IFRS 13 defines Level 1 inputs as quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date; while Level 2 inputs are defined as inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. [IFRS 13 App A]. Both definitions consider observable inputs in different ways, and the table below summarises such differences.
- The price must be for an asset or liability that is identical to the asset or liability being measured.
- The price must be unadjusted1.
- The price must be quoted in active markets.
- The entity must have access to the market at the measurement date.
- The price can be for an asset or liability that is similar to the asset or liability being measured if it is a quoted price.
- The price can be adjusted2.
- The price can be quoted in inactive markets.
- The price does not need to be directly observable, but it must be corroborated by observable market data.
1 Any adjustment to a Level 1 input results in a fair value measurement categorised within a lower level of the fair value hierarchy.
2 If the adjustment is significant to the entire fair value measurement, the whole fair value measurement would fall in Level 3 category (see section (ii) Adjustments to inputs below and Q&A 5).
i. Identical vs. similar assets or liabilities
In order to be categorised as Level 1, the price must be for an asset or liability that is identical to the asset or liability being measured. One example is when the asset is a share actively traded on a stock exchange – the quoted price is for an identical asset, so it would be categorised as Level 1.
When the price for an identical asset or liability is not available, an entity can use a quoted price for an asset or liability that is similar to the asset or liability being measured. As a result, the input would be classified as Level 2 within the fair value hierarchy.
In these situations, assets or liabilities being compared should be similar enough in order to provide an appropriate starting point for the fair value measurement. It is important to understand the characteristics of the asset or liability being measured when compared to the item being used as a benchmark. Differences between the items can affect the fair value, and adjustments might be required in order to reflect such differences. However, if a Level 2 input requires an adjustment which is unobservable and significant to the entire fair value measurement, the measurement would be categorised within Level 3 of the fair value hierarchy.
Adjustments to observable inputs are dealt with in section (ii) below. Level 3 fair value measurements are covered in Q&A 5.
Example of identical financial assets
An entity bought American Depositary Receipts (ADRs) of a Brazilian bank, Itau, on the New York Stock Exchange (NYSE). Itau’s ADRs are identified by the code ‘ITUB’ on NYSE (each ADR traded on NYSE is identified by a unique code). At the closing date, the entity obtains available prices published by NYSE, and the price under the code ‘ITUB’ represents the fair value for that specific financial asset. Such a price meets the definition of a Level 1 input.
Example of similar non-financial assets
An entity owns a property located in the centre of London which it measures at fair value. At the reporting date, the entity obtains price per square metre information derived from observed transactions involving comparable properties. The comparable properties are similar assets, but not identical. The price per square metre is therefore a Level 2 input. Further adjustments to reflect differences in physical conditions and location of the properties are likely to be needed, which would normally result in the classification of the entire measurement as Level 3. See section (ii) below for further information on adjustments to observable inputs.
See also Q&A 5 and 6 for further information on the categorisation within the fair value hierarchy of investment property fair value measurements.
ii. Adjustments to inputs
Any adjustment to a Level 1 input results in a fair value measurement categorised within a lower level of the fair value hierarchy. [IFRS 13 para 79].
A price must be unadjusted in order to be categorised as Level 1. For example, financial instruments traded on active markets are categorised as Level 1 when no adjustments are made to the publicly available prices.
However, as discussed in section (i) above, Level 2 inputs consider prices for items that are similar (but not identical) to those being measured. Therefore, an entity should consider which adjustments to a price for a similar asset or liability are necessary to reflect the differences between the items being compared. Adjustments to Level 2 inputs might vary depending on factors specific to each asset or liability. Those factors include the following:
- the condition or location of the asset (for example, adjustments to price per square metre data in order to reflect differences in the location and physical conditions of properties); and
- the level of activity in the markets within which the inputs are observable (see section (iii) for adjustments to prices traded on inactive markets).
Please note that, if a Level 2 input requires an adjustment which is unobservable and significant to the entire fair value measurement, the measurement would be categorised within Level 3 of the fair value hierarchy. Q&A 5 deals with situations where an unobservable input is significant enough to make the whole fair value measurement Level 3.
Example of adjustments to observable inputs: non-financial assets
An entity owns an office building which is classified as investment property and is measured at fair value. Some similar properties in close proximity have been traded during the year, providing a reasonable starting point in order to determine the fair value of the building owned by the entity. Management concluded that the average price per square metre should be adjusted to reflect differences in physical characteristics (for example, location, physical conditions and size). The judgement as to whether such adjustments are significant or not will drive the conclusion on whether the whole fair value measurement should be categorised in Level 2 or Level 3 (see Q&A 5 for further information on how to assess whether an unobservable input is significant enough to make the whole fair value measurement Level 3).
Example of adjustments to observable inputs: financial instruments
An entity uses discounted cash flow analysis to measure the fair value of a cross-currency interest rate swap (CCIRS). Management determines the appropriate discount rate based on yield curves observed at commonly quoted intervals, which meets the definition of a Level 2 input (see section (iv) below). At the reporting date, the CCIRS is in a liability position (assume that there are no significant credit enhancements related to the CCIRS).
Management must take into account credit risk when measuring the fair value of financial instruments, including derivatives in liability position. [IFRS 13 para 42]. However, public information on the entity’s own credit risk (for example, credit default swaps, bond spreads, external ratings and other comparable instruments) is not available. Therefore, management uses internal assumptions in order to determine its own credit spread, which meets the definition of a Level 3 input.
The computation of the discount rate included two variables: yield curves, which are observed at commonly quoted intervals (Level 2); and the entity’s own credit risk (Level 3). The judgement as to whether the entity’s own credit spread is a significant input will drive the conclusion on whether the whole fair value measurement should be categorised within Level 2 or Level 3. See Q&A 5 for further information on how to assess whether an unobservable input is significant enough to make the whole fair value measurement Level 3.
iii. Active vs. inactive market
A price must be quoted in active markets in order to be categorised as Level 1 within the fair value hierarchy. An active market is defined as a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis. [IFRS 13 App A].
When the price is quoted in a market that is not active, quoted prices might not be indicative of fair value, because they could include transactions that are not orderly (for example, forced liquidations or distress sales). Some common indicators of inactive markets include low volume of recent transactions and when price quotations are not based on current information. In this situation, the price should be adjusted in order to reflect the assumptions that market participants would use in pricing an asset or liability in an orderly transaction at the reporting date.
Example of prices quoted in inactive markets
An entity holds a 1% equity interest in a public company. The equity interest is classified as available for sale. The volume of trading for this equity instrument on the stock exchange was relatively low during the reporting period (for example, there were only a few widely dispersed transactions during the year). There is a wide bid-ask spread, and price quotations vary substantially among market-makers. The most recent trade happened two months before the closing date. Management has concluded that the effects due to passage of time over the last months are not significant and uses the available quoted price as the best estimation for the fair value of the non-controlling equity interest at the closing date.
Because the information relates to a quoted price in an inactive market, the price does not meet the definition of Level 1 input.
iv. Access to the market at the measurement date and observability
Under IFRS 13, management determines fair value based on a transaction that would take place in the principal market or, in its absence, the most advantageous market. The principal market is the market with the greatest volume and level of activity for the asset or liability.
An entity must have access to the market at the measurement date in order to categorise the measurement as Level 1 within the fair value hierarchy. An entity would have access to the market if: a) it has the ability to transact at that quoted price in an exchange market; or b) there are dealers standing ready to transact with the entity at that price.
The definition of Level 2 inputs includes inputs that are not directly observable but are corroborated by market data. Such market-corroborated inputs could be determined through mathematical or statistical techniques, such as correlation and interpolation. IFRS 13 does not provide specific guidance on the application of such techniques.
Example of access to a market at the measurement date
A commodities trader holds commodity X for which it has access to a wholesale market. The retail and wholesale markets have similar volume and level of activity for the commodity. However, the retail market selling prices are usually higher. The commodities trader cannot use the higher retail price as the fair value of commodity X, because the commodities trader cannot access the retail market.
Example of input corroborated by observable market data
An entity entered into a two-year interest rate swap (IRS). The IRS pays LIBOR + 1% and receives 5%. At the reporting date, the fair value of the IRS is positive and the counterparty’s credit risk is considered insignificant (assume significant amount deposited as collateral and high-quality credit risk of the counterparty). The IRS is not exchange traded and there are no other transaction prices available, so management uses discounted cash flow analysis to measure fair value. The contractual cash flows of the IRS are discounted at rates provided by a yield curve observed at commonly quoted intervals.
The yield curve is built based on yields on instruments linked to LIBOR, such as future contracts traded on an active market. Future contracts have standardised maturity dates (for example, the first working day of each month). Because future contracts are limited to specific maturities, an interpolation methodology must be applied in order to find the market rate for all other maturities. For example, in the case of two future contracts expiring on 1 October 20X1 and 1 November 20X1, an interpolation methodology would need to be applied in order to determine the market rates for all dates between 1 October 20X1 and 1 November 20X1.
As the intervals of the yield curve can be corroborated by observable market data (in this example, future contracts quoted on active markets are the market evidence), such inputs meet the definition of Level 2 input.