A Clear Guide to Fair Value Hierarchy: Levels 1, 2, and 3
In today’s financial reporting landscape, fair value measurement plays a critical role in providing transparency and accuracy. Whether you’re an accountant, financial analyst, or investor, understanding how fair value is determined under IFRS 13 (Fair Value Measurement) or ASC 820 (US GAAP) is essential.
One of the most important concepts here is the Fair Value Hierarchy, which categorizes inputs used in valuation into three levels: Level 1, Level 2, and Level 3.
This hierarchy ensures consistency, comparability, and clarity in how assets and liabilities are measured at fair value. Let’s break it down.
Which is more reliable — Level 1, Level 2, or Level 3 fair value inputs?
Understanding the Fair Value Hierarchy isn’t just accounting — it’s decoding trust in numbers.
What is the Fair Value Hierarchy?
The Fair Value Hierarchy is a framework that prioritizes the use of observable market data over unobservable inputs in measuring fair value.
Main principle: The more market-based and observable the data, the higher its reliability in determining fair value.
- Level 1: Most reliable (direct market prices)
- Level 2: Moderately reliable (derived market data)
- Level 3: Least reliable (unobservable inputs, assumptions)
Level 1: Quoted Prices in Active Markets
Definition: Level 1 inputs are unadjusted quoted prices for identical assets or liabilities in active markets that the entity can access at the measurement date.
- Key Characteristics: Directly observable, no adjustments required, highest reliability
- Examples: Listed equity shares, actively traded bonds, mutual fund units with published NAV
Why It’s Reliable: Relies on actual market transactions where supply and demand determine the price.
Level 2: Observable Inputs Other Than Level 1
Definition: Level 2 inputs are observable for the asset or liability, either directly or indirectly, but are not quoted prices for identical items in active markets.
- Key Characteristics: Based on market data but requires adjustments or modeling
- Examples: Corporate bonds valued using yield curves, interest rate swaps, property valuations based on comparable sales
Reliability: Still market-based but requires valuation techniques to adjust observable inputs.
Level 3: Unobservable Inputs
Definition: Level 3 inputs are unobservable and rely heavily on the entity’s own assumptions about market participant perspectives.
- Key Characteristics: Based on internal data and judgment, high subjectivity
- Examples: Private equity investments, complex derivatives, unique real estate valuations, long-term uncertain liabilities
Reliability: Least reliable because it involves subjective estimates without full market validation.
Comparing the Levels
| Level | Data Source | Reliability | Example |
|---|---|---|---|
| Level 1 | Quoted prices in active markets | Highest | Listed shares |
| Level 2 | Observable market data (adjusted) | Moderate | Corporate bonds |
| Level 3 | Internal assumptions | Lowest | Private equity |
Why the Hierarchy Matters
- Transparency: Helps users of financial statements understand valuation methods
- Consistency: Ensures comparability across entities
- Risk Assessment: Higher reliance on Level 3 means higher estimation risk
Practical Example
Imagine a company holds:
- Listed shares of ABC Ltd. → Level 1 (direct market quote)
- 10-year corporate bonds → Level 2 (based on observable yield curves)
- Stake in a private startup → Level 3 (valuation based on management assumptions)
This classification must be disclosed in financial statements under IFRS 13/ASC 820.
Conclusion
The Fair Value Hierarchy ensures that financial reporting uses the most reliable and market-based data available.
- Level 1: Direct market prices – highest reliability
- Level 2: Market data with adjustments
- Level 3: Internal models and assumptions – highest subjectivity
For investors, analysts, and auditors, understanding where a valuation falls in the hierarchy is critical for assessing both accuracy and risk in reported numbers.
