FAR distinctions between Level 1, Level 2, and Level 3 inputs and their disclosure consequences.
ASC 820 ranks fair value inputs by observability. The hierarchy does not rank assets by quality, risk, or importance. It ranks the inputs used to measure fair value, with the highest priority given to quoted prices in active markets for identical items and the lowest priority given to significant unobservable assumptions.
FAR questions usually test whether a fact pattern supports Level 1, Level 2, or Level 3 classification. The strongest answer depends on the exact input, whether the market is active, whether the item is identical or only similar, and whether unobservable assumptions are significant.
| Level | Input type | Typical evidence | Subjectivity |
|---|---|---|---|
| Level 1 | Quoted price for an identical asset or liability in an active market the entity can access | Exchange-traded equity security with active daily trading | Lowest |
| Level 2 | Observable inputs other than Level 1 quoted prices | Quoted prices for similar items, quoted prices in inactive markets, observable yield curves, credit spreads, market-corroborated inputs | Moderate |
| Level 3 | Unobservable inputs significant to the measurement | Internal cash flow forecasts, internally developed discount rates, expected volatility, default probabilities | Highest |
flowchart TB
A["Fair value measurement"] --> B["Level 1: active market quote for identical item"]
A --> C["Level 2: observable input other than Level 1"]
A --> D["Level 3: significant unobservable input"]
B --> E["Highest input priority"]
C --> F["Market-corroborated but less direct"]
D --> G["Lowest input priority and heavier disclosure"]
The classification is based on the lowest-level input that is significant to the entire fair value measurement. A valuation model is not Level 2 if a significant assumption in the model is unobservable.
Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. This is the clearest and most objective fair value evidence.
Key requirements:
Common examples include actively traded common stock, exchange-traded funds with active quoted prices, or other identical instruments quoted in active markets. If the entity adjusts the quoted price for a significant factor, the measurement may no longer qualify as Level 1.
Level 2 inputs are observable, but they are not unadjusted quoted prices for identical items in active markets. They still rely on market evidence, but the evidence is less direct than Level 1.
Level 2 inputs may include:
Level 2 is common for fixed-income securities, derivatives priced with observable market inputs, loans valued with observable yield curves, and real estate measurements that rely on comparable market data with minor adjustments.
The exam trap is broker quotes. A binding quote supported by observable market activity may support Level 2. A purely indicative quote with little market corroboration may require Level 3 if significant judgment is needed.
Level 3 inputs are unobservable inputs used when relevant observable inputs are unavailable. They reflect the assumptions that market participants would use, based on the best information available in the circumstances. Level 3 does not mean the measurement is invalid; it means the measurement depends significantly on judgment.
Common examples include:
Level 3 measurements require stronger documentation and more disclosure because users need to understand the assumptions, changes in those assumptions, and sensitivity to estimation uncertainty.
The hierarchy level is determined by the lowest-level input that is significant to the fair value measurement.
| Fact pattern | Likely classification | Reason |
|---|---|---|
| Identical public shares quoted in an active exchange | Level 1 | Unadjusted quoted price for the exact item in an active market |
| Similar corporate bond prices plus observable credit spreads | Level 2 | Inputs are observable but not identical Level 1 prices |
| Real estate valued with comparable sales and minor location adjustments | Level 2 | Market inputs are observable and adjustments are not significant |
| Private startup investment valued using internal revenue forecasts | Level 3 | Significant unobservable assumptions drive the measurement |
| Derivative valued using observable yield curves plus significant internally estimated volatility | Level 3 | A significant input is unobservable |
This rule prevents a measurement from being classified as Level 2 merely because some observable data is present. If a significant unobservable input drives the result, the whole measurement is Level 3.
Fair value hierarchy classification can change when market activity, input availability, or valuation technique changes. Transfers are not arbitrary. They must follow the entity’s policy for recognizing transfers and should be explained when material.
| Transfer | Possible cause | Exam interpretation |
|---|---|---|
| Level 1 to Level 2 | An active market becomes less active or quoted prices are no longer directly transactable | The identical quoted price is no longer sufficient Level 1 evidence |
| Level 2 to Level 3 | Observable market inputs disappear or become unreliable | Significant unobservable assumptions now drive the measurement |
| Level 3 to Level 2 | New observable market data becomes available and significant | The measurement is now supported by market-corroborated inputs |
| Level 2 to Level 1 | An identical item begins trading in an active market the entity can access | Unadjusted active-market quote becomes available |
For FAR, the important reasoning is why the input quality changed. A transfer is about observability and market activity, not whether the asset became more or less profitable.
The disclosure burden increases as subjectivity increases. Level 1 measurements generally require less explanation because users can see the market price source. Level 3 measurements require more explanation because the fair value depends on significant assumptions.
| Disclosure area | Level 1 | Level 2 | Level 3 |
|---|---|---|---|
| Hierarchy classification | Yes | Yes | Yes |
| Valuation technique | Usually simple | Usually explained | Explained in detail |
| Significant inputs | Usually obvious from quoted price | Observable inputs disclosed when relevant | Significant unobservable inputs disclosed |
| Transfers between levels | Disclose when required | Disclose when required | Disclose when required |
| Roll-forward activity | Not generally the focus | Not generally the focus | Required for Level 3 recurring measurements |
| Sensitivity to assumptions | Limited | Limited unless important | Important when unobservable assumptions are significant |
| Trap | Better FAR reasoning |
|---|---|
| Treating Level 3 as prohibited | Level 3 is allowed when observable inputs are unavailable, but it requires more disclosure |
| Classifying by asset type instead of input type | The hierarchy classifies the inputs used in the measurement |
| Treating similar-item quotes as Level 1 | Level 1 requires an identical item in an active market |
| Ignoring inactive markets | Quoted prices in inactive markets generally do not qualify for Level 1 |
| Letting a small unobservable input control the classification | Only significant inputs affect the hierarchy level |
| Ignoring transfer explanations | Material transfers require a clear reason tied to input observability or market activity |