The fair value
hierarchy distinguishes between observable market inputs (Level 1),
inputs derived from observable market data (Level 2), and inputs based
on unobservable data (Level 3).
Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. These inputs are considered the most reliable because they represent actual market prices.
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. These inputs may include interest rates, yield curves, or market prices of similar assets or liabilities.
Level 3 inputs are unobservable inputs that reflect the entity's assumptions about market data that is not readily observable. These inputs require significant judgment and estimation by the entity and are generally used when there is little or no market activity for the asset or liability.
The fair value hierarchy helps users of financial statements understand how fair values have been determined and the level of reliability of those values. By disclosing the level of inputs used in determining fair values, entities provide transparency and guidance to users in assessing the quality of the information provided.