What is the significance of 'unobservable inputs' in determining the fair value of Chocolate Bash's financial instruments?
Chocolate_Bash 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, December 31, 2022, & December 31, 2021, 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 38)
What This Means (2024 FDD)
According to Chocolate Bash's 2024 Franchise Disclosure Document, the valuation of financial instruments is based on a hierarchy that prioritizes the inputs used in valuation techniques, specifically whether these 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 hierarchy is structured into three levels, with Level 1 giving the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities, and Level 3 assigning the lowest priority to unobservable inputs.
Level 3 valuations, which rely on unobservable inputs, are used when fair values are determined using pricing models, discounted cash flows, or similar techniques, and at least one significant model assumption or input is unobservable. This means that the values are based more on internal estimates and assumptions rather than verifiable market data.
For a prospective Chocolate Bash franchisee, this is important because it provides insight into how the company values its financial assets and liabilities. The fact that the carrying amounts of Chocolate Bash's financial assets and liabilities approximate their fair value as of December 31, 2023, December 31, 2022, and December 31, 2021, suggests that the company's financial reporting is relatively straightforward and that there are no significant discrepancies between the book value and the estimated market value of its assets and liabilities. However, the use of Level 3 measurements, which rely on unobservable inputs, introduces a degree of subjectivity and estimation in the valuation process, which potential franchisees should be aware of.