Why does a result arise under local GAAP – and how is the tax calculated?
Under financial leasing in accordance with local GAAP, a result often arises that may not be immediately intuitive. Why is the result affected even though the lease payment remains the same each month? And how does this relate to deferred tax? In this article, we explain why the difference between depreciation and principal repayment creates a temporary effect – and how the tax on that effect is calculated in practice.
Why does a temporary result arise in a financial lease?
The result arises because, from day one, both a liability and an asset are recognized in equal amounts. The asset is depreciated on a straight-line basis, meaning the depreciation expense is the same each month.
The amortization – that is, the reduction of the liability – varies from month to month because the lease payment is fixed throughout the term of the lease. The payment is calculated using an annuity model, meaning the total amount paid each month remains the same, while the portion allocated to interest and amortization changes over time.
The lease payment consists of an interest portion and an amortization portion. At the beginning of the lease term, the liability is higher than it will be later, which means the interest portion of the lease payment is larger and therefore leaves less room for amortization.
For example, if the lease payment is SEK 5,000 and there is an outstanding liability, the interest portion is applied first, and the remaining amount reduces the liability through amortization. In the following month, a larger portion will have been amortized compared to the previous month, which means the liability is lower. As a result, the interest in the second month is lower, allowing the amortization portion to be higher.
At the beginning of a lease, it is common for depreciation to exceed amortization. This means that the asset decreases slightly faster than the liability. As a result, an equity effect arises, meaning that equity on the debit side reflects the difference between the asset and the liability.
As the lease progresses, the amortization portion increases. This means that the difference between amortization and depreciation gradually decreases, until around the midpoint of the lease term, when amortization begins to exceed depreciation. Equity therefore builds up during the early part of the lease, up to a breakpoint where it instead begins to decline. By the end of the lease term, the difference is normally zero, and no equity remains. This is why the result in a lease is considered temporary.
The Local GAAP adjustment – the difference between depreciation and amortization
For example, if we have a lease that runs for three years and annual lease payments of SEK 100,000, the full SEK 100,000 will affect the result each year, as it represents an expense.
In addition to this, a temporary expense and a temporary result also arise. The so-called Local GAAP adjustment represents the difference between depreciation and amortization. If, for example, the adjustment results in a negative amount of SEK 2,000, this means that in the first year we recognize SEK 100,000 in expenses less SEK 2,000. The result is therefore SEK 98,000. In the following year, SEK 100,000 in lease payments is again recognized as an expense, and the adjustment may then be plus or minus zero. The Local GAAP adjustment is therefore insignificant that year.
In the third year, we again pay SEK 100,000 in lease payments, and the adjustment will then be the opposite. Since the interest portion at that point is small and the amortization portion is larger, amortization will exceed depreciation. As a result, the amount may be positive SEK 2,000.
The negative SEK 2,000 in the first year, zero in the second year, and positive SEK 2,000 in the third year mean that the total adjustment over the three years is zero. The lease payments, however, still amount to SEK 300,000 over the three-year period. The result is therefore temporary.
Deferred tax – how is the tax on the result calculated?
A deferred tax is recognized on the result, meaning that part of the result consists of deferred tax. If, for example, the result amounts to SEK 2,000, it is multiplied by the corporate tax rate. In this example, SEK 2,000 multiplied by 20.6 percent results in tax of SEK 412. The net amount is therefore SEK 1,588, and the tax of SEK 412 is recognized as deferred tax.
Since the tax follows the result, it will reverse to zero when the lease term ends. Both the result and the tax on that result therefore represent temporary differences between the asset and the liability.