Fair value hierarchy: Level 1, Level 2, and Level 3

The fair-value hierarchy classifies the inputs used in a fair-value measurement according to their observability. Level 1 uses unadjusted quoted prices for identical items in active markets; Level 2 uses other observable inputs; Level 3 uses unobservable inputs.

The hierarchy describes the evidence supporting a valuation. It does not rank assets from good to bad.

Fair value measures an exit price

Under the IFRS framing used here, fair value is the price received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.

The measurement is distinct from historical purchase cost, management’s preferred selling price, and cash already received. An accounting standard determines when fair value is required and where a change in measurement appears in the financial statements.

Observable inputs differ from a quoted identical-item price

An active-market quote for an identical listed holding supplies a different kind of evidence from the quoted price of a comparable instrument. The comparable price can require adjustments for terms, credit, liquidity, or other differences.

Observable yield curves and market prices can support a model-based valuation. Using a model does not by itself make every input Level 3. The distinction is whether the relevant inputs are observable, rather than whether a spreadsheet performed the arithmetic.

Unobservable inputs include assumptions for which the measurement lacks suitable market observations. Forecast cash flows and a judgmental discount-rate adjustment can make the result sensitive to choices that a quoted-price measurement does not require.

Valuation sensitivity exposes the role of assumptions

Take a simplified asset expected to pay $100,000 annually forever, starting one year from now. With no growth and a 10% discount rate, the model gives $1 million. At 12.5%, the same cash-flow forecast gives $800,000.

The $200,000 difference comes entirely from the discount-rate assumption. The calculation does not establish which rate a market participant would use; it identifies the consequence of choosing one rate rather than the other.

A valuation record therefore needs the measurement date, cash-flow assumptions, market inputs, significant adjustments, and sensitivity to changes. The point estimate alone hides those dependencies.

A valuation gain is distinct from cash realization

Take 5,000 shares bought at $40 and measured later at a relevant quoted price of $46. Their value has increased from $200,000 to $230,000. The $30,000 measurement change does not put $30,000 into the holder’s bank account.

Less observable inputs increase the need to examine assumptions. They do not prove that an asset is worthless, fraudulent, or uncollectible. Conversely, a directly observable price does not make the issuer safe or guarantee a future sale price.