The following article provides brief and concise information on the relationship between investments and depreciation in perpetual retirement.
IFRS 16 in business valuation
IFRS 16 specifies the requirements for recording, measuring, presenting and disclosing leases in the financial statements of companies that account in accordance with International Financial Reporting Standards (IFRS). The accounting rule of the International Accounting Standards Board (IASB) was published in January 2016 and is mandatory for the first time to fiscal years beginning on or after January 1, 2019.
For the lessee, the successor standard of IAS 17 leases only provides for a single accounting model. For the lessee, this model means that all assets and liabilities arising from lease agreements must be recognized in the balance sheet, unless the term is 12 months or less or it is a low-value asset (in each case optional).
The application of IFRS 16 has a direct impact on valuation issues. The reclassification of (former) operate-lease ratios increases the valuation-relevant free cash flow. At the same time, the capital base is expanded to include the present value of the newly accounted leases and reduces capital costs. However, the deduction capital to get from the total company value to the equity value is increasing.
“Do these three effects cancel out? If so, in which constellation and when can changes in value be expected?”
Effects on the development of the DCF value
The neutrality of this accounting change with regard to equity valuation based on company valuations before and after application of the new standard only exists if operate-lease relationships have already been dealt with in terms of their financial character before the changeover to IFRS 16.
This means that even before the introduction of the IFRS 16 standard, Operate Leasing was regarded as a form of debt financing with contractually fixed cash flows discounted at a debt interest rate.
Rating agencies Standard & Poors and Moody's have been consistently following this approach for decades.
Otherwise, and this is probably the rule of current valuation practice, leasing expenses that were previously discounted at the total cost of capital are now valued at the cost of borrowing. This results in a lower equity value. This effect also applies to 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 01.01.2019.
Especially for companies with significant off-balance leasing, the value effect can be unexpectedly strong. Valuers who attribute this solely to less promising economic prospects for the valuation object should be certain that they have already done their job correctly in terms of financing theory under the old IAS 17 standard.