8.3 Level 2 Inputs

8.3.1 General

ASC 820-10

Level 2 Inputs

35-47 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.

35-48 If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs include the following:

Quoted prices for similar 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, for example:
1. Interest rates and yield curves observable at commonly quoted intervals
2. Implied volatilities
3. Subparagraph superseded by Accounting Standards Update No. 2011-04.
4. Subparagraph superseded by Accounting Standards Update No. 2011-04.
5. Credit spreads.
6. Subparagraph superseded by Accounting Standards Update No. 2011-04.
Market-corroborated inputs.

35-49 Paragraph 820-10-55-21 discusses Level 2 inputs for particular assets and liabilities.

Level 2 Inputs

55-21 Examples of Level 2 inputs for particular assets and liabilities include the following:

Receive-fixed, pay-variable interest rate swap based on the London Interbank Offered Rate (LIBOR) swap rate. A Level 2 input would be the LIBOR swap rate if that rate is observable at commonly quoted intervals for substantially the full term of the swap.
Receive-fixed, pay-variable interest rate swap based on a yield curve denominated in a foreign currency. A Level 2 input would be the swap rate based on a yield curve denominated in a foreign currency that is observable at commonly quoted intervals for substantially the full term of the swap. That would be the case if the term of the swap is 10 years and that rate is observable at commonly quoted intervals for 9 years, provided that any reasonable extrapolation of the yield curve for Year 10 would not be significant to the fair value measurement of the swap in its entirety.
Receive-fixed, pay-variable interest rate swap based on a specific bank’s prime rate. A Level 2 input would be the bank’s prime rate derived through extrapolation if the extrapolated values are corroborated by observable market data, for example, by correlation with an interest rate that is observable over substantially the full term of the swap.
Three-year option on exchange-traded shares. A Level 2 input would be the implied volatility for the shares derived through extrapolation to Year 3 if both of the following conditions exist:
1. Prices for one-year and two-year options on the shares are observable.
2. The extrapolated implied volatility of a three-year option is corroborated by observable market data for substantially the full term of the option.
In that case, the implied volatility could be derived by extrapolating from the implied volatility of the one-year and two-year options on the shares and corroborated by the implied volatility for three-year options on comparable entities’ shares, provided that correlation with the one-year and two-year implied volatilities is established.
Licensing arrangement. For a licensing arrangement that is acquired in a business combination and was recently negotiated with an unrelated party by the acquired entity (the party to the licensing arrangement), a Level 2 input would be the royalty rate in the contract with the unrelated party at inception of the arrangement.
Finished goods inventory at a retail outlet. For finished goods inventory that is acquired in a business combination, a Level 2 input would be either a price to customers in a retail market or a price to retailers in a wholesale market, adjusted for differences between the condition and location of the inventory item and the comparable (that is, similar) inventory items so that the fair value measurement reflects the price that would be received in a transaction to sell the inventory to another retailer that would complete the requisite selling efforts. Conceptually, the fair value measurement will be the same, whether adjustments are made to a retail price (downward) or to a wholesale price (upward). Generally, the price that requires the least amount of subjective adjustments should be used for the fair value measurement.
Building held and used. A Level 2 input would be the price per square foot for the building (a valuation multiple) derived from observable market data, for example, multiples derived from prices in observed transactions involving comparable (that is, similar) buildings in similar locations.
Reporting unit. A Level 2 input would be a valuation multiple (for example, a multiple of earnings or revenue or a similar performance measure) derived from observable market data, for example, multiples derived from prices in observed transactions involving comparable (that is, similar) businesses, taking into account operational, market, financial, and nonfinancial factors.

As noted in the guidance above, a Level 2 input represents an observable input that is not a Level 1 input. Level 2 inputs include:

A quoted price for an identical asset or liability in an inactive market (see Section 8.2.2.1 for discussion of when a market is considered inactive).
A quoted price for a similar asset or liability in an active or inactive market (see Section 8.3.1.1 for discussion of the meaning of a similar asset or liability).
Inputs other than quoted market prices that are observable for the asset or liability, such as interest rates, volatilities, and credit spreads.
Market-corroborated inputs (see Section 8.3.1.2).

8.3.1.1 Similar Assets or Liabilities

In measuring the fair value of an asset, liability, or equity instrument for which a Level 1 measurement does not exist, an entity might use a quoted price for a “similar” asset or liability. As discussed in ASC 820-10-35-48, quoted prices for similar assets or liabilities represent Level 2 inputs. If an entity observes a quoted price in an inactive market for an identical asset or liability and determines that it is a relevant observable input for which no significant adjustment is required, typically little, if any, weight would be given to quoted prices for similar assets or liabilities. However, if a quoted price for the identical item being measured does not exist or must be adjusted (e.g., because the quoted price is not current), the entity may use quoted prices for similar assets or liabilities when applying a valuation technique to measure fair value.

An entity must use judgment in determining whether an asset or liability is “similar” to the asset or liability being measured at fair value. In making this determination, the entity must (1) understand the terms and other factors that affect the fair value of the asset or liability being measured and the asset or liability for which a quoted price exists and (2) identify and assess any differences in these terms and factors. Entities should also consider the extent to which adjustments to the quoted price may be necessary to reflect the effects of such differences. For example, entities may need to make adjustments to reflect differences in the condition, location, or risks (including nonperformance risk and liquidity risk) of the comparable items. Although a quoted price for a similar asset or liability is a Level 2 input, significant unobservable adjustments to that quoted price may render the fair value measurement a Level 3 measurement.

An entity may measure the fair value of a liability or equity instrument from the perspective of a market participant holding the item as an asset. In doing so, the entity might use the quoted price of an identical or similar liability or equity instrument that is traded as an asset. However, the quoted price should be adjusted for factors specific to the asset that do not apply to the fair value measurement of the entity’s liability or equity instrument. ASC 820-10-35-16D(b) indicates, for example, that an adjustment may be required when “[t]he unit of account for the asset is not the same as for the liability or equity instrument. For example, for liabilities, in some cases the price for an asset reflects a combined price for a package comprising both the amounts due from the issuer and a third-party credit enhancement.” In addition, if the entity is measuring the fair value of a liability or equity instrument from the perspective of a market participant holding the identical item as an asset, and the asset held by another party includes a characteristic restricting its sale, in accordance with ASC 820-10-35-16D, “the fair value of the corresponding liability or equity instrument also would include the effect of the restriction.” However, if the liability or equity instrument is being measured on the basis of the quoted price of a similar asset, an adjustment to remove the effect of the restriction would generally be required if a quoted price for the identical asset, had it been available, would not have included a characteristic restricting its sale. Such adjustment may render the fair value measurement a Level 3 measurement.

Connecting the Dots

In October 2008, the IASB’s Expert Advisory Panel issued a report, Measuring and Disclosing the Fair Value of Financial Instruments in Markets That Are No Longer Active (the “IASB Expert Advisory Panel report”), which describes practices entities use when measuring financial instruments at fair value. Paragraph 32 of the report gives the following examples of the basic terms of a financial instrument with contractual cash flows (entities may consider these terms, and any associated differences, when assessing whether the instrument being measured is “similar” to the instrument for which a quoted price exists):

(a) the timing of the cash flows: when the entity expects to realise the cash flows related to the instrument.

(b) the calculation of the cash flows: for example, for a debt instrument the interest rate that applies (ie the coupon), or for a derivative instrument how the cash flows are calculated in relation to the underlying instrument or index (or indices).

(i) prepayment options (one or both parties can demand or make an early payment).

(ii) extension options (one or both parties can extend the period of the instrument).

(iii) conversion options (one or both parties can convert the instrument into another instrument).

(iv) put or call options (one or both parties can exchange the instrument for a defined amount of cash or other assets or liabilities).

(d) protection of the rights of the parties to the instrument: for example:

(i) terms relating to credit risk in debt instruments, such as collateral, event of default and margin call triggers.

(ii) subordination of the instrument, for example the priority of the instruments in the event of a winding up.

(iii) the legal enforceability of the cash flows.

Further, paragraph 33 of the report notes that “to measure the fair value of an instrument it is necessary to assess the return that market participants would require on the instrument to compensate for the risk related to:

(a) the amount and timing of the cash flows for the instrument.

(b) uncertainty about the ability of the counterparty to make payments when due (credit risk). This is a factor even if the counterparty is a financial institution.

This principle is consistent with the fair value measurement principles in ASC 820. Accordingly, in determining whether instruments are similar and whether an adjustment to a quoted price is necessary, an entity should consider any differences between (1) compensation that market participants would require for the risk associated with the instrument being measured and (2) compensation required for the instrument for which a quoted price exists. For example, the instrument being measured may be in greater relative supply than the instrument for which a quoted price exists. In this situation, a liquidity risk difference would need to be factored into the fair value calculation as an adjustment to the quoted price for the similar instrument.

See Section 10.1 for further discussion of the IASB Expert Advisory Panel report.

8.3.1.2 Market-Corroborated Inputs

ASC 820-10-35-48(d) indicates that Level 2 inputs can be market-corroborated inputs, which are defined in ASC 820-10-20 as “[i]nputs that are derived principally from or corroborated by observable market data by correlation or other means.” It may be difficult to determine whether an input is correlated to observable market data. Correlation is a statistical concept indicating the strength and direction of a linear relationship between two variables. The same statistical thresholds (e.g., number of data points, 95 percent confidence level) applied in establishing that a hedging relationship under ASC 815 is highly effective under a regression analysis should be used in establishing correlation under ASC 820. For more information about performing a regression analysis, see Section 2.5.2.1.1.2 of Deloitte’s Roadmap Hedge Accounting.

8.3.1.2.1 Inputs With Shorter Terms

An input used to measure the fair value of an asset or liability may only be observable for a portion of the life of the asset or liability. In these circumstances, the fair value measurement is a Level 2 measurement only if both of the following conditions are met:

Condition 1: The input is observable for substantially the full term of the asset or liability — ASC 820-10-35-48 states, in part, “If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability.” While not a bright line, if the input is observable for 90 percent or more of the term of the asset or liability, it would meet this condition.
Condition 2: The impact of the unobservable period is not significant to the fair value of the asset or liability — When the input meets condition 1, the entity must consider ASC 820-10-55-21(b), which indicates that the effect of the unobservable term must not be significant to the measurement in its entirety for the measurement to be classified as Level 2. An entity must use judgment in determining whether the effect of the unobservable period is significant.

The example below illustrates how to consider market-corroborated inputs used in a fair value measurement.

Example 8-9

Power Purchase Agreement — Quoted Price for Substantially Full Term

Entity E enters into a fixed-price four-year agreement to sell 50 MW of on-peak power for delivery at location ABC beginning on January 1, 20X2, and continuing through December 31, 20X5. On March 31, 20X2, E is determining the fair value of the agreement. Active market quotes are available for forward contracts to sell power at location ABC for three years (March 31, 20X2, to March 31, 20X5). Accordingly, E will use the three years of observable forward pricing data and develop an expectation for the remaining nine months (i.e., April 1 to December 31, 20X5) by employing a model that relies on pricing data and weather patterns from the previous four years. The model also incorporates all relevant physical constraints (e.g., capacity of existing and planned power plants near location ABC and projected supply and demand). The estimate for the remaining nine months represents an unobservable input.

Since the forward price curve is observable for only 36 of the 45 months (i.e., 80 percent of the term), it does not meet condition 1, which requires that the input be observable for substantially the full term. Therefore, the fair value measurement is a Level 3 measurement. Note that if the forward price curve had been observable for 90 percent or more of the term, E would still need to consider whether the effect of the unobservable term is significant to the fair value measurement to conclude that the measurement is a Level 2 measurement.

8.3.2 Adjustments to Level 2 Inputs

ASC 820-10

Level 2 Inputs

35-50 Adjustments to Level 2 inputs will vary depending on factors specific to the asset or liability. Those factors include the following:

The condition or location of the asset
The extent to which inputs relate to items that are comparable to the asset or liability (including those factors described in paragraph 820-10-35-16D)
The volume or level of activity in the markets within which the inputs are observed.

35-51 An adjustment to a Level 2 input that is significant to the entire measurement might result in a fair value measurement categorized within Level 3 of the fair value hierarchy if the adjustment uses significant unobservable inputs.

An entity may need to adjust Level 2 inputs to measure the fair value of an asset, liability, or equity instrument. Depending on the nature and significance of the adjustment, the fair value measurement of the entire asset, liability, or equity instrument may need to be categorized within Level 3 of the fair value hierarchy. See Section 8.4 for discussion of Level 3 inputs and Section 8.1.2 for discussion of how to categorize a fair value measurement containing multiple inputs that differ in terms of the categorization within the fair value hierarchy.

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