Valuation Standards – An attempt to standardize subjectivity
[As first published in The Bombay Chartered Accountant Journal]
‘Valuation is the process of determining the economic worth of a subject under certain assumptions and limiting conditions for a particular purpose on a particular date.’
The above description gets closest to defining ‘Valuation’ from a financial and economic perspective. Such a process of valuation usually culminates into an ‘estimation of value’, that is generally performed by a person with the desired skill-sets. Since long, the valuation exercises have been the domain of various subject-matter-experts, each claiming to be one in a specific category. The nuances of such specific categories, e.g. real property, financial assets, personal assets, intangibles, etc. ensured that the profession of valuation remained scattered across various professional silos operating in a particular domain area.
In the recent past, various developments and factors in the Indian context have contributed to the thought-process of creating a distinct class of professionals who would be entrusted with the responsible need of performing valuations. The shift to the fair-value based financial reporting, fragmented regulatory regime surrounding valuations, advent of the insolvency and bankruptcy code and enhanced stakeholder expectations, were the key contributors to the thought-process of creating a distinct class of professionals to focus on performing valuations. The Companies Act, 2013 (‘Act’), more specifically section 247 therein, incarnated this distinct class of professionals as ‘Registered Valuers’.
The Act envisages an entire framework under which the Registered Valuer is expected to function. Amongst the many constituents of this framework, is an important obligation on the Registered Valuer to ensure the conduct of the valuation exercise is in accordance with the valuation standards as notified by the Central Government. Unlike the other contemporaries, being Accounting Standards, Auditing Standards, Standards of Internal Audit, etc. the Valuation Standards have, in a sense, a self-defeating role in standardizing the judgments, estimations, subjectivities, presumptions and perceptions that are an inherent basis and purpose of a valuation exercise. Each of these attributes are a clear antithesis to ‘standardization’. Having said that, there is a real opportunity to standardize the processes surrounding valuation and the broad contours of a valuation exercise, basis of which a valuation professional can apply his expertise.
Globally, there are different valuation standards that are applicable to different jurisdictions. More notable ones being (a) the International Valuation Standards (‘IVS’) issued by the International Valuations Standards Council, applicable to various countries, (b) the Uniform Standards of Professional Appraisal Practice (‘USPAP’) issued by The Appraisal Foundation – USA (‘TAF’), predominantly applied in the United States of America and (c) European Valuation Standards (‘EVS’) as issued by The European Group of Valuers’ Association, applicable to certain countries in the European region. These prominent set of valuation standards are more different then similar, in their construct, approach, guidance and application. Whilst attempts are being made to bridge the divergence between these prominent valuation standards, significant differences remain between these prominent international standards. Whilst the IVS tend to be highly principle-based in their approach, the EVS and USPAP are fairly rule-based in their approach. The EVS ecosystem particularly also provides detailed technical guidance on nuances of the valuation process through guidance notes, codes and technical documentation.
Indian Regulatory Position on Valuation Standards
Rule 8 of Companies (Registered Valuers and Valuation) Rules, 2017 mandates every Registered Valuer to comply with valuation standards as notified by the Central Government.
Till date, no valuation standards have yet been notified under the Companies Act, 2013 and the duty has been entrusted to a committee formed by the central government, i.e. ‘Committee to advise on valuation matters’ to recommend the valuation standards to the Central Government for an eventual notification on their applicability.
The Act envisages 3 (three) different asset classes, being a) Land and Building, b) Plant and Machinery and c) Securities or Financial Assets; and the Registered Valuer shall practice only in the specific asset class for which the Registered Valuer is qualified for. Intangible assets are a part of Securities or Financial Assets. One would expect that the committee would recommend valuation standards separately for each asset class. It will be interesting to observe the outcome of this process and the road map set by the committee for promulgation of valuation standards under the Act.
Until such time the Central Government formulates and notifies the valuation standards, the Registered Valuer shall perform valuation engagements in accordance with (a) internationally accepted valuation standards or (b) valuation standards adopted by any registered valuation organization.
Meanwhile, the Institute of Chartered Accountants of India (‘ICAI’) recognising the need to have consistent, uniform and transparent valuation policies and harmonise the diverse practices in use in India, constituted the Valuation Standards Board (‘VSB’) on 28th February, 2017. The composition of the VSB is broad-based and ensures participation of all interest groups in the standard-setting process. Amongst various other functions, the main function of the VSB is to formulate Valuation Standards to be recommended by ICAI to Registered Valuers Organisations in India, the Government and other regulatory bodies in India and abroad for adoption and implementation. Based on the recommendation of the VSB, the ICAI at its landmark 375th meeting issued a set of Valuation Standards aka ‘ICAI Valuation Standards’.
These ICAI Valuation Standards are applicable to members of the ICAI for all valuation engagements on a mandatory basis under the Companies Act, 2013. In respect of valuation engagements under other statutes like Income Tax, SEBI, FEMA, etc. it will be on recommendatory basis for the members of the Institute. These Valuation Standards are effective for the valuation reports issued on or after 1st July, 2018. There are currently 8 (eight) valuation standards along with Preface and Framework documents that have been made applicable by the ICAI. They are as follows:
The standards have been neatly grouped into three different number scalable series, with 1XX series dealing with a set of standards that are fundamental common principles being applicable to across asset classes, the 2XX series dealing with the specifics of performing a valuation engagement and the 3XX series dealing with explicit matters in relation to an asset class. The currently applicable ICAI Valuation Standards cover only the asset class of Securities or Financial Assets under the 3XX series. On the other hands, the IVS as issued by International Valuation Standards Council are as below:
Since the ICAI Valuation Standards are mandatory for chartered accountants, we shall discuss in detail on those standards. The ICAI Valuation Standards are drafted by a committee of experts appointed by the VSB and are curated keeping in sight the nuances surrounding the valuation ecosystem in India along with the peculiar conditions of the Indian regulatory regime. A synopsis of the ICAI Valuation Standards and key provisions in each of the above standards is covered below:
Preface to the ICAI Valuation Standards
The Preface acts a pre-cursor to understanding the backdrop to valuation standards. The preface delves in detail into formation and functioning of the Valuation Standards Board, the scope of valuation standards and the procedure to issue a valuation standard. The mandatory nature of the standards is also an attribute being derived from the Preface.
Framework for the Preparation of Valuation Report
The Framework sets out the concepts that underline the preparation of valuation reports in accordance with the ICAI Valuation Standards. The Framework acknowledges the fact that the ICAI Valuation Standards may not be able to cover every nuance of a valuation engagement and accordingly a valuation professional is expected to apply his judgment to the matter. The Framework further elaborates the factors on which the judgment should be based including the regulatory guidance surrounding such an application of judgment. The Framework prescribes a) Understandability, b) Reliability and c) Reliance as the three principal qualitative characteristics that make the information in the valuation report useful to the users of the valuation report. The Framework also prescribes fundamental ethical principles to be followed by the valuation professional, being a) Integrity and fairness, b) Objectivity, c) Professional competence and due care, d) Confidentiality and e) Professional behaviour.
In case of a conflict between the ICAI Valuation Standards and Framework, the provisions of ICAI Valuation Standards would prevail.
ICAI Valuation Standard 101 – Definitions
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 ICAI Valuation Standards.
The standard prescribes 48 definitions that are used in other ICAI Valuation Standards. Various terms which are more generally and colloquially used have been defined in this standard, e.g. As-is-where-is Basis, Goodwill, Fair value, Forced Transaction, Highest and best use, Observable inputs, etc. It is evident from the drafting of the standard that attempt has been made to maintain parity of common definitions that are also defined in the accounting standards.
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.
ICAI Valuation Standard 102 – Valuation Bases
This standard defines important valuation bases, prescribes the measurement assumptions on which the value will be based and explains the premises of values.
‘Valuation Base’ is as an indication of the type of value being used in an assignment. Different valuation bases may lead to different conclusions of value. Therefore, it is important for the valuation professional to identify the bases of value pertinent to the engagement. This standard defines the following valuation bases:
(a) Fair value;
(b) Participant specific value; and
(c) Liquidation value
On the other hand, ‘Valuation Premise’ refers to the conditions and circumstances how an asset is deployed.
In a given set of circumstances, a single premise of value may be adopted while in some situations multiple premises of value may be adopted. Some common premises of value prescribed in the standard are as follows:
(a) highest and best use;
(b) going concern value;
(c) as is where is value;
(d) orderly liquidation; or
(e) forced transaction.
A valuation professional shall select an appropriate valuation base considering the terms and purpose of the valuation engagement. The standard also recognises the multiplicity of ‘valuation premises’ based on the conditions and circumstances how an asset is deployed. For instance, a ‘Liquidation Value’ being the ‘Valuation Base’ with ‘Forced Transaction’ being the ‘Valuation Premise’ can result in a completely different valuation outcome for a same asset being valued on a ‘Fair Value’ as ‘Valuation Base’ with ‘Highest and Best Use’ as the ‘Valuation Premise’.
ICAI Valuation Standard 103 – Valuation Approaches and Methods
The objective of this standard is to provide guidance on different valuation approaches and methods that can be adopted to determine the value of an asset. The standard lays down three main valuation approaches:
(a) Market Approach
(b) Income Approach
(c) Cost Approach.
The appropriateness of a valuation approach for determining the value of an asset would depend on valuation bases and premises. The standard requires that valuation approaches and methods shall be selected in a manner which would maximise the use of relevant observable inputs and minimise the use of unobservable inputs. It is also possible to use multiple methods are arrive at combination value or weighted value.
ICAI Valuation Standard 103 is one of the lengthiest of the valuation standards and delves on various commonly used methods that are adopted vis-à-vis the different approaches. Few of the methods discussed under this standard include:
(a) Market Approach Methods:
(b) Income Approach
(c) Cost Approach
ICAI Valuation Standard 201 – Scope of Work, Analyses and Evaluation
This standard prescribes the basis for(a) determining and documenting the scope/terms of a valuation engagement, responsibilities of the valuer and the client;(b) the extent of analyses and evaluations to be carried out by the valuer; and(c) responsibilities of the valuer while relying on the work of other experts.
The standard prescribes detailing of certain key attributes that form a part of a valuation engagement and such attributes must be documented by way of engagement letter. The minimum contents of an engagement letter are also prescribed in the standard.
The standard is an important guiding factor on the extent of analyses and evaluation that should be conducted by a valuation professional in conducting the valuation exercise, including the level of review of non-financial information, ownership information, general information, subsequent events, etc. The standard also provides guidance on necessary evaluation to be conducted by the valuation professional in placing reliance on the work of other experts.
In placing reliance on work of other experts, the valuer shall evaluate the skills, qualification, and experience of the other expert in relation to the subject matter of his valuation. It is for the valuer to evaluate whether the expert has sufficient resources to perform the work in a specified time frame and also explore the relationship which shall not give rise to the conflict of interest.
If the work of any third party expert is to be relied upon in the valuation assignment, the description of such services to be provided by the third party expert and the extent of reliance placed by the valuer on the expert’s work shall be documented in the engagement letter. The engagement letter should document that the third party expert is solely responsible for their scope of work, assumptions and conclusions.
ICAI Valuation Standard 202 – Reporting and Documentation
The objective of this Standard is to prescribe the minimum contents of the valuation report depending upon the nature of the engagement and specify the responsibility of a valuer in preparing the relevant documentation for arriving at a value. The standard also deals with the functionality of a management representation and its limitations.
In relation to the documentation to be maintained by a valuation professional, the standard provides adequate direction in relation to maintenance of sufficient and appropriate evidence of the valuation exercise. The minimum set of documentation that should be preserved by the valuation professional is also prescribed by the standard.
ICAI Valuation Standard 301 – Business Valuation
This standard provides guidance for valuation professionals who are performing business valuation or business ownership interests valuation engagements. The standard acknowledges the fact that such a business valuation may be carried out for various different purposes including for financial transactions, dispute resolution, reporting requirements, compliance requirements, internal planning, etc.
The standard lays down a step-by-step methodology in performing business valuation as under:
(a) define the premise of the value
(b) analyse the asset to be valued and collect the necessary information;
(c) identify the adjustments to the financial and non-financial information for the valuation;
(d) consider and apply appropriate valuation approaches and methods;
(e) arrive at a value or a range of values; and
(g) identify the subsequent events, if any.
The standard also provides guidance on commonly used methods for business valuation across the different approaches that are used in the valuation of a business.
ICAI Valuation Standard 302 – Intangible Assets
In an increasing knowledge-driven new-age economy, the valuation of intangibles is of greater and heightened importance. The objective of this standard is to prescribe specific guidelines and principles which are applicable to the valuation of intangible assets that are not dealt specifically in another ICAI valuation standard. The standard defined an intangible asset as an identifiable non-monetary asset without physical substance. The interplay of goodwill with intangible assets and their distinct natures is well enshrined in the standard.
The standard elucidates on the various types of intangible assets and goes on to provide detailed guidance on various methods that are commonly used in valuation of intangible assets across the different valuation approaches. Apart from other methods, the greenfield method and the distributor method are also guided for in the standard.
ICAI Valuation Standard 303 – Financial Instruments
The term ‘financial instrument’ has a common adaption across financial reporting and valuation. This standard establishes principles, suggests methodology and considerations to be followed by a valuation professional in performing valuation of financial instruments. For the purposes of this Standard, financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Equity instruments, derivatives, debt instruments, fixed income and structured products, compound instruments, etc. are certain examples of financial instruments.
The principles laid down in this standard are generally consistent with the broad principles of IND AS, although the IND AS provide far more detailed guidance including specific classifications of inputs (level 1, level 2 and level 3) and their preferred usage in a valuation exercise.
Acknowledging the prevalence of market, income and cost approach, the standard discourages the use of cost approaches as it more commonly used in non-financial asset valuation. Amongst various other matters, the standard deals with certain special considerations surrounding (a) the entity control environment, (b) the determination of present value in a valuation technique, (c) adjustment to credit risks in a valuation exercise.
As evident from the above synopsis, the ICAI Valuation Standards set the right platform for a valuation professional to perform his valuation exercise. These standards have put in place various guard-rails to which the subjectivity and estimation element of a valuation exercise, can be subjected to. One of the important enhancements to the quality of valuation reporting under the ICAI Valuation Standards is the enhanced disclosure requirements that are mandated by the ICAI Valuation Standards. The minimum disclosure requirements also enhance comparability and provide a sense of underlying assumptions that are considered by the valuer in making his assessment.
Given this fact and the cohesiveness of the ICAI Valuation Standards adequately capturing the Indian nuances, it would not be surprising if the ‘Committee to advise on valuation matters’ as set up by the Ministry of Corporate Affairs recommends the ICAI Valuation Standards as notified valuation standards under the Act, especially for the securities and financial assets class.
One will need to wait and watch the adoption of ICAI Valuation Standards by other registered valuation organisations and their applicability for other regulatory purposes.
The ICAI Valuation Standards pushes the practice of valuation into certain required rigours of documentation, reporting, reliance on experts, evaluation of a control environment, etc. that would only act a catalyst to further enhance the reliance on the report of the valuation professional. While the domain does not and by its very nature cannot, remove the element of ‘subjectivity’, the robust nature of ICAI Valuation Standards along with the enhanced disclosure requirements have the potential go a long way in setting the right principles and providing the right directional clarity to the professional valuer performing a valuation exercise. The needle of balance between subjectivity and standardization has certainly moved a fair bit towards standardization.
Interested in this topic or wanting to know more? Share your thoughts and we will be happy to assist.