Fair value under Ind AS 113 is not simply “whatever a valuer estimates.” It is a market-based measurement built around 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. ICAI’s fair value concept paper page also emphasises that fair value reflects market-participant assumptions and current market conditions rather than an entity-specific view.
For finance teams, auditors and valuers, one of the most important practical parts of Ind AS 113 is the fair value hierarchy. The hierarchy does not rank valuation methods from “best” to “worst.” It ranks the inputs used in a fair value measurement according to how observable they are.
What is the purpose of the fair value hierarchy?
The hierarchy is designed to improve consistency and comparability in fair value measurements and disclosures. It gives the highest priority to observable market evidence and the lowest priority to unobservable inputs developed when market evidence is limited.
A useful first-party reference is ICAI’s Chartered Accountant Journal discussion of fair value hierarchy discipline, which describes the three-level structure: Level 1 for unadjusted quoted prices in active markets, Level 2 for other observable inputs and Level 3 for unobservable inputs.
Level 1 inputs: direct quoted prices for an identical item
Level 1 is the most directly observable category. The classic case is an unadjusted quoted price in an active market for an identical asset or liability.
For example, suppose a company holds listed equity shares that trade frequently on an active stock exchange and an observable quoted market price is available for those exact shares at the reporting date. Subject to the facts of the market and instrument, that quoted price is the type of input associated with Level 1.
The key words are identical, active market and unadjusted quoted price. A price for a merely similar instrument is not automatically Level 1. If a quoted price has to be significantly adjusted using less observable assumptions, the hierarchy conclusion also needs to be reconsidered.
Level 2 inputs: observable, but not Level 1 quoted prices
Level 2 covers inputs other than Level 1 quoted prices that are observable for the asset or liability, directly or indirectly. Typical examples can include quoted prices for similar instruments, observable interest rates and yield curves, credit spreads, implied volatilities and market-corroborated inputs.
Consider a corporate bond that is not actively quoted in an identical-instrument market. A valuation model may instead use observable benchmark yields, observable credit spreads for comparable issuers and other market data. If the significant inputs are observable and no significant unobservable assumption drives the result, the measurement may fall within Level 2.
This illustrates an important rule: using a valuation model does not automatically make a measurement Level 3.
Level 3 inputs: significant unobservable assumptions
Level 3 uses unobservable inputs where relevant observable inputs are not available. Those inputs should still reflect assumptions that market participants would use; they are not simply management’s preferred internal forecast.
An unquoted start-up investment, for example, may be valued using a discounted cash flow model. If the result depends significantly on assumptions such as long-term revenue growth, margins, probability-weighted outcomes or risk adjustments for which market evidence is limited, the measurement can fall within Level 3.
Level 3 does not mean the valuation is automatically unreliable. It means the measurement depends more heavily on judgement and unobservable inputs, making documentation, review and disclosure especially important.
The key classification rule: look at the lowest significant input
A single valuation can use inputs from more than one hierarchy level. The measurement is not classified by counting how many Level 1, Level 2 or Level 3 inputs appear in the model. The practical focus is the lowest-level input that is significant to the fair value measurement as a whole.
Assume a valuation uses an observable risk-free yield curve, an observable industry credit spread and one unobservable adjustment for a special contractual feature. If that unobservable adjustment is insignificant, it may not determine the hierarchy level. If it is significant to the overall valuation, however, the measurement may be classified in Level 3 even though most other inputs are observable.
Do not classify the asset; classify the measurement
“Listed shares are Level 1,” “bonds are Level 2,” or “unquoted investments are Level 3” may be useful shorthand, but they are not safe conclusions without examining the actual market and inputs.
- A listed security may not provide a usable Level 1 input if the relevant quote is not for an identical instrument or the market evidence does not support Level 1 treatment.
- A debt instrument can use Level 1 evidence when an active-market quote for the identical instrument is available.
- An unquoted instrument may use substantial observable market inputs, but a significant unobservable assumption can still result in Level 3 classification.
Valuation technique and hierarchy level are different questions
A discounted cash flow model is not automatically Level 3, and a market-comparable method is not automatically Level 2. The hierarchy level depends on the observability and significance of the inputs used. This is a useful review check when a valuation report appears to have derived its hierarchy conclusion merely from the method name.
Practical three-example comparison
- Example A — actively traded listed share: an unadjusted quoted price for the identical share in an active market points toward Level 1.
- Example B — less-liquid corporate bond: a valuation using observable benchmark yields and market credit spreads, without significant unobservable adjustments, can point toward Level 2.
- Example C — unquoted early-stage equity: a DCF or probability-weighted model driven by significant unobservable forecasts and risk assumptions can point toward Level 3.
These are illustrations, not automatic classifications. The reporting entity must evaluate the actual market and significant inputs at the measurement date.
Finance and audit review checklist
- Confirm why fair value is required or permitted. Ind AS 113 provides the measurement framework; the relevant accounting requirement determines when fair value is used.
- Identify the asset or liability being measured. Do not begin with a hierarchy label.
- List every significant valuation input. Separate direct quoted prices, observable market data and unobservable assumptions.
- Challenge adjustments to quoted or observable data. A significant adjustment can change the hierarchy conclusion.
- Identify the lowest-level significant input. Use that input to determine the classification of the measurement as a whole.
- Reconcile the conclusion. The valuation report, working papers and financial-statement disclosure should be consistent.
- For Level 3 measurements, strengthen documentation. Preserve support for key assumptions, market-participant rationale and changes from the prior measurement date.
Common mistakes to avoid
- Calling every DCF valuation Level 3 merely because a model is used.
- Calling every market-based valuation Level 1 even when the quote is for a similar rather than identical item.
- Ignoring a significant unobservable adjustment because most other inputs are observable.
- Using entity-specific assumptions without considering how market participants would price the item.
- Treating the hierarchy as a ranking of valuation techniques instead of a hierarchy of inputs.
Practical takeaway
The simplest way to apply the Ind AS 113 hierarchy is to ask three questions in order: Is there an unadjusted active-market quote for the identical item? If not, which significant inputs are observable? Finally, does any significant unobservable input drive the measurement? The answer should follow the inputs actually used, not the asset label or valuation technique. That discipline makes fair value classification easier to defend in valuation reviews, audits and financial-statement disclosures.
