Fair value measurements are
required or permitted under Ind AS for many financial instruments and
non-financial assets and liabilities. They are required for quoted and unquoted
investments in shares, bonds, receivables, payables, derivatives, etc. As also
in certain situations for non-financial items, such as in determining
impairment of property, plant, equipment or goodwill. This article attempts to
discuss whether the current markets post the Covid outbreak can be considered
as not being orderly and therefore ignored for determining the fair values for
the year ending 31st March, 2020 financial statements.
Before we attempt to address the
moot question, whether markets as on 31st March, 2020 were orderly
or not, let us first look at the various provisions of Ind AS 113 Fair Value
Measurement.
(i)
Paragraph 2 of Ind AS 113 states that ‘Fair value is a market-based
measurement, not an entity-specific measurement. For some assets and
liabilities, observable market transactions or market information might be
available. For other assets and liabilities, observable market transactions and
market information might not be available. However, the objective of a fair
value measurement in both cases is the same – to estimate the price at which an
orderly transaction to sell the asset or to transfer the liability would take place
between market participants at the measurement date under current market
conditions (i.e., an exit price at the measurement date from the
perspective of a market participant that holds the asset or owes the
liability).’
(ii) Paragraph 3 of Ind AS 113
states that ‘When a price for an identical asset or liability is not
observable, an entity measures fair value using another valuation technique
that maximises the use of relevant observable inputs and minimises the use of
unobservable inputs. Because fair value is a market-based measurement, it is
measured using the assumptions that market participants would use when pricing
the asset or liability, including assumptions about risk. As a result, an
entity’s intention to hold an asset or to settle or otherwise fulfil a
liability is not relevant when measuring fair value.’
(iii) Paragraph 61 of Ind AS 113
states as follows ‘An entity shall use valuation techniques that are
appropriate in the circumstances and for which sufficient data are available to
measure fair value, maximising the use of relevant observable inputs and
minimising the use of unobservable inputs.’
(iv) Ind AS 113 defines orderly
transaction as ‘A transaction that assumes exposure to the market for a
period before the measurement date to allow for marketing activities that are
usual and customary for transactions involving such assets or liabilities; it
is not a forced transaction (e.g. a forced liquidation or distress sale.).’
IDENTIFYING TRANSACTIONS THAT ARE NOT
ORDERLY
Ind AS 113.B38 states that ‘If
an entity concludes that there has been a significant decrease in the volume or
level of activity for the asset or liability in relation to normal market
activity for the asset or liability (or similar assets or liabilities), further
analysis of the transactions or quoted prices is needed. A decrease in the
volume or level of activity on its own may not indicate that a transaction
price or quoted price does not represent fair value or that a transaction in
that market is not orderly.’
Ind AS 113.B43 provides guidance
for determination of whether a transaction is orderly (or is not orderly).
Whether there has been a significant decrease in the volume or level of
activity requires comparison to normal market activity level. B43 lists down
the following circumstances that may indicate that a transaction is not
orderly:
(a) There was not adequate
exposure to the market for a period before the measurement date to allow for
marketing activities that are usual and customary for transactions involving
such assets or liabilities under current market conditions.
(b) There was a usual and
customary marketing period, but the seller marketed the asset or liability to a
single market participant.
(c) The seller is in or near
bankruptcy or receivership (i.e., the seller is distressed).
(d) The seller was required to
sell to meet regulatory or legal requirements (i.e., the seller was forced).
(e) The transaction price is an
outlier when compared with other recent transactions for the same or a similar
asset or liability.
OBSERVATIONS AND CONCLUSIONS
Fair value is a measurement of a
date-specific exit price estimate based on assumptions (including those about
risks) that market participants would make under current market conditions.
The fair value measurement objective is to determine an exit price at the
measurement date from the perspective of a market participant. Fair value of
the asset or liability reflects conditions as of the measurement date and not
a future date. It would not be appropriate for an entity to disregard
market prices at the measurement date, unless those prices are from
transactions that are not orderly. The concept of an orderly transaction is
intended to distinguish a fair value measurement from the price in a distressed
sale or forced liquidation. The intent is to convey the current value of
the asset or liability at the measurement date, not its potential value at a
future date.
The current situation may make it
challenging to estimate the price that would be obtained due to highly volatile
markets and / or a lack of an active market existing for certain instruments
(e.g. derivatives that are not traded on an exchange). However, the objective
of ‘fair value’ will continue to be to determine a price at which an orderly transaction
would take place between market participants under conditions that existed at
the measurement date. It would not be appropriate to adjust or disregard
observable transactions unless those transactions are determined to be not
orderly. There is a high bar to conclude that a transaction price is not
orderly under Ind AS 113.B43, which provides a list of factors to consider if a
transaction is not orderly. The author believes that there is an implicit
rebuttable presumption that observable transactions between unrelated parties
are orderly. In almost all instances, such transactions are considered orderly.
Therefore, the evidence necessary to conclude an observable transaction between
unrelated parties is not orderly should be incontrovertible. Accordingly,
the fair value of an investment in an active market (e.g. BSE, NSE, etc.) would
continue to be calculated as the product of the quoted price for the individual
instrument times the quantity held (commonly referred to as ‘P times Q’), even
in times of significant market volatility. Volatility may raise questions
as to whether current pricing is reflective of fair value. However, the
standard does not permit current market evidence to be dismissed on the basis
of volatility alone.
Some may argue that in the
current environment there is an element of forced selling and that fair value
measurement is not intended to reflect prices in a forced or distressed sale.
Nevertheless, the presence of distressed or forced sellers in a market may
influence the price that could be obtained by a non-distressed seller in an
orderly transaction.
Fair value measurement would
consider how the Covid outbreak and any actions taken by governments at the
reporting date would have impacted market participants’ valuation assumptions.
Current market conditions may appear to be a ‘distress sale’, however, if such
conditions exist broadly in the market, then those factors should be
incorporated into a fair value measurement. It would be incorrect to adjust a
measure for expected ‘rebounds’ in value. For financial instruments with level
1 prices (those that are quoted on an active market), even if there is a
significant decline in activity on that market, this does not mean that the
price has become unobservable or that it was
under a distress sale or a forced liquidation.
Whilst determining a valuation
for other than level 1 category of instruments (i.e., those that are quoted in
an active market), preparers of financial statements may have to use valuation
techniques. This may be the case for several unquoted shares or derivatives or
bonds, etc. Preparers using valuation techniques may have to consider the
impact of Covid-19 on various assumptions including discount rates,
credit-spread / counter-party credit risk, etc. In doing so, the aim will
be to maximise observable inputs and minimise unobservable inputs. The
observable inputs will reflect current market conditions at the balance sheet
date and should not be ignored.
The
ICAI guidance ‘Impact of Corona Virus on Financial Reporting and the
Auditors Consideration’ states that ‘It may not be always appropriate to
conclude that all transactions in such a market are not orderly. Preparers
should be guided by the application guidance in Ind AS 113 that indicates
circumstances in which the transaction is not considered an orderly
transaction.’ Though the ICAI guidance does not provide any detailed
guidance, it makes no exception to complying with the requirements of the
Standards. For Indian GAAP, similar considerations will apply in respect of
financial assets within the scope of AS 13 Accounting for Investments.
