Under the Indian GAAP, assets and liabilities were required to be recorded at their book values. However, under Indian Accounting Standards (Ind AS), certain assets and liabilities are required to be recorded at a fair value on each reporting date. This has opened up new opportunities for valuers in India. However, it is imperative for the valuers to understand the principles of valuations as specified in those standards.
Ind AS 113- “Fair Value Measurement” (the Ind AS) sets out a framework for measuring fair value and provides disclosure requirements[1].
This article attempts to summarize the principles enumerated in the Ind AS from a valuer’s perspective.
Fair Value
Fair value is defined 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. Orderly transaction is defined as a transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g. a forced liquidation or distress sale).
Fair value is a market-based measurement, not an entity-specific measurement. It is an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Market participants are buyers and sellers in the principal market (or most advantageous market) for the asset and liability, who are independent of each other, having a reasonable understanding of the assets and liability and are able to and willing to enter into a transaction.
‘Principal Market’ and ‘Most Advantageous Market’
While a ‘principal market’ is the market with the greatest volume and level of activity for the asset or liability, ‘most advantageous market’ is the market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs.
A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the principal market for the asset or liability. In the absence of a principal market, the most advantageous market for the asset or liability is considered. What is required is that the entity must have access to the principal (or most advantageous) market at the measurement date. It is not required that the entity is able to sell the asset or transfer the liability on the measurement date.
While measuring fair value, characteristics of the asset or liability should be taken into account from the market participants perspective. For e.g, condition and location of the asset, restrictions, if any, on the sale or use of the asset, etc.
The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability is not adjusted for transaction costs (costs directly related to sale of the asset or transfer of the liability). The reason being that the transaction costs are not a characteristic of an asset or a liability and are specific to a transaction and will differ depending on how an entity enters into a transaction. However, transaction costs do not include transport costs, if location is a characteristic of the asset.
Inputs to Valuation Techniques
Valuation techniques used to measure fair value should maximise the use of observable inputs and minimise the use of unobservable inputs. Observable inputs are inputs which are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability. Unabsorbable Inputs are inputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability.
Examples of markets in which inputs might be observable include exchange markets, dealer markets, brokered markets and principal-to-principal markets.
Inputs should be consistent with the characteristics of the asset or liability that market participants would take into account in a transaction for the asset/ liability. Premiums or discounts that reflect size as a characteristic of the asset or liability can be considered. For example a control premium when measuring the fair value of a controlling interest. However, premiums or discounts that reflect size as a characteristic of the entity’s holding are not permitted in a fair value measurement. For example, a blockage factor that adjusts the quoted price of an asset or a liability because the market’s normal daily trading volume is not sufficient to absorb the quantity held by the entity.
To increase consistency and comparability in fair value measurements and related disclosures, the Ind AS establishes a fair value hierarchy that categorises the inputs used for fair value measurement into following three levels:
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. If there are multiple active markets in which the inputs are available, the inputs available in the principal market for the asset or liability should be used. In the absence of a principal market, the most advantageous market for the asset or liability can be used. Choice of market will also depend on whether the entity can enter into a transaction for the asset or liability at the price in that market at the measurement date.
Adjustment to a Level 1 input are not permitted except in the following circumstances:
(a) when an entity holds a large number of similar (but not identical) assets or liabilities that are measured at fair value and a quoted price in an active market is available but not readily accessible for each of those assets or liabilities individually.
(b) when a quoted price in an active market does not represent fair value at the measurement date. This might happen in case significant events take place after the close of a market but before the measurement date.
(c) when measuring the fair value of a liability/ an entity’s own equity instrument using the quoted price for the identical item traded as an asset in an active market and that price needs to be adjusted for factors specific to the item or the asset.
If no adjustment to the quoted price of the asset is required, the result is a fair value measurement categorised within Level 1 of the fair value hierarchy. However, any adjustment to the quoted price of the asset results in a fair value measurement categorised within a lower level of the fair value hierarchy.
Level 2 inputs are inputs, other than quoted prices included within Level 1, that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include the following:
1) quoted prices for similar assets or liabilities in active markets.
2) quoted prices for identical or similar assets or liabilities in markets that are not
3) inputs other than quoted prices that are observable for the asset or liability, for example interest rates and yield curves observable at commonly quoted intervals; implied volatilities; and credit spreads.
4) market-corroborated inputs.[2]
Adjustments to Level 2 inputs will vary depending on factors specific to the asset/ liability. Those factors include the condition or location of the asset; the extent to which inputs relate to items that are comparable to the asset or liability; and the volume or level of activity in the markets within which the inputs are observed. An adjustment to a Level 2 input that is significant to the entire measurement might result in a fair value measurement categorised within Level 3 of the fair value hierarchy.
Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs are used to measure fair value to the extent that relevant observable inputs are not available. However, unobservable inputs should reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.
Assumptions about risk include the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and the risk inherent in the inputs to the valuation technique. It might be necessary to include a risk adjustment when there is significant measurement uncertainty, for example, when there has been a significant decrease in the volume or level of activity when compared with normal market activity for the asset/liability.
Unobservable inputs should be developed using the best information available in the circumstances, which may also include the entity’s own data.
If an observable input requires an adjustment using an unobservable input and that adjustment results in a significantly higher or lower fair value measurement, the resulting measurement would be categorised within Level 3 of the fair value hierarchy.
Valuation Techniques
Following are few of the principles should be considered while selecting a valuation technique/s:
- Valuation techniques to be used should be appropriate in the circumstances and for which sufficient data are available to measure fair value.
- Valuation technique should maximise the use of relevant observable inputs and minimise the use of unobservable inputs.
- Multiple valuation techniques can be used. If multiple valuation techniques are used, the results should be evaluated considering the reasonableness of the range of values indicated by those results.
- If at the time of initial recognition, transaction price is considered as fair value and in subsequent periods, a valuation technique that uses unobservable inputs is used to measure fair value, the valuation technique should be calibrated so that at initial recognition the result of the valuation technique equals the transaction price. Calibration ensures that the valuation technique reflects current market conditions, and it helps an entity to determine whether an adjustment to the valuation technique is necessary.
- Valuation techniques used to measure fair value should be applied consistently. However, a change in a valuation technique or its application (e.g a change in its weightage when multiple valuation techniques are used or a change in an adjustment applied to a valuation technique) is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances.
Following are the different valuation approaches followed for measurement of fair value:
Market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or a group of assets and liabilities, such as a business. In this approach, market multiples are used derived from a set of comparables. The selection of the appropriate multiple requires judgement, considering qualitative and quantitative factors specific to the measurement.
Cost approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).
Income approach converts future amounts to a single current amount by discounting those to present value. When the income approach is used, the fair value measurement reflects current market expectations about those future amounts.
Examples of valuation techniques are present value techniques, option pricing models, such as the Black-Scholes-Merton formula or a binomial model, the multi-period excess earnings method etc.
Present value technique
Under income approach, present value is a tool used to link future amounts (e.g. cash flows) to a present amount using a discount rate. Present value technique captures all the following elements from the perspective of market participants at the measurement date:
1) an estimate of future cash flows for the asset or liability being measured.
2) expectations about possible variations in the amount and timing of the cash flows representing the uncertainty inherent in the cash flows.
3) the time value of money, represented by the rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows and pose neither uncertainty in timing nor risk of default to the holder (i.e. a risk-free interest rate).
4) the price for bearing the uncertainty inherent in the cash flows (i.e. a risk premium).
5) other factors that market participants would take into account in the circumstances.
6) for a liability, the non-performance risk relating to that liability, including the entity’s own credit risk.
Following general principles should be considered while using present value technique:
A. Cash flows and discount rates should take into account only the factors attributable to the asset or liability being measured.
B. To avoid double-counting or omitting the effects of risk factors, discount rates should reflect assumptions that are consistent with those inherent in the cash flows. For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using contractual cash flows of a loan . That same rate should not be used if using expected (i.e. probability-weighted) cash flows because the expected cash flows already reflect assumptions about the uncertainty in future Instead, in such case, a discount rate that is commensurate with the risk inherent in the expected cash flows should be used.
C. Assumptions about cash flows and discount rates should be internally consistent. For example, nominal cash flows, which include the effect of inflation, should be discounted at a rate that includes the effect of inflation. The nominal risk-free interest rate includes the effect of inflation. Real cash flows, which exclude the effect of inflation, should be discounted at a rate that excludes the effect of inflation. Similarly, after-tax cash flows should be discounted using an after-tax discount rate. Pre-tax cash flows should be discounted at a rate consistent with those cash flows.
D. Discount rates should be consistent with the underlying economic factors of the currency in which the cash flows are denominated.
E. When using a present value technique to measure the fair value of a liability that is not held by another party as an asset (e.g. a decommissioning liability), the future cash outflows should be estimated that market participants would expect to incur in fulfilling the obligation. Those future cash outflows shall include market participants’ expectations about the costs of fulfilling the obligation and the compensation that a market participant would require for taking on the obligation. Such compensation includes the return that a market participant would require for undertaking the activity and assuming the risk associated with the obligation.
Initial recognition of fair value
Transaction price is entry price while the fair value is exit price. However, in many cases, the transaction price is considered as fair value if the transaction to buy the asset takes place in the market in which the asset would be sold. When determining whether fair value at initial recognition equals the transaction price, factors specific to the transaction and to the asset/liability should be taken into account.
However, in certain situations, like related party transactions, forced sale or sale under duress, sale in a market other than principal market/ most advantageous etc., market transaction price cannot be considered a fair value of an asset/liability at initial recognition.
Non-financial assets- valuation premise
A fair value measurement of a non-financial asset assumes the ‘highest and best use’ (HABU) of non-financial assets by the market participants. HABU is use of the asset that would maximise the value of the asset and that is physically possible, legally permissible and financially feasible.
Liabilities and an entity’s own equity instruments
A fair value measurement assumes that a liability/ an entity’s own equity instrument is transferred to a market participant at the measurement date. It means that a liability would remain outstanding and the transferee would be required to fulfil the obligation. The liability would not be settled with the counterparty or otherwise extinguished on the measurement date. Similarly, it assumes that on transfer, an entity’s own equity instrument would remain outstanding and the transferee would take on the rights and responsibilities associated with the instrument. The instrument would not be cancelled or otherwise extinguished on the measurement date.
Following general principles should be considered while valuing liabilities/ entity’s own equity instruments:
- Fair value is measured by considering the observable inputs (quoted price) for the transfer of an identical or a similar liability/ entity’s own equity instrument.
- When such quoted price is not available and the identical item is held by another party as an asset, fair value of the liability/ equity instrument is considered from the perspective of a market participant that holds the identical item as an asset at the measurement date.
- When such quoted price is not available and identical item is not held by another party as an asset, the fair value of the liability/ equity instrument is measured using a valuation technique from the perspective of a market participant that owes the liability or has issued the claim on equity.
- When measuring the fair value of a liability, an entity shall take into account the effect of its credit risk (credit standing) and any other factors that might influence the likelihood that the obligation will or will not be fulfilled. In case of a liability issued with an inseparable third-party credit enhancement that is accounted for separately from the liability, the issuer would take into account its own credit standing and not that of the third party guarantor when measuring the fair value of the
- The effect of a restriction that prevents the transfer of a liability/ an entity’s own equity instrument is either implicitly or explicitly included in the other inputs to the fair value Therefore, a separate input or an adjustment to other inputs relating to the existence of such restriction is not required to be considered.
Disclosure requirements under the Ind AS
As per the Ind AS, an entity is required to disclose certain information for each class of assets and liabilities measured at fair value. Valuer may provide some of the required inputs in his valuation report which may help the entity while complying with the disclosure requirements. Following are few of the disclosure requirements applicable under the Ind AS which a valuer should consider while performing valuation analysis and drafting valuation report:
- The level of the fair value hierarchy within which the fair value measurements are categorised in their entirety.
- The amounts of any transfers between Level 1 and Level 2 of the fair value hierarchy and the reasons for those transfers.
- For fair value measurements categorised within Level 2 and Level 3 of the fair value hierarchy, a description of the valuation technique(s) and the inputs used in the fair value measurement.
- If there has been a change in valuation technique, reasons for the change.
- For fair value measurements categorised within Level 3 of the fair value hierarchy, quantitative information about the significant unobservable inputs (e.g. a market multiple or future cash flows) used in the fair value
- For recurring fair value measurements categorised within Level 3 of the fair value hierarchy, a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if such change might result in a significantly higher or lower fair value measurement.
- For financial assets and financial liabilities, if changing one or more of the unobservable inputs to reflect reasonably possible alternative assumptions would change fair value significantly, effect of those changes and how it is calculated.
Conclusion
Considering the complexities involved in determination of fair value under the Ind AS, it is imperative for a valuer to carry out a comprehensive analysis of information provided by the entity and publicly available information; market compatables; industry and economic environment. During such analysis, valuation techniques, inputs and assumptions must be used keeping the principles and requirements stated in the Ind AS into consideration.
(Information in this article is intended to provide only general information of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions.)
Manish Agarwal is a chartered accountant and a registered valuer. He can be reached at [email protected] or +91- 75062 71888
[1] The measurement and disclosure requirements of the Ind AS do not apply to share-based payment transactions (Ind AS 102), Leasing transactions (Ind AS 17) and measurements that have some similarities to fair value but are not fair value, such as net realisable value in Ind AS 2, Inventories, or value in use in Ind AS 36, Impairment of Assets.
[2] Inputs that are derived principally from or corroborated by observable market data by correlation or other means.
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