Fair value measurement uses a hierarchy of inputs to ensure consistency and transparency. The approach is prescribed in global guidance: IFRS 13 was issued by the International Accounting Standards Board and ASC 820 guidance was issued by the Financial Accounting Standards Board. Both standards prioritize market-based evidence and require disclosures that explain the inputs and valuation techniques used.
The three levels explained
Level 1 inputs are the most reliable and consist of quoted prices in active markets for identical assets or liabilities. A publicly traded stock with a quoted price on an active exchange is a typical example where fair value is directly observable. Level 2 inputs include observable inputs other than quoted prices for identical items. These can be quoted prices for similar assets in active markets, quoted prices in markets that are not active, or observable interest rates and yield curves. Level 3 inputs are unobservable and rely on the reporting entity’s own assumptions about what market participants would use in pricing the asset or liability. Valuation techniques applied to Level 3 often involve discounted cash flow models or option-pricing models that use management’s best estimate of future cash flows, risks and discount rates.
Relevance, causes and consequences
The hierarchy matters because it directly influences measurement reliability, earnings volatility and the extent of required disclosures in financial statements. Markets that are illiquid, fragmented or affected by political or territorial instability push valuations toward Level 3, increasing judgment and audit scrutiny. Cultural and institutional differences in market transparency can also shift inputs—for example, family-owned businesses in some regions may lack observable market prices, while mature markets supply abundant Level 1 data. Environmental instruments such as renewable energy credits or carbon allowances can be particularly sensitive to valuation input availability and regulatory changes, affecting both corporate reporting and local markets.
When observable inputs are scarce, reliance on unobservable inputs can materially affect reported asset values and investor decisions; this creates incentives for robust governance, independent valuation specialists and clear disclosures. Standard setters require that entities disclose the level of inputs used and reconcile movements in Level 3 measurements so users can assess the quality of the valuation and the risks associated with subjective assumptions.