Final answer:
The fair value hierarchy is a classification system that ranks the inputs used in valuing financial instruments into three levels: Level 1, Level 2, and Level 3. Each level represents the reliability and relevance of the fair value measurements.
Step-by-step explanation:
The fair value hierarchy is a classification system that ranks the inputs used in valuing financial instruments. It provides a framework for determining the reliability and relevance of fair value measurements. The hierarchy consists of three levels: Level 1 - quoted prices in active markets for identical assets or liabilities; Level 2 - inputs other than quoted prices that are observable, either directly or indirectly; Level 3 - unobservable inputs based on the entity's own assumptions.
For example, if a financial instrument has a price that can be easily obtained from a stock exchange, it would be classified as Level 1. If the price is based on similar assets in the market, it would be classified as Level 2. If the price is determined using the entity's own valuation model, it would be classified as Level 3.