fair value pricing could only be done by internal estimates or other mark-to-model procedures during 2007's credit crunch. As such, regulators needed a way to inform investors about securities where value could be open to interpretation.

## Benefits of Holding Level 1 Assets

Level 1 assets are one way to measure the strength and reliability of an entity’s balance sheet. Because the valuation of Level 1 assets is dependable, certain businesses can enjoy incremental benefits relative to another business with fewer Level 1 assets. For example, banks, investors, and regulators look favorably on an entity with a majority of assets that have a market-based valuation because they can rely on supplied financial statements. If a business heavily uses derivatives and a majority of its assets fall into the Level 2 or 3 category, then interested parties are less comfortable with the valuation of these assets.

The issue with assets outside Level 1 is best displayed during times of distress. Naturally, during a volatile market, liquidity and market depth erode and many assets will not enjoy a reasonable price discovery mechanism. These assets then need to be valued by appraisals or according to a model. Both of these are less than perfect methods, so investors and creditors often lose confidence in reported valuations. During periods of peak uncertainty, such as during the depths of the [Great Recession](https://www.investopedia.com/terms/g/great-recession.asp), Level 3 assets are especially scrutinized—with pundits calling [mark-to-model](https://www.investopedia.com/terms/m/mark_to_model.asp) methods more like mark-to-myth.

## The Bottom Line

Level 1 assets are the most liquid and transparent and include stocks and bonds with regular market-based pricing mechanisms. Level 1 assets are more reliable and transparent, and are favored by investors and regulators in assessing the strength of a company's balance sheet. Level 2 and Level 3 assets are less liquid than Level 1 assets, making them more difficult to value in volatile markets.

Federal Accounting Standards 157 is the framework that guides the classification of all of these assets based on valuation reliability.

When evaluating investments or balance sheet strength, it's important to consider asset classification, as Level 1 assets might offer more stability in uncertain markets.