Fair Value Hierarchy: Definition, Levels, Examples

Most companies use the historical value method of deriving their asset’s value. This process includes taking the asset’s cost and deducting any impairment and depreciation to reach the book value. The same method applies to deriving the value of liabilities. However, some accounting standards also require or allow companies to measure items at fair value.

What is a Fair Value?

The term “fair value” has various definitions in accounting and finance. It usually refers to the price a willing buyer and seller will pay or receive for an asset in an orderly transaction. The fair value of an item will also depend on the measurement date. Similarly, it may also be the price paid to transfer a liability in similar market conditions at a specific date.

Add your business to our business directory https://harbourfronts.com/directory/ Add your business. Also check out other businesses in the directory

In short, the fair value represents the market value of an asset or liability. However, there are several criteria attached to it. As mentioned, it requires the market participants to be willing to transact. It also needs an orderly transaction or one considered an arm’s length transaction. The criterion for a measurement date is also crucial to establish a fair value for an item.

Sometimes, however, the fair value of an item may not be straightforward to determine. Since fair value is market-based and not entity-specific, there are several hurdles that companies may face. For example, companies may come across several fair values for a specific item from different markets. These inputs can confuse how to determine an item’s fair value. For that, companies must use the fair value hierarchy.

What is the Fair Value Hierarchy?

The fair value hierarchy refers to the different classes in which accounting standards classify inputs. As mentioned, companies may come across several sources that provide information about an item’s fair value. These values may differ based on the input they take. Similarly, the markets where these prices generate also impact the fair value.

The fair value hierarchy categorizes inputs used in fair value determination into three levels. This hierarchy provides the highest priority to Level 1 inputs. In case these inputs are not available, companies must use Level 2 inputs. Lastly, companies can use Level 3 inputs when the above two cannot be determined. Each of these differs from the others, as discussed below.

Level 1 Inputs

Level 1 inputs include quoted prices for identical items in an active market on the measurement date. For example, it may be a bid price for an asset or an ask price for a liability. Level 1 inputs are the most reliable evidence for fair value.

Level 2 Inputs

Level 2 inputs are directly or indirectly observable inputs rather than quoted prices. These may include the value of similar items in active or inactive markets. For example, a valuation multiple for a business unit based on the sale of similar entities is a level 2 input. After Level 1, level 2 inputs take priority.

Level 3 Inputs

In some cases, identifying level 1 and 2 inputs may not be possible. Therefore, companies must use level 3 inputs that are unobservable. It may include prices from a company’s own data, adjusted for specific conditions. For example, cash or profit forecasts used to evaluate an asset would fall into this category. Level 3 inputs have the lowest priority in the fair value hierarchy.

Conclusion

Fair value is the market price for an asset or liability at a specific date between willing market participants. The fair value hierarchy identifies three categories for inputs. Usually, companies use level 1 inputs that have the highest priority. When level 1 inputs are not available, companies must use level 2 inputs. Lastly, companies can use level 3 inputs if none of the above can be determined. Level 3 inputs take the lowest priority.

Further questions

What's your question? Ask it in the discussion forum

Have an answer to the questions below? Post it here or in the forum

LATEST NEWSRussia Nears Economic Milestone of Buying Yuan Soon as Sanctions, Oil-Cap Hit Eases
Russia Nears Economic Milestone of Buying Yuan Soon as Sanctions, Oil-Cap Hit Eases

Russia is likely to resume buying foreign currency for its reserves as soon as this month as rising oil earnings stabilize public finances despite US and European efforts to squeeze Kremlin income.

Stay up-to-date with the latest news - click here
LATEST NEWSApple escapes a trade secret verdict over a key smartwatch feature that could have cost the company as much as $1.85 billion
Apple escapes a trade secret verdict over a key smartwatch feature that could have cost the company as much as $1.85 billion

A jury failed to reach a unanimous verdict in a trial during which medical-devices company Massimo claimed Apple ripped off its blood-oxygen sensor.

Stay up-to-date with the latest news - click here
LATEST NEWSUS lawmakers dig into partisan corners as debt ceiling default looms
US lawmakers dig into partisan corners as debt ceiling default looms

WASHINGTON — U.S. lawmakers responded to news that the federal government could be unable to pay its bills as soon as June 1 by digging in on partisan positions, even as Democratic President Joe Biden agreed to meet with lawmakers on the debt ceiling next…

Stay up-to-date with the latest news - click here
LATEST NEWSTop Economic Events to June 29
Top Economic Events to June 29

May 2 (Reuters) – For other diaries, please see: Top Economic Events Emerging Markets Economic Events Government Debt Auctions Political and General News U.S. Federal Reserve Today in Washington ————————————————————- This Diary is filed daily. ** Indicates new events ————————————————————- TUESDAY, MAY 2 WELLINGTON –…

Stay up-to-date with the latest news - click here
LATEST NEWSChina’s exit bans multiply as political control tightens under Xi
China’s exit bans multiply as political control tightens under Xi

HONG KONG — China is increasingly barring people from leaving the country, including foreign executives, a jarring message as the authorities say the country is open for business after three years of tight COVID-19 restrictions. Scores of Chinese and foreigners have been ensnared by exit…

Stay up-to-date with the latest news - click here

Leave a Reply