Key Points
- Level 2 inputs rely on observable market data, but the auditor must evaluate any adjustments the entity applies to that data.
- IFRS 13.83 lists six categories of Level 2 input, from quoted prices for similar assets to credit spreads derived from market transactions.
- An adjustment using a significant unobservable input (such as an entity-specific liquidity discount) reclassifies the entire measurement to Level 3.
- Most interest rate swaps, corporate bonds with infrequent trading, and real estate valued from comparable sales fall into Level 2.
What is Fair Value Hierarchy: Level 2?
IFRS 13.81 defines Level 2 inputs as those that are observable for the asset or liability, either directly or indirectly, but do not qualify as Level 1 quoted prices. The distinction matters on engagements because Level 2 measurements require the auditor to evaluate a valuation technique, not simply verify a price against a market feed.
IFRS 13.83 provides six categories. Quoted prices for similar (not identical) assets in active markets sit at one end. At the other end sit inputs derived from, or corroborated by, observable market data through correlation or other means (credit default swap spreads used to adjust a bond yield, for instance). The entity selects the input most representative of fair value and applies adjustments for differences in condition, location, restriction, or activity level. ISA 540.18 requires the auditor to evaluate whether the method, significant assumptions, and data are appropriate. For Level 2, that evaluation centres on whether the adjustments applied to observable inputs are reasonable and consistently applied across reporting periods.
A measurement starts as Level 2 but migrates to Level 3 the moment a significant unobservable input enters the calculation. IFRS 13.73 determines the classification by the lowest-level input significant to the entire measurement. Practitioners who overlook this rule routinely misclassify measurements, understating both the disclosure burden and the estimation uncertainty visible to users.
Worked example: Rossi Alimentari S.p.A.
Client: Italian food production group, FY2025, revenue €67M, IFRS reporter. Rossi holds a €4M nominal position in fixed-rate corporate bonds issued by a mid-cap European packaging company. The bonds are listed on Euronext Dublin but traded only seven times in December 2025. No reliable Level 1 closing price exists for the measurement date.
Step 1 — Determine that Level 1 is unavailable
The bonds are listed, but the average daily volume in December was below €200,000 and the bid-ask spread widened to 180 basis points at year-end. The market does not meet the IFRS 13.A definition of active (transactions of sufficient frequency and volume to provide pricing information on an ongoing basis). The quoted price is therefore not a Level 1 input.
Step 2 — Identify observable Level 2 inputs
Rossi's finance team sources a broker quote of 96.40 (clean price per €100 nominal) from two dealers. The team also obtains the issuer's credit spread of 185 basis points over the euro mid-swap curve, derived from recent secondary-market trades of the same issuer's shorter-dated bonds. The euro mid-swap curve itself is a directly observable input.
Step 3 — Apply the valuation technique
Using a discounted cash flow model, Rossi discounts the bond's remaining coupon payments (3.25% fixed, semi-annual) and principal redemption at the euro mid-swap rate plus the 185 basis point credit spread. The model produces a fair value of €3,862,000 for the €4M nominal position. The two dealer quotes (implying €3,856,000 and €3,870,000) corroborate the model output.
Step 4 — Confirm Level 2 classification and disclose
No significant unobservable input drives the measurement. The credit spread is corroborated by recent market transactions, and the discount curve is directly observable. IFRS 13.93(b) requires Rossi to disclose the Level 2 classification and the valuation technique (discounted cash flow). IFRS 13.93(d) does not require disclosure of individual unobservable inputs because none is significant.
Conclusion: the fair value of €3,862,000 for Rossi's corporate bond position is defensible as a Level 2 measurement because every significant input is observable or corroborated by market data, and the DCF output sits within the range implied by independent dealer quotes.
Why it matters in practice
Teams classify a measurement as Level 2 when a significant unobservable input (a management-derived liquidity premium or an entity-specific growth rate, for instance) affects the result. IFRS 13.73 classifies the entire measurement by the lowest-level input that is significant to the fair value. One significant unobservable input moves the measurement to Level 3, triggering the full IFRS 13.93(d) sensitivity disclosure. ISA 540.20 requires the auditor to evaluate whether the data the entity used is relevant and reliable, which includes testing whether each input is genuinely observable.
Entities obtain a single broker quote and treat it as sufficient Level 2 evidence without corroboration. IFRS 13.B45 notes that the weight given to a particular input depends on the extent to which it is observable. ISA 500.7 requires the auditor to evaluate whether audit evidence is sufficient and appropriate. A lone, uncorroborated broker quote in an inactive market sits closer to Level 3 than Level 2, particularly when the broker has no obligation to transact at the quoted price.
Level 2 vs. Level 3 inputs
| Dimension | Level 2 | Level 3 |
|---|---|---|
| Input observability | Inputs are observable directly (quoted prices for similar items) or indirectly (derived from or corroborated by market data) | Inputs are unobservable; entity uses internal data, assumptions, or models with no market corroboration |
| Auditor effort | Evaluate the valuation technique and test whether adjustments to observable data are reasonable | Evaluate the model, challenge every significant assumption, test sensitivity, and often engage a valuation specialist |
| Disclosure requirements | IFRS 13.93(b) level classification and valuation technique description | IFRS 13.93(d) requires quantitative disclosure of each significant unobservable input plus sensitivity analysis per IFRS 13.93(h) |
| Typical instruments | Corporate bonds in inactive markets, interest rate swaps, foreign currency forwards, real estate from comparable sales | Private equity stakes, complex structured products, biological assets, goodwill impairment models relying on management projections |
| Transfer trigger | A measurement leaves Level 2 when an unobservable input becomes significant | A measurement may enter Level 2 if new observable corroboration becomes available for a previously unobservable input |
The practical consequence: misclassifying a Level 3 measurement as Level 2 masks estimation uncertainty from financial statement users and exposes the auditor to a documentation gap that regulators flag during inspections.
Related terms
Frequently asked questions
How do I audit a Level 2 fair value measurement?
The auditor evaluates the valuation technique (market approach, income approach, or both), tests whether each input is observable or corroborated by observable data, and assesses the reasonableness of any adjustments. ISA 540.18 directs the auditor to evaluate the method, the significant assumptions, and the data. For Level 2, the central question is whether the adjustments applied to observable inputs are supported and consistently applied.
When does a Level 2 measurement move to Level 3?
A measurement moves to Level 3 when an unobservable input that is significant to the entire fair value enters the calculation. IFRS 13.73 sets this threshold. Common triggers include a management-estimated illiquidity discount applied to a broker quote, or an entity-specific assumption about prepayment speed on a mortgage-backed security. The auditor should challenge whether each adjustment is genuinely derived from or corroborated by market data.
Does the auditor need a specialist for Level 2 valuations?
Not always. ISA 620.7 requires the auditor to engage a specialist when the matter requires expertise beyond the audit team's competence. Plain-vanilla interest rate swaps valued from mid-swap curves rarely need a specialist. Structured products with multiple adjustments, or instruments where the boundary between Level 2 and Level 3 is contested, often do.