Perspectives On Fair Value Under Ind As (Part 2)

Under Part 1 which was published in February 2018, we had discussed the broad principles underlying fair value measurement as enshrined in Ind AS 113- Fair Value Measurements. In this part,  we would be broadly understanding the requirements for measurement and disclosure of fair value for various types of assets, liabilities and equity under various Ind ASs as indicated in Part 1, coupled with the benefits and perils of fair value accounting followed by certain practical considerations for first time adoption by Phase II entities based on the learnings gathered from the Phase I entities.

BROAD PRESCRIPTION ON FAIR VALUE UNDER CERTAIN Ind ASs:
As indicated earlier, the following are the main Standards which prescribe the use of fair value either for measurement, disclosure or assessment purposes.

Ind AS 36- Impairment of Assets:

The broad objectives of this Standard are as under:

a) To observe if there are any indicators of impairment of various assets.
b) To measure the recoverable amount and compare the same with the carrying value of the asset.
c) To impair the assets if the carrying value is greater than the recoverable amount.

The key consideration for assessing impairment is the determination of the recoverable amount which is defined as the higher of the “Value in Use” or “Fair value less Costs of Disposal”.

“Value in Use” for the purpose of the above assessment is determined by estimating the future cash flows that can be derived from the continuous use of the asset including its realisable value on ultimate disposal and discounting the same at an appropriate rate after considering the risk, premium or discount as applicable.The principles underlying the present value technique as per Ind AS 113 as discussed in Part 1 need to be kept in mind whilst estimating the future cash flows and the discount rate to be applied for arriving at the value in use.

The “Fair Value less Cost of Disposal” for the purpose of the above assessment refers to the amount arising from the sale of an asset or CGU in an arm’s length transaction less the cost of disposal. The costs of disposal includes legal costs, stamp duty and other similar levies, as applicable, cost of removing the asset and direct incremental costs to bring the asset into a selling condition. However, finance costs and income tax expenses need to be excluded whilst determining the cost of disposal. For determining the fair values,  the principles as enunciated under Ind AS 113 as discussed in part 1 need to be kept in mind. However, there is no bar on the type of valuation technique to be used.

Apart from the other disclosures, Ind AS 36 requires the following specific disclosures dealing with fair value:

a) The basis used for determining the recoverable amount keeping in mind the fair value hierarchy as per Ind AS 113 discussed earlier.
b) The key assumptions and the discount rate considered for determining the value in use as defined above.

Ind AS 103- Business Combinations:

This Standard deals with the initial recognition of assets and liabilities in respect of business combinations which could be in the nature of acquisitions or amalgamation under common control transactions. In respect of business combinations accounted for under the “acquisition method”, the initial recognition of assets and liabilities is as under:

– Recognising and measuring all the identifiable assets, whether tangible or intangible, including those that are not previously recognised by the acquiree, and liabilities (including contingent liabilities) at fair value as determined as per Ind AS 113.

– Any contingent consideration which forms a part of the transaction also needs to be accounted at fair value in accordance with Ind AS 109 or 113, as applicable.

– Any goodwill resulting from the transaction needs to be tested annually for impairment in accordance with Ind AS 36 as discussed above.

This is one of the key Standards wherein extensive use of fair valuation is mandated. The broad principles governing fair valuation under Ind AS 113 would need to be kept in mind depending upon the nature of the assets and liabilities being acquired.

Further, apart from the other matters, the main challenge lies in identifying the intangible assets acquired as a part of the business combination which have not been recognised by the acquiree, but which meet the recognition and identifiability criteria and to allocate a fair value to them as a part of the overall consideration. This would require significant judgements based on the business rationale and other commercial considerations of the transaction. The broad principles governing the determination of fair value as discussed later, under Ind AS 38 – Intangible Assets would need to be kept in mind. The following are some of the broad categories related to intangible assets arising from acquisitions under business combination:
– Marketing
– Customer
– Artistic
– Contractual
– Technology

Ind AS 109- Financial Instruments:

This is another Standard which almost entirely rests on the premise of fair valuation. The underlying theme of the Standard is that all financial assets and liabilities should be initially measured at fair value as determined under Ind AS 113, which would normally be the transaction price, unless proved otherwise as discussed below.

Para B 5.1.2A of Ind AS 109 provides that the transaction price may need to be adjusted on initial recognition if there is a fair value as evidenced by a quoted price in an active market for an identical asset or liability (level 1) or based on a valuation technique that uses data only from observable markets (level 2).

The way the financial instruments are classified under Ind AS 109 drives their subsequent measurement.

Whilst the valuation of quoted financial instruments is quite straight forward, it is the valuation of unquoted and complex financial instruments, including derivatives, which poses various challenges given their hybrid nature and the difficulty in quantifying the associated risks. Whilst a detailed discussion of the valuation methods is beyond the scope of this study, the broad underlying principles are briefly touched upon hereunder.

For ease of understanding, financial instruments are classified into the following broad categories for valuation purposes:
a) Bonds and its variants
b) Forwards and futures
c) Call and put options
d) Equity Instruments

In respect of the instruments indicated in (a) to (c) above, determination of fair value needs to  consider the various specific features like conversion options, put and call options, caps and floors and various other subjective assessments and judgements which are captured through various mathematical models. However, if such instruments are traded and quoted on a recognised stock exchange, the challenges in determining fair value are much less.

Equity Instruments:

The valuation of equity instruments is dependent on the underlying valuation of the company which has issued these instruments. For this purpose, the appropriate valuation methodology from amongst the various methods as discussed earlier would need to be considered dependent upon the nature of the business / industry and the purpose of the valuation whether on a going concern or liquidation basis etc.
 
A question which often arises in case of unquoted equity shares is the basis and frequency with which the fair value needs to be measured due to lack of credible recent information being available and consequently whether the cost can be considered as the fair value. In this context, para B 5.2.3 of Ind AS 109 provides that in limited circumstances, cost may be an appropriate estimate of fair value, especially in case if insufficient more recent information is available to measure fair value, or if there is a wide range of possible fair value measurements and cost represents the best estimate of fair value within that range. Further, para B5.2.4 of Ind AS 109 provides for a list of some of the following indicators, amongst others, where cost might not be representative of the fair value:

a) Significant change in the performance of the investee compared with budgets, plans or milestones.
b) Changes in expectation that the investee’s technical product milestones will be achieved.
c) Significant change in the market for the investee’s equity or its products or potential products.
d) Significant change in the global economy or the economic environment in which the investee operates.
e) Significant change in the performance of comparable entities, or in the valuations implied by the overall market.

Ind AS 28- Investments in Associates and Joint
Ventures:

The Standard provides that an investment in an associate or joint venture should be accounted by using the equity method under which the investment is initially recognised at acquisition cost. Subsequent to the acquisition, the difference between the cost of the investment and the investee’s share of the net fair value of the identifiable assets and liabilities, determined in accordance with Ind AS 113, is accounted as under:

– Goodwill – if the cost of the investment is greater than the investee’s share of the net fair value of the assets and liabilities. This goodwill is to be adjusted with the carrying value of the investment and is neither eligible for amortisation nor is it to be tested for impairment.

– Capital Reserve– if the investee’s share of the net fair value of the assets and liabilities is greater than the cost of the investment.

Further, such investments are to be tested for impairment in accordance with Ind AS 36 as a single asset.

Ind AS 38- Intangible Assets:

Any intangible asset which satisfies the recognition criteria as per the Standard shall be measured at cost. However, in the following situations, the intangible assets are required to be measured at fair value:

– Business Combinations – As discussed above, in such cases the cost shall be the fair value as on the acquisition date.

– Government Grants – In such cases, the entity shall recognise both the intangible asset and the grant initially at the fair value as per Ind AS 20 – Accounting for Government Grants and Disclosure of Government Assistance.

– Acquisition for non-monetary consideration– If any intangible asset is acquired in exchange of non-monetary considerations, the cost shall be the fair value of the asset given up or the fair value of the asset received which is more evident.

An entity has an option of choosing the revaluation model for subsequent measurement of intangible assets. However, for this purpose, the revaluations shall be done with sufficient regularity to ensure that the carrying value does not differ materiality from the fair value determined in accordance with Ind AS 113. Further, the entire class of intangible assets shall be subjected to revaluation. The frequency of revaluation depends upon the changes in the fair value of the intangible assets being revalued.

Whilst a detailed discussion of the valuation methods to be adopted for intangible assets is beyond the scope of this study, the broad underlying principles are briefly touched upon hereunder.

– Income Approach– As discussed earlier, this approach converts future cash flows to a single present value and discounting the same based on a rate or return that considers the relative risk of the cash flows. This approach is most commonly used to value technology and customer related intangibles, brands, trademarks and non-compete arrangements. The following variations to the income approach are also used to measure certain types of intangible assets:

a) Multi period excess earnings method as discussed earlier.

b) Relief from Royalty method– which is generally used for assets subject to licencing. The fair value of the asset under this method is the present value of the licence fee avoided by owning the asset (i.e. the savings in royalty).

c) With and without method – the value of the intangible asset in question is calculated by taking the difference between the business value estimated under two sets of cash flow projections for the whole business and without the intangible asset in question.

– Market Approach – This method is used for certain type of assets which trade as separate portfolios such as FMCG or pharmaceutical brands or licences.

– Cost Approach – This method is adopted for certain types of intangibles that are readily replicated or replaced such as software, assembled workforce etc.

Further, all intangible assets with a finite useful life need to be amortised and tested for impairment in accordance with Ind AS 36. Finally, all intangible assets with an indefinite useful life need to be tested annually for impairment.

Ind AS 102- Share Based Payments:

Ind AS 102 deals with the following types of share based payments:

– Equity settled share based payments
– Cash settled share based payments
– Share based payment transactions with alternatives

All transactions involving share based payments are recognised as expenses or assets over the underlying vesting period. Transactions with employees are measured on the date of grant and those with non-employees are measured when the goods or services are received.

In case of measurement of equity settled share based payment transactions, the goods or services received by an entity are directly measured at the fair value of such goods or services received. However, in case such fair value cannot be estimated reliably, the fair value is measured with reference to the fair value of the equity instruments granted.

In case of measurement of cash settled share based payment transactions, the goods or services received by an entity and the liability incurred will be measured at the fair value of the liability. This liability has to be re-measured at each reporting date, up to the date of settlement and changes in the fair value are to be recognised in the profit or loss for the period.

In case of transactions with employees, the fair value of the equity instrument must be used and if it is not possible, the intrinsic value may be used.

The term fair value is defined in the Standard as the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged between knowledgeable, willing parties in an arm’s length transaction.  This definition is different in some respects from the definition in Ind AS 113.

Ind AS 16– Property, Plant and Equipment:

Any item of property, plant or equipment which satisfies the recognition criteria as per the Standard shall be measured at acquisition cost.

An entity has an option of choosing the revaluation model for subsequent measurement of property, plant or equipment. However, for this purpose, the revaluations shall be done with sufficient regularity to ensure that the carrying value does not differ materiality from the fair value determined in accordance with Ind AS 113. Further, the entire class of property, plant or equipment shall be subjected to revaluation. The frequency of revaluation depends upon the changes in the fair value of the property, plant or equipment being revalued.

Whilst a detailed discussion of the valuation methods to be adopted for property, plant and equipment is beyond the scope of this study, the broad underlying principles are briefly touched upon hereunder.

– Market Value:– In case of real estate properties, the market approach is best suited by considering relevant information generated by market transactions for similar assets.

– Replacement Value:- In case of equipment, the replacement value is the most suitable method since that represents the price that an acquirer would pay after adjusting for obsolescence, physical wear and tear and other technological considerations.

Ind AS 40- Investment Property:
Any item of investment property which satisfies the recognition criteria as per the Standard shall be measured at acquisition cost.

Unlike in the case of property, plant and equipment and intangible assets, the subsequent measurement of investment property should be on the basis of the cost model. However, there is a mandatory requirement to disclose the fair value of investment property on the basis of a valuation by an independent valuer who holds a recognised and relevant professional qualification.
Whilst the fair value would need to be determined in accordance with the principles laid down in Ind AS 113, Ind AS 40 also lays down certain broad parameters, as under, for determining the fair value, which  valuers would need to keep in mind.

– When measuring the fair value of investment property in accordance with Ind AS 113, an entity shall ensure that the fair value reflects, among other things, rental income from current leases and other assumptions that market participants would use when pricing investment property under current market conditions.

– There is a rebuttable presumption that an entity can reliably measure the fair value of an investment property on a continuing basis. However, in exceptional cases when the fair value of the investment property is not reliably measurable on a continuing basis (e.g. there are few recent transactions, price quotations are not current or observed transaction prices indicate that the seller was forced to sell) and alternative reliable measurements of fair value (for example, based on discounted cash flow projections) are not available, or if an entity determines that the fair value of an investment property under construction is not reliably measurable but expects the fair value of the property to be reliably measurable when construction is complete, it shall measure the fair value of that investment property either when its fair value becomes reliably measurable or construction is completed (whichever is earlier). In such cases, specific disclosures need to be given.

– If an entity has previously measured the fair value of an investment property, it shall continue to measure the fair value of that property until disposal (or until the property becomes owner-occupied property or the entity begins to develop the property for subsequent sale in the ordinary course of business) even if comparable market transactions become less frequent or market prices become less readily available.

Ind AS 41 – Agriculture:

This Standard applies to biological assets, agricultural produce at the point of harvest and government grants related to biological assets.

The fair value of biological assets and agricultural produce at the point of harvest shall be measured in accordance with Ind AS 113.

A biological asset needs to be measured on initial recognition as well as at the end of each reporting period at its fair value less cost to sell, unless the same cannot be determined in which case it needs to be measured at cost less accumulated depreciation and accumulated impairment losses.

Any agricultural produce harvested from an entity’s biological assets should also be measured at its fair value less the cost to sell at the point of harvest.

BENEFITS AND PERILS OF FAIR VALUE ACCOUNTING:
As is the case with any journey, the journey of fair value accounting under Ind AS also has a smooth ride and at the same time there are several roadblocks. Let us now briefly review its benefits as well as understand its perils and challenges.

Benefits of Fair Value Accounting:

Some of the major benefits of fair value accounting are discussed below:

– Realistic Financial Statements – Companies reporting under this method have financial statements that are more accurate than those not using this method. When assets and liabilities are reported for their actual value, it results in more realistic financial statements. When using this method, companies are required to disclose information regarding changes made on their financial statements. These disclosures are done in the form of footnotes. Companies have an opportunity for examining their financial statements with actual fair values, allowing them to make wise choices regarding future business operations.

– Benefit to Investors – Fair value accounting offers benefits for investors as well, since fair value accounting lists assets and liabilities for their actual value. Accordingly, financial statements reflect a clearer picture of the company’s health. This allows investors to make wiser decisions regarding their investment options with the company. The required footnote disclosures allow investors a way of examining the effects of the changes in statements due to fair values of the assets and liabilities.

– Timely Information – Since fair value accounting utilises information specific for the time and current market conditions, it attempts to provide the most relevant estimates possible. It has a great informative value for a firm itself and encourages prompt corrective actions.

– More data than historical cost – Fair value accounting enhances the informative power of the financial statements vis–a-vis the historical cost. Fair value accounting requires an entity to disclose extensive information about the methodology used, the assumptions made, risk exposure, related sensitivities and other issues that result in a more thorough financial statement.

– Mirrors Economic Reality – Proponents of fair-value accounting argue that using fair-value measurements is necessary for financial records to represent the economic reality of the business. Since conventional accounting only allows for asset values to be written down, book values tend to underestimate the value of assets. Fair-value accounting allows the value of investments as well as other assets (subject to choices being exercised) to be written up and down as market values change. Perils and Challenges of Fair Value Accounting:

Though there are several benefits in adopting fair value accounting, it is not without its fair share of perils and challenges, some of which are discussed hereunder:

– Frequent Changes – In times of volatility, values can change quite frequently which would lead to major swings in a company’s value and earnings. Publicly held companies find this difficult as investors may find it difficult to value the company when such swings take place. Additionally, the potential for inaccurate valuations can lead to audit problems, which are discussed separately.

– Less Reliable – Traditional accountants may find fair value accounting less reliable than historical costs. When an item has different values across different regions and entities, accountants must make a judgement call on valuing items on their books. If a company with similar assets or investments values items differently than another, issues may arise because of the differences in valuation methods.

–Inability to value certain Assets – Businesses with specialised assets may find it difficult to value these items on the open market. When no market information is available, accountants must make a professional judgement on the item’s value. Accountants must also make sure that all valuation methods used are viable and take into account all technical aspects of the item.

– Subjectivity – For assets that are not actively traded on a public exchange, fair-value measurements are subjectively determined. While the Accounting Standards provide a hierarchy of inputs for fair-value measurements, only level 1 inputs are unadjusted quoted market prices in active markets for identical items. If these are not available, the company either has to look to similar items in active markets, inactive markets for identical items, or unobservable company-provided estimates. These level 2 and level 3 estimates can also be a bone of contention between auditors and management.

Challenges for Auditors:

Whilst there are several challenges in adopting fair value accounting, by far the greatest challenge in implementing fair value accounting is faced by the auditors since they cannot abdicate their responsibilities on the ground that the fair values are determined by specialists and experts. In this context, SA-540 on Auditing Accounting Estimates, Including Fair Value Estimates, makes it clear that the auditors should identify and assess the risk of material misstatements and perform appropriate procedures to mitigate the same. However, several challenges are likely to be encountered by auditors in the course of their audit of the fair value estimates whether determined by the Management or the experts / specialists, due to the following factors:

– Fair value accounting estimates are expressed in terms of the value of a current transaction or financial statement item based on conditions prevalent at the measurement date;

-The need to incorporate judgements concerning significant assumptions that may be made by others such as experts employed or engaged by the entity or the auditor;

– The availability (or lack thereof) of information or evidence and its reliability;

– The choice and sophistication of acceptable valuation techniques and models;

– The need for appropriate disclosure in the financial statements about measurement methods and uncertainty, especially when relevant markets are illiquid; and

– The possibility of Management Bias in making estimates, selection of the method of valuation and finally the valuer itself (if there is a conflict of interest)!

SA-540 deals with the overarching requirement for the auditor to obtain sufficient appropriate audit evidence that fair value measurements and disclosures are in accordance with the entity’s applicable financial reporting framework. Within the SA, additional requirements tailor the requirements in other SAs to the audit of fair value; in particular, those dealing with the following matters:

– SA-315 – Understanding the entity and its environment and assessing the risks of material misstatement,
–  SA-330 – Responding to assessed risks;
–  SA-240 – Responsibilities relating to fraud;
–  SA-570 – Going Concern;
–  SA-620 – Using the work of an expert;
–  SA-580 – Obtaining management representations; and
– SA-260 – Communicating with those charged with governance.

Thus it is imperative for the auditor to ensure that the requirements of the SAs are complied with by taking due care and exercising professional scepticism whilst auditing the fair value estimates and documenting the reasonableness of the management estimates and judgements regarding fair value, keeping in mind the principles laid down in Ind AS-113.

PRACTICAL CHALLENGES AND DECISIONS FOR IMPLEMENTATION BY PHASE II ENTITIES:

Key Learnings from Phase I Entities due to Adoption of Fair Value Accounting:

Some of the key learnings in the context of fair value accounting during the transition to Ind AS by phase I companies are of a net increase in the net worth of the top 100 listed entities due to adoption of fair value accounting in respect of investments (including in group companies) and property plant and equipment based on the options available on transition (which are discussed below) with a corresponding reduction in the Profit after Tax due to increased depreciation on property, plant and equipment as a result of fair value thereof.

Implementation Issues by Phase II Entities due to Adoption of Fair Value Accounting:

The transition to Ind AS by Phase II entities is already underway for the remaining listed entities and other entities having a net worth of more than Rs. 250 crores during the current financial year ending 31st March, 2018 and they would need to take certain decisions on the accounting choice from a fair value perspective keeping in mind the following matters, whilst transitioning to Ind AS.

Mandatory Fair Value Accounting:

In respect of the following areas fair value accounting would be mandatory, except that in certain cases an option has been given to adopt it either retrospectively or prospectively, as indicated there against, as provided for in Ind AS 101- First Time Adoption of Ind AS.

In respect of the first two items before taking any decision to adopt fair value retrospectively, the entity would need to take into account whether all the data and information is available to enable the computation of the fair value since origination, including but not limited to details of the cash flows and other data and assumptions required for valuation purposes. If the necessary data is not available or it is impractical and costly to reconstruct the same, the entity could adopt fair value prospectively from the date of transition. These decisions would accordingly have an impact on the net worth on the date of transition.

In respect of Ind AS 103, the entity has three options as under, to account for business combinations as per the acquisition method on a fair value basis, as provided in Ind AS 101:

a) To restate past business combinations retrospectively; or
b)  To restate past business combinations from any other earlier date,  in which case, all business combinations after that date would have to be restated; or
c) To apply Ind AS 103 prospectively.
This choice, like in the earlier two cases, would depend upon whether the necessary data and information is available as also the business rationale of the earlier acquisitions to enable fair values to be attributed to any intangibles especially against any goodwill which is accounted, whose amortisation would need to be reversed and it would need to be tested for impairment annually. Any such decisions could have a significant impact on the consolidated net worth.

Voluntary Fair Value Accounting:

The most significant decision for entities with regard to fair value on transition to Ind AS is whether to elect to measure an item of property, plant and equipment at the date of transition at its fair value and use that fair value as its deemed cost in accordance with para D5 of Ind AS 101.

Further, as per para D6 of Ind AS 101, a first-time adopter may elect to use a previous GAAP revaluation of an item of property, plant and equipment at, or before, the date of transition to Ind ASs as deemed cost at the date of the revaluation, if the revaluation was, at the date of the revaluation, broadly comparable to:
 
a) fair value; or
b) cost or depreciated cost in accordance with Ind ASs, adjusted to reflect, for example, changes in a general or specific price index.

The requirements discussed above also apply to intangible assets which meet the recognition and revaluation criteria as per Ind AS 38.

It needs to be noted that the above requirement is different from adopting the fair value model as laid down under Ind AS 16 and is a one-time decision to use the fair value as the new deemed cost which may have an immediate positive impact on the net worth but would impact the profitability on an ongoing basis if depreciation needs to be provided, unless the asset in question is land.

Finally, the above decisions on transition would have tax implications including under MAT, which have not been separately discussed but which would also need to be factored in before a final decision is taken.

CONCLUSION:
The above evaluation is just the tip of the ice-berg on a subject that is quite vast and complex. However, fair value accounting is here to stay and it would impact the way the financial statements are evaluated and also impact the auditors but prove to be a bonanza for valuation specialists who can laugh all the way to the bank!