Fair Value Hierarchy under Ind AS 113: Level 1, Level 2 and Level 3

The fair value hierarchy classifies measurements based on observability of inputs, not on whether a valuation model is simple or complex. Level 1 uses unadjusted quoted prices in active markets for identical items, Level 2 uses other observable inputs, and Level 3 relies significantly on unobservable inputs. In practice, the accounting works best when commercial facts are separated from the technical assessment and every significant judgement can be traced to source evidence. Incorrect hierarchy classification can mislead users about valuation uncertainty. A robust approach connects commercial substance, the Ind AS 113 decision criteria, measurement evidence and presentation consequences in one coherent file.

Apply Level 1 narrowly

The accounting logic. Level 1 requires an unadjusted quoted price in an active market for an identical asset or liability accessible at measurement date. Operationally, entities should verify identity, market activity and accessibility before using the highest hierarchy level. The main judgement risk is calling a broker quote for a similar instrument Level 1. Evidence should be retained at the same level of detail as the accounting conclusion, with assumptions version-controlled and exceptions explicitly approved.

Identify observable Level 2 inputs

The decision point. Level 2 can include quoted prices for similar items, observable yield curves, implied volatilities, credit spreads and market-corroborated inputs. For implementation, valuation files should show source and observability window of each material input. Where errors often arise is classifying a model Level 2 merely because some inputs come from a data vendor. The accounting result should reconcile to the underlying contract, valuation or subledger rather than rely on a standalone spreadsheet conclusion.

Recognise significant Level 3 inputs

The core requirement. A measurement falls within Level 3 when significant inputs are unobservable, even if many other inputs are observable. In a controlled close process, the entire measurement is categorised based on the lowest-level input significant to the measurement. A common weakness is splitting one measurement across hierarchy levels to make disclosure appear more observable. The working paper should identify the relevant facts, source data, judgement and conclusion so that an independent reviewer can reproduce the decision.

Assess market activity and adjustments

The principle. A quoted price from an inactive market or a quote requiring significant unobservable adjustment may not retain Level 1 or Level 2 status. For a review-ready file, liquidity and price-verification processes should assess whether market evidence remains observable. The risk to avoid is keeping Level 1 classification after trading activity has collapsed. Where the conclusion is sensitive to a contractual clause or estimate, the file should show the alternative outcome and why the selected treatment is more appropriate.

Track transfers between levels

The technical anchor. Transfers should be governed by a consistent policy for determining when events or changes in circumstances are deemed to have occurred. In application, hierarchy status should be reviewed at each reporting date with reasons documented. A frequent failure mode is changing levels with no trigger analysis or inconsistent transfer dates. A concise review note should state the trigger, the rule applied, the evidence considered and the financial-statement consequence.

Practical illustration

Assume a corporate bond is valued using an observable government yield curve plus an observable sector spread but requires a significant entity-specific liquidity adjustment derived from internal estimates. Even though most inputs are observable, the significant unobservable adjustment can make the overall measurement Level 3. The illustration is deliberately simplified: its purpose is to show how the accounting conclusion follows the underlying facts rather than to prescribe a single mechanical answer for every entity. Before posting an entry, the preparer should reconcile contractual terms, management's commercial intent, relevant estimates and system data to the specific accounting requirement. Where the outcome is sensitive, the file should show the key judgement and explain why the selected assumption is reasonable at the reporting date.

Documentation and control points

Professional application depends as much on process quality as technical knowledge. For this topic, a minimum control set should cover market activity test; input observability map; significance assessment; hierarchy approval; and transfer log. Ownership should be clear between the business, finance and any legal, tax, valuation, credit-risk or other specialists whose evidence is required. Source data should be dated and version-controlled; manual adjustments should show preparer, reviewer, rationale and approval. The final accounting memorandum should connect the conclusion to the general ledger or relevant subledger, presentation and disclosures. If facts or estimates change, the entity should reassess the conclusion when required and preserve an audit trail explaining the change.

Closing perspective

The hierarchy tells users how much of a valuation is grounded in observable market evidence; it should follow the inputs that actually drive the result. The most useful way to apply Ind AS 113 is to treat the requirement as a decision framework rather than a compliance slogan. When the facts, accounting criteria, measurement evidence, controls and disclosure implications are considered together, the result is more consistent across reporting periods and easier to explain to management, auditors and users of the financial statements.