IFRS 16 – Leases: Impact on Valuation & Financials

Impact on Valuation –

(A)    Intrinsic Valuation

Under IFRS 16, with all leases being treated as Financial Lease, Net Debt is set to increase there by pushing the Enterprise Value, higher. However, we don’t foresee any significant impact on Equity Value. Thus, valuation of company will increase (primarily under M&A scenario) but shareholder’s value is set to remain intact.

(B)    Relative Valuation

Due to change proposed in IFRS 16, the impact on market multiples would be based on underlying lease portfolio. Both EV and EBITDA are set to increase under IFRS 16, there by impact all relative valuation multiples. EBITDA multiple would be the most impacted valuation multiple. Thus, the comparison across companies would be meaningless unless appropriately adjustments are made to ensure apple to apple comparison.

(C)    Conclusion

Until companies fully adopt the new leases standard, it is hard to predict how the metrics used in business valuations will change. In our view, IFRS 16 shall materially impact the valuation of companies that have greater off-balance sheet leases. Sectors, which have significant amounts of off-balance sheet leases, such as airlines, retailers and travel and leisure are likely to see greater changes in financial ratios and valuations compared to industries like healthcare that have lower off-balance sheet leases. The overall valuation change is subjective as it depends on both, profitability and debt levels, which in turn are dependent on the characteristics of the lease portfolio as well as change in lease term, size of the lease portfolio and discount rate.

Impact on Financials –

The implementation of IFRS 16 would lead to positive impact on the income statement as it would translate into higher operating profit numbers and overall profitability. On the balance sheet front, Assets and Liabilities, both would increase, while equity is like to decrease. In cash flow statement, the overall net cash flow would remain unchanged.

(A)    Background

International Accounting Standards Board (IASB) issued IFRS 16 – Leases, in January 2016, to be effective for the financial period beginning on or after January 1, 2019. IFRS 16 replaces the previous lease standard, IAS 17. IFRS 16 discontinues the classification of leases into Operating and Financial leases. Under this new standard, all (material) leases will be treated as finance leases, except for short-term and low values leases, in the statement of financial position. The lessee will recognize the asset and liability for the lease, while in the statement of Profit & Loss, the lessee will recognize the interest cost and depreciation of the leases asset instead of the operating lease expenses.

For lessor, IASB decided to carry forward the lessor accounting model in IFSR 16 as per IAS 17. The standard expects the lessor to disclose components of lease income, risk management of leased assets and distinguish financing and operating lease.

(B)    Implementation

IASB observed that over 14,000 globally listed companies (of about 30,000 listed companies) disclosed information about off-balance sheet leases in their annual reports. IFRS 16 is expected to affect the amounts reported by almost half of the listed companies. Currently, more than 500 foreign SEC registrants with a worldwide market capitalization of US$7tn use IFRS standard in their US filing.