Do business valuers need to reduce their profit forecasts due to an IFRS 16 ‘headwind’?

BVWire–UKIssue #8-1
November 5, 2019

appraisal standards and regulations
IFRS, accounting, lease

IFRS 16, now in effect, has been called many things, and an excellent new analysis by The Footnotes Analyst supports a new conclusion: Lease-heavy companies may increasingly see their profits suffer as they comply, particularly if lease liabilities are inflation-linked. Business valuers may need to consider this new factor if they’re doing a DCF analysis for enterprises with significant long-term leases.

‘Capitalised lease liabilities of an inflation-linked lease do not include expected inflation,’ the author states. ‘This [may] result in a lower liability and lower initial expense compared with an equivalent lease with no inflation link.’

In Beware the IFRS 16 Inflation Headwind, the 28 October post examines Tesco—an obvious case study as a large listed enterprise with extensive long-term (averaging 30 years, in some cases) right-of-use liabilities—in an industry with compressed margins. The conclusion should catch the attention of any analyst looking at investment opportunities or enterprise values:

We estimate that Tesco’s inflation-linked leases result in a pre-tax profit headwind of about 2.2 percentage points of growth. If inflation were included in the measurement of the lease liability instead, we estimate it would increase from the reported £10.3bn to approximately £15.2bn.

Under both IFRS 16 and US GAAP, lease liabilities and right-of-use assets are now remeasured each period. For Tesco and many other businesses with leases that are adjusted for changes in the inflation index, ‘remeasuring the liability increases the carrying value of the right of use asset, producing a rising depreciation expense and an operating profit headwind.’

BVWire—UK highly recommends this 28 October analysis. While the effect on future profits as reported under IFRS and GAAP may not always be as dramatic as depicted here, the authors also point out ‘it is unusual to exclude inflation from liability measurement in financial reporting. Other liabilities, such as pension obligations or environmental liabilities, must include the effects of inflation, either explicitly in the forecast cash flows, or by applying a real discount rate to the cashflows excluding inflation.’ So the business valuation impact of IFRS 16 has few comparable models for analysts to follow.

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