Key Takeaways
- Observable inputs include quoted prices, interest rate curves, credit spreads, and implied volatilities derived from active or inactive markets.
- IFRS 13.67 requires entities to maximise the use of observable inputs and minimise reliance on unobservable inputs.
- Audit effort drops significantly when a measurement rests on observable data rather than management-generated assumptions.
- Around 60–70% of financial instrument fair values at mid-market European corporates rely on Level 2 observable inputs rather than quoted prices or models.
What is Observable Inputs?
IFRS 13.67 establishes a clear priority: observable inputs first. The standard does not define observability through a binary test. Instead, it draws the line at whether the data is developed using market data obtained from sources independent of the entity. A quoted share price on Euronext is observable. A management-generated revenue forecast used to value an intangible asset is not.
Level 2 inputs under IFRS 13.81 cover four categories. Quoted prices for similar (not identical) assets in active markets come first. Quoted prices for identical or similar assets in markets that are not active follow. Then come inputs other than quoted prices that are directly observable (interest rate swap curves, for instance). The fourth category is market-corroborated inputs, where the data is derived principally from or corroborated by observable market data through correlation or other means.
The auditor's task under ISA 540.13(b) is to evaluate whether the inputs the entity selected are relevant and reliable. When the input is observable, the auditor traces it to a third-party source (a pricing service, an exchange feed, a central bank rate). When the entity adjusts an observable input (for credit risk, for liquidity, for differences between the instrument and the reference asset), the adjustment itself may be unobservable, and IFRS 13.73 requires classification based on the lowest-level input that is significant to the entire measurement.
Worked example: Dupont Ingenierie S.A.S.
Client: French engineering services firm, FY2025, revenue €92M, IFRS reporter. Dupont holds an interest rate swap with a notional of €15M, entered to convert a floating-rate bank loan to a fixed rate. The swap has 3.2 years remaining. Dupont measures the swap at fair value through profit or loss under IFRS 9.
Step 1 — Identify the valuation technique
Dupont's finance team measures the swap using a discounted cash flow model (income approach per IFRS 13.B10). The model projects net cash flows based on the difference between the fixed rate (2.4%) and the forward EURIBOR curve, then discounts those flows to present value.
Step 2 — Source the observable inputs
The forward EURIBOR curve at 31 December 2025 is sourced from Refinitiv. The discount curve uses the EUR overnight index swap (OIS) rate. Both curves are derived from active interbank markets with daily price formation. The 3-year EUR OIS rate at year-end is 2.15%.
Step 3 — Apply the credit valuation adjustment
Dupont applies a credit valuation adjustment (CVA) of €18,000 to reflect the counterparty bank's credit risk and a debit valuation adjustment (DVA) of €6,200 to reflect its own credit risk. The CVA uses the bank's CDS spread (observable at 42 basis points). The DVA uses Dupont's implied credit spread, estimated at 185 basis points from comparable French mid-cap corporate bond yields.
Step 4 — Calculate fair value and classify
The undiscounted net cash flows total €412,000 in Dupont's favour. Discounted at the OIS curve and adjusted for CVA and DVA, the swap's fair value is €386,800. The DVA of €6,200 represents 1.6% of fair value. Management concludes this is not significant to the entire measurement, and classifies the swap as Level 2.
Conclusion: the fair value of €386,800 is defensible because every material input (forward EURIBOR curve, OIS discount curve, counterparty CDS spread) traces to an independent market source, and the one estimated input (Dupont's own credit spread) is not significant enough to move the measurement out of Level 2.
Why it matters in practice
- Teams document the fair value of a derivative but omit evidence that the inputs are actually observable at the measurement date. A yield curve sourced in October does not support a December measurement. ISA 540.20 requires the auditor to evaluate whether the data used is relevant to the measurement date, and the file should contain curves or price feeds dated at or near the reporting date.
- Entities treat a market-corroborated input as fully observable without documenting the correlation methodology. IFRS 13.81(c) allows corroborated inputs at Level 2, but the entity must demonstrate how the input was derived from or corroborated by market data. A credit spread "based on" comparable bonds needs a documented selection of comparables, a spread extraction method, and a rationale for any adjustments. Without that documentation, the input defaults to unobservable.
Observable inputs vs. unobservable inputs
| Dimension | Observable inputs | Unobservable inputs |
|---|---|---|
| Source | Market data from sources independent of the entity (IFRS 13.67) | Entity-generated assumptions developed using the best information available (IFRS 13.87) |
| Hierarchy level | Level 1 (quoted prices for identical items) or Level 2 (other observable data) | Level 3 only |
| Examples | Quoted share prices, EURIBOR curves, CDS spreads, comparable transaction multiples | Management revenue forecasts, entity-specific discount rates, marketability discounts without market evidence |
| Disclosure burden | Level classification and valuation technique description (IFRS 13.93) | Full quantitative disclosure of each significant unobservable input plus narrative sensitivity analysis (IFRS 13.93(d), (h)) |
| Audit effort | Trace to source, confirm measurement-date relevance, test any adjustments | Evaluate reasonableness of assumptions, perform sensitivity analysis, consider alternative estimates per ISA 540.18 |
The practical consequence: when an entity shifts an input from observable to unobservable (or vice versa), the hierarchy classification changes, the disclosure requirements change, and the audit procedures change. ISA 540.20 expects the auditor to evaluate whether inputs remain appropriate. A transfer between levels is not a formality.
Related terms
Frequently asked questions
How do I verify that an input qualifies as observable?
Trace the input to a source independent of the entity. IFRS 13.B34 states that observable inputs are developed using market data, such as publicly available information about actual events or transactions. If the input comes from a pricing service, verify that the service uses market-derived data, not model-generated estimates. If the entity adjusts the input, evaluate whether the adjustment introduces an unobservable element significant enough to change the hierarchy classification under IFRS 13.73.
Can an observable input become unobservable between reporting periods?
Yes. A corporate bond spread that was observable when the market was liquid can become unobservable if trading activity drops and pricing services switch to model-based estimates. IFRS 13.B37 acknowledges that the availability of observable inputs varies by instrument and by market conditions. The auditor should reassess the hierarchy classification at each reporting date per ISA 540.13(b), not carry forward the prior-period classification without evidence.
Does using a pricing service automatically make the input Level 2?
Not always. IFRS 13.B45 notes that inputs from pricing services may be either observable or unobservable depending on the methodology the service uses. If the service derives the price from actual market transactions, the input is observable. If the service uses a matrix pricing model with entity-specific or unobservable assumptions, the resulting input may belong at Level 3. The auditor should understand the pricing service's methodology before concluding on the hierarchy level.