What are the levels of the fair value hierarchy established by GAAP?

• A. Only two levels: quoted and unquoted prices
• B. Three levels: Level 1 - quoted prices in active markets; Level 2 - observable inputs; Level 3 - unobservable inputs
• C. Four levels that include projected values
• D. Only one level based on historical cost

Answer: (B)

The answer is correct because GAAP establishes a fair value hierarchy that categorizes the inputs used in valuation techniques into three distinct levels.

• Level 1 includes quoted prices for identical assets or liabilities in active markets, which are considered the most reliable indicators of fair value. This level reflects market consensus and is based on observable market data.

• Level 2 consists of observable inputs other than the quoted prices included in Level 1. These can include quoted prices for similar assets or liabilities in active markets or other non-binding quotes, providing less reliable but still relevant information for valuation.

• Level 3 encompasses unobservable inputs that are not derived from market data, representing the least reliable fair value measurement. These inputs are often based on the entity’s own assumptions about what market participants would use in pricing an asset or liability, typically involving more judgment and estimates.

The other answer choices are inaccurate because they either oversimplify the fair value hierarchy by only including two levels, incorrectly suggest there are four levels that include projected values, or imply a singular level based solely on historical cost, which is not part of the fair value measurement framework established under GAAP.