IFRS 16 effects in M&A

In 2006 the International Accounting Standards Board (IASB) decided to take a closer look at how the accounting for leases could be revolutionized and after a long discussion, finally published the new leasing standard IFRS 16 in 2016. It replaced the IAS 17 standard, which was almost 20 years old, and came into force on January 1st, 2019.

IFRS what!?! You are probably asking! Why should you care? You are an investment banker and not an accountant, right? Well, even though you must know your accounting when working in M&A, this new standard has a huge impact on valuation of companies.

But first things first:

What is IFRS 16?

So far, the situation has been this way: If, for example, a company decided to lease a private jet instead of buying it, the existing payment obligation usually did not appear in the balance sheet as a liability at all. According to the previous standard IAS 17, the company could choose whether to treat the transaction as a finance lease or an operating lease, depending on the distribution of opportunities and risks between the two business partners.

A finance lease that is more like a leveraged “purchase” had to be recognised as an asset in the assets and as a liability in the liabilities. An operating lease, on the other hand, which had the character of a “lease”, did not have to be shown in the balance sheet as a pending transaction. A mention in the appendix was sufficient.

However, many companies used this method of choice for balance sheet cosmetics, as no one reads the appendix anyway. IFRS 16 removes this possibility to choose and introduces a single model that effectively moves almost all operating leases on to the balance sheet.

Impacts on the financial statements

As you might have guessed this will change a lot of important key figures, and mostly not for the better. Debt and interest charges rise, while equity ratio declines – not to mention costs for implementation, review and reassessment.

On the other hand, costs are shifted in the profit & loss statement. With operating leasing in place, the payments were shown in ‘operating expenses’. By bringing the operating leases on to the balance sheet, an entity recognises additional fixed assets (and of course liabilities) together with a corresponding ‘depreciation’ and ‘interest’ component in the P&L.

In the cash flow statement, the repayment of the principal component of the lease payment will be recorded as a financing activity and the interest element may be recorded as either financing, operating or investing rather than as a single operating cash flow.

Now that you know the basics, we can get down to the nitty-gritty:

Effects in M&A

In very simplified terms, the enterprise value (EV ) of a company can be calculated as a multiple of its EBITDA. To derive the purchase price (equity value) net debt (Short-Term Debt + Long-Term Debt – Cash and Cash Equivalents) is deducted from the EV.

You have learned that bringing a lease on to the balance sheet under IFRS 16 effectively replaces the lease expense (which is recorded above the EBITDA line) with interest and depreciation expenses (which are recorded below the EBITDA line). All else being equal, this leads to a higher EV.

We also know that capitalising a lease increases net debt by the lease liability, suggesting a higher net-debt deduction when deriving the equity value if the definition of debt in an M&A transaction captures ‘lease liabilities’.

As a result, capitalising a lease may increase or decrease the purchase price for the equity depending on whether the effect of the EBITDA increase (multiplied by the transaction multiple) is greater than the increase in debt.

The logical conclusion is that a high multiple means that the incremental increase in EV will be magnified to a greater extent and therefore will more likely exceed the offsetting increase in lease debt.

High Multiple Scenario  
OldNew
EBITDA 2019€ 15€ 20
Multiple12x12x
EV€ 180€ 240
Net Debt€ -25€ -70
Equity Value€ 155€ 170

 

Low Multiple Scenario  
OldNew
EBITDA 2019€ 15€ 20
Multiple5x5x
EV€ 75€ 100
Net Debt€ -25€ -70
Equity Value€ 50€ 30

 

Good for highly valued sectors – bad for traditional sectors with lower multiples. Whether and how the new standard will change comparable company multiples and the view on valuation has to be determined by future transactions.