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CINA (Certificate in International Accounting)

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1 (Certificate in International Accounting) Debt Issue 1st half-year 2016 Foreword by the lecturer / learning hints This lesson unit deals with important items of the debt capital of a company, including liabilities and provisions. In a first step, we will differentiate between the types of debt that exist under IFRS and US GAAP. In the area of ​​provisions, there are numerous differences in terms of approach and valuation compared to the HGB. In the case of pension provisions, the assumptions and methods on which the valuation is based are the focus, while in the case of other provisions, the focus is on the delimitation from other liability items, the recognition criteria and the question of correct valuation. Among other things, we will deal with the provision of individual items in accordance with IFRS. In terms of liabilities, there are comparatively minor differences to the HGB. Differences can arise with questions about possible discounting and the consideration of discounts. Finally, prepaid expenses are dealt with. Contents 1. Delimitation of debts Approach of provisions Valuation of provisions Important individual provisions Pension provisions Liabilities Accruals and deferrals Former exam questions Solutions to lesson No Outlook for lesson No Differentiation of debts The IFRS differentiate between the following types of debts (debts in other words): Debts i.e.s. (liabilities), accruals, provisions (provisions), and contingent liabilities. For the delimitation of the above debts, it depends on the degree of certainty with which the claim and / or the amount of the future obligation can be determined: debts i.e.s. exist if the time of the claim and the amount of the obligation can be determined with sufficient certainty. Deferred debts represent debts for which the time of utilization and / or the amount cannot be determined with certainty, but can be determined with a high degree of certainty (see IAS 37.11b). This includes e.g. future expenses from outstanding invoices, vacations not yet taken by employees, etc. Even if estimates are occasionally required to determine their amount or when it occurs, the uncertainty with accrued debts is lower than with provisions. 1

2 Deferred debts are usually to be shown under trade payables or under other liabilities (see IAS 37.11). Since accrued liabilities are more of a liability than provisions, the provisions of IAS 39 may also apply here (see IAS 37.2). In line with Section 249 (1) of the German Commercial Code (HGB), provisions are debts whose due date and / or amount is uncertain (see IAS 37.10). Due to their uncertainty, both the recognition and measurement of the provisions can depend to a large extent on expectations and estimates. The uncertainty about the due date or the amount of the debts is the criterion for delimiting the provisions to the accrued debts and the debts i.e.s. Unlike debts, i.e. accrued debts and provisions, contingent debts are generally not recognized as a liability, but merely trigger disclosure requirements in the notes. IAS 37 links the definition of contingent liabilities to the recognition criteria for provisions (see IAS 37.10). In the following, we will therefore first explain the recognition criteria for provisions before we return to contingent liabilities. Overview of delineation of debts According to US-GAAP, a distinction must be made between debts i.e., accruals for loss contingencies and contingent debts (see ASC). Accrued liabilities are not explicitly listed under US GAAP. 2

3 2. Approach of provisions Approach (whether at all) and valuation (how high) of provisions are two strictly separate steps, even under IFRS and US-GAAP. Recognition criteria According to IFRS and US-GAAP, the recognition criteria for provisions are linked to the general definition and recognition criteria for liabilities (see Tutorial No. 2, Section 2.). According to IFRS (see IAS 37.14) and US-GAAP, a provision is to be recognized if a current (legal or constructive) obligation arises from a past event, the fulfillment of the obligation is probable through the outflow of resources with economic benefit, and a reliable estimate of the amount of the obligation is possible. Legal or factual obligation According to IFRS and US-GAAP, provisions require the existence of an external obligation. Pure expense provisions, i.e. internal obligations - as they were still permissible before the BilMoG in the HGB, the international standards do not know. Provisions i.s.d. 249 para. 1 sentence 2 HGB for neglected maintenance that is made up within three months of the following year is not permitted under IFRS and US-GAAP (see also below for more details). The external obligation must be either a legal or a factual obligation. While a legal obligation requires a contract, a law or other public law regulation, order, notification, etc., a factual obligation according to IAS only exists if the definition criteria mentioned there are met. Current obligation as a result of a past event A current obligation as a result of a past event only exists if the reporting party has no realistic alternative to evade the obligation. By definition, this inalienability always exists if the fulfillment of an obligation can be legally (contractually or legally) enforced (legal obligation) (see IAS 37.17 (a)) or if other parties have a justified expectation that the company will Will fulfill the obligation (constructive obligation) (see IAS 37.17 (b)). If, for example, a company offers guarantees on a goodwill basis within the scope of its usual business conduct without any legal obligation, provisions must be set up for this because there are corresponding expectations on the part of customers, the non-fulfillment of which would be associated with economic disadvantages, and insofar as a fulfillment of this factual obligation is assumed can. However, the inalienability due to a past event can no longer be assumed if future expenses are offset by future income, i.e. if the company only accepts future expenses in order to maintain future business activities (see IAS 37.19f.) . As a result of a change in the law, your company is obliged to install smoke filters in all factories by June 30, 2005. If the smoke filter has not been installed by this time, there is a risk of a fine. On December 31, 2004, it is assumed that you have not yet installed the smoke filter. Does IFRS require a provision to be recognized? 3rd

4 No, because according to IAS 37 the company can still evade the obligation as of December 31, 04: Since your company can avoid these expenses through its future activities, e.g. by changing the production process, there is no present obligation for future expenses under IAS. Ultimately, your company will only install the smoke filters in order to be able to continue generating sales with the factories. On June 30, 2005, the smoke filters are still assumed to have not been installed. At the latest now, a provision should be recognized according to IFRS or US-GAAP, right? Not for failing to install smoke filters: Your company is undisputedly legally obliged to have smoke filters installed, but the company can evade this obligation. The approach of a provision for the impending fine is to be assessed differently: If you have not yet installed a smoke filter by June 30, 2005, you can probably no longer evade the fine unless you can prove that the competent authority is sleeping and thus an approach based on the probability criterion fails. Probability As a central criterion, the recognition of a provision under IFRS presupposes that the claim from the current obligation is probable. According to IAS, this is the case if there is more to be said for than against the outflow of resources. If the probability of occurrence is more than 50%, the provision must be set up. If the expected probability of the outflow of benefits is 50% or less, then no provision may be recognized. In this case, however, the company may have to indicate a contingent liability in the notes. There is clearly no right to vote here! An excessive formation of provisions, driven by the German principle of prudence, is explicitly rejected under IFRS and US-GAAP. The IASB framework in marginal 37 is already clear here: a cautious approach does not, for example, permit the creation of hidden reserves or overestimate provisions or the deliberately excessive recognition of debts or expenses, since the financial statements would then not meet the reliability criterion. As a result, the creation of provisions should not be cautious, but rather neutrally. This is often one of the main intellectual hurdles when converting to IFRS: Provisions as a reserve for bad times, which every good businessman likes to create, are then at least theoretically, the practice often looks different according to IFRS. Reliable estimate The recognition criterion of the reliable estimate of the amount of the obligation is specified by the IASB in IAS 37.25f. generally regarded as almost always met. In practice, however, there are definitely other cases, as you will see in the attendance week. US-GAAP US-GAAP basically uses the same methodological approach as under IFRS. Often, however, literature and practice call for a higher probability threshold of more than 70-80% for the provision approach. Delimitation of contingent liabilities and provisions The delimitation of provisions from contingent liabilities is of particular importance, since a provision according to IFRS (with the exception of future demolition, clearance and dismantling obligations, see Letter No. is to be recognized in profit or loss and thus reduces the result, while contingent liabilities 4

5 i.d.r. only trigger certain disclosure requirements. If a company closes the financial year with a profit, it may aim to recognize a provision; Conversely, in the case of an expected loss, the obligation to disclose in connection with the contingent liabilities may be preferred to a (further) reduction in profit by recognizing a provision. According to IAS 37.13 (b), there is a contingent liability in distinction to provisions: If there is only a possible (instead of current) obligation because the occurrence of the obligation depends on future events that are not fully under the control of the company, e.g. possible obligations from litigation risk or from granted debtor warrants, or if there is a current obligation but the condition of a probable occurrence on the balance sheet date is not met, or if there is a current obligation but the amount of the obligation cannot be reliably determined. In connection with contingent liabilities, according to IAS, the accounting company must present the underlying facts and make an estimate of the financial impact in the notes. The investor is thus informed about the facts and can, depending on his own risk appetite, include the possible burden in the assessment or not. Legal disputes The Linde Group or one of its group companies is involved in ongoing or foreseeable court or arbitration proceedings in the normal course of business. In 2010, the Brazilian competition authority CADE imposed bus fines on a number of large gas companies, including Linde's Brazilian subsidiary, for alleged antitrust violations between 1998 and 2004. The Linde Group accounts for around BRL 188 million. Based on the current rate on the reporting date, this corresponds to approx. EUR 60 million. From today's perspective, Linde assumes that this decision will not stand up to judicial review. In addition, Linde is involved in ongoing or foreseeable court or arbitration proceedings in which the likelihood of a claim is unlikely or the impact on the economic situation of the Linde Group will be negligible. For all other proceedings in which Linde is involved, appropriate provisions have been made for any financial burdens at the respective Group company. (Source: Annual Report 2014 of LINDE AG, p. 243, Appendix under Item [38] Contingent liabilities and other financial obligations) If the probability of a burden is so low that its occurrence can be viewed as remote, there is no accounting further information is required in the appendix. There are no clear percentage limits for this. Scope for design when accounting for provisions and contingent liabilities It should not be overlooked that the accounting party has room for maneuver when assessing a provision in contrast to contingent liabilities: Does a company estimate the likelihood of claims arising from a legal dispute, e.g. greater than 50%, a provision must be made. However, if the probability is only 50%, expressed in an exaggerated manner, it is a contingent liability that must be reported. In most legal disputes, even an experienced lawyer will not want to reliably judge the value of the probability in a possible interval of e.g. 40% to 60% assumes. With appropriate representation and loading 5

In a 40/60 scenario, it should be possible to justify both the formation of a provision and the waiver of it. In individual cases, accounting companies are forced to make use of existing discretion: For the purpose of delisting, the remaining minority shareholders were forced out of the company in return for cash compensation (so-called squeeze out). Some of the minority shareholders considered the cash compensation to be inappropriately low in relation to the company value and initiated a judicial review of the amount of the compensation. The arbitration proceedings had not yet been completed on the balance sheet date. If the company wanted to set up a provision for impending additional payments from the arbitration proceedings on the balance sheet date, this would amount to an admission of debt to the court and the suing minority shareholders (cf.). The accounting for provisions can therefore also be viewed as a typical example of factual leeway under IFRS. Accounting law modernization law (BilMoG) With the accounting law modernization law, expense provisions and maintenance provisions for maintenance that are carried out within 3 to 12 months after the balance sheet date have been abolished. A passivation ban now applies to these. However, maintenance provisions for maintenance that are carried out within 3 months of the balance sheet date are still to be recognized. For reasons of tax neutrality, these are still subject to a passivation requirement. Further changes arose in the context of the valuation (253 (1) sentence 2 HGB): 1) Liabilities are to be recognized at their settlement amount (instead of the previous amount to be repaid). This change should clarify that not only obligations in cash, but also obligations in kind and in kind are covered by 253 (1) sentence 2 HGB. Nothing has changed in terms of content: payment obligations are (still) to be valued at the repayment amount, payments in kind or obligations in kind at the monetary amount expected to be expended at the time of performance. 2) When valuing provisions, expected price and cost increases must be taken into account (restriction of the reference date principle). 3) Provisions with a term> 1 year must be discounted. 3. Valuation of provisions The simplest case of valuation is when the amount of the provision can be measured with certainty to a large extent. This applies e.g. for demolition or for decontamination obligations, if these are based on an expert opinion. The calculation of vacation accruals is not an example, as these are usually based on IFRS and US-GAAP. are not to be subsumed under provisions, but under (deferred) liabilities (see Section 1.). The other extreme is also easy from the accounting perspective; namely when an estimate is not at all reliably possible for special reasons. In this case, it is a contingent liability for which, among other things, a comprehensive description of the underlying facts is required in the appendix (see section 2.). 6th

7 A classic example from practice: You work for a software company that is accused by the antitrust authorities of violating essential competition laws. The company is expected to be broken up. Although this results in considerable expenses and is extremely likely to occur, no amounts can be sensibly estimated. It is not possible to set up a provision.In most practical cases, there will be some degree of uncertainty about the level of future exposure. The international standards then provide for the following procedure: In the case of a large number of individual items, the uncertainty about the amount, both under IFRS and US GAAP, must be resolved by calculating an expected value. Historical experience or comparative values ​​from similar cases are used here. If such values ​​are not available, there may be an obligation that cannot be reliably determined (see IAS 37.39). Your company sells cell phones. The legal guarantee of 2 years applies to the cell phones sold. You must set up a provision for the cell phones sold during the reporting period for the expected warranty costs. However, a separate provision is not to be made for every cell phone sold, but rather a provision for all cell phones sold on the basis of empirical values. For example, if experience has shown that 5% of the cell phones sold have to be reworked, for which an average cost of 10 arises and cell phones have been sold, a provision of x 5% x 10 = must be created. If there are several possible individual values ​​that have a different probability of occurrence, the most likely value for the provision must be selected in accordance with IFRS and US GAAP. This is the individual value that has the highest probability of occurrence (see IAS 37.40). An employee of your company was laid off after four years of employment and is suing for severance pay. According to established German case law before labor courts, the employee is entitled to a severance payment equal to half of the length of service in years, expressed in monthly salaries (i.e. two monthly salaries). The employee demands an annual salary; the company has not yet offered any severance pay. The maximum risk is therefore an annual severance payment, the minimum risk no severance payment. On the basis of established case law, however, an amount of two months' salary is the most likely. This amount is to be deferred according to IFRS and US-GAAP. If the possible individual values ​​have an identical probability of occurrence, the average amount must be selected according to IAS. According to US-GAAP, the lowest value is used. In any case, however, the maximum risk must be disclosed in the appendix. Your premises were contaminated with oil. The local authority has obliged you to repair the damage. At the end of the year, there were two contradicting reports on the amount of the expected costs. Both reports come from renowned environmental experts. According to IFRS the middle amount is to be set aside, according to US GAAP the lower one. In both cases, the maximum risk must be disclosed. 7th

8 An estimate of the often uncertain time at which a future economic burden will occur plays a role in the valuation of provisions insofar as long-term provisions must be discounted under IFRS if the time value of money is significant (see IAS 37.45). This applies e.g. for guarantee services that are to be provided longer than one year after the reporting date or for future demolition, clearance, restoration or dismantling obligations. The compounding of long-term provisions over the period until their cash outflow is to be recorded as interest expense according to IAS. According to US-GAAP, such discounting is not generally regulated, although it is mandatory in certain individual cases. This applies e.g. for dismantling and disposal obligations (ASC), or only optionally permitted, e.g. for environmental protection provisions (ASC). With the BilMoG, the mandatory discounting for provisions with a term of> 1 year (regardless of materiality aspects) was anchored in the HGB in 253 (2) HGB. 4. Important individual provisions The following are some examples of important provisions and the regulations that apply to them under IFRS and US GAAP. The practical application based on important individual provisions will be deepened in the attendance week. Guarantee / Warranty: Provision of the expected services at full cost. Goodwill payments are also subject to a provision if, based on past experience, it can be expected that the company will provide them. Process risks: Because of the probability analysis, the statements of the legal advisor are of great importance. According to practical experience, Anglo-Saxon lawyers are quite used to giving the corresponding estimates, while German colleagues mostly want to avoid them for fear of liability risks. Provisions for contingent losses from contracts for the value of the obligation exceeding the consideration; However, the devaluation of capitalized assets (e.g. work in progress) generally takes precedence over a provision for potential losses. Vacant premises: Creation of a provision for potential losses i.h.d. Rental expenses until the expected sublease (or until the end of the lease, if shorter). Annual financial statement costs: If the amount can be determined with a high degree of certainty, the future expenses are to be shown as a deferred liability (liability), otherwise as a provision. Evaluation is controversial: According to the predominant (albeit controversial) opinion in the literature, only the external costs can be passivated. In some cases, the inclusion of the additional internal costs caused by the preparation of the financial statements is also represented. Partial retirement: pro rata transfer of the overtime worked during the first period to the provisions. In the opinion of the German auditors, top-up payments in IDW RS HFA 3 according to IFRS had to be recognized immediately at the beginning; according to US-GAAP pro rata allocation of the top-up amounts. Due to the change in IAS 19 for fiscal years beginning, the accounting for the top-up amounts was also changed. These have to be added pro rata since 2013. Restructuring: Strict requirements according to IAS 37.70ff .; a formal plan must be in place that defines the individual measures, has been approved by the responsible bodies and provides for implementation so promptly that no more significant changes are to be expected. IFRS: essential points of the plan must at least be made known to the works council; US-GAAP: The plan must be detailed enough that the 8

9 individual affected persons can calculate the payments they are entitled to and the plan must have already been made known to the affected employees. Failure to maintain: Cannot be restored. Is it a general overhaul i.s.d. IAS 16.14, an amount equal to the expected costs is removed from the acquisition costs or the book value of the property, plant and equipment and depreciated separately over the period up to the first general overhaul (component approach, see Letter No. 3). Demolition, clearing, restoration and dismantling obligations: Must e.g. If tenant fixtures are removed again, the corresponding provision is to be taken into account during the installation (booking: fixed assets to provision, see Lesson No. 3). Because of the long-term nature, the amount must be discounted accordingly. 5. Pension provisions The accounting for pension obligations is regulated in IAS 19, according to US-GAAP especially in ASC 715. IAS 19 was fundamentally revised in 2011. The new regulations are to be applied for the first time for fiscal years. Our following explanations as well as the CINA course week therefore generally refer to IAS 19 in the version valid for fiscal years beginning. We will only briefly review the old regulations of IAS 19 that are still applicable to the financial statements at the end of the year in the relevant sections. Defined contribution versus defined benefit pension plans The decisive factor for the type of accounting for pension plans is whether they are defined contribution or defined benefit plans (IAS 19.27ff.). A pension plan that is not unequivocally defined-contribution is generally considered to be defined-benefit (IAS 19.8). In the case of a defined contribution plan, the employer is only obliged to make clearly defined contributions (e.g. in the absolute amount or in relation to the salary); A poor development of the capital base that builds up must not lead to an obligation going beyond the contributions made (subsidiary liability) or to an obligation to make additional contributions on the part of the employer (IAS 19.8 and IAS 19.27). A classic example of this is the BfA's statutory pension system in Germany. Here the employer has done his duty by paying the contributions, regardless of how high the resulting pension payments will be. The risk lies with the employee. In the case of defined contribution plans, the company only has to record the periodically expended contributions as an expense in the annual financial statements (IAS 19.50ff.). There are no long-term provisions. The focus of the following considerations is therefore the performance-related obligations, for which the employer has to pay for a certain amount of the later benefits. IAS 19 and the corresponding US GAAP regulations are based on the so-called expense-related approach to accounting for defined benefit pension obligations. The focus is on the pension expense to be recognized in the income statement; the standard strives for the most uniform possible cross-period progression of the pension expenses to be recorded. Balance sheet recognition of pension provisions IAS 19 does not contain any separate recognition requirements for pension provisions. This means that the general principles of the IASB framework regarding the approach of debt apply (see Tutorial No. 2, Section 2.). Instead of a detailed description of specific recognition criteria for pension provisions, 9

10 IAS 19 clearly applies to the measurement of defined benefit obligations. The pension provision to be recognized in the balance sheet at the end of a period is the result of the following in IAS in conjunction with IAS 19.57 (a) (iii) and (b) (please read!): Present value of the defined benefit obligation as of the reporting date - fair value of plan assets (if any) = net debt or pension provision as of the reporting date present value of the defined benefit obligation as of the reporting date The present value The defined benefit obligation is the discounted amount of the expected future pension payments that are required to settle the pension obligations resulting from previous work. The projected unit credit method is used to determine the present value of the pension obligation as of the reporting date in accordance with IAS 19 or US GAAP. Thus, for each expected future pension benefit of the reporting company, (only) that part of the total expected future obligation is to be included in the determination of the present value that has already been earned by the employee entitled to the pension on the respective balance sheet date through his work (see IAS 19.64ff.). Plan assets To put it simply, plan assets are assets that the company has deposited to finance the pension plans. The plan assets reduce the pension provision to be recognized in accordance with IFRS and US GAAP by the amount of the fair value. The IFRS understand plan assets to mean two things (see IAS 19.8 and IAS ff.): On the one hand, this includes the assets of a long-term fund that is held exclusively to meet the performance obligations to the eligible employees. The fund must be a legally independent unit from the accounting company. The funds tied up in it may only be used to make pension payments to employees. The creditors of the accounting company may not have access to the fund's assets, even in insolvency proceedings. Furthermore, the fund assets may generally not be repaid to the accounting company. On the other hand, so-called qualified insurance policies are part of the plan assets. This is an insurance policy from an insurance company. According to IAS 24, the insurance company may not belong to the related companies and persons of the accounting company. With regard to access restrictions, the same requirements apply as for the fund assets. A typical example are reinsurance policies, provided that they meet the requirements for plan assets (especially no access by creditors in the event of insolvency). If you take a look at the various annual reports, international differences in the systems of old-age provision with regard to the recording of plan assets become apparent: The investment of pension funds in securities, which has long been common in the Anglo-Saxon area, has only become increasingly important in Germany in recent years. In the appendix to annual reports, for example, plan assets are netted against the present value of the pension obligation for German (subsidiary) companies, often only for a short period in the past. The fluctuations in the value of the securities therefore also have an indirect effect on the valuation of pension benefits

11 exhibitions. In recent years, losses on the capital market resulted in some substantial shortfalls to cover the existing pension obligations. Net debt or net asset value If the present value of the pension obligation on the balance sheet date exceeds the plan assets measured at fair value, the relevant pension plan is underfunded by the amount of the net debt (IAS 19.57 (a)). The net debt corresponds to the pension liability or pension provision to be recorded in the IFRS financial statements. In the rare case (in Germany) that the plan assets exceed the present value of the pension obligation on the balance sheet date, a net asset value is given. One then speaks of the overfunding of the pension obligation. Pension expenses to be recorded in the income statement The pension expenses to be recorded in the income statement are made up as follows in accordance with IAS 19.57 (c): Current service costs +/- net interest on the net debt / net asset + past service costs and gains or losses from the compensation = pension expenses in the income statement The service cost is the increase in the present value of the defined benefit obligation that is attributable to the work performed by the employees in the reporting period (IAS 19.8). This is the amount by which the pension obligation is to be increased because the employee has earned additional pension entitlements through the work performed in the previous period. To determine the net interest on the net debt, the discount rate used to determine the present value of the pension provision must be multiplied by the net debt (or the net asset value): Net interest expense = discount interest rate * net debt According to IAS, a discount rate in the amount of the returns on The closing date for high-quality, fixed-income corporate bonds can be achieved on the market. What does the net interest expense actually stand for? The net interest expense is a balance that is made up of two components: (IAS): 1) interest expense from the compounding of the present value of the pension obligation, and 2) interest income from plan assets. Excursus: Review of IAS 19 (old) Before the amendment to IAS 19, the above components had to be determined independently of one another: While there were no changes in determining component 1 (interest expense), the expected return on plan assets (component 2) was the company depending on the investment strategy. These estimates often tended to be optimistic, as these predicted returns ultimately reduced the pension expenses to be recognized in the income statement, depending on the amount of plan assets. Hopes regarding the expected return on plan assets could thus be factored into the calculation of the pension expenses. According to the amendment to IAS 19, interest income from plan assets is assumed to be (only) the amount of the discount rate, i.e. the amount of the yields for high-quality, fixed-income corporate bonds. Given the currently low discount rate, the assumed return on plan assets is therefore not infrequently undervalued when it comes to measuring pension expenses. 11

12 Also, the assumed return in the amount of the discount rate does not take into account the fact that the composition of plan assets and the investment strategy differ from company to company. Depending on whether real estate, stocks or fixed-income securities were deposited as plan assets, the returns on plan assets should differ significantly from one another. Important: The current service cost and the net interest are to be determined at the beginning of the reporting period. This is namely the amounts that are to be added to the pension provision during the year. In the absence of better knowledge, the additions to pension provisions during the year are determined on the basis of the data that was valid on the last balance sheet date or at the beginning of the reporting period. We want to illustrate the above explanations using an example. Maier AG grants pension commitments to managerial staff for the first time in December 01. For the time being, Maier AG does not want to endow plan assets to finance the pension plan.The present value of the pension obligation, calculated by the actuary on the basis of a discount rate of 5%, amounts to Since plan assets are not available, the company recognizes a pension provision in the amount of the present value of the pension obligation determined. Since the actuarial assumptions applicable to the applicable actuarial assumptions are not yet known, the applicable assumptions, including the discount rate of 5%, were used to determine the pension expenses to be recognized in P&L 02. According to the expert opinion, the present value of the pension obligation develops as expected (plan value): Present value of pension obligation Service cost interest expense = * 5% Present value of pension obligation While the service cost represents the addition to the pension obligation based on the work management performed in 02, the interest cost results from the compounding of the The company therefore adds the present value to the provision every quarter during the year 02. The provision therefore amounts to (initially) at the end of 02. This arises if the pension plan is changed retrospectively for previous periods in favor of the beneficiary (see IAS 19.8, IAS 19.99ff.). Finally, the effects (profits or losses) of curtailments or compensations such as Severance payments, transfers or reductions to be included in the pension expense for the period. These gains and losses occur e.g. if employees of the reporting company entitled to a pension are fully (or partially) compensated within a defined benefit pension plan (see IAS 19.99ff.). Pension expenses to be recorded in the EK: revaluations According to the understanding of IAS 19, the total pension expenses (or performance-related costs) to be recorded in the statement of comprehensive income are made up not only of the pension expenses to be recorded in the income statement, but also of the other comprehensive income (OCI, Equity) so-called remeasurements together (IAS): 12

13 Pension expenses to be recorded in the income statement + revaluations to be recorded in the other result (OCI) = total performance-related costs While we have already explained the pension expenses to be recorded in the income statement and (hopefully) reconstructed using the above example, we will now look at the in the EK so-called revaluations to be recorded. These are made up as follows (IAS): (a) actuarial gains and losses (b) the return on plan assets with the exception of the amounts included in the net interest on the net debt (the net asset value). For a better understanding of the background and recording of the revaluations, we will continue with our example case: In our initial example, we added a total of service cost and interest expense to the pension provision during the year. The addition was based on the underlying assumptions (in particular the discount rate). The provision amounted to (initially) at the end of 02. Shortly before the end of 02, the appraiser is commissioned again. This is intended to determine the actual present value of the pension obligation on the basis of the assumptions applicable to (actual value as of). For this purpose, the applicable discount rate of 4.5% is used as a basis. The actual value determined by the appraiser on the basis of this discount rate for the amount now arithmetically a shortfall between the present value of the obligation () and the provision () previously recognized on the balance sheet date at the end of 02. This shortfall is an actuarial loss that only arose from the fact that the calculation of the present value was based on changed actuarial assumptions (here the discount rate). The question arises as to whether further (actuarial loss) must be added to the provision formed during the year () at the end of 02. (Note: You can certainly answer the question at this point with the knowledge you have already acquired: According to IAS, the amount to be recorded in the balance sheet is the difference between the balance sheet date values ​​of the present value of the pension obligation (here) and plan assets (here zero) more are to be added to the provision.) A special feature of the accounting of pension obligations according to IFRS and US-GAAP is the recording of actuarial gains and losses. Before we explain the recording of actuarial gains and losses, their background should first be presented. Determining the present value of a defined benefit obligation requires the use of a number of assumptions about the expected level of actuarial variables that determine the value of the pension obligation. These parameters include e.g. (IAS 19.75f.): Discount rate, probability of death, fluctuation, wage, salary and pension development. While IAS 19 does not provide any specific regulations with regard to most of the actuarial assumptions, except that the corresponding parameters must be determined on the basis of realistic expectations (see IAS 19.75), the discount rate to be used is determined very precisely. The long-term interest rate for senior fixed-rate 13

14 interest-bearing corporate bonds to be used on the valuation date (see IAS 19.83). In addition to changing the discount rate, e.g. A changed assessment of the salary development can also lead to a change in the present value of the defined benefit obligation. The differences between the present values ​​of the obligation are referred to as actuarial gains and losses (see IAS 19.8). So it happens e.g. an actuarial gain if the probability of death is estimated to be higher than on the previous reporting date. There is also an actuarial profit if the salary and pension development assumed at the beginning of the year has to be revised downwards at the end of the financial year. The most important cause of actuarial gains or losses is the change in the discount rate: if the discount rate falls, the present value of the pension obligation increases and vice versa. The present values ​​of pension obligations are therefore subject to great volatility over time due to the development of interest rates. Considerable actuarial losses have occurred in recent years, particularly as a result of the drop in the discount rate. The main assumptions used to calculate the pension obligation and the pension expenses (interest rate, salary / pension increase) are to be stated in the notes and can thus be compared between the companies. Back to our question from the previous example: How are actuarial gains and losses to be recognized each year? According to IAS 19 (old), there were essentially three methods for recording actuarial gains and losses. According to the current version of IAS 19 (IAS 19 (2011)), the recording of actuarial gains and losses is stipulated: Only the recognition of all actuarial gains and losses at the time they arise is permitted (so-called SORIE method). With the SORIE method, the actuarial gains and losses are recorded in other comprehensive income (OCI, EK) with no effect on income, and indeed finally, i.e. they no longer have any effect on the income statement (IAS, please read!). The recording of all actuarial gains and losses at the point in time they arise means, in the initial example, that actuarial losses are also added to the allocation to the pension obligation during the year. Recognition with no effect on income means that the offsetting entry is made in equity or OCI: OCI to pension provision This means that the pension provision is included in the balance sheet in the annual financial statements. In summary, the pension provision developed as follows in the 02 financial year: Pension provision Pension expenses (P&L) actuarial. Losses (OCI) Pension provision If the provision approach is determined on the basis of the formula in IAS (balance sheet approach), the following calculation results: Present value of pension obligation Fair value of plan assets 0 Pension provisions The deviations between the actuarial gains and losses are not officially subsumed under the term actuarial gains and losses Interest income from plan assets in the amount of the discount rate and the actual income from plan assets (IAS (b), IAS). Rather, they represent other revaluations. This is due to the fact that the income included in the pension expense does not start at the beginning of 14

15 of the reporting period can be estimated, but stereotypically assumed in the amount of the discount rate. Nonetheless, by their nature they are something like actuarial gains and losses and are also recognized in other comprehensive income. In the annual financial statements, as far as we know, no distinction has been made between actuarial gains and losses and other revaluations with regard to the disclosure of actuarial gains and losses. However, it remains to be seen how practice will develop in this regard. In accordance with the formula for determining the net interest expense, Maier AG has based a return on the plan assets invested in the amount of the discount rate of 5%. In fact, Maier AG achieved a return of 5.5% in 02 from the plan assets. On the one hand, Maier AG consequently has to record a revaluation gain of 0.5% * the fair value of the plan assets in other comprehensive income. Important: Revaluations recorded in other comprehensive income may not be reclassified as expenses or income in a subsequent reporting period, i.e. they will never be recorded in the income statement again (IAS, read!) Excursus: Review of the recording of actuarial gains / losses according to IAS 19 (old) According to IAS 19 (old), various methods for recording actuarial gains and losses were still conceivable. In addition to the SORIE method, which is now mandatory, the so-called corridor method (option 2) and, in some cases, the income-effective recording of all actuarial gains and losses at the time they arise (option 3) were considered. The first and third options have in common that the actuarial gains or losses were allocated in full to the provision in the year in which they arose, in the case of the SORIE method with no effect on results via equity, with option 3, however, fully recognized in profit or loss. The corridor method preferred in practice by non-DAX companies, however, did not provide for the complete recording of all actuarial gains and losses, but only an amount exceeding the so-called 10% corridor, divided by the remaining working hours of the employees. The 10 corridor according to IAS (old) was defined as 10% of the higher of a) the fair value of the plan assets and b) the present value of the pension obligation. Of the total actuarial gains and losses as of the balance sheet date, either none at all or only a comparatively small proportion of the actuarial gains / losses had to be recognized in profit or loss and allocated to the provision within the corridor. In the amount of the unrecognized actuarial losses / gains, there was therefore an underfunding / overfunding between the present value of the pension obligation and the provision recognized during the year. We will explain the individual components of the pension provision and the pension expenses again in the attendance week. Deviating regulations according to US-GAAP According to US-GAAP, analogous to IFRS, the full pension obligation including all actuarial gains / losses must always be recognized in the balance sheet. The pension provision according to US GAAP is thus also determined as follows (see ASC): 15

16 Present value of the defined benefit obligation as of the balance sheet date - fair value of plan assets = pension provision as of the balance sheet date The actuarial gains / losses are also posted completely to equity (OCI) as they arise. In contrast to IFRS, the actuarial gains and losses do not necessarily remain in equity, but are recognized over time in the income statement using the corridor method if and to the extent that they exceed a certain base amount (corridor). For the corridor method, see page 15. There are also differences in the composition of the pension expenses to be shown in the income statement. According to US GAAP, this is made up as follows (ASC ff.): Service cost for the period + interest cost - expected return on any plan assets - / + actuarial gains and losses to be recognized + past service cost to be recognized +/- effects of any plan curtailments or compensations = Pension expenses for the period Differences arise when determining the return on plan assets. While interest income from plan assets in the amount of the discount rate is assumed under IAS 19, under US GAAP the company has to estimate the expected income from plan assets in the reporting period at the beginning of the financial year, taking into account the composition of the plan assets and the investment strategy. Differences also arise due to the recycling of actuarial gains and losses recognized in equity using the corridor method, as provided for in US GAAP. If at all, only an amount exceeding the 10% corridor divided by the remaining working hours of the authorized employees is recorded in the income statement (line 4 of the above graduated calculation). Deviating regulations according to HGB The different valuation of pension provisions according to HGB and international accounting was one of the most important transition items in the past when converting financial statements to international standards. The BilMoG has significantly adapted the valuation of pension provisions according to HGB to international standards. However, the following differences still exist: In the HGB, there is still an obligation to pass on pension commitments that were made after January 1, 1987 (this date can be traced back to the Accounting Directive Act of that time). In international law, however, all commitments (including so-called old commitments and indirect obligations, e.g. based on support fund models) must be postponed. In the past, the German Commercial Code (HGB) did not specify the valuation method. For the purposes of preparing the uniform balance sheet, the HGB usually used the tax partial value method according to 6a EStG (equal distribution method). With the BilMoG, rules for the valuation of pension provisions and comparable obligations were explicitly anchored in the HGB. These may optionally be valued according to the tax partial value method or according to the projected unit credit method. According to IFRS and US-GAAP, however, it is mandatory to use the projected unit credit method. In the HGB there was previously an option, but under IFRS and US GAAP there was an obligation to take into account future changes in wages, salaries and pensions. In the accounting practice according to HGB at that time, such future developments were based on tax law 16

17 Prohibition of inclusion mostly not taken into account. Since the BilMoG, wage and pension increases have to be taken into account when calculating the pension obligation. The HGB has adapted to international accounting standards. In the past, the HGB allowed an interest rate to discount future obligations in a range of 3% to 6%. However, since a discount rate of 6% was mandatory according to the Income Tax Act and the pension provisions in the HGB financial statements have so far generally been were determined in accordance with the tax regulations, an interest rate of 6% was applied in these cases. Since the BilMoG, a 7-year average interest rate (instead of the interest rate on the reporting date) has to be used as a basis for discounting pension obligations. According to the German Commercial Code, this is intended to reduce random fluctuations from year to year. According to Section 253 (2) of the German Commercial Code (HGB), the company has the choice of either using the 7-year average interest rate for the actual (average) remaining term of the obligation or of applying a flat-rate remaining term of 15 years. Both interest rates are announced monthly by the Bundesbank. The (average) interest rate specified by the Deutsche Bundesbank in accordance with HGB-BilMoG was 4.53% on for a remaining term of 15 years. For the discount rate on the reporting date according to IAS, the German (subsidiary) companies were more in a range of 1.66 2.05%. Actuarial gains and losses must continue to be taken into account immediately in the income statement according to the German Commercial Code. According to international standards, such adjustments are usually distributed over the remaining service life of the relevant pension beneficiaries or recognized directly in equity. The BilMoG created an exception to the ban on offsetting. If assets are only used to meet pension obligations and are not accessible to other creditors, the pension provision must be offset against the value of the assets. Only the difference is then shown in the balance sheet. In this specific case, there is also an exception to the lowest value principle: the pension assets are valued at fair value.If the value of the pension obligations is higher than the fair value of the pension assets, a pension provision is recognized, otherwise an asset is shown. Here the HGB was obviously adapted to the requirements of the international standards. The changes made by the BilMoG led to higher pension obligations for most companies, including those under the German Commercial Code. The difference between the pension obligation before and after BilMoG was recognized in profit or loss as an extraordinary expense. However, this can take place over a maximum period of 15 years (cf. Art. 67 (2) EGHGB). 6. Liabilities Financial liabilities, including trade payables, loan liabilities and certain other liabilities, are part of a company's financial instruments in terms of their content, analogous to financial assets, and are therefore regulated in IAS 32/39. We will therefore come across some of the regulations that have already been explained in connection with the requirements. Financial liabilities are to be valued at their fair value analogously to the valuation of all financial instruments at the time of acquisition (see IAS 39.43). This forms the acquisition costs. As a result, financial liabilities in accordance with IAS, analogous to financial assets, are basically to be carried forward 17

18 to be valued at acquisition costs (using the effective interest method). For the definition and composition of the amortized cost, we refer to our explanations in letter no. 4, section 4.Special features from the regulations of the IAS (initial assessment) and IAS (subsequent assessment) result e.g. in the case of long-term trade payables that do not bear interest at market conditions (e.g. the two-year interest-free deferral of the purchase price of fixed assets by the supplier). In this case, the liability is discounted at the initial valuation with a correspondingly lower valuation of the fixed assets acquired. The resulting lower depreciation of fixed assets will be compensated in the course of the subsequent valuation by adding interest to the liability except for the repayment amount on the due date (see also lesson No. 3). The above valuation rules in accordance with IFRS also result in a treatment of a discount taken that deviates from the German HGB. In the HGB, there is a right to choose between capitalization and pro rata amortization and immediate consideration as expenses. According to IAS, the liability must be measured at its fair value at the time of addition, and subsequently at amortized cost. Therefore, the discount is to be deducted from the liability at the time of addition and interest is to be added to the loan liability over the term of the loan agreement up to its fulfillment or nominal value. Your company accounts in accordance with IFRS and takes out a loan of 1 million from your house bank in the financial year. An interest rate of 4% and a discount of T 50 were agreed, so that only T 950 are paid out from the loan. The difference between the disbursement and the repayment amount (= discount) may be recognized as an expense immediately or deferred over the term of the loan according to Section 250 (3) HGB. According to IFRS, however, the loan liability is to be recognized at the time of addition at the fair value. Since the bank only paid out T 950, the amount paid out corresponds to the fair value. The following is to be posted: Cash to loan liability T 950. The loan liability is to be accrued successively over the term of the loan. Excluded from the valuation at amortized cost are liabilities that are to be regarded as held for trading due to the speculative intention associated with them and are therefore to be assigned to the FVTPL category, and those that are subject to the requirements of the fair value option (see Lesson No. 5). were optionally assigned to the FVTPL category. These are then to be valued at fair value through profit or loss. The categorization as FVTPL is a rare exception for industrial or service companies. If there are liabilities in a foreign currency, these are to be converted at the exchange rate on the reporting date according to IAS (a). The resulting translation losses or gains are to be recognized immediately in profit or loss in accordance with IAS. This regulation was also adopted by the BilMoG via the new 256a HGB in the HGB, provided that it is a matter of liabilities with a remaining term of less than one year. According to the German Commercial Code (HGB), the loan liability would be at the time of addition with the repayment or settlement amount i.h.v. 1 million to passivate. 18th

19 7. Prepaid expenses In contrast to German law, the accounting of prepaid expenses is not explicitly regulated in international accounting, i.e. there is no separate standard for this. Partial regulations can only be found selectively in individual standards, e.g. IAS 20, which deals with investment grants and grants (cf. Tutorial No. 3, Section 2.) However, this supposed problem is more a question of reporting. While the balance sheet classification scheme of 266 HGB requires separate reporting of the active and deferred income, there is no corresponding item in the minimum classification requirements in IAS 1.54. These are therefore usually included in the IFRS financial statements. reported under other (non-financial) assets or liabilities. The question of the approach of a deferred item according to IFRS, whether on the assets or liabilities side, is primarily assessed according to the regulations in the many individual standards and interpretations of the IFRS. If nothing is regulated there, the decisive factor is whether the item in question meets the definition and recognition criteria of an asset or liability according to the framework (IAS 1.27f.). 8. Former exam questions The sample solutions to the following questions can be found in Lesson No Provision for compensation for damages A competitor of your company is asserting claims for compensation against your company for a patent infringement. The lawyer of your company has basically affirmed the existence of a corresponding claim. With regard to the amount of the obligation, he estimates any amount between 3 7 million to be equally likely. In the financial statements under commercial law, the valuation was cautious based on prudent business judgment. Which values ​​are used in the financial statements according to HGB, IFRS and US-GAAP? In each case in millions. 2. Discount HGB IFRS US-GAAP a) b) c) d) e) f) g) h) You have taken out a loan with a nominal value of 1 million. This was paid out after deduction of a discount of T 50. The repayment is to be made in one sum on December 31, 2007. The discount was immediately booked as an expense in the HGB financial statements. What is the correct accounting for the discount in the IFRS financial statements? a) Since the discount is interest, the expenses must be offset immediately in accordance with IAS 23. b) According to IAS 23, the capitalization of the discount and pro rata expense recording is required. c) The immediate recording of expenses for the discount is not permitted under IFRS. The discount is offset as an expense using the effective interest method over the term of the loan. d) The immediate recording of expenses for the discount is not permitted under IFRS. The discount is therefore only offset as an expense at the end of the term of the loan. What is the value of the liability in the IFRS financial statements? a) T 950 b) T 960 c) T 990 d) T