I. Introduction
The past practice according to IAS 17 towards leasing contracts was based on an off-balance and principle-of-economic-property perspective. Depending on the chances and risks linked to the leased item, the respective contract was classified as either a finance lease or an operating lease and displayed in the profit and loss statement. Due to the discretionary scope - concerning the different allocation of opportunities and risks for the lessee and the lessor - which results from the standard, this approach has been subject to criticism for a long time. So it was the case that similar issues were treated in a completely different way.

In January 2016, the IASB issued IFRS 16 - the new lease standard – which applies to annual reporting periods beginning on or after 1 January 2019.

The new lease model has been developed on the basis of a simple lease contract which meets the criteria of an asset respectively of a liability. Consequently, the new standard introduced a comprehensive and consistent on-balance-sheet right-of-use approach and abolished the past practice according to IAS 17.

Against this background, this newsletter would examine whether and how the business value of a non-listed company changes, if the on-balance-sheet assets and liabilities of lease contracts are included into the valuation calculus. The ignorance of operating leases in the valuation calculus can often be observed in practice, although in parts of the valuation literature there is a demand for the consideration of operating leases in the business valuation, if the lease is from material significance.

II. Lease accounting according to IFRS 16
IFRS 16 is constructed as an on-balance-sheet right-of-use approach. Yet the accounting models of lessees and lessors differ. For the lessee, the distinction between operating and finance leases has been abolished. Instead he has to recognize a right-of-use asset, which is an asset that represents the lessee’s right to use an underlying asset for the lease term, as well as a lease liability, as the present value of the lease payments that are not paid at that date. Hence nearly all leases need to be recognized.

The lessor still has to make an appropriate differentiation between an operating and a finance lease. In the case of an operating lease, the lessor has to recognize the lease payments as income and the underlying asset, which is subject to the lease arrangement, on the balance sheet. For finance leases, the lessor has to recognize assets held under a finance lease in his statement of financial position as a receivable, amounting to the net investment in the lease.

III. Implication on Business Valuation
Prima facie, the changed accounting method of leases might have no impact on business valuation, as neither the cash flow of the company, nor the existing contract, nor the actual tax burden change. Nevertheless, the change rather impacts the annual result as well as – and this is probably the most important factor – the financial debt structure.

Furthermore, based on the assumption that changes of an accounting principle should have no influence on a business value - as there is no change in the economic reality of the company - it is questionable whether the new right-of-use approach really has an actual effect on the valuation.

Although the literature has already demanded to consider leases of material significance in the determination of the financial leverage in the past, in practice so far this was hardly the case. Reasons for this might be missing information of the Valuation Analyst, for reasons of simplicity or an insufficient sensitization.

However, the influence is obvious. The risk of the company to be valued is expressed in the cost of capital which includes the beta-factor. This not only considers the market specific risk but also the individual company specific financial risk. The company specific financial risk results from the market value of debt. Consequently, it makes a difference whether the market value of the liabilities includes those from leasing or not.

Due to the fact that various leasing liabilities have not occurred in the balance sheet so far, they have not been taken into account concerning the debt structure. This resulted in a lower beta-factor and accordingly in lower costs of capital. In the end this leads to a higher company value.

If the leasing liabilities are now taken into account, the (arithmetical) enterprise values will decrease when compared to the previous procedure. This is reinforced by the fact that the gearing ratio is influenced especially by the higher net debt.

IV. Conclusion
Even if this cannot be explained from an economic point of view, we expect the new lease accounting to have an impact on (arithmetical) company values, namely a decrease. For companies with a high number of leased assets, it should therefore be assessed whether and how high this effect exactly is.

If there are any aspects which we may assist, please do not hesitate to contact:

Partner of ShineWing DORNBACH- Dr. Thomas Tesche
ttesche@dornbach.de (Tel. +49 (0) 681 8 91 97 - 31)

Partner of ShineWing DORNBACH - Prof. Christoph Hell
chell@dornbach.de (Tel. +49 (0) 681 8 91 97 - 19)

Partner of Advisory Services- Mr. Kevin Lam
Kevin.lam@shinewing.hk (Tel. 3583 8000)