Fair Value Hierarchy
A three-level classification system ranking the reliability of inputs used to measure the fair value of assets and liabilities.
What is Fair Value Hierarchy?
The fair value hierarchy, established under FASB ASC 820 and IFRS 13, categorizes the inputs used in fair value measurements into three levels based on their observability and reliability. Level 1 inputs are quoted prices in active markets for identical assets or liabilities—the most reliable, such as the price of publicly traded shares. Level 2 inputs are observable inputs other than Level 1—such as prices for similar assets or interest rates derived from market data. Level 3 inputs are unobservable, based on management's own assumptions about what market participants would use—the least reliable, applied to illiquid or unique assets like private equity holdings or certain derivatives. Companies must disclose which level applies to each fair value measurement in their financial statement footnotes.
Example
A bank's balance sheet includes Level 1 assets (exchange-traded equities valued at market prices), Level 2 assets (agency mortgage-backed securities priced using observable spread data), and Level 3 assets (private equity stakes valued using discounted cash flow models with internal assumptions). Level 3 assets require the most scrutiny from auditors and investors.