A change in accounting norms–visible in results from the current quarter–may result in significant changes to the way debt, profits, and key financial ratios are calculated.
The impact could affect already indebted sectors such as telecom, and could necessitate changes to covenants surrounding their agreements with lenders. The accounting of liabilities in the June quarter could result in significant volatility in the results season, which would be the first one where the effect of the new accounting norms come into effect.
The new accounting standard, IndAS 116, effectively requires companies to treat the obligation to meet long-standing operational expenses, like rentals for heavy machinery in the infrastructure segment or aircraft in the aviation segment, as debt liabilities.
Pradeep Suresh, partner at tax firm BDO India, said that the move is a bid to improve transparency. But it also has the effect of increasing debt shown on the books of these companies, since all such contracts involving periodic payouts against a future liability will be treated as such.
“Telecom companies have towers based on operating leases, which will translate into large borrowings on the balance sheet. Airline and retail companies, which have similar expenses, would be impacted. Infrastructure companies, which use heavy equipment on lease, would also be affected. If you’re a lessee, and your lease contract is denominated in another currency, the lease liability will get re-stated on a quarterly basis. The fluctuations can be substantial unless the liability is hedged,” said Suresh.
Aashish Gupta, director, Grant Thornton India LLP, said companies that have significant operating leases, particularly in the aviation, logistics, shipping sectors, where payments are staggered over periods exceeding one year, would be especially affected. The present value of all the contractual future lease payments would be considered for calculating the total liability on the balance sheet. Where payments are in foreign currency, the setting up of such liabilities could significantly increase the volatility in the profit and loss account.
“For companies where the present value of lease payments is for instance $1 billion, a single rupee change in the exchange rate could result in a Rs 100 crore change to the bottom line,” Gupta said.
An analysis of recent studies shows that the increase in total debt for the aviation segment is in excess of 100 per cent. Changes in debt/equity ratio, a measure of how indebted a company is, are also in double digits for key sectors. Additionally, earnings before interest, tax, depreciation, and amortization show an increase because expenses are lower.
Both lenders and companies in already indebted companies may have to navigate the effect on their agreements.
Sandip Khetan, partner and national leader, financial accounting advisory services, EY India, said companies should ordinarily engage with lenders in advance of the adoption of the new standard and update them about the impact on the balance sheet and financial ratios. Once the bank has understood and reviewed the proposed changes, they should be able to appreciate the same and agree to the amendment to the existing debt covenant arrangements.
“If the same is not agreed to by the bank, the company needs to ensure it is in compliance with the existing debt covenants. Otherwise this may trigger default on the debt covenant, which needs to be managed sensitively in the current environment,” said Khetan.