Valuation of Financial Instrument

Introduction:

Financial instrument are those contracts that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Some of examples of financial instruments are investment in equity instruments of other entity, derivatives, debt instruments, compound instruments, deferred purchase considerations, trade receivables, trade payable etc. Valuation of financial instruments is commonly required for financial reporting purpose, in case of business combinations, share-based payments, off-market transactions, risk management, tax allocations, dispute resolution, purchase-price allocations, liquidation, etc.

Considering the multiple categorization and different usages of a financial instrument valuation harmonization of valuation principles followed in India was highly required. The Institute of Chartered Accountants of India (ICAI) constituted the Valuation Standards Board (VSB) on 28^th   February, 2017. The VSB of ICAI has issued eight sets of valuation standards and also Framework for the Preparation of Valuation Report in accordance with the ICAI Valuation Standards. The Valuation Standard 303 (VS 303) issued by ICAI laid down principles on valuation of financial instruments. ICAI Valuation Standard 303 Financial Instruments, shall be applied for the valuation reports issued on or after 1st July, 2018. This article briefs on principles prescribed in VS 303 with regard to valuation of Financial Instrument.

Selection of Valuation Method:

Valuation Standard 303 “Financial Instruments” prescribes followings are the indicative factors that need to be consider for determining appropriate method or combination of methods for the purpose of valuation of financial instruments: –

1. The valuation base and terms and conditions of the instrument being valued: –

In selection appropriate valuation method, due consideration must be given to the nature of instrument and the terms conditions embodying with instrument. While determining the market comparable the terms and conditions of the instrument plays and important role.

 2. The purpose of valuation: –

The purpose for which valuation is being used is also a determining factor. Generally, in the case of business combination transaction the valuation methodology which consider more observable inputs is given priority over other approaches.      

3. The control framework of the entity and input data sets: –

In selection of the appropriate valuation method, a valuer shall also give importance to the control environment under which the entity and the instrument operates. The control environment consists the entity’s internal governance and control objectives, procedures and their operating effectiveness with the objective of enhancing the reliance on the valuation process and outcome thereof. A valuer, if relying on valuation inputs provided by the entity, shall form independent opinion on the valuation control environment and factor outcome on the valuation method, approach, outcome and reporting thereof.

Financial instruments being generally aligned to market linked factors, the usage of market linked methods with observable inputs is usually the preferred approach to arrive at a value. Valuation of certain financial instruments, for example, investment in equity instruments of other entity, may in some circumstances be based on the inherent business valuation from which the financial instrument derives value. In a single line it can be said that the valuer should use the valuation method which maximize the use of relevant observable inputs and minimize the use of unobservable inputs.

Methods of Valuation of Financial Instruments:

Followings are methods prescribed in ICAI Valuation Standard 303: –

Market Approach Valuation: –

• This method uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or a group of assets and liabilities.
• In market approach, the value of the financial instrument is determined by considering traded prices of such instrument in an active market; or prices and other relevant information generated by market transactions involving identical or comparable (similar) assets.
• In absence of an active market benchmark price, comparable pricing or private transaction pricing may also be considered

Income Approach Valuation: –

• Income approach is the valuation approach that converts maintainable or future amounts (e.g., cash flows or income and expenses) to a single current i.e., discounted amount.
• In this approach value of a financial instrument is determined based on the expected economic benefits by way of income, cash flows or cost savings generated by such financial instrument and level of risk associated with such financial instrument. It generally involves discounting future amounts to a single present value after adjusting inherent risks.
• Black-Scholes-Merton formula or a binomial model and similar other pricing models are examples of income approach, that incorporate present value techniques and reflect both the time value and the intrinsic value of an option.

Cost Approach Valuation: –

• Cost approach is a valuation approach that reflects the amount that would be required currently to replace the service capacity of an asset.
• From the perspective of a market participant seller, the price that would be received for the asset is based on the cost to a market participant buyer to acquire or construct a substitute asset of comparable utility.
• The usage of cost method is of more predominance in valuation of non-financial assets.

Consistency in Applying Valuation Methods:

Once the valuation method has been used, such valuation method shall be applied consistently. However, in following circumstances a change in valuation method may be required:

• Change in terms or regulations governing the instrument;
• New markets development;
• New information becomes available;
• Information previously used is no longer available;
• Valuation techniques improvement; or
• Market conditions change.

Use of Present Value Technique in determining Value of Financial Instrument under Income Approach: –

Present value is an integral tool used in the income approach to link future amounts to a present amount using a discount rate. The valuation of a financial instrument using a present value technique captures all the followings at the valuation date: –

• an estimate of future cash flows for the asset or liability being measured;
• expectations about possible variations in the amount and timing of the cash flows representing the uncertainty inherent in the cash flows;
• the time value of money, represented by the rate on risk-free security that have maturity dates or duration that coincide with the period covered by the cash flows
• the price for bearing the uncertainty inherent in the cash flows (i.e., a risk premium)
• Credit risk i.e. risk of default associated with instrument as well as with issuer

Measurement of credit risk involves lots of subjectivity and judgments. Followings factors normally considered while measuring the credit risk: –

• Counter party risk: The credit-risk measurement is influenced by the financial strength of the issuer or any guarantors and will involve considerations for present and projected financial performance of the parties; and performance and prospects for the macro industry sector in which the entity/business operates.
• Capital leveraging: The amount of borrowing deployed to operationalize the assets from which an instrument’s return is derived, or the overall capital leveraging profile of the issuer can affect the volatility of returns to the issuer and also the credit risk of the instrument.
• Security hierarchy: Establishing the security hierarchy of an instrument is important in assessing the credit risk. Lower hierarchy in security charge would usually result in a higher credit risk profile.
• History of default: Default occurred in the recent past in payment obligations on borrowings, payable, etc. is relevant in evaluating the financial stress and resulting credit risk therefrom.

Conclusion:

The Valuation Standard (VS) 303 “Financial Instruments “will able to harmonize the valuation practices across the country but still there are some of issues like methodology for determining risk premium, assigning a value for credit risk etc. need to be addressed.

Reference: ICAI Valuation Standards