Observable Inputs Guide:
Observable inputs play a critical role in developing fair values for assets and liabilities under modern financial reporting standards. These inputs, derived from market-based data, form the foundation of valuation techniques used in compliance with accounting frameworks such as IFRS 13 and ASC 820.
This guide explores what observable inputs are, how they fit into the fair value hierarchy, and how finance professionals apply them in practice for valuation and financial reporting.
What Are Observable Inputs?
Observable inputs are data points that reflect assumptions market participants would use when pricing an asset or liability. These inputs are developed from sources that are independent, verifiable, and based on actual market activity, rather than internal estimates.
They include:
- Quoted prices for identical or similar assets in active or inactive markets
- Interest rates and yield curves observable at commonly quoted intervals
- Credit spreads, default rates, and liquidity premiums derived from market data
- Market-corroborated inputs such as pricing services or broker quotes
Crucially, observable inputs are not entity-specific. They are intended to reflect the perspective of a typical market participant, not management’s internal view.
Role in Fair Value Measurement
Under both IFRS 13 and ASC 820, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
To ensure consistency and reliability in fair value measurement, these standards establish a three-level fair value hierarchy based on the observability of inputs:
The Fair Value Hierarchy
- Level 1 Inputs:
Quoted prices in active markets for identical assets or liabilities (e.g., listed equities on a major stock exchange). - Level 2 Inputs:
Observable inputs, other than quoted prices in Level 1, including:- Quoted prices for similar assets in active markets
- Quoted prices for identical or similar assets in inactive markets
- Interest rates, yield curves, credit spreads
- Market-corroborated inputs from independent sources
- Level 3 Inputs:
Unobservable inputs that rely on management’s own assumptions, used when observable data is not available.
Observable inputs are categorized within Level 2 and represent the most widely used data in financial instrument valuations, real estate appraisals, and other complex asset or liability measurements.
Practical Examples of Observable Inputs in Finance
1. Valuation of Corporate Bonds
A finance team valuing a corporate bond may use:
- Observed yield curves from benchmark rates (e.g., LIBOR or SOFR)
- Credit spreads based on bonds with similar ratings and maturities
- Market price quotes from pricing vendors
These are Level 2 observable inputs, providing a market-driven basis for valuation.
2. Interest Rate Swap Valuation
In valuing an interest rate swap, observable inputs might include:
- Forward interest rate curves
- Counterparty credit spreads
- Observable volatility assumptions
These are sourced from active markets and third-party data providers.
3. Real Estate Investment Valuation
For investment property valuation:
- Recent sale prices of similar properties in the same area
- Market rental rates
- Market-derived cap rates
All of the above are observable inputs if derived from active market activity and external data.
Why Observable Inputs Matter
- Transparency: They ensure valuations are based on publicly available or verifiable data, reducing subjectivity.
- Auditability: External, market-based inputs support defensible fair value measurements during audits or regulatory reviews.
- Compliance: Using observable inputs aligns with requirements under IFRS, US GAAP, and other international standards.
- Comparability: Because observable inputs are not entity-specific, they promote consistent valuations across companies and reporting periods.
Common Challenges and Considerations
Market Inactivity:
In illiquid markets, it may be difficult to obtain observable inputs. In such cases, entities must disclose the use of Level 3 inputs and explain why observable data was not available.
Data Source Reliability:
Observable inputs must be obtained from reputable sources — pricing vendors, broker quotes, and published market data must be independently verified and supportable.
Adjustments to Observable Inputs:
Adjustments may be necessary to reflect the characteristics of the asset or liability. However, excessive adjustments could invalidate the classification as Level 2 and may shift the measurement to Level 3.
Best Practices for Applying Observable Inputs
- Document all assumptions and data sources used in valuations, especially for audit trails.
- Validate the independence and consistency of third-party pricing services or broker quotes.
- Use multiple data points where possible to confirm the reliability of observable inputs.
- Ensure inputs reflect current market conditions, particularly at period-end reporting dates.
Frequently Asked Questions
Are observable inputs always considered Level 2?
Yes, by definition. If they are not directly quoted in active markets (Level 1), but still derived from market-based data, they fall under Level 2.
What’s the difference between observable and unobservable inputs?
Observable inputs come from external market sources. Unobservable inputs are based on internal models, forecasts, or assumptions, and are used only when market data is unavailable.
Can management override observable inputs?
Only in limited cases. If market data does not reflect orderly transactions or is deemed distorted, adjustments can be made, but they must be justified and disclosed transparently.
Finally, whether you’re preparing valuations or reviewing audit documentation, this Observable Inputs Guide serves as a practical resource for applying Level 2 market data correctly.
Key Takeaways
- Observable inputs are market-based data used to develop fair values for assets and liabilities.
- They are central to Level 2 of the fair value hierarchy under IFRS 13 and ASC 820.
- Common sources include interest rates, credit spreads, pricing services, and broker quotes.
- Use of observable inputs ensures objectivity, auditability, and regulatory compliance.
- Finance professionals must evaluate data quality, independence, and market relevance when applying these inputs.
Further Reading: