Learning Outcomes
After reading this article, you will be able to explain how IFRS 13 defines and applies the fair value hierarchy (Levels 1–3), distinguish between input levels, identify the most reliable fair value evidence, and describe how entities must measure and disclose fair values for financial statement purposes.
ACCA Financial Reporting (FR) Syllabus
For ACCA Financial Reporting (FR), you are required to understand the principles and application of fair value measurement, especially the fair value hierarchy set out by IFRS 13. This includes:
- The definition of 'fair value' for financial reporting
- The use of valuation techniques to measure fair value
- The hierarchy of inputs (Levels 1, 2, and 3) required for fair value measurement
- The prioritization of observable inputs over unobservable inputs
- Disclosure requirements relating to fair value measurements and the hierarchy levels
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- According to IFRS 13, how are Level 1, Level 2, and Level 3 inputs defined within the fair value hierarchy?
- Why does IFRS 13 give highest priority to Level 1 inputs when measuring fair value?
- Give an example of an asset measured using Level 2 inputs and describe the type of information required.
- True or false? An entity may choose to use Level 3 inputs over Level 2 inputs if Level 2 inputs are available.
Introduction
IFRS 13 Fair Value Measurement provides a consistent definition and single source of guidance for measuring fair value across all IFRS standards. To ensure fair values reported in financial statements are reliable and comparable, IFRS 13 requires entities to classify inputs used in valuation techniques into a three-level hierarchy. Understanding this hierarchy helps ensure the most objective and relevant information is used whenever possible.
Key Term: fair value
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.
The Fair Value Hierarchy: Levels 1–3
Fair value measurements must use inputs that maximize the use of observable data and minimize the use of unobservable data. IFRS 13 organizes inputs into three levels, with Level 1 being the most reliable.
Key Term: fair value hierarchy
A framework within IFRS 13 for classifying inputs to valuation techniques as Level 1 (highest priority), Level 2, or Level 3 (lowest priority).
Level 1 Inputs
Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. They provide the most reliable evidence of fair value and must be used whenever available.
- Example: The quoted share price of publicly traded equity instruments.
Level 2 Inputs
Level 2 inputs are observable inputs other than quoted prices included in Level 1. These may include:
- Quoted prices for similar assets or liabilities in active markets
- Quoted prices for identical or similar assets in markets that are not active
- Inputs that are observable for the asset or liability, such as interest rates, yield curves, or credit spreads
Level 2 inputs typically require some adjustments because a direct price for the exact asset or liability is not available.
- Example: Valuing bonds based on prices for similar bonds.
Level 3 Inputs
Level 3 inputs are unobservable inputs for the asset or liability. These are used when observable inputs are not available, and may require significant estimation and judgment. Typically, these are developed internally, using all reasonably available and relevant information.
- Example: Valuing a privately held equity investment for which there is no observable market data, using discounted cash flow projections.
Key Term: Level 1 inputs
Unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.Key Term: Level 2 inputs
Observable inputs other than Level 1, such as quoted prices for similar assets in active markets or for identical assets in inactive markets.Key Term: Level 3 inputs
Unobservable inputs for the asset or liability, based on the entity’s assumptions about market participants’ assumptions.
Applying the Hierarchy in Practice
Entities must always prioritize Level 1 inputs if available. If Level 1 inputs are not available, entities assess whether Level 2 inputs may be used. Level 3 inputs are used only when neither Level 1 nor Level 2 inputs can be applied.
When measuring fair value, the classification is based on the lowest level input that is significant to the overall valuation. Significant use of unobservable Level 3 inputs increases measurement uncertainty, making disclosure especially important.
Worked Example 1.1
An entity holds 1,000 shares in ListedCo, traded on an active stock exchange. The closing price at the reporting date is $5 per share.
Question: How should the entity determine the fair value of this asset?
Answer:
As the shares are traded in an active market and an unadjusted quoted price is available ($5 per share), this is a Level 1 input. The fair value is $5 × 1,000 = $5,000, measured using Level 1 inputs.
Worked Example 1.2
Zeta Ltd owns an investment property in a city with few recent sales of identical buildings, but there are recent sales of similar properties. Management adjusts these prices for differences in property size and age.
Question: What level of the fair value hierarchy applies to this measurement?
Answer:
Zeta Ltd uses Level 2 inputs — observable prices for similar properties, adjusted for known differences. Some adjustments are needed, but the inputs are still based on observable market data.
Worked Example 1.3
Omega Plc needs to value a specialized industrial machine for which no observable prices exist and limited comparable data is available. Omega Plc determines fair value using a discounted cash flow model based on expected future cash flows.
Question: What level of inputs are being used, and what are the disclosure implications?
Answer:
Omega Plc is using Level 3 inputs—unobservable internally generated estimates. Detailed disclosure about valuation techniques and assumptions is required, as these inputs will significantly affect measurement reliability and users’ understanding.
Exam Warning
When measuring fair value under IFRS 13, do not select Level 3 inputs simply because they are easiest. If observable Level 1 or 2 inputs are available, they must be prioritized. Failure to use the most reliable available evidence may result in non-compliance and loss of exam marks.
Fair Value Measurement and Disclosure
IFRS 13 requires entities to disclose for each class of asset or liability measured at fair value:
- The level within the fair value hierarchy (1, 2, or 3)
- The valuation technique(s) used
- For Level 3 measurements, the significant unobservable inputs and a description of the valuation process
Detailed disclosures help users assess the reliability and subjectivity of reported fair values, especially where significant estimation uncertainty exists.
Summary
IFRS 13 requires that fair value measurements maximize the use of relevant observable inputs and minimize use of unobservable inputs. Level 1 inputs have highest priority, providing greatest reliability; where not available, entities must proceed to Level 2, and only if necessary, Level 3. Transparency in valuation approach and disclosure is critical.
Key Point Checklist
This article has covered the following key knowledge points:
- Define 'fair value' per IFRS 13
- Describe the three levels of the fair value hierarchy and their characteristics
- Distinguish between observable (Levels 1/2) and unobservable (Level 3) inputs
- Apply the hierarchy in selecting appropriate valuation techniques
- Identify required disclosures for fair value measurements at each level
- Explain why maximizing use of observable inputs is required for all fair value measurements
Key Terms and Concepts
- fair value
- fair value hierarchy
- Level 1 inputs
- Level 2 inputs
- Level 3 inputs