By: Chander Sawhney is Partner – Valuation & Deals, Corporate Professionals, Corporate Professionals Group
Ind AS will be applicable to subsidiaries, joint ventures (JVs), associates as well as holding companies of the entities covered in the roadmap. Here is how companies will need to work it out…
Indian corporates are in the process of changeover to a new set of accounting standards called the Indian Accounting Standards (Ind AS). The roadmap regarding application of Ind AS is based on the listing status and net worth of a company. It is important to note that Ind AS will also apply to subsidiaries, joint ventures (JVs), associates as well as holding companies of the entities covered in the roadmap. Ind AS apply to both consolidated and stand-alone financial statements. Adoption of Ind AS will be challenging but at the same time will be rewarding as well, since it is likely to result in improved comparability, transparency and quality of financial statements. One fundamental change in Ind AS is the significant increase in focus on Fair Value accounting.
The Ind AS are applicable from 1.4.2016 to companies (listed and unlisted) whose Networth is equal to or exceed INR 500 crores. From 1.4.2017, it is expected to expand to all Listed Companies and those unlisted companies whose Networth is equal to or exceed INR 250 crores. w.e.f. 1.4.2018, it is expected to be applied to all companies with Networth over INR 250 crores.
As Ind AS focus more on substance rather than legal form, therefore it is expected that more entities will be consolidated under Ind AS, as a parent would consolidate based on control over the investee having exposure or rights to variable returns from its involvement which is not in Indian GAAP. Further a push towards the increased use of fair value-driven accounting under Ind AS, could have a fundamental impact on financial statements as a whole.
Under Indian GAAP, no emphasis was given to Purchase Price Allocation, as net assets were generally recorded based on the carrying value in the acquiree’s balance sheet. Ind AS 103 places significant importance on the Purchase Price Allocation process. All identifiable assets of the acquired business must be recorded at their fair values. Many intangible assets that would previously have been included within goodwill must be separately identified and valued. Therefore, it is also expected that under Ind AS, goodwill could generally be lower compared to Indian GAAP mainly due to the recognition of intangibles.
|FINANCIAL ASSETS||FINANCIAL LIABILITY||COMPOUND INSTRUMENT|
|Investments in Equity Instrument of another entity||Mandatory Redemption of Preference Shares||Optionally Convertible Bonds / Debentures|
|Investment in Debt Instrument of another entity||Mandatory Interest Payments||Fully Convertible Bonds / Debentures|
|Trade Receivables||Contingent Settlement Provision, which may rise at the occurrence of any event|
|Derivate Financial Assets (Options & Futures)|
|Non-redeemable Preference Shares|
Other areas of financial valuation under Ind AS include Investment in Securities, Derivative Financial Instruments, Borrowings, Preference Shares/Debentures, ESOPs, Non-Controlling Interest, Contingent Claim considerations (Earn Outs), Corporate Guarantee etc.
Ind AS 113 is a dedicated Standard on Fair Value Measurement
Fair value is defined 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 a market-based measurement, NOT an entity-specific 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 fulfill a liability is NOT relevant when measuring fair value
Ind AS 109 deals with Fair Value of Financial Instruments
Some of the challenges we face in valuing complex/hybrid financial instruments are as under-
- Separating the Liability and Equity Component
The distinction between equity and liability component of any financial instrument is of careful consideration before making out which valuation methodology we need to apply. A preference share, for example, may display either equity or liability characteristics depending on the substance of the rights attaching to it.
Non-Redeemable Preference Shares: Fair Value Hierarchy:
- Level 1: It includes financial instruments measured using quoted prices. The Fair value of all equity instruments which are traded in the stock exchanges is valued using the closing price as at the reporting period. The mutual funds are valued using the closing NAV – market based methodology.
- Level 2: The fair value of financial instruments that are not traded in an active market is determined using valuation techniques which maximize the use of observable market data and rely little as possible on entity specific estimates – comparable companies multiples methodology.
Fair valuation of whole instrument by applying the Comparable Companies Multiples Methodology i.e. valuation Comparable Instrument (with similar terms and credit status) is getting in the market.
Fair valuation of liability component (if any) i.e. fair valuation of interest component that Company is bond to pay to the holder which will be calculated by discounting the interest payments to present value.
Finally the fair value of the liability component is deducted from the fair value of the instrument as a whole, with the resulting residual amount being recognized as the equity component.
However, this level can only be applied when similar and comparable instrument (with similar terms and credit status) is available in the market.
- Level 3: This level is for unlisted equity securities, contingent consideration and indemnification assets which can be valued by using discounted cash flow methodology and complex option pricing methods including black scholes methodology, binomial methodology, etc.
Fair valuation of liability component (if any) i.e. fair valuation of interest component that Company is bond to pay to the holder of instrument which will be calculated by discounting the interest payments to present value.
Fair valuation of Equity component i.e. Fair Valuation of the Company by applying DCF methodology. Classification of embedded derivative component is necessary which depended upon the terms of financial instrument issued because it has huge impact on the fair value of derivative component.
Accordingly proper evaluation of terms of agreement is of utmost important. However there are various other factors in compound financial instrument valuation which makes it more challenging like:
- Volatility: historical or implied
- Default risk or credit risk adjustment
- Listed comparable compound instrument with similar terms
- Probability for magnitude of up and down moves in value of underlying asset while building binomial tree
- Calculation of value of the embedded derivative feature i.e. premium value that holder of the instrument has paid by applying Black Scholes or Binomial Methodology.
- Summation of premium value calculated through black scholes or binomial methodology and face value of instrument is fair valuation of whole instrument.
- Allocation of fair value between equity, liability and derivative component for accounting purpose.
Ind AS requires application of fair value principles, which would result in significant differences from financial information being presented currently. With increased scrutiny from regulators and investors, management and auditors will have to ensure that fair valuation of assets and liabilities is not only technically correct and supportable but also complies with principles of Ind AS.