Observable inputs

What Are Observable Inputs?

Observable inputs are market-corroborated data points utilized in valuation techniques to determine the fair value of financial assets and financial liabilities. These inputs are derived from sources external to the reporting entity, reflecting actual market transactions or information available to market participants. They are a critical component of fair value measurement, a key aspect of financial reporting and the broader category of accounting standards.

The use of observable inputs is prioritized by major accounting frameworks, including Generally Accepted Accounting Principles (GAAP) in the United States, primarily under ASC 820, and International Financial Reporting Standards (IFRS), specifically IFRS 13. These standards establish a fair value hierarchy that categorizes inputs into three levels based on their observability, with observable inputs occupying Level 1 and Level 2. The objective is to maximize the use of reliable, market-based data to ensure consistency and comparability in financial statements.

History and Origin

The emphasis on observable inputs in fair value measurement gained significant traction with the development of contemporary accounting standards. In the United States, the Financial Accounting Standards Board (FASB) introduced Statement No. 157, Fair Value Measurements (later codified into ASC 820), in 2006. This standard provided a single definition of fair value and established a framework for its measurement, including the crucial fair value hierarchy that prioritizes inputs based on their observability. The goal was to increase the consistency and comparability of fair value measurements and related disclosures.¹⁰

Internationally, the International Accounting Standards Board (IASB) issued IFRS 13, Fair Value Measurement, in May 2011, which became effective for annual periods beginning on or after January 1, 2013. IFRS 13 converged significantly with ASC 820, providing a consistent global framework for fair value measurement and explicitly prioritizing the use of observable inputs over unobservable inputs.⁹ These standards were a response to the increasing complexity of financial instruments and the need for more transparent and reliable valuations, particularly as financial markets evolved.

Key Takeaways

• Prioritization: Accounting standards mandate maximizing the use of observable inputs and minimizing the use of unobservable inputs in fair value measurements.
• Hierarchy: Observable inputs are classified into Level 1 (quoted prices in active markets for identical assets/liabilities) and Level 2 (other observable inputs).
• Reliability: Valuations relying on observable inputs are generally considered more reliable and objective because they are based on market data rather than entity-specific assumptions.
• Transparency: The fair value hierarchy requires companies to disclose the level of inputs used, enhancing transparency for users of financial statements.
• Market-Based: Observable inputs underscore the principle that fair value is a market-based measurement, reflecting the price at which an orderly transaction would occur between market participants.

Formula and Calculation

While observable inputs are not a formula themselves, they are the essential building blocks for various valuation techniques used to calculate fair value. These techniques fall broadly into market approaches, income approaches, and cost approaches. The objective of any valuation technique is to estimate the "exit price"—the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction at the measurement date.

⁸For instance, in a market approach, the fair value of an asset might be determined by:

Here, the "Comparable Asset Price" would be an observable input, such as a Level 2 input derived from recent transactions of similar assets. The "Adjustment Factor" might also be based on observable market data, like differences in credit risk or liquidity risk between the subject asset and the comparable.

Similarly, within an income approach like a discounted cash flow (DCF) model, observable inputs like prevailing market interest rates, bond yields, or equity risk premiums are used to determine the discount rate. While future cash flow projections involve some unobservable assumptions, the discount rate should reflect market-based expectations of return for assets with similar risks.

Interpreting the Observable Inputs

Interpreting observable inputs involves understanding their quality and relevance within the fair value hierarchy. Level 1 inputs, such as quoted prices for identical assets in active markets, are considered the most reliable and require no adjustment. If available, these inputs should be used without exception. F⁷or example, the closing price of a publicly traded stock on a major exchange is a Level 1 observable input.

Level 2 inputs are those that are observable, either directly or indirectly, but are not Level 1 prices. These might include quoted prices for similar assets in active markets, quoted prices for identical or similar assets in inactive markets, interest rates, yield curves, or credit spreads. W⁶hen using Level 2 inputs, judgment is required to determine the necessary adjustments to reflect the specific characteristics of the asset or liability being valued. The closer these inputs are to direct market observations for the exact asset, the more robust the valuation. Understanding the nature and source of these inputs is crucial for assessing the reliability of the resulting fair value measurement.

Hypothetical Example

Consider a private equity firm, "Horizon Capital," that holds a portfolio of various investments. One such investment is a publicly traded corporate bond that is actively traded on an exchange. Another is a privately held company for which no direct market comparable exists.

To determine the fair value of the corporate bond at the end of the reporting period, Horizon Capital would use its closing price on the exchange. This is a Level 1 observable input because it is an unadjusted quoted price in an active market for an identical financial instrument. The valuation is straightforward and highly reliable.

For the privately held company, Horizon Capital cannot rely on Level 1 inputs. Instead, it might look to Level 2 observable inputs. This could involve examining recent transactions of comparable public companies, using observable market multiples (e.g., price-to-earnings ratios, enterprise value-to-EBITDA multiples) from those public companies, and then adjusting these multiples for differences in size, growth prospects, and liquidity risk. The market multiples themselves are observable, but the adjustments introduce judgment. If no such observable comparable transactions exist, the firm might have to rely more heavily on unobservable inputs, such as internal financial forecasts, which would categorize the valuation as Level 3.

Practical Applications

Observable inputs are fundamental across a wide range of financial applications, underpinning the credibility and accuracy of financial reporting.

• Financial Reporting and Compliance: Companies use observable inputs to comply with fair value accounting standards (ASC 820 and IFRS 13) when preparing their financial statements. This ensures that assets and liabilities are reported at values reflective of current market conditions, not just historical costs. The U.S. Securities and Exchange Commission (SEC) frequently reviews the quality of disclosure about these measurements.
  *⁵ Investment Portfolio Valuation: Investment funds, mutual funds, and hedge funds frequently value their portfolios using observable inputs. Publicly traded stocks, bonds, and exchange-traded derivatives are often valued using Level 1 inputs, while over-the-counter (OTC) derivatives and less liquid securities may rely on Level 2 inputs, such as broker quotes or prices derived from observable market parameters.
• Mergers & Acquisitions (M&A): In M&A transactions, observable inputs are crucial for valuing target companies and their assets. Public company comparables (market multiples) and market-derived discount rates for discounted cash flow analysis are prime examples of observable inputs used in due diligence and negotiation.
• Risk Management: Financial institutions employ observable inputs in their risk management frameworks to assess market risk, credit risk, and liquidity risk. For instance, bond yields and credit spreads are observable inputs that inform the pricing of credit derivatives and the valuation of debt portfolios.
• Regulatory Capital Calculation: Banks and other financial institutions use fair value measurements, heavily relying on observable inputs, to determine their regulatory capital requirements. The accurate valuation of assets impacts a bank's capital ratios and its ability to absorb potential losses.

Limitations and Criticisms

While observable inputs are preferred for their reliability, their availability can be a significant limitation, particularly in illiquid or distressed markets. When an active market for an asset or liability does not exist, or when market activity significantly declines, companies must increasingly rely on Level 2 or even Level 3 inputs, which are less objective. The determination of whether a market is "active" or "inactive" often requires considerable judgment.

⁴A notable debate surrounding fair value accounting and its reliance on observable inputs emerged during the 2008 financial crisis. Critics argued that the requirement to "mark-to-market" (value assets using current market prices) exacerbated the crisis by forcing companies to record significant write-downs on assets like mortgage-backed securities, even if they did not intend to sell them. This, some contended, could create a downward spiral, where falling market prices led to forced sales, further depressing prices.

However, academic research generally suggests that fair value accounting, while a messenger of declining asset values, did not significantly contribute to the severity of the crisis. Studies indicate that the problems stemmed more from the underlying credit deterioration than from the accounting methodology itself, and that empirical evidence does not strongly support claims of excessive write-downs solely due to fair value accounting., ³N²onetheless, the episode highlighted the challenges of applying fair value measurements when observable inputs become scarce or distorted due to market dysfunction. This situation often necessitates greater use of management judgment and more extensive disclosure about the sensitivity analysis of valuations to changes in unobservable inputs.

Observable Inputs vs. Unobservable Inputs

The distinction between observable inputs and unobservable inputs is fundamental to the fair value measurement hierarchy.

The core difference lies in their source and verifiability. Observable inputs are external and market-driven, reflecting actual transactions and market conditions. Unobservable inputs, conversely, stem from the reporting entity's own assumptions about how market participants would price an asset or liability, often when no active market or comparable transactions exist. While both are used in valuation techniques, accounting standards prioritize the former to ensure financial reporting provides a true and fair view of an entity's financial position.

FAQs

What are the three levels of observable inputs?

Observable inputs are categorized into two levels within the fair value hierarchy: Level 1 and Level 2. Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities. Level 2 inputs are other observable data, such as quoted prices for similar assets or liabilities in active markets, or quoted prices for identical or similar assets in markets that are not active.

¹### Why are observable inputs important in fair value measurement?

Observable inputs are crucial because they enhance the reliability, objectivity, and comparability of fair value measurements. By using market-based data, they reduce the need for subjective judgments, allowing financial statements to better reflect the current economic reality of an asset or liability's worth. This transparency aids investors and other stakeholders in making informed decisions.

Can observable inputs ever be adjusted?

Level 1 observable inputs are generally used without adjustment. However, Level 2 observable inputs may require adjustments to account for differences between the asset or liability being valued and the comparable market data. These adjustments must be consistent with how a hypothetical market participants would consider them. If significant adjustments using unobservable inputs are required, the measurement might move to Level 3.

How do observable inputs relate to market-to-market accounting?

"Mark-to-market" accounting is largely synonymous with fair value accounting, particularly when fair value is determined using Level 1 observable inputs. It refers to valuing assets and liabilities at their current market price. When an asset has readily available quoted prices in an active market, it is "marked-to-market" using these highly observable inputs.