The International Financial Reporting Standards (IFRS) and the International Accounting Standards (IAS) have become the mandatory financial reporting standards for public interest entities in more than 150 jurisdictions around the world, and are also commonly used by international private groups for reporting purposes. As from January 2019 a new standard, namely IFRS 16, will come into effect. This standard relates to lease reporting and will replace the current standard IAS 17.
Under the current standard, leases are treated as either finance leases (capital leases) or operating leases. From an accounting perspective, a finance lease is posted on the lessee’s balance sheet as both an asset and a liability (and therefore has a P&L impact as depreciation from asset and interest payment from liability), whereas an operating lease appears only in the P&L under the form of rent. With the new IFRS 16, the vast majority of leases will be required to be capitalised. This will have a large impact on financial statements as many companies have a significant amount of operating leases.
On the balance sheet, a company applying IFRS 16 will need to introduce (a) an asset which reflects the “right of use” of the underlying asset and (b) a liability, which represents the obligation to make lease payments. The valuation of the lease liability will follow the typical approach to the valuation of loans by calculating the present value of the lease rentals plus the present value of any expected payments at the end of the lease.
On the P&L, IFRS 16 results in significantly higher EBITDA, as all components of the expenses relating to the leases (depreciation and interest expense) are added back. However, these costs are “front loaded” under IFRS 16, meaning that the accounted depreciation and interest expense will exceed the actual rent in the first periods (resulting in a lower net result), but will be lower than the rent in the last periods.
The reclassification of operating leases as finance leases and its impact on both the balance sheet and P&L will without a doubt have a significant impact on corporate valuation. In fact, looking at EV/EBITDA multiples only, the Enterprise Value (or “EV”), being the market value of all ownership interests and asset claims from both equity and debt, is expected to go up due to the extra lease liability on the balance sheet. On the other hand, the denominator (EBITDA) is expected to increase as explained above. It can be expected that in many cases the EV/EBITDA multiple will fall.
However, an in depth case by case analysis will be required in order to determine the exact impact of this major reporting change at the company, industry, and general level.
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