Concept
The application of the Accounting Standards Codification (ASC) 820 framework to evaluated bond prices is a foundational process in modern financial reporting. It provides a disciplined structure for classifying the inputs used to determine the fair value of fixed-income securities. This system is predicated on a simple, yet powerful, principle ▴ the reliability of a valuation is directly tied to the observability of the data that underpins it.
For portfolio managers and financial controllers, mastering this hierarchy is a matter of regulatory compliance and a fundamental component of a robust risk and valuation apparatus. The framework categorizes valuation inputs into a three-tier hierarchy, which dictates the perceived reliability of the resulting bond price.
At the apex of this structure are Level 1 inputs. These are unadjusted quoted prices for identical assets in active markets. For bonds, this is the cleanest possible data point ▴ a price for a specific CUSIP trading with sufficient frequency and volume to provide continuous, reliable pricing information. A U.S. Treasury bond that trades thousands of times a day on a major exchange represents a classic Level 1 asset.
The valuation is direct, verifiable, and requires minimal judgment. The system views this input as the highest standard of evidence for fair value.
The ASC 820 hierarchy is a system for classifying the reliability of data inputs used in fair value measurements, not the assets themselves.
The majority of evaluated bond prices, however, fall into the second tier. Level 2 inputs are observable, either directly or indirectly, but are not the quoted prices of identical assets in active markets. This is where evaluated pricing from third-party services for corporate, municipal, and other less-liquid government bonds typically resides. These services derive prices using observable data points such as quoted prices for similar bonds, benchmark yield curves, interest rate swaps, and credit spreads for comparable issuers.
The process, often called matrix pricing, uses these observable inputs to model a price for a bond that does not trade frequently. The critical distinction is that while the inputs are market-corroborated, the final price is the output of a model, introducing a layer of abstraction beyond a direct quote.
The final category, Level 3, is reserved for valuations derived from unobservable inputs. These are inputs for which there is little, if any, market activity at the measurement date. A bond valuation would fall into this category if it relied significantly on an issuer’s internal cash flow projections, a proprietary pricing model with non-market-based assumptions, or broker quotes that cannot be corroborated with other observable data.
This level applies to the most illiquid or distressed debt, where a reliable market-based price cannot be determined. Consequently, Level 3 valuations require the most extensive disclosure and are subject to the highest degree of scrutiny from auditors and regulators, as they depend heavily on the reporting entity’s own assumptions about what market participants would use to price the asset.
Strategy
The Strategic Implications of Classification
The classification of a bond within the ASC 820 hierarchy is a strategic decision with significant consequences for a firm’s financial statements, risk perception, and operational workflow. The designation of a bond as Level 1, 2, or 3 directly impacts how investors, auditors, and regulators assess the reliability of a firm’s balance sheet. A portfolio heavily weighted towards Level 1 assets is perceived as transparent and liquid, while a significant concentration in Level 3 assets can signal higher risk and valuation uncertainty, potentially impacting a firm’s cost of capital and counterparty relationships.
Developing a robust classification strategy begins with establishing a clear and consistent valuation policy. This policy must define the specific criteria for each level and outline the methodology for assigning bonds to them. For evaluated bond prices, the core of the strategy revolves around the due diligence performed on third-party pricing services. A firm cannot simply accept a vendor’s price and its corresponding level designation.
Instead, a proper strategy involves a deep understanding of the vendor’s methodology. This includes analyzing the inputs they use, their process for handling thinly traded securities, and their quality control procedures. The goal is to independently corroborate that the vendor’s inputs are indeed observable and market-based, justifying a Level 2 classification.
A firm’s valuation policy is the strategic blueprint for applying the ASC 820 hierarchy, translating accounting principles into operational controls.
Differentiating Level 2 and Level 3 Inputs
A central challenge in applying ASC 820 to evaluated bond prices is the demarcation between Level 2 and Level 3. The distinction hinges on the significance of unobservable inputs to the overall valuation. An evaluated price for a corporate bond might start with a Level 2 methodology, using benchmark yields and observable credit spreads. However, if the pricing service applies a significant liquidity discount or an adjustment based on a proprietary model that cannot be substantiated with market data, that unobservable input could push the entire valuation into Level 3.
A sound strategy requires a quantitative framework for assessing the significance of these unobservable inputs. This could involve sensitivity analysis to determine how much the final price changes in response to a change in the unobservable input. If a small change in an internal assumption leads to a large change in the bond’s fair value, that input is likely significant. The firm’s valuation committee must establish clear thresholds for this determination.
This process of “challenging the vendor” is critical. It involves regular meetings with the pricing service, back-testing their prices against actual trades, and comparing prices across multiple vendors to identify discrepancies that may point to the use of unobservable inputs.
The following table outlines the key characteristics and strategic considerations for each level of the hierarchy as it applies to bonds:
| Hierarchy Level | Primary Bond Types | Valuation Input Source | Strategic Implication |
|---|---|---|---|
| Level 1 | Actively traded U.S. Treasuries, certain sovereign bonds, and exchange-traded bond funds. | Unadjusted quoted prices from active exchanges for identical assets. | Highest transparency and perceived liquidity; minimal valuation risk. |
| Level 2 | Corporate bonds, municipal bonds, mortgage-backed securities, and less-active government bonds. | Evaluated prices from third-party vendors using observable inputs like benchmark yields, credit spreads, and prices of similar assets. | Represents the bulk of institutional bond holdings; strategy focuses on vendor due diligence and methodology validation. |
| Level 3 | Distressed debt, private placement bonds, complex structured products with no active market. | Internal models using unobservable inputs, such as proprietary cash flow projections or non-corroborated broker quotes. | Highest scrutiny from auditors and regulators; requires extensive disclosure and robust internal controls to justify valuations. |
Execution
An Operational Workflow for Bond Classification
Executing a compliant and defensible valuation process under ASC 820 requires a detailed, repeatable operational workflow. This workflow translates the strategic policies of the firm into a set of concrete actions performed by the valuation team. It ensures consistency in classification and provides a clear audit trail for every security in the portfolio. The objective is to create a system where the classification of a bond is the logical output of a structured analytical process.
The following steps provide a procedural guide for classifying evaluated bond prices within the ASC 820 hierarchy:
- Initial Security Identification ▴ For each new bond acquired, capture all relevant identifiers, including CUSIP, issuer, coupon, maturity, and any embedded options. This data forms the basis of the valuation record.
- Active Market Assessment ▴ The first determination is whether an active market exists for the identical security. This involves checking trading volumes on relevant exchanges or platforms. If the bond trades with sufficient frequency and volume to provide ongoing pricing, it is a candidate for Level 1. For most corporate and municipal bonds, this will not be the case.
- Primary Vendor Pricing ▴ Obtain the evaluated price from the firm’s primary third-party pricing service. This price is the starting point for the Level 2 assessment.
- Vendor Methodology Inquiry ▴ Access the pricing vendor’s transparency data for the specific bond. This data should detail the inputs used to generate the price. The operational task is to map these inputs to the ASC 820 definitions.
- Were the inputs observable? (e.g. benchmark treasury curve, credit default swap spreads for the same issuer, prices of recently traded bonds from the same sector and credit rating).
- Was a matrix pricing convention used? Document the specific comparable bonds used in the matrix.
- Were any unobservable inputs applied? (e.g. a liquidity adjustment for a thinly traded issue, an assumption about default recovery rates that differs from market consensus).
- Significance Test for Unobservable Inputs ▴ If unobservable inputs were used, the team must execute the firm’s significance test. This involves quantifying the impact of the unobservable input on the final price. If the impact exceeds the firm’s pre-defined threshold, the bond must be moved to Level 3.
- Secondary Price Corroboration ▴ Compare the primary vendor’s price against a secondary source. This could be another pricing vendor, non-binding broker quotes, or recent trade data (TRACE for corporate bonds). Significant discrepancies warrant further investigation and may indicate that the primary price is not representative of fair value.
- Final Classification and Documentation ▴ Based on the analysis, assign the bond to Level 1, 2, or 3. The entire process, including the data sources checked, the vendor methodology analysis, the results of the significance test, and the price corroboration, must be documented in the valuation record for that security. This documentation is the primary evidence provided to auditors.
A Deeper Look at Level 2 Valuation Inputs
For a typical investment-grade corporate bond classified as Level 2, the evaluated price is not a single data point but the result of a complex calculation. The table below provides a granular example of the inputs that a pricing service might use to value a specific bond and how those inputs are justified as observable under ASC 820.
| Valuation Component | Example Input | Source of Observability (Justification for Level 2) |
|---|---|---|
| Base Rate | 5-Year U.S. Treasury Yield Curve | Actively quoted market prices for U.S. Treasury securities (Level 1 inputs). |
| Credit Spread Adjustment | Credit spread derived from a basket of similarly rated (e.g. A+) industrial bonds with 4-6 year maturities. | Observable trading data (TRACE) and vendor-evaluated prices for the comparable bonds in the basket. |
| Issuer-Specific Adjustment | Credit Default Swap (CDS) spread for the specific issuer. | Observable quotes from the interdealer CDS market. |
| Liquidity Premium | A minor premium based on the bond’s issue size and recent trade frequency compared to more liquid benchmarks. | Considered observable if the premium is derived from market-wide data on bid-ask spreads for bonds with similar characteristics. Becomes unobservable if it is a subjective, discretionary adjustment. |
| Resulting Evaluated Price | Calculated price based on the sum of the components. | Classified as Level 2 because all significant inputs (Base Rate, Credit Spread, CDS Spread) are derived from observable market data. |
References
- Financial Accounting Standards Board. “Accounting Standards Codification Topic 820, Fair Value Measurement.” FASB, 2011.
- Goh, Baldwin, et al. “The Efficacy of ASC 820’s Fair Value Hierarchy.” Contemporary Accounting Research, vol. 32, no. 4, 2015, pp. 1439-1477.
- Khan, Urooj. “A Literature Review on Fair Value Accounting.” International Journal of Disclosure and Governance, vol. 8, no. 4, 2011, pp. 283-304.
- Laux, Christian, and Christian Leuz. “The Crisis of Fair-Value Accounting ▴ Making Sense of the Recent Debate.” Accounting, Organizations and Society, vol. 34, no. 6-7, 2009, pp. 826-834.
- Riedl, Edward J. and George Serafeim. “Information Asymmetry, Corporate Disclosure, and the Cost of Capital.” The Accounting Review, vol. 86, no. 3, 2011, pp. 1025-1055.
- Christensen, Peter O. and Gerald A. Feltham. “Economics of Accounting ▴ Volume I.” Springer, 2003.
- Veronesi, Pietro. “Fixed and Variable Rate Bonds and the Term Structure of Interest Rates.” The Journal of Finance, vol. 54, no. 5, 1999, pp. 1839-1865.
- Duffie, Darrell, and Kenneth J. Singleton. “Credit Risk ▴ Pricing, Measurement, and Management.” Princeton University Press, 2003.
Reflection
Valuation as a System of Intelligence
The framework of ASC 820, when applied to the complexities of bond pricing, transcends mere accounting compliance. It compels an institution to construct a system of intelligence around its valuation processes. The hierarchy forces a critical examination of data sources, a disciplined approach to model reliance, and a transparent method for communicating risk.
Viewing this framework as an architectural challenge rather than a reporting burden is the first step toward building a more resilient and defensible operational structure. The quality of a firm’s balance sheet is a direct reflection of the quality of the systems that produce it.
Beyond the Classification
Ultimately, the designation of a bond as Level 1, 2, or 3 is an output. The true value lies in the rigor of the process that leads to that output. Does your firm’s valuation workflow possess the integrity to withstand auditor scrutiny? Is the due diligence on your pricing vendors continuous and challenging, or is it a check-the-box exercise?
The answers to these questions reveal the true strength of your financial reporting infrastructure. The ASC 820 hierarchy provides the blueprint; the quality of the execution determines the integrity of the final structure.
Glossary
Fair Value
Level 1 Inputs
Quoted Prices
Credit Spreads
Level 2 Inputs
Matrix Pricing
Unobservable Inputs
Bond Valuation
Asc 820
Third-Party Pricing Services
Valuation Policy
Evaluated Price
