When does a fair value measurement fall into Level 3?

Question

AcadiFi · Accepted Answer

Level 3 applies when fair value is measured using significant unobservable inputs — inputs for which market data is unavailable, so the entity must develop them using the best information available, including its own data. A measurement is classified at the lowest level of input that is SIGNIFICANT to the entire measurement. So yes: one significant Level 3 input pushes the whole thing to Level 3.

Worked example: Nebula Growth Capital holds a preferred equity stake in Kairos Biogenics, a pre-revenue private biotech. Valuation uses (a) observable comparable company EV/R&D multiples — Level 2 inputs, and (b) an unobservable probability-of-FDA-approval assumption of 22% applied to a hypothetical $640M terminal value — Level 3. Because the approval probability materially drives the $18M carrying value, the entire position is Level 3.

Common Level 3 inputs: private company DCF growth rates, illiquid PE fund NAV, complex structured note prepayment assumptions, own-credit-risk adjustments for exotic derivatives, bespoke option volatility for unlisted equity.

Required disclosures under IFRS 13 / ASC 820 for Level 3: (1) reconciliation of opening to closing balances including unrealized gains/losses in P&L and OCI, (2) quantitative disclosure of significant unobservable inputs, (3) sensitivity analysis showing effect of reasonably possible alternative inputs, (4) description of valuation process and governance.

Exam tip: auditors and CFA exam both emphasize that Level 3 classification requires enhanced disclosure — a frequent tested concept.

When does a fair value measurement fall into Level 3?

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