Fair Valuation in Agricultural Sector

Agenda Introduction Ind-AS 113 Framework Challenges for Fair Valuation in Agricultural Sector Questions & Answers

Equal to historical cost? Introduction What is Fair Value? Market price? Arm’s Length Price? Transaction Price? Equal to historical cost?

Ind-AS 113 – Framework for Fair Valuation Ind-AS 41 – Agriculture Biological Assets Agricultural Produce Shall be measured on initial recognition and at the end of each reporting period at its fair value less costs to sell Agricultural produce harvested from an entity’s biological assets shall be measured at its fair value less costs to sell at the point of harvest. Ind-AS 113 – Framework for Fair Valuation

Ind-AS 41 – Examples of items to be fair valued Biological assets Agricultural produce Products resulted through processing after the harvest Sheep Wool Threads, carpets, yarn Fruit trees Reaped fruits Processed fruits Cotton Plants Harvested Cotton Threads, clothes Sugar Cane Harvested Cane Sugar Dairy Cattle Milk Cheese Tea bushes Leaves Tea Grape Vine Grapes Wine Oil Palms Picked Fruits Palm Oil Rubber Trees Harvested Latex Rubber Products Timber Tree Plantation Felled Trees Logs, Lumber

IND-AS 113 – Fair Value

Objectives Provide single source of guidance Clarify definition of fair value Provide clear framework for measuring fair value Enhance fair value disclosures Does not deal with when is fair value required

Definition “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.” Exit price concept Consider characteristics of asset/liability: Condition Location Restrictions on sale/use Excludes transaction costs Includes transport costs Example: The fair value of cattle at a farm is the price for the cattle in the principal market less the transport and other costs of getting the cattle from the farm to that market.

Steps to measure Fair Value Step 1 – Determine asset/liability to be fair valued [unit of account] Step 2 – Determine Principal or Most Advantageous Market [market participants’ perspective] Step 3 – For non-financial assets, determine what is Highest and Best Use Step 4 – Evaluate valuation techniques to determine fair value (Market Approach, Cost Approach, Income Approach) Step 5 – Disclosures (Fair Value Hierarchy)

Example: Identification and Grouping of Biological Assets Based on significant attributes of Biological Asset such as age, consumable character, reproduction capacity or quality. Example: For measurement purposes, a wood producer divides his tree plantations depending on their growth and, more precisely, depending on the volume per tree so that the value of the trees is calculated in correspondence with the grouping. Dividing the biological assets can also be carried out from a regional point of view. Example: A wood producer with activity worldwide divides his tree plantations in the regions Brazil and Central America, because there are strong differences between the different regions concerning the thickness of the trunk and this characteristic has a decisive influence upon the fair value

Step 2: Identify the market Use principal market if available “The market with the greatest volume and level of activity for the asset or liability.” Otherwise, use most advantageous market “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 taking into account transaction costs and transport costs.” Most advantageous market should be used only in the absence of principal market

Step 2: Identify the market - Example Asset can be sold in 2 markets with same levels of activity. What is the fair value? Fair value: 23 Most advantageous market: 22

Step 2: Identify the market – Market Participants’ Perspective Use assumptions & characteristics that market participants consider Market-based measurement, not entity-specific Market participants: Independent Knowledgeable Able to transact Willing to transact

Step 3: Determination of Highest and Best Use Non-financial asset fair values based on Highest and Best Use Highest and Best Use stand-alone basis or combined with other assets and/or liabilities based on market participants’ perspective; intentions irrelevant physically possible; legally permissible; financially feasible usually, but not always, current use

Step 3: Determination of Highest and Best Use - Impact Land This will be particularly significant for an entity with land used for farming. If the highest and best use of the land is, for example, with a factory built on the land, the fair value of land has two components: the value of land assuming its current use (farming) and the incremental value to fair value (i.e. amount by which the fair value of land differs from the value in its current use) Biological Asset The highest and best use of sheep for a buyer may be to obtain wool, however the current use by the entity might be production of mutton or lamb.

Step 3: Determination of Highest and Best Use - Challenges Significant for entity with land used for farming. Example: With a factory built on the land, the fair value of land has two components: the value of land assuming its current use (farming) and the incremental value to fair value (i.e. amount by which the fair value of land differs from the value in its current use). Significant impact on the value of biological assets Example: The highest and best use of sheep for a buyer may be to obtain wool, however the current use by the entity might be production of mutton or lamb. The extent of the impact will vary for different types of biological assets such as consumable biological assets and bearer biological assets. Therefore, the range of values will be based on the different uses of the asset coupled with the impact of pricing trends for given commodities at a point in time.

Step 4: Valuation Techniques Market Approach Income Approach Cost Approach Assess appropriateness based on circumstances Maximize observable inputs Change in technique acceptable if equally or more representative of fair value

Step 4: Valuation Techniques - Application Market Approach : Many biological assets have relevant market-determined prices or values available, as they are often basic commodities that are traded actively. For example, calves and piglets If an active market does not exist: The most recent market transaction price, provided that there has not been a significant change in economic circumstances between the date of that transaction and the balance sheet date. Market prices for similar assets with adjustment to reflect differences. Sector benchmarks, such as the value of an orchard expressed per export tray, bushel, or hectare and the value of cattle expressed per kilogram of meat.

Step 4: Valuation Techniques - Application Income Approach Present value of the future cash flows expected to be generated from the asset. Reason: Lack of active markets and lack of reliable quoted market prices. Includes directly attributable cash inflows and outflows. Inflows: Price in the market of the harvested crop for each harvest over the asset’s life Outflows: Incurred to raise or grow the asset and get it to market, for example, direct labour, feed, fertilizer, and transport costs Market: Where the asset will be sold Discount Rate: Pre-tax discount rate Instances in which this approach is relevant include long-term biological assets, such as plantation forests, tea plantations, and vineyards, but this is also appropriate for some short-term assets.

Step 4: Valuation Techniques - Application Cost Approach Best indicator when limited biological transformation takes place, for instance , in case of the fruit trees planted right after the closing date; Applies where price is barely influenced by the biological transformation process, for instance for the initial growth in a pine plantation that has a production cycle of 30 years; Applies when no known reliable parameters are available, e.g. prices or growth rates or physical volumes.

Step 5: Fair Value Hierarchy Level Characteristics Example Level 1 Observable Quoted prices for identical assets or liabilities in active markets (unadjusted Quoted Equity Shares on a Stock Exchange London Metal Exchange (LME) futures contract prices Level 2 Quoted; similar items in active markets Quoted; identical/similar items, no active market Foreign Currency Forward Contract where inputs for measurement such as discount rate curves and interest rate curves are based on the observable market data Level 3 Unobservable inputs (e.g., a company’s own data) Market perspective is still required Models that incorporate management assumptions that cannot be corroborated with observable market data.

Accounting for Fair Value Changes All the biological assets and agricultural produce have to be valued at Fair Value less costs to sell at each reporting date. The difference between the fair value as on the two reporting dates has to be accounted for in the Profit and Loss Account. This can result in significant volatility in profits year-on-year. Initial losses on biological assets typically arise when a biological asset is purchased. The cost of the biological asset is often higher than the fair value less costs to sell, as the latter represents an exit price, and transaction expenses therefore create a loss. Initial gains on biological assets arise when new biological assets are generated – for example, when a calf or a piglet is born

Examples

Example 1: Biological Assets attached to land In some cases there isn’t an isolated market for biological asset, but only for combined asset. Enterprise can use the value as starting point for determining the fair value of biological asset by deducting the fair value of land. Example: An enterprise buys a vineyard. Details are as under: Therefore fair value of the Grape vine is 3.5 Million INR Particulars Total Price Price of Land Land Improvement Grapevine Beginning of the year 12 Million INR 8 Million INR 1 Million INR 3 Million INR Closing Date 12.8 Million INR 8.2 Million INR 1.1 Million INR 3.5 Million INR

Example 2: Value of Partly Grown Salmon While there is a market for fully grown salmon, there is no market for a partly grown salmon. In such case, how do you fair value partly grown salmon? Answer: The fair value of a partly grown salmon is measured by projecting the cash inflows from the sale of the salmon fully grown, less the cash outflows needed to grow the salmon to its marketable weight and discounting them to a present day value.

Example 3: Poultry Farming How do you fair value the chickens in a Poultry Farming? Answer: Fair value can be different at various stages and various techniques will be used at different stages. Breeding – 1 to 8 weeks Growing – 9 to 28 weeks Laying – 29 to 68 weeks There are market for hens under breeding and growing stage as there are ready breeders and growers. For hens under laying stage, this can be valued based on the present value techniques (Various estimates will have to be applied such as production yield, market prices for eggs, rearing and other direct costs, discount rate etc.)

Example 4: Fair Value of Tea Plantations Tea Plantations have an estimated 60 year economic life after initial harvesting of tea bushes. There is generally no active market for tea plantations in India. How will tea plantations be fair valued? Answer: The most appropriate approach will be calculation of net present value of future cash flows associated with tea plantations. This will include estimating Future yield rates; Selling prices are based on expected future costs; Growing, processing and selling costs which could be based on long term average levels; Cash flows are to be discounted at a pre tax rate, that takes into account the cost of capital plus a suitable risk factor; and An appropriate rental charge is included to represent the use of the developed land on which the trees are planted.

Example 5: Fair Value of Timber Forest Income Approach - Discounted Cash Flow Method: The most acceptable and widely used – mainly due to lack of active markets for large plots of forest land, implies a lack of reliable quoted market prices for standing timber. Key assumptions include – harvesting plans, timber prices, forestry costs, growth rates, and the discount rate Market Approach: Can be used if there is a market for certain species and quality of standing timber mostly plantations with relatively short rotation cycle typically between 5-20 years Historical Cost: Newly planted trees – Cost is the most appropriate approximate of the fair value. Additionally, cost is applied where there are no known reliable parameters, e.g. prices or growth rates or physical volumes

Example 6: Fair Value of Growing Almond Crop While Almond Tree Plantation can be valued using Discounted Cash Flow Technique, how do you measure the fair value of a growing almond crop? Answer: Valuation: Current almond selling prices and current growing, processing and selling costs. The calculated crop value is then discounted to take into account that it is only partly developed, and then further discounted by a suitable factor to take into account the agricultural risk until crop maturity

CHALLENGES

Challenges Ind-AS 41 and 113 will bring in a lot of changes and will have wider impact including recognition, measurement and disclosures. Few of the challenges that could come up are as follows : What should be considered as a unit of account? Should it be an individual assets or a group of assets? How should the assets be grouped together to be measured for fair value? How the markets should be determined? Which markets should be considered? In the absence of any market, how should an entity develop a hypothetical market? Incorporating and estimating market participants’ characteristics in the absence of a principal market could be a real challenge What if there are rate regulations e.g. sugar industry?

Challenges (contd..) Estimating fair value technique through income approach involves significant judgement and estimations e.g. how do you factor in climate changes for a tea plantation where the estimated yields span up to 60 years Establishing models for fair valuation could become very complex Ind-AS 101 – Deemed Cost Exemption – Bearer Plants Under market approach, using prices for recent transactions could be faulty or may not be fruitful for instance, in a rubber plantation, there may not exist an active market for the rubber plantation. Even if a market exists, no two plots will be the same. Where markets exist, often they are restricted to smaller plots, not on a scale that is of interest to strategic or financial investors. Further, significant volatility in market prices can distort the valuations For certain items, historical cost may be appropriate but may not be relevant

Benefits of Fair Value Measurement Reflect current market conditions Financial statements reflect the impact of current market conditions on financial instruments More transparency Investors and other users have greater insight into management’s views as to ultimate settlement amounts Benefits Communication and Knowledge Sharing Lack of market prices requires the use of models to determine fair value

Conclusion While there are significant challenges, this is going to be the future and hence a detailed understanding is required Significant changes to the organizational framework, including developing, attracting and retaining competent staff will be crucial Previous experience in other parts of the world is available and will help in reducing the implementation challenges Once models are developed, they can be used for years. Role of auditors

Questions?

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