Companies which report their financial statements under IFRSs, and are undergoing their 2019 audit, must now comply with the new lease standard – IFRS 16.
This standard, which came to effect as from 1st January 2019, will require companies to bring most, if not all, of their leases on-balance sheet.
This will add more transparency and comparability across companies. Now we can fully understand a company’s contractual obligations and better compare balance sheets and financial reporting metrics across companies and industries.
This new accounting standard will no longer make a distinction between finance leases and operating leases; all leases, bar short-term leases and low value leases, will be treated as finance leases. Lessees will now have to recognise a right-of-use asset and the associated obligation as a liability on the statement of financial position. While in the income statement, the lessee will recognise an imputed interest cost and the amortisation of the leased asset instead of the operating lease expenses. This will lead to the following implications:
• An increase in net debt – since the obligation is now recognised on the face of the financial statements;
• A higher Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) since the imputed interest cost and amortisation have replaced the operating lease expense, which was previously classified before EBITDA;
• Similar to the point above, Earnings Before Interest and Tax (EBIT) will be also higher, as part of the lease payment will be reflected as interest cost; and
• A higher invested capital as a right-of-use asset is being recognised. This will lower the return on capital invested ratio.
Since this standard will alter the EBITDA, which is commonly used as a proxy for cash generation, many have asked me whether this change in accounting standard will impact the company’s value and what are its implications when valuing a business.
The short answer is no. As with all financial reporting standards, IFRS 16 will not impact the equity value of a business.
The value of a business is a function of its fundamentals, being: the cash generation; the growth in those cash flows; and the risks associated with earning those cash flows. Since changes in accounting standards do not alter the fundamentals of the business, but change the way they are presented, the value of the business will not be impacted.
Nevertheless, this does not mean that the new lease standard will not impact how a business valuation is conducted. To make a fair assessment of IFRS 16 and business valuations, business valuers now need to be wary of the implications and adjustments they need to consider when applying the two widely used valuation techniques – the discounted cash flow (DCF) approach, and the relative valuation approach.
In the DCF approach, which essentially discounts future cashflows to today’s value, including all cash flow generated and used by a business is essential. The natural starting point in a DCF is the EBITDA of the business – which is a widely used proxy for cash generation from operations. If the lease payments, are omitted from the DCF calculation, as these will no longer be considered in the EBITDA figure, then the value derived from the DCF will be erroneously overstated. In lieu of this, business valuers need to deduct the lease payments from the post-IFRS 16 EBITDA.
These lease payments can be found on the statement of cash flows. If this information is difficult to extract, and the business valuer cannot exactly ascertain the lease payments, a quick fix, albeit not entirely accurate, is to assume that the annual amortisation of the right-of-use asset and the annual imputed interest on the lease (which are both found on the income statement) are equal to the annual lease payment.
Over the lifetime of the lease, the impact of IFRS 16 on the income statement will be neutral – as the amortisation of the right-of-use asset and the imputed interest on leased asset will equal the lease payments over the life of the lease. However, one must be mindful that in reality the net annual impact of this standard on the income statement will fluctuate.
IFRS 16, because of the interest component, will frontload most of the impact on the income statement, with the latter years being more favourable on the business’ income statement. Another possible solution would be to disregard the lease payments completely and treat the lease liability obligation on the statement of financial position as debt.
Thus, when the business valuer computes the enterprise value (the value of the business), the lease liability, along with other balance sheet items, is subtracted from the enterprise value to arrive at the equity value. This however creates two issues: the first is that the enterprise value will be overstated, although the equity value will not be overstated.
The second is that business valuers need to remember to factor in lease payments in the terminal value calculation since the lease liability on the statement of financial position is for a pre-determined and finite number of years.
Valuations based on market multiples are also affected by the switch to IFRS 16, as it influences valuation multiples. A very common multiple used to value businesses is the EV/EBITDA (enterprise value on EBITDA). Both the numerator and denominator will be affected by this accounting change.
The impact on the numerator will depend on whether the lease payments are omitted in the calculation of the enterprise value or not, and the denominator will increase as EBITDA increases. As a result, post IFRS 16 EV/EBITDA multiple will differ from the pre IFRS 16 EV/EBITDA multiple.
The vast majority of EV/EBITDA multiples will decrease, the magnitude will depend on how many leases a business has on its balance sheet. This will make it more difficult to compare multiples across time periods. An important mitigating factor is to consistently calculate these valuation multiples across companies and across time periods. For example, rather than relying on third party platforms for valuation multiples, business valuers can compute the valuation multiples themselves to make sure that the multiples are consistently calculated throughout.
Although this standard will not affect business valuations, it has introduced new attention areas when conducting a valuation. DCF valuations will become more complex and more sensitive to errors. Furthermore, inconsistencies between valuation multiples that are EBITDA based could easily lead to under or over valuation. Business valuers need to be more mindful of leases as of January 2019 and exercise extra caution when valuing a business, whichever methodology they choose to adopt.
About the Author: Michael J. Agius – Manager, Transaction Advisory Services
Michael holds a Bachelor (Hons.) in Economics from the University of Malta and is also a qualified accountant. In 2018, he has completed, with High Honours, the Advanced Valuation Certificate from New York University – Leonard N. Stern School of Business.
At Grant Thornton Michael takes care of valuations, raising of finance, due diligences, debt restructuring, impairment reviews, risk and scenario stress testing analysis and financial modelling and preparation of financial projections. As a result he has serviced a varied portfolio of clients in the private and public sector in industries ranging from hospitality, healthcare, real estate, retail, renewable energy, and information technology.