ASC 820 Worked Examples: Leveling Real Assets Through the Fair Value Hierarchy
Three real-world assets, worked through the Level 1, Level 2, and Level 3 classification tests side by side.
Applying the Hierarchy to Three Real Assets
ASC 820’s fair value hierarchy is easy to state in the abstract — Level 1 quoted prices, Level 2 observable inputs, Level 3 unobservable inputs — but the classification only becomes intuitive after you’ve leveled a handful of real positions. This guide works through three assets that sit at different points on the hierarchy.
Example 1: Exchange-Traded Equity Security (Level 1)
Company X holds 10,000 shares of a NYSE-listed company. At the measurement date, the closing price is $42.15 per share.
Fair value = 10,000 × $42.15 = $421,500. Because this is a quoted price in an active market for an identical asset, with no adjustment made for the size of the holding (blockage discounts are explicitly prohibited by ASC 820 for instruments with a quoted price in an active market), this is a Level 1 measurement — the cleanest and least judgmental category in the hierarchy.
Example 2: Corporate Bond, Not Actively Traded (Level 2)
Company X also holds a corporate bond that does not trade frequently enough to have a reliable quoted price of its own. A pricing service provides a value based on quoted prices for similar bonds from the same issuer, adjusted for the specific bond’s coupon, maturity, and credit spread, using inputs that are all observable in the market (benchmark yield curves, credit default swap spreads for the issuer).
Because the valuation relies on inputs other than quoted prices that are directly or indirectly observable — quoted prices for similar instruments, market-corroborated yield curves — this is a Level 2 measurement. The key test: could a market participant substantially replicate this valuation using inputs anyone with market data access could observe? If yes, it’s Level 2, even though there’s no single quoted price for this exact bond.
Example 3: Privately Held Investment (Level 3)
Company X holds a minority equity stake in a private company with no observable market. Management values the stake using a discounted cash flow model built on internally forecasted revenue growth rates, an estimated discount rate built up from a risk-free rate plus company-specific risk premiums, and a terminal value multiple derived from limited comparable private transactions.
The significant inputs here — the growth forecast, the company-specific risk premium, the terminal multiple — are unobservable; they reflect management’s own assumptions about what market participants would use, not data pulled directly from the market. This is a Level 3 measurement, and it carries the heaviest disclosure burden: a reconciliation of beginning and ending balances, a description of the valuation technique and significant unobservable inputs, and quantitative sensitivity information (Part 5 of this series covers these disclosure requirements in full).
The Classification Test in One Sentence
Ask which inputs actually drive the value, not which inputs are merely used somewhere in the model. A Level 3 measurement can still use some observable inputs (a risk-free rate, for instance) — what pushes it to Level 3 is that at least one significant input is unobservable. Classification is determined by the lowest level input that is significant to the fair value measurement in its entirety.
A Common Trap: Transfers Between Levels
When a bond that was Level 2 stops trading in a way that supports observable pricing (say, the issuer’s credit deteriorates sharply and comparable quotes dry up), it may need to move to Level 3. ASC 820 requires disclosure of transfers between Level 1 and Level 2, and transfers into and out of Level 3, along with the reason for the transfer. Preparers should treat a leveling assessment as a recurring exercise each reporting period, not a one-time classification made when the asset was first acquired.
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