What is the ASC 820 fair value hierarchy (Level 1, 2, 3)?

Fair value is measured using a three-level input hierarchy that prioritizes observable market data over management judgment. The hierarchy ranks inputs—not valuation techniques—from most reliable (Level 1) to least reliable (Level 3), with the overarching goal of increasing consistency and comparability in fair value measurements and related disclosures (ASC 820-10-35-37). An entity must always use the highest-quality inputs available and cannot bypass a superior level merely for convenience. - Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. A quoted price in an active market provides the most reliable evidence of fair value and must be used without adjustment (ASC 820-10-35-41). Common examples include publicly traded equity securities, on-the-run Treasury bonds, and exchange-traded futures contracts. Because these prices are directly observable, management judgment plays no role in setting the measurement.

How should an entity classify a security that trades infrequently on an exchange—Level 1 or Level 2—and what evidence supports that classification?

- Level 2 inputs are observable inputs other than quoted prices included in Level 1. They include quoted prices for similar assets in active markets, quoted prices for identical or similar assets in inactive markets, and observable market data such as interest rates, yield curves, and credit spreads. Note that an adjustment to a Level 2 input that is significant to the entire measurement and based on unobservable data will push the entire measurement into Level 3 (ASC 820-10-35-38). Typical Level 2 measurements include corporate bonds priced using observable Treasury spreads and interest rate swaps valued from forward yield curves. - Level 3 inputs are unobservable and used only when relevant observable inputs are unavailable. They reflect the entity's own assumptions about what market participants would use—such as internally developed cash flow projections, long-run revenue growth rates, entity-specific discount rates, and volatility estimates derived from historical data. Because these inputs rely heavily on judgment, Level 3 measurements carry the greatest estimation uncertainty and require the most robust disclosure.

When using a valuation model with blended inputs (50% Level 1, 30% Level 2, 20% Level 3), how does the 'significance' test determine the overall hierarchy level?

- Hierarchy classification is based on the lowest level of input that is significant to the fair value measurement in its entirety. A single significant unobservable input can move an otherwise observable measurement down to Level 3. The availability and relative subjectivity of inputs can also affect the selection of appropriate valuation techniques (ASC 820-10-35-38). - Adjusting a Level 1 price and staying in Level 1. Any significant adjustment to a quoted market price moves the measurement out of Level 1. Stale prices or liquidity discounts are common triggers. - Misclassifying Level 2 vs. Level 3. Teams often underestimate how much an unobservable adjustment (e.g., a liquidity or credit risk premium) affects the overall measurement. If that adjustment is significant, the measurement belongs in Level 3—regardless of how many observable inputs were also used. - Skipping the hierarchy entirely. Entities sometimes select a valuation technique without first determining whether Level 1 inputs exist. ASC 820 requires maximizing observable inputs at every level; convenience is not a valid reason to bypass a higher level. - Inconsistent period-to-period classification. Transfers between levels must be disclosed and recognized at the end of the reporting period. Failing to monitor market activity changes (e.g., a market becoming inactive) leads to misclassification errors. - Confusing the unit of account with the valuation unit. The hierarchy applies to the unit of account specified by other GAAP topics. Aggregating instruments or splitting them for hierarchy purposes without a basis in the applicable standard is not permitted.

What documentation and reconciliation disclosures are required for a Level 3 private equity investment that moves $100k during the year due to management revaluation?

- ASC 820-10-35-37 — Establishes the fair value hierarchy to increase consistency and comparability in measurements and disclosures; foundational authority for the three-level structure. - ASC 820-10-35-41 — Mandates that a quoted price in an active market shall be used without adjustment; the core rule for Level 1 classification. - ASC 820-10-35-38 — Addresses how the availability and subjectivity of inputs affect valuation technique selection and hierarchy categorization, including the impact of significant unobservable adjustments on level classification.

ASC 820 Fair Value Hierarchy — Level 1 2 3

ASC 820 Fair Value Hierarchy — Core Rule

Fair value is measured using a three-level input hierarchy that prioritizes observable market data over management judgment. The hierarchy ranks inputs—not valuation techniques—from most reliable (Level 1) to least reliable (Level 3), with the overarching goal of increasing consistency and comparability in fair value measurements and related disclosures (ASC 820-10-35-37). An entity must always use the highest-quality inputs available and cannot bypass a superior level merely for convenience.

How ASC 820 Fair Value Hierarchy Works

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. A quoted price in an active market provides the most reliable evidence of fair value and must be used without adjustment (ASC 820-10-35-41). Common examples include publicly traded equity securities, on-the-run Treasury bonds, and exchange-traded futures contracts. Because these prices are directly observable, management judgment plays no role in setting the measurement.

Level 2 inputs are observable inputs other than quoted prices included in Level 1. They include quoted prices for similar assets in active markets, quoted prices for identical or similar assets in inactive markets, and observable market data such as interest rates, yield curves, and credit spreads. Note that an adjustment to a Level 2 input that is significant to the entire measurement and based on unobservable data will push the entire measurement into Level 3 (ASC 820-10-35-38). Typical Level 2 measurements include corporate bonds priced using observable Treasury spreads and interest rate swaps valued from forward yield curves.

Level 3 inputs are unobservable and used only when relevant observable inputs are unavailable. They reflect the entity's own assumptions about what market participants would use—such as internally developed cash flow projections, long-run revenue growth rates, entity-specific discount rates, and volatility estimates derived from historical data. Because these inputs rely heavily on judgment, Level 3 measurements carry the greatest estimation uncertainty and require the most robust disclosure.

Hierarchy classification is based on the lowest level of input that is significant to the fair value measurement in its entirety. A single significant unobservable input can move an otherwise observable measurement down to Level 3. The availability and relative subjectivity of inputs can also affect the selection of appropriate valuation techniques (ASC 820-10-35-38).

ASC 820 Fair Value Hierarchy — Common Pitfalls

Adjusting a Level 1 price and staying in Level 1. Any significant adjustment to a quoted market price moves the measurement out of Level 1. Stale prices or liquidity discounts are common triggers.
Misclassifying Level 2 vs. Level 3. Teams often underestimate how much an unobservable adjustment (e.g., a liquidity or credit risk premium) affects the overall measurement. If that adjustment is significant, the measurement belongs in Level 3—regardless of how many observable inputs were also used.
Skipping the hierarchy entirely. Entities sometimes select a valuation technique without first determining whether Level 1 inputs exist. ASC 820 requires maximizing observable inputs at every level; convenience is not a valid reason to bypass a higher level.
Inconsistent period-to-period classification. Transfers between levels must be disclosed and recognized at the end of the reporting period. Failing to monitor market activity changes (e.g., a market becoming inactive) leads to misclassification errors.
Confusing the unit of account with the valuation unit. The hierarchy applies to the unit of account specified by other GAAP topics. Aggregating instruments or splitting them for hierarchy purposes without a basis in the applicable standard is not permitted.

ASC 820 Fair Value Hierarchy — Key Paragraphs

ASC 820-10-35-37 — Establishes the fair value hierarchy to increase consistency and comparability in measurements and disclosures; foundational authority for the three-level structure.
ASC 820-10-35-41 — Mandates that a quoted price in an active market shall be used without adjustment; the core rule for Level 1 classification.
ASC 820-10-35-38 — Addresses how the availability and subjectivity of inputs affect valuation technique selection and hierarchy categorization, including the impact of significant unobservable adjustments on level classification.