The fair value hierarchy under ASC 820 is a three-level ranking of the inputs used to measure fair value, ordered by how observable those inputs are in the market. Level 1 covers unadjusted quoted prices in active markets for identical assets or liabilities. Level 2 covers other observable inputs, whether direct quotes for similar items or market data like interest rates and credit spreads. Level 3 covers unobservable inputs, where the entity develops its own assumptions about how a market participant would price the item. The level assigned to any given measurement is set by the lowest-level input that is significant to the result, which in turn drives how much judgment the entity applies and how heavily the measurement gets disclosed.1Financial Accounting Standards Board. Summary of Statement No. 157
Why the Hierarchy Ranks Inputs, Not Assets
A common source of confusion is thinking the levels describe types of assets. They don’t. The hierarchy classifies the inputs that go into a valuation, and the same kind of asset can land in different levels depending on what data is available. A corporate bond with an active trading market produces a Level 1 measurement; the same issuer’s less-liquid bond, valued using yield curves and credit spreads for similar securities, produces a Level 2 measurement; a private note with no comparable market data and modeled cash flows produces a Level 3 measurement. The organizing principle is the exit price — what a seller would receive in an orderly transaction between market participants at the measurement date — and the levels rank how directly the market speaks to that price.
Level 1 Inputs
Level 1 sits at the top because it demands the least judgment. These inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. An active market is one where transactions happen frequently enough and in sufficient volume to produce ongoing pricing information. Common stock trading on the New York Stock Exchange and Treasury securities quoted on a government bond market are the textbook examples.
When a Level 1 price is available, the entity must use it without adjustment.1Financial Accounting Standards Board. Summary of Statement No. 157 No haircut for holding a large block, no premium for a controlling interest, no tweak for the fact that selling the entire position at once might move the market. The standard specifically prohibits blockage factors, meaning discounts that reflect the price impact of selling a large quantity in a single transaction. Fair value for a Level 1 instrument is the quoted price multiplied by the quantity held, even when the position exceeds the market’s normal daily trading volume. That rule keeps Level 1 measurements clean and verifiable: an auditor can confirm the number by looking at the same exchange feed as everyone else.
Level 2 Inputs
When an identical asset does not trade on an active exchange, the measurement drops to Level 2. These inputs are still observable, either directly as prices or indirectly through data that can be corroborated with market information, but they require more work than pulling a closing quote. Level 2 covers several situations:
- Quoted prices for similar assets in active markets. A corporate bond with a slightly different maturity or coupon rate trading actively can serve as a pricing reference for a comparable bond that trades less frequently.
- Quoted prices for identical assets in inactive markets. If the same bond exists but rarely changes hands, the last quoted price can qualify as a Level 2 input, though the entity may need to consider whether that price still reflects current conditions.
- Observable market data other than quoted prices. Interest rates, yield curves, credit spreads, and prepayment speeds all fall here. Over-the-counter derivatives such as interest rate swaps are frequently valued using these inputs.
Matrix pricing is a common technique at this level for debt securities. Rather than relying on a direct quote for each individual bond, matrix pricing uses the security’s relationship to benchmark quoted securities, matching on features like credit quality, maturity, and coupon, to derive a fair value. The standard treats matrix pricing as a form of the market approach, and it works well when a company holds a large portfolio of similar but not identical debt instruments.2Financial Accounting Standards Board. Accounting Standards Update 2011-04: Fair Value Measurement (Topic 820) One point worth flagging: using matrix pricing instead of a direct Level 1 quote pushes the measurement into a lower level of the hierarchy, even if the underlying benchmark securities have Level 1 prices of their own.
Level 3 Inputs
Level 3 is where fair value measurement gets genuinely difficult. These inputs are unobservable. There is little or no market activity for the asset or liability, so the entity must develop its own assumptions about how market participants would price the item. Private equity stakes, complex structured products, and certain intangible assets land here because no exchange or dealer market produces a quoted price.
The standard does not give entities a blank check to mark assets at whatever value they prefer. Even though the starting point is internal data, including proprietary cash flow projections, discount rate assumptions, and expected growth rates, the entity must frame those assumptions from the perspective of an outside buyer or seller. The question is always what a knowledgeable, willing market participant would pay, not what management hopes the asset is worth. This market-participant lens is the main safeguard against bias, and auditors scrutinize it closely. If a company changes its valuation model or methodology, it should expect questions about why the change was made, how it affects the fair value estimate, and whether the new approach better reflects how the market would price the item.
Documentation requirements at this level are substantially heavier than at Levels 1 or 2. Entities must justify the specific inputs chosen, explain why those inputs align with market-based expectations, and, for public companies, disclose the range and weighted average of significant unobservable inputs. After amendments made by ASU 2018-13, entities may substitute a different quantitative measure for the weighted average if that measure more reasonably reflects the distribution of inputs, without having to explain why the weighted average was omitted.
Calibration at Initial Recognition
When an entity acquires a Level 3 asset and plans to use a valuation model for subsequent measurements, the model must be calibrated so that its output equals the transaction price at inception, assuming that transaction price represents fair value. This prevents a company from booking a gain or loss on day one simply because its internal model produces a number different from what it actually paid. Any gap between the model’s output and the transaction price gets recognized later, as the uncertainty in the inputs or the model is resolved over time.
Determining the Level of the Overall Measurement
A single fair value measurement often draws on inputs from more than one level. The rule for classifying the measurement as a whole is straightforward: the level is set by the lowest-level input that is significant to the result. A discounted cash flow model built primarily on Level 2 observable inputs but relying on one significant unobservable assumption produces a Level 3 measurement. A valuation technique that uses mostly Level 2 inputs produces a Level 2 measurement; the same technique fed primarily with Level 3 inputs produces a Level 3 measurement. Choice of valuation technique — market approach, income approach, or cost approach — does not by itself determine the level. What matters is how observable the inputs feeding that technique are, and the standard requires entities to maximize the use of observable inputs and minimize reliance on unobservable ones regardless of which technique they choose.
Where the Hierarchy Applies
ASC 820 does not decide which items on a balance sheet get measured at fair value. Other standards in the codification make that call. ASC 820 only answers the “how” question: once another topic requires or permits a fair value measurement, ASC 820 supplies the definition, the hierarchy, the allowable valuation techniques, and the disclosure rules. Several areas fall outside its reach, including share-based compensation under Topic 718, revenue recognition under Topic 606, and measurements that resemble fair value but use a different concept such as standalone selling price. Within its scope, the hierarchy applies broadly, from publicly traded equity securities and derivatives to goodwill impairment tests and business combination purchase-price allocations.
How the Level Drives Disclosure
The level assigned to a measurement determines how much a company has to tell readers about it. At a minimum, entities disclose the fair value for each class of assets and liabilities, broken out by level. These disclosures typically appear in a tabular format in the financial statement notes, giving readers a quick read on how much of the balance sheet rests on hard market data versus internal estimates.
The standard distinguishes between recurring measurements — those required at the end of every reporting period, like trading securities or derivatives carried at fair value — and nonrecurring measurements triggered by specific events such as an impairment write-down. Disclosure obligations are heavier for recurring items. For nonrecurring items, the entity discloses the fair value at the relevant measurement date and the reason the measurement was taken.
Level 3 Rollforward and Transfers
For recurring Level 3 measurements, public companies must provide a full reconciliation from the opening balance to the closing balance, broken out by total gains and losses recognized in earnings, gains and losses recognized in other comprehensive income, purchases, sales, issues, settlements, and transfers into or out of Level 3.2Financial Accounting Standards Board. Accounting Standards Update 2011-04: Fair Value Measurement (Topic 820) Transfers into Level 3 must be disclosed separately from transfers out. Nonpublic entities get some relief. After amendments under ASU 2018-13, nonpublic entities are not required to provide the full rollforward but must still disclose transfers into and out of Level 3 as well as purchases and issues of Level 3 assets and liabilities.
Recent Changes to the Disclosure Set
ASU 2018-13 streamlined parts of the disclosure framework while adding new requirements. It eliminated the obligation to disclose the amounts of and reasons for transfers between Level 1 and Level 2, removed the requirement to describe the valuation process for Level 3 measurements, and dropped the policy-for-timing-of-transfers disclosure. In exchange, it added a requirement for public companies to disclose unrealized gains and losses included in other comprehensive income for recurring Level 3 measurements and clarified that entities must disclose the range and weighted average of significant unobservable inputs used in Level 3 valuations. The net effect is fewer boilerplate disclosures and more targeted information about the inputs most prone to management judgment.