What makes an input 'unobservable' in the context of Bombs Away's Level 3 financial instruments?
Bombs_Away Franchise · 2024 FDDAnswer from 2024 FDD Document
Financial Accounting Standards Board ("FASB") guidance specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). The three levels of the fair value hierarchy are as follows:
- Level 1 Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 primarily consists of financial instruments whose value is based on quoted market prices such as exchange-traded instruments and listed equities.
- Level 2 Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly (e.g., quoted prices of similar assets or liabilities in active markets, or quoted prices for identical or similar assets or liabilities in markets that are not active).
- Level 3 Unobservable inputs for the asset or liability. Financial instruments are considered Level 3 when their fair values are determined using pricing models, discounted cash flows or similar techniques and at least one significant model assumption or input is unobservable.
Source: Item 21 — FINANCIAL STATEMENTS (FDD page 35)
What This Means (2024 FDD)
According to Bombs Away's 2024 Franchise Disclosure Document, unobservable inputs are a key component in determining the fair value of financial instruments, specifically within Level 3 measurements. Level 3 measurements rely on inputs that are not based on direct market data but instead reflect the company's own assumptions. This contrasts with Level 1 measurements, which prioritize unadjusted quoted prices in active markets, and Level 2, which uses observable inputs other than quoted prices from Level 1.
For Bombs Away, financial instruments are classified as Level 3 when their fair values are derived using methods like pricing models or discounted cash flows. A critical factor is that at least one significant assumption or input used in these models is unobservable. This means that the valuation is based on internal estimates and judgments rather than verifiable market data.
This approach carries implications for prospective franchisees as it highlights the subjectivity involved in valuing certain financial instruments. While the FDD provides audited financial statements, understanding the assumptions behind Level 3 valuations is crucial for assessing the financial health and performance of Bombs Away. Franchisees should be aware that these valuations are based on internal assessments, which may differ from objective market values.