What is the Fair Value Measurement Hierarchy?
The fair value hierarchy is a three-level framework used under IFRS 13 and US GAAP (ASC 820) to rank the inputs used to measure an asset or liability's fair value. It prioritizes observable market data over unobservable estimates, so financial statement users know how reliable a fair value figure really is.
The fair value hierarchy classifies valuation inputs into Level 1 (quoted prices in active markets), Level 2 (observable inputs other than quoted prices), and Level 3 (unobservable inputs based on management's own assumptions).
- 1↓Level 1Quoted prices in active markets for identical assets or liabilities (e.g., listed shares). Most reliable, no adjustment needed.
- 2↓Level 2Observable inputs other than quoted prices — e.g., quoted prices for similar assets, interest rates, yield curves.
- 3Level 3Unobservable inputs based on the entity's own assumptions — e.g., discounted cash flow models for a private company.
Step-by-step worked examples
A company holds shares of a publicly traded corporation on the NYSE, quoted at $45 per share. Which level applies?
The shares trade in an active market with a directly observable quoted price. This is a Level 1 input — no adjustment or model is required. Fair value = quoted price × number of shares held.
A company owns a corporate bond that doesn't trade often, but similar bonds trade actively and yield curves are observable. Which level?
No direct quoted price exists for this specific bond. However, comparable bond prices and market interest rates are observable. This is a Level 2 input — fair value is estimated using observable market data for similar instruments.
A company must value a private equity investment in a startup with no market comparables, using a discounted cash flow model with internally-forecast growth rates. Which level?
There is no active market and no comparable observable inputs. The valuation relies on management's own unobservable assumptions (growth rate, discount rate). This is a Level 3 input — the least reliable but sometimes only feasible method.
Flashcards
Quick quiz
Q1.Which level uses quoted prices in active markets for identical items?
Q2.A discounted cash flow model based on management's internal growth assumptions is an example of:
Q3.Which IFRS standard governs fair value measurement?
Q4.Observable prices for similar (not identical) assets fall under:
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Common mistakes
Assuming all market-based valuations are Level 1. — Correct: Only quoted prices for identical items in active markets qualify as Level 1; similar-item prices are Level 2.
Treating Level 3 as invalid or non-GAAP. — Correct: Level 3 is a legitimate, standard-permitted level — it's simply less reliable and requires extra disclosure.
Believing the hierarchy ranks assets, not inputs. — Correct: The hierarchy classifies the inputs used in the valuation technique, not the asset itself.
Ignoring disclosure requirements for Level 3 assets. — Correct: IFRS 13 requires a reconciliation of Level 3 balances and sensitivity analysis of unobservable inputs.
FAQ
What is the fair value hierarchy?
A three-level framework (Level 1, 2, 3) under IFRS 13 that ranks the inputs used to measure fair value by their observability.
What is the fair value measurement hierarchy formula?
There is no single formula — classification depends on whether inputs are quoted prices (Level 1), other observable data (Level 2), or unobservable assumptions (Level 3).
What are examples of fair value hierarchy levels?
Level 1: listed equity shares. Level 2: interest-rate swaps priced from yield curves. Level 3: a private company valued with a DCF model.
How do you determine the fair value hierarchy level of an asset?
Ask whether an identical item has a quoted price (Level 1); if not, whether observable market data exists (Level 2); if not, the entity must use its own assumptions (Level 3).