IFRS: A Fair Valuation Perspective Presentation by Varun Gupta Managing Director, American Appraisal India IFRS Summ

1. IFRS: A Fair Valuation Perspective Presentation by Varun Gupta Managing Director, American Appraisal India IFRS Summit � Roadmap to Convergence November 2010

2. Contents 2 Fair Value: Definition, Core Principles and Hierarchy Standards requiring fair valuation IFRS 3 � Business Combinations IAS 38 � Intangible Assets IAS 16 � Property Plant & Equipment IAS 36 � Impairment of Assets IAS 39 � Financial Instruments IFRS 2 � Share Based Payments

3. Fair Value The transition 3 Like the existing definition of fair value in IFRSs, the proposed definition assumes that the exchange transaction is hypothetical and is orderly (ie it is not a forced liquidation or distress sale). However, the existing definition of fair value: ? does not specify whether an entity is buying or selling the asset; ? is unclear about what is meant by �settling� a liability because it does not refer to the creditor, but to knowledgeable, willing parties; and ? does not explicitly state whether the exchange or settlement takes place at the measurement date or at some other date. In the Board�s view, the proposed definition of fair value remedies these deficiencies. It also conveys more clearly that fair value assumes an orderly transaction between market participants, and thus is a market-based measurement, not an entity-specific measurement. A fair value measurement shall assume that the transaction to sell the asset or transfer the liability takes place in the most advantageous market to which the entity has access. The most advantageous market is the market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after considering transaction costs and transport costs. Because different entities (and businesses within those entities) with different activities enter into transactions in different markets, the most advantageous market for the same asset or liability might be different for different entities. Therefore, the most advantageous market (and thus, market participants) shall be considered from the perspective of the reporting entity. An entity need not undertake an exhaustive search of all possible markets to identify the most advantageous market. The market in which the entity would normally enter into a transaction for the asset or liability is presumed to be the most advantageous market. In the absence of evidence to the contrary, an entity may assume that the principal market for the asset or liability is the most advantageous market, provided that the entity can access the principal market. The principal market is the market with the greatest volume and level of activity for the asset or liability. Why not define fair value as an entry price?The Board asked various parties to provide input on whether, in practice, they interpret �fair value� in particular context in IFRSs as a current entry price or a current exit price. The Board used the feedback in determining whether to define fair value as a current exit price, or to remove the term �fair value� and use the terms �current exit price� and �current entry price� depending on the measurement objective in each IFRS that uses the term �fair value�. The Board concluded that a current entry price and a current exit price will be equal when they relate to the same asset or liability on the same date in the same form in the same market. Therefore, the Board considered it unnecessary to make a distinction between a current entry price and a current exit price in IFRSs with a market-based measurement objective (ie fair value), and decided to define fair value as a current exit price. In many cases, any difference between an entry price and an exit price is related to a difference in the unit of account for the entry and exit transactions. Determining the unit of account is beyond the scope of the fair value measurement project. Does an exit price definition of fair value imply a liquidation value? No. Liquidation values imply an immediate sale in which the seller is compelled to enter into a transaction. Fair value, on the other hand, is an orderly transaction in which both the buyer and the seller are willing, but not required, to transact. As with the current definition of fair value in IFRSs, an exit price is not a liquidation value, but the price for an arm�s length transaction completed in the normal course of business between knowledgeable, willing parties (market participants). An exit price reflects the highest and best use of an asset. When the highest and best use of an asset is �in use� (ie the asset is used together with other assets), the fair value of the asset is the price that would be received in a current transaction to sell the asset to a market participant who holds (or could obtain) the other assets (complementary assets). Thus, for example, the exit price for specialised machinery is not the scrap value of the machinery, but the price that would be received in a sale to a market participant that would use that machinery. Like the existing definition of fair value in IFRSs, the proposed definition assumes that the exchange transaction is hypothetical and is orderly (ie it is not a forced liquidation or distress sale). However, the existing definition of fair value: ? does not specify whether an entity is buying or selling the asset; ? is unclear about what is meant by �settling� a liability because it does not refer to the creditor, but to knowledgeable, willing parties; and ? does not explicitly state whether the exchange or settlement takes place at the measurement date or at some other date. In the Board�s view, the proposed definition of fair value remedies these deficiencies. It also conveys more clearly that fair value assumes an orderly transaction between market participants, and thus is a market-based measurement, not an entity-specific measurement. A fair value measurement shall assume that the transaction to sell the asset or transfer the liability takes place in the most advantageous market to which the entity has access. The most advantageous market is the market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after considering transaction costs and transport costs. Because different entities (and businesses within those entities) with different activities enter into transactions in different markets, the most advantageous market for the same asset or liability might be different for different entities. Therefore, the most advantageous market (and thus, market participants) shall be considered from the perspective of the reporting entity. An entity need not undertake an exhaustive search of all possible markets to identify the most advantageous market. The market in which the entity would normally enter into a transaction for the asset or liability is presumed to be the most advantageous market. In the absence of evidence to the contrary, an entity may assume that the principal market for the asset or liability is the most advantageous market, provided that the entity can access the principal market. The principal market is the market with the greatest volume and level of activity for the asset or liability. Why not define fair value as an entry price?The Board asked various parties to provide input on whether, in practice, they interpret �fair value� in particular context in IFRSs as a current entry price or a current exit price. The Board used the feedback in determining whether to define fair value as a current exit price, or to remove the term �fair value� and use the terms �current exit price� and �current entry price� depending on the measurement objective in each IFRS that uses the term �fair value�. The Board concluded that a current entry price and a current exit price will be equal when they relate to the same asset or liability on the same date in the same form in the same market. Therefore, the Board considered it unnecessary to make a distinction between a current entry price and a current exit price in IFRSs with a market-based measurement objective (ie fair value), and decided to define fair value as a current exit price. In many cases, any difference between an entry price and an exit price is related to a difference in the unit of account for the entry and exit transactions. Determining the unit of account is beyond the scope of the fair value measurement project. Does an exit price definition of fair value imply a liquidation value? No. Liquidation values imply an immediate sale in which the seller is compelled to enter into a transaction. Fair value, on the other hand, is an orderly transaction in which both the buyer and the seller are willing, but not required, to transact. As with the current definition of fair value in IFRSs, an exit price is not a liquidation value, but the price for an arm�s length transaction completed in the normal course of business between knowledgeable, willing parties (market participants). An exit price reflects the highest and best use of an asset. When the highest and best use of an asset is �in use� (ie the asset is used together with other assets), the fair value of the asset is the price that would be received in a current transaction to sell the asset to a market participant who holds (or could obtain) the other assets (complementary assets). Thus, for example, the exit price for specialised machinery is not the scrap value of the machinery, but the price that would be received in a sale to a market participant that would use that machinery.

4. Fair Value Definition As per FASB SFAS 157 (Nov 2006) and IASB exposure draft of Fair Value Measure (May 2009): �Fair Value is 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 (an exit price)� A fair value measurement requires an entity to determine: (a) the particular asset or liability that is the subject of the measurement (consistently with its unit of account). (b) for an asset, the valuation premise that is appropriate for the measurement (consistently with its highest and best use). (c) the most advantageous market for the asset or liability. (d) the valuation technique(s) appropriate for the measurement, considering the assumptions that market participants would use in pricing the asset or liability and the level of the fair value hierarchy within which the inputs are categorised. 4 The asset or liability might be a stand-alone asset or liability (eg a financial instrument or an operating asset) or a group of assets or liabilities (eg a cash-generating unit or a business) depending on the unit of account prescribed by IFRSs applicable to the asset or liability or group of assets or liabilities. In determining whether fair value at initial recognition equals the transaction price, an entity shall consider factors specific to the transaction and the asset or liability. For example, the transaction price is the best evidence of the fair value of an asset or liability at initial recognition unless: (a) the transaction is between related parties. (b) the transaction takes place under duress or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty. (c) the unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction, the transaction includes unstated rights and privileges that are separately measured or the transaction price includes transaction costs. (d) the market in which the transaction takes place is different from the market in which the entity would sell the asset or transfer the liability, ie the most advantageous market. For example, those markets might be different if the entity is a securities dealer that transacts in different markets with retail customers (retail market) and with other securities dealers (inter-dealer market).The asset or liability might be a stand-alone asset or liability (eg a financial instrument or an operating asset) or a group of assets or liabilities (eg a cash-generating unit or a business) depending on the unit of account prescribed by IFRSs applicable to the asset or liability or group of assets or liabilities. In determining whether fair value at initial recognition equals the transaction price, an entity shall consider factors specific to the transaction and the asset or liability. For example, the transaction price is the best evidence of the fair value of an asset or liability at initial recognition unless: (a) the transaction is between related parties. (b) the transaction takes place under duress or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty. (c) the unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction, the transaction includes unstated rights and privileges that are separately measured or the transaction price includes transaction costs. (d) the market in which the transaction takes place is different from the market in which the entity would sell the asset or transfer the liability, ie the most advantageous market. For example, those markets might be different if the entity is a securities dealer that transacts in different markets with retail customers (retail market) and with other securities dealers (inter-dealer market).

5. Fair Value Core Principles Orderly Transaction Assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary; NOT a forced liquidation or distress sale In the absence of an actual transaction, assumes a hypothetical transaction from the perspective of a market participant that holds the asset or owes the liability Most Advantageous (or Principal) Market Assumes the transaction takes place in the most advantageous market for the entity �Most advantageous market� is the market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after considering transaction costs and transport costs Fair value, however, is not adjusted for transaction costs If there is no advantageous market, fair value is based on the principal market for the asset (that market with the greatest volume and level of activity for the asset or liability) Market Participants Independent of the reporting entity; that is, they are not related parties. Knowledgeable, having a reasonable understanding about the asset or liability and the transaction based on all available information Able and willing to transact for the asset or liability; that is, they are motivated but not forced or otherwise compelled to do so 5

6. Fair Value Fair Value Hierarchy Fair Value Hierarchy Prioritizes the inputs to valuation techniques; not the valuation techniques Gives highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities Gives lowest priority to unobservable inputs Level I Inputs Quoted prices (unadjusted) in active markets for identical assets or liabilities Level II Inputs Quoted prices (unadjusted) in active markets for similar assets or liabilities Quoted prices (unadjusted) in inactive markets for similar/ identical assets or liabilities Level III Inputs Unobservable inputs for the asset or liability, that is, inputs that reflect the reporting entity�s own assumptions about the assumptions market participants would use in pricing the asset or liability 6

7. IFRSStandards Requiring Fair Valuation 7 IFRS 3 � Business Combinations IAS 38 � Intangible Assets IAS 16 � Property Plant & Equipment IAS 36 � Impairment of Assets IAS 39 � Financial Instruments IFRS 2 � Share Based Payments *The other standards that also need fair valuation are IAS 17 (Leases), IAS 28 (Investment in Associates), IAS 40 (Investment Property), and IFRIC 12 (Service Concession Agreements)

8. IFRS 3 & IAS 38Business Combinations (IFRS 3) & Intangible Assets (IAS 38) 8 For entities adopting IFRS for the first time, IFRS 3 applies to all business combinations from their date of transition to IFRS Option to report prior period acquisitions also Key changes relative to existing Indian rules Merger accounting (pooling of interests method) is not applicable Tangible and Intangible assets acquired as part of business combinations need to be fair valued Intangible assets with finite lives must be amortised over the estimated lives Goodwill and infinite lived intangibles not to be amortised. Instead, to be tested for impairment.

9. 9 * Cash Equivalent include deferred consideration, shares issued, sellers� liabilities assumed, etc. ** As per the revised IFRS 3(effective July�2009), transaction costs are no longer a part of purchase consideration # Liabilities include contingent liabilities and liabilities recorded in acquired entity�s stand-alone financials IFRS 3 & IAS 38 Purchase Price Allocation (2/2)

10. IFRS 3 & IAS 38 Case Study: Purchase Price Allocation 10

11. IFRS 3 & IAS 38 Valuation of Intangible Assets 11 How to identify various intangible assets? Understanding the business being acquired and based on industry knowledge Reading of various documents SPA / SHA Due-diligence reports Discussions with the management Research on past deals Challenges Understanding the market participant view Data availability at asset level Consensus between the acquirer and the target company on certain issues Identifying and valuing certain intangible assets/ liabilities , like Onerous Contracts

12. IAS 16Property, Plant & Equipment (PP&E) 12 Key changes relative to existing Indian rules Option to use cost model or revaluation model Componentization of PP&E Assets to be depreciated over their useful lives after adjusting for residual value Annual reassessment of useful life and residual value

13. IAS 16Property, Plant & Equipment (PP&E) 13 Whilst option to use cost model is available, IFRS 1 requires the opening Balance Sheet to comply with all the IFRSs that are effective on that date Under Indian GAAP, the method of calculating depreciation and recognizing capital expenses is different from IFRS Hence book values (historical costs) may not be in compliance with IFRS, necessitating fair valuation as of the date of transition. This does not necessarily mean fair valuation will be required on subsequent reporting dates.

14. Component Accounting � Requirements 14 Requirements If an asset has several components which are significant, can be physically separated from the principal asset and have different usage pattern/ useful lives, these components should be recognized separately and should be depreciated based on their respective useful lives. May require recognition of a large number of components separately. Improves depreciation accounting and thus the measurement of operating profits and losses. Approach to Componentization Discussion with technical/ maintenance personnel Understanding of process flow Maintenance requirements Analysis of maintenance and inspection records International benchmarks from similar industry

15. Valuation approaches for PP&E 15 Income Capitalization Approach (also referred to as Income Approach): Considers income and expense data relating to the asset being valued and estimates value through a capitalization process. Usually used as a cross check. Sales Comparison Approach (also referred to as Market Approach): Considers the sales of similar or substitute assets and related market data, and establishes a value estimate through comparison. Cost Approach: Considers the possibility that, as a substitute for the purchase of a given property, one could construct another property that is either a replica of the original or one that could furnish equal utility. Two commonly used variants of the cost approach: Replacement cost method (�asset of equal utility�) Reproduction cost method (�exact replica�)

16. IAS 36Impairment of Assets 16 IAS 36 prescribes procedures to ensure that assets are carried at no more than their recoverable amount Key implications relative to existing Indian rules Goodwill and indefinite life intangible assets are required to be tested for impairment not only if there is an impairment indication but also on an annual basis.

17. IAS 36Impairment testing 17 Typical impairment indicators (triggering event): Significant change in operating environment, e.g., introduction of new technology/ regulation or general deterioration in economic environment Change in capital markets leading to increase cost of capital Fall in asset values or market capitalization below book value of net assets Actual net cash flows or operating profit significantly worse than original forecast Testing for impairment Impairment loss measured by the excess of the asset�s carrying value over its recoverable amount Recoverable amount defined as the greater of fair value less costs to sell, and value in use Cash flows used for determining value in use are pre-tax cash flows. Discount rate to be used for this purpose is the pre-tax rate.

18. IAS 39Accounting for Financial Instruments 18 Financial assets and liabilities need to be initially recognized at fair value. Subsequent measurement depends on how the financial instrument is categorized If an instrument is classified as a hedging instrument (for which it has to meet certain conditions), special hedge accounting rules apply. For other instruments, the following categories apply: Liabilities: two categories

19. IAS 39Accounting for Financial Instruments (contd.) 19 Assets: four categories Unless classified as hedges, all derivatives (including embedded derivatives) are measured at fair value (fall in the FVTPL category)

20. IFRS 2Share-based Payments 20 IFRS requires an entity to recognize share-based payment transactions in its financial statements Fair value of the equity instruments granted is required as at grant date. Valuation to be based on market prices, if available, and to take into account the terms and conditions upon which those equity instruments were granted. In the absence of market prices, fair value is estimated using appropriate valuation techniques Key implications relative to existing Indian rules Value is measured with reference to the fair value of the equity instruments granted as opposed to intrinsic value under Indian GAAP

21. 21 Valuation Models used Black-Scholes Model (with or without modifications) Binomial lattice model Trinomial lattice model Monte � Carlo simulation Other customized models Challenges Each instrument is unique (or at least will have some unique feature) requiring the model to be built afresh Initial structuring of instrument often does not consider potential accounting impact Market data availability/ different sources provide different data Valuation of Financial Instruments

22. Varun Gupta Managing Director vgupta@american-appraisal.com Mumbai:Level 1, Trade Centre Bandra -Kurla Complex, Mumbai - 400 051 Tel- +91 22 4070 0200 New Delhi:Level 12, Building No. 8, Tower C DLF Cyber City, Phase II, Gurgaon - 122 022 Tel - +91 11 3222 3555 Bangalore:Level 15, Concorde Tower, UB City 1 Vittal Mallya Road, Bangalore - 560 001Tel - +91 80 3299 6221 www.american-appraisal.co.in Thank you! 22

23. IAS 39Classification between Equity & Liability 23 Under Indian GAAP there is no mandatory requirement for instruments to be classified based on substance rather than form. For example, preference shares are treated as capital even though they may, in substance, be a liability in some cases. IAS 39 is likely to change the way some on these instruments are categorized. Some of these changes are � Classification as a financial liability or an equity instrument is according to the substance of the contract, not its legal form. The enterprise must make the decision at the time the instrument is initially recognized. The classification is not subsequently changed based on changed circumstances. Once an instrument is classified as equity and recorded in the balance sheet, it is not measured again going forward. Liability instruments are treated as per the category in which they fall. Compound Instruments: Some financial instruments including convertible instruments have both a liability and an equity component from an issuer's perspective. In such cases, IAS 32, a companion to IAS39, requires that the component parts be accounted for and presented separately as liability and equity. The split is made at issuance and not revised for subsequent changes in market interest rates, share prices, or any other event that changes the likelihood that the conversion option will be exercised. In case of inception date accounting, the issuer of the compound instrument first computes the financial liability component and the residual value (issue amount reduced by the fair value of the financial liability) will be equity.

24. IAS 39Key changes introduced by IFRS 9 24 Status of IFRS 9 To replace difficult to understand, apply and interpret IAS 39 with more principle based and less complex standard. Must be applied starting 1 January 2013, with early adoption permitted IFRS 9 Financial Instruments issued on12 November 2009, covering only classification and measurement of financial assets IFRS 9 reissued on 28 October 2010, incorporating new requirements on accounting for financial liabilities Work in progress for other aspects like hedge accounting & impairment. Key changes introduced by IFRS 9 At initial recognition, an entity shall measure all financial assets at fair value and shall classify financial assets as subsequently measured at either amortized cost or fair value on the basis of both: the entity�s business model for managing financial assets; and the contractual cash flow characteristics of the financial asset. The concept of �embedded derivatives� does not apply to financial assets within the scope of the Standard and the entire instrument must be classified and measured in accordance with the above guidelines Unquoted equity instruments can no longer be measured at cost less impairment (must be at fair value).

25. IAS 39Key changes introduced by IFRS 9 25 Impact on accounting of some of the instruments