Key Points
- Level 3 measurements rely on unobservable inputs such as entity-specific growth rates and discount rates that cannot be corroborated against active market data.
- IFRS 13.93 (d) requires quantitative disclosure of every significant unobservable input used in a Level 3 measurement.
- Auditors typically spend two to four times more hours on a Level 3 valuation than on a Level 1 or Level 2 item of comparable size.
- Misclassifying a Level 3 measurement as Level 2 understates the required disclosures and conceals estimation uncertainty from financial statement users.
What is fair value hierarchy: Level 3?
The FRC's 2023 thematic review of fair value disclosures found insufficient granularity in Level 3 reporting as a recurring finding across mid-tier files. Level 3 is where fair value auditing gets uncomfortable: the inputs are unobservable and management builds the assumptions internally. The file should tell a story that a reviewer can follow from input selection through to the point estimate.
IFRS 13.86 defines Level 3 inputs as unobservable inputs for the asset or liability. The entity uses these when observable market data is not available, and IFRS 13.89 requires that unobservable inputs reflect the assumptions market participants would use when pricing the asset or liability, including assumptions about risk. That last phrase is the audit pressure point: management must adopt a market-participant perspective, not an entity-specific one, even though the inputs themselves are generated internally.
In practice, Level 3 measurements concentrate in unlisted equity investments, investment property in illiquid markets, contingent consideration from business combinations, and intangible assets acquired in a purchase price allocation. ISA 540.18 requires the auditor to evaluate management's point estimate by assessing the valuation technique, the significant assumptions, the data used, and the consistency of application. For Level 3, this typically means engaging a valuation specialist and testing the sensitivity of the output to changes in key inputs. IFRS 13.93 (h) adds a requirement that the entity disclose a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs, together with the interrelationships between those inputs where relevant.
Worked example: Rossi Alimentari S.p.A.
Client: Italian food production group, FY2025, revenue EUR 67M, IFRS reporter. In March 2024, Rossi acquired 100% of a regional olive oil brand for EUR 4,200,000. The purchase price allocation identified a customer-relationships intangible asset. At 31 December 2025, Rossi must remeasure the contingent consideration payable to the seller, which depends on the brand's FY2026 revenue exceeding EUR 6,000,000.
Step 1 — Identify the measurement and its hierarchy level
The contingent consideration is a financial liability measured at fair value through profit or loss under IFRS 9 . No quoted price exists for the instrument. No observable market inputs (yield curves or credit spreads for identical obligations) are available because the payment depends on the acquired brand's future revenue. The measurement falls within Level 3.
Step 2 — Select the valuation technique and key inputs
Rossi's finance team applies a probability-weighted expected-value approach under IFRS 13.62 (income approach). Management identifies two scenarios. Scenario A (revenue exceeds EUR 6,000,000, probability 70%): payment of EUR 800,000 due in April 2027. Scenario B (revenue falls short, probability 30%): no payment. The discount rate is 6.5%, derived from the entity's incremental borrowing rate adjusted for the counterparty credit risk of the obligation.
Step 3 — Calculate fair value
Expected payment is (EUR 800,000 x 0.70) + (EUR 0 x 0.30) = EUR 560,000. Discounting EUR 560,000 at 6.5% for 15 months produces a present value of EUR 516,700. This is the fair value of the contingent consideration liability at 31 December 2025.
Step 4 — Test sensitivity and document the range
The auditor varies the revenue-threshold probability between 55% and 85%. At 55% probability the fair value drops to EUR 406,300. At 85% probability it rises to EUR 627,100. Management's point estimate of EUR 516,700 sits within the range. The auditor also tests a discount rate shift of plus or minus 100 basis points, producing a band of EUR 510,400 to EUR 523,100.
Rossi's Level 3 fair value of EUR 516,700 for the contingent consideration is defensible. The probability-weighted approach uses two discrete scenarios grounded in trailing revenue data, and the discount rate is traceable to observable components adjusted for entity-specific credit risk. The sensitivity analysis confirms the point estimate falls within a reasonable band.
Why it matters in practice
Audit files frequently lack a documented assessment of whether management's unobservable inputs reflect a market-participant perspective rather than an entity-specific one. IFRS 13.89 is explicit: Level 3 inputs must reflect assumptions that market participants would use. Teams record the inputs and the calculation but skip the step of asking whether a hypothetical buyer would adopt the same growth rate or discount rate. Ticking and bashing the model arithmetic is not enough. ISA 540.23 requires the auditor to evaluate whether significant assumptions are reasonable, and that evaluation must consider the market-participant requirement. Nobody enjoys pushing back on management's assumptions in a PPA model, but skipping it is how files get flagged at inspection.
Entities group multiple Level 3 instruments into a single disclosure line without providing the quantitative input detail that IFRS 13.93 (d) demands. Each class of Level 3 instrument requires separate disclosure of significant unobservable inputs, the range of those inputs, a weighted average where appropriate, and a narrative sensitivity description.
Level 3 vs. Level 2 inputs
| Dimension | Level 3 | Level 2 |
|---|---|---|
| Input type | Unobservable: entity-developed assumptions and internal models based on management forecasts | Observable: quoted prices for similar items, yield curves, credit spreads, implied volatilities |
| Management judgment | High: the entity selects assumptions that market participants would use, with limited external corroboration | Moderate: inputs are market-derived, though adjustments for differences in condition or liquidity may require judgment |
| Disclosure burden | IFRS 13.93 (d)–(h): quantitative inputs, sensitivity analysis, narrative description, reconciliation of opening to closing balances | IFRS 13.93 (b)–(c): level classification, valuation technique description |
| Audit effort | Highest: specialist involvement common, sensitivity testing expected, point-estimate evaluation under ISA 540.18 , and range analysis documented | Moderate: auditor verifies the inputs against external sources and evaluates the adjustment methodology |
| Typical instruments | Unlisted equity, contingent consideration, investment property in thin markets, complex derivatives with unobservable correlation inputs | Corporate bonds with infrequent trades, interest rate swaps from yield curves, foreign currency forwards, fair value less costs of disposal derived from comparable sales |
The practical consequence: a Level 3 classification triggers a reconciliation table ( IFRS 13.93 (e)) showing the opening balance, gains or losses in profit or loss and OCI, purchases, sales, issues, settlements, and transfers. Level 2 measurements require no such roll-forward. Overlooking this disclosure requirement is one of the most common omissions in mid-tier audit files.
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Frequently asked questions
How do I document a Level 3 fair value in the audit file?
Record the valuation technique (income or market approach per IFRS 13.62), every significant unobservable input with its value or range, the sensitivity of the output to changes in those inputs, and the rationale for the selected point estimate. ISA 540.39 requires the auditor to document the basis for concluding whether the estimate is reasonable. Attach the valuation specialist's report where one was engaged.
Does a Level 3 measurement require a valuation specialist?
No standard mandates specialist involvement, but ISA 620.7 requires the auditor to determine whether specialised knowledge is needed. At firms we have worked with, teams engage a specialist when a Level 3 measurement exceeds 25% to 50% of materiality or involves a technique the engagement team cannot independently evaluate. The decision belongs to the engagement partner and should be documented at planning.
When can a Level 3 measurement move to Level 2?
A measurement reclassifies from Level 3 to Level 2 when a previously unobservable input becomes observable. IFRS 13.95 requires disclosure of all transfers between levels, including the reasons. For example, if a comparable transaction occurs in the market that provides an observable reference for an input previously derived from internal models, the entity reclassifies the measurement in the period the transfer occurs.