Fair Value Hierarchy

The fair value hierarchy is defined in US GAAP (ASC 820) and IFRS (IFRS 13). Level 1 inputs are unadjusted quoted prices in active markets for identical assets, such as listed equities. Level 2 inputs are observable but not Level 1, such as quoted prices for similar assets or model inputs like yield curves. Level 3 inputs are unobservable and rely on the entity’s own assumptions, as for many private equity, private credit and real estate holdings.

Fund financial statements disclose investments by level, and Level 3 positions require additional disclosure, including valuation techniques, significant unobservable inputs and a reconciliation of movements during the period. Auditors typically focus most attention on Level 3.

Pitfalls include classifying positions based on asset type rather than the actual inputs used, not reassessing levels when market activity changes, and weak documentation for Level 3 assumptions. The operational pricing hierarchy should produce evidence that supports each classification.