Will changes to financial reporting affect the value of my business?

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By Michael Stewart, Corporate Finance Assistant Manager, Armstrong Watson LLP

The value of your business could be significantly impacted as a result of proposed changes to accounting standards.

Several amendments were suggested following the latest review of the financial reporting standard applicable in the UK and the Republic of Ireland (known as FRS 102). The standard applies to the financial statements of companies and other types of entities that prepare accounts under UK GAAP (Generally Accepted Accounting Standards).

The proposed amendments, suggested in Financial Reporting Exposure Draft 82, are not yet final and the treatment of the suggested changes, in a valuation context, are yet to be confirmed, however, there are several key areas you should be aware of if you are selling your business and these changes are implemented. 

Two key changes have been proposed - the introduction of a new model of revenue recognition and a new procedure regarding accounting for leases.  

How might these amendments impact the value of your business?

1. Changes to Revenue Recognition

The revenue recognition changes are likely to have little impact on your business valuation, with the only consideration being a potential decrease in maintainable EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation), a benchmark used to measure a company’s performance and valuation. This would occur as a result of decreased revenue, as a result of revenue no longer being recognised over time - as it is currently - and instead only recognised after some contracts are completed. However, a review of your business engagement letters could limit the potential impact of this.

2. Changes to Lease Accounting

Proposed changes to lease accounting could have large repercussions on the technical value of a business.

Firstly, the change from the current treatment of operating lease costs for items - such as rent being recognised as rental costs in the profit and loss account - to the suggested treatment of rental costs being recognised as depreciation, will greatly increase a company’s EBITDA. This would be as a result of the newly recognised depreciation costs being added back as the ‘D’ part of the EBITDA adjustment, whereas currently, they are included within administrative expenses and therefore not added back to the profit. This means under the typical technical methods of valuing a business, when we apply a multiple to a maintainable EBITDA, the resulting value of the business will be greater than under current lease accounting rules.

Secondly, the change to the whole of the lease being brought onto the balance sheet at the start of the contract, instead of being recognised as an expense on a straight-line basis over the life of the lease, will mean that when making a technical ‘cash free debt free’ adjustment to get to the equity value of the business, the debt reduced from the value will be much higher than under the current lease accounting rules, decreasing the final equity value of the business.

How can advisers ensure valuations remain consistent?

In reality, your business’s value should not change following the implementation of FRS changes – it should be worth the same value – but as the proposed amendments change some of the treatments to financial statements, valuation methods may need to be adjusted to keep consistency with how the market currently operates to ensure valuations remain consistent. For example, advisers could: 

• ignore the depreciation adjustments relating to what were previously operating lease items to get to a maintainable EBITDA that reflects the current standards
• lower multiples to counteract the increase in maintainable EBITDA
• include the right of use of an asset, which is introduced to the assets part of adding the lease into the accounts; as a cash-like item to contra off against the increase in debt from the leases being brought into the balance sheet
• include the lease as a non-adjusting item and exclude from the debt in the Enterprise to Equity Value adjustments
• do nothing, as the lease accounting adjustment increases the Enterprise Value but decreases the Equity Value, these both offset each other in turn so that no further adjustments are required from advisers.

Until the changes are confirmed, the impact on the valuation of a business is as yet unknown, however, this does provide food for thought, as should the proposed changes be introduced and no adjustments made to the method of the valuation, incorrect values could then be paid or received as a result.

With so many considerations, it is essential for those looking to buy or sell a business to engage with an adviser who fully understands the implications and options, and can potentially use that knowledge to your advantage.