Financial instrument can be said as those contracts that gives rise to a financial asset for one organization and produces a financial liability for another. Some examples of financial instruments used by an entity are trade payables, investment purchase considerations, trade receivables etc. Valuation of financial instruments is conducted for the purpose of share-based payments, reporting the financial, risk management, in case of business combinations, tax allocations, off-market transactions, liquidation, dispute resolution, purchase-price allocations and many other factors.
On 28th February, 2017, a Valuation Standards Board (VSB) was constituted by the Institute of Chartered Accountants of India (ICAI) after considering the multiple categorization and different usages of valuation of financial instrument. It observed that harmonized, valuation principles must be followed in India. The Valuation Standard 303 was issued by ICAI that lays down principles on the valuation of financial instruments in this regard.
Financial instruments must have an alignment with the factors linked with the market. The valuer must use a valuation method either it be for valuation of shares or valuation of immovable property or in this case valuation of financial instruments, should maximize the use of all the relevant inputs that are observable and minimize the use of any input that is unobservable simultaneously.
Methods of Valuation of Financial Instruments:
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The Institute of Chartered Accountants of India have prescribed three methods for valuation of Financial Instruments in its Valuation Standard 303. These methods are as followed-
- Income Approach for Valuation of Financial Instruments: In this valuation method the maintainable or the future amounts for example cash flows, income and expenses are converted to a single current or discounted amount.
In this approach the valuation of financial instrument is determined and based on the expected economic and monetary benefits by the way of income, cost savings or cash flows generated by a particular financial instrument. It is also based on the level of risk that is associated with the used financial instrument. It calculates the value after adjusting the inherited risks by discounting the future amounts to a single present value.
Some examples of the Income Approach for valuation are Black-Scholes-Merton formula, a binomial model and similar other pricing models. These methods incorporate the techniques of present value to reflect the value of time and an option’s intrinsic value.
- Cost Approach Valuation of Financial Instruments: To replace the service capacity of an asset, the amount that would be currently required is reflected by this approach or valuation method.
For acquiring an asset that is substitute for the previous one and has comparable utility, the price to be received for the asset is totally based on the cost for the buyer participating in the market. This is done from the perspective of a seller as a market participant.
Using the cost method is more predominance for valuating, the non-financial assets of a company.
- Market Approach Valuation of Financial Instruments: This method uses prices and other relevant information generated during the market transactions for valuation of the financial instruments. It involves the identical assets that are comparable, liabilities or a group of assets and liabilities for valuating.
In market approach for valuation of the financial instrument the valuation service is determined by considering the traded prices of that particular instrument in the active market.
If an active market benchmark price is absent, then private transactions or comparable pricing can be considered for the valuation.
Selecting the method for Valuation of Financial Instruments:
The ICAI Valuation Standard 303 for Financial Instruments prescribes the indicative factors described below that a person or valuer needs to be consider to choose an appropriate method or various methods in combination for valuation of financial instruments. These factors are:
- The purpose of valuation: The purpose for which valuation of financial instruments is being conducted determines the method or approach used for the same. In case of a combine transaction in business the method of valuation is considers the more observable inputs and are given more priority than the other approaches.
- The basis of valuation and terms and conditions of the instrument that is being valued: While selecting a more suitable and appropriate valuation approach, due consideration is to be given to the nature of financial instrument. The terms and conditions of the instrument are also considered duly. When the market comparable is determined for valuation of financial instrument, the embodied terms and conditions plays a very important role.
- The framework of control in the entity and sets of input data: In selection of an appropriate valuating method, a valuer must give importance to the control environment in the organization under which the company and the instrument becomes operative. The control environment usually consists the methods of internal governance, control objectives, procedures and their effectivity during operation. These are considered with the aim to enhance the reliability on the valuation process and its outcome. If a valuer relies on the valuation inputs that have been provided by the company, then he/she must form an independent opinion on the control environment for valuation of financial instruments.