Fair Value Hierarchy (Level 1, 2 and 3)
Why two investments on the same balance sheet, both labelled 'fair value', can carry wildly different levels of confidence — one priced off a stock ticker updated every second, the other based on a spreadsheet model nobody outside the company can fully verify.
In plain English
Imagine a company's balance sheet shows two investments, both labelled at their 'fair value' of ₹100 crore each. The first is a stake in a large, actively-traded listed company — its value comes directly from the stock exchange's closing price, a number nobody can seriously dispute. The second is a stake in a private startup with no public market at all — its ₹100 crore value comes from an internal valuation model, built on assumptions about future growth and comparable company multiples, none of which can be checked against a real, observable market price. Both show up as '₹100 crore, at fair value' on the balance sheet — but any serious reader of the accounts should treat these two numbers very differently. The Fair Value Hierarchy exists specifically to flag that difference.
Words you'll need first
The most reliable tier: the fair value comes directly from a quoted price in an active market for an identical asset — a listed share's closing price on the NSE or BSE, for instance. There's no modelling, no estimation, no judgement involved; it's simply the price the market itself set that day, for exactly this asset.
The least reliable tier: the fair value is built substantially from the company's OWN assumptions and models, because no observable market price or comparable data exists at all — a stake in an unlisted startup, or a complex structured financial product, are typical examples. Ind AS 113 requires extensive additional disclosure for Level 3 assets specifically because of this inherent uncertainty, including sensitivity analysis showing how the valuation would change under different assumptions.
Level 2 sits in between
Level 1 (most reliable)
Quoted prices for identical assets in active markets — listed shares, actively-traded government bonds. High confidence, essentially no room for management judgement to influence the number.
Level 3 (least reliable)
Valuations built substantially on the company's own unobservable assumptions — private company stakes, some real estate, complex derivatives without an active market. Genuine estimation is unavoidable, and different, equally reasonable analysts could arrive at meaningfully different values for the same asset.
A worked example, with numbers
| Asset | Fair value (₹ crore) | Hierarchy level | Valued using |
|---|---|---|---|
| Listed equity shares | 500 | Level 1 | NSE closing price |
| Corporate bonds (not actively traded) | 300 | Level 2 | Comparable bond yields |
| Unlisted startup investments | 150 | Level 3 | Internal valuation model |
| Total investment portfolio | 950 | — | — |
- All ₹950 crore is reported identically as 'Investments, at fair value' on the face of the balance sheet — the Level 1/2/3 distinction only becomes visible in the notes, which is exactly why reading past the balance sheet's face value into the fair value hierarchy note matters.
- The ₹500 crore Level 1 portion can be verified independently by anyone in seconds, simply by checking the stock exchange; the ₹150 crore Level 3 portion cannot be independently verified at all without access to the company's own valuation model.
- If that Level 3 valuation model's key assumption were revised even modestly, the reported ₹150 crore could easily move by a meaningful amount — this sensitivity is exactly why Ind AS 113 requires disclosure of how the Level 3 valuation would change under different reasonable assumptions.
- A company with a rising proportion of Level 3 assets in its total portfolio is carrying more genuine valuation uncertainty than the same total rupee figure would suggest for a portfolio weighted toward Level 1.
What it does to the financial statements
Impact on the P&L
- Changes in the fair value of investments generally flow through either the P&L or Other Comprehensive Income each period, depending on how the specific investment is classified under Ind AS 109 — meaning fair value MOVEMENTS, not just the balance sheet figure, can meaningfully affect reported profit.
- Level 3 fair value changes are inherently more judgement-driven than Level 1 changes, since they depend on revising the company's own model assumptions rather than simply reading a new market price.
- A company reporting large, favourable Level 3 fair value gains deserves particular scrutiny of the assumptions behind them, since a Level 3 gain reflects a choice about how to value something nobody else can independently price.
- Transfers of an asset between hierarchy levels (say, an investment that used to be Level 3 becoming Level 1 after an IPO) are separately disclosed, since they signal a genuine change in how reliably that asset's value can now be verified.
Impact on the Balance Sheet
- The fair value hierarchy itself doesn't change what value is reported on the balance sheet — Level 1, 2, and 3 assets are all shown at their respective fair values identically — it only changes the CONFIDENCE a reader should place in that number.
- A company's total 'Investments' line can look identically sized to a peer's, while carrying a very different underlying risk profile if one company's balance is concentrated in Level 3 and the other's in Level 1.
- For companies holding meaningful private equity or other unlisted stakes, the Level 3 portion of the balance sheet often represents the single largest source of genuine valuation uncertainty in the entire set of financial statements.
- Auditors apply extra scrutiny to Level 3 valuations specifically because of this inherent unverifiability, often requiring independent valuation experts to review these estimates.
Which standard covers this
In India this is governed by Ind AS 113 – Fair Value Measurement, notified under the Companies (Indian Accounting Standards) Rules and applicable to companies that follow Ind AS, providing a single, unified framework for how 'fair value' should be measured and disclosed wherever it's used across other standards, including Ind AS 109 for financial instruments.
How it's recognised globally
Globally, the equivalent is IFRS 13, and Ind AS 113 mirrors its Level 1/2/3 hierarchy and disclosure requirements closely. Under US GAAP, equivalent guidance sits in ASC 820, which actually pioneered this exact three-level hierarchy concept before IFRS adopted a closely aligned version — this is one of the more genuinely globally converged areas of accounting, since the underlying logic doesn't leave much room for a fundamentally different national approach. Minor differences remain in some detailed disclosure requirements, but the core three-tier hierarchy and its philosophy are essentially identical across Indian, IFRS and US GAAP reporting.
Real example — Indian listed company
Info Edge is a particularly instructive Indian example of the fair value hierarchy in practice, given how much of its balance sheet consists of strategic minority investments across a range of internet and technology businesses at different stages of maturity. Its listed holdings — most notably its remaining stake in Zomato/Eternal, covered in the Associates & Joint Ventures article — sit at the more observable end of the spectrum once the investee is publicly listed and actively traded. But Info Edge has also historically held numerous earlier-stage, unlisted startup investments across its portfolio, which, for as long as they remain private, fall into Level 3: valued using internal models and assumptions about growth prospects and comparable private-market transactions, rather than any observable, independently-verifiable market price. As individual portfolio companies progress from early-stage private investments toward eventual public listings, a share of Info Edge's own balance sheet effectively migrates from Level 3 toward Level 1 over time — a genuinely useful, real illustration of exactly the kind of level transfer this article describes.
Where you'll see this
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