What Changes to Lease Accounting Mean for M&A Transactions
Following a lengthy gestation period, IFRS 16 Leases will apply to accounting periods commencing from 1 January 2019 onwards. The changes will affect businesses in different ways, and they have been documented by the IASB and others. Here, Phil Hersey, Heiko Ziehms, and Anna Hartley of Berkeley Research Group (BRG) discuss the implications for M&A transactions and related disputes.
Sir David Tweedie, the previous head of the International Accounting Standards Board (IASB), famously joked in 2008 that one of his lifelong ambitions was to fly in an aircraft that was on an airline’s balance sheet. His comment came amid wider concerns over off-balance-sheet financing during and after the financial crisis. Listed companies using IFRS or US GAAP are estimated to have approximately $2.9 trillion of lease commitments off-balance sheet. Following the global financial crisis, the IASB initiated a process in 2010 of changing accounting standards. The revisions to lease accounting introduced by IFRS 16 are perhaps the most significant element of these reforms.
Operating leases will move on to the balance sheet
Under current international accounting standards, namely IAS 17, leases are classified as either ‘finance leases’ or ‘operating leases’. For lessees, IFRS 16 removes this distinction and introduces a single model that effectively moves almost all operating leases on to the balance sheet.
The changes are intended to improve comparability and provide a more complete picture of liabilities. Under IAS 17, the vastly different accounting treatments for operating and finance leases meant that similar businesses operating in the same sector were not always comparable, depending on the terms of their leasing agreements or the judgment applied in their definition. Leases for some sectors are highly material and a key source of finance. Until now, operating leases have allowed this finance to be kept off-balance sheet, giving a potentially incomplete picture of an entity’s liabilities and leverage.
The objective of the new standard is to provide the users of financial statements with a fuller picture of a company’s leverage and aid the comparability of financial statements across companies. The changes will affect key deal metrics and will be pertinent to M&A disputes.
By bringing the operating leases on to the balance sheet, an entity recognises additional fixed assets (termed ‘right-of-use’ assets) together with a corresponding lease liability, resulting in an increase in reported gearing and net debt.
In the income statement, there will be a reduction in operating expenses (the operating lease payments) which will be offset by an increase in depreciation and interest.
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, under IAS 7, be recorded as either financing, operating or investing rather than as a single operating cash flow. This means that free cash flow (operating cash flow less investing cash flow) will change.
The effects of the changes on the income statement and multiples-based valuation are shown in the illustrative example below. It shows 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 Enterprise Value (EV). Capitalising a lease also increases net debt by the lease liability, suggesting a higher net-debt deduction in the equity bridge if (as is the case very often) the definition of debt in an M&A transaction captures ‘lease liabilities’.
Relevance of operating lease treatment (IAS 17) and IFRS 16 to multiples-based valuation
It would be a coincidence if the two effects—the increase in EV and the higher net debt deduction for leases—offset each other exactly, and in reality they usually do not. Consequently, capitalising a lease may increase or decrease the purchase price for the equity. The effects leading to a decrease in the net purchase price from moving to the new lease accounting standard are shown in the graph below, where the diagonally shaded area for the Equity Value bar is the net reduction in purchase price.
Effect of lease accounting treatment on the Equity Bridge
Valuation multiples and the effect on the net purchase price
One key determinant of whether the net purchase price will increase or decrease in multiple-based valuations is the multiple itself. As a general rule, 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.
In theory, valuation multiples should adjust so the effects of higher EVs and higher debt exactly offset each other and the only net change to purchase prices reflects secondary effects. This logic is comparable to what observers expect for the stock market, where it is said that analysts are already ‘pricing in’ leases, regardless of the accounting. In reality, such efficient price-setting in M&A transactions is far from certain. It may therefore be more difficult for M&A markets to shake off the net effects on prices of M&A transactions than for stock markets. Consider, for example, that when valuing a non-listed business, the valuation multiple is often calculated with reference to comparable listed companies. As a result of the new standard, the comparable company multiples may also change or need to be restated.
This means that in highly valued, high-growth sectors (say technology), adopting IFRS 16 may put further upward pressure on valuations in deals. Conversely, for lower multiples, it would be more likely that any change in enterprise value would be below the change in debt. Thus, a significant downturn in the M&A market leading to lower valuations may in some cases be exacerbated by a net debt deduction in excess of the benefit to enterprise value from a higher EBITDA. When it rains, it pours.
Differences to US GAAP
Under US GAAP, parallel updates to lease accounting standards also bring most leases on to the balance sheet (Topic 842). However, the finance and operating lease distinction has been maintained. Operating leases will continue to be recognised as a single operating expense in the income statement, on a straight-line basis over the lifetime of the lease.
In the equity bridge above, this means that there will be no upward effect on EV (due to increased EBITDA), but net debt will be increased by the lease liability, if it is included in the definition of net debt. Under an EBITDA-based valuation method, practitioners should be aware, therefore, that the lease liability should already have reduced EBITDA under US GAAP, and deducting the lease liability would mean double counting the lease obligation.
Cash flow-based valuations
The position in a discounted cash flow valuation is potentially even more complex. Some valuation practitioners already adjust operating leases to include them on the balance sheet. The effect of IFRS 17 will depend on the extent to which their valuation assumptions are consistent with those required by the standard.
For all others, capitalising the former operating leases will lead to changes in their valuation models to not only free cash flow, but also weighted average cost of capital and gearing. While in theory this should have no effect on value, in reality complex models will likely lead to differences in valuation outcomes.
Further, it is important for M&A practitioners using the cash-flow statement as the primary to source for their cash-flow forecasts to be aware that the repayment of the lease principal will be recorded as a financing cash flow and the payment of the interest element may be recorded as financing, operating or investing cash flows. For example, it is important for M&A practitioners using discounted cash flow (DCF) models to avoid deducting interest from free cash flow when there is also a deduction for lease debt—a potential ‘double dip’.
The accounting changes may expose unpleasant truths about a target entity which, in turn, can affect business decisions. As an example, changes to the accounting treatment for defined benefit pension schemes have purportedly been an important factor in the demise of such schemes in recent years, because companies were forced to disclose shortfalls in scheme funding.
For some entities, IFRS 16 may highlight high levels of leverage. Additional leverage could even result in noncompliance with loan covenants, perhaps triggering indemnity clauses or regulatory capital requirements for companies in the financial sector. Certain profitability ratios, such as return on assets and return on capital employed, will also fall as a result of the additional assets taken on balance sheet. Transactions may be viewed as riskier or less attractive. In an M&A context, this may affect whether a deal happens or not.
The impact is not evenly spread
Some sectors make extensive use of material operating leases; in other sectors, they are far less significant. Further, companies within a sector use different business models (e.g. while operating leases are widely used in the airline industry, some airlines own their own aircraft).
There is also a lengthy transition period. The standard comes into force for accounting periods commencing 1 January 2019 onwards, but early adoption is permitted if the entity has already implemented IFRS 15: Revenue from Contracts with Customers. In theory, entities may have implemented the changes already, whereas other entities may only provide audited figures in early 2020, when they issue an annual report for a year-end 31 December 2019.
Impact on M&A disputes
Many M&A-related disputes originate from ambiguous wording in contracts or judgmental areas of accounting. As with many new accounting standards, IFRS 16 opens the door to both of these causes of disputes.
Ambiguity can originate from agreements that were concluded before IFRS 16 was finalised where the financial statement effects of IFRS 16 were not foreseen. For example, many earn-out clauses agreed several years ago make reference to EBITDA but may not have foreseen the increase of EBITDA from converting lease charges to depreciation and interest. Other earn-outs make reference to net income, and these may be impacted by the frontloading of interest expenses. Further, lease accounting may affect financial covenants in loan agreements. All of this can lead to disagreements.
Similarly, the introduction of IFRS 16 opens judgmental accounting areas. Related disputes are often the result of one party, usually the preparer of financial information, exercising discretion in accounting choices to produce outcomes to benefit itself. Under the new standard, right-of-use assets and accompanying liabilities are valued using a set of assumptions for interest rates, the exercise of options, inflation, future reinstatement costs, residual value guarantee payments, etc. which can have a large impact on the value of asset and liability.
The interest rate used to value the lease liability is the “interest rate implicit in the lease” at its inception date. Where this cannot be established, the lease liability is estimated using the “incremental cost of borrowing” for the lease, which will be the case for many leases. Determining the incremental cost of borrowing—the rate that an entity would borrow to acquire the right-to-use asset (i.e. borrowing secured on that asset reflecting that entity’s credit rating)—s highly judgmental. The nature of net-present-value calculations used to value the liability is such that small changes in the discount rate can have a material impact on the valuation of the liability. In a corporate transaction, increasing the estimated incremental cost of borrowing would reduce net debt and, depending on the deal price mechanism, may increase the value of an entity. This is a potential area of dispute.
Under IFRS 16, the lease term is the non-cancellable period of a lease together with periods covered by options to extend if the lessee is “reasonably certain to exercise that option” and to terminate if the lessee is “reasonably certain not to exercise that option”. Where deal consideration is calculated based on an agreed EBITDA multiple less net debt, the timing for the exercise of such options may be critical. If the lessee (target company) exercises options to extend leases before completion, additional lease liabilities will be created and included within the net debt deduction. However, there will be no offsetting increase in the EV derived from the EBITDA multiple.
There remains an inconsistency between the leasing of physical assets and of intangible assets (licensing). Most intangible assets are not subject to the new standard. For operating leases incorporating both physical assets and intellectual property (IP), the allocation between the two elements is a potentially complex judgmental area. Whether sellers would argue for a higher or lower share for physical assets will depend on the deal price mechanism, the age of the assets, etc. However, the effect could also be material.
The reform of lease accounting will have significant implications for determination of the purchase price in M&A transactions. The impact on each company will vary, and thus the impact on M&A transactions will be deal specific. Practitioners need to ensure they are aware of how the changes will affect the target entity’s accounts, its valuation and the specifics of the completion mechanism in the Sale and Purchase Agreement. It is this intersection of disciplines—the accounting, valuation and pricing mechanism in the contract—where things can go wrong once the new standard is implemented and that could lead to M&A-related disputes.
Another cause of future M&A-related disputes concerns the areas of judgment that the new lease accounting standard introduces. IFRS 16 is a forward-looking valuation of lease liabilities and consequently involves the target entity assessing the probability of exercising break clauses or lease options and the cost of funding. The buyer and seller’s judgment concerning such subjective assessment may differ, potentially resulting in post-acquisition disputes.
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The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions, position or policy of Berkeley Research Group, LLC or its other employees and affiliates.
 IFRS, “IASB shines light on leases by bringing them onto the balance sheet” (13 January 2016), available at: http://www.ifrs.org/news-and-events/2016/01/iasb-shines-light-on-leases-by-bringing-them-onto-the-balance-sheet/
 In the example above, a ‘break-even’ EBITDA multiple (i.e. a multiple that would make equity values identical alternatively using IAS 17 or IFRS 16) is 8.98.