Ind AS 113 Fair Value Hierarchy — Level 1, Level 2 & Level 3 Inputs Explained for CA Exams
Fair value accounting can feel abstract until you break it down into one simple question: How reliable is the price you are using? That is exactly what the fair value hierarchy under Ind AS 113 answers. Once you understand the logic behind each level, examiner questions become straightforward — not scary.
Let's walk through this together, the way I have explained it to students for decades.
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What Is the Fair Value Hierarchy?
Ind AS 113 defines fair value as the price you would receive to sell an asset (or pay to transfer a liability) in an orderly transaction between market participants on the measurement date. The standard then ranks all the inputs used to arrive at that price into three levels — from most reliable to least reliable.
Think of it as a trust ladder:
- Level 1 = Maximum trust (market gives you the price directly)
- Level 2 = Medium trust (you adjust or derive the price from market data)
- Level 3 = Minimum trust (you build the price largely from your own assumptions)
The standard requires entities to use the highest level of input available. You cannot jump to Level 3 estimates if a quoted market price exists.
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Level 1 Inputs — Quoted Prices in Active Markets
What counts as Level 1?
A Level 1 input is an unadjusted quoted price in an active market for an identical asset or liability that the entity can access on the measurement date.
Key word: identical
If the asset is similar but not identical, you are already moving toward Level 2. The moment you adjust the quoted price for any reason, you exit Level 1.
Classic examples
- Equity shares listed on NSE or BSE — the closing market price is a Level 1 input.
- Government securities quoted on a recognised exchange.
- Commodity futures traded on a regulated exchange (e.g., MCX gold futures for a standard contract).
How examiners test Level 1
Examiners often give you a scenario where a company holds listed equity shares and also holds an unlisted security. They ask you to classify inputs. The listed shares = Level 1. The unlisted security = not Level 1. Students who confuse 'market-related' with 'Level 1' lose marks here.
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Level 2 Inputs — Observable Inputs Other Than Level 1
What counts as Level 2?
Level 2 inputs are observable — either directly (actual prices) or indirectly (derived from prices) — but they are not the unadjusted quoted prices of identical assets.
Examples to remember
- Quoted price of a similar (not identical) bond adjusted for credit risk differences.
- Interest rates and yield curves that are observable for substantially the full term of the instrument — for example, MIBOR-based swap rates.
- Implied volatility derived from quoted option prices.
- Price of a property in an active market for a comparable property, adjusted for location or condition differences.
The adjustment rule
A small adjustment to a Level 1 price keeps you at Level 2. But if the adjustment is so significant that it relies primarily on your internal assumptions, you slide into Level 3.
How examiners test Level 2
A favourite exam pattern: a company values an interest-rate swap using observable yield curves but the swap has a specific credit adjustment. Classify the inputs. Answer: Level 2, because observable data is still the primary driver. Examiners also test whether students know that quoted prices for similar (not identical) assets belong here — not Level 1.
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Level 3 Inputs — Unobservable Inputs
What counts as Level 3?
Level 3 inputs are unobservable — they reflect the entity's own assumptions about what market participants would use, because no observable market data is available.
Examples to remember
- Projected future cash flows of a start-up with no comparable listed peers (used in a DCF model).
- Long-term growth rates or discount rates developed internally for a privately held subsidiary.
- Customer attrition rates used in valuing an intangible asset acquired in a business combination.
- Fair value of unlisted equity instruments valued using internal financial projections.
Why Level 3 requires more disclosure
Because Level 3 is the least verifiable, Ind AS 113 demands extensive disclosures — including a reconciliation of opening and closing balances, sensitivity analysis, and the valuation techniques used. Examiners love asking about disclosure requirements at Level 3.
How examiners test Level 3
A common question: an entity measures goodwill impairment using a DCF model with internally estimated cash flows and a self-derived discount rate. Students must identify this as Level 3 and discuss the sensitivity disclosure requirement. Another pattern: give a mixed-input scenario and ask whether the overall measurement is Level 2 or Level 3 — the answer depends on the significance of the unobservable inputs to the entire measurement.
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The Significance Test — The Examiner's Favourite Twist
When a measurement uses inputs from more than one level, the overall classification follows the lowest level input that is significant to the entire fair value measurement.
Quick logic check:
- If you use 80% observable data and 20% internal estimates, but that 20% is material to the final price → the measurement is Level 3.
- If the unobservable portion is immaterial → it may still be Level 2.
This single rule generates the most examiner trick questions. Practise applying it to scenarios.
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Quick Revision Table
| Level | Input Type | Reliability | Common Example | |-------|-----------|-------------|----------------| | 1 | Quoted price, identical asset, active market | Highest | NSE-listed shares | | 2 | Observable, similar asset or derived data | Medium | Comparable bond yield | | 3 | Unobservable, entity's own assumptions | Lowest | DCF with internal projections |
(Always verify current thresholds and disclosure requirements in the latest ICAI study material / announcement before your exam.)
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Common Exam Mistakes to Avoid
- Treating a similar asset's quoted price as Level 1 — it is Level 2.
- Forgetting that any significant adjustment to a Level 1 price drops the classification.
- Ignoring the significance test when inputs from multiple levels are used.
- Missing that Level 3 measurements require a sensitivity disclosure — this is a standalone exam question in itself.
- Confusing 'unobservable' with 'unreasonable' — Level 3 inputs must still represent what market participants would use, not just what management prefers.
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FAQs
Q1. Can a single fair value measurement use inputs from more than one level? Yes, absolutely. Many real-world valuations blend observable and unobservable inputs. The overall measurement is then classified at the lowest level of input that is significant to the measurement — so even one significant Level 3 assumption makes the whole measurement a Level 3 measurement.
Q2. Is the fair value hierarchy the same under IFRS 13 and Ind AS 113? The hierarchy structure is substantially converged. However, always check the ICAI study material for any India-specific carve-outs or modifications before applying it in your answer — verify in the latest ICAI study material / announcement.
Q3. Do I need to memorise valuation techniques for each level? Yes — especially for Level 3. Ind AS 113 recognises the market approach, income approach (e.g., DCF), and cost approach. Examiners may ask you to identify the appropriate technique for a given scenario and link it to the correct level of the hierarchy.
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Fair value hierarchy questions reward students who understand the logic behind each level, not just a memorised list. Build that understanding now, while the concepts are fresh. To stay on track across all your Ind AS topics without missing a single chapter, grab the free day-by-day study planner at caparveensharma.com/free-planner?src=article — it maps your syllabus to your exam date automatically. And for case-scenario practice on Ind AS 113 and other standards, explore the full course library at caparveensharma.com, where CA Parveen Sharma's 36 years of teaching experience are packed into every module.