For Bombs Away, what is the relationship between the observability of inputs and the level assigned to an asset or liability?
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, the observability of inputs used to determine the fair value of financial instruments directly impacts the level assigned within a hierarchy. This hierarchy prioritizes valuation techniques based on whether the inputs are observable or unobservable. Observable inputs are derived from market data obtained from independent sources, while unobservable inputs reflect the company's own market assumptions. This is part of standard accounting practices.
The hierarchy consists of three levels. Level 1 gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities. Level 2 includes inputs other than quoted prices within Level 1, but are still observable for the asset or liability, either directly or indirectly, such as quoted prices of similar assets in active markets. Level 3 gives the lowest priority to unobservable inputs, where fair values are determined using pricing models, discounted cash flows, or similar techniques with at least one significant unobservable model assumption or input.
For a prospective Bombs Away franchisee, understanding this hierarchy is crucial for interpreting the company's financial statements. It demonstrates how Bombs Away values its assets and liabilities, and the degree to which these valuations rely on market data versus internal assumptions. Level 3 valuations, which rely heavily on unobservable inputs, may carry more risk or uncertainty compared to Level 1 valuations that are based on readily available market prices. Franchisees should pay close attention to the methods Bombs Away uses to determine these values, as they can impact the overall financial health and stability of the franchise system.