The Fair Value Hierarchy: Explaining Levels 1, 2, and 3

Fair value is the price an entity would receive for selling an asset or pay to transfer a liability in a standard transaction. To enhance consistency in measuring these values, accounting standards like U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) established the fair value hierarchy.

This framework categorizes the inputs used in valuation techniques into three levels. The hierarchy prioritizes these inputs to ensure that measurements are comparable across different companies.

The Three Levels of the Hierarchy

Level 1

Level 1 inputs are the highest priority and considered the most reliable measure of fair value. These are unadjusted quoted prices in active markets for assets or liabilities identical to the ones being measured. For an input to qualify as Level 1, the market must have transactions with enough frequency and volume to provide ongoing pricing information.

An example of a Level 1 asset is a share of a publicly traded company on the New York Stock Exchange (NYSE), as the price is readily available in a highly active market. U.S. Treasury bonds that are actively traded also have quoted prices that qualify as Level 1 inputs. No adjustments are made to these quoted prices.

Level 2

Level 2 inputs are data points, other than Level 1 quoted prices, that are observable for the asset or liability, either directly or indirectly. Observable inputs are developed using market data, such as interest rates and credit spreads, that can be corroborated by external sources. These inputs are used when a direct quoted price in an active market is not available.

Corporate bonds that are not traded frequently and interest rate swaps are common examples of Level 2 instruments. Their value is not based on a direct daily quote but is derived from observable inputs. For instance, a bond’s value might be determined by using a benchmark yield curve and adding a credit spread based on the issuer’s rating; these observable inputs make the valuation reliable even without a direct quote.

Level 3

Level 3 inputs are the lowest priority and are used when observable inputs are not available. These inputs are unobservable and are based on the reporting entity’s own data and assumptions about what market participants would use to price the asset or liability. Because they involve significant management judgment, Level 3 measurements are subject to the most uncertainty and require extensive disclosure.

Private equity investments are a classic example of a Level 3 asset. With no active market, a company must use its own financial models, such as discounted cash flow (DCF) analysis, to estimate the value. These models rely on unobservable inputs like future revenue growth projections. Goodwill, an intangible asset from an acquisition, is also tested for impairment using Level 3 inputs tied to internal forecasts.

Valuation Techniques and Inputs

Valuation techniques are the methods used to process inputs into a final measurement. Companies select a technique that is appropriate for the circumstances and for which sufficient data is available, maximizing the use of observable inputs whenever possible.

The Market Approach

The market approach is a valuation technique that uses prices and other relevant information from market transactions involving identical or comparable assets or liabilities. It can be applied with Level 2 inputs, for example, by using market multiples from comparable public companies to value a similar, but not identical, private company.

The Income Approach

The income approach converts future amounts, such as cash flows or earnings, into a single, discounted present value. This technique is frequently used for Level 3 measurements where direct market data is unavailable. A discounted cash flow (DCF) analysis, a common income approach method, requires projecting a company’s future financial performance and selecting a discount rate to reflect the risk of those cash flows.

The Cost Approach

A third method is the cost approach, which determines value based on the amount that would currently be required to replace the service capacity of an asset, often referred to as the current replacement cost. The cost approach is less common for financial assets but can be used for certain non-financial assets, like specialized equipment. The inputs for replacement cost might be derived from vendor quotes or other market data, potentially falling into Level 2 or Level 3.

Financial Statement Disclosures

Companies must provide detailed disclosures in their financial statements about how they determine fair value. This includes a table that categorizes assets and liabilities measured at fair value into the three levels of the hierarchy. This format shows the types of assets and liabilities and their fair value amounts categorized under each level.

This disclosure offers insight to investors. A large concentration of assets in Level 1 indicates their values are based on objective market prices, suggesting high liquidity and valuation certainty. In contrast, a substantial amount of assets in Level 3 signals a reliance on management’s internal models and assumptions, which introduces more subjectivity and uncertainty.

Accounting standards also mandate disclosures about movements within the hierarchy, such as significant transfers between Level 1 and Level 2. For Level 3 measurements, a “roll-forward” reconciliation is required. This schedule details changes in the Level 3 balance during the reporting period, showing purchases, sales, gains or losses, and transfers, offering transparency into the most subjective valuations.