Fair Value Hierarchy: Levels, Examples, and Reporting Tips

Modern accounting standards rely increasingly on fair value measurements to provide a realistic snapshot of a company’s financial position. However, not all fair value inputs are equally reliable or objective. That’s why both IFRS 13 and ASC 820 introduced a three-level fair value hierarchy — a framework that categorizes inputs used in valuation techniques based on their observability and reliability.

This article explains the purpose and structure of the fair value hierarchy, details the characteristics of Level 1, Level 2, and Level 3 inputs, and illustrates how they are applied with examples across asset types.

1. What Is the Fair Value Hierarchy?

The fair value hierarchy is a classification system that ranks inputs to valuation techniques based on how directly observable and market-based they are.

It ensures that financial statements distinguish between:

• Objective, market-based prices (Level 1)

• Estimates based on market proxies (Level 2)

• Entity-specific assumptions (Level 3)

Both IFRS 13 and ASC 820 require that fair value measurements be categorized according to the lowest level of input that is significant to the entire valuation.

This provides users of financial statements with insight into the reliability and subjectivity of reported fair values.

2. Level 1 Inputs: Quoted Prices in Active Markets

Level 1 inputs are the most reliable and objective.

They consist of:

Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

Key Features:

• Based on observable, actual market transactions

• No adjustments are needed or permitted

• Applicable only when identical instruments are traded

Examples:

• Equity securities listed on the NYSE or NASDAQ

• Government bonds actively traded in public markets

• Mutual fund units with published daily NAVs

• Listed commodity contracts or precious metals with liquid markets

Practical Scenario:

A company holds 10,000 shares of a publicly traded stock. The closing price on the reporting date is $50 per share.

Fair Value (Level 1) = 10,000 × $50 = $500,000

No adjustments or modeling are required, and the value is fully market-based.

3. Level 2 Inputs: Observable, Indirect Market Data

Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable, either directly or indirectly.

They include:

Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.

Key Features:

• Based on market-derived data (not model-driven)

• May include quoted prices for similar assets

• Can involve adjustments to reflect differences in asset terms

• Often apply to assets traded in less active markets

Examples:

• Corporate bonds valued using benchmark yield curves

• Interest rate swaps priced using forward interest rates and discounted cash flows

• Real estate measured using comparable sales of similar properties

• Pricing services or matrix pricing for structured products

Practical Scenario:

A company holds a corporate bond that does not trade frequently. A similar bond from the same issuer, with the same maturity but a different coupon, trades at 98.5. After adjusting for the coupon difference, the estimated fair value is $970 per $1,000 face value.

The pricing uses observable market data, but not identical inputs, so this is a Level 2 measurement.

4. Level 3 Inputs: Unobservable Estimates and Assumptions

Level 3 inputs are unobservable inputs based on the entity’s own assumptions about what market participants would use to price the asset or liability.

They are used when observable inputs are not available, often due to illiquidity or the unique nature of the instrument.

Level 3 fair value reflects the entity’s best estimate, taking into account all available information.

Key Features:

• Based on internal models and assumptions

• Often includes discounted cash flow (DCF) models

• High degree of judgment and estimation risk

• Requires robust disclosure and sensitivity analysis

Examples:

• Private equity investments with no active market

• Intangible assets acquired in a business combination

• Real estate in specialized locations

• Complex or structured derivatives without active counterparties

Practical Scenario:

A company owns a 20% stake in a private startup. The company estimates the fair value using a DCF model, applying a 12% discount rate and forecasted cash flows based on five-year projections.

Since no observable market data is available and the valuation relies heavily on assumptions, this is a Level 3 measurement.

5. Summary of the Three Levels

Level 1

• Basis: Quoted prices for identical instruments

• Reliability: Highest

• Adjustments: None

• Subjectivity: Minimal

Level 2

• Basis: Quoted prices for similar items, or observable market data

• Reliability: High, but less than Level 1

• Adjustments: Allowed and common

• Subjectivity: Moderate

Level 3

• Basis: Unobservable inputs and models

• Reliability: Lowest

• Adjustments: Full modeling

• Subjectivity: High — requires disclosures and sensitivity analysis

6. Disclosures and Reconciliation Requirements

Both IFRS 13 and ASC 820 require entities to:

• Categorize all fair value measurements within the hierarchy

• Disclose valuation techniques and inputs used for each level

• Explain changes in classification, if any

• Provide reconciliations for Level 3 assets and liabilities:

  • Opening and closing balances

  • Gains and losses (realized/unrealized)

  • Purchases, sales, issuances, settlements

  • Transfers in and out

IFRS also requires:

• A sensitivity analysis for Level 3 inputs

• A narrative explaining valuation uncertainty

7. Importance for Analysts and Investors

The fair value hierarchy is a powerful tool for:

• Evaluating the reliability of reported values

• Understanding valuation risk and subjectivity

• Identifying exposure to illiquid or opaque instruments

• Comparing valuation transparency across companies

In particular, a high proportion of Level 3 assets may signal:

• Greater reliance on management assumptions

• Potential difficulty in liquidating positions

• More volatile or uncertain valuations