What actually drives the result under IFRS 16? That is precisely the question IFRS 16 expert Richard Nilsson answers in this article. He explains how the liability and the asset develop over the contract period, why the difference between them becomes the so-called IFRS adjustment, and uses concrete examples to show how this impacts both the income statement and the balance sheet.
Through the calculation, an acquisition value is established, which represents the amount recognized at the start of the contract, both as an asset and as a liability. The liability is gradually amortized, while the asset is depreciated over the contract term. The asset is allocated over the depreciation period, with the same amount expensed each period. This means the asset decreases by an equal amount – period by period or month by month.
– The liability, however, is a bit more complex. A lease payment consists of both an interest portion and an amortization portion. At the beginning of a contract, the liability is at it's highest, which means a larger share of the lease payment is interest. As the liability decreases, the interest expense also decreases, says Richard Nilsson, IFRS 16 expert.
The amortization portion is what remains of the lease payment after the interest expense has been deducted. This means that amortization starts at a lower level but gradually increases as the liability decreases.
– The IFRS adjustment is simply the difference between what is depreciated and what is amortized during a given period. At the beginning of a lease term, the depreciation is higher than the amortization, but around the midpoint of the agreement, this reverses, and the amortization becomes higher than the depreciation. The difference between these two figures continuously constitutes the IFRS adjustment, explains Richard, and continues:
– Over time, the total of all results equals zero. However, during the term of the lease, there is a difference — and that difference is recognized as ‘profit or loss’ in the income statement, and as ‘retained earnings’ or ‘equity’ on the balance sheet. On this amount, a deferred tax is calculated as: result × – corporate tax rate.
For example, a profit of SEK 10,000 would generate a deferred tax of 10,000 × –20.6% = 2,060. The income statement would then show a post-tax profit of 7,940, with a deferred tax of 2,060 SEK.
– On the balance sheet, the asset is recorded on the debit side and the liability on the credit side. Since these decrease at different rates, the difference between them represents equity. In most cases, the asset is depreciated slightly faster than the liability is amortized. This means the asset value will be somewhat lower than the liability, Richard explains.
He continues:
– The asset on the debit side therefore becomes slightly smaller than the liability on the credit side, and as a result, the profit at the beginning of the lease term appears on the debit side. From the midpoint of the agreement onward, the profit instead appears on the credit side, as the liability decreases more than the remaining asset. By the end of the lease term, there is no remaining asset or liability, and the final year’s result means that the equity side of the balance sheet shows equal amounts on the debit and credit sides – they offset each other, leaving the total balance at zero.