fair value

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.

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.