There are 3 valuation approaches into which fair value inputs or assumptions are made. The inputs are classified as observable and non-observable. The fair value inputs are placed in a fair value hierarchy [ note that the valuation techniques are not put into a hierarchy, just the inputs to those techniques ].
Note About Different Level Of Fair Value Hierarchy:
(a) The inputs are prioritized into 3 levels – Level 1, 2 and 3.
Level 1 : Fair value inputs are quoted prices in active markets for identical assets or liabilities. Note the references to active markets and the need for identical items.
Level 2: Fair value inputs are inputs other than quoted market prices in level 1 that are observable for the asset or liability, either directly as prices or indirectly being derived from prices. These inputs are observable and may be inputs from information other than prices such as interest rate curves.
Adjustments may have to be made to these prices based on condition of the assets.
Level 3 : Fair value inputs are not based on observable market data. These are un-observable inputs. This information may sometimes be based on entity-specific data adjusted for factors concerning market participants.
(b) The fair value hierarchy gives the highest priority to quoted market prices in active markets for identical assets and liabilities [level 1] and lowest priority to un-observable inputs [level 3].
(c) The availability of inputs and their relative subjectivity affect the selection of the valuation technique in fair value hierarchy.
(d) The fair value measure is categorized in its entirety at the same level of the fair value hierarchy as the lowest level input that is significant to the entire fair value measurement.
Questions about whether prices determined using level 3 inputs should be called fair values are based on issues about
- the reliability of the fair value numbers
- the cost of generating such numbers
- the relevance and understandability of these numbers: will users of financial reports treat all fair values the same regardless of the level of inputs?
Past experience with entities such as Enron do not inspire confidence in the use of fair value numbers based on un-observable inputs. Whether disclosure about fair value hierarchy will assist to overcome these problems is an issue on which there is still ongoing debate. The standard-setters believe that disclosure will assist in the interpretation of the fair value numbers.