ICAI

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………

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