Indian Accounting Standard (Ind AS) 113

Ind AS 113 is a dedicated standard on Fair Value Measurement (FVM). In the previous blog, we had discussed about “Origination of Ind AS and its Convergence with IFRS[n1] ”. In this blog, key concepts, basic assumptions, fair value hierarchy and the various techniques prescribed by Ind AS 113 for FVM.

What actually is FAIR Value (FV)?

As defined “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”.

What is an orderly transaction?

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 (eg. a forced liquidation or distress sale).

Who are the market participants?

Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics

·        They are independent of each other, i.e. they are not related parties as defined in Ind AS 24

·        They are knowledgeable, having a reasonable understanding about the asset or liability

·        They are able to enter into a transaction for the asset or liability

·        They are willing to enter into a transaction for the asset or liability, i.e. they are motivated but not forced or otherwise compelled to do so.

What is Principal Market or Most Advantageous Market?

Principal Market:Market with the greatest volume and level of activity for the asset or liability

The Most Advantageous Market:Market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability

What are the key concepts of measuring FAIR Value?

·        Fair Value is a market-based measurement, not an entity-specific measurement

·        Fair value represents exit price and not entry price; transaction price is the entry price

·        It is measured using the assumptions that market participants would use, when pricing the asset or liability, including assumptions about risk. As a result, an entity’s intention to hold           an asset or to settle or otherwise fulfill a liability is not relevant when measuring fair value· Fair Value measurement is not adjusted for transaction costs as they are not attribute                 of assets or liabilities

There are some transaction assumptions in Fair Value Measurement which needs to be considered

What is FV Hierarchy and why is it needed?

The FVM contains a three-level hierarchy of FVM inputs to:

·        Provide greater transparency and comparability of FV measurements

·        Maximize the use of observable market data and minimize the use of unobservable inputs

·        Establish classification of fair value measurement level 1, 2 or 3 for disclosure purpose

·        Assessing the significance of a particular input to the FMV in its entirety require judgment, considering factors specific to the asset or liability

MAXIMIZE LEVEL 1 INPUTS AND MINIMIZE LEVEL 3 INPUTS

There is no 1 particular technique to determine the Fair Value. An entity can use a valuation technique which is

·        Appropriate in the Circumstances and

·        For which Sufficient Data is available and

·        Maximizing use of relevant Observable Inputs and

·        Minimize use of Unobservable Inputs

For FVM, an entity requires to determine the following:

·        Asset / Liability: The particular asset / liability that is the subject of measurement maybe either a stand-alone asset / liability or a group of assets / liabilities

·        Principal / Most advantageous market:The principal (or most advantageous market) for the asset or liability

·        Non-financial assets:For a non-financial asset, the valuation premise that is appropriate for measurement (consistent with its highest and best use)

The various techniques prescribed by Ind AS 113 are:

·        Market Approach: Uses prices and other relevant information generated by market transactions involving comparable assets/liabilities/business, considering qualitative and             quantitative factors (Comparable Companies Valuation Method)

·        Cost Approach:Reflects the amount that would be required currently to replace asset (Replacement Cost method)

·        Income Approach: converts future amounts to current (i.e. discounted) amount (ex-Cash Flows or Income and Expenses) resulting in the current market expectations about those   future amounts.  Present Value Techniques (Discounted Cash Flow Method); ( Option Pricing Models (Black Scholes or Binomial models); Multi period excess earning method (used for Intangibles)

Since there are different approaches, the Company needs to keep in mind when to use which method.

When a single valuation technique should be appropriate?

Eg: A single valuation technique will be appropriate when valuing an Asset or Liability using Quoted prices in an Active market for identical assets or liabilities

How to Conclude the Fair Value?

If multiple valuation techniques are used to measure Fair Value, the results shall be evaluated considering reasonableness of the range of values.

Fair Value measurement is the point within the range that is most representative of the Fair Value in the circumstances.

Now, we will explain in detail each of the three approaches:

1)      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.

Various techniques include:

·        Market Multiplesof similar publicly listed companies (Revenue, EBITDA, EBIT, Price to Book etc. adjusted for differences in growth, risk and profitability)

·        Matrix pricingis a mathematical technique used principally to value some types of financial instruments, such as debt securities, without relying exclusively on quoted prices for the specific securities, but rather relying on the securities' relationship to other benchmark quoted securities.

2)   Cost Approach

Reflects the amount that would be required to replace the service capacity of an asset, often referred to as current replacement cost.

The value of an asset will be the price that the market participant buyer will pay to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. That is because a market participant buyer would not pay more for an asset than the amount for which it could replace the service capacity of that asset. Obsolescence encompasses physical deterioration, functional (technological) obsolescence and economic (external) obsolescence and is broader than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (using specified service lives).

For Non-financial assets:

Value=Current Replacement Cost + Obsolescence

3) Income Approach

The income approach converts future amounts (e.g. cash flows or income and expenses) to a single current (i.e. discounted) amount. When the income approach is used, the FVM reflects current market expectations about those future amounts.

Various techniques include:

·        Present value techniques (Discounted Cash Flow Method when valuing a business)

·        Option pricing models (Black-Scholes-Merton formula, Monte Carlo Simulation, Binomial models (i.e. a lattice model, in valuing ESOP or put/call options))

·        The multi-period excess earnings method, used to measure for some intangible assets

·        Relief-from-royalty Method (e.g. Valuing Brand or IP)

·        With-and-without Method (e.g. Valuing Non-Compete agreements)

Change in valuation techniques:

Valuation techniques used to measure fair value shall be applied consistently. However, a change in the valuation technique or application of multiple valuation techniques is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances.

Examples:

• New markets develop or market conditions change

• New information is available

• Information previously used is no longer available

• Valuation techniques improve

Concluding Thoughts:

Ind AS requires application of FV principles, which would result in significant differences from financial information being presented currently. Given the complexities involved in Ind AS valuation, it is imperative for a valuer to undertake a detailed evaluation of Agreement terms, Peer companies, and industry analysis keeping all parameters in mind. The independent valuers must consider all information provided by the management, publicly available information pertaining to the company and remove the bias and subjectivity in the valuation process to ascertain the fair value of the business. With valuation techniques evolving, new methodologies are being developed to improve transparency.