Is ‘fair valuation’ important for the IBBI Valuation Exam?

Is ‘fair valuation’ important for the IBBI Valuation Exam?


How important is ‘fair valuation’ for the Insolvency and Bankruptcy Board of India (IBBI) Valuation Examination?

Fair valuation is a recurring theme in the Insolvency and Bankruptcy Board of India (IBBI) Valuation exam for securities or financial assets (SFA). As per its year 2020 syllabus (https://ibbi.gov.in/SFAsyllabuswef01062020.pdf) the techniques of fair valuation are covered under the heading Overview of Valuation.

IBBI has assigned this topic a weightage of 4%. Within this topic, several flavours of fair valuation are discussed including legal or legislative definitions of fair value.

Financial reporting under Indian Accounting Standards (Ind AS) is a separate topic within the syllabus for the IBBI valuer’s exam (SFA asset class) carrying a total weightage of 5%. This section strictly deals with accounting standards only. Apart from Ind-AS 113 Fair Value Measurement, the student must also familiarise himself with Business Combinations (Ind-AS 103) and Impairments of Assets (Ind-AS 36).

The student of the IBBI’s valuation exam must be thorough with the accounting standard definition (Ind-AS 113 Fair Value Measurement) as well as the meaning in certain tax legislations.

But mainly, the student must understand fair value as it is understood by international convention and its usage in investment finance. Accounting definitions are usually strictly interpreted and carries importance as far as financial reporting is concerned.

This subject is important as one can see that roughly 9% in the valuer’s exam is dedicated to simple definition and distinctions between different flavours of fair valuation.

Now let’s move on to know more about fair valuation and its history.

Fair Valuation

Depending on who you ask, fair value is a term with several meanings. In investing, it refers to an asset's sale price agreed upon by a willing buyer and sellers, assuming both parties are knowledgeable and enter the transaction freely. For example, securities have a fair value that's determined by a market where they're traded.

In accounting, fair value represents the estimated worth of various assets and liabilities that must be listed on a company's books.

Fair value accounting, also referred to as mark-to-market, is the practice of recording assets and liabilities at their current market price. The fair value is the amount that the asset could be sold, or a liability settled for a value that is fair to both the buyer and the seller.

The best way to determine the fair value of an asset is by letting the market valuate it by listing it in an exchange to be publicly traded. Fair value accounting standards is one among the foremost widely known valuation standards. It’s increasingly important in cases such as business sale, or assets acquisitions.

Fair value accounting is a financial reporting approach that requires or permits entities to measure and report assets at the price assets would sell and liabilities at the estimated price that a holder would have to pay in order to discharge the liability. (Zyla, 2012).

Where once financial statements were based totally on historical costs, now under certain circumstances, fair value is usually the idea of measurement for reporting for both financial and nonfinancial assets and liabilities. The concept of fair value has been evolving for quite a century. The issuance of ASU 2011‐ 04 marks the top of the FASB's fair value measurement project. Therefore, it appears that the accounting and reporting requirements for fair value measurement will still exist in their present form for the foreseeable future.

A historical cost is a measure of value used in accounting in which the value of an asset on the balance sheet is recorded at its original cost when acquired by the company. Usually, companies record long-term assets at their historical cost.

One of the basic accounting principles laid out under generally accepted accounting principles (GAAP) is the historical cost. Highly liquid assets may be recorded at fair market value, and impaired assets may be written down to fair market value. Impairment may occur to certain assets, including intangibles such as goodwill. With asset impairment, an asset's fair market price has dropped below what's originally listed on the record. An asset impairment charge is a typical restructuring cost as companies revaluate the value of certain assets and make business changes.

For example, earlier goodwill must be tested and reviewed a minimum of annually for any impairment (subsequently, goodwill must be reviewed more frequently). If it is worth less than the recorded value on the books, the asset is considered impaired. If it's risen in value, no change is formed to historical cost. In the case of impairment, the devaluation of an asset based on present market conditions would be a more conservative accounting practice than keeping the historical cost intact. When an asset is written off thanks to asset impairment, the loss directly reduces a company's net income.

Fair value accounting may be a way of measuring the assets and liabilities that are listed on the company’s financial statements. The valuation principle was implemented by the Financial Accounting Standards Board (FASB) or International Accounting Standards Board (IASB) to standardize the calculation of monetary instruments by watching their historical cost.

Here are the subsequent concepts that are an inherent a part of fair market price accounting:

• Rather than being based on the historical transaction or amount, the fair value is based on market conditions on the measurement date. Fair value does not care for historical data regarding the value of the asset, but only about the market value at the measurement time.

• The fair value depends on the objective or purpose of the buyer or seller. For example, in case of a forced liquidation, the price of the asset will be lower since it is a rushed sale.

• In order to achieve fair value, the transaction must be orderly and not be contaminated by outside factors, such as pressure to sell like business liquidation.

• Last but not least, fair value can be achieved from a sale with a third party. In order for the price to be really fair, it should not be influenced from a related party like a company insider.

There are three levels of input information for determining the fair value of an asset or liability. Please note that these levels are not used to create fair values for assets or liabilities. IFRS 13 Fair Value Measurement explains and defines the hierarchy of the three levels.

Level 1 input are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. A quoted market price in an active market provides the most reliable evidence of fair value and is used without adjustment to measure fair value whenever available, with limited exceptions. One example is stocks listed in the stock exchange.

Level 2 inputs are inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, such as two buildings in a similar location.

Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs are used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. An entity develops unobservable inputs using the best information available in the circumstances, which might include the entity's own data, taking into account all information about market participant assumptions that is reasonably available. Fair value accounting requires that the fair market value or an estimation of a market price be used represent the discounted value of expected cash flows.

This principle has been around since the first 1990s but was amended in 2006 to bring better clarity.

Hopefully this article gives you a start and kindles your interest in the topic of valuation. The syllabus for the Insolvency and Bankruptcy Board of India (IBBI) Valuation Examination expects a candidate to be familiar with the definitions of fair valuation and its close derivatives such as intrinsic value, market value or fair market value and other terms. You may download the valuer examination for asset class securities or financial assets here -https://ibbi.gov.in/SFAsyllabuswef01062020.pdf.