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IFRS 16 in business valuation

IFRS 16 sets out the requirements for the recognition, measurement, presentation and disclosure of leases in the annual financial statements of companies that prepare their accounts in accordance with International Financial Reporting Standards (IFRS).

Written by

Peter Schmitz

Published on

TABLE OF CONTENT

IFRS 16 sets out the requirements for the recognition, measurement, presentation and disclosure of leases in the annual financial statements of companies that prepare their accounts in accordance with International Financial Reporting Standards (IFRS). The accounting standard issued by the International Accounting Standards Board (IASB) was published in January 2016 and is mandatory for the first time for financial years beginning on or after January 1, 2019.

The successor standard to IAS 17 Leases only provides a single accounting model for the lessee. For the lessee, this model means that all assets and liabilities from lease agreements must be recognized in the balance sheet, unless the term is 12 months or less or the asset is of low value (optional in each case).

The application of IFRS 16 has a direct impact on measurement issues. The reclassification of (former) operating leases increases the free cash flow relevant to measurement. At the same time, the capital base is broadened by the present value of the newly recognized leases and reduces the cost of capital. However, the deductible capital required to arrive at the equity value from the total enterprise value increases.

Question: Do these three effects cancel each other out? If so, in what constellation and when can changes in value be expected?

Effects on the development of the DCF value

This accounting change is only neutral with regard to the determination of equity value on the basis of business valuations before and after application of the new standard if operating leases were already treated according to their financial nature before the transition to IFRS 16.

This means that operating leases were already considered a form of debt financing with contractually fixed cash flows discounted at a borrowing rate prior to the adoption of IFRS 16.

The rating agencies Standard & Poor's and Moody's have consistently pursued this approach for decades.

Otherwise, and this is probably the rule in common valuation practice, lease expenses that were previously discounted at the total cost of capital are now valued at the cost of debt. This leads to a lower equity value. This effect also occurs for impairment calculations and related issues.

How can pitfalls in IFRS financial statements be avoided?

Auditors, valuers and preparers of IFRS financial statements should be aware of this effect and interpret declines in the value of DCF valuations over time, before and after the introduction of IFRS 16 on January 1, 2019, with caution.

The value effect can be unexpectedly strong, especially for companies with significant off-balance sheet leases. Valuers who attribute this solely to the less promising economic prospects of the valuation object should be sure that they have already carried out their work correctly in terms of financing theory under the old IAS 17 standard.

Wrapping it up

The introduction of IFRS 16 has a significant impact on business valuation, particularly in the context of DCF valuations. The inclusion of leases as liabilities on the balance sheet changes the free cash flow, the capital base and the cost of capital. Valuers must be aware of the methodological and theoretical implications in order to avoid misinterpretations.

FAQs

What is IFRS 16?
How does IFRS 16 affect business valuation?
Why could the equity value decrease as a result of IFRS 16?
What is the difference between operating leases and finance leases in the context of IFRS 16?
How should valuers deal with the transition to IFRS 16?
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