IFRS 13 provides that this Standard establishes a fair value hierarchy that categorises the inputs to valuation techniques used to measure fair value into three levels, giving the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).
The Definition of Fair Value
The Standard defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Level 1: Quoted Prices
The Standard provides that Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
Level 2: Observable Inputs Other Than Quoted Prices
The Standard provides that Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
Level 3: Unobservable Inputs
The Standard provides that Level 3 inputs are unobservable inputs for the asset or liability, used to measure fair value to the extent that relevant observable inputs are not available.
How Is the Level Determined When Inputs Fall Into Different Levels?
The Standard provides that, where the inputs used to measure the fair value of an asset or a liability might be categorised within different levels of the fair value hierarchy, the fair value measurement is categorised in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement.
Illustrative Example (with Assumed Figures)
Suppose an entity measures the fair value of an investment in listed shares that trade at a quoted price of 50 monetary units per share in an active market the entity can access directly; this measurement is categorised within Level 1, because the only input used is an unadjusted quoted price. If, instead, a valuation model is used to measure the fair value of an investment property based on observable market rental rates (a Level 2 input) plus an unobservable discount-rate assumption that is significant to the measurement, the entire measurement is categorised within Level 3. This is a purely illustrative example.
Why Does the Fair Value Hierarchy Matter?
The fair value hierarchy aims to increase the consistency and comparability of fair value measurements across different entities, by giving priority to inputs observable in the market over inputs that depend on management's internal estimates. The higher the level of inputs used (from Level 1 to Level 3), the greater the measurement's reliance on the entity's own judgements and assumptions, which is why the disclosure requirements linked to this classification require an entity to explain the valuation techniques and significant inputs used for each class of assets or liabilities measured at fair value. The hierarchy also helps users of financial statements gauge the relative degree of uncertainty in each measurement, since Level 3 measurements are generally viewed with more caution than Level 1 measurements because they rely on inputs that are not observable in the market.
Legal References
- IFRS 13 — Fair Value Measurement — Paragraphs 9, 72, 73, 76, 81 and 86.
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