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 28th 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.
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.
Followings are methods prescribed in ICAI Valuation Standard 303: –
Market Approach Valuation: –
Income Approach Valuation: –
Cost Approach Valuation: –
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:
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: –
Measurement of credit risk involves lots of subjectivity and judgments. Followings factors normally considered while measuring the credit risk: –
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