31.2 Fair Value Hierarchy and Disclosures
Key Takeaways
- Fair value is an exit price from the perspective of market participants in the principal market, not the entity's preferred sale price or historical cost.
- Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities and have the highest priority.
- Level 2 inputs are observable but not Level 1, while Level 3 inputs are unobservable and require the most judgment and disclosure.
- Valuation approaches include market, income, and cost approaches; the selected technique should maximize observable inputs and fit the asset, liability, and unit of account.
- A measurement is classified at the lowest level of any input significant to the whole measurement, so one significant Level 3 input makes the entire measurement Level 3.
Fair Value Is An Exit Price
The 2026 FAR Blueprint includes fair value measurements in Area III, Select Transactions. Candidates must identify valuation techniques and use assumptions such as highest and best use, market participant assumptions, unit of account, and the cost, income, and market approaches according to the fair value hierarchy. This is not only a disclosure topic. A TBS can hand you broker quotes, pricing-service data, appraisals, cash flow estimates, and market spreads, then ask which input controls the measurement and at what level it lands.
Fair value (ASC 820) is 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. That is an exit price, not an entry price (what you paid). It is measured in the principal market -- the market with the greatest volume and activity for the asset -- or the most advantageous market if no principal market exists. Transaction costs are considered in choosing the most advantageous market but are not deducted from the fair value itself. The entity's own intentions matter only if market participants would share the same assumption.
The Hierarchy
| Level | Input type | Example | CPA exam clue |
|---|---|---|---|
| Level 1 | Quoted price in an active market for the identical asset or liability | Exchange closing price for the same listed share | No adjustment needed; active market exists |
| Level 2 | Observable inputs other than Level 1 | Quoted price for a similar bond, yield curve, credit spread, matrix pricing, inactive-market quote | Market data exists, but not for the identical active-market item |
| Level 3 | Unobservable inputs | Internal cash flow forecast, entity-developed volatility, management's own default estimate | Little or no observable market data |
Level 1 has the highest priority because it is the most direct evidence. If a company owns a share that trades in an active market, the quoted price for that exact share is normally Level 1, and management cannot move to a model just because it thinks the price is temporarily depressed. Level 2 is observable but less direct -- a corporate bond valued with quoted prices for similar bonds, observable rate curves, or market-corroborated credit spreads. Level 3 uses unobservable assumptions; it is permitted when observable data is unavailable but carries more estimation risk and disclosure.
Valuation Approaches
Three approaches appear repeatedly on FAR:
- Market approach -- uses prices and information from transactions involving identical or comparable assets, liabilities, or businesses (for example, comparable-company multiples or recent comparable sales).
- Income approach -- converts future amounts to a single present value, such as discounted cash flow (DCF) or an option-pricing model like Black-Scholes.
- Cost approach -- reflects the current replacement cost of the asset's service capacity, adjusted for obsolescence.
For nonfinancial assets, fair value assumes the asset's highest and best use by market participants, even if the reporting entity uses the asset differently or not at all. A parcel of land held idle is still measured at its highest-and-best-use value. For financial instruments, the unit of account controls whether you value one instrument, a portfolio, or a net risk exposure -- follow the unit specified by the applicable guidance and the fact pattern, not your own preference.
Disclosure Mindset
Fair value disclosures help users gauge measurement uncertainty. Recurring fair value measurements generally require the hierarchy level, the valuation techniques and inputs used, and transfers between levels. Level 3 measurements demand the most detail:
- A rollforward of beginning to ending balances (purchases, sales, settlements, transfers in and out).
- The significant unobservable inputs and the valuation processes used.
- A description of any change in valuation technique and the reason for it.
- Sensitivity or the effect of reasonably possible alternative assumptions for certain measurements.
The point is not to memorize every table. It is to recognize that Level 3 estimates need more explanation because users cannot verify them against observable quotes.
Exam Workflow
- Identify the asset, liability, or unit of account being measured.
- Ask whether an unadjusted active-market quoted price for the identical item exists (Level 1).
- If not, separate observable inputs from unobservable inputs.
- Select the valuation approach (market, income, or cost) that fits the fact pattern.
- Maximize observable inputs and minimize unobservable inputs.
- Classify the entire measurement at the lowest level of any input significant to it.
A single measurement can blend inputs. If a significant input is Level 3, the whole measurement is Level 3 even when other inputs are observable -- a frequent FAR trap that distinguishes the correct answer from the tempting Level 2 distractor.
Liabilities And Nonperformance Risk
Fair value of a liability assumes it is transferred to a market participant, not settled with the counterparty, and reflects the entity's own nonperformance risk (including its own credit risk) both at initial recognition and each subsequent measurement. When a quoted price for transferring the identical liability is not available, the standard looks to the price of the identical item held by another party as an asset.
Two more exam points: a quoted price in an active market should be used without adjustment for a position's size (no blockage factor, even for large holdings), and transfers between levels are recognized at a consistent point in the reporting period that the entity discloses. These judgment rules separate ASC 820 questions from simple arithmetic and frequently anchor the higher-difficulty multiple-choice items.
A company values a listed equity security using the unadjusted quoted price for the identical shares in an active exchange market on the measurement date. Which fair value hierarchy level applies?
A private debt investment is valued using a discounted cash flow model. The discount rate is based partly on observable market yields, but the expected default rate is a significant unobservable input developed by management. How should the fair value measurement generally be classified?