What Are Unobservable Inputs?
Unobservable inputs refer to the valuation inputs for an asset or liability that are not readily available in active markets and cannot be corroborated by market data. These inputs are typically developed using a reporting entity's own assumptions about what market participants would use to price the asset or liability, based on the best information available in the circumstances. They are a critical component of financial reporting and valuation models, particularly under Fair Value measurement standards within the broader category of Financial Reporting. When valuing assets or liabilities, accounting standards prioritize the use of observable inputs over unobservable inputs to enhance reliability and comparability of financial information. Unobservable inputs are often categorized as Level 3 inputs within the fair value hierarchy.
History and Origin
The concept of fair value measurement, and by extension the classification of inputs into observable and unobservable categories, gained prominence with the development of modern accounting standards. In the United States, the Financial Accounting Standards Board (FASB) issued ASC 820, Fair Value Measurement, providing a unified framework for fair value. Internationally, the International Accounting Standards Board (IASB) issued IFRS 13, Fair Value Measurement, which became effective in 2013 and also provides comprehensive guidance on fair value measurement and disclosure, including the fair value hierarchy that distinguishes between observable and unobservable inputs. IFRS 13 was developed to enhance consistency and reduce complexity in fair value measurements across various accounting standards. This hierarchy gives the highest priority to Level 1 (quoted prices in active markets for identical assets or liabilities) and the lowest priority to Level 3, which relies on unobservable inputs.
Key Takeaways
- Unobservable inputs are valuation assumptions for assets or liabilities that lack direct market data.
- They are categorized as Level 3 within the fair value hierarchy, indicating the highest degree of subjectivity.
- Their use is necessary when observable market data is unavailable, particularly for illiquid or unique assets.
- Companies must disclose the methodologies and assumptions used for these inputs in their financial statements.
- Reliance on unobservable inputs can introduce significant estimation uncertainty and impact the reliability of fair value measurements.
Interpreting Unobservable Inputs
When a fair value measurement relies significantly on unobservable inputs, it indicates that the valuation involves a high degree of judgment and estimation rather than direct market evidence. This is because unobservable inputs are derived from an entity's own assumptions about what a market participant would use in pricing an asset or liability, based on the best information available when observable data is scarce or non-existent4. The financial community scrutinizes valuations heavily dependent on Level 3 inputs due to their inherent subjectivity. Disclosures regarding these inputs are crucial for users of financial statements to understand the potential volatility and uncertainty associated with such valuations.
Hypothetical Example
Consider a private equity firm that holds a significant stake in a nascent biotechnology startup that has no public trading history or comparable acquisitions. To determine the fair value of this investment for its quarterly financial statements, the firm cannot rely on observable market prices (Level 1 or 2 inputs). Instead, it must develop unobservable inputs.
The firm might project the startup's future revenue growth and profitability based on its internal business plan, expected drug development milestones, and management's assumptions about market penetration. It would then use a Discounted Cash Flow (DCF) model, where these projected cash flows are discounted back to their present value using a discount rate that reflects the specific risks of the startup and industry. The projected cash flows and the discount rate in this scenario are examples of unobservable inputs, as they are not directly observable in the market but are instead based on the firm's best estimates and judgments.
Practical Applications
Unobservable inputs are primarily applied in situations where active markets for identical or similar assets and liabilities do not exist. This often pertains to items valued using Level 3 Inputs within the fair value hierarchy3. Common practical applications include:
- Private Equity and Venture Capital Investments: Valuing stakes in private companies or early-stage startups where no public market exists.
- Complex Financial Instruments: Assessing the fair value of bespoke derivatives, structured products, or illiquid debt securities.
- Intangible Assets: Determining the value of internally developed software, patents, brands, or customer relationships for financial reporting, especially during due diligence for mergers and acquisitions.
- Real Estate: Valuing unique or specialized properties, particularly in illiquid markets, where comparable sales data is scarce.
- Impairment Testing: For assets where a market price is not available, such as goodwill or certain long-lived assets, companies use models that rely on projections of future cash flows and other internal assumptions to perform impairment testing.
In these scenarios, valuation techniques like the Income Approach (e.g., discounted cash flow) or the Cost Approach are employed, heavily relying on unobservable inputs like projected cash flows, growth rates, and discount rates, adjusted for entity-specific risks.
Limitations and Criticisms
The reliance on unobservable inputs introduces inherent limitations and criticisms, primarily due to the increased subjectivity and potential for estimation uncertainty. Unlike observable inputs that are market-driven, unobservable inputs depend on management's judgment and internal data, which can be challenging for external users to verify or compare.
A significant criticism centers on the potential for management bias. When market data is absent, the assumptions made for Level 3 Inputs can directly influence reported fair values, which may lead to concerns about the transparency and reliability of reporting standards. This subjectivity can impact investor confidence and raise questions about the quality of financial reporting. The lack of transparency in Level 3 valuation inputs has been linked to concerns about potential over-valuation and the hoarding of losses, which could exacerbate liquidity shocks during adverse market events2.
Furthermore, significant changes in these underlying assumptions can lead to substantial and sudden adjustments in reported fair values, contributing to volatility in financial statements and making it difficult for stakeholders to perform accurate risk assessment.
Unobservable Inputs vs. Observable Inputs
The distinction between unobservable inputs and observable inputs is fundamental in fair value accounting and the fair value hierarchy.
| Feature | Unobservable Inputs (Level 3) | Observable Inputs (Level 1 & 2) |
|---|---|---|
| Source | Entity's own assumptions, internal data, and estimations. | Market-derived data from active or inactive markets. |
| Availability | Not readily available in the marketplace. | Publicly available, directly or indirectly. |
| Subjectivity | High; significant management judgment required. | Low; objective, verifiable market data. |
| Reliability | Lower; prone to estimation uncertainty and potential bias. | Higher; more reliable and comparable. |
| Examples | Projected cash flows, internally developed volatility assumptions, private company discount rates. | Quoted prices for identical assets in active markets (Level 1); quoted prices for similar assets, interest rates, yield curves (Level 2). |
While observable inputs are preferred due to their objectivity and verifiability, unobservable inputs become necessary when market-based data is scarce or nonexistent. The fair value hierarchy, established by accounting standards, prioritizes the use of observable inputs and requires extensive disclosure when unobservable inputs are significant to a fair value measurement1.
FAQs
Why are unobservable inputs used if they are less reliable?
Unobservable inputs are used out of necessity when there is insufficient market data to determine the fair value of an asset or liability. For unique, illiquid, or privately held instruments, directly observable prices or comparable market transactions simply do not exist. In such cases, entities must rely on their best estimates and assumptions, consistent with how hypothetical market participants would price the item under current market conditions.
How are unobservable inputs verified?
The verification of unobservable inputs primarily relies on robust internal controls, documented valuation methodologies, and external audits. While direct market corroboration is absent, auditors review the reasonableness of the assumptions, the integrity of the data used, and the consistency of the valuation models with generally accepted accounting standards. Companies are also required to provide extensive disclosures about the assumptions and sensitivity of fair value measurements based on these inputs.
Do unobservable inputs impact financial stability?
The use of unobservable inputs can have implications for financial stability, especially during periods of market stress. When a significant portion of assets is valued using these subjective inputs, there can be a lack of transparency and a potential for delayed recognition of losses. This can make it difficult for regulators and other market participants to assess the true exposure and health of financial institutions, potentially contributing to systemic risk if valuations are not adequately managed or disclosed.