For Bombs Away, what is the significance of an input being unobservable in determining the level of 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.
As of December 31, 2023, the carrying amounts of the Company's financial assets and liabilities reported in the balance sheets approximate their fair value.
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 is a key factor in determining the fair value of financial instruments. The document references Financial Accounting Standards Board (FASB) guidance, which prioritizes valuation techniques based on whether the inputs are observable (reflecting market data) or unobservable (reflecting market assumptions). This hierarchy is used to classify the reliability and relevance of the data used to determine the value of Bombs Away's assets and liabilities.
Level 1 measurements, which have the highest priority, rely on unadjusted quoted prices in active markets for identical assets or liabilities. Level 2 measurements use inputs other than quoted prices within Level 1 but are still observable, either directly or indirectly. In contrast, Level 3 measurements, which have the lowest priority, rely on unobservable inputs. This means that the fair values are determined using models like discounted cash flows, where at least one significant assumption or input is not based on market data.
For a prospective Bombs Away franchisee, this means that some of the company's reported asset and liability values may rely on internal assumptions rather than verifiable market data. While the FDD states that as of December 31, 2023, the carrying amounts of Bombs Away's financial assets and liabilities approximate their fair value, it's important to understand that the reliability of these values can vary depending on the level of inputs used in their determination. Franchisees should be aware of the potential for subjectivity in these valuations, especially when unobservable inputs (Level 3) are used, as these could be more susceptible to management's assumptions and estimates.