On 13 January 2016, the IASB published the long-awaited IFRS 16 Leases, which has been adopted as AASB 16 in Australia.
Understanding the new standard - What does it mean for your balance sheet?
There are important implications impacting the valuation of companies that you need to understand, including:
Rent is no longer an operational expense
This new standard effectively removes rent as an operating expense. Instead of recognising rent as part of operating expenses, under AASB 16, lessees will now recognise a depreciation expense on their right-to-use assets and an interest expense on their lease liability.
EBITDA & EBIT will be affected
The effect of this will be to increase EBITDA and EBIT and similar metrics. In some cases this will have a major impact. This is because the costs previously included in operating expenses are now being added back as part of interest and depreciation.
Cash flows will be presented in a new way
Your company’s reported cash flows will also need to be presented differently. Previously, operating lease would have been treated as an operating expense. Now the cash outflow will have to be split between the repayment of principal, which would be within investment cash flows and interest on the lease liability, which would be included within financing cash flows.
The challenges for company valuations
The accounting changes will present challenges to the valuation industry. Below are seven areas that will need to be potentially navigated.
- From the adoption date onwards, reported EBITDA and EBIT multiples will be impacted by the change in the way EBITDA and EBIT is calculated. Depending on the mix of leases of each entity, the degree of the impact on earnings will vary.
- The reported Enterprise Values of comparable listed entities is likely to increase as debt on balance sheets will increase (from the recognition of additional finance lease liabilities), whilst in theory, equity valuations should remain unchanged. EV/EBITDA and EV/EBIT multiples could both increase or decrease depending on the ratio of increases in EV compared to the decrease in EBIT/EBITDA.
- The comparability of EBITDA multiples between companies that lease properties and companies that own properties will become more difficult to assess.
- AASB 16 is not required to be retrospectively accounted for. So, for the interim, there will be a discrepancy between the way that historical EBIT and EBITDA multiples and current/forecast multiples are calculated. What this means for valuers, is that historical transaction multiples will have to be scrutinised and adjusted to ensure valuers are comparing apples with apples.
- There may be inconsistencies in the way that consensus forecast EBITDA/EBIT multiples are assessed and presented in valuation data platforms during the transitional phase to IFRS/AASB 16. Valuers will need to understand whether these estimates are presented on a pre or post adoption of AASB 16 basis.
- When calculating the weighted average cost of capital of companies, the debt to equity ratios will need to adjusted to reflect the additional debt that entities will now recognise and the change in the way that operating cash flows are presented.
- Where entities have operating leases shortly due to expire on the balance sheet, the debt component on the balance sheet will only reflect the negative impact on valuation for the remaining term of the lease. Consideration will need to be given to recognising the negative impact of renewing these leases.
Unless the work needed to address these issues is undertaken by the data platform providers such as Bloomberg and S&P Capital IQ, valuers will also need to spend more time analysing the results of comparable entities to ensure they understand the lease accounting within comparable entities.
The bottom line – what to remember
Clearly accounting policies adopted by an entity should not impact on the economic value of that entity. However, AASB 16 is going to impact the way that valuations are prepared and will require valuers to spend more time undertaking the analysis of how leases are recognised both within the company being valued and the comparable companies utilised.
Final thoughts. It’s not all bad news
On the positive side, the impact of AASB 16 being adopted is not going to be fully felt until the end of 2019 as it is only to be applicable for the period beginning on or after January 2019. However, early adoptions will be permitted for entities that also apply AASB 15 Revenue from Contracts with Customers before 1 January 2019. Therefore, this is an issue that will need to be at least considered in valuations prepared prior to the end of 2019.