Fair value hierarchy

To increase the consistency and comparability in fair value measurements and related disclosures, IFRS 13 (paras 72-90) established a fair value hierarchy that categorises the inputs to valuation techniques into three levels:

  • Level 1: Quoted (unadjusted) market prices in active markets for identical assets or liabilities,
  • Level 2: Valuation techniques for which the lowest level input that is significant to the fair value measurement is directly or indirectly observable,
  • Level 3: Valuation techniques for which the lowest level input that is significant to the fair value measurement is unobservable.

Further explanations are as follows:

What is the definition of Level 1 inputs?

As defined above, Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.

Observable inputs – Inputs that are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability.

What is the definition of Level 2 inputs?

As defined above, 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. If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs would include, for example, quoted prices for similar assets or liabilities.

What is the definition of Level 3 inputs?

As defined above, Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs should be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective should remain the same; that is, an exit price from the perspective of a market participant that holds the asset or owes the liability.

Unobservable inputs should be developed based on the best information available in the circumstances, which might include the reporting entity’s own data. In developing unobservable inputs, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity shall not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Therefore, the reporting entity’s own data used to develop unobservable inputs should be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.

Guidance

As a general principle, IFRS 13 mandates the use of quoted prices in active markets for identical assets and liabilities whenever available. With limited exceptions, quoted prices in active markets should not be adjusted when determining the fair value of identical assets and liabilities, as the IASB believes these prices provide the most reliable evidence of fair value.

Quoted prices in active markets for identical liabilities and instruments classified in an entity’s shareholders’ equity are Level 1 measurements. These instruments would likewise be categorized in Level 1 when a quoted price exists for the identical instrument traded as an asset in an active market, and no adjustment to the quoted price is required.

For example, the fair value of corporate debt issued by a reporting entity would be a Level 1 measurement if the asset corresponding to the issuer’s liability (i.e., the corporate bond) trades in an active market and no adjustment is made to the quoted price. While the liability itself is not transferred in an active market, the IASB concluded that Level 1 classification is appropriate when the identical instrument trades as an asset in an active market.

If an adjustment to the corresponding asset’s price is required to address differences between the asset and the liability or equity instrument (as discussed in chapter 9), the adjusted price would not be a Level 1 measurement. For example, an adjustment to the quoted price of an asset that includes the effect of a third-party credit enhancement would be warranted when measuring the fair value of the liability. In this case, the corresponding asset and the liability would be deemed to have different units of account (as discussed in section 9.2.2).

Also, look at Matrix pricing

Level 2 inputs

Level 2 inputs include the following:

  • Quoted prices for similar assets or liabilities in active markets
  • quoted prices for identical or similar assets or liabilities in markets that are not active.
  • inputs other than quoted prices that are observable for the asset or liability, for example:
    • interest rates and yield curves observable at commonly quoted intervals;
    • implied volatilities; and
    • credit spreads.
  • market-corroborated inputs.

Fair value hierarchy

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