With the introduction and the subsequent adoption of Ind AS by many Indian companies, the emphasis on valuation has increased.
The basis of value is closely related to the purpose of a given valuation exercise and can often vary. Selecting an appropriate basis of value is critical. For example, Fair Value is generally used for financial reporting purposes while Fair Market Value is used for tax reporting purposes. Other standards of value include investment value, liquidation value etc. Investment value reflects the value to a specific buyer/seller while liquidation value reflects the possible price of a business or an asset when operations are being discontinued or the assets/liabilities are being sold piece meal. Typically, Fair Value is a commonly utilized basis of value. Ind AS 113 – Fair Value Measurement defines Fair Value 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
Key aspects of Fair Value as per Ind AS 113 include:
- Fair Value is based on the exit pricee. the price that would be received to sell an asset or paid to transfer a liability, not the transaction price or entry price or the price that was actually paid for the asset or that was received to assume the liability. Generally, entry and exit prices are different. The idea of exit price is based on expectations about the sale or transfer price from the perspective of market participants as of the valuation date.
- Fair Value emphasizes the concepts of a “principal market” and the “most advantageous market” with respect to the business/asset being valued. The principal market is defined as the market with the greatest volume and level of activity for the subject asset or liability. Ind AS 113, specifies that in the absence of a principal market, the most advantageous market should be considered. The most advantageous market is the market that maximizes the amount that would be received to sell a given asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transportation costs.
- Fair Value measurements should reflect market participant assumptions in pricing an asset or liability. Market participants are assumed to be buyers and sellers in the principal (or most advantageous) market that are knowledgeable independent, unrelated parties willing and able to transact for the asset or liability being Fair Valued without compulsion.
- The highest and best use (“HABU”) of a nonfinancial asset or group of nonfinancial assets and nonfinancial liabilities is the use by market participants that maximises the value of the nonfinancial assets/liabilities. This Fair Value concept considers (i) the different ways of utilizing the individual asset/liability, i.e. the highest and best use, and (ii) the valuation premise, whether the maximum value is on a standalone basis or in combination with other assets.
- Fair Value measurements should consider characteristics of the assets/liabilities being valued such as the condition, location, restrictions associated with the sale or use of an asset as applicable. Liability fair valuations should reflect nonperformance risk.
Fair value hierarchy: To promote consistency and comparability in fair value measurements, Ind AS 113 establishes a Fair Value hierarchy that categorises valuation related inputs into three levels, namely:
- Level 1 inputs – these inputs are quoted prices (unadjusted) in active markets for identical assets/liabilities that the entity can access at the measurement date. As a quoted price in an active market provides the most reliable evidence of Fair Value, it should be utilized to measure Fair Value whenever available. Common examples of Level 1 inputs include listed equity securities and open ended mutual funds with daily published net asset values.
- Level 2 inputs – these inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include (i) quoted prices for similar assets or liabilities in active markets; (ii) quoted prices for identical/similar assets or liabilities in markets that are not active; (iii) inputs other than quoted prices that are observable for the asset or liability, such as interest rates, yield curves, and implied volatilities; and (iv)market-corroborated inputs. Adjustments to Level 2 inputs vary depending on factors specific to the asset or liability, including (i) condition or location of the asset; (ii) the extent to which inputs relate to items that are comparable to the asset or liability; and(iii) the volume or level of activity in the markets within which the inputs are observed.
- Level 3 inputs – these inputs are unobservable inputs for assets/liabilities. Unobservable inputs are used to measure Fair Value to the extent that relevant observable inputs are not available. The unobservable inputs should reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. An entity should develop unobservable inputs using the best information available. In developing unobservable inputs, an entity may begin with its own data, but it should adjust the data to ensure consistency with a market participant view point. Common examples of Level 3 inputs include management prepared business forecasts utilized in a discounted cash flow model.
In estimating the Fair Value of an asset/liability, valuation techniques are used that are appropriate under the circumstances and for which sufficient data is available to measure Fair Value, thus maximising the use of relevant observable inputs and minimising the use of unobservable inputs.
In some cases a single valuation technique will be appropriate, for example when valuing an asset/liability using Level 1 quoted prices in an active market for identical assets/liabilities. In other cases, multiple valuation techniques can be considered i.e. when valuing a cash generating unit. If multiple valuation techniques are used, the results should be evaluated considering the reasonableness of the range of values.
Valuation techniques used to measure Fair Value should be applied consistently. However, a change in a valuation technique or its application is reasonable if the change results in a measurement that is equally or more representative of Fair Value under the circumstances (for example a change in the entity’s product offerings, a change in business environment, achange in the industry or market conditions etc).