Which fair value measurement level uses unobservable inputs?

• A. Level 1 uses quoted prices in active markets.
• B. Level 3 uses unobservable inputs.
• C. Level 2 uses observable inputs.
• D. Level 1 uses unobservable inputs.

Answer: (B)

Unobservable inputs are used in the highest tier of the fair value hierarchy. This level relies on inputs that aren’t directly observable in the market, so the valuation depends on internal assumptions and models. You’d use this level when there’s no active market or reliable data for the asset or liability, such as valuing a privately held company or a complex instrument that lacks quoted prices. The unobservable inputs can include things like discount rates, future cash flow projections, or other management estimates that influence the outcome.

By contrast, one lower level uses quoted prices in active markets for identical assets, and the other uses observable inputs other than quoted prices (like prices for similar assets or inputs derived from observable data). Since Level 3 hinges on internal, unobservable inputs, it’s the appropriate categorization for valuations driven by those internal assumptions rather than market quotes.