Corporate Financial Reporting · Fair Value Measurement (Ind AS 113)

Fair Value Hierarchy: Level 1, 2 and 3 Inputs

Updated 11 October 2026 · Fact-checked

The Ind AS 113 fair value hierarchy ranks the inputs to a valuation technique into three levels. Level 1 is unadjusted quoted prices in active markets for identical items. Level 2 is other observable inputs. Level 3 is unobservable inputs. To classify, find the lowest-level input that is significant to the whole measurement.

Understand Fair Value Hierarchy: Level 1, 2 and 3 Inputs

Fair value is estimated using inputs: prices, rates, volatilities, cash flow forecasts. Some inputs can be seen in the market. Others are your own estimates. Ind AS 113 ranks inputs by how reliable and comparable they are. It does this so users can judge how much to trust a fair value figure.

The hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1). It gives the lowest priority to unobservable inputs (Level 3). Level 2 sits between them.

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. Think of a listed share on NSE that trades daily and that you hold.

Level 2 inputs are inputs other than Level 1 quoted prices that are observable for the asset or liability, directly or indirectly. They include quoted prices for similar items in active markets, quoted prices for identical or similar items in markets that are not active, and inputs such as interest rates and yield curves at commonly quoted intervals, implied volatilities and credit spreads. They also include market-corroborated inputs. If the item has a specified (contractual) term, a Level 2 input must be observable for substantially the full term.

Level 3 inputs are unobservable inputs. Examples are a financial forecast for a cash-generating unit built on the entity's own data, or historical volatility used to price an option.

The whole measurement gets one level. If an observable input needs an adjustment using an unobservable input, and that adjustment is significant to the whole measurement, the result falls in Level 3. The level of the measurement is therefore set by the lowest-level input that is significant to it.

Key rules to remember

Level 1 input: Quoted price (unadjusted) + active market + identical item + accessible at measurement date; All four conditions must hold. Miss one and it is not Level 1.
Level 2 input: Observable, directly or indirectly, other than Level 1 quoted prices; Includes similar items in active markets, identical or similar items in inactive markets, interest rates, yield curves, implied volatilities, credit spreads and market-corroborated inputs. For a contractual term, it must be observable for substantially the full term.
Level 3 input: Unobservable inputs for the asset or liability; Used only to the extent relevant observable inputs are not available.
Level of the whole measurement: Level = lowest level of any input that is significant to the entire measurement; An observable input adjusted by a significant unobservable adjustment makes the measurement Level 3.
Adjustments to Level 1: No adjustment to a Level 1 input, except in three stated cases; The cases are a large number of similar items priced by matrix pricing, a quoted price that no longer represents fair value at the measurement date, and a liability or own equity instrument priced from the identical item held as an asset. An adjustment moves the measurement to a lower level. For the third case, no adjustment means Level 1.
Level 3 disclosure (recurring): Narrative sensitivity to unobservable inputs; for financial instruments, effect of reasonably possible alternative assumptions if significant; Significance is judged against profit or loss, total assets or total liabilities, or total equity when changes go through OCI.

How to solve Fair Value Hierarchy: Level 1, 2 and 3 Inputs questions

Use this method for any question that asks you to classify a fair value measurement or explain its level.

1List every input used in the valuation: prices, rates, volatilities, forecasts, adjustments.
2For each input, ask: is it a quoted price, unadjusted, in an active market, for an identical item the entity can access at the measurement date? If yes, it is Level 1.
3If not Level 1, ask whether it is observable directly or indirectly (similar items, inactive markets, yield curves, implied volatility, credit spreads, corroborated data). If yes, it is Level 2. Check that it is observable for substantially the full term if the item has a contractual term.
4If the input is the entity's own estimate and cannot be corroborated by market data, it is Level 3.
5Check for adjustments. Did you adjust a quoted price? Is the adjustment observable or unobservable, and is it significant to the whole measurement?
6Assign the whole measurement the lowest level of any significant input.
7State the reason in one sentence quoting the key words, such as 'unadjusted', 'active market', 'identical' or 'unobservable'.
8If asked, add the Level 3 disclosures: sensitivity narrative and the effect of alternative assumptions.

Quickest way: Three-question filter

When to use it: In the MCQ section, where you have about three minutes per question and need a fast, reliable classification.

Ask: unadjusted quote, active market, identical item? Yes means Level 1.
Otherwise ask: can the key input be seen or corroborated in the market? Yes means Level 2.
Otherwise it is Level 3: the input comes from the entity's own data or model assumptions.
Before you finalise, scan for an adjustment or a trap word such as 'adjusted', 'similar', 'not active', 'historical' or 'own forecast'.
If two inputs sit at different levels, pick the lower one, provided it is significant.

Common mistakes in Fair Value Hierarchy: Level 1, 2 and 3 Inputs

Calling a quoted price Level 1 when the market is not active.
Students see the word 'quoted' and stop reading.
Fix: A quoted price in a market that is not active is Level 2. Level 1 needs an active market and an identical item.
Treating Level 1 prices of similar shares as Level 1 for your own shares.
Similar looks identical at a glance.
Fix: Quoted prices for similar assets in active markets are Level 2. Only identical items qualify for Level 1.
Classifying the measurement by the highest-level input used.
Students assume one good observable input is enough.
Fix: Classify by the lowest-level input that is significant to the entire measurement. A significant unobservable input makes it Level 3.
Treating an adjusted Level 1 price as still Level 1.
The adjustment seems minor.
Fix: Except for a liability or own equity instrument priced from the identical asset with no adjustment, adjusting a Level 1 input results in a lower level. An adjustment for new information after market close, or the use of matrix pricing, also lowers the level.
Classifying historical volatility as Level 2.
Historical prices are observable, so the volatility looks observable.
Fix: Under the standard's example, historical volatility for pricing an option is Level 3. Implied volatility corroborated for the full term is Level 2.
Ignoring the full-term requirement for Level 2 inputs.
Students check only that a rate exists today.
Fix: For items with a contractual term, the input must be observable for substantially the full term. If the unobserved part is significant, the input is Level 3.

Worked examples

Example 1

Nirmal Industries Ltd holds 50,000 equity shares of Kaveri Ltd, which are listed on NSE and trade actively every day. The closing price on the reporting date is ₹240 per share. Nirmal uses this price without adjustment. It also holds an unlisted debenture of Sagar Ltd. Its value is derived from a yield curve observable at commonly quoted intervals for the full term, plus a credit spread observed for comparable debentures. Classify each measurement and compute the fair value of the Kaveri shares.

Show the solution

Kaveri shares: the price is quoted, unadjusted, in an active market, for an identical item that Nirmal can access at the reporting date. This is Level 1.
Fair value = 50,000 × ₹240 = ₹1,20,00,000.
Sagar debenture: there is no quoted price for the item itself. The yield curve is observable at commonly quoted intervals for the full term, and the credit spread is observed for comparable debentures. These are Level 2 inputs.
No significant unobservable input is used, so the whole measurement is Level 2.

Answer: Kaveri shares: Level 1, fair value ₹1,20,00,000. Sagar debenture: Level 2, because it is based on observable yield curve and credit spread inputs.

Example 2

Meghna Ltd measures a three-year option on exchange-traded shares. One-year and two-year option prices are observable. Case A: Meghna extrapolates implied volatility to year 3 and corroborates it with observable three-year implied volatility of comparable entities' shares. Case B: Meghna uses the shares' historical volatility from past prices. Separately, Meghna measures a quoted bond price (Level 2 input) and adjusts it for a sale restriction; the adjustment is unobservable and significant to the entire measurement. Classify all three.

Show the solution

Case A: implied volatility derived by extrapolation and corroborated by observable market data for substantially the full term is a Level 2 input. If no other significant input is unobservable, the measurement is Level 2.
Case B: historical volatility typically does not represent current market participants' expectations about future volatility. Under the standard's example, it is a Level 3 input. The measurement is Level 3.
Restricted bond: the starting price is Level 2, but the adjustment for the restriction is unobservable and significant to the entire measurement. The measurement is therefore categorised as Level 3.

Answer: Case A: Level 2. Case B: Level 3. Restricted bond: Level 3, because a significant unobservable adjustment is applied to a Level 2 price.

Exam tips

In MCQs, read for trap words: 'adjusted', 'similar', 'not active', 'historical', 'own forecast'. They decide the level.
Always give the reason in the words of the standard: 'unadjusted quoted price in an active market for identical items' for Level 1. Examiners award marks for the reason.
For case scenarios, classify each asset separately, then note that the level of the whole measurement follows the lowest significant input.
Learn the standard's examples: MIBOR swap rate and implied volatility are Level 2, while historical volatility, a long-dated currency swap rate that cannot be corroborated, and a cash-generating unit forecast from own data are Level 3.
If a question asks about disclosure, mention the Level 3 sensitivity narrative and the effect of reasonably possible alternative assumptions for financial instruments.

Practice questions from Fair Value Measurement (Ind AS 113)

Fair Value Hierarchy: Level 1, 2 and 3 Inputs in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CA FinalFair Value Hierarchy: Level 1, 2 and 3 Inputs

Fair Value Hierarchy: Level 1, 2 and 3 Inputs: frequently asked questions

What is the difference between Level 2 and Level 3 inputs?

Level 2 inputs are observable, directly or indirectly, such as yield curves, implied volatilities, credit spreads or prices of similar items. Level 3 inputs are unobservable and usually rest on the entity's own data. The test is whether market data can see or corroborate the input.

Can a quoted price ever be Level 2?

Yes. A quoted price for a similar item in an active market, or for an identical or similar item in a market that is not active, is Level 2. A Level 1 price that is adjusted, for example by matrix pricing or for events after market close, also falls to a lower level.

How do I decide the level when inputs come from different levels?

Use the lowest level of any input that is significant to the entire measurement. If an observable input is adjusted using a significant unobservable input, the measurement is Level 3.

Is an unlisted equity investment always Level 3?

No rule says that. The level depends on the inputs. If the valuation relies on observable market data, such as multiples from comparable listed companies, it may be Level 2. If significant inputs are your own forecasts or unobservable adjustments, it is Level 3.