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An important new consideration in company valuations

By Ensors Team
13th Nov 2019

Keeping up to date – Leases and Company valuations

If you are dealing with a matter which requires a business valuation it is important to ensure your expert is up to date with the latest accounting standards.

Company valuations are likely to be impacted by the introduction of IFRS 16 (Leases) which is an accounting standard applicable to accounting periods starting on or after 1 January 2019 – i.e. we are now approaching the time where we are likely to start to see financial statements prepared using the new standard.

The new standard applies to companies applying international financial reporting standards (IFRS) and companies applying UK GAAP if they have converted to IFRS or the FRS 101 Reduced Disclosure Framework rather than FRS 102.

The impact of the standard

Under IFRS16 all leases, regardless of the previous classification between Operating or Finance leases, will be treated in a similar way to Finance leases. This is likely to have the most significant impact on companies using operating leases as off-balance sheet financing.  Companies utilising short term property leases (i.e. shops and cafes) or using significant assets under operating leases (i.e. companies in the transportation sector) are expected to see the greatest impact.

Companies will need to recognise an asset for the right to use the leased assets and they will also need to recognise a liability for the lease payments.  This will increase both assets and liabilities on the company balance sheet and it can significantly affect the presentation of the expenditure in the profit and loss account as well as altering the recorded profit.

The impact on the P&L will result in lease payments no longer being shown within operating profits, interest costs will be increased, and depreciation charges will be increased on the higher asset base.  This will impact on the values reported in cash flow statements as well as earnings metrics; such as the earnings before interest, tax, depreciation and amortisation (EBITDA).

The impact on valuations

It is likely that the changes outlined above will result in an increased EBITDA.  EBITDA values from historical periods may therefore not be directly comparable to the new IFRS16 values.  This will also impact on the multiples applicable to the business and once the enterprise value (debt free / cash free value of the trade) has been established the equity adjustments required to calculate the equity value will also need further detailed consideration.

Whilst it is arguable a change in accounting treatment should not impact on the underlying value of a business it must be remembered that these changes can impact on the profitability in each year (e.g. higher costs recognised at the start of a lease) and a change in presentation may impact on the opinions of some readers of the financial statements. Significantly increased liabilities may raise concern to funders and impact on some analysis ratios and increased interest costs are likely to impact on banking covenants.

One thing for certain is that the valuation should not be impacted because the valuer has overlooked the change in accounting treatment and they need to address the changes no matter what basis of valuation is appropriate for the company in question.

This blog has been drafted to make readers aware that the new standard, IFRS16, will impact on valuation methodology.  If you would like further guidance on how valuation methodology will be impacted in relation to a specific business, please contact the Ensors Corporate Finance and Forensic accounting team.