Fair Value or Fair Market value – What’s the big deal?

So, this time, the topic I have chosen is Fair Value or Fair Market Value – What’s the big deal? In fact, many of you might be thinking that they are similar terms.

Well, they are not. Let’s look at their definitions.

Starting with Fair Value, it is defined in Ind AS 113 (IFRS 13), Fair Value Measurement as:

“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”.

Fair value is further comprehensively defined in paragraph 24 of Ind AS 113 (IFRS 13), Fair Value Measurement as:

“Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (i.e. an exit price) regardless of whether that price is directly observable or estimated using another valuation technique”.

As I have explained in my previous blog “Fair Value Definitions in Accounting Standards”, certain other Indian Accounting Standards and Accounting Standards have differing definitions of fair value.

Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 (CIRP Regulations) define fair value as:

“Fair value means the estimated realisable value of the assets of the corporate debtor, if they were to be exchanged on the insolvency commencement date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had acted knowledgeably, prudently and without compulsion”.

As we can see the fair value definition in CIRP Regulations is quite similar to that in Ind AS 113 except for the fact that it does not cover liabilities and does not specify any market.

ICAI Valuation Standards (ICAI VS) has copied the definition of fair value from Ind AS 113. International Valuation Standards (IVS) do not define fair value.

There may be various statutes around the world that also define and use the term fair value.

Now coming to fair market value (FMV). FMV is not defined in any accounting standard or valuation standard. IVS refers to the definition of FMV in tax regulations in USA which (Regulation §20.2031-1) which states:

“The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts”.

IVS also refers to the definition of FMV adopted by the Organisation for Economic Co-operation and Development (OECD) which is

“The price a willing buyer would pay a willing seller in a transaction on the open market”.

Like in the case of fair value, there may be various statutes around the world that also define and use the term fair market value.

Let’s now look at the differences between fair value and FMV.

A key difference between fair value and FMV is that fair value is computed at a unit of account level.

Unit of account refers to the level at which an asset or liability is aggregated or disaggregated in an Ind AS for recognition purposes. For example, in respect of shares, each share is a unit of account since each share can be transferred individually. Hence for fair valuation, the value per share is to be calculated without considering any premium or discount for an entity’s holding in a company. So, control premium cannot be considered, and neither can a discount that may be applicable on a bulk sale of shares on a stock exchange. However, discount for lack of marketability in respect of shares or an unlisted company or a private company can be considered since lack of marketability is a characteristic of each individual share of that company.

However, premiums or discounts can be considered for calculating FMV.

Secondly, fair value basically focuses on the principal market, and in its absence, the most advantageous market. FMV does not restrict itself to any market.

Thirdly, fair value is primarily used for accounting purposes. Accounting Standards, whether the old AS or the new Ind AS, both use the term fair value for accounting purposes. IBC 2016 also requires fair valuation of the corporate debtor for the purposes of insolvency resolution. However, FMV is not used anywhere either in the accounting standards or in IBC 2016.

Fourthly, both the IND AS 113/IFRS 13 specify that fair valuation should maximise the use of observable inputs and minimise the use of unobservable inputs. Observable inputs are those that are readily obtainable say, a stock market quotation of the redemption value of a mutual fund unit. Unobservable inputs are those that are developed by the entity such as cash flow projections. In fact, three levels of input hierarchy have been provided in Ind AS 113/ IFRS 13 with level 1 being unadjusted quoted prices and level 3 being unobservable inputs. The standards give highest priority to level 1 inputs.

There are no such levels of inputs in computation of FMV though both ICAI VS and IVS specify that the use of observable inputs should be maximised in all types of valuations.

Fifthly, in the Indian context, the term FMV is primarily used in the Income Tax law. There are a number of provisions which require FMV to be considered for computing taxable income. However, the definition of FMV differs in different rules.

For example, while the rule relating to issuance of equity shares by an unlisted company requires valuation to be carried out by a merchant banker on a discounted cash flows (DCF) basis, the rules relating to transfer or acquisition of movable property including shares prescribe different methods of valuation.

For computation of perquisite value in respect of shares issued by an unlisted company to employees as sweat equity or under ESOPs, the FMV is defined as a value computed by a merchant banker without specifying any method, while in the case of an  issue of shares by a listed company as sweat equity or under ESOPs, the rule specifies that the average of opening and closing price on the relevant date shall be the FMV.

The rule regarding acquisition or transfer of equity shares of an unlisted company specify an adjusted net asset value basis to arrive at FMV while in case of a an acquisition or transfer of shares or securities  of a listed company, the FMV shall be the transaction price, if the transaction is carried out on a stock exchange, or the lowest price of the share or security on any stock exchange on the valuation date, if the transaction is not carried out on a stock exchange.

In respect of unlisted shares or securities other than equity shares, the rules prescribe that the FMV shall be the price that such shares or securities would fetch in an open market as determined by a merchant banker or a chartered accountant.

For other types of movable assets such as jewelry or artworks, the rule prescribes open market value as FMV.

The income tax law does not refer to fair value at all. Neither the customs law nor the GST law uses the terms fair value or fair market value.

Amazing! Jio Platforms gets eight investments in seven weeks aggregating Rs. 97,886 crores.

Amazing! Jio Platforms gets eight investments in seven weeks aggregating Rs. 97,886 crores.

The latest investment is by Abu Dhabi Investment Authority (ADIA) of Rs. 5,683.50 crores for 1.16% stake valuing Jio Platforms at Rs. 4.91 lakh crores. According to RIL’s presentation on annual results for the year ended 31 March 2020, RIL’s digital services had revenue of Rs. 54,216 crores, EBITDA of Rs. 21,654 crores and net profit of Rs. 5,562 crores.

Revenue, EBITDA and PAT multiples are over 9, 22 and 88 respectively.

Total market cap of Reliance Industries Limited (RIL) on Monday 8 June 2020 was Rs. 9.96 lakh crores. This means that the value of Jio Platforms is approximately half of RIL’s value.

Investors in Jio Platforms include Facebook, Silver Lake, Vista Equity Partners, General Atlantic, KKR, Mubadala and ADIA. 

The total stake taken by these investors in Jio Platforms is 21.06%. Facebook has the largest investment with 9.99%.

As of 31 March 2020, Jio had 38.75 crore subscribers and is the largest telecom player in India by number of users. According to TRAI, the total telephone and broadband subscribers in India as of 31 December 2019 were 117.24 crores and 66.19 crores respectively. Figures for 31 March 2020 are not yet available.

RIL, in partnership with WhatsApp, has already launched JioMart in 200 cities to compete with the likes of Amazon, Flipkart and BigBasket.

Apart from investments in Jio Platforms, RIL also had a successful rights issue of Rs.53,124 crore, India’s largest rights issue. In its presentation on annual results for year ended 31 March 2020, RIL has also mentioned that the due diligence by Saudi Aramco for its acquisition of 20% stake in RI’s oil to chemical’s business is on track.

Amendments to Indian Accounting Standards (Ind AS) issued in July 2020

Ministry of Corporate Affairs (MCA) has issued the Companies (Indian Accounting Standards) Amendment Rules, 2020 dated 24 July 2020. The rules are effective from the date of publication in the Official Gazette of India i.e. 24 July 2020.

All amendments are effective for periods beginning 1 April 2020 or later. However, amendments relating to Ind AS 116, Leases, can be applied for financial year beginning 1 April 2019 or later if the financial statements for that period have not yet been authorised for issue. Accordingly, the amendments apply to the financial results for the quarter ended 30 June 2020, where such financial results have not yet been declared.

The amendments are mostly in line with the expected Ind AS amendments that I had indicated in my earlier post of 19 June 2020 (https://joy-consulting.in/2020/06/19/expected-amendments-to-indian-accounting-standards-ind-as-in-2020/).

Amendments to Ind AS are as follows:

Ind AS 103, Business Combinations (Ind AS 103)

The definition of “business” and related guidance included in the standard for the purposes of identifying where an acquisition is a business, to apply business combination accounting, has been amended.

Previous definition of business included in Ind AS 103 is as follows:

“An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants”.

The amended definition of business is as follows:

“An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing goods or services to customers, generating investment income (such as dividends or interest) or generate other income from ordinary activities”.

Key change is that the definition of business is narrowed to focus on providing goods or services to customers, generating investment income or generate other income from ordinary activities instead of the earlier wider focus of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.

Earlier the standard also provided that a business need not include all of the inputs and processes that the seller used in operating that business if market participants are capable of acquiring the business and continuing to produce outputs, for example, by integrating the business with their own inputs and processes. This requirement is now deleted.

Instead, the amended guidance requires that to be considered a business, an integrated set of activities and assets, must include at a minimum, an input and a substantive process that together contribute to the ability to create output. Additional guidance has been provided to assess whether a process is substantive or not.

The integrated set of activities and assets shall be capable of being conducted and managed as a business by a market participant. How the seller was using or how the buyer intends to use is not relevant. Further, to be a business without outputs, there will now need to be an organised workforce for it to constitute a business.

The amended guidance provides that if an acquired set of activities and assets has outputs, continuation of revenue does not on its own indicate that both an input and a substantive process have been acquired. An acquired set of activities and assets that is not a business might have liabilities i.e. the presence of liabilities does not mean that the set of acquired activities and assets is a business.

The standard earlier provided that if a particular set of activities and assets included goodwill, then such set of activities and assets was presumed to be a business. This presumption has now been deleted.

The amendment also provides that an entity can apply a ‘concentration test’ that, if met, eliminates the need for further assessment. Under this optional test, where substantially all of the fair value of gross assets acquired is concentrated in a single asset (or a group of similar assets), the assets acquired would not represent a business. The amended standard provides detailed guidance in this respect.

Following steps are included in the concentration test:

  • Gross assets to exclude cash & cash equivalents, deferred tax assets, and any goodwill resulting from deferred tax liabilities;
  • Identify fair value of gross assets – fair value of purchase consideration + fair value of NCI + fair value of previous held interests – (cash & cash equivalents + deferred tax assets + any goodwill resulting from deferred tax liabilities)
  • Identify assets (single identifiable assets or group of similar assets) and their fair values.
  • If for accounting purposes, a group of assets is recognised and measured as a single identified asset, then such group is a single asset.
  • If one tangible asset is attached to, and cannot be removed physically and used separately, from another tangible asset, then both assets to be treated as one.
  • For identifying similar assets – nature of each single asset and risks associated with managing and creating outputs from assets,  have to be considered. Guidance is also provided where assets cannot be similar e.g. tangible and intangible assets, different classes of tangible or intangible assets, financial and non-financial assets, financial assets of different classes e.g. loans and equity investments, identifiable assets in the same class but where they have significantly different risk characteristics. 

The changes to the definition of a business will likely result in more acquisitions being accounted for as asset acquisitions across all industries, particularly real estate, pharmaceutical, and oil and gas.

Ind AS 107, Financial Instruments: Disclosures (Ind AS 107)

Ind AS 107 has been amended to require disclosure of the nominal amount of hedging instruments to which the reliefs are applied, any significant assumptions or judgements made in applying the reliefs, and qualitative disclosures about how the entity is impacted by IBOR reform and is managing the transition process.  

The disclosures are applicable to companies applying exceptions in respect of interest rate benchmark reforms as inserted in Ind AS 109, Financial Instruments.

Ind AS 109, Financial Instruments (Ind AS 109)

Hedge accounting requirements included in Ind AS 109 have been amended to provide limited relief to financial statement preparers from the effects of the forthcoming IBOR (Interbank Offered Rate, also called interest rate benchmark) reform.

The amendments provide as follows:

  1. The amendments shall be applied to all hedging relationships directly affected by interest rate benchmark reform. Exceptions to hedge accounting are as specified in the amendments. Companies will have to continue to apply all other hedge accounting requirements to hedging relationships directly affected by interest rate benchmark reform.
  • A hedging relationship is directly affected by interest rate benchmark reform only if the reform gives rise to uncertainties about:
    • the interest rate benchmark (contractually or non-contractually specified) designated as a hedged risk; and/ or
    • the timing or amount of interest rate benchmark-based cash flows of the hedged item or of the hedging instrument.
  • The amendments require an entity to assume that:
  • the interest rate on which the hedged cash flows are based does not change as a result of the reform. Hence, where the hedged cash flows may change as a result of IBOR reform (for example, where the future interest payments on a hedged forecast debt issuance might be SONIA + X% rather than GBP LIBOR + Y%), this will not cause the ‘highly probable’ test to be failed;
  • the interest rate benchmark on which the hedged cash flows (contractually or non-contractually specified) are based is not altered as a result of the reform; and
  • the interest rate benchmark on which the cash flows of the hedged item, hedging instrument or hedged risk are based is not altered by IBOR reform and hence the economic relationship and hedge effectiveness is not affected.
  • Under the amendments, where only a risk component is hedged, the risk component only needs to be separately identifiable at initial hedge designation and not on an ongoing basis. In the context of a macro hedge, where an entity frequently resets a hedging relationship, the relief applies from when a hedged item was initially designated within that hedging relationship.
  • A company shall cease to apply the exceptions above as follows :
  • When the uncertainty arising from interest rate benchmark reform is no longer present; In respect of 3(a) above, at the earlier of (a) above and when the hedging relationship that the hedged item is a part of is discontinued;
    • In respect of 3(b) above, (a) above and when the entire amount accumulated in the cash flow hedge reserve with respect that discontinued hedging relationship has been reclassified to profit and loss;
    • In respect of 3(c)) above, (a) above and to a hedging instrument, when the uncertainty arising from interest rate benchmark reform is no longer present with respect to the timing and the amount of interest rate benchmark-based cash flows of the hedging instrument.
  • The amendments can be applied retrospectively to all hedging relationships affected by the  interest rate benchmark reform that existed at the beginning of the reporting period in which the entity first applies these amendments or to those which were designated thereafter, and to amount accumulated in the cash flow hedging reserve that existed at the beginning of the reporting period in which the entity first applies these amendments.

For details on IBOR reform and its business and accounting consequences please read my blog post at https://joy-consulting.in/2020/06/15/ibor-reform-what-in-the-heavens-is-that/  or my LinkedIn post at https://www.linkedin.com/feed/update/urn:li:activity:6678171533095108608/.

Ind AS 116, Leases (Ind AS 116)

Ind AS 116 has been amended to provide limited relief to lessees in respect of rent concessions arising due to Covid-19 pandemic. No relief has been allowed to the lessors.

The amendments provide a practical expedient that lessees may elect to not treat any rent concessions, provided by lessors as a direct consequence of Covid-19 pandemic, as lease modifications. However, to be eligible for this relief,

  1. the revised consideration for the lease should be less than or equal to the lease consideration immediately before the change,
  • the rent concession should be for a period that does not extend beyond 30 June 2021 (for example, lease rents are reduced for a period upto 30 June 2021 and increased for periods thereafter), and
  • there is no substantial modification to the other terms and conditions of the lease.

This means that such rent concessions can be taken by the lessees directly to the statement of profit and loss. However, the lessees will have to continue to account for interest expense and depreciation on right-of-use assets as before.

Lessees are required to apply this practically expedient retrospectively, recognising the cumulative effect of initially applying the amendment as an adjustment to the opening balance of retained earnings. However, in the Indian context, since the impact of Covid-19 was felt on business only in the later part of March 2020, the cumulative impact may not be significant.

Lessees are also required to provide disclosures about application of the practical expedient and its impact on profit or loss.

Ind AS 1, Presentation of Financial Statements (Ind AS 1) and Ind AS 8, Accounting Policies, Changes in Accounting Estimates and Errors (Ind AS 8)  

The definition of “materiality” and related guidance has been amended in Ind AS 1.

Previous definition of materiality included in Ind AS 1 and Ind AS 8 is as follows:

“Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor”.

The amended definition of materiality is as follows:

“Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity”.

The amendments clarify that the information is obscured if it is communicated in a way that would have a similar effect for primary users of financial statements to omitting or misstating that information. The amendments provide examples of circumstances when a material information is obscured as follows:

  • information regarding a material item, transaction or other event is disclosed in the financial statements but the language used is vague or unclear;
  • information regarding a material item, transaction or other event is scattered throughout the financial statements;
  • dissimilar items, transactions or other events are inappropriately aggregated;
  • similar items, transactions or other events are inappropriately disaggregated; and
  • the understandability of the financial statements is reduced as a result of material information being hidden by immaterial information to the extent that a primary user is unable to determine what information is material.

The amendments state that an entity is required to consider the characteristics of the users of its financial statements and also its own circumstances while determining what information can reasonably be expected to influence decisions made by the primary users of financial statements.

The amendments also clarify the meaning of ‘primary users of general purpose financial statements’ to whom those financial statements are directed, by defining them as ‘existing and potential investors, lenders and other creditors’ that must rely on general purpose financial statements for much of the financial information they need, and that, at times even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.

Ind AS 8, Accounting Policies, Changes in Accounting Estimates and Errors (Ind AS 8) 

The existing amendment of materiality has been deleted from Ind AS 8. Instead, now a reference has been made to the amended definition of materiality in Ind AS 1.

Ind AS 10, Events after the Reporting Period (Ind AS 10)

Only consequential amendment made based on amendments in the definition of materiality in Ind AS 1.

Ind AS 34, Interim Financial Reporting (Ind AS 34)

Only consequential amendment made based on amendments in the definition of materiality in Ind AS 1.

Ind AS 37, Provisions, Contingent Liabilities and Contingent Assets (Ind AS 37) Only consequential amendment made to the requirement for disclosure of a restructuring announced or implemented after the reporting period, based on amendments in the definition of materiality in Ind AS 1.

Comparison of ICAI Valuation Standards 2018 with International Valuation Standards (effective 31 January 2020) – Part II

In this series of blog posts, I am writing about the Comparison of ICAI Valuation Standards 2018, effective 1 July 2018 (“ICAI VS”) with International Valuation Standards, effective 31 January 2020 (“IVS”).

I have already written the first post introducing ICAI VS and IVS, and also covered their objectives, topics under various standards, types of valuation standards viz. general standards and asset standards, and framework.

Today, I am covering the definitions in the two sets of standards.

While most of the definitions in ICAI VS are included in ICAI VS 101, Definitions, in IVS, only certain definitions are included in the Glossary and others are included at relevant places in respective standards.

While comparing the definitions in the two sets of standards, I find that there are only a few definitions which are defined in ons et of standards and not in the other. Similarly, there are some definitions which are more detailed in one set of standards than the other.

The definitions are as follows:

ICAI VS (ICAI Valuation Standard – 101)  IVS (Glossary)  
The objective of this valuation standard is to prescribe specific definitions and principles which are applicable to the ICAI Valuation Standards, dealt specifically in other standards. The definitions enunciated in this Standard shall guide and form the basis for certain terms used in other valuation standards prescribed herein. The definitions contained in this standard define the terms used in the ICAI Valuation Standards. This Standard may not contain certain definitions which are considered to be basic from finance and accounting perspective as the professionals are expected to have basic knowledge and understanding of such terms.  This glossary defines certain terms used in the International Valuation Standards.    This glossary is only applicable to the International Valuation Standards and does not attempt to define basic valuation, accounting or finance terms, as valuers are assumed to have an understanding of such terms (see definition of “valuer”).  
Scope The terms defined in this Standard do not apply in valuation where a valuer is required to use a definition prescribed by any law, regulations, rules or directions of any government or regulatory authority. In case the valuer is required to use a definition that significantly depart from those contained herein, the valuer shall explain the reason for departure and disclose in the valuation report. While undertaking a valuation engagement, a valuer shall refer the terms defined in this Standard.   
Active Market: Active Market is a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis. For listed securities, active market would refer to one where activity/transaction is ongoing and as defined in the guidelines issued by SEBI.  Not defined.
Asset: The word asset would refer to the assets that need to be valued during an engagement and will also include a group of assets, a liability or a group of liabilities, business or business ownership interests. Any reference to the term asset also includes liability.  Asset or Assets:  To assist in the readability of the standards and to avoid repetition, the words “asset” and “assets” refer generally to items that might be subject to a valuation engagement.  Unless otherwise specified in the standard, these terms can be considered to mean “asset, group of assets, liability, group of liabilities, or group of assets and liabilities”.  
As-is-where-is Basis: The term as-is-where-is basis will consider the existing use of the asset which may or may not be its highest and best use.  As-is-where-is Basis is not defined in IVS. However, IVS 104 Bases of Value defines current use/ existing use as “the current way an asset, liability, or group of assets and/or liabilities is used.  The current use may be, but is not necessarily, also the highest and best use”.  
Business Valuation: It is the act or process of determining the value of a business enterprise or ownership interest therein.  See “Valuation”
Client: Client would mean an entity or a person for whom valuation is conducted, which/who commissions the valuation engagement and is identified as client in the valuation engagement letter entered into between such entity/ person and the valuer.  Client: The word “client” refers to the person, persons, or entity for whom the valuation is performed.  This may include external clients (ie, when a valuer is engaged by a third-party client) as well as internal clients (ie, valuations performed for an employer).    
Comparable Companies Multiple Method: This method is also known as Guideline Public Company Method. It involves valuing an asset based on market multiples derived from prices of market comparables traded on active market.  IVS 105 Valuation Approaches and Methods provides that “Guideline publicly-traded comparable method utilises information on publicly traded-comparables that are the same or similar to the subject asset to arrive at an indication of value”.  
Comparable Transaction Multiple Method: This method is also known as Guideline Transaction Method. It involves valuing an asset based on transaction multiples derived from prices paid in transactions of assets to be valued/market comparable (comparable transactions).  IVS 105 Valuation Approaches and Methods provides that “the comparable transactions method, also known as the guideline transactions method, utilises information on transactions involving assets that are the same or similar to the subject asset to arrive at an indication of value”.
Control Premium: Control Premium is an amount that a buyer is willing to pay over the current market price of a publicly-traded company to acquire a controlling interest in an asset. It is opposite of discount for lack of control to be applied in case of valuation of a noncontrolling/minority interest.   IVS 105 Valuation Approaches and Methods provides that “Control Premiums (sometimes referred to as Market Participant Acquisition Premiums or MPAPs) and Discounts for Lack of Control (DLOC) are applied to reflect differences between the comparables and the subject asset with regard to the ability to make decisions and the changes that can be made as a result of exercising control. All else being equal, participants would generally prefer to have control over a subject asset than not.  However, participants’ willingness to pay a   Control Premium or DLOC will generally be a factor of whether the ability to exercise control enhances the economic benefits available to the    owner of the subject asset”.  
Cost approach: It is a valuation approach that reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).  IVS 105 Valuation Approaches and Methods provides that “The cost approach provides an indication of value using the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or by construction, unless undue time, inconvenience, risk or other factors are involved.  The approach provides an indication of value by calculating the current replacement or reproduction cost of an asset and making deductions for physical deterioration and all other relevant forms of obsolescence”.  
Discount Rate: Discount Rate is the return expected by a market participant from a particular investment and shall reflect not only the time value of money but also the risk inherent in the asset being valued as well as the risk inherent in achieving the future cash flows.  IVS 105 Valuation Approaches and Methods defines Discount Rate as “the rate at which the forecast cash flow is discounted should reflect not only the time value of money, but also the risks associated with the type of cash flow and the future operations of the asset”.
Discounted Cash Flow (‘DCF’) Method: The DCF method values the asset by discounting the cash flows expected to be generated by the asset for the explicit forecast period and also the perpetuity value (or terminal value) in case of assets with indefinite life.  IVS 105 Valuation Approaches and Methods provides that “under the Discounted Cash Flow (‘DCF’) Method the forecasted cash flow is discounted back to the valuation date, resulting in a present value of the asset. In some circumstances for long-lived or indefinite-lived assets, DCF may include a terminal value which represents the value of the asset at the end of the explicit projection period. In other circumstances, the value of an asset may be calculated solely using a terminal value with no explicit projection period. This is sometimes referred to as an income capitalisation method”.  
Documentation: The term documentation includes the record of valuation procedures performed, relevant evidence obtained, and conclusions that the valuer has reached.  Documentation is not defined in IVS, however, IVS 102 Investigations and Compliance provides that “a record must be kept of the work performed during the valuation process and the basis for the work on which the conclusions were reached for a reasonable period after completion of the assignment, having regard to any relevant statutory, legal or regulatory requirements. Subject to any such requirements, this record should include the key inputs, all calculations, investigations and analyses relevant to the final conclusion, and a copy of any draft or final report(s) provided to the client”.  
Fair value: Fair value is 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 valuation date.  IVS do not define fair value. However, IVS 104 Bases of Value includes definition of fair value as defined in IFRS, as defined by OECD, and as defined by certain countries such as Canada and USA.  
Forced transaction: Forced transaction is a transaction where a seller is under constraints to sell an asset without appropriate marketing period or efforts to market such asset.IVS do not define forced transaction. However, IVS 104 Bases of Value provides that the term “forced sale” is often used in circumstances where a seller is under compulsion to sell and that, as a consequence, a proper marketing period is not possible and buyers may not be able to undertake adequate due diligence.   
Going concern value: It refers to the value of a business enterprise that is expected to continue to operate in the future.  IVS 200 Businesses and Business Interests provides that “ the value of a business may differ from the sum of the values of the individual assets or liabilities that make up that business.  When a business value is greater than the sum of the recorded and unrecorded net tangible and identifiable intangible assets of the business, the excess value is often referred to as going concern value or goodwill”.  
Goodwill: The term goodwill is defined as an asset representing the future economic benefits arising from a business, business interest or a group of assets, which has not been separately recognised in other assets.  IVS 200 Businesses and Business Interests provides that “ the value of a business may differ from the sum of the values of the individual assets or liabilities that make up that business.  When a business value is greater than the sum of the recorded and unrecorded net tangible and identifiable intangible assets of the business, the excess value is often referred to as going concern value or goodwill”.  
Highest and best use: The highest and best use is the use of a non- financial asset by market participants that would maximise the value of the asset or the group of assets (e.g. a business) within which the asset would be used.    IVS 104 Bases of Value defines Highest and best use as “the highest and best use is the use of an asset that maximises its potential and that is possible, legally permissible and financially feasible.  The highest and best use may be for continuation of an asset’s existing use or for some alternative use.  This is determined by the use that a market participant would have in mind for the asset when formulating the price that it would be willing to bid”.  
Income approach: It is a valuation approach that converts maintainable or future amounts (e.g., cash flows or income and expenses) to a single current (i.e., discounted or capitalised) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations about those future amounts.  IVS 105 Valuation Approaches and Methods provides that “the income approach provides an indication of value by converting future cash flow to a single current value.  Under the income approach, the value of an asset is determined by reference to the value of income, cash flow or cost savings generated by the asset”.
Intangible Asset: An intangible asset is an identifiable non-monetary asset without physical substance.  IVS 210 Intangible Assets defines Intangible Asset as  “an intangible asset is a non-monetary asset that manifests itself by its economic properties.  It does not have physical substance but grants rights and/or economic benefits to its owner”.  
“Intended Use” is not defined in ICAI VS. However, the term is used at several places in the Framework and various standards. From a reading of the Framework and various standards it can be inferred that the definition of “intended use” is same as that included in IVS.  Intended Use: The use(s) of a valuer’s reported valuation or valuation review results, as identified by the valuer based on communication with the client.  
Intended User: While not specifically defined, the Framework provides that the intended users of valuation may be present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies and the public. They require valuation report for their specific purpose and the requirements may vary depending on the intended user.  Intended User: The client and any other party as identified, by name or type, as users of the valuation or valuation review report by the valuer based on communication with the client.
Integration costs: It refers to additional one time/ recurring expenses which may need to be incurred by an acquirer, e.g., alignment of employment terms/ remuneration for employees of the target entity with the acquiring entity.  Not defined.
Jurisdiction: The term jurisdiction will include the regulatory and legal environment in the boundaries of which the valuation asset is located.  Jurisdiction: The word “jurisdiction” refers to the legal and regulatory environment in which a valuation engagement is performed. This generally includes laws and regulations set by governments (eg, country, state and municipal) and, depending on the purpose, rules set by certain regulators (eg, banking authorities and securities regulators).  
Liquidation value: It is the amount that will be realised on sale of an asset or a group of assets when an actual/hypothetical termination of the business is contemplated/assumed.  IVS 104 Bases of Value defines Liquidation Value as “the amount that would be realised when an asset or group of assets are sold on a piecemeal basis. Liquidation Value should take into account the costs of getting the assets into saleable condition as well as those of the disposal activity”.  
Market approach: Market approach is a valuation approach that uses prices and other relevant information generated by market transactions involving identical or comparable (i.e., similar) assets, liabilities or a group of assets and liabilities, such as a business.  IVS 105 Valuation Approaches and Methods states that “the market approach provides an indication of value by comparing the asset with identical or comparable (that is similar) assets for which price information is available”. 
Market participants: Market participants are willing buyers and willing 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, that is, they are not related parties as defined under applicable accounting framework and set of reporting/ accounting standards therein, although the price in a related party transaction may be used as an input to a fair value measurement if the entity has evidence that the transaction was entered into at market terms; they are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due care that is usual and customary; they are able to enter into a transaction for the asset or liability; and 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.  Market Participants are not defined in IVS. However, IVS 104 Bases of Value implies Market Participants to be “buyers and sellers in a market”.
Not defined.May: The word “may” describes actions and procedures that valuers have a responsibility to consider.  Matters described in this fashion require the valuer’s attention and understanding.  How and whether the valuer implements these matters in the valuation engagement will depend on the exercise of professional judgement in the circumstances consistent with the objectives of the standards.  
Not defined.Must: The word “must” indicates an unconditional responsibility.  The valuer must fulfill responsibilities of this type in all cases in which the circumstances exist to which the requirement applies.  
Observable inputs: Inputs that 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.  “Observable inputs” are not defined in IVS. However, the term “observable inputs” is used in various standards. From a reading of various standards, it can be inferred that the definition of observable inputs is the same as that included in ICAI VS.
Orderly liquidation: An orderly liquidation refers to the realisable value of an asset in the event of a liquidation after allowing appropriate marketing efforts and a reasonable period of time to market the asset on an as-is, where-is basis.  IVS 104 Bases of Value provides that “an orderly liquidation describes the value of a group of assets that could  be realised in a liquidation sale, given a reasonable period of time to find a purchaser (or purchasers), with the seller being compelled to sell on an as-is, where-is basis”.  
Orderly transaction: Orderly transaction is a transaction that assumes exposure to the market for a period before the valuation date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities and it is not a forced transaction. The length of exposure time will vary according to the type of asset and market conditions.   While orderly transaction is not defined in IVS, in  IVS 104 Bases of Value it is implied that an “orderly transaction” is one which has a typical marketing period.
Participant is not defined in ICAI VS. However, from a reading of various standards, the definition of Participant may be inferred as being the same as in IVS.Participant: The word “participant” refers to the relevant participants pursuant to the basis (or bases) of value used in a valuation engagement (see IVS 104, Bases of Value).  Different bases of value require valuers to consider different perspectives, such as those of “market participants” (eg, Market Value, IFRS Fair Value) or a particular owner or prospective buyer (eg, Investment Value).  
Participant specific value: Participant specific value is the estimated value of an asset or liability considering specific advantages or disadvantages of either of the owner or identified acquirer or identified participants.   While IVS does not define participant specific value,  it has a similar definition in “Investment value”. IVS 104 Bases of Value defines Investment value as  “as the value of an asset to a particular owner or prospective owner for individual investment or operational objectives. Investment Value is an entity-specific basis of value.  Although the value of an asset to the owner may be the same as the amount that could be realised from its sale to another party, this basis of value reflects the benefits received by an entity from holding the asset and, therefore, does not involve a presumed exchange.  Investment Value reflects the circumstances and financial objectives of the entity for which the valuation is being produced. It is often used for measuring investment performance”.  
Premise of value: Premise of value refers to the conditions and circumstances how an asset is deployed.   Premise of value: Premise of value is not defined in the Glossary. It is defined in IVS 104 Bases of Value as “A premise of value or assumed use describes the circumstances of how an asset or liability is used”.  
Present value: It is an integral tool used in the income approach to link future amounts (e.g., cash flows or values) to a present amount using a discount rate.  IVS 105 Valuation Approaches and Methods provides that “under the DCF method the forecasted cash flow is discounted back to the valuation date, resulting in a present value of the asset”.   
Purpose: The word purpose implies the reason for which valuation is being conducted.  Purpose or “Purpose of Valuation” or “Valuation Purpose”: The word “purpose” refers to the reason(s) a valuation is performed. Common purposes include (but are not limited to) financial reporting, tax reporting, litigation support, transaction support, and to support secured lending decisions.  
Relief from Royalty (RFR) Method: A method in which the value of the asset is estimated based on the present value of royalty payments saved by owning the asset instead of taking it on lease It is generally adopted for valuing intangible assets that are subject to licensing, such as trademarks, patents, brands, etc.   IVS 210 Intangibles Assets states that  “under the relief-from-royalty method, the value of an intangible asset is determined by reference to the value of the hypothetical royalty payments that would be saved through owning the asset, as compared with licensing the intangible asset from a third party.  Conceptually, the method may also be viewed as a discounted cash flow method applied to the cash flow that the owner of the intangible asset could receive through licensing the intangible asset to third parties.”  
Replacement Cost Method: It is also known as ‘Depreciated Replacement Cost Method’ and involves valuing an asset based on the cost that a market participant shall have to incur to recreate an asset with substantially the same utility (‘comparable utility’) as that of the asset to be valued, adjusted for obsolescence.  IVS 105 Valuation Approaches and Methods defines Replacement Cost method as “a method that indicates value by calculating the cost of a similar asset offering equivalent utility”.
Reproduction Cost Method: This method involves valuing an asset based on the cost that a market participant shall have to incur to recreate a replica of the asset to be valued, adjusted for obsolescence.  IVS 105 Valuation Approaches and Methods defines Reproduction Cost method as “a method under the cost that indicates value   by calculating the cost to recreating a replica of an asset”.
Rule of Thumb or Benchmark Value: Rule of thumb or benchmark indicator is used as a reasonable check against the values determined by the use of other valuation approaches in a valuation engagement.    Not defined.
Scope of work: It describes the work to be performed, responsibilities and confidentiality obligations of the Client and the valuer respectively, and limitation of the valuation engagement.  IVS 101 Scope of Work states that “a scope of work (sometimes referred to as terms of engagement) describes the fundamental terms of a valuation engagement, such as the asset(s) being valued, the purpose of the valuation and the responsibilities of parties involved in the valuation”.  
Not defined.Should: The word “should” indicates responsibilities that are presumptively mandatory. The valuer must comply with requirements of this type unless the valuer demonstrates that alternative actions which were followed under the circumstances were sufficient to achieve the objectives of the standards.   In the rare circumstances in which the valuer believes the objectives of the standard can be met by alternative means, the valuer must document why the indicated action was not deemed to be necessary and/or appropriate.   If a standard provides that the valuer “should” consider an action or procedure, consideration of the action or procedure is presumptively mandatory, while the action or procedure is not.  
Significant/material: While considering any particular aspect to be significant/ material from a valuation standpoint is a valuer’s professional judgement, any aspect of valuation will be significant/ material if its application or ignorance can significantly change or impact the overall value.  Significant and/ or Material: Assessing significance and materiality require professional judgement. However, that judgement should be made in the following context: Aspects of a valuation (including inputs, assumptions, special assumptions, and methods and approaches applied) are considered to be significant/material if their application and/or impact on the valuation could reasonably be expected to influence the economic or other decisions of users of the valuation; and judgments about materiality  are made in light of the overall valuation engagement and are affected by the size or nature of the subject asset.As used in these standards, “material/ materiality” refers to materiality to the valuation engagement, which may be different from materiality considerations for other purposes, such as financial statements and          their audits.  
Subject or Subject Asset are not defined in ICAI VS. However, from a reading of various standards, the definition of “subject” can be implied to be the same as in IVS.  Subject or Subject Asset: These terms refer to the asset(s) valued in a particular valuation engagement.  
Subsequent Event: An event that occurs subsequent to the valuation date could affect the value; such an occurrence is referred to as a subsequent event.  Not defined.
Synergies: Synergies is a concept which indicates that the combining effect of two or more assets or group of assets and liabilities or two or more entities in terms of their value and benefits will be or is likely to be, greater than that of their individual values on a standalone basis.   IVS 104 Bases of Value defines Synergies as “Synergies” refer to the benefits associated with combining assets. When synergies are present, the value of a group of assets and liabilities is greater than the sum of the values of the individual assets and liabilities on a stand-alone basis.  Synergies typically relate to a reduction in costs, and/or an increase in revenue, and/or a reduction in risk”.   
Terminal value: Terminal value represents the present value at the end of explicit forecast period of all subsequent cash flows to the end of the life of the asset or into perpetuity if the asset has an indefinite life.   IVS do not define Terminal value, however  IVS 105 Valuation Approaches and Methods implies terminal value to be the value of the asset, which is expected to continue beyond the   explicit forecast period, estimated at the end of that period.   
Transaction costs: Transaction costs are the costs to sell an asset or transfer a liability in the principle (or most advantageous) market for the asset that are directly attributable to the disposal of the asset or transfer of liability and which meet both the following criteria: they result directly from and are essential to that transaction; they would not have been incurred by the entity, had the decision to sell the asset or transfer the liability not been made. No adjustment will be made for any taxes payable by either party as a direct result of the transaction.  While IVS do not define Transaction costs,  IVS 104 Bases of Value states that most bases of value represent the estimated exchange price of an asset without regard to the seller’s costs of sale or the buyer’s costs of purchase and without adjustment for any taxes payable by either party as a direct result of the transaction.   This implies that the transaction costs are  “seller’s costs of sale or the buyer’s costs of purchase, and  taxes payable by either party as a direct result of the transaction”.     
Unobservable inputs: 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.  Not defined. The term “unobservable inputs” is not included in IVS.
Valuation: Not specifically defined. However, from a reading of the objective of the valuation report as mentioned in the Framework, a valuation is “a comprehensive appraisal of and determining a user-specific value for one or more items”.  Valuation: A “valuation” refers to the act or process of determining an estimate of value of an asset or liability by applying IVS.  
While the term Valuation Reviewer is not defined in ICAI VS. ICAI VS 201 Scope of Work, Analyses and Evaluation provides that the scope of work of a valuation engagement may include  valuation review, where the work of another valuer is reviewed. As part of a valuation review, the reviewer may perform certain valuation procedures and/or providing an opinion of value. Accordingly, the definition of “Valuation Reviewer” may be construed accordingly.  Valuation Reviewer: A “valuation reviewer” is a professional valuer engaged to review the work of another valuer.  As part of a valuation review, that professional may perform certain valuation procedures and/or provide an opinion of value.  
Value: A value is an estimate of the value of a business or business ownership interests, arrived at by applying the valuation procedures appropriate for a valuation engagement and using professional judgment as to the value or range of values based on those procedures.  Value (n): The word “value” refers to the judgement of the valuer of the estimated amount consistent with one of the bases of value set out in IVS 104 Bases of Value.  
Valuer: A valuer is a professional (which can be an individual or a legally established entity) who is given the responsibility to conduct or undertake valuation.  Valuer: A “valuer” is an individual, group of individuals or a firm who possesses the necessary qualifications, ability and experience to execute a valuation in an objective, unbiased and competent manner.  In some jurisdictions, licensing is required before one can act as a valuer.  
Valuation base: Valuation base means the indication of the type of value being used in an assignment.   IVS 104 Bases of Value defines Bases of Value as “Bases of value (sometimes called standards of value) describe the fundamental premises on which the reported values will be based.  It is critical that the basis (or bases) of value be appropriate to the terms and purpose of the valuation assignment, as a basis of value may influence or dictate a valuer’s selection of methods, inputs and assumptions, and the ultimate opinion of value”.    
Valuation date: Valuation date is the specific date at which the valuer estimates the value of the underlying asset.  While IVS do not define Valuation date, IVS 101 Scope of Work states that “the valuation date must be stated. If the valuation date is different from the date on which the valuation report is issued or the date on which investigations are to be undertaken or completed then where appropriate, these dates should be clearly distinguished”.   Further,  IVS 104 Bases of Value,  while explaining the definition of Market Value states that “on the valuation date” requires that the value is time-specific as of  a given date.  Because markets and market conditions may change,   the estimated value may be incorrect or inappropriate at another time. The valuation amount will reflect the market state and circumstances as at the valuation date, not those at any other date”.   This implies that  the valuation date is the specific date at which the valuer estimates the value of the underlying asset.  
With and Without Method (WWM): Under WWM, the value of the intangible asset to be valued is equal to the present value of the difference between the projected cash flows over the remaining useful life of the asset under the following two scenarios:  business with all assets in place including the intangible asset to be valued; and  business with all assets in place except the intangible asset to be valued.    IVS 210 Intangible Assets states that  “the with-and-without method indicates the value of an intangible asset by comparing two scenarios: one in which the business uses the subject intangible asset and one in which the business does not use the subject intangible asset (but all other factors are kept constant)”.
Weight/Weightage: Weight/weightage refers to the importance given to a particular value determined using a particular valuation method/ approach.Weight: The word “weight” refers to the amount of reliance placed on a particular indication of value in reaching a conclusion of value (eg, when a single method is used, it is afforded 100% weight). Weighting: The word “weighting” refers to the process of analysing and reconciling differing indications of values, typically from different methods and/or approaches.  This process does not include the averaging of valuations, which is not acceptable (emphasis supplied).  

It is important to note that IVS Glossary has defined “may”, “must”, and “should” from the perspective of a valuer’s responsibilities. While these terms are also used in ICAI VS, these are not defined in ICAI VS. I believe it would a good practice for valuers, who are carrying out valuation engagements in compliance with ICAI VS, to consider and use the definitions of “may”, “must” and “should”, as given in IVS, while discharging their duties and responsibilities as a valuer.

To be continued………

Fair valuation and similar requirements in accounting standards

A number of accounting standards, whether Indian Accounting Standards included the Companies (Indian Accounting Standards) Rules, 2015 (Ind AS) or Accounting Standards Companies (Accounting Standards) Rules, 2006 (AS), require, or provide an option, to preparers of financial statements to measure various assets and liabilities at fair value.

Further, a number of accounting standards require assets and liabilities to be based on measurements which have similarities to fair value but are not fair value.

I have already discussed the definitions of fair value in various accounting standards in one of my earlier posts.

Mandatory fair valuation of income, expense, assets, and liabilities is required under following accountings standards:

Ind AS

  • Ind AS 102, Share-based Payment, requires
    • for equity settled share-based payment transactions, to measure the transaction at fair value of goods or services received unless the fair value cannot be reliably estimated,
    • in case the fair value of goods or services received cannot be estimated reliably (for example in the case of employee share-based payment transactions), then the transaction shall be measured at the fair value of equity instrument issued, and
    • for cash settled share-based payment transactions (such as share appreciation rights or phantom share option plans), to measure the transaction at fair value of goods or services received and the liability incurred. Such liability is remeasured at fair value on each reporting date till the liability is settled.
  • Ind AS 103, Business Combinations, requires all assets and liabilities acquired and purchase consideration paid/ payable in a business combination which is not a common control transaction, to be measured at fair value.
  • Ind AS 107, Financial Instruments: Disclosures, requires disclosure of fair values of certain items on the reporting date, such as
    • assets held as collateral which are freely available to the lender for selling or repledging without any default by the borrower,
    • fair values of various classes of financial assets and financial liabilities except for lease liabilities (including those which are measured at amortised cost, unless such amortised cost reasonably approximates the fair value e.g. in case of short-term trade receivables), and
    • fair values of certain transferred financial assets and their associated liabilities where such financial assets have not been derecognised in their entirety or where there are assets and liabilities which are associated with derecognised financial assets.
  • Ind AS 109, Financial Instruments, for all financial assets where cash flows are not solely payments of principal and interest on the principal outstanding e.g.
    • equity instruments (except those in subsidiaries, associates and joint ventures held by an investment entity such as a mutual fund, unit trust, investment linked insurance fund, alternative investment funds and similar entities),
    • derivative instruments (including derivatives on interests in subsidiaries, associates and joint ventures),
    • convertible instruments such as optionally or compulsorily convertible debentures/ bonds, or optionally or compulsorily convertible preference shares, and
    • loans given where the return is linked to performance measures such as revenue or profitability.
  • Ind AS 109, Financial Instruments, for all financial assets where cash flows are solely payments of principal and interest on the principal outstanding, but the business model of the reporting entity is either to hold such financial assets for trading e.g.
    • investments held for trading, or
    • to hold such financial assets within a business model whose objective is achieved by collecting contractual cash flows and selling financial assets e.g.
      • trade receivables where either the company may hold them till realised or factor them without recourse,
      • investments held in fixed income instruments which may either be held till maturity or sold to realise gains.
  • Ind AS 109, Financial Instruments, for all financial liabilities which are held for trading.
  • Ind AS 110, Consolidated Financial Statements, read with Ind AS 109, Financial Instruments, where investments in a subsidiary are held by an investment entity such as a mutual fund, unit trust, investment linked insurance fund, alternative investment funds and similar entities.
  • Ind AS 116, Leases, requires the manufacturer or dealer lessors to recognise revenue at the lower of fair value of the underlying asset, and the present value of lease payments discounted using a market rate of interest.
  • Appendix A, Distribution of Non-cash Assets to Owners, to Ind AS 10, Events after the Reporting Period, where non-cash assets are distributed to owners (dividend) and such non-cash assets are not controlled by the same parties before and after the distribution. The liability for dividend payable is required to be measured at the fair value of non-cash assets to be distributed.
  • Ind AS 16, Property, Plant & Equipment, Ind AS 38, Intangible Assets, and Ind AS 40, Investment Property, when an item on property, plant or equipment is acquired in exchange for non-monetary assets or a combination of monetary and non-monetary assets. In such a case, the fixed asset acquired shall be measured at its fair value (or the fair value of the assts given up, if the fair value of the asset acquired is not reliably measurable) except in cases where
    • the transaction lacks commercial substance, or
    • the fair value of neither the asset acquired, nor the asset given up is reliably measurable.
  • Ind AS 19, Employee Benefits, requires that plan assets relating to
    • a post-employment defined benefit plan, and
    • other long-term employee benefit plan,be measured at fair value on the reporting date.  
  • Ind AS 20, Accounting for Government Grants and Disclosure of Government Assistance, requires government grant related to assets including non-monetary grant to be measured at fair value. Such fair value of government grant may either then
    • be recognised as deferred income or
    • deducted in arriving at the carrying amount of the respective asset.
  • Ind AS 40, Investment Property, requires fair value of investment property on the reporting date to be disclosed in financial statements.      

AS

  • AS 10, Property, Plant & Equipment, AS 13, Accounting for Investments (in respect of investment properties), and AS 26, Intangible Assets, when an item on property, plant or equipment is acquired in exchange for non-monetary assets or a combination of monetary and non-monetary assets. In such a case, the fixed asset acquired shall be measured at its fair value (or the fair value of the assts given up, if the fair value of the asset acquired is not reliably measurable) except in cases where
    • the transaction lacks commercial substance, or
    • the fair value of neither the asset acquired, nor the asset given up is reliably measurable.
  • AS 13, Accounting for Investments, requires that
    • if an investment is acquired, or partly acquired, by the issue of shares or other securities, the acquisition cost should be the fair value of the securities issued, or
    • if an investment is acquired in exchange for another asset, the acquisition cost of the investment should be determined by reference to the fair value of the asset given up. Alternatively, the acquisition cost of the investment may be determined with reference to the fair value of the investment acquired if it is more clearly evident.
  • AS 13, Accounting for Investments, requires that current investments should be measured at lower of cost and fair value on the reporting date, determined either on an individual basis or by category of investments but not on an overall (or global) basis.
  • AS 15, Employee Benefits, requires that plan assets relating to
    • a post-employment defined benefit plan, and
    • other long-term employee benefit plan be measured at fair value on the reporting date.  
  • AS 19, Leases, requires a lessee to recognise a finance lease, at inception, as an asset and a liability at the lower of
    • the fair value of the asset, and
    • present value of minimum lease payments computed based on interest rate implicit in the lease or if such interest rate is not practicable to determine, then the incremental borrowing rate of the lessee. 
  • AS 20, Earnings Per Share, requires dilutive options and other dilutive potential equity shares to be considered as exercised at fair value of the underlying shares to calculate dilutive earnings per share.

Following accounting standards provide financial statement preparers an option to measure certain assets and liabilities at fair value:

Ind AS

  • Ind AS 101, First-time Adoption of Indian Accounting Standards, provides an option to first-time preparers of Ind AS financial statements to not restate business combinations prior to the date of transition, in accordance with Ind AS 103, Business Combinations. However, an entity may choose to restate earlier business combinations on and from a specific date. Such restatement will then require fair valuation of all assets and liabilities of the Acquiree on the acquisition date.
  • Ind AS 101, First-time Adoption of Indian Accounting Standards, provides an option to first-time preparers of Ind AS financial statements to fair value items of property, plant and equipment, intangible assets and right-to-use assets (or to use a previous GAAP revaluation) and then use such fair value/ previous GAAP revaluation as deemed cost of such assets.
  • Ind AS 101, First-time Adoption of Indian Accounting Standards, provides an option to first-time preparers of Ind AS financial statements to fair value investments in subsidiaries, associates and joint ventures and then use such fair value as deemed cost of such investments in its separate financial statements.
  • Ind AS 106, Exploration for and Evaluation of Mineral Resources, provides for a reporting entity to elect between cost model and revaluation model for subsequent measurement of exploration and evaluation assets following either the revaluation model as provided in Ind AS 16, Property, Plant & Equipment, or in Ind AS 38, Intangible Assets, depending upon the classification of such assets as tangible or intangible.
  • Ind AS 109, Financial Instruments, provides an option to preparers of financial statements to designate financial assets and financial liabilities at fair value through profit or loss, and hence fair value such items, if there is an accounting mismatch between financial assets and liabilities, and in case of financial liabilities, also if certain other conditions are met.
  • Ind AS 16, Property, Plant & Equipment, and Ind AS 38, Intangible Assets, provide for a reporting entity to elect between cost model and revaluation model.
    • In case of revaluation model, the reporting entity is required to measure one or more classes of property, plant and equipment or intangible assets at fair value on the reporting date.
    • If revaluation model is used, then revaluations shall be made with sufficient regularity to ensure that the carrying amounts do not materially differ from those which would be determined using fair value at the end of the reporting period.
    • However, in case of intangible assets, fair value has to be determined with reference to an active market and hence, may not be practicable in most cases.
  • Ind AS 27, Separate Financial Statements, provides an option to the preparers of financial statements to elect to measure investments in subsidiaries, associates, and joint ventures either at cost or at fair value in separate (stand-alone) financial statements. However, such election is available only to entities which are not investment entities and on a category by category basis.
  • Presently, Ind AS 40, Investment Property, does not allow for investment properties to be measured at fair value, though a disclosure of fair values on the reporting date is required. However, The Institute of Chartered Accountants of India (ICAI) has issued an exposure draft to allow financial statement prepares to elect revaluation model for measurement of investment properties, in line with the option provided in International Accounting Standard 40, Investment Property.

AS

  • AS 10, Property, Plant & Equipment, provides for a reporting entity to elect between cost model and revaluation model.
    • In case of revaluation model, the reporting entity is required to measure one or more classes of property, plant and equipment or intangible assets at fair value on the reporting date.
    • If revaluation model is used, then revaluations shall be made with sufficient regularity to ensure that the carrying amounts do not materially differ from those which would be determined using fair value on the balance sheet date.
  • AS 14, Accounting for Amalgamations, provides that in case of an amalgamation in the nature of purchase, the transferee company has an option either
    • to record assets and liabilities of the transferor company at their existing carrying amounts, or
    • to allocate the purchase consideration to individual identifiable assets and liabilities on the basis of their fair values on the date of amalgamation.

However, AS 26, Intangible Assets, requires that the amount recognised for intangible assets should be restricted to an amount that does not create or increase the capital reserve arising at the date of the amalgamation.

A number of accounting standards require assets and liabilities to be based on measurements which have similarities to fair value but are not fair value. These are:

Ind AS

  • Ind AS 105, Non-current Assets Held for Sale and Discontinued Operations, requires
    • a non-current asset (or disposal group) held for sale to be measured at lower of its carrying value and fair value less costs to sell, and
    • a non-current asset (or disposal group) held for distribution to owners to be measured at lower of its carrying value and fair value less costs to distribute.
  • Ind AS 2, Inventories, requires various types of inventories to be measured as
    • inventories held by producers of agricultural and forest produce, agricultural produce after harvest, and minerals and mineral products which are measured at net realisable value in accordance with well-established practices in those industries,
    • inventories held by commodity broker-traders at fair value less costs to sell, and
    • other inventories at lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
  • Ind AS 19, Employee Benefits, requires defined benefit liability in respect of post-employment benefit plans and other long-term employee benefit plans, to be measured on the basis of actuarial valuation using the projected unit credit method.
  • Ind AS 33, Earnings Per Share, requires options, warrants and their equivalents to be considered as exercised at the average market value of the underlying shares to calculate dilutive earnings per share.
  • Ind AS 36, Impairment of Assets, requires calculation of the recoverable amount of an asset or a cash-generating unit (CGU) for the purposes of testing impairment of such asset or CGU. Recoverable amount is higher of the fair value less cost of disposal of the asset or CGU or its value in use. Value in use is the present value of future cash flows expected to be derived from an asset or CGU. Value in use differs from fair value in a number of respects such as
    • unlike fair value, which is calculated from a market participant’s perspective, value in use is entity specific and considers factors, such as synergies, which a market participant may not consider;
    • the cash flow projections to calculate value in use are limited to the remaining life of the asset or assets included in the CGU and cash flows from disposal at the end of life of such assets, and also do not consider capacity enhancement or improvement in efficiency of asset or CGU;
    • pre-tax cash flows are required to be considered for calculating value in use;
    • cash flow projections should be based on a steady or declining rate of growth unless an increasing rate can be justified;
    • the growth rate shall not exceed the long-term average growth rate for the products, industries, or country or countries in which the entity operates, or for the market in which the asset is used; and
    • the discount rate to be used for discounting the cash flows is required to be a pre-tax rate which comprises the time value of money, and the risks specific to the asset for which the future cash flow estimates have not been adjusted. Such risks also include country risk, currency risk and price risk, as applicable.
  • Ind AS 37, Provisions, Contingent Liabilities and Contingent Assets, requires that a provision should be computed using a discounted cash flow approach and should be based on
    • the best estimate of the expenditure required to settle the obligation at the end of the reporting period considering the risks and uncertainties surrounding events and circumstances, and
    • discounting to present value using a pre-tax discount rate that reflects the market assessments of the time value of money and the risks specific to the liability if such risks have not been adjusted in the estimated cash flows.
  • Ind AS 41, Agriculture, requires
    • a biological asset to be measured at fair value less costs to sell on initial recognition and on the reporting date, and
    • agricultural produce harvested from an entity’s biological assets to be measured at its fair value less costs to sell at the point of harvest.

AS

  • AS 2, Valuation of Inventories, requiresmeasurement of
    • inventories held by producers of livestock, agricultural and forest products, and mineral oils, ores and gases to the extent that they are measured at net realisable value in accordance with well-established practices in those industries, and
    • other inventories at lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
  • AS 10, Property, Plant and Equipment, requires items of property, plant and equipment that are retired from active use and held for disposal to be stated at lower of their carrying amounts and net realisable value.
  • AS 15, Employee Benefits, requires defined benefit liability in respect of post-employment benefit plans and other long-term employee benefit plans, to be measured on the basis of actuarial valuation using the projected unit credit method. 
  • AS 28, Impairment of Assets, requires calculation of the recoverable amount of an asset or a cash-generating unit (CGU) for the purposes of testing impairment of such asset or CGU. Recoverable amount is higher of net selling price (defined as amount obtainable from the sale of an asset in an arms’ length transaction between knowledgeable, willing parties less the cost of disposal) of the asset or CGU or its value in use. Value in use is the present value of future cash flows expected to be derived from an asset or CGU. Value in use differs from fair value in a number of respects such as
    • unlike fair value, which is calculated from a market participant’s perspective, value in use is entity specific and considers factors, such as synergies, which a market participant may not consider;
    • the cash flow projections to calculate value in use are limited to the remaining life of the asset or assets included in the CGU and cash flows from disposal at the end of life of such assets, and also do not consider capacity enhancement or improvement in efficiency of asset or CGU;
    • pre-tax cash flows are required to be considered for calculating value in use;
    • cash flow projections should be based on a steady or declining rate of growth  unless an increasing rate can be justified;
    • the growth rate shall not exceed the long-term average growth rate for the products, industries, or country or countries in which the entity operates, or for the market in which the asset is used; and
    • the discount rate to be used for discounting the cash flows is required to be a pre-tax rate which comprises the time value of money, and the risks specific to the asset for which the future cash flow estimates have not been adjusted. Such risks also include country risk, currency risk and price risk, as applicable.
  • AS 29, Provisions, Contingent Liabilities and Contingent Assets, requires that a provision for decommissioning, restoration and similar liabilities which are recognised as cost of property, plant, and equipment, should be computed using a discounted cash flow approach and should be based on
    • the best estimate of the expenditure required to settle the obligation at the end of the reporting period considering the risks and uncertainties surrounding events and circumstances, and

be discounted to present value using a pre-tax discount rate that reflects the market assessments of the time value of money and the risks specific to the liability if such risks have not been adjusted in the estimated cash flows.

Comparison of ICAI Valuation Standards 2018 with International Valuation Standards (effective 31 January 2020) – Part I – Introduction

Photo by Pixabay on Pexels.com

I have already written about the requirements for valuation standards in India and have also indicated important sets of valuation standards presently prevalent in the world.

In this series of blog posts, I will be writing about the Comparison of ICAI Valuation Standards 2018, effective 1 July 2018 (“ICAI VS”) with International Valuation Standards, effective 31 January 2020 (“IVS”).

While Companies (Registered Valuers and Valuation) Rules, 2017 (Valuation Rules) require that any valuation carried out by a registered valuer shall be carried out in accordance with the valuation standards notified by the Central Government and until such valuation standards are notified, a valuer shall make valuation as per

  1. internationally accepted valuation standards (emphasis supplied);
  2. valuation standards adopted by any registered valuers organisation,

no particular set of valuation standards has been mandated by the Government.

ICAI VS have been developed and issued by the Valuation Standards Board (“VSB”) of The Institute of Chartered Accountants of India (“ICAI”) with the objectives of having consistent, uniform, and transparent valuation policies and to harmonise the diverse practices in use in India. ICAI VS have been adopted by ICAI Registered Valuers Organization (“ICAI RVO”).

ICAI requires chartered accountants to mandatorily follow ICAI VS while carrying out valuations required under the Companies Act, 2013 and that ICAI RVO also requires its members (registered valuers) to follow ICAI VS while conducting valuations.

IVS are developed and issued by International Valuation Standards Council (“IVSC”) with the objectives to

  1. develop high quality International Valuation Standards (IVS) which ensure consistency, transparency and confidence in valuations throughout the world, and;
  2. encourage the adoption of IVS, along with valuation professionalism provided by Valuation Professional Organisations throughout the world.

While IVS are followed by a number of valuers in India, there is no mandatory requirement in India to follow IVS. Valuers may follow IVS or any other set of internationally accepted valuation standards.

The objectives of both ICAI VS and IVS are as follows:

ICAI VS  IVS  
The objective of issuing the Valuation Standards is to standardise the various principles, practices and procedures followed by registered valuers and other valuation professionals in valuation of assets, liabilities, or a business. The Valuation Standards set out concepts, principles and procedures which are generally accepted internationally having regard to legal framework and practices prevalent in India.  The Standards will provide a benchmark to the professionals to ensure uniformity in approach and quality of valuation output.  The objective of the IVS is to increase the confidence and trust of users of valuation services by establishing transparent and consistent valuation practices.  A standard will do one or more of the following: identify or develop globally accepted principles and definitions,identify and promulgate considerations for the undertaking of valuation assignments and the reporting of valuations,identify specific matters that require consideration and methods commonly used for valuing different types of assets or liabilities.

Various documents and standards included in both sets of valuation standards are as follows:

ICAI VS  IVS  
Preface to the ICAI Valuation Standards  Introduction
Framework for the Preparation of Valuation Report in accordance with the ICAI Valuation Standards  IVS Framework
General Standards  
ICAI Valuation Standard 101- Definitions  Glossary
ICAI Valuation Standard 102 – Valuation Bases  IVS 104 Bases of Value
ICAI Valuation Standard 103 – Valuation Approaches and Methods  IVS 105 Valuation Approaches and Methods
ICAI Valuation Standard 201 – Scope of Work, Analyses and Evaluation  IVS 101 Scope of Work IVS 102 Investigations and Compliance
ICAI Valuation Standard 202 – Reporting and Documentation  IVS 103 Reporting
Asset Standards  
ICAI Valuation Standard 301 – Business Valuation  IVS 200 Businesses and Business Interests
ICAI Valuation Standard 302 – Intangible Assets  IVS 210 Intangible Assets
 IVS 220 Non-Financial Liabilities  
 IVS 300 Plant and Equipment  
   IVS 400 Real Property Interests
 IVS 410 Development Property  
ICAI Valuation Standard 303 – Financial Instruments  IVS 500 Financial Instruments
Other Documents  
 Basis for Conclusions  
 Technical Information Paper 1 Discounted Cash Flow  
 Technical Information Paper 2 The Cost Approach for Tangible Assets  
 Technical Information Paper 3 The Valuation of  Intangible Assets  
 Technical Information Paper 4 Valuation Uncertainty  

IVS 220 Non-Financial Liabilities was issued in 2019 effective 31 January 2020. In addition, IVSC has issued an exposure draft of IVS 230 Inventory.

As we can see from the above table, while ICAI VS are focused more on valuers of securities and financial assets, IVS is more comprehensive as it covers valuation of non-financial assets and non-financial liabilities as well. Further, there are supporting documents available along with IVS to assist valuers in their valuations which are not available along with ICAI VS.

General Standards

General Standards set forth requirements for the conduct of all valuation assignments including establishing the terms of a valuation engagement, bases of value, valuation approaches and methods, and reporting. They are designed to be applicable to valuations of all types of assets and for any valuation purpose.

 

Asset Standards

Asset Standards include requirements related to specific types of assets. These requirements must be followed in conjunction with the General Standards when performing a valuation of a specific asset type. 

Preface to ICAI VS provides that the responsibility for the preparation of valuation report in compliance with the Valuation Standards and for adequate disclosure of information that supports the conclusion is that of the valuer.

It further provides that the Valuation Standards will be mandatory from the respective date(s) mentioned in the Valuation Standard(s). The mandatory status of Valuation Standard implies that while preparing the valuation report, it will be the responsibility of the valuer to comply with the Valuation Standard. Valuation Report cannot be described as complying with the Valuation Standards unless they comply with all the requirements of each relevant Valuation Standard, to the extent applicable.

On the other hand, Introduction to IVS provides that the IVS consist of mandatory requirements that must be followed in order to state that a valuation was performed in compliance with the IVS.  Certain aspects of the standards do not direct or mandate any particular course of action, but provide fundamental principles and concepts that must be considered in undertaking a valuation.

The IVS Framework also mentions that when a statement is made that a valuation will be, or has been, undertaken in accordance with the IVS, it is implicit that the valuation has been prepared in compliance with all relevant standards issued by the IVSC.

Key differences between Framework for the Preparation of Valuation Report in accordance with the ICAI Valuation Standards and IVS Framework are as follows:

Preparation of Valuation Report in accordance with the ICAI Valuation Standards  IVS Framework
The purpose of the Framework is to inter-alia: assist in promoting harmonisation of practices, valuation standards and procedures relating to the preparation of valuation reports by providing a basis for identifying approaches and methodologies of valuation; assist valuers in applying ICAI Valuation Standards in preparation of valuation report and in dealing with topics that are yet to form the subject of an ICAI Valuation Standard.  The IVS framework serves as a preamble to the IVS.  The IVS Framework consists of general principles for valuers following the IVS regarding objectivity, judgement, competence, and acceptable departures from the IVS.   
The ICAI Valuation Standards are to be applied for the valuation of assets and liabilities. Any reference to the term asset also includes liability.  The standards can be applied to the valuation of both assets and liabilities.  To assist the legibility of these standards, the words asset or assets have been defined to include liability or liabilities and groups of assets, liabilities, or assets and liabilities, except where it is expressly stated otherwise, or is clear from the context that liabilities are excluded.  
The valuer provides a written valuation report containing the minimum requirements as per the ICAI Valuation Standards. In addition, the valuer considers other reporting responsibilities, including communicating with those charged with governance when it is appropriate to do so.  When a statement is made that a valuation will be, or has been, undertaken in accordance with the IVS, it is implicit that the valuation has been prepared in compliance with all relevant standards issued by the IVSC
The term valuer as used in this Framework means the registered valuer registered with the Registering Authority under Section 247 of the Companies Act 2013 and Rules made thereunder for carrying out valuation of assets belonging to a class or classes of assets.   The term valuer also includes a valuer undertaking valuation engagement under other Statutes like Income Tax, SEBI, FEMA, RBI etc.Valuer has been defined as “an individual, group of individuals, or a firm possessing the necessary qualifications, ability and experience to undertake a valuation in an objective, unbiased and competent manner.  In some jurisdictions, licensing is required before one can act as a valuer. Because a valuation reviewer must also be a valuer, to assist with the legibility of these standards, the term valuer includes valuation reviewers except where it is expressly stated otherwise, or is clear from the context that valuation reviewers are excluded.  
In the absence of any definition, or lack of guidance, for a specific term or expression in the Valuation Standards, the valuer shall use its judgement while performing the valuation assignment in such a manner so that the information is: relevant to the economic decision-making needs of intended users; and reliable, in the valuation reports represent faithfully the information contained therein;  reflect the economic substance and not merely the legal form of an item;  are neutral, i.e., free from bias; are prudent; and are complete in all material respects.   To be useful, the underlying information in a valuation report must be reliable. Information has the quality of reliability when it is free from material error and bias and can be relied upon by users to represent faithfully that which, it either purports to represent or could reasonably be expected to represent.    To be reliable, the information contained in valuation report must be neutral, that is, free from bias. The valuation reports are not considered neutral if, by the selection or presentation of information, the reports influence the making of a decision or judgement in order to achieve a predetermined result or outcome.  The process of valuation requires the valuer to make impartial judgements as to the reliability of inputs and assumptions.  For a valuation to be credible, it is important that those judgements are made in a way that promotes transparency and minimises the influence of any subjective factors on the process.  Judgement used in a valuation must be applied objectively to avoid biased analyses, opinions, and conclusions.   It is a fundamental expectation that, when applying these standards, appropriate controls and procedures are in place to ensure the necessary degree of objectivity in the valuation process so that the results are free from bias.  The IVSC Code of Ethical Principles for Professional Valuers provides an example of an appropriate framework for professional conduct.     
In making the judgement described above, the valuer shall refer to, and consider the applicability of, the following sources in descending order: the prescriptions laid down in Companies (Registered Valuers and Valuation) Rules, 2017, as amended from time to time; the requirements in this Framework;  the requirements in the applicable accounting standards as may be notified by the Ministry of Corporate Affairs and where applicable the accounting standards issued by the Institute of Chartered Accountants of India; and in the absence thereof, those of the other standard-setting bodies that use a similar framework to develop valuation standards, other authoritative literature relating to valuation and accepted industry practices, to the extent that these do not conflict with any of the requirements of ICAI Valuation Standards.A “departure” is a circumstance where specific legislative, regulatory, or other authoritative requirements must be followed that differ from some of the requirements within IVS.  Departures are mandatory in that a valuer must comply with legislative, regulatory, and other authoritative requirements appropriate to the purpose and jurisdiction of the valuation to be in compliance with IVS.  A valuer may still state that the valuation was performed in accordance with IVS when there are departures in these circumstances.    The requirement to depart from IVS pursuant to legislative, regulatory, or other authoritative requirements takes precedence over all other IVS requirements.   As required by IVS 101 Scope of Work, para 20.3 (n) and IVS 103 Reporting, para 10.2 the nature of any departures must be identified (for example, identifying that the valuation was performed in accordance with IVS and local tax regulations).  If there are any departures that significantly affect the nature of the procedures performed, inputs and assumptions used, and/or valuation conclusion(s), a valuer must also disclose the specific legislative, regulatory or other authoritative requirements and the significant ways in which they differ from the requirements of IVS (for example, identifying that the relevant jurisdiction requires the use of only a market approach in a circumstance where IVS would indicate that the income approach should be used).   Departure deviations from IVS that are not the result of legislative, regulatory, or other authoritative requirements are not permitted in valuations performed in accordance with IVS.  
The fundamental ethical principles that all valuers are required to observe are:   Integrity and Fairness The valuer should be straightforward and honest in all professional and business relationships and maintain the highest standards and integrity and fairness.   Objectivity The valuer should not allow bias, conflict of interest or undue influence of others to override professional or business judgments.   Professional Competence and Due Care The valuer should maintain professional knowledge and skill at the level required to ensure that an intended user receives competent professional service based on current developments in practice, legislation and techniques and act diligently and in accordance with applicable technical standards and code of conduct.   Confidentiality The valuer should respect the confidentiality of information acquired as a result of professional and business relationships and, therefore, not disclose any such information to third parties without proper and specific authority, unless there is a legal or professional right or duty to disclose, nor use the information for his personal advantage or third parties.   Professional Behaviour The valuer should comply with relevant laws and regulations and avoid any conduct that disrepute to the profession.   Professional Judgement The valuer plans and performs a valuation assignment in order to obtain sufficient appropriate information. The valuer considers materiality, risk, and the quantity and quality of available information when planning and performing the valuation assignment, in particular when determining the nature, timing and extent of evidence-gathering procedures.   Professional Skepticism The valuer plans and performs a valuation assignment with an attitude of professional skepticism recognising that circumstances may exist that cause the information used or contained in the valuation report to be materially misstated. An attitude of professional skepticism means the valuer makes a critical assessment, with a questioning mind, of the validity of information obtained and is alert to information that contradicts or brings into question the reliability of documents or representations by the responsible party.  Objectivity The process of valuation requires the valuer to make impartial judgements as to the reliability of inputs and assumptions.  For a valuation to be credible, it is important that those judgements are made in a way that promotes transparency and minimises the influence of any subjective factors on the process.  Judgement used in a valuation must be applied objectively to avoid biased analyses, opinions, and conclusions.   It is a fundamental expectation that, when applying these standards, appropriate controls and procedures are in place to ensure the necessary degree of objectivity in the valuation process so that the results are free from bias.  The IVSC Code of Ethical Principles for Professional Valuers provides an example of an appropriate framework for professional conduct.    Competence Valuations must be prepared by an individual or firm having the appropriate technical skills, experience, and knowledge of the subject of the valuation, the market(s) in which it trades and the purpose of the valuation.   If a valuer does not possess all of the necessary technical skills, experience and knowledge to perform all aspects of a valuation, it is acceptable for the valuer to seek assistance from specialists in certain aspects of the overall assignment, providing this is disclosed in the scope of work (see IVS 101 Scope of Work) and the report (see IVS 103 Reporting).    The valuer must have the technical skills, experience, and knowledge to understand, interpret and utilise the work of any specialists.  
Objective of Valuation Report The objective of a valuation report is to present the result of findings of a comprehensive appraisal of and revealing a user-specific value for, one or more items.   
Qualitative characteristics of valuation report: UnderstandabilityRelevanceMaterialityFaithful representationSubstance over formPrudenceCompleteness   
Constraints on relevant and reliable information in valuation report: ·       Balance between benefit and cost Balance among qualitative characteristics   

To be continued……..

Requirements for Valuers to follow Valuation Standards in India

Valuations are required for buyers and sellers to determine transaction prices of businesses, assets, and liabilities, for regulatory purposes (such as for company law and foreign exchange management), for tax purposes and for financial reporting (accounting) purposes.

Valuations are relied upon by investors, lenders, regulators, taxmen, and auditors. Also, valuations vary based on their objective. Hence, it is of utmost importance that valuations be as accurate as possible considering the objectives of the valuation and the information available.

Valuation standards assist the valuers in ensuring uniformity in approach and quality of valuation output and in achieving consistency and comparability of valuation practices.

Valuation standards provide generally accepted principles and definitions required for valuation. They also provide considerations that a valuer must consider while undertaking valuation assignments and in preparing valuation reports.

Valuations conducted applying valuation standards have greater acceptability and in cases of disputes, it becomes easier for courts/ arbitrators to rely on valuations if they are prepared applying valuation principles.

There are various sets of valuation standards in the world, the more important ones being:

  1. International Valuation Standards, effective 31 January 2020 (IVS), issued by International Valuations Standards Committee (IVSC).
  2. European Valuation Standards, 2016 (Blue Book) issued by The European Group of Valuers’ Associations (TEGoVA).
  3. ASA Business Valuation Standards, 2009 read with ASA Principles of Appraisal Practice and Code of Ethics, both issued by American Society of Appraisers, USA (ASA).
  4. Uniform Standards of Professional Appraisal Practice 2020-21 (USPAP) issued by The Appraisal Foundation, USA.
  5. AICPA VS Toolkit comprising various valuation standards issued by American Institute of CPAs (AICPA).
  6. RICS – Valuation Global Standards effective 31 January 2020 (The Red Book) issued by The Royal Institution of Chartered Surveyors, U.K. (RICS).
  7. ICAI Valuation Standards 2018 (ICAI VS) issued by The Institute of Chartered Accountants of India (ICAI) and adopted by ICAI Registered Valuers Organization (ICAI RVO).

In India, Companies (Registered Valuers and Valuation) Rules, 2017 (Valuation Rules) require that any valuation carried out by a registered valuer shall be carried out in accordance with the valuation standards notified by the Central Government and until such valuation standards are notified, a valuer shall make valuation as per

  1. internationally accepted valuation standards (emphasis supplied);
  2. valuation standards adopted by any registered valuers organisation.

Valuation Rules apply to valuations to be carried out by registered valuers. However, presently registered valuers are only required to carry out valuations prescribed  under the Companies Act, 2013 (Act) and those specified under The Insolvency and Bankruptcy Code, 2016 (IBC 2016).

IBBI’s CIRP Regulations provide that fair value and liquidation value of the corporate debtor to be determined in accordance with internationally accepted valuation standards (emphasis supplied). Further, IBBI’s Liquidation Process Regulations provide that valuation of assets of the corporate debtor be computed in accordance with Valuation Rules.

Foreign Exchange Management rules and regulations provide that the price of shares/ securities of an unlisted Indian company be carried out by a chartered accountant or a cost accountant or a merchant banker as per internationally accepted methodology for valuation on an arm’s length basis. These rules and regulations do not require compliance with any valuation standards nor do they require valuation to be conducted by a registered valuer.

In respect of a foreign direct investment in a limited liability partnership, Foreign Exchange Management rules and regulations provide that the investment be made at a fair price which is worked out as per any valuation norm which is internationally accepted or adopted as per market practice and a valuation certificate to be issued by a chartered accountant or a cost accountant or by an approved valuer from the panel maintained by the Central Government.

Income Tax Act, 1961 and rules made thereunder also do not specify that valuations of shares/ assets should be carried out based on any valuation standards.

Hence, it can be seen from the above that there is no requirement in India for a valuer to follow any particular set of valuation standards except that ICAI requires chartered accountants to mandatorily follow ICAI VS while carrying out valuations required under the Act and that ICAI RVO also requires its members (registered valuers) to follow ICAI VS while conducting valuations.

Even though there is no requirement to follow valuation standards under foreign exchange management law or income tax law or where valuations are carried out other than for tax or regulatory purposes, it is suggested that valuers follow a set of valuation standards as compliance with valuation standards increases the reliability and acceptance of valuations.

It has been noticed that many registered valuers follow IVS and some may be following The Red Book (RICS – Global Valuation Standards), particularly for valuation of immoveable property and plant and machinery.

There appears to be a misconception amongst the valuers that Valuation Rules require registered valuers to follow IVS and not any other set of valuation standards. However, till the time valuation standards are notified by the Central Government, registered valuers can follow any of the internationally accepted valuation standards or the valuation standards adopted by the registered valuers organisation of which they are member.

Relationship between Retrospective Restatement and Reopening (Revision) of Financial Statements

Ind AS 8, Accounting Policies, Changes in Accounting Estimates and Errors (Ind AS 8) defines Retrospective Restatement (Restatement) as “correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred” (emphasis supplied).

Ind AS 8 defines Prior Period Errors as

 “Omissions from, and misstatements in, the entity’s financial statements of one or more prior periods arising from a failure to use, or misuse of, reliable financial information that:

  1. was available when financial statements for those periods were approved for issue; and
  2. could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements.

Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights and misinterpretation of facts, and fraud”.

Restatement requires the correction of material prior period errors retrospectively in the first set of financial statements approved for issue after their discovery by:

  1. restating the comparative amounts for the prior period(s) presented in which the error occurred; or
  2. if the error occurred before the earliest prior period presented, restating the opening balance of assets, liabilities and equity for the earliest period presented.

Ind AS 1, Presentation of Financial Statements (Ind AS 1) also requires a presentation of a third balance sheet as at the beginning of the preceding period if the restatement has a material effect on the information in the balance sheet at the beginning of the preceding period.

Accounting Standards included in the Companies (Accounting Standards) Rules, 2006 (AS) do not require any retrospective restatement of financial statements on discovery of a prior period error.

AS 5, Net Profit or Loss for the Period, Prior period Items and Changes in Accounting Policies (AS 5) defines prior period items as “items of income or expense which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods”.

AS 5 does not require any retrospective restatement of financial statements on discovery of prior period items but requires such items to be disclosed in the statement of profit or loss of the current financial period.

Hence, the concept of restatement of financial statements is applicable to only those companies which prepare financial statements in compliance with Indian Accounting Standards (Ind AS).

Now coming to reopening of financial statements.

Reopening of financial statements is not covered in any accounting standards whether AS or Ind AS.

Reopening  (revision) of financial statements can be defined as revision of the financial statements of a company after they have already been adopted by the shareholders.

There was no provision for such reopening or revision of financial statements under the Companies Act, 1956. The Institute of Chartered Accountants of India (ICAI) required a Chartered Accountant who was an auditor of the company which revised its already adopted financial statements to qualify the audit report in this aspect quantifying all the amendments made to revised financial statements.

However, there are specific provisions regarding reopening of financial statements in the Companies Act, 2013 (Act).

Section 130 of the Act prescribes that a company shall not re-open its books of account or recast its financial statements unless an application has been made by the Central Government or a regulatory body or authority to a court of competent jurisdiction or to the National Company Law Tribunal (NCLT) and such appropriate order is passed by such court or NCLT. It may be noted that an application under this section can only be made in case:

  1. The relevant earlier accounts were prepared in a fraudulent manner; or
  2. The affairs of the company were mismanaged during the relevant period, casting a doubt on the reliability of financial statements.

Section 131 of the Act allows the Board of Directors of a company to prepare revised financial statements or revised Board report in respect of any of the three preceding years financial years after obtaining the approval of NCLT after making an application. The section allows a company to revise its financial statements only if it appears to the directors that

  1. the financial statements of the Company; or
  2. the report of the Board

do not comply with section 129 or section 134 of the Act.

Section 129 of the Act states that the financial statements shall be prepared in compliance with the accounting standards prescribed under section 133 of the Act. Section 134 prescribes the manner of approval and authentication of the financial statements and the Board report and the contents of the Board report.

In my opinion, a reopening and revision of earlier years’ financial statements would be required in cases where the discovery of errors (including fraud) and/ or other facts and circumstances that come to light, lead to a conclusion that the earlier years’ financial statements may not be reflecting a true and fair view of the financial position and financial performance of the company in those years.

An example of reopening and revision of financial statements is that of CG Power and Industrial Solutions Limited (CGPISL), which upon discovering certain fraudulent financial transactions in earlier years first restated the comparative numbers in its financial statements for the year ended 31 March 2019 and thereafter applied to NCLT under section 131 of the Act to allow it to reopen and revise its financial statements of earlier years. Also, Ministry of Corporate Affairs (MCA), filed an application, in November 2019, to reopen and revise the financial statements of the Company under section 130 of the Act.

Based on news reports, NCLT approved MCA’s application to reopen and revise CGPISL’s financial statements in March 2020.

Prior to this, NCLT had allowed, in January 2019, to reopen financial statements for past five years of IL&FS and its subsidiaries. 

A retrospective restatement of financial statements may lead to reopening and revision of earlier years’ financial statements. However, a reopening and revision of earlier years’ financial statements will not lead to restatement of financial statements since the revised financial statements of previous year will form the comparatives to be included in current year’s financial statements.

Another difference between a retrospective restatement of financial statements and a reopening and revision of earlier years’ financial statements is that while restatement is permitted only under Ind AS, the provisions of the Act regarding reopening and revision of financial statements apply to all financial statements whether prepared in compliance with Ind AS or in compliance with AS.

Also, while a restatement of the financial statements is in the Company’s own hands, a reopening and revision of financial statements requires approval of NCLT. As noted from the example of CGPISL above, the process of obtaining such approval may be time consuming.

The relationship between restatement of financial statements and reopening of financial statements can be explained with the help of the following two examples.

EXAMPLE 1

A Ltd.’s financial year ends on 31 March.

A Ltd had income from providing services in a foreign country, say USA, for a number of years.

Based on advice received by A Ltd., that its provision of services in the USA amounts to having a Permanent Establishment in the USA and that it is liable to pay tax in USA on its income earned in the USA, A Ltd. started making a provision for income tax payable in USA and interest thereon from year ended 31 March 2016 onwards.

The interest payable on income tax payable in USA was also included in the income tax expense and the income tax provision made.

During the year ended 31 March 2020, A Ltd. paid the income tax payable in USA and interest thereon upto the date of payment of the tax.

Based on the provisions of the Indian income tax law, A Ltd. has determined that the interest on income tax paid in USA can be claimed by it as a deduction (on payment basis) in arriving at taxable income in India, and accordingly, it has computed its current tax expense and current tax provision for the year ended 31 March 2020 after considering the interest paid.

There has been no change in the Indian income tax law provisions in this regard in the last 10 years.   

A Ltd. had a net worth in excess of Rs. 250 crores as of 31 March 2018 and accordingly it prepared its first Ind AS compliant financial statements for the year ended 31 March 2019 with the transition date of 1 April 2017.

For simplicity’s sake, it is assumed that there is no GAAP difference between AS and Ind AS so far as A Ltd. is concerned. Also, that the Indian income tax rate has been considered at a constant 30% for all the years presented. Under India – USA double tax avoidance treaty, credit for income tax paid in USA can be availed while paying Indian income tax.

Relevant extracts of the financial statements of A Ltd. for various years are as follows:

It may be noted that under both AS 22, Accounting for Taxes on Income (AS 22) and Ind AS 12, Income Taxes (Ind AS 12) define income tax as tax based on taxable profits. Accordingly, interest paid/ payable on delayed payment of income tax does not meet the definition of income tax. Instead, such interest is in the nature of a financing charge and accordingly, should be disclosed as a part of interest expense.

Accordingly, interest on USA income tax should be reclassified as interest expense for the year ended 31 March 2020. Also, the comparative figures for the year ended 31 March 2019 should be restated to show such interest as part of interest expense. Since, in earlier years, such interest has already been considered as a deduction to arrive at profit after tax, there is no adjustment required in retained earnings as of 1 April 2018.

However, since such interest is allowed as a deduction for computing taxable income in India on payment basis, creation of a provision for such interest without actual payment is a deductible temporary difference (under Ind AS 12) and timing difference (under AS 22), and accordingly, deferred tax asset should have been created on provision of such interest.

Hence, comparatives for the year ended 31 March 2019, included in the financial statements for the year ended 31 March 2020, should be restated to include deferred tax assets in respect of provision made during the year. Further, opening retained earnings as of 1 April 2018 should be adjusted for deferred tax adjustment and creation of deferred tax asset on the amount of provision existing as of 31 March 2018.

Based on the above, the restated financial statements of A Ltd. are as follows:

Considering that the change in amount of total current liabilities, income tax provision, deferred tax assets, interest expense and total income tax expense is material for all the earlier years, apart from restatement of comparatives in the financial statements for the year ended 31 March 2020, A Ltd. should assess whether the changes are material enough for it to reopen and revise its financial statements of preceding three years following the provisions of section 131 of the Act.

EXAMPLE 2

B Ltd.’s financial year ends on 31 March. B Ltd. prepares its financial statements following Ind AS. The transition date to Ind AS was 1 April 2016.

C Ltd. amalgamated with B Ltd.  C Ltd. is not under common control with B Ltd. The appointed date of amalgamation as per the scheme of arrangement filed with NCLT is 1 April 2017. The approval of NCLT to the scheme of arrangement was received in April 2020 and the scheme became effective as of 1 May 2020.

For each of the financial years, the assets, liabilities, income, and expenses of C Ltd. are roughly half those of B Ltd.

B Ltd.is yet to issue its financial statements for the year ended 31 March 2020.

Ind AS 103, Business Combinations (Ind AS 103) provides that a business combination (including amalgamations) should be accounted for on the acquisition date which is the date on which the acquirer obtains control of the acquiree.  Accordingly, in case of an amalgamation, the acquisition date is the date on which the scheme of arrangement became effective since before that date both the amalgamating and the amalgamated companies were independent companies. However, as per a circular dated 21 August 2019 issued by the Ministry of Corporate Affairs (MCA), in case of a scheme under the Companies Act, 2013, the Appointed Date is deemed to be the acquisition date/ date of transfer of control under Ind AS 103.

Accordingly, B Ltd. is required to account for the amalgamation of C Ltd. with itself on and from 1 April 2017.

While, a retrospective acquisition date is not a prior period error, I believe that B Ltd. is required to restate the comparative figures in the financial statements for the year ended 31 March 2020 and also the opening balance of retained earnings and assets and liabilities as of 1 April 2018 to reflect the business combination from 1 April 2017. Considering that the restatements are material, B Ltd. is also required to present a third balance sheet as of 1 April 2018 (restated) as  a part of its financial statement for the year ended 31 March 2020. It may be noted that Ind AS 103 does not specifically require the third balance sheet.

Further, considering that the date of acquisition as per Ind AS 103 read with MCA’s circular is 1 April 2017, in my opinion, B Ltd. should also reopen and revise its financial statements for the years ended 31 March 2018 and 31 March 2019 following the provisions of section 131 of the Act.

Alternatively, considering the time period involved in obtaining approval of NCLT, B Ltd. may first reopen and revise its financial statements for the years ended 31 March 2018 and 31 March 2019 following the provisions of section 131 of the Act and then, prepare the financial statements for the year ended 31 March 2020 which will include comparatives based on the revised financial statements for the year ended 31 March 2019. I hope, I have been able to explain the relationship between retrospective restatement and reopening/ revision of financial statements.

Expected Amendments to Indian Accounting Standards (Ind AS) in 2020

As we know, amendments to Ind AS follow amendments to IFRSs (International Financial Reporting Standards). IASB (International Accounting Standards Board) has issued a few amendments to IFRS which are effective from 2020. Accordingly, it is expected that these amendments will be incorporated in Ind AS this year by Ministry of Corporate Affairs (MCA) by issuing Companies (Indian Accounting Standards) Amendment Rules.

Amendments to IFRS are as follows:

IFRS 3, Business Combinations (IFRS 3)

IASB has amended the definition of “business” and related guidance included in the standard for the purposes of identifying where an acquisition is a business to apply business combination accounting. These amendments are effective from accounting periods beginning on or after 1 January 2020 with earlier application permitted.

Previous definition of business included in IFRS 3 is as follows:

“An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants”.

The amended definition of business is as follows:

“An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing goods or services to customers, generating investment income (such as dividends or interest) or generate other income from ordinary activities”.

Key change is that the definition of business is narrowed to focus on providing goods or services to customers, generating investment income or generate other income from ordinary activities instead of the earlier wider focus of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.

Earlier the standard also provided that a business need not include all of the inputs and processes that the seller used in operating that business if market participants are capable of acquiring the business and continuing to produce outputs, for example, by integrating the business with their own inputs and processes. This requirement is now deleted. Instead, the amended guidance requires that to be considered a business, an integrated set of activities and assets, must include at a minimum, an input and a substantive process that together contribute to the ability to create output. Further, to be a business without outputs, there will now need to be an organised workforce for it to constitute a business.

Further, the amended guidance provides that if an acquired set of activities and assets has outputs, continuation of revenue does not on its own indicate that both an input and a substantive process have been acquired. Additional guidance has been provided to assess whether a process is substantive or not.

The standard earlier also provided that if a particular set of activities and assets included goodwill, then such set of activities and assets was presumed to be a business. This presumption has now been deleted.

The amendment also provides that an entity can apply a ‘concentration test’ that, if met, eliminates the need for further assessment. Under this optional test, where substantially all of the fair value of gross assets acquired is concentrated in a single asset (or a group of similar assets), the assets acquired would not represent a business. The amended standard provides detailed guidance in this respect.

The changes to the definition of a business will likely result in more acquisitions being accounted for as asset acquisitions across all industries, particularly real estate, pharmaceutical, and oil and gas.

IFRS 9, Financial Instruments (IFRS 9)

IASB has amended the hedge accounting requirements included in IFRS 9 to provide limited relief to financial statement preparers from the effects of the forthcoming IBOR (Interbank Offered Rate) reform. These amendments are effective from accounting periods beginning on or after 1 January 2020 with earlier application permitted.

For details on IBOR reform and its business and accounting consequences please read my or on my blog post at https://joy-consulting.in/2020/06/15/ibor-reform-what-in-the-heavens-is-that/  or my linkedin post at https://www.linkedin.com/feed/update/urn:li:activity:6678171533095108608/.

IFRS 16, Leases (IFRS 16)

IASB has amended IFRS 16 to provide limited relief to lessees in respect of rent concessions arising due to Covid-19 pandemic. No relief has been allowed to the lessors. These amendments are effective from accounting periods beginning on or after 1 June 2020 with earlier application permitted.

The amendments provide a practical expedient that lessess may elect to not treat any rent concessions, provided by lessors as a direct consequence of Covid-19 pandemic, as lease modifications. However, to be eligible for this relief,

  1. the revised consideration for the lease should be less than or equal to the lease consideration immediately before the change,
  2. the rent concession should be for a period that does not extend beyond 30 June 2021, and
  3. there is no substantial modification to the other terms and conditions of the lease.

This means that such rent concessions can be taken by the lessees directly to the statement of profit and loss. However, the lessees will have to continue to account for interest expense and depreciation on right-of-use assets as before.

Lessees are also required to provide disclosures about application of the practical expedient and its impact on profit or loss.

IAS 1, Presentation of Financial Statements (IAS 1) and IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors (IAS 8)  

IASB has amended the definition of “materiality” and related guidance. The amendment is effective for accounting periods beginning on or after 1 January 2020. Early application is permitted.

Previous definition of materiality included in IAS 1 and IAS 8 is as follows:

“Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor”.

The amended definition of materiality is as follows:

“Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity”.

The amendments clarify that the information is obscured if it is communicated in a way that would have a similar effect for primary users of financial statements to omitting or misstating that information. The amendments also state that an entity assesses materiality in the context of the financial statements as a whole.

The amendments also clarify the meaning of ‘primary users of general purpose financial statements’ to whom those financial statements are directed, by defining them as ‘existing and potential investors, lenders and other creditors’ that must rely on general purpose financial statements for much of the financial information they need.

Ind AS 7, Statement of Cash Flows (Ind AS 1)

It appears that an inadvertent error has crept into Ind AS 7 consequent to the amendments made by Ind AS 116, Leases (Ind AS 116). 

Paragraph 17 of Ind AS 7 provides examples of cash flows arising from financing activities.

Instead of replacing paragraph 17(e) “Cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease”, paragraph 17(c) “Cash proceeds from issuing debentures, loans, notes, bonds, mortgages, and other short-term and long-term borrowings” has been replaced by “Cash payments by a lessee for the reduction of the outstanding liability relating to a lease”.

Consequently, an important element of financing activities has been removed as an example from IAS 7 and instead we have two examples relating to leases of which one i.e 17(e) is no longer applicable since, consequent to the issuance of Ind AS 116,  there is no concept of a finance lease with respect to a lessee. Members of NFRA (National Financial Reporting Authority) are cognizant of this error and it is expected that MCA will correct this error at the earliest.

IBOR Reform – What in the heavens is that?

After reading the heading, some of you may be asking what is IBOR?

Well, IBOR stands for Interbank Offered Rate which is a benchmark interest rate. There are number of IBORs in the world today including well known ones to us such as LIBOR (London Interbank Offered Rate), Euribor (Euro Interbank Offer Rate) and MIBOR (Mumbai Interbank Offer Rate). Such rates include credit risk of banks/ financial institutions offering such rates.

Now, many of you might be asking, okay, I know what IBOR stands for but why should I worry about IBOR reform?

IBOR reform is important as most regulators are moving away from IBORs. In fact, most IBORs including LIBOR and Euribor are expected to be phased out by the end of 2021 and replaced with other benchmark rates such as SOFR (Secured Overnight Funding Rate) for US Dollar denominated instruments, SONIA (Reformed Sterling Overnight Interest Average) for British Pound denominated instruments, and €STR (Euro Short Term Rate). Such rates are usually risk-free rates as these are based on government bond rates.

Regulators have become uncomfortable with IBOR because of because they are based on trader quotes rather than actually observed rates. Regulators’ discomfort significantly increased after the LIBOR rate fixing scandal came to light in 2012. The traders were colluding with each other to rig LIBOR and thus to make profits.

Now, some of you might say, the IBORs are phasing out, so what?

Well, it should matter to all those who are involved with companies which have lent or borrowed money in foreign currencies. This will particularly have significant impact on banks and other financial institutions who borrow and lend money in foreign currencies. All such companies, whether following Indian Accounting Standards (“Ind AS”) or Accounting Standards (“AS”), will be impacted. However, banks and financial institutions may also have to follow any guidelines issued by the Reserve Bank of India in this respect.

It should be noted that a vast majority of financial instruments in the world (especially lending/ borrowings) are linked to IBORs. PwC[1] has indicated that financial instruments of over 350 trillion US Dollars are linked to LIBOR alone.

In the Indian context, most of the lending/ borrowings denominated in foreign currency are linked to IBOR, mostly to LIBOR. These could be plain vanilla loans, bonds, debentures, and convertible instruments such as foreign currency convertible bonds (“FCCBs”). Also, other financial instruments such as supplier’s credit and interest-bearing advances against contracts which are in foreign currency may also be linked to IBOR.

The first impact of IBOR reform is at business and finance/ treasury level.

Since, interest rates in current contracts are linked to IBOR, the interest rate clauses in all lending/ borrowing agreements will become inoperative when respective IBORs are phased out. Hence, all lenders and borrowers need to renegotiate their contracts to move away from IBOR and link the interest rates from the current IBOR to another applicable benchmark rate. The lenders need to ensure that their interest income on lending does not decrease while the borrowers need to ensure that the interest expense on their borrowings does not increase.

In fact, it is quite possible, that lenders may already have reached out to borrowers for renegotiating the agreements. Also, some lenders have already started to include clauses to cover other benchmark rates on phasing out of applicable IBOR in their lending contracts.

Second impact is at the accounting level.

There are two accounting impacts – first relates to modification of the lending/ borrowing contract and second relates to hedge accounting if the lender/ borrower has a hedge in respect of foreign currency lending/ borrowing, particularly against the interest rate, and follows hedge accounting.

A change in benchmark rate in respective contracts will result in modification of respective financial instrument contracts. While we have no guidance regarding modification of financial instruments in accounting standards included in the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as “AS’), there is extensive guidance in this regard in Indian Accounting Standard 109, Financial Instruments (Ind AS 109) included in the Companies (Indian Accounting Standards) Rules, 2015.

Ideally, companies following AS should also follow the accounting provided in Ind AS 109 to account for the modification of lending/ borrowing contracts, as applicable. However, I hope that the Institute of Chartered Accountants of India (“ICAI”) will issue an advisory on this in due course.

Under Ind AS 109, a gain/ loss on modification needs to be computed and taken to statement of profit and loss when the modification occurs. International Accounting Standards Board (“IASB”) has issued an exposure draft, as part of its phase 2 of the project regarding IBOR reform and its effect on financial reporting,  to amend IFRS 9, Financial Instruments and IFRS 4, Insurance Contracts  to provide some relaxations on financial instruments modification accounting and hedge accounting once an IBOR is replaced with another benchmark rate in financial instrument contracts. It is expected that the final amendments will be issued sometime in third quarter of 2020.

We can expect similar amendments to be made to Ind AS 109 and Ind AS 104 at an appropriate time and also to the Guidance Note on “Accounting for Derivates” (“GN”) issued by ICAI which is applicable to entities which are preparing AS compliant financial statements.

Now coming to the impact of IBOR reform on hedge accounting.

Replacement of benchmark with other interest rates may lead to failure of certain hedges to qualify for hedge accounting. Consequently, hedge accounting will have to be discontinued as of today.

IBOR Reform will affect companies in all industries that have applied hedge accounting for IBOR-related hedges, such as hedges of loans, bonds and borrowings with instruments such as interest rate swaps, interest rate options, forward rate agreements and cross-currency swaps.

This can happen when future interest cash flows that depend upon an IBOR (for example, future LIBOR-based interest payments on issued debt hedged with an interest rate swap) are no longer “highly probable” beyond the date at which the relevant IBOR is expected to cease being published.

Secondly, both Ind AS 109 and the GN require a forward-looking prospective assessment in order to apply hedge accounting. Ind AS 109 requires there to be an economic relationship between the hedged item and the hedging instrument, whereas GN requires the hedge to be expected to be highly effective. Given the uncertainties arising from IBOR reform, including when IBORs will be replaced and with what rate(s), this might become difficult to demonstrate currently. This could give rise to hedge ineffectiveness in the prospective assessment, in particular where the replacement of the benchmark rate is expected to occur at different times in the hedged item and the hedging instrument. The uncertainties described above in the context of prospective assessments could also affect GN’s retrospective effectiveness requirement.

Thirdly, in some hedges, the hedged item or hedged risk is a non-contractually specified IBOR risk component. An example is a fair value hedge of fixed-rate debt where the designated hedged risk is changes in the fair value of the debt attributable to changes in an IBOR. In order for hedge accounting to be applied, both Ind AS 109 and GN require the designated risk component to be separately identifiable. Given the uncertainties arising from IBOR reform, this might cease to be the case.

However, the good news is that IASB, as part of Phase 1of the project regarding IBOR reform and its effect on financial reporting, has issued certain amendments to IFRS 9 and IFRS 7, Financial Instruments Disclosures, providing  reliefs to hedge accounting in the period before the reform.

These amendments are effective from accounting periods beginning 1 January 2020 with earlier application permitted.

We can expect similar amendments in Ind AS 109 and Ind AS 107 to be issued by Ministry of Company Affairs in the near future. ICAI had already issued an exposure draft of the proposed amendments to Ind AS 109 and Ind AS 107 in 2019. We also hope that ICAI will provide similar reliefs in the GN.

These amendments provide as follows:

  • Firstly, the amendments require an entity to assume that the interest rate on which the hedged cash flows are based does not change as a result of the reform. Hence, where the hedged cash flows may change as a result of IBOR reform (for example, where the future interest payments on a hedged forecast debt issuance might be SONIA + X% rather than GBP LIBOR + Y%), this will not cause the ‘highly probable’ test to be failed.
  • Secondly, the amendments provide that an entity assumes that the interest rate benchmark on which the cash flows of the hedged item, hedging instrument or hedged risk are based is not altered by IBOR reform and hence the economic relationship and hedge effectiveness is not affected.
  • Thirdly, under the amendments, where only a risk component is hedged, the risk component only needs to be separately identifiable at initial hedge designation and not on an ongoing basis. In the context of a macro hedge, where an entity frequently resets a hedging relationship, the relief applies from when a hedged item was initially designated within that hedging relationship.
  • IFRS 7 has been amended to require disclosure of the nominal amount of hedging instruments to which the reliefs are applied, any significant assumptions or judgements made in applying the reliefs, and qualitative disclosures about how the entity is impacted by IBOR reform and is managing the transition process.  

I hope I have provided some clarity on the issue. Entities which have financial instruments (loans given/ borrowings, etc.) in foreign currencies should start a dialogue with their counterparties, if not already done so. Also, entities may consult their auditors/ accounting experts on accounting implications arising from IBOR reform based on facts and circumstances in their case.

[1]Source: https://www.pwc.com/gx/en/industries/financial-services/publications/libor-reference-rate-reform.html