Fair Value Measurement: Level 1, 2 and 3 Inputs Explained (ASC 820)
By SimplyCPA · 24 October 2026
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- Definition: Fair value is an exit price — what you'd receive to sell an asset (or pay to transfer a liability) in an orderly transaction between market participants.
- Level 1: Unadjusted quoted prices for identical items in active markets.
- Level 2: Other observable inputs — quoted prices for similar items, inactive markets, interest rates, yield curves.
- Level 3: Unobservable inputs — the entity's own assumptions.
- Classification: A measurement takes the level of the lowest-level input that is significant to it.
What fair value means
Under ASC 820, fair value is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. Three words matter:
- Exit price — what you'd get selling, not what you paid buying.
- Market participants — the assumptions a typical buyer would make, not the company's own intentions.
- Orderly — not a forced or distressed sale.
The fair value hierarchy
| Level | Inputs | Examples |
|---|---|---|
| 1 | Unadjusted quoted prices for identical assets or liabilities in active markets | Shares listed on a major exchange |
| 2 | Observable inputs other than Level 1 prices | Quoted prices for similar assets; prices in inactive markets; interest rates, yield curves, credit spreads |
| 3 | Unobservable inputs reflecting the entity's own assumptions | A discounted cash flow valuation of a private company or a unique asset |
The level of a whole measurement is set by the lowest-level input that is significant to it. A valuation that mostly uses observable data but relies significantly on one unobservable input is Level 3. Level 3 measurements need the most disclosure.
Valuation approaches
- Market approach — prices of identical or comparable items.
- Income approach — converts future amounts to a present value (discounted cash flows, option pricing).
- Cost approach — the current replacement cost of the asset's service capacity.
For non-financial assets, fair value assumes the asset's highest and best use by market participants, even if the company uses it differently.
Principal market, most advantageous market, and the cost trap
Fair value is measured in the principal market — the one with the greatest volume of activity for the item. Only if there's no principal market do you use the most advantageous market: the one that maximises the net amount received.
- Transaction costs (such as broker commissions) are used to choose the most advantageous market, but are not deducted from fair value.
- Transport costs to get the asset to market are deducted from fair value.
An asset trades in two markets, and neither is the principal market.
Market A: price $30, transaction costs $3, transport $2 → net $25.
Market B: price $32, transaction costs $6, transport $2 → net $24.
Market A is most advantageous. Fair value = $30 − $2 transport = $28 (transaction costs aren't deducted).
Practice MCQ
A company values an interest rate swap using a model whose inputs are observable yield curves and credit spreads. Which level is the measurement?
(A) Level 1 (B) Level 2 (C) Level 3 (D) It isn't fair value
Answer: B. The inputs are observable but aren't quoted prices for the identical item.
Fair value appears throughout our FAR investments notes.