Overview of IFRS 16: lessee’s perspective
IFRS 16 consists in capitalizing leases which were not recorded on financial statements under IAS 17. On the balance sheet, right-of-use assets appear on the active side, referring to the right of using a leased item for a duration determined contractually. Additionally, lease payments are now accounted for as a financial obligation on the passive side, calculated as the present value of future lease payments due. Unsurprisingly, this results in a substantial increase in net debt, especially for businesses considerably relying on leasing strategies.
The income statement is also reshaped post-IFRS 16: operating leases are no longer classified as operating expenses, thus resulting in a substantial rise in EBITDA; as such, EBITDA could be considered as a proxy for EBITDAR under IAS 17. Additional D&A expenses related to right-of-use assets are also recorded, meaning that EBIT is also impacted, but to a lower extent. Interest expenses also increase due to the new lease liability accounted for in the balance sheet. All in all, the net income value should not fluctuate post-IFRS 16.
Though the accounting standard should have no impact on a company’s cash position, cash flow from operating activities typically rises since the outflow due to leases is no longer accounted for; meanwhile, cash flow from financing activities goes down as the payment of the lease debt principal and entitling interests are now recorded.
Finally, the distinction between operating and capital leases no longer exists. Another important consideration is that short-term leases i.e. with lease terms shorter than 12 months are not in the scope of application of IFRS 16. This already highlights the importance of lease terms when dealing with the new accounting standard.
How businesses cope with IFRS 16
Obviously, the impact of this new accounting standard is very variable across industries. While leasing is very common in some industries (e.g. retail, airlines), it is not the case in others (e.g. financial services). PwC carried out a study in 2016 to assess the impact of the new leases standard on 3,199 companies subject to IFRS reporting worldwide. This study showed for instance that the median increase in debt in retail amounts to +98 % post-IFRS 16, while this same increase only amounted to +6 % in the financial services sector. Similarly, the median increase in EBITDA was +41 % for retail versus only +6 % for financial services.
This results in an accounting impact being more difficult to interpret from one industry to the other, and more specifically from one company to the other. Furthermore, it leads to the following conclusions: firstly, the impact of IFRS 16 is likely to create a gap between most affected and least affected companies; secondly, any bank, consulting or other advisory group has no choice but to familiarize with the range of consequences IFRS 16 has to understand how to deal with it and properly advise clients.
Implications on various metrics: focus on EBITDA and net debt
While several indicators are considerably impacted by IFRS 16, we will focus on two major indicators: EBITDA and net debt.
Relying on the assumption that EBITDA is a key metric used for valuation, this becomes somehow more debatable post-IFRS 16. Obviously, EBITDA is a very convenient metric, which is rather easy to understand and explain; it is also a widely used metric and therefore, it seems very unlikely that an accounting standard could impact that. However, relying too much on EBITDA may become misleading, especially when it is considered a proxy for cash flow; as a matter of fact, the implementation of IFRS 16 takes EBITDA further away from the real cash position of a company since operating leases are no longer subtracted from its value. The room for misinterpretation therefore increases, especially when looking at the historical performance of a company and dealing with both IAS 17 and IFRS 16 EBITDA figures. Having in mind that what investors mostly care about is the cash generation of a potential target, reported EBITDA may lose importance when carrying out valuation. Therefore, an interesting approach could be to focus on cash-adjusted EBITDA or other cash-based metrics (e.g. cash-flow yields, cash-based multiples) in valuation contexts.
Regarding net debt calculation for valuation purposes, complexities also appear post-IFRS 16. Firstly, that comes from the variable impact IFRS 16 has across industries: lease liabilities significantly vary from one company to another, even in the same sector, the reason being that lease liabilities are only recorded for the remaining lease term; any potential lease renewal is not accounted for in the net debt metric. With that regard, the notion of lease term becomes more difficult to tackle, and discussions regarding lease continuation arise. It is thus expectable that there will be major debates on how to normalize debt and on the amount of net debt to use in valuation, especially in sectors in which leases represent a considerable amount of the cost structure. Net debt was already a metric requiring thorough due diligence and subject to negotiations in M&A processes under IAS 17, and this will certainly accelerate post-IFRS 16.
How to choose between pre- and post-IFRS 16 valuation
In this transition towards IFRS 16, a lot of uncertainties remain. Having in mind what we described before, it is undeniable that IFRS 16 has created new challenges for company valuation. Currently, adjustments are sometimes made to provide a pre- and post-IFRS 16 vision of a company’s financials, mainly to ensure comparability of data over time. This seems suitable in the short term to support users of financial statements during the transition period; yet whether this will be the case in the long term is questionable. This comes from the confusion arising from both the uncertainties of where the transition period will lead, and the uncertainties arising from the use of non-GAAP indicators like EBITDA, which have no clear definition. Bearing in mind that the goal of valuation is to precisely calculate what a business is worth, whether pre- or post-IFRS 16 valuation is more accurate becomes debatable.
Pre-IFRS 16 valuation has the advantage of enabling consistency with past practices, but will become outdated and time-consuming in the long term: indeed, companies may keep reporting IAS 17 financials to help investors understand the recent implementation of IFRS 16, but that will certainly stop in the future, when investors become more familiar with the accounting standard. Moreover, for sectors in which the effects of IFRS 16 are hardly noticeable, there is no point to provide pre-IFRS 16 financials unless it is to analyze the historical performance of a company. This further highlights the fact that a transition period is currently taking place, which may last shorter or longer depending on the sector one analyzes and the speed at which investors get up to date on IFRS 16. Having that in mind, suggesting that pre-IFRS 16 will prevail could be considered true in the near future, but not in the long term.
So will post-IFRS 16 M&A valuation practices prevail? That becomes undeniable when adopting a long-term perspective. How, though, still needs to be clarified. The sector under analysis will play a key role in determining this: least IFRS 16 impacted sectors have no incentive in changing the practices they have witnessed in the past years. Here, there is little doubt that the new leases standard will not have implications on the way valuation is carried out. That is not the case for heavily impacted sectors though, for which adaptation is trickier; this is why stating that the transition will go smoothly can be considered true, but only to the extent of little impacted sectors which will have no adaptation problem to the new standard. This underlines one important consideration: it is very likely that M&A valuation becomes even more industry-specific than it has been up until now, by using even more industry-specific metrics for example. It finally emphasizes the fact that the transition towards IFRS 16 will constrain valuation and deal execution behaviors to adapt.
Valuation methods post-IFRS 16: trading multiples, precedent transactions and DCF
The issue with trading multiples is that the method relies on the assumption that companies are comparable; even if the increase in enterprise value (‘EV’) should be offset by an increase in EBITDA, it effectively doesn’t always happen and thus the comparability of EV/EBITDA multiples can be obstructed. Therefore, for most affected sectors, IFRS 16 may lead to a situation in which multiples are not comparable anymore. The first implication of this is that the peer selection has to be made in an even more thorough way to ensure comparability among the peer group. The second implication is that other multiples such as P/E, EV/FCF or even EV/EBIT may regain importance: the advantage of P/E specifically is that the financials used to calculate the multiple are not impacted. The third implication is that lease terms become an important consideration when looking at a set of comps. Even if businesses can remain comparable in spite of different lease terms, what may happen is that lease terms are homogenized among a set of comps using an industry average for example.
Moving on to the precedent transaction valuation method, the first thing to have in mind is that transactions often took place before IFRS 16 became mandatory. As such, the EV/EBITDA multiples were typically calculated under IAS 17, which is why, for consistency, adjustments are needed. Here, the room for error increases, and the adjusted data provided will differ from the publicly available data, which also increases the need for backing financials. This further underscores the relevance of the debate around pre- or post-IFRS 16 valuation discussed previously; yet it will also depend on how important this valuation method will be considered to value a target.
When it comes to DCF valuation, the increase in EBITDA results in an increase in Free Cash Flows to the Firm which will be discounted. Moreover, cash outflows related to leases will only be accounted for only during the remaining lease term as part of net debt, and therefore plugging in lease continuation into FCFF becomes key to avoid any inaccurate valuation. One solution could be to plug in the present value of future lease payments into the terminal value calculation. Additionally, IFRS 16 will also impact the WACC, which is lower post-IFRS 16 as the debt-to-equity ratio usually increases. Here again, the likelihood of making errors increases and therefore understanding the new accounting standard is essential.
Relevant considerations for deal execution
Even if EVs typically rise post-IFRS 16 given the increase in net debt, equity value should remain unchanged. Indeed, the new accounting standard cannot justify any price increase for investors, which is why pre- and post-IFRS 16 equity values should remain equal. Reaching that conclusion can become more challenging because of the way IFRS 16 affects the various valuation methods, but is a priority for deal executers. All in all, one of the major issues arising from IFRS 16 implementation is the need for additional crosschecks when carrying out valuation. Indeed, as the accounting standard is rather new, it will be necessary, at least during the transition period, to make sure that the equity value calculated remains consistent with the value that would have been found under IAS 17.
Investors may require more support to understand what the cash generation and value of their potential targets is, thus emphasizing the importance of M&A advisors and due diligence providers. Moreover, how data providers adapt to the shift towards IFRS 16 will also be interesting: their role will be key to evaluate whether the transition towards IFRS 16 is irreversible or not, as the data they provide is used by most transaction advisory companies. It will thus be interesting to see whether they start reporting both pre- and post-IFRS 16 metrics.
Finally, IFRS 16 may encourage corporates to lease rather than own assets given the positive impact it has on EBITDA and EV. It is therefore expectable that the mix between leasing and ownership will be reassessed, at least at the end of the lease terms. This is an important thing to have in mind when analyzing the target’s leasing strategy. Regarding lease terms, the impact of IFRS 16 will not only be sector-specific but also geography-specific; indeed, the typical lease duration obviously varies from one sector to another, but also from one region to another. Moreover, the lease duration has a considerable impact on company valuation as different lease liabilities are plugged into the EV. This also highlights the importance of assistance provided by advisors when taking over a company.
Conclusion
IFRS 16 is a complex accounting standard to deal with given its recent mandatory implementation. From a valuation perspective, its accounting consequences require adaptation and increase the room for errors, thus showing the drawbacks of valuation shortcuts such as the EV bridge calculation or EV/EBITDA multiples. Needless to say that these are very helpful and useful formulas and indicators, yet with IFRS 16, the risk is to provide an inaccurate valuation of a company. This emphasizes the importance of using cash-based valuation methods as main valuation methods rather than multiple-based methods. Therefore, another important thing to question is the extent to which these non-GAAP based valuation methods are relevant and sustainable in the long term. From a deal execution perspective, a big work has to be carried out to sensitize investors as quickly and efficiently as possible to IFRS 16: indeed, they have to fully grasp the fact that IFRS 16 consequences are obviously only accounting consequences.
