INDIVIDUAL Assignment of ADVANCED FINANCIAL

ACCOUNTING I

Section: 2
Prepared by

NAME ID.NO
1.MOKRIYAW MOKONIN_______________________UGE/18943/12
2. MEKDES MOKONIN_________________________UGE/18916/12

LECTURER: Tamirat.H
(MSC)
GOOD LUCK!!

Contents
CHAPTER 6: Asset valuation for financial reporting.....................................................................................3
6.1 Basic of Valuation..............................................................................................................................3
6.2 Overview of international valuation standards..................................................................................4
6.3 Valuation Approaches and Methods.................................................................................................5
 6.3.1 Market Approach.......................................................................................................................5
CAPITALIZATION OF CASH FLOW (CCF) METHOD................................................................6
DISCOUNTED CASH FLOW (DCF) METHOD............................................................................6
6.3.2 Income Approach........................................................................................................................7
6.3.3 Cost Approach............................................................................................................................8
6.4 Valuation report................................................................................................................................8

CHAPTER 6: Asset valuation for financial reporting

6.1 Basic of Valuation
All companies deal with valuation from time to time. Capital budgeting,
company and asset valuation, or value based management rely on valuation.

Two approaches are the foundation of valuation, discounted cash flow

valuation and relative valuation. The first one is a bottom-up approach where
the present value of an asset’s future cash flows is calculated, the second
determines the value of an asset by comparing it to similar other assets.

While relative valuation is well applicable by common sense, DCF needs

considerable understanding of the relevant input parameters. As DCF is a vital
approach to valuation in life sciences and the basis of decision tree analysis
and real options valuation, it is worthwhile to discuss in detail how the method
is properly applied.

basic principles of professional business valuation.

1. Future Profitability
Future profitability is the only thing that determines the current value. The
price should be based on what a buyer can expect in future earnings, not how
the business performed in the past.  Past revenue tells us about business
momentum but we are more focused on what’s left over after all the expenses
of running the business have been paid.

2. Cash Flow
Insurance or financial service businesses don’t have many tangible assets, so
the real value is in the cash flow generated through clients (specifically the
cash flow over and above the cost of running the business).

3. Potential Risk
Simply put, less risk is rewarded with a higher price.  The more risk a buyer
must assume, the less they’re willing to pay.  The greater the certainty that a
percentage of cash flow comes from recurring cash flow and the sustainability
of recurring cash flow will decrease the risk and increase the valuation price.

4. Objectivity vs Subjectivity
There is a mix of art and science that goes into valuing a book of business.
There’s an objective review of revenue, expenses but then there’s the
subjective view on understanding what might make one book more valuable
than another (even if they generate the same revenue).  The subjective side
might include looking at the deal itself; terms of payment, guarantees, claw-
back clauses and the seller’s involvement in the transition.

5. Motivation and Determination

At the end of the day, it doesn’t matter how accurate or realistic the valuation
put on a business.  The final price will be determined by the two parties
involved and how motivated and determined they are to complete the deal.
The best outcome is when both the seller and buyer feel that they’ve met a
fair price.

6.2 Overview of international valuation standards

The International Valuation Standards (IVS) are standards for undertaking valuation
assignments using generally recognized concepts and principles that promote
transparency and consistency in valuation practice. The IVSC also promotes
leading practice approaches for the conduct and competency of professional values

The International Valuation Standards Council (IVSC) is an independent,

not-for-profit organization committed to advancing quality in the valuation
profession. Our primary objective is to build confidence and public trust in
valuation by producing standards and securing their universal adoption and
implementation for the valuation of assets across the world. We believe that
International Valuation Standards (IVS) are a fundamental part of the financial
system, along with high levels of professionalism in applying them.
Valuations are widely used and relied upon in financial and other markets, whether
for inclusion in financial statements, for regulatory compliance or to support
secured lending and transactional activity. The International Valuation Standards
(IVS) are standards for undertaking valuation assignments using generally
recognized concepts and principles that promote transparency and consistency in
The IVSC also promotes leading practice approaches for the
conduct and competency of professional values.
The IVSC Standards Board is the body responsible for setting the IVS. The Board
has autonomy in the development of its agenda and approval of its publications. In
developing the IVS, the Board:
• follows established due process in the development of any new standard,
including consultation with stakeholders (values, users of valuation services,
regulators, valuation professional organizations, etc) and public exposure of all
new standards or material alterations to existing standards,
• liaises with other bodies that have a standard-setting function in the
financial markets,
• conducts outreach activities including round-table discussions with invited
constituents and targeted discussions with specific users or user groups.
The objective of the IVS is to increase the confidence and trust of users of
valuation services by establishing transparent and consistent valuation practices.
A standard will do one or more of the following:
• identify or develop globally accepted principles and definitions,
• identify and promulgate considerations for the undertaking of valuation
assignments and the reporting of valuations,
• identify specific matters that require consideration and methods commonly used
for valuing different types of assets or liabilities.
The objective of the IVS is to increase the confidence and trust of users of
valuation services by establishing transparent and consistent valuation practices.
A standard will do one or more of the following:
• identify or develop globally accepted principles and definitions,
• identify and promulgate considerations for the undertaking of valuation
assignments and the reporting of valuations,
• identify specific matters that require consideration and methods commonly used
for valuing different types of assets or liabilities.

6.3 Valuation Approaches and Methods

Consideration must be given to the relevant and appropriate valuation approaches. One or
more valuation approaches may be used in order to arrive at the value in accordance with the
basis of value. The three approach

he’s described and defined below are the main approaches used in valuation. They are all based
on the economic principles of price equilibrium, anticipation of benefits or substitution.

The principal valuation approaches are:

(a) market approach,
(b) income approach, and
(c) cost approach.

Valuation Approaches and Methods may be applied to the valuation of businesses and business
interests.

When selecting an approach and method, in addition to the requirements of this standard, a
value must follow the requirements of IVS Valuation Approaches and Methods, including

6.3.1 Market Approach

The income approach is often used as the primary approach in the valuation of
operating companies. The two most frequently utilized methods of the income approach
are as follows:
CAPITALIZATION OF CASH FLOW (CCF) METHOD

The CCF method is a single period valuation model that converts a company’s benefit
stream into value by dividing it by a rate of return that is adjusted for growth
(capitalization rate). This method is used when the company expects long-term, stable
cash flows into perpetuity. When this method is used, the valuator uses the recent
historical results of the company as a proxy for future operations.

DISCOUNTED CASH FLOW (DCF) METHOD

The DCF method is a multiple period valuation model that converts a future series of
benefit streams into value by discounting them to present value at a rate of return that
reflects the risk inherent in the benefit stream. This method is based on the theory that
the value of a company is equal to the present value of its projected future benefits over
a specific period of time, plus the present value of a residual value. In order to execute
this method, the valuator uses forecasts or projections for the company (which are
typically provided by management). If you believe your historical results do not capture
the anticipated growth of your business, this method would be useful to determine the
company’s value.

When the comparable transactions considered involve the subject asset, this method is
sometimes referred to as the prior transactions method.

If few recent transactions have occurred, the value may consider the prices of identical or
similar assets that are listed or offered for sale, provided the relevance of this information is
clearly established, critically analyzed and documented. This is sometimes referred to as the
comparable listings method and should not be used as the sole indication of value but can be
appropriate for consideration together with other methods. When considering listings or offers
to buy or sell, the weight afforded to the listings/ offer price should co\nsider the level of
commitment inherent in the price and how long the listing/offer has been on the market. For
example, an offer that represents a binding commitment to purchase or sell an asset at a given
price may be given more weight than a quoted price without such a binding commitment.

A subset of the comparable transactions method is matrix pricing, which is principally used to
value some types of financial instruments, such as debt securities, without relying exclusively
on quoted prices for the specific securities, but rather relying on the securities’ relationship to
other benchmark quoted securities and their attributes

The key steps in the comparable transactions method are:

 identify the units of comparison that are used by participants in the relevant market,
 identify the relevant comparable transactions and calculate the key valuation metrics for
those transactions,
 perform a consistent comparative analysis of qualitative and quantitative similarities and
differences between the comparable assets and the subject asset,
 make necessary adjustments, if any, to the valuation metrics to reflect differences between
the subject asset and the comparable assets
 apply the adjusted valuation metrics to the subject asset, and
 if multiple valuation metrics were used, reconcile the indications of value.

A value should analyze and make adjustments for any material differences between the
comparable transactions and the subject asset. Examples of common differences that could
warrant adjustments may include, but are not limited to:

 material characteristics (age, size, specifications, etc),

 relevant restrictions on either the subject asset or the comparable assets,
 geographical location (location of the asset and/or location of where the asset is likely to
be transacted/used) and the related economic and regulatory environments,
 profitability or profit-making capability of the assets,
 historical and expected growth,
 yields/coupon rates,
 types of collateral,
 unusual terms in the comparable transactions,

6.3.2 Income Approach

The income approach is one of three major groups of methodologies, called
valuation approaches, used by appraisers. It is particularly common in commercial real
estate appraisal and in business appraisal. The fundamental math is similar to the
methods used for financial valuation, securities analysis, or bond pricing. However,
there are some significant and important modifications when used in real estate
or business valuation.
While there are quite a few acceptable methods under the rubric of the income
approach, most of these methods fall into three categories: direct
capitalization, discounted cash flow, and gross income multiplier.

The market approach is appealing because it allows for a comparison of similar

companies. If you want to sell your house, you will likely look on Zillow to determine a
price for similar homes or homes in the same neighborhood – which is essentially what
the market approach is for businesses. The market approaches rely on transaction
multiples derived from the earnings and value information provided to various
databases. The valuator then takes the estimated market multiple and multiplies it by
the subject company’s earnings to arrive at the subject company’s value.

The income approach provides an indication of value by converting future cash flow to a single current
value. Under the income approach, the value of an asset is determined by reference to the value of
income, cash flow or cost savings generated by the asset.

The income approach should be applied and afforded significant weight under the following
circumstances:

 the income-producing ability of the asset is the critical element affecting value from a
participant perspective, and/or
 Reasonable projections of the amount and timing of future income are available for the subject
asset, but there are few, if any, relevant market comparable.

A fundamental basis for the income approach is that investors expect to receive a return on their

investments and that such a return should reflect the perceived level of risk in the investment.

Generally, investors can only expect to be compensated for systematic risk

6.3.3 Cost Approach

Cost approach valuation applies the assumption that a property’s fair value can
be equated to the cost of building a similar property. The costs involved would
include the value of the underlying land and improvements to it. Cost approach
method also factors in the depreciation on these improvements and deducts it
from the overall value of the property to arrive at a more realistic price.
The cost approach provides an indication of value using the economic principle that a buyer will
pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase
or by construction, unless undue time, inconvenience, risk or other factors are involved. The
approach provides an indication of value by calculating the current replacement or
reproduction cost of an asset and making deductions for physical deterioration and all other
relevant forms of obsolescence.

Broadly, there are three cost approach methods:

 replacement cost method: a method that indicates value by calculating the cost of a
similar asset offering equivalent utility,
 reproduction cost method: a method under the cost that indicates value by calculating
the cost to recreating a replica of an asset, and
 summation method: a method that calculates the value of an asset by the addition of
the separate values of its component parts.

6.4 Valuation report

A valutation report is a professional assessment of the market value of a property by a
certified valuer. The report is based on the general condition of the home (observed via
a visit), recent and relevant sales history and other pertinent market data.

The property valuation report includes property information – rates, size of the land and
building, physical details on the construction and condition of the dwelling, details on
any immediate issues that may need addressing – as well as information on
comparative sales in the area.

Valuation Report contains a conclusion as to the value of shares, assets or an

interest in a business that is based on a comprehensive review and analysis of the
business, its industry and all other relevant factors, adequately corroborated and
generally set out in a detailed Valuation Report.

Valuation is typically performed by us for:

 Litigation – midsized to large share, business or asset values;
 Litigation – damage quantification;
 Estate Litigation;
 Sale/purchase of a minority shareholder to a majority shareholder; and
 Family law purposes when the company is large and the expectation the
client will be going to arbitration or court proceedings to resolve the matter.
We set out the following table summarizing the similarities and
differences between the three reports: