Fair value measurements are categorized in their entirety based on the lowest level input that is significant to the entire fair value measurement. This is summarized in the following diagram. [IFRS 13 72–73]
The level into which a fair value measurement is categorized in its entirety is determined with reference to the observability and significance of the inputs used in the valuation technique.
Level 1 inputs: categorization into Level 1 can only be achieved through using a quoted price in an active market for an identical asset or liability, without adjustment. [IFRS 13.73–74, IFRS 13 76, IFRS 13 81, IFRS 13 86, IFRS 13 Definitions]
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable:
- either directly available (that is, as prices), or
- indirectly (that is, adjusted from quoted (Level 1) or directly available (comparable cases) (Level2) prices);
Level 3 inputs are inputs that are based on unobservable inputs.
Significance of an input
If fair value is measured using inputs from multiple levels of the fair value hierarchy, the inclusion of a lower level input in an entity’s measurement may indicate that the input is significant. This is because the entity’s decision to include the lower level input provides evidence that it considers the input to be significant to the overall measurement of fair value. [IFRS 13 73–74]
However, the final determination of whether inputs are significant is a matter of judgment that requires an entity to consider:
- factors specific to the asset or liability; and
- the importance of the input to the overall fair value measurement, including the quantitative effect of the input on the overall fair value measurement and possible alternative assumptions for the input. [IFRS 13 73]
If multiple unobservable inputs are used, in our view the unobservable inputs should be considered individually and in total for the purpose of determining their significance. For example, it would not be appropriate to categorize in Level 2 a fair value measurement that has multiple Level 3 inputs that are individually significant to that measurement but whose effects happen to offset. If factors such as volatility inputs are used, an entity could apply some form of comparability methodology (e.g. a stress test of the sensitivity of the fair value estimate to an option’s volatility input or a with and without comparison to assist in determining significance).
Hierarchy classification particulars
Following are some particular situations on the classification into level 1, 2 or 3 input levels:
Publicly traded equity investment subject to security-specific restriction(s)
Generally, Level 2 or Level 3. For securities that, absent the security-specific restriction, are publicly traded in an active market (i.e. the observed price is a Level 1 input for the unrestricted security), an entity adjusts the publicly available price for the effects of the restriction to arrive at the fair value of the restricted security. Any such adjustments will cause the overall fair value measurement to be categorized as a Level 2 or Level 3 measurement. [IFRS 13 75]
Although the overall fair value measurement will be a Level 2 or Level 3 measurement, further adjustments to the publicly traded price are generally not appropriate. [IFRS 13 79]
Publicly traded equity investments held indirectly through an intermediate entity
It depends. The categorization of an asset or liability in the fair value hierarchy is based on the lowest level input that significantly affects the fair value measurement in its entirety. A reporting entity first determines the unit of account prescribed by the Topic/Subtopic that applies to the intermediate entity and the publicly traded equity investments held indirectly. Generally, we expect that a direct investment in an intermediate entity will represent the unit of account being measured at fair value, instead of investments held indirectly by the intermediate entity. [IFRS 13 14, IFRS 13 73]
In instances where the sole purpose of the intermediate entity is to hold the publicly traded equity investments, the fair value of the investment in the intermediate entity may be determined by adjusting the fair value of the publicly traded equity investments for the effects of risks (e.g. liquidity risk) of the intermediate entity.
Regardless of whether adjustments were applied to the fair value of the publicly traded equity investments, when the intermediate entity is the unit of account being measured, the investment in the intermediate entity is not an identical asset to the publicly traded equity investments. Therefore, assuming that the intermediate entity is not listed, it would not be appropriate to categorize the investment in Level 1 of the hierarchy.
The intermediate entity may hold assets and/or liabilities in addition to its investments in the publicly traded equity investments. In this case, the categorization of the investments in Level 2 or Level 3 of the hierarchy will depend on whether significant unobservable inputs were used to value these assets and/or liabilities.
In instances where the intermediate entity is consolidated by the reporting entity, the publicly traded equity investments (the individual shares) held by the intermediate entity become the unit of account of the consolidated reporting entity. If the publicly traded equity investments have a quoted price in an active market for the identical asset, then the equity investments are categorized in Level 1 of the hierarchy. If the market for the publicly traded equity investments is not active, then the investments are categorized in Level 2 or 3 of the hierarchy.
In certain instances, the intermediate entity may be an investment company in which the fair value of the investment is estimated using the net asset value as a practical expedient. In these instances, the fair value is not categorized in the hierarchy.
Equity investment in a privately held company
Generally, the fair value measurement of an equity investment in a privately held company is a Level 3 input.
The categorization of an asset or liability in the fair value hierarchy should be based on the lowest level input that significantly affects the fair value measurement in its entirety. To determine an investment’s categorization in the hierarchy, an entity should consider the technique used to value the investment as well as the inputs to the measurement. Usually, there are no current observable prices for shares in private companies and accordingly, the measurement of fair value is based on valuation techniques that use unobservable inputs. [IFRS 13 73–74]
For example, one common technique for valuing equity securities using the market approach is basing the measurement on multiples of income statement amounts (e.g. EBITDA, net income, revenue) for similar companies. For this technique, the multiples used in the fair value measurement should, if available and applicable, be calculated based on publicly available market information for similar companies that have actively traded equity securities. [IFRS 13 B5–B6]
However, although market information should be used if available and relevant, the overall fair value measurement of the equity securities measured using this technique generally will be a Level 3 measurement because the other inputs into the measurement technique (e.g. entity-specific income statement amounts, comparability adjustments) are not observable. [IFRS 13.73]
One of the other inputs that needs to be considered is a discount for the nonmarketable nature of the unquoted equity investment being measured, as compared with equity instruments of the similar companies that are publicly traded and, therefore, likely to be more liquid. An adjustment to reflect the non-marketable nature of the investment generally will result in a fair value measurement categorized as a Level 3 measurement. [IFRS 13 69]