Financial Instruments and Fair Value Measurement

Introduction and context

Financial instruments are central to modern finance: they transfer capital, allocate risk, provide liquidity, and support pricing and investment decisions. They also create some of the most difficult accounting judgments because their reported amounts depend on contractual cash flows, business models, market conditions, credit risk, and management intentions.

This chapter is primarily based on the principles of IFRS 9 Financial Instruments and IFRS 13 Fair Value Measurement, with terminology that is also broadly relevant under comparable national standards. The central accounting challenge is to report an instrument in a manner that faithfully represents both its economic characteristics and the entity’s exposure to risk. Classification determines the subsequent measurement basis; measurement determines reported profit, loss, equity, and financial position; and disclosure allows users to understand uncertainty in those measurements.

Learning objectives

By the end of this chapter, the reader should be able to:

1. Distinguish financial assets, financial liabilities, and equity instruments.
2. Apply the classification tests for financial assets and liabilities.
3. Calculate amortised cost using the effective interest method.
4. Explain fair value, valuation techniques, and the fair value hierarchy.
5. Apply the expected credit loss model and distinguish it from incurred-loss approaches.
6. Explain recognition, derecognition, modification, and reclassification.
7. Analyse derivatives, hedge accounting, and associated risks.
8. Evaluate market, credit, and liquidity risk and the governance of valuation.

1. The architecture of financial-instrument accounting

A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another. A financial asset may be cash, an equity instrument of another entity, a contractual right to receive cash or another financial asset, or a contractual right to exchange financial instruments under potentially favourable conditions. A financial liability is a contractual obligation to deliver cash or another financial asset, or to exchange financial instruments under potentially unfavourable conditions.

Examples include trade receivables, bonds, loans, deposits, preference shares, ordinary shares, leases within the relevant standard’s scope, forwards, futures, swaps, and options. Physical commodities are not normally financial instruments, although contracts to buy or sell commodities can become financial instruments when they are net-settled or held for trading.

The accounting model has three linked questions:

• What is the instrument and what contractual rights and obligations does it create?
• How will the holder manage the instrument, and what cash flows does it contractually generate?
• What measurement basis and presentation best represent its economic substance?

A useful conceptual distinction is between measurement uncertainty and credit uncertainty. Measurement uncertainty concerns the price or value assigned to an instrument. Credit uncertainty concerns whether the counterparty will perform. The two interact but are not identical.

2. Classification of financial assets

Under IFRS 9, classification of a financial asset is determined by two principal tests:

1. the entity’s business model for managing the asset; and
2. the contractual cash-flow characteristics of the asset, commonly called the SPPI test: solely payments of principal and interest on the principal amount outstanding.

2.1 Business-model assessment

The business model is assessed at a level reflecting how groups of assets are managed, rather than by management’s intention for one individual instrument. Evidence includes performance evaluation, remuneration practices, sales frequency and reasons, risk-management policies, and how managers communicate with senior management.

The principal business-model categories are:

The assessment is not a mechanical count of sales. Occasional sales due to credit deterioration, concentration limits, or liquidity management may be consistent with holding to collect. However, frequent sales motivated by short-term price movements generally indicate a different business model.

2.2 The SPPI test

Principal is the fair value of the financial asset at initial recognition, although it may change over time through repayments, premiums, discounts, and interest accrual. Interest normally represents consideration for the time value of money, credit risk, other basic lending risks, administrative costs, and a profit margin.

Cash flows fail SPPI when they expose the holder to unrelated equity-price, commodity-price, or other leveraged risks. A bond whose return is linked to the price of gold, for example, generally does not meet SPPI because the return is not solely compensation for a basic lending arrangement.

The assessment must consider contractual terms such as leverage, contingent features, non-recourse provisions, prepayment options, and modified time-value-of-money features. A feature is not automatically inconsistent with SPPI; the question is whether the resulting cash flows are consistent with a basic lending arrangement.

2.3 Resulting categories

Financial assets are generally classified as follows:

• Amortised cost: business model is hold to collect and SPPI is satisfied.
• Fair value through other comprehensive income (FVOCI): for debt instruments, the business model is hold to collect and sell and SPPI is satisfied.
• Fair value through profit or loss (FVTPL): the residual category, including assets that fail SPPI or are managed on another basis.
• Equity instruments at FVOCI: an irrevocable election may be made at initial recognition for an equity investment that is not held for trading. Gains and losses are generally not recycled to profit or loss on disposal, although dividends meeting the relevant conditions are recognised in profit or loss.

3. Financial liabilities and equity

A financial liability is normally measured subsequently at amortised cost, except for liabilities at FVTPL, derivative liabilities, financial guarantee contracts, and certain loan commitments. An entity may designate a liability at FVTPL when permitted, particularly where doing so eliminates or significantly reduces an accounting mismatch.

The treatment of own-credit risk for a liability designated at FVTPL is important. Changes in fair value attributable to changes in the entity’s own credit risk are generally presented in other comprehensive income, unless that presentation would create or enlarge an accounting mismatch. This prevents a deterioration in an entity’s credit standing from automatically producing a counterintuitive profit in profit or loss.

The distinction between liability and equity is based on substance. An equity instrument evidences a residual interest after deducting all liabilities. A contractual obligation to deliver cash normally indicates a liability, even if the instrument is legally described as a share. Compound instruments, such as convertible bonds, may contain both liability and equity components when the conversion feature meets the relevant conditions.

4. Recognition, initial measurement, and transaction costs

An entity recognises a financial asset or liability when it becomes party to the contractual provisions of the instrument. Initial measurement is generally at fair value, plus or minus transaction costs for instruments not measured at FVTPL. For an asset or liability at FVTPL, transaction costs are expensed immediately.

Fair value at initial recognition is normally the transaction price, but the two can differ. A difference may arise when a transaction is not at market terms, when an instrument includes an unobservable feature, or when the transaction occurs under compulsion. Any resulting “day-one” gain or loss must be recognised only when the relevant standard permits it and the fair value is supported by appropriate evidence.

5. Amortised cost and the effective interest method

Amortised cost is a measurement process rather than simply the original invoice amount. It incorporates principal repayments, the allocation of premiums and discounts, transaction costs, and interest calculated using the effective interest rate.

The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the instrument to its gross carrying amount at initial recognition. For a financial asset, the gross carrying amount is used before deducting the loss allowance.

Here, GCA₀ is the initial gross carrying amount, CFₜ is the contractual or estimated cash flow in period t, EIR is the effective interest rate per period, and n is the number of periods. The formula assumes cash flows and the rate are stated using the same time interval.

For a non-credit-impaired asset, interest revenue is calculated as:

The closing gross carrying amount before impairment is:

Worked example: amortised cost

On 1 January, an entity purchases a three-year bond for CU 950. The bond’s face value is CU 1,000, pays an annual coupon of CU 50, and has an effective interest rate of 6.00%. Assume annual payments and no impairment.

Year 1 interest revenue is CU 950 × 6% = CU 57. The carrying amount at year-end is CU 950 + CU 57 − CU 50 = CU 957.

Year 2 interest revenue is CU 957 × 6% = CU 57.42. The carrying amount is CU 957 + CU 57.42 − CU 50 = CU 964.42.

Year 3 interest revenue is CU 964.42 × 6% = CU 57.87, subject to rounding. After receipt of the final coupon and CU 1,000 principal, the balance reduces to approximately zero. The difference between the purchase price and redemption amount is therefore recognised progressively through interest revenue rather than at maturity.

6. Fair value measurement

Fair value is 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 necessarily the price paid to acquire an asset. The measurement assumes a market-participant perspective and an orderly transaction; a forced liquidation is not the assumed market.

Important principles include:

• Fair value is measured for a particular asset or liability.
• Non-financial assets may be valued using their highest and best use.
• The principal market is used when it exists; otherwise the most advantageous accessible market is considered.
• Transaction costs are not an adjustment to fair value, although transport costs may be relevant where location is a characteristic of the asset.
• A liability is valued from the perspective of a market participant that would assume the obligation, including non-performance risk.

6.1 Valuation approaches

The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. Quoted prices in active markets are generally the strongest evidence.

The income approach converts future amounts, such as cash flows or earnings, into a single present value. A basic discounted-cash-flow relationship is:

FV is the present value estimate, CFₜ is the expected cash flow in period t, rₜ is the discount rate applicable to that period, and n is the number of periods. The model is applicable only when cash-flow forecasts, discount rates, timing, and risk adjustments are supportable and internally consistent.

The cost approach reflects the amount currently required to replace the service capacity of an asset. It is more common for specialised tangible assets than for ordinary traded financial instruments.

6.2 Fair value hierarchy

IFRS 13 ranks inputs, not valuation techniques:

A valuation is classified at the lowest level of input that is significant to the entire measurement. A model containing observable discount rates but a significant unobservable default assumption may therefore be Level 3.

Level 3 measurements require enhanced governance: model validation, independent price verification, sensitivity analysis, documentation of assumptions, and controls over valuation adjustments. A sensitivity disclosure should explain how reasonably possible changes in significant unobservable inputs could affect fair value.

7. Impairment and expected credit losses

The expected credit loss (ECL) model recognises credit losses before a default necessarily occurs. It is applied to financial assets measured at amortised cost, debt instruments at FVOCI, lease receivables, contract assets, certain loan commitments, and financial guarantee contracts within scope.

ECL is a probability-weighted estimate of credit losses, discounted to the reporting date. A practical conceptual expression is:

Here, pₛ is the probability of scenario s, LGDₛ is loss given default, EADₛ is exposure at default, and DFₛ is the discount factor. The summation covers relevant scenarios. This is an analytical representation, not a requirement that every entity use a complex statistical model. Estimates must reflect reasonable and supportable information, including historical data, current conditions, and forecasts.

The three-stage model operates as follows:

• Stage 1: at initial recognition and while credit risk has not increased significantly, recognise 12-month ECL. This is not the cash shortfall expected only from defaults in the next twelve months; it is the portion of lifetime ECL associated with default events possible within that period.
• Stage 2: when credit risk has increased significantly since initial recognition, recognise lifetime ECL.
• Stage 3: when the asset is credit-impaired, recognise lifetime ECL and calculate interest revenue on net carrying amount, generally gross carrying amount less loss allowance.

For trade receivables and similar portfolios, a simplified approach may permit lifetime ECL from initial recognition. Provision matrices can be useful, but they must be adjusted for forward-looking information and changing portfolio risk.

The assessment of significant increases in credit risk should not rely solely on delinquency. It may incorporate rating migration, probability of default, sector conditions, covenant breaches, refinancing difficulty, collateral trends, and macroeconomic forecasts. Governance should address model risk, data quality, management overlays, and the risk of optimistic bias.

8. Derecognition, modification, and reclassification

A financial asset is derecognised when contractual rights to cash flows expire or when it is transferred and the transfer qualifies for derecognition. Transfer analysis considers whether substantially all risks and rewards have been transferred. If neither transfer nor retention is conclusive, control is assessed. Continuing involvement may require recognition of an associated asset or liability.

A financial liability is derecognised when the obligation is discharged, cancelled, or expires. An exchange of debt instruments with substantially different terms, or a substantial modification of terms, is accounted for as extinguishment of the original liability and recognition of a new one. A common quantitative indicator is whether the present value of revised cash flows, discounted using the original effective interest rate, differs by at least 10% from the present value of remaining original cash flows. This is a practical assessment rather than a substitute for considering qualitative changes.

Reclassification of financial assets occurs only when an entity changes its business model for managing a portfolio. It is not driven by a change in intention concerning an individual asset. Reclassification is prospective and can change the carrying amount and treatment of accumulated gains or losses according to the new category.

9. Derivatives and embedded features

A derivative typically has three characteristics: its value changes in response to an underlying variable, it requires little or no initial net investment compared with similar contracts, and it is settled at a future date. Forwards, futures, swaps, and options are common examples.

Derivatives are generally measured at fair value through profit or loss unless they are designated in an eligible hedging relationship. Their leverage makes them efficient risk-management tools but also creates substantial exposure to market, counterparty, liquidity, and model risk.

An embedded derivative is a component of a hybrid contract whose economic characteristics and risks are not closely related to those of the host contract. Under IFRS 9, financial assets containing embedded derivatives are generally classified as a whole under the business-model and SPPI requirements. Separate accounting for embedded derivatives remains relevant in certain financial liabilities and non-financial host contracts.

10. Hedge accounting

Hedge accounting aligns the recognition of gains and losses on a hedging instrument with the accounting for the hedged item. It is not a method for hiding losses; it is a representation of a documented risk-management relationship.

The principal hedge types are:

• Fair value hedge: hedges exposure to changes in fair value of a recognised asset, liability, or firm commitment. Changes in the hedging instrument and the hedged risk component are generally recognised in profit or loss.
• Cash flow hedge: hedges variability in cash flows. The effective portion of the hedging instrument’s gain or loss is recognised in OCI and accumulated in the cash-flow hedge reserve, with appropriate later reclassification when the hedged cash flows affect profit or loss or become part of a non-financial asset.
• Hedge of a net investment in a foreign operation: addresses foreign-currency exposure in a net investment, with effective portions generally recognised in OCI.

Eligibility requires formal designation and documentation, an eligible hedging instrument and hedged item, an economic relationship, credit risk not dominating the relationship, and an appropriate hedge ratio. Effectiveness is evaluated on an ongoing basis. Forecast transactions must be highly probable where the relevant cash-flow hedge requirements apply.

11. Risk analysis

Market risk

Market risk is the risk of changes in fair value or future cash flows caused by movements in interest rates, foreign-exchange rates, equity prices, commodity prices, or volatility. Duration, interest-rate sensitivity, scenario analysis, stress testing, and value-at-risk may support management, but no single metric captures all risks. A value-at-risk estimate, for example, depends heavily on historical windows, distributional assumptions, and correlations.

Credit risk

Credit risk is the possibility that a counterparty will fail to meet contractual obligations. It affects receivables, loans, debt securities, derivatives, guarantees, and settlement processes. Concentration by borrower, industry, geography, rating, collateral, and maturity should be monitored. Netting and collateral reduce exposure only when legally enforceable and operationally reliable.

Liquidity risk

Liquidity risk is the possibility that an entity cannot meet obligations when due without unacceptable loss. It arises from funding mismatches, margin calls, early redemptions, collateral requirements, and thin markets. Cash-flow maturity analyses should distinguish contractual and behavioural assumptions, identify committed facilities, and include stressed scenarios.

12. Applied case: Northstar Manufacturing Ltd.

The following is an illustrative case, not a report of an actual entity.

Background

Northstar holds a CU 10 million portfolio of government and corporate bonds. It collects coupons but periodically sells securities to fund acquisitions and rebalance credit concentrations. It also has a variable-rate bank loan and uses an interest-rate swap to reduce exposure to rising rates.

Problem

At year-end, management proposes amortised-cost accounting for all bonds because the securities are “mostly held for income.” One corporate issuer has experienced a rating downgrade. The valuation team also uses a broker quote for a thinly traded bond without assessing whether the quote is executable.

Analysis and approach

The portfolio business model must be assessed at the portfolio level. Regular sales for rebalancing and investment management may indicate hold-to-collect-and-sell rather than hold-to-collect. Each bond must then pass SPPI. Bonds meeting both conditions may qualify for FVOCI; others may be FVTPL.

The downgraded issuer requires a reassessment of significant increases in credit risk. Northstar should compare current and initial credit risk, use forward-looking information, and recognise lifetime ECL if the Stage 2 threshold is met. The downgrade is evidence, but not an automatic conclusion without considering the full credit profile.

The broker quote should be evaluated for market activity, bid-ask spreads, recent transactions, and whether it represents an orderly transaction. If significant unobservable adjustments are necessary, the measurement may be Level 3. Independent price verification and sensitivity analysis are appropriate.

The interest-rate swap is recognised at fair value. If formal hedge-accounting requirements are met, Northstar may designate a cash-flow hedge of variable interest payments. Otherwise, changes in the swap’s fair value generally affect profit or loss, potentially creating volatility.

Outcome and learning points

Northstar’s original proposal is rejected because classification depends on evidence about portfolio management, not a broad statement of intent. The revised process combines accounting classification, ECL monitoring, valuation controls, and hedge documentation. The case demonstrates that financial-instrument accounting is an integrated risk-governance process rather than a year-end measurement exercise.

13. Governance, ethics, technology, and contemporary developments

Valuation and impairment involve estimates that can materially affect reported performance. Ethical risks include selecting optimistic assumptions, delaying recognition of deterioration, manipulating model inputs, and presenting a Level 3 value with unjustified precision. Effective governance requires segregation of front-office valuation from independent review, model validation, audit trails, approval of overlays, and transparent disclosure of uncertainty.

Technology supports this process through automated data capture, valuation engines, market-data feeds, machine-learning credit models, and continuous monitoring. However, artificial intelligence does not remove professional judgment. Models may reproduce historical bias, fail during structural breaks, or obscure causal reasoning. Human challenge, explainability, data lineage, access controls, and override governance remain essential.

Current professional practice increasingly emphasises climate-related and other emerging risks where they affect cash-flow forecasts, credit risk, collateral values, or fair-value assumptions. Such effects should be incorporated when they are relevant and supportable, without inventing unsupported numerical adjustments. Regulatory scrutiny also continues to focus on model risk, liquidity under stress, valuation uncertainty, and comparability of disclosures.

14. Best-practice implementation framework

A robust financial-instrument control framework should:

1. Maintain an instrument inventory linked to contractual terms and legal documentation.
2. Document business-model assessments and SPPI judgments.
3. Reconcile subledgers, custodial records, and general-ledger balances.
4. Use independent price verification and establish valuation adjustment policies.
5. Validate ECL models, monitor overrides, and back-test outcomes.
6. Maintain hedge documentation before or at designation.
7. Perform stress tests for market, credit, funding, and collateral risks.
8. Review derecognition, modifications, and netting arrangements legally and operationally.
9. Disclose accounting policies, hierarchy levels, valuation techniques, sensitivities, and risk concentrations clearly.
10. Preserve evidence so that a reviewer can reproduce the classification and measurement conclusion.

Chapter Summary

Financial instruments are classified and measured according to their contractual characteristics and the way they are managed. Financial assets may be measured at amortised cost, FVOCI, or FVTPL; debt classification depends principally on the business model and the SPPI test. Amortised cost applies the effective interest method, which allocates premiums, discounts, and transaction costs over the instrument’s life. Fair value is an exit price based on market-participant assumptions and is supported by market, income, or cost approaches. The Level 1–3 hierarchy communicates the observability of valuation inputs, while Level 3 measurements require particularly strong governance.

The expected credit loss model introduces forward-looking recognition of credit deterioration through 12-month and lifetime loss measurements. Derecognition, modification, reclassification, derivatives, and hedge accounting require careful analysis of contractual rights, risks, and documentation. Finally, market, credit, liquidity, model, and ethical risks must be managed as connected dimensions of financial reporting and enterprise risk governance.

Key Terms

Financial instrument: A contract creating a financial asset for one entity and a financial liability or equity instrument for another.

Financial asset: Cash, an equity instrument of another entity, or a contractual right to receive or exchange financial resources.

Financial liability: A contractual obligation to deliver cash or another financial asset.

Equity instrument: A contract evidencing a residual interest after deducting liabilities.

Amortised cost: Initial amount adjusted for repayments, effective interest, and impairment allowances where applicable.

Effective interest rate: The rate that discounts estimated future cash flows to the initial carrying amount.

Business model: The manner in which a group of financial assets is managed to generate cash flows.

SPPI test: Assessment of whether cash flows are solely payments of principal and interest.

FVTPL: Fair value through profit or loss.

FVOCI: Fair value through other comprehensive income.

Fair value: Exit price in an orderly transaction between market participants at the measurement date.

Level 1 input: Unadjusted quoted price for an identical item in an active market.

Level 2 input: Observable input other than a Level 1 quoted price.

Level 3 input: Significant unobservable valuation input.

Expected credit loss: Probability-weighted present value of expected credit shortfalls.

Credit-impaired: A condition indicating that one or more events adversely affect expected cash flows.

Derivative: A contract whose value responds to an underlying variable, requires little initial investment, and settles in the future.

Hedge accounting: Accounting that aligns gains and losses on hedging instruments with the hedged exposure.

Derecognition: Removal of an asset or liability from the statement of financial position when the relevant recognition conditions cease to apply.

Liquidity risk: Risk of inability to meet obligations when due without unacceptable loss.

Review Questions

Short Answer Questions

1. What are the two principal tests used to classify financial assets under IFRS 9?
2. Define the effective interest rate and explain its purpose.
3. What is the difference between a Level 1 and a Level 3 fair-value measurement?
4. Distinguish 12-month ECL from lifetime ECL.
5. Identify the three principal types of hedge accounting.

Long Answer Questions

1. Explain the classification categories for financial assets and evaluate how business-model evidence affects classification.
2. Discuss the principles of fair value measurement, including market-participant assumptions, valuation approaches, and the hierarchy of inputs.
3. Explain the expected credit loss model, including staging, forward-looking information, and governance challenges.
4. Analyse the accounting consequences of modifying or extinguishing a financial liability.
5. Discuss how derivatives and hedge accounting can reduce risk while creating accounting, model, and governance challenges.

Analytical / Application Questions

1. An entity buys a bond at CU 950, receives annual coupons of CU 50, and applies a 6% effective interest rate. Calculate the carrying amount after the first year and explain why it differs from the cash received.
2. A bond portfolio generates coupon income but is regularly sold to manage concentration and liquidity. Analyse whether amortised cost or FVOCI is more defensible, identifying the additional test required.
3. A corporate borrower’s rating falls sharply, its industry enters recession, and collateral values decline. Design an ECL assessment and identify the evidence needed to determine whether lifetime ECL is required.

Multiple Choice Questions with Answers

Question 1

Which combination is required for a debt instrument to be measured at amortised cost under the general IFRS 9 model?

A. Hold to collect business model and SPPI cash flows

B. Hold to trade business model and SPPI cash flows

C. Hold to collect and sell business model and failed SPPI cash flows

D. Any business model provided the instrument has a fixed maturity

Correct Answer: A. Hold to collect business model and SPPI cash flows

Question 2

A bond has a gross carrying amount of CU 950 and an effective interest rate of 6%. What is the first-year interest revenue before considering impairment?

A. CU 50.00

B. CU 54.00

C. CU 57.00

D. CU 60.00

Correct Answer: C. CU 57.00

Question 3

Which input is normally classified as Level 1 in the fair-value hierarchy?

A. An internal default probability

B. An unadjusted quoted price for an identical share in an active market

C. A broker estimate adjusted for liquidity

D. A discounted-cash-flow forecast using management assumptions

Correct Answer: B. An unadjusted quoted price for an identical share in an active market

Question 4

When does an entity generally recognise lifetime expected credit losses under the three-stage model?

A. Only when contractual cash flows have expired

B. When credit risk has increased significantly since initial recognition

C. Only when the asset is classified at FVTPL

D. Only at the date of initial recognition

Correct Answer: B. When credit risk has increased significantly since initial recognition

Question 5

Which statement best describes fair value?

A. The original purchase price of an asset

B. The amount an entity hopes to receive from a customer

C. The price to sell an asset or transfer a liability in an orderly market-participant transaction

D. The replacement cost in every circumstance

Correct Answer: C. The price to sell an asset or transfer a liability in an orderly market-participant transaction

Question 6

Which feature is characteristic of a derivative?

A. It always requires payment of the full underlying amount immediately

B. Its value changes in response to an underlying variable

C. It can never be settled in cash

D. It is always measured at amortised cost

Correct Answer: B. Its value changes in response to an underlying variable

Question 7

In a cash-flow hedge, the effective portion of the hedging instrument’s gain or loss is generally recognised initially in:

A. Other comprehensive income

B. Revenue

C. Inventory

D. Share capital

Correct Answer: A. Other comprehensive income

Question 8

What is the main purpose of the SPPI test?

A. To determine whether an instrument is legally enforceable

B. To assess whether contractual cash flows represent basic lending cash flows

C. To calculate an entity’s liquidity ratio

D. To determine the market’s bid-ask spread

Correct Answer: B. To assess whether contractual cash flows represent basic lending cash flows

Question 9

Which risk concerns the possibility that an entity cannot meet obligations when due without unacceptable loss?

A. Market risk

B. Credit risk

C. Liquidity risk

D. Basis risk

Correct Answer: C. Liquidity risk

Question 10

A valuation uses observable yield curves but a significant unobservable default assumption. At what level is the measurement generally classified?

A. Level 1

B. Level 2

C. Level 3

D. Unclassified because mixed inputs are prohibited

Correct Answer: C. Level 3