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Introduction
IFRS 16 Leases was published in early 2016 by the International Accounting Standards Board (IASB) and will apply from January 2019. The new standard was the result of years of debate, and it will significantly change the accounting for leases, and as a result significantly change the presentation of accounts. IFRS 16 is therefore not just an accounting technical matter, it is vital that valuation methods are adjusted to deal with the new accounting landscape.
The new standard
Under the current standard (IAS 17), leases are treated as either finance leases or operating leases. Where significant risk and reward remains with the lessor, the lease is treated as an operating lease. At present many leases are thus classified as “operating” including in particular property (e.g. shops, pubs, restaurants, offices, warehouses etc). An operating lease is, in essence, accounted for simply as rent in the P&L. This allows, in effect, “off balance sheet” financing of property or other assets and makes comparison between companies harder.
With the new IFRS 16, the vast majority of leases are required to be capitalised. The P&L will then reflect not the rental, but the depreciation on the asset and “interest” on the lease obligation. As many companies have significant assets under operating leases the impact on financial statements will be very large indeed.
On the balance sheet, a company applying IFRS 16 will need to introduce an asset which reflects the “right of use” of an underlying asset, e.g. the use of an office in London. It also needs to reflect a liability, which equals the obligation to make lease payments. This lease liability is the present value of lease rentals plus the present value of any expected payments at the end of the lease. On day one, the value of the asset is likely to be set equal to the lease liability on day one.
IFRS 16 allows two ways to determine the “interest rate” for the present value calculation of the lease liability. If the implicit rate in the lease contract is known, this can be used. Otherwise, the incremental borrowing rate for each lease needs to be determined (i.e. the more leases, the bigger the lease liability on the balance sheet, and the higher the incremental borrowing rate may be).
The valuation of the lease liability therefore will follow the typical approach to the valuation of loans, by reference to the terms of the loan/lease and by determining a discount rate which reflects factors such as the economic environment, the company’s credit rating or standing, the lease terms, the nature and quality of (any) collateral provided, country risk and currency risk.
After initial determination, the lease liability will also need to be updated (and the asset value restated as well) if there are, for example, changes in the lease payments due to lease modification, changes in the lease payments due to changes in index or rate, changes in lease terms or changes in the assessment as to whether e.g. an option to purchase may be exercised or not. Clearly, if a company has a large leased property estate, for example a retail chain, the work required to value the lease obligations, and to amend them for changes in the lease contracts or assessment of likely use of the lease, will be substantial.
In the P&L, as noted above, there will no longer simply be “rent” included in operating profit. Instead, there will be depreciation of the asset and “interest” on the lease liability (at the interest rate determined to value the liability).
For example:
- 20 year lease, at annual rental of £1m
- Incremental borrowing rate of 6%
Balance sheet:
- Liability of £11.5m – Present value of £1m payments at 6% p.a.
- Asset of £11.5m – to match the liability
P&L:
- Depreciation of £573,000 – e.g. straight line basis over 20 years
- Interest of £688,000 – interest cost on the liability at 6%
The income statement will have a total charge of £1.26m as opposed to the £1m actual cash rental. Under IFRS 16 the costs is front loaded – in later years the P&L charge will be less than the actual cash cost of the rental.
This also means that after year one there is a mismatch between asset and liability, as the asset is down by £573,000 (depreciation) but the liability is down by £312,000 (£1m rental less interest of £688,000).
This is just a very high level summary of the key change in IFRS 16 and does not consider the complex first year transition options, if you would like to read more please see our BDO guide to IFRS 16.
Impact on ratios
As a result of the adoption of IFRS 16 the accounts of many companies will change very dramatically. For many companies there will be:
- A big increase in assets; and
- An equally large increase in liabilities.
This will mean that all standard capital and debt ratios will change dramatically – and this could also have an impact on, for example, banking covenants.
With regard the P&L, as rental would be before EBITDA but depreciation and interest is after EBITDA, the EBITDA results will in many cases go up significantly.
You would expect EV to go up (due to the extra lease liability), but EBITDA to go up as well (as rental no longer included in EBITDA), but it is expected that in many cases the EV/EBITDA multiple will in fact fall.
Clearly, with the adoption of IFRS 16 from January 2019 (early adoption is allowed as well), it will be absolutely critical to consider the detail behind any multiple data for quoted companies to understand where they are in the transition and how much their accounts have changed as a result of the transition.
In addition, local GAAP may well differ from IFRS 16 going forward, so the old adage of ensuring not to compare apples and oranges is more relevant than ever!
Impact on valuation of companies
In principle, IFRS 16 creates a more unified accounting system, and more comparability. Whether a retail chain owns stores or leases them, the EBITDA is likely to be much closer, as in either case, the funding element is either straight loans and interest or lease obligations and notional “interest” but in both cases below the EBITDA line.
However, by reference to the same example, if the leases have an expected average life of 4 years left and the lease liability reflects this (low liability), a simple valuation based on EBITDA would go badly wrong. This is because the EBITDA does not reflect either the rent or lease liability, but if you ignore that after 4 years the company would have no shops to retail from, you are clearly overstating the earnings and thus value of the company with the leases (compared with the company that owns the property).
In the retail sector, we can consider to calculate the store level EBITDA, which will include the actual rent cost or the fair value of the rental cost.
Similarly, when using a DCF valuation approach, much thought will need to go into where and how to adjust for the leases compared to the new accounting figures.
Conclusion
IFRS 16 will have a significant impact on the accounts of many companies, which will in turn lead to changes in many valuation ratios and multiples. In valuing any business it will be critical to consider how the changes in the accounts and multiples for quoted companies are reflected in the valuation of any business going forward.