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New look for leases

The new international accounting standard for leases came into effect at the start of this year. Deloitte’s David Honey and Stephen Maloney explain the changes and the impact on deals.

Though lease accounting might not be the primary reason for a company’s choice of lease, it is certainly a major factor for many in their decision-making. And for accounting periods starting on or after 1 January 2019, the new leasing international accounting standard – IFRS 16 – came into effect. It is mandatory for all IFRS reporters, such as listed companies, but will also need to be adopted by other non-listed IFRS reporters. Among them, numerous private equity-backed businesses and larger privately owned corporates are already applying IFRS, or may be considering it in future.

Under the new standard, a lessee’s binary and sometimes judgemental distinction between operating and finance leases no longer exists.

Instead, almost all leases will be on balance sheet. Only leases of 12 months’ duration or less or leases of low value assets (circa £4,000 or less) will be able to be treated as off-balance sheet with their rental payments simply treated as expenses. On lessees’ balance sheets a potentially significant new liability will be recognised – the discounted value of the committed lease payments over the lease term. The leased asset will also be brought onto the balance sheet. While at lease inception the gross asset and liability recognised will typically be equal, subsequently the liability will exceed the value of the asset, resulting in a reduction in net assets and potentially also distributable reserves.

On the profit and loss, an operating lease under the old standard would have resulted in a straightline operating expense that reduced EBITDA. Under IFRS 16 the expense will be split between interest and depreciation – the former being front-loaded because of the higher outstanding liability at the start of the lease. Given that the operating expense will be replaced by interest and depreciation, there will be an uplift in a company’s EBITDA.

Consequences for acquisitions

The new treatment of operating leases will affect M&A in several ways. First, from a pricing perspective, a traditional EBITDA-multiple-less-net-debt approach to valuing a business will likely generate a significantly different result with the adoption of IFRS 16 – unless the multiple is flexed to reflect the underlying rental cash flows being unaltered.

As a result, while many sellers are presenting results on an IFRS 16 basis (with enhanced EBITDA), many purchasers are still pricing on a pre-IFRS 16 basis. It is expected that such an exercise will become increasingly challenging to perform as the use of IFRS 16 becomes more commonplace. Companies may be unlikely to continue to track their results on the old IAS 17 basis for this purpose. Management bonus schemes and earn-out agreements may also need recalibrating to take account of these changes (if the agreements do not already specify that they are to be calculated on a ‘frozen GAAP’ basis) to avoid unintended outcomes.

Similarly, the new accounting standard may have an impact on the calculation of debt covenants, which may need revisiting with the debt provider (again, if not based on frozen GAAP). Indeed, any potential issues with covenants would ideally have been addressed well ahead of IFRS 16 becoming mandatory. From a UK tax perspective, for leases that would have been classified as off-balance sheet operating leases, deductions are generally anticipated to be obtained for both the depreciation and front-loaded interest expense. This has the potential to accelerate UK tax deductions for such leases.

More flexibility

The impact of the standard on the lease market will only become clear with time. Some lessees may seek to negotiate greater flexibility in their property leases, other lessees may consider becoming owneroccupiers. Asset owners, meanwhile, may now think quite differently about the prospect of entering into sale and leaseback transactions.

Deloitte’s guidance to IFRS 16, the new leasing accounting standard, can be found here.

About the article

Read the full article in the Corporate Financier  March 2019 edition. Access this magazine as well as our extensive archive brought to you by the ICAEW Corporate Finance Faculty.