IFRS 13 Fair Value Hierarchy: Level 1, Level 2, Level 3 and Indian Market Applications

IFRS 13 Fair Value Hierarchy: Level 1, Level 2, Level 3 and Indian Market Applications

By Sai Manikanta Pedamallu (ACCA, CMA US, CSCA US, CGMA, ACMA, Dip IFRS, M.Com, MBA, MA)

Lead Instructor, Global Fin X | www.globalfinx.in/manikanta

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The fair value hierarchy is IFRS 13's transparency mechanism. It does not change how fair value is measured. It tells users how reliable that measurement is, by ranking the inputs used in the valuation from the most objective to the most subjective.

A Nifty 50 stock priced at the NSE closing quote and an unlisted startup equity stake valued using a management DCF are both fair value measurements under IFRS 13. But they carry very different levels of uncertainty. The hierarchy makes that difference visible, through both the level classification and the disclosure requirements attached to each level.

This post covers the three hierarchy levels in detail, the lowest-level-significant-input rule, transfers between levels, the disclosure requirements that change by level, and how Indian market conditions affect where most common financial instruments actually land.

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The Purpose of the Hierarchy

IFRS 13's hierarchy ranks inputs, not valuation techniques. An entity can use the income approach (DCF) and still produce a Level 1 measurement if every input into that DCF is directly observable from active markets. Conversely, a market approach using comparable company multiples is Level 3 if the multiples require significant unobservable adjustment.

The hierarchy exists because observable inputs reduce measurement subjectivity. When a price is directly quoted in an active market for an identical instrument, there is minimal room for management to influence the number. When a valuation relies entirely on management's projections of future cash flows and a discount rate built from internal assumptions, the output depends heavily on those assumptions, and small changes can produce large swings in the reported fair value.

The hierarchy makes this spectrum visible and drives a proportionate disclosure response: Level 1 requires minimal disclosure; Level 3 requires quantitative sensitivity analysis, reconciliation of movements, and description of the valuation process.

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Level 1: Quoted Prices in Active Markets for Identical Assets

Level 1 is the highest priority. It requires a quoted price, unadjusted, in an active market, for an identical asset or liability, accessible to the entity at the measurement date.

Four conditions all must be present:

Quoted price: A price, not an estimate. A published closing price on a recognised exchange.

Unadjusted: The price is used as-is. No modifications for size, liquidity, or entity-specific factors.

Active market: A market with sufficient frequency and volume of transactions to provide pricing information on an ongoing basis. Regular transactions, not just occasional trades.

Identical asset or liability: The same instrument, not a comparable one.

What Qualifies as Level 1 in India

NSE and BSE listed equities (Nifty 50, Sensex constituents): These trade in active markets with continuous pricing throughout the trading day. The closing price on the measurement date is Level 1. An entity holding Reliance Industries shares values them at the NSE closing price. No adjustment permitted.

Exchange-traded government securities (G-secs via NDS-OM): Government securities traded on the RBI's NDS-OM (Negotiated Dealing System Order Matching) with daily turnover around Rs. 67,000 crore have sufficient activity to qualify as an active market for liquid maturities. The benchmark 10-year G-sec is Level 1 for most reporting purposes.

Exchange-traded derivatives (NSE F&O): Futures and options on the Nifty 50, Bank Nifty, and major individual stocks traded on the NSE derivatives segment are Level 1 instruments. Settlement prices published by NSE are Level 1 inputs.

ETFs listed on NSE/BSE with active trading: Nifty 50 ETFs, gold ETFs, and other actively traded ETFs with continuous market prices are Level 1.

When Level 1 Cannot Be Used

Even where a quoted price exists, Level 1 may not apply in two situations.

First, if the entity holds a block of shares so large that selling it would move the market, the quoted price may not reflect the price the entity would actually receive. This is a blockage discount situation. IFRS 13 is explicit: blockage discounts are not permitted as adjustments to Level 1 measurements. The entity uses the quoted price multiplied by the quantity held, even if selling that quantity at the market price is unrealistic. The blockage concern does not make the price Level 2; it remains Level 1.

Second, if the market is not active at the measurement date, the quoted price from that market is not Level 1. A thin market with infrequent and small-volume trades, where bid-ask spreads are wide and prices are stale, is not an active market even if it technically has a quoted price. The measurement drops to Level 2.

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Level 2: Observable Inputs Other Than Level 1

Level 2 inputs are observable, derived from market data, but not the direct quoted price of an identical instrument in an active market. They require some degree of adjustment or inference.

Examples of Level 2 inputs:

Quoted prices for similar (but not identical) assets in active markets. A corporate bond with the same credit rating and similar maturity to one that is quoted, but with slightly different terms.

Quoted prices for identical assets in markets that are not active. A mid-cap stock that trades infrequently. The price exists but the market is thin.

Observable inputs other than quoted prices: benchmark interest rates (MIBOR, SOFR), yield curves, credit spreads observable from active bond markets, implied volatilities from exchange-traded options, foreign exchange rates.

Market-corroborated inputs: inputs derived from observable market data through correlation or other means.

The key test: can the input be derived from market data without significant unobservable adjustment? If yes, it is Level 2. If the adjustment is significant, it is Level 3.

What Falls at Level 2 in India

OTC interest rate swaps referencing MIBOR: The swap fair value is calculated using the MIBOR forward curve and discount factors derived from the market. Both are observable. Level 2.

Forward foreign exchange contracts (USD/INR, EUR/INR): Valued using observable spot rates plus forward points derived from active interbank market data. Level 2.

Corporate bonds not actively traded on secondary markets: India's corporate bond secondary market is structurally thin. While government securities see average daily turnover of around Rs. 67,000 crore, corporate bond secondary market daily turnover is approximately Rs. 6,000 crore, roughly one-tenth. Many individual corporate bonds trade rarely or not at all in the secondary market. Their fair value is determined using matrix pricing: interpolating from the yields of comparable bonds (same rating, similar maturity and sector) that do trade. The inputs are observable (benchmark G-sec yields, credit spreads for that rating category), but they apply to similar rather than identical instruments. Level 2.

Mutual fund NAVs (non-listed): The NAV of a debt mutual fund is published daily by the AMC and is based on observable market prices for the underlying securities. Level 2 (or Level 1 for exchange-listed ETFs with active trading).

Derivatives on commodity prices (gold, crude oil) using exchange prices for similar contracts: If the specific contract is not exchange-traded but is priced using observable exchange quotes for adjacent maturities, Level 2.

Quoted prices for NSE/BSE listed equities in thin trading: A small-cap stock listed on NSE but with extremely low daily volumes and wide bid-ask spreads, where recent trade prices may not reflect a genuine orderly market, may be Level 2 rather than Level 1 if the market is not considered active.

The Adjustment Test

The most practical question when distinguishing Level 2 from Level 3: is the adjustment to the observable input significant to the overall fair value measurement?

An interest rate swap valued using the MIBOR curve with a minor credit valuation adjustment (CVA) for counterparty risk is Level 2 if the CVA is small. If the counterparty is in severe financial distress and the CVA represents a large portion of the instrument's fair value, the CVA is a significant unobservable input. The measurement becomes Level 3.

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Level 3: Unobservable Inputs

Level 3 inputs have no observable market data behind them. They are developed using the entity's own assumptions about what market participants would use, based on the best information available in the circumstances.

Level 3 is not a measurement failure. Many assets simply have no active market and no close comparables. The fair value measurement must still be completed, using the best available evidence. What changes is the disclosure: Level 3 measurements carry the highest disclosure burden precisely because the output depends most heavily on judgment.

Unobservable inputs must still reflect market participant assumptions, not entity-specific preferences. An entity cannot use its own overly optimistic growth projections in a DCF just because the inputs are unobservable. The projection must represent what market participants would use, even if that requires downward adjustment from internal forecasts.

What Falls at Level 3 in India

Unlisted equity investments in Indian companies: India has tens of thousands of unlisted companies. PE funds, strategic investors, and NBFCs hold significant portfolios of unlisted equity. No quoted price exists. Comparable listed companies may provide some market data for multiples, but the unlisted company requires significant adjustment for size, liquidity, stage of development, and risk profile. The liquidity discount alone is often 20-35%, depending on the stage and exit horizon. The overall measurement is Level 3.

Investment property in Tier 2 and Tier 3 cities: For DLF's Delhi NCR commercial properties, reasonably active transaction markets provide comparable data. For a developer with investment properties in smaller cities where comparable transactions are rare, the fair value of those properties uses capitalisation rates and rental assumptions that cannot be sourced from active market data. Level 3.

Biological assets under IAS 41: Fair values of tea plantations (Tata Consumer Products), rubber estates, and plantation crops in India involve long-dated DCF models with unobservable inputs: yield per hectare, harvest cycles, commodity price forecasts, and discount rates. These are Level 3 measurements.

Decommissioning liabilities: An oil and gas company's obligation to restore a wellsite at end of life uses management estimates of future restoration costs, escalation assumptions, and discount rates. The restoration cost estimate is not observable. Level 3.

Customer relationship intangibles in purchase price allocation: Under IFRS 3, customer relationships acquired in a business combination are recognised at fair value using the multi-period excess earnings method. The inputs: customer attrition rate, revenue attributable to each customer cohort, contributory asset charges, and discount rate. None of these are directly observable. Level 3.

Goodwill impairment testing (VIU vs fair value): While VIU under IAS 36 is not a fair value measurement, entities that use fair value less costs to sell as the recoverable amount often use Level 3 inputs: projected revenue, EBITDA margins, terminal growth rates, and discount rates for cash generating units with no observable market price.

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The Lowest-Level-Significant-Input Rule

When a fair value measurement uses inputs from multiple levels, the overall measurement is classified at the level of the lowest significant input. A measurement cannot be Level 2 just because most inputs are observable if one unobservable input is significant to the overall result.

Worked example: A corporate bond is valued using:

• The G-sec benchmark yield: observable (Level 2 input)
• A credit spread for the issuer's rating category: observable from active bond markets (Level 2 input)
• An illiquidity premium for a specific bond with very thin secondary trading: not directly observable, estimated by management (Level 3 input)

If the illiquidity premium is 20 basis points on a bond trading at 200 basis points over G-sec, the illiquidity premium represents 10% of the total spread. If auditors and management assess this as significant to the overall measurement, the bond is Level 3. If the illiquidity premium is 5 basis points on a 200 basis point spread (2.5%), and the rest of the valuation uses observable inputs, it may be assessed as not significant, keeping the measurement at Level 2.

"Significant" is a judgment call. It requires documentation. Entities that classify measurements as Level 2 when a material unobservable input is present face audit challenge.

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Transfers Between Levels

Transfers between hierarchy levels are recognised at the end of the reporting period, not the date the transfer condition is met. Entities must disclose transfers into and out of each level separately.

Level 1 to Level 2: A listed security whose market becomes inactive during the period. The closing price is no longer from an active market. The measurement moves to Level 2.

Level 2 to Level 3: An observable input that was previously market-corroborated becomes unobservable due to deterioration in market liquidity or the disappearance of comparable transactions. Common during market stress.

Level 3 to Level 2: A previously illiquid instrument develops secondary market trading, making comparable pricing observable. Less common, but occurs as markets develop.

During the COVID-19 period in March to May 2020, several Indian corporate bond and real estate asset categories that had been Level 2 saw their markets become inactive. Entities holding those assets reclassified measurements to Level 3 and applied additional unobservable assumptions to determine fair value. The reverse migration back to Level 2 occurred as markets normalised.

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Disclosure Requirements by Level

IFRS 13 disclosure requirements scale with the hierarchy level. The table below summarises what is required by level for recurring fair value measurements.

The reconciliation of Level 3 movements is one of the most information-rich disclosures in financial statements. For a NBFC or PE fund with significant unlisted equity portfolios, the Level 3 movement table shows: opening balance, additions (new investments), disposals, gains and losses in P&L, gains and losses in OCI, transfers in and out, and closing balance. Analysts use this to assess the track record of the entity's fair value estimates over time.

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Practical Classification: Indian Instruments at a Glance

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The Indian Market Context: Why Level 3 Is More Prevalent Here

In developed capital markets, secondary trading data for corporate bonds, real estate, and private equity is more readily available. The US high-yield bond market, for instance, has active secondary trading with Bloomberg BVAL prices serving as Level 2 inputs for most instruments.

India's capital market structure pushes more valuations into Level 3 than the same assets would produce in developed markets.

India's corporate bond secondary market has average daily turnover of approximately Rs. 6,000 crore against total outstanding corporate bonds of around Rs. 47 lakh crore. Secondary market turnover is a small fraction of outstanding issuance. Most corporate bonds do not trade on any given day. This makes even moderate-sized corporate bond portfolios dependent on matrix pricing with credit spread assumptions that carry unobservable components.

Indian real estate transaction data is fragmented, often delayed, and varies significantly by micromarket. A developer cannot easily find three or four truly comparable recent transactions to benchmark a commercial property in a Tier 2 city. Valuers use capitalisation rates derived from limited data and informed judgment. Level 3.

Indian PE and venture capital portfolios, which represent significant balance sheet items for many NBFCs, insurance companies, and family offices, are largely unlisted. The valuation of these portfolios is one of the highest-judgment areas in Indian financial reporting.

This has a practical implication for anyone reading Indian Ind AS financial statements: a larger proportion of total assets will be Level 3 than in a comparable European or US entity. The Level 3 reconciliation and sensitivity disclosures deserve close reading.

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Ind AS 113 vs IFRS 13: The Hierarchy

The hierarchy under Ind AS 113 is identical to IFRS 13. Level definitions, the lowest-level-significant-input rule, transfer recognition timing, and disclosure requirements are the same.

The RBI carve-out applies specifically to bank treasury portfolios. Under RBI's investment classification norms (HTM, AFS, HFT categories), government securities are valued using different rules for regulatory reporting than IFRS 13's fair value hierarchy. A bank's IFRS 13 Ind AS disclosure and its regulatory valuation return are reconciled in the notes, which is why bank fair value notes are more complex than those of non-bank entities.

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What Big 4 Auditors Focus On

Level 2 vs Level 3 boundary calls. The most judgment-intensive and most commonly challenged classification is the boundary between Level 2 and Level 3. Auditors test whether inputs classified as Level 2 are genuinely observable without significant unobservable adjustment. For corporate bond portfolios, auditors test the source of credit spread inputs, the liquidity premium assumptions, and whether comparable bond data actually exists for the issuers in the portfolio.

Active market assessment. Auditors challenge whether markets used for Level 1 classification are genuinely active. For mid-cap and small-cap Indian equities with low trading volumes, auditors assess bid-ask spreads, trading frequency, and volume data to determine whether the market qualifies as active. Stocks trading fewer than a handful of times per week, or where the quoted price has not changed for several days, may not be in an active market.

Level 3 sensitivity disclosure adequacy. IFRS 13 requires quantitative sensitivity analysis for Level 3 measurements: what happens to the fair value if a significant unobservable input changes by a reasonable amount? Auditors assess whether the disclosed sensitivity ranges are realistic and whether the sensitivity has been calculated correctly. A sensitivity disclosure that uses a 1% change in discount rate for a 15-year DCF valuation may understate the true sensitivity.

Level 3 reconciliation completeness. The opening-to-closing reconciliation must capture all movements: purchases, sales, gains in P&L, gains in OCI, and transfers. Auditors trace each line item in the reconciliation to underlying transaction data and valuation records. Missing items or aggregated disclosures that obscure movements are challenged.

Transfer identification. Auditors test whether transfers between levels have been identified, assessed for timing (end of period, not mid-period), and disclosed. In years with market disruption, transfers from Level 2 to Level 3 are particularly important to identify.

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Dip IFRS Exam Angle

The fair value hierarchy is consistently tested in Dip IFRS, both as classification scenarios (classify each instrument into Level 1, 2, or 3) and as disclosure knowledge questions.

Most tested areas:

Classifying instruments by level: given a list of instruments with descriptions of available market data, assign each to Level 1, 2, or 3 and justify the classification. Know the conditions for Level 1 (quoted, unadjusted, active market, identical) and the key distinguishing features of Level 2 (observable but not Level 1) versus Level 3 (unobservable, significant judgment).

The lowest-level-significant-input rule: if a measurement uses observable and unobservable inputs, it is classified at the level of the lowest significant input. Know this and apply it to multi-input scenarios.

Blockage discounts: IFRS 13 prohibits adjusting Level 1 quoted prices for blockage. An entity holding a large block of shares uses the quoted price multiplied by the quantity, without discount. This is a standard exam trap.

Level 3 disclosure requirements: know that Level 3 requires quantitative sensitivity analysis, a reconciliation of movements, and identification of gains and losses recognised in P&L versus OCI.

Common traps:

Downgrading to Level 2 because the entity holds a large block: blockage does not take a measurement out of Level 1.

Treating all DCF measurements as Level 3: a DCF using only observable inputs (benchmark yield curves, observable credit spreads) can be Level 2. The approach does not determine the level; the inputs do.

Classifying an infrequently-traded listed security as Level 1: if the market is not active, the quoted price is not Level 1. Assess market activity, not just the presence of a quote.

Forgetting that transfers are recognised at period-end: in an exam scenario where a market becomes inactive mid-year, the reclassification is at the reporting date, not the date the market became inactive.

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FAQ

Can an entity choose a lower hierarchy level to avoid Level 3 disclosures?

No. IFRS 13 requires maximising observable inputs and minimising unobservable inputs. An entity cannot deliberately use less observable inputs to place a measurement at Level 2 when Level 1 data is available. Equally, if the only reliable inputs are unobservable, the measurement is Level 3 regardless of the entity's preference.

Is a broker quote a Level 1 or Level 2 input?

It depends. A broker quote for an instrument actively traded on an exchange where the broker simply passes through the exchange price is effectively Level 1. A broker quote that represents the broker's own estimate for an instrument not actively traded, based on model-derived pricing, is Level 2 or Level 3 depending on the observability of the model inputs.

Does using the income approach (DCF) automatically mean Level 3?

No. A DCF model whose inputs are all derived from observable market data (benchmark rates, observable credit spreads, quoted forward prices) produces a Level 2 measurement. DCF with significant unobservable inputs (management growth projections, unobservable discount rates) is Level 3. The approach does not determine the level; the inputs do.

What happens if an entity cannot determine the fair value of a Level 3 asset?

For equity instruments at FVTPL, IFRS 9 provides a limited exception: if a range of fair values is large and the probabilities of various estimates cannot be reasonably assessed, cost may be an appropriate estimate of fair value. This exception is narrow and cannot be used simply because management finds valuation difficult.

How often do Level 3 measurements need to be updated?

Every reporting period, for assets and liabilities measured at fair value. The entity must assess whether the unobservable inputs remain appropriate at each measurement date, recalibrate the valuation technique if market conditions have changed, and update the Level 3 reconciliation.

Do Level 3 disclosures apply to fair value measurements disclosed in notes but not recognised on the balance sheet?

Yes, but with reduced requirements. IFRS 13 distinguishes between recurring fair value measurements (on the balance sheet each period) and non-recurring measurements (measured at fair value in specific circumstances, such as assets held for sale under IFRS 5). Non-recurring Level 3 measurements require disclosure of the valuation technique and inputs but not a full movement reconciliation.

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Enroll with Global Fin X

The fair value hierarchy appears in every area of IFRS where fair value is used: financial instruments (IFRS 9), investment property (IAS 40), business combinations (IFRS 3), biological assets (IAS 41), and impairment (IAS 36). Understanding where Indian instruments fall in the hierarchy and why is essential for the Dip IFRS exam and for any finance or audit role working with Indian listed entities. Our programme covers IFRS 13 across two posts with detailed lectures, worked examples, exam-style MCQs, and a dedicated LMS for working professionals.

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Faculty profile: www.globalfinx.in/manikanta

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This is Post 26 of the Global Fin X IFRS Series. Previous: IFRS 13: Definition, Scope and the Three Approaches. Next: Post 27: IFRS 16 Leases: What Goes on the Balance Sheet and Why.