Lease accounting: A surprising deal-breaker in M&A transactions

Back in 2019, IFRS 16 Leases introduced significant changes to how businesses record leases. Rather than recognising operating leases solely as expenses, companies are now required to capitalise these leases as a right-of-use (ROU) asset with a corresponding lease liability on the balance sheet. This change was intended to increase transparency around operating leases, which were historically kept off the books.

Despite being in force for six years, IFRS 16 continues to complicate M&A transactions, particularly when one party reports under IFRS and the other does not. Many non-IFRS reporting entities follow Special Purpose Financial Reporting for For-Profit Entities (SPFR), which still allows leases to be expensed as rental costs.

This accounting difference often leads to misaligned value expectations between buyers and sellers. While IFRS 16 increases earnings before interest, taxes, depreciation and amortisation (EBITDA), equity value does not fundamentally change if the accounting standard is applied. The impact on M&A transactions is more pronounced in “cash-free, debt-free” asset acquisitions than in share purchase transactions.

Key financial due diligence considerations

Normalised earnings and valuation impact

IFRS 16 removes lease expenses from the profit and loss statement and replaces them with depreciation and interest, inflating EBITDA. Since businesses are often valued based on EBITDA using market multiples, it’s critical that earnings are normalised to reflect the actual economic impact of lease costs:

IFRS 16 seller, non-IFRS buyer

If the target reports under IFRS 16 and the buyer does not, lease expenses should be deducted from EBITDA when assessing value. If left unadjusted, EBITDA is overstated by the annual lease costs, and the resulting enterprise value (EV) is further amplified due to the earnings multiple. This mismatch, if discovered during due diligence, can cause deals to fall over.

A savvy buy-side advisor should raise this early. If the deal is priced using an inflated EBITDA and a pre-agreed multiple, the buyer may overpay, especially in an asset purchase where lease liabilities are not adjusted. If the seller is unaware of this impact, recalibrating their price expectations can be difficult, particularly if they have already earmarked the proceeds for future plans. 

Even if the parties agree to the same EV, the buyer must accept a higher EV/EBITDA multiple, which may make the deal unattractive, especially if the multiple exceeds the buyer’s own trading multiple (in the case of listed companies). The internal investment committee may not approve non-value-accretive deals. 

SPFR seller, IFRS buyer

If the target reports under SPFR and the buyer follows IFRS, a buyer's initial non–binding indicative offer may appear unattractive if it is based on EV/EBITDA multiples from comparable IFRS reporting companies. Without normalising for lease costs, the implied EV/EBITDA multiples appear lower under IFRS 16, and the buyer could miss out on quality targets due to mispricing.

Net debt and purchase price adjustments

Under IFRS 16, lease liabilities are recorded as debt, influencing several valuation elements:

• Net debt calculations should include lease liabilities to ensure EV is assessed appropriately.
• Purchase price adjustments must account for lease obligations, particularly when in cash-free, debt-free transactions.
• A clear distinction should be made between financial debt and lease obligations to avoid misstatements in EV. IFRS 16 lease liabilities must be carefully considered when identifying debt-like items in the purchase price adjustment and working capital mechanisms.

Discount rates and lease terms

​Determining the appropriate discount rate and lease term under IFRS 16, especially when leases include options to extend or terminate, involves careful consideration and judgment. Under IFRS 16, lessees measure lease liabilities by discounting lease payments using either:​ 

• Interest Rate Implicit in the Lease (IRIL): This is the rate that causes the present value of lease payments and the unguaranteed residual value to equal the sum of the fair value of the underlying asset and any initial direct costs of the lessor. ​or
• Lessee’s Incremental Borrowing Rate (IBR): If the IRIL cannot be readily determined, the lessee uses its IBR, defined as the rate a lessee would pay to borrow funds over a similar term, with similar security, to obtain an asset of similar value in a similar economic environment. ​

Determining the IRIL can be challenging, especially for property leases, due to limited information about the fair value of the underlying asset, expected residual value, and lessor's initial direct costs. In such cases, lessees often default to using their IBR. IBR also requires significant judgement and can be complex depending on the asset quality and the company’s circumstances. 

For meaningful comparisons, parties generally prefer to assess values on pre-IFRS 16 basis.

Best Practices for M&A Professionals

To mitigate IFRS 16 related risks in M&A transactions:

• Buyers should clarify lease accounting methods early and discuss any potential value impacts with the seller as soon as practicable.
• Sellers should consult their financial advisor and consider normalised EBITDA on a pre-IFRS 16 basis to avoid mispricing.
• Both parties should align net debt calculations to ensure lease liabilities are correctly adjusted in EV and purchase price calculations.

Conclusion 

IFRS 16 continues to have a material impact on deal success and financial due diligence, particularly in lease-heavy industries and cross-framework transactions. Diligent adjustments to EBITDA, net debt, and working capital calculations may be required to ensure parties are on the same page when transacting. 

At Baker Tilly Staples Rodway, we specialise in insights-driven financial due diligence and deal advisory. Our team of experts can advise you on effective IFRS 16 adjustments to promote fairness and mitigate risks in M&A transactions. 

The above is intended to be used as general background information and should not be relied upon without taking advice specific to your business circumstances. Contact our M&A team to discuss how we can help navigate accounting standard considerations in your next transaction.