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New accounting rules may hurt cos with long-term leases: CLSA

The lease expense will be split between depreciation and interest expenses, the brokerage said.
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Mumbai: The new accounting standard AS-116, which came into effect from April, is expected to significantly impact financial reporting for companies with long leases such as retail firms, multiplexes and hotels, according to foreign brokerage CLSA. 

The brokerage said retailers and multiplexes typically sign rental deals for nine or 15 years with 15 per cent cost escalation every three years, leading to long-term commitments on these leases. Hotels also lease properties on long terms.

Hotels operate third-party assets on long operating leases known as ‘business conducting arrangements’ and these arrangements are for an initial period of 3-25 years with a minimum lock-in period of 3-13 years with escalation clauses, the brokerage said. CLSA said these are non-cancellable operating lease commitments. 

Rental costs which form 5-17 per cent of revenues of these companies are currently accounted above the operating profit before tax (also called Ebitda or earnings before interest, tax, depreciation and amortisation) line and there is no ancillary impact on the balance sheet. 

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However, the new accounting standard, which has been applicable with effect from April 2019, mandates recognition of a ‘lease liability’ and a corresponding ‘right to use asset’ on the balance sheet, said CLSA. 

The lease expense will be split between depreciation and interest expenses, the brokerage said. 

CLSA said that the escalation built into the agreement would mean there would be a front-loaded pattern of expense for most leases even when they pay constant annual rentals. 

“This is expected to result in ballooning balance sheets, considerable reductions in reported PAT (profit after tax), yet increases in Ebitda, an impact on RoCEs (return on capital employed), and increases in reported gearing,” said CLSA. 

The brokerage said that the new accounting standard will lead to a sharp increase in Ebitda and Ebitda margins, while net profit of the initial years of the lease will be lower. Companies which have longer lease periods will be impacted more, said CLSA. 

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