Lease Analysis in Due Diligence: IFRS 16, ASC 842, and Deal Implications
Lease obligations are no longer off-balance sheet. Under IFRS 16 and ASC 842, most leases appear as right-of-use assets and lease liabilities on the balance sheet. This has fundamentally changed how diligence teams analyze leases and how lease obligations affect deal pricing.
For targets with significant real estate, fleet, or equipment lease portfolios, the lease analysis is a material workstream that directly impacts EBITDA, net debt, and the purchase price mechanism.
Impact on EBITDA
The most significant effect of lease accounting changes is on EBITDA. Under the previous standard (IAS 17 / ASC 840), operating lease payments were a single expense line in operating costs. Under IFRS 16 and ASC 842, that expense is replaced by depreciation of the right-of-use asset and interest on the lease liability.
This means EBITDA increases because lease expense is no longer an operating cost above EBITDA. The increase can be substantial. A retailer with $50 million in annual operating lease expense sees EBITDA rise by $50 million under IFRS 16 compared to the previous treatment.
For deal pricing, this creates a comparability challenge. Is the deal being priced on pre-IFRS 16 EBITDA or post-IFRS 16 EBITDA? The multiple applied should be consistent with the EBITDA definition used. The diligence team must present both views and clearly identify the lease-adjusted EBITDA bridge.
This directly connects to the broader EBITDA adjustments framework. Lease adjustments should be shown as a distinct category in the earnings bridge so the buyer and their lenders can assess EBITDA on whichever basis they prefer.
Net Debt Treatment
The SPA must address whether lease liabilities are included in the definition of net debt. Three approaches are common:
Include all lease liabilities in net debt. This is the most conservative approach and is increasingly common. All right-of-use liabilities are deducted from enterprise value alongside financial debt.
Exclude lease liabilities from net debt. The lease portfolio is treated as an operating cost and excluded from the debt adjustment. EBITDA is adjusted to deduct lease payments (reverting to a pre-IFRS 16 basis).
Include selectively. Finance leases are included in net debt; operating leases are excluded. This maintains the pre-IFRS 16 distinction between lease types, which ASC 842 still supports but IFRS 16 does not.
The diligence team should model the purchase price impact under each approach and highlight the interaction between net debt treatment and the EBITDA definition used for pricing.
Lease Portfolio Analysis
A thorough lease analysis covers:
Completeness
Verify that all lease obligations are identified and recorded. Common omissions include:
- Short-term leases (under 12 months) exempted from capitalization
- Low-value asset leases exempted under IFRS 16
- Embedded leases within service contracts
- Leases with related parties, particularly owner-occupied properties
The most frequent issue in middle-market deals is unrecorded related party leases for premises owned by the seller or affiliated entities. These leases may be at non-market terms and may not survive closing.
Key Terms
Document the material terms of significant leases:
- Remaining term and renewal options
- Rent escalation mechanisms (fixed, CPI-linked, market rent reviews)
- Break clauses and termination penalties
- Restoration obligations at lease end
- Change of control provisions that may be triggered by the transaction
Fair Value Assessment
Compare lease terms to current market rates. Favorable leases (below market rent) are an asset. Unfavorable leases (above market rent) are a liability. Both should be quantified because:
- Under acquisition accounting, leases may need to be revalued to market
- Non-market leases with related parties require adjustment to arm's-length terms
- Favorable lease terms represent value that the buyer is acquiring
Occupancy and Utilization
Assess whether the target is using all its leased space and assets:
- Vacant or underutilized properties represent a cost without corresponding revenue
- Subleased space generates income but may face sublease risk if the master lease expires
- Equipment leases for assets that are no longer needed represent committed costs
Working Capital Implications
Lease-related balances that may appear in working capital include:
- Prepaid rent and lease incentive amortization
- Lease-related deposits and guarantees
- Accrued rent for stepped rent arrangements
The diligence team should ensure these items are consistently treated in the net working capital analysis and that the boundary between lease-related balances and operating working capital is clearly defined in the SPA.
Post-Close Considerations
The buyer should understand the lease portfolio they are inheriting:
- Total annual lease cost. The committed cash outflow for lease payments.
- Remaining committed expenditure. The total undiscounted lease payments over the remaining term.
- Flexibility. The ability to exit or renegotiate leases if the business strategy changes.
- Capital expenditure. Leasehold improvement requirements and restoration obligations at lease end.
For carve-out transactions, lease analysis is particularly complex because the target may occupy space within a larger facility leased by the parent. New lease arrangements must be negotiated as part of the separation.
Process Efficiency
Lease analysis requires extracting and normalizing data from lease agreements, lease schedules, and accounting records. For targets with hundreds of leases, this is a data-intensive exercise. Teams that use standardized data extraction processes can import lease data from property management systems and ERP modules efficiently, reducing the time spent on data compilation and increasing the time available for analytical review.