Fair Value Hierarchy Level 1, Level 2, Level 3. Fair Value Accounting

In this video, I explain fair value hierarchy level 1, 2 and 3 when it comes to fair value accounting.
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In the context of fair value measurement, Level I, Level II, and Level III refer to the hierarchy of inputs used to determine the fair value of assets and liabilities. This hierarchy prioritizes the use of observable inputs by requiring that the most reliable and relevant inputs be used when available.
Level I Inputs:
These are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
Examples include stock prices from a public exchange (like the NYSE or NASDAQ) where the stock is frequently traded.
These are considered the most reliable and transparent valuations since they are directly observable.
Level II Inputs:
These are inputs other than quoted prices included within Level I that are observable for the asset or liability, either directly or indirectly.
They often include:
Quoted prices for similar assets or liabilities in active markets.
Quoted prices for identical or similar assets or liabilities in markets that are not active.
Inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates, yield curves, volatility measures, etc.)
These are used when Level I inputs are not available.
Level III Inputs:
These are unobservable inputs for the asset or liability.
They reflect an entity's own assumptions about what market participants would use to price the asset or liability.
These might be used when there's little to no market activity for the asset or liability at the measurement date.
Examples include certain private equity investments, complex derivatives, or real estate assets in illiquid markets.
Since Level III inputs are based on unobservable data, they are considered the least reliable and involve the most judgment.
In practice, when determining the fair value of an asset or liability, an entity would ideally use Level I inputs when available. If Level I inputs are not available, the entity would then consider Level II inputs. Level III inputs would be used when neither Level I nor Level II inputs can be used. The goal is to achieve the most accurate and objective fair value measurement possible, so the hierarchy is designed to prioritize more observable and less subjective inputs.
In the context of fair value accounting, the "principal market" refers to the market with the greatest volume and level of activity for an asset or liability. When determining the fair value of an asset or liability, the price in the principal market is prioritized because it's considered to represent the most accurate and reliable valuation.
Here's a breakdown:
Principal Market: This is the market with the most volume and activity for the asset or liability in question. It's the first place entities look when determining fair value. If an entity can access the principal market, the price in that market is the fair value, regardless of prices in any other market.
Most Advantageous Market: If the principal market isn't accessible to the entity, or if there isn't a principal market, the entity would then look to the "most advantageous market." This is the market that maximizes the amount that would be received for the asset (or minimizes the amount that would be paid for the liability) after considering transaction costs.
Access to the Market: It's important to note that an entity must have access to a market on the measurement date to use the prices from that market. Just because a market exists doesn't mean the entity can use prices from it if the entity can't access the market.
The idea behind using the principal market (or if not available, the most advantageous market) is to get a fair value measurement that represents an orderly transaction between market participants at the measurement date under current market conditions.
The concept of the principal market and the guidelines for determining fair value are defined in accounting standards like the Financial Accounting Standards Board's (FASB) Accounting Standards Codification (ASC) Topic 820, "Fair Value Measurement."
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[@salahmaleknakhla3026]

Thanks a lot for valuable information ❤

[@AccountingLectures]

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[@mahekbadlani]

Very informative lecture.......really needed that ....😊

[@AccountingLectures]

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