What it means
Many assets and liabilities, such as shares, bonds and derivatives, appear on a balance sheet at their fair value rather than their original cost. Before this standard, the rules for measuring fair value were scattered across many pronouncements.
FASB 157 brought them together and gave a single definition, which is now part of the US accounting codification as Topic 820. The definition focuses on an exit price.
Fair value is what you would receive if you sold the asset today, not what you paid for it and not what you hope to receive. This keeps the measure grounded in the market and not in the opinion of management.
The standard created a hierarchy of inputs. Level 1 inputs are quoted prices in active markets for identical items, such as the price of a listed share.
Level 2 inputs are other observable data, such as prices of similar assets or interest rate curves, and Level 3 inputs are unobservable and rely on the company's own assumptions. The higher the level number, the more judgement involved and the less certain the figure.
Level 3 valuations, for example of private investments or complex securities, are the most subjective and receive the most scrutiny from auditors and regulators. Companies must disclose how much of their fair-valued assets fall into each level.
The standard became especially prominent during the financial crisis, when markets for some securities froze and prices were hard to observe. Debates arose about whether firms should value assets at distressed market prices or at models of what they were worth over the long run.
The rules were clarified to say how to measure fair value when markets are not active, but the exit price principle remained. For readers of financial statements, the practical use is simple.
Check the notes for the split between levels and ask how much of the balance sheet depends on estimates. A company with a large Level 3 share is relying more on assumptions, and its reported value could change if those assumptions are wrong.
In practice
Real-world examples.
Example
A fund holds 100,000 shares of a listed company priced at $30 on an exchange. The holding is valued at $3,000,000 using the quoted price. This is a Level 1 measurement because the price is observable in an active market.
Example
A company owns a corporate bond that does not trade every day. The valuation team uses prices of similar bonds and the current yield curve to estimate its worth. This is a Level 2 measurement based on observable inputs.
Example
A venture capital fund values its stake in a young private company using a financial model and its own assumptions about growth and risk. No market price exists, so the measurement is Level 3. Auditors review the model carefully and the fund discloses the assumptions used.
Formula
Calculation
Level 3 share = Level 3 assets / total assets measured at fair value x 100
Suppose a company reports fair-valued assets of $5,000,000 in Level 1, $3,000,000 in Level 2 and $2,000,000 in Level 3. Total = 5,000,000 + 3,000,000 + 2,000,000 = $10,000,000. Level 3 share = 2,000,000 / 10,000,000 x 100 = 20%. This means one-fifth of the fair-valued assets rely on unobservable inputs and management estimates.Case study
Seen in the real world.
Harbour Point Insurance is an illustrative, fictional insurer with a $500,000,000 investment portfolio. In a calm market, 85% of the portfolio was in Level 1 and Level 2 assets, with a small amount in Level 3 private holdings.
When the market turned, trading in some mortgage-related securities stopped, and prices became hard to find. The finance team moved the valuation of $40,000,000 of those securities from Level 2 to Level 3 and disclosed the change and the assumptions used.
In this fictional story, the Level 3 share rose from 5% to 13% of the portfolio, and the auditor asked for extra evidence on the models. The lesson is that fair value figures can become more uncertain exactly when markets are stressed, and transparency about inputs is part of the answer.
Watch out
Common mistakes.
- Assuming that fair value is the same as cost or the price a company paid for an asset.
- Treating all fair values as equally reliable, when Level 3 figures rely on unobservable estimates.
- Using the old name only, when the standard is now part of the codification as Topic 820.
Questions
People also ask.
What is the fair value hierarchy?
It is a three-level ranking of the inputs used to measure fair value, from quoted market prices (Level 1) to unobservable estimates (Level 3).
What is meant by an exit price?
It is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction at the measurement date.
Does FASB 157 apply outside the United States?
It is a US standard, but international rules in IFRS 13 are broadly similar in approach.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related