IFRS 13 Fair-Value Hierarchy: Common Level 3 Pitfalls in Hong Kong Audits

IFRS 13 and HKFRS 13 define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is an exit price, not management's preferred value or an entity-specific forecast, and for non-financial assets it reflects market participants' highest and best use. Where significant inputs are unobservable, the measurement falls into Level 3 of the fair-value hierarchy, and it is here that Hong Kong audits most often encounter difficulty.

Classifying the measurement, not the technique

The hierarchy comprises three input levels: Level 1 (unadjusted quoted prices in active markets for identical items), Level 2 (other observable inputs) and Level 3 (unobservable inputs). The classification is determined by the lowest-level input that is significant to the entire measurement. A discounted-cash-flow model is not automatically Level 3, but a significant unobservable adjustment to an otherwise observable price can push a measurement into Level 3. Auditors should test whether the classification follows the inputs actually used rather than the label attached to the valuation method.

Management data versus market-participant evidence

IFRS 13 requires valuation techniques that maximise relevant observable inputs. Where observable inputs are unavailable, internal data may serve as a starting point, but it must be adjusted when reasonably available information indicates that market participants would use different assumptions, including assumptions about risk. A recurring pitfall is the unadjusted use of management budgets, discount rates or growth assumptions that do not reflect market-participant perspectives.

Changes in technique and comparables

IFRS 13 permits a change in valuation technique or its application when the change produces an equally or more representative fair-value measurement, with the change and its reasons disclosed. The AFRC's July 2025 inspection report identified insufficient evaluation of market rents, capitalisation rates, valuers' adjustments, tenancy details and comparable transactions in property valuations. Its 2024 inspections covered 51 public-interest-entity engagements and 46 non-PIE engagements; those totals are not a property-valuation failure rate. Changes in technique or comparables should nonetheless be treated as audit questions requiring evidence.

The full Level 3 disclosure package

IFRS 13.93 requires quantitative information on significant unobservable inputs and a description of the entity's valuation processes for Level 3 measurements. For recurring Level 3 measurements, it also requires an opening-to-closing reconciliation, separately explained transfers into and out of Level 3, and narrative sensitivity and input-interrelationship disclosures. For financial assets and liabilities, a further quantified sensitivity is required if reasonably possible alternative assumptions would change fair value significantly. Incomplete reconciliations and generic sensitivity language remain common findings.

Audit evidence and the role of experts

A valuer's report does not replace audit work. HKSA 540 (Revised) requires risk-responsive evidence on the method, significant assumptions, data, the selected estimate and related disclosures. It directs auditors to assess data relevance and reliability, possible management bias and estimation uncertainty; using a management's expert still requires evaluation of that expert's work as audit evidence. The AFRC's 3 October 2025 year-end audit focus highlighted real estate, private equity and private credit exposed to estimation risk, directing attention to methodology, models, transaction timing, comparables, discount rates, discounts for lack of marketability, growth rates and cash flows, and cautioning against relying on experts without evaluating their work.

Recent inspection and standard-setting developments

The AFRC's 14 July 2026 annual inspection report identified, in financial-services engagements, insufficient evaluation of significant management assumptions, inadequate evaluation of experts' work and insufficient testing of source data supplied to experts. It also reported failures to evaluate terminal-value assumptions in discounted-cash-flow impairment assessments. These are related audit findings, not a separately reported Level 3 failure rate.

Current valuation standards place more weight on input provenance. The IVS edition published on 31 January 2024 became effective on 31 January 2025, introducing IVS 104, Data and Inputs, which emphasises data quality and selection, and updating IVS 106, Documentation and Reporting, including record-keeping requirements directly relevant to supporting significant Level 3 inputs. In February 2026, the HKICPA noted that tariffs may reduce comparable transactions or require significant adjustments to previously observable inputs; preparers should reassess market-participant assumptions, hierarchy classification and the resulting Level 3 disclosures, though a transfer is not automatic merely because tariffs exist. Proposed IVS changes opened for consultation on 30 January 2026 and closed on 30 April 2026, with publication intended for January 2027 and effectiveness in January 2028; they are not part of the edition effective in 2025.

Practical implications

• Document how the lowest-level significant input drives the hierarchy classification.
• Challenge management assumptions against market-participant evidence and adjust internal data where necessary.
• Ensure the full IFRS 13.93 disclosure package is complete, including reconciliations and sensitivities.
• Evaluate experts' work and test source data rather than relying on the valuation report alone.
• Monitor transfers between levels and reassess classification as market conditions change.

For further detail, see IFRS 13 and the AFRC's inspection and audit focus publications.