What are Unobservable Inputs?

Unobservable inputs are inputs used in fair value accounting for which there is no market information available, which instead use the best information available for pricing assets or liabilities. An unobservable input may include the reporting company’s own data, adjusted for other reasonably available information. Examples are an internally-generated financial forecast and the prices contained within an offered quote from a distributor. Unobservable inputs can be quite subjective.

The most favored approaches to deriving fair values for assets and liabilities are those that maximize the use of relevant observable inputs and minimize the use of unobservable inputs. Observable inputs are derived from market data that properly reflect the assumptions that third parties would use when setting prices for assets and liabilities. Examples of markets that are considered to provide observable inputs are stock exchanges, dealer markets, and brokered markets.

Types of Unobservable Inputs

There are several types of unobservable inputs that may be used to develop the value of an asset or liability. Here are several examples:

Estimated future cash flows. A business could estimate an asset valuation based on the amount of annual cash flows expected to be generated by it, discounted to their present value using an appropriate discount rate.
Third party quotes. A business could estimate the value of an asset based on quotes that it has received for similar assets from third parties, adjusted for differences between the condition and features of the quoted assets.

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Fair Value Accounting

Examples of Unobservable Inputs

Here are three examples of unobservable inputs used in fair value accounting:

Discount rates for private companies. When valuing a private company with no active market, an entity might estimate a discount rate based on the company’s risk profile, industry conditions, and expected cash flows, rather than using observable market rates.
Projected cash flows for illiquid assets. For complex or illiquid financial instruments like certain structured products or privately held investments, fair value may rely on internally developed projections of future cash flows, based on management’s assumptions.
Volatility estimates for custom derivatives. When valuing customized or exotic derivatives for which there is no active market, firms may use internal models to estimate volatility, based on historical data and management’s expectations rather than market data.

These inputs fall under Level 3 of the fair value hierarchy