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Accounting and Measurement Policies

(49) Effects from new accounting standards and other presentation and measurement changes

First-time application of IAS 29 ‟Financial Reporting in Hyperinflationary Economies” in Argentina

During the financial year under review, Argentina was classified as a hyperinflationary economy in accordance with IAS 29. Therefore, the respective non-monetary items disclosed in the consolidated balance sheet as of January 1, 2018, were no longer carried at historical cost, but on the basis of current costs, adjusted for the inflationary effects in previous periods. In accordance with IAS 21 ‟Effects of Changes in Foreign Exchange Rates”, financial statement figures from previous years reported in non-hyperinflationary reporting currencies have not been adjusted. Further information can be found in Note (52) ‟Currency translation”.

Changes to accounting and measurement principles applicable to interest and penalties related to income taxes

IAS 12 ‟Income Taxes” shall be applied to interest and penalties related to income taxes only if these items are based on profit before tax. In all other cases, such items are within the scope of application of IAS 37 ‟Provisions, Contingent Liabilities and Contingent Assets”. Therefore, all obligations in connection with interest and penalties related to income taxes that are within the scope of application of IAS 37 are disclosed separately under the ‟other provisions” item in the consolidated balance sheet. This applies in particular to interest payables which are related to income tax obligations. Adjustments of figures pertaining to previous years are disclosed in the column ‟Reclassification of interest and penalties related to income taxes”, in the section ‟Effects of changed accounting and measurement policies on the consolidated balance sheet as of December 31, 2017, and January 1, 2018”. Further information can be found in Note (26) ‟Other provisions”. There were no changes in the disclosure of income and expenses from interest and penalties in connection with income taxes, given that these items were previously not disclosed within income taxes.

Changes to accounting and measurement principles resulting from IFRS 9 ‟Financial Instruments”

IFRS 9 sets forth new rules for classification and measurement of financial instruments and the impairment of financial assets as well as for hedge accounting. The modified retrospective method was used for the adoption of IFRS 9 at the Group, with the exception of the provisions for hedge accounting. In the case of hedging relationships where the Group used options as hedging instruments, the first-time application of IFRS 9 was made retrospectively, as required, by disclosing comparative information for prior periods (see ‟Adjustments of prior periods” in this Note). In the case of hedging relationships where the Group used forward contracts as hedging instruments, the new IFRS 9 rules were applied for the first time using the prospective method.

Classification and measurement

According to IFRS 9, the classification and measurement of financial assets are determined by the business model of the company and the characteristics of the cash flows of the respective financial asset. Upon initial recognition, a financial asset is designated either as ‟at amortized cost”, ‟at fair value through other comprehensive income” or ‟at fair value through profit or loss”.

For equity instruments held as of January 1, 2018, that are not held for trading, the Group has uniformly exercised the option of recognizing future changes in fair value in other comprehensive income in the consolidated statement of comprehensive income, and thus retaining them in consolidated equity upon disposal of the financial instrument.

The first-time application of IFRS 9 did not lead to any material changes in the disclosure of financial liabilities.

Impairments

The first-time application of IFRS 9 resulted in the application of a new impairment model which takes into account expected credit losses already at initial recognition of a financial asset. This accounting change leads to an earlier recognition of impairment losses for financial assets. The following financial assets are affected by the new impairment model:

  • Trade accounts receivable
  • Contract assets
  • Other debt instruments measured at amortized cost
  • Debt instruments measured at fair value through other comprehensive income

The Group uses the simplified impairment model for trade accounts receivable and contract assets pursuant to which any credit losses expected to occur over the entire lifetime of the relevant financial assets are taken into account. Further information can be found in Note (60) ‟Financial assets”.

Hedge accounting

The Group applied the hedge accounting provisions of IFRS 9 effective January 1, 2018, and did not opt for the option to continue to apply IAS 39. The existing hedging relationships were continued, even after the first-time application of IFRS 9.

The adjustments relevant to the Group arising from the first-time application of the IFRS 9 provisions regarding hedge accounting are presented below:

  • In the case of hedging relationships where the Group uses options as hedging instruments, only the intrinsic value of options has been designated as the hedging instrument since the first-time application of IFRS 9. Changes in the fair value of the time value component of options that are used for hedge accounting have to be recognized in other comprehensive income and in a new reserve for hedging costs within equity. The subsequent accounting of these amounts depends on the type of the hedged transaction. The table presented under ‟Adjustments of prior periods” shows the effects on the affected financial statement components arising from the retrospective application of the hedging approach in accordance with IFRS 9.
  • In the case of hedging relationships where the Group uses forward contracts as hedging instruments, only the spot element is designated as a hedging instrument. Changes in the fair value of the forward element in forward contracts are initially recognized in a new reserve for hedging costs within equity. The subsequent accounting of these amounts depends on the type of the hedged transaction. These amendments did not have any impact on the consolidated balance sheet as of January 1, 2018.

The following reclassifications and measurement effects upon first-time application of IFRS 9 resulted from the change in the classification and measurement of financial assets as well as the amended impairment requirements:

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Reconciliation of financial assets from IAS 39 to IFRS 9 as of January 1, 2018

€ million

Measurement category Retained earnings Gains/losses recognized in equity
Consolidated balance sheet item IAS 39 IFRS 9 Explanation Carrying amount in accordance with IAS 39 Dec. 31, 2017 Remeasure­ment due to the application of the impairment model Carrying amount in accordance with IFRS 9 Jan. 1, 2018 Retained
earnings/net
retained profit effect Jan. 1, 2018
Fair value reserve for equity instrustuments Jan. 1, 2018 Available­for­sale financial assets Jan 1, 2018 Fair value reserve for debt instruments Jan. 1, 2018
Cash and cash equivalents Cash and cash equivalents Subsequent measurement at amortized cost 589 589
Trade accounts receivable Loans and receivables Subsequent measurement at amortized cost ➞ a 2,923 – 15 2,908 – 13
Current financial assets Loans and receivables Subsequent measurement at amortized cost 47 47
Available-for-sale financial assets Subsequent measurement at fair value through other comprehensive income (debt instruments) ➞ b 35 35 1 – 1
Derivatives without a hedging relationship Derivatives without a hedging relationship 9 9
Other current financial assets Loans and receivables Subsequent measurement at amortized cost ➞ a 247 – 1 246 – 1
Derivatives with a hedging relationship Derivatives with a hedging relationship 30 30
Non-current financial assets Loans and receivables Subsequent measurement atamortized cost 12 12
Derivatives without a hedging relationship Derivatives without a hedging relationship 13 13
Available-for-sale financial assets Subsequent measurement at fair value through profit or loss (debt instruments) ➞ c+d 420 297 8 – 8
Subsequent measurement at fair value through other comprehensive income (debt instruments) ➞ e 123 29 – 6 – 23
Other non-current financial assets Loans and receivables Subsequent measurement at amortized cost 29 29
Derivatives without a hedging relationship Derivatives without a hedging relationship 46 46
Derivatives with a hedging relationship Derivatives with a hedging relationship 15 15
 
Financial assets 4,415 – 16 4,399
 
Adjustments from the first-time application of IFRS 9 23 – 6 – 31 – 1

The first-time application of IFRS 9 led to the following transition effects:

  1. As of January 1, 2018, the first-time application of IFRS 9 led to an increase in impairment losses from expected credit risks of financial assets in the amount of € 16 million (before taking deferred taxes into account). This increase related mainly to trade accounts receivable.
  2. Debt instruments in the amount of € 35 million, which represented available-for-sale debt instruments under IAS 39, were designated as measured at ‟fair value through other comprehensive income” in accordance with IFRS 9. As of January 1, 2018, this reclassification led to a transfer within gains/losses recognized in equity from available-for-sale financial assets to the fair value reserve for debt instruments in the amount of € – 1 million.
  3. Pursuant to IFRS 9, financial assets from contingent considerations with a carrying amount of € 277 million were designated as debt instruments ‟measured at fair value through profit or loss”. As of January 1, 2018, this reclassification led to a transfer within gains/losses recognized in equity (due to market value fluctuations) from available-for-sale financial assets to retained earnings in the amount of € –1 million.
  4. Financial assets from closed investment funds in the amount of € 18 million were designated as ‟measured at fair value through profit or loss” in accordance with IFRS 9, given their cash flows were not solely payments of principal and interest. As of January 1, 2018, this reclassification led to a transfer within gains/losses recognized in equity (due to market value fluctuations) from available-for-sale financial assets to retained earnings in the amount of € 9 million.
  5. Equity instruments with a carrying amount of € 123 million have been recognized at fair value through other comprehensive income in the consolidated statement of comprehensive income. As of January 1, 2018, the first-time application of IFRS 9 resulted in a reclassification, in the amount of € 23 million, from gains/losses recognized in equity (due to available-for-sale financial assets) to equity instruments measured through other comprehensive income. Within retained earnings, an additional amount of € 29 million was reclassified from retained earnings/net retained profit to equity instruments measured through other comprehensive income due to impairment losses recognized through profit or loss in the past.

Changes to accounting and measurement principles resulting from IFRS 15 ‟Revenue from Contracts with Customers”

IFRS 15 defines comprehensive principles for revenue recognition as well as for the provision of information about the nature, amount, timing and uncertainty of revenue from contracts with customers. Since the Group generates approximately 95% of its revenues from contracts on the sale of goods that usually have a simple structure and normally do not constitute long-term contracts, the first-time application of IFRS 15 only had minor effects on the Group’s assets, liabilities, financial position, and financial performance.

Within the context of the introduction of IFRS 15, the Group made use of the option to apply the modified first-time application method and thus recognized the cumulative adjustments in retained earnings as of January 1, 2018. Comparative information for prior periods was not disclosed under IFRS 15. The changes to the accounting and measurement principles as well as the resulting adjustment effects from the first-time application of IFRS 15 and the impact on equity as of January 1, 2018, or the consolidated income statement, were as follows:

  • Timing of transfer of control: In the case of specific supplies of goods, the transfer of control and thus the timing of revenue recognition in accordance with IFRS 15 occurred later than the transfer of risks and rewards within the meaning of IAS 18. As of January 1, 2018, inventories and contract liabilities for the supply of goods were recognized for which the related revenues were already recognized in 2017 in accordance with IAS 18. However, these revenues did not meet the criteria for revenue recognition under IFRS 15 as of the date of first-time application. As of January 1, 2018, this led to a reduction in retained earnings in the amount of € 20 million (before tax). The new rules did not have a material impact on the consolidated income statement for fiscal 2018.
  • Out-licensing of intellectual property: With the application of IFRS 15, out-licensing intellectual property led, in some cases, to earlier revenue recognition as compared with IAS 18 if the out-licensed intellectual property meets the right-to-use criteria (recognition of revenue at a point in time), rather than right-to-access criteria (recognition over a period of time) and the consideration is not paid in the form of sales- or usage-based royalties. As of January 1, 2018, contract liabilities for licenses were derecognized which would have led to a recognition of revenue at a point in time (at the inception of the license) on the basis of an assessment pursuant to IFRS 15. Accordingly, this led to an increase in retained earnings in the amount of € 17 million (before tax) as of the date of transition. In fiscal 2018, these new rules resulted in a decrease in net sales and in other operating income in the low single-digit million euro range.
  • Long-term supply contracts with minimum purchase quantities (take-or-pay contracts): Occasionally, contracts with customers provide for minimum purchase quantities. In such cases, in accordance with IFRS 15, the expected transaction price attributable to the minimum purchase quantity had to be allocated to the individual supplies. However, under IAS 18, revenue was recognized in the amount of the invoiced selling price for the individual supplies. A contract asset was recognized as of January 1, 2018. This led to a corresponding increase in retained earnings by € 4 million (before tax). The impact of these new rules on the consolidated income statement for fiscal 2018 was negligible.
  • Multiple-element contracts: Revenues from multiple-element contracts are recognized when the respective contract component is delivered or rendered. In the Life Science business sector, there were multiple-element contracts with service components to a minor extent. In future, the transaction price will have to be allocated in some cases in a different manner than under IAS 18. This led to a slight increase in retained earnings as of January 1, 2018. The impact on the consolidated income statement for fiscal 2018 was negligible.

Besides the adjustment effects described above, the first-time application of IFRS 15 had the following presentation effects on the consolidated balance sheet as of January 1, 2018:

  • Sales deductions from refunds related to contracts with customers were reclassified from trade accounts payable into the separate item ‟Refund liabilities” in the consolidated balance sheet, effective January 1, 2018. Therefore, trade accounts payable declined by € 431 million.
  • As of January 1, 2018, discounts that customers were expected to apply when making payments were recognized in the consolidated balance sheet as reductions of trade accounts receivable. This led to a slight reduction in trade accounts payable and trade accounts receivable.
  • The presentation of customer refund claims was adjusted according to IFRS 15; since January 1, 2018, assets resulting from expected product returns were presented within other current assets, provided that resale of the returned products was deemed possible. Effective January 1, 2018, this led to a slight increase in trade accounts payable and other current assets.

Moreover, the new rules of IFRS 15 in the following areas were of no relevance – or only very minor relevance – for the Group:

  • variable consideration
  • revenue recognition over time for long-term service contracts and customer-specific construction contracts
  • consignment arrangements
  • collaboration agreements
  • costs of obtaining or fulfilling a contract
  • principal-agent relationships
  • bill-and-hold arrangements
  • financing components
  • barter transactions
  • repurchase agreements
  • separate performance obligations from transportation or other logistic services

The following table shows the consolidated income statement in the reporting period had IAS 18 been applied on an ongoing basis:

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2018
€ million IFRS 15 (as reported) Reconciliation to IAS 18 IAS 18
Net sales 14,836 – 6 14,830
Cost of sales – 5,382 3 – 5,379
Gross profit 9,454 – 3 9,451
 
Other operating income 627 1 628
Other income and expenses/financial result – 8,621 – 8,621
Profit before income tax 1,461 – 2 1,459
 
Income tax – 368 – 1 – 369
Profit after tax from continuing operations 1,093 – 3 1,090
Profit after tax from discontinued operation 2,303 2 2,305
Profit after tax 3,396 – 1 3,395

Effects of changed accounting and measurement policies on reserves as of December 31, 2017, and January 1, 2018

The following table shows the effects of the first-time application of IAS 29, IFRS 9 and IFRS 15 on reserves as of December 31, 2017, and January 1, 2018, respectively.

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€ million
December 31, 2017 (as reported) 12,357
IFRS 9 (after income tax) 1
Hedge accounting (mandatory retrospective adoption) 1
December 31, 2017 (restated)/January 1, 2018 (before adjustments) 12,358
IFRS 9 (before income tax) 16
Reclassification of financial assets 32
Expected credit loss on trade accounts receivable and other debt instruments – 16
Income tax effect IFRS 9 2
IFRS 15 (before income tax) 2
Timing of transfer of control from the sale of goods – 20
Out-licensing of intellectual property 17
Take-or-pay contracts 4
Multiple-element arrangements 1
Income tax effect IFRS 15 – 2
IAS 29 (after income tax) 4
Hyperinflation in Argentina 4
January 1, 2018 (restated) 12,379

Effects of changed accounting and measurement policies on the consolidated balance sheet as of December 31, 2017, and January 1, 2018

The following table shows the effects of the aforementioned changes to the accounting and measurement principles on the consolidated balance sheet.

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IFRS 9 IAS 12/IAS 37 IFRS 9 IFRS 15 IAS 29
€ million Dec. 31, 2017 (as reported) Reclassification (mandatory retrospective adoption) Reclassification of interest and penalties related to income taxes Dec. 31, 2017 (restated)/ January 1, 2018 (before adjustments) Reclassification Remeasurement Reclassification Remeasurement Remeasurement Jan. 1, 2018 (after adjustments)
Non-current assets                    
Goodwill 13,582 13,582 1 13,582
Other intangible assets 8,317 8,317 8,317
Property, plant and equipment 4,512 4,512 2 4,514
Non-current financial assets 444 444 444
Other non-current assets 205 205 205
Deferred tax assets 1,106 1,106 1 – 2 1,105
28,166 28,166 1 – 2 2 28,167
Current assets                    
Inventories 2,632 2,632 5 2 2,639
Trade accounts receivable 2,923 2,923 – 15 – 4 2,904
Current financial assets 90 90 90
Other current assets 731 731 – 1 1 4 735
Income tax receivables 490 490 490
Cash and cash equivalents 589 589 589
Assets held for sale
7,455 7,455 – 16 – 3 9 2 7,447
Total assets 35,621 35,621 – 15 – 3 7 5 35,614
                   
Total equity                    
Equity capital 565 565 565
Reserves 12,357 1 12,358 32 – 15 4 12,379
Gains/losses recognized in equity 1,082 – 1 1,081 – 32 1,049
Equity attributable to shareholders of Merck KGaA, Darmstadt, Germany 14,003 14,003 – 15 4 13,992
Non-controlling interests 63 63 63
14,066 14,066 – 15 4 14,055
Non-current liabilities                    
Provisions for pensions and other post-employment benefits 2,257 2,257 2,257
Other non-current provisions 788 788 788
Non-current financial liabilities 8,033 8,033 3 8,036
Other non-current liabilities 354 354 – 3 – 17 334
Deferred tax liabilities 1,489 1,489 1 1,489
12,919 12,919 – 17 1 12,903
Current liabilities                    
Current provisions 414 43 457 457
Current financial liabilities 2,790 2,790 2,790
Trade accounts payable 2,195 2,195 – 434 1,761
Refund liabilities 431 431
Income tax liabilities 1,059 – 43 1,016 1,016
Other current liabilities 2,175 2,175 25 2,200
Liabilities directly related to assets held for sale
8,635 8,635 – 3 25 8,657
Total equity and liabilities 35,621 35,621 – 15 – 3 7 5 35,614

Adjustments of PREVIOUS periods

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€ million 2017
as reported IFRS 9 adjustment IFRS 5 adjustment adjusted
Consolidated Income Statement        
Net sales 15,327 – 809 14,517
Cost of sales – 5,320 249 – 5,071
Gross profit 10,007 – 560 9,446
       
Marketing and selling expenses – 4,702 353 – 4,349
Administration expenses – 930 31 – 899
Research and development costs – 2,140 32 – 2,108
Other operating income 1,227 – 14 1,212
Other operating expenses – 937 56 – 880
Operating result (EBIT)1 2,525 – 102 2,423
       
Financial result – 300 5 1 – 294
Profit before income tax 2,224 5 – 101 2,129
       
Income tax 386 – 1 43 428
Profit after tax from continuing operations 2,610 4 – 57 2,557
Profit after tax from discontinued operation 57 57
Profit after tax 2,610 4 2,615
       
thereof: attributable to shareholders of Merck KGaA, Darmstadt, Germany (net income) 2,600 4 2,605
thereof: attributable to non-controlling interests 10 10
       
Earnings per share in € (basic/diluted)        
– attributable to continuing operations 5.98 0.01 – 0.12 5.87
– attributable to discontinued operation 0.12 0.12
       
       
Consolidated Statement of Comprehensive Income        
Profit after tax 2,610 4 2,615
Items of other comprehensive income that may be reclassified to profit or loss in subsequent period:        
Cost of cash flow hedge reserve        
Fair value adjustments – 5 – 5
Tax effect 1 1
Other comprehensive income – 1,843 – 4 – 1,847
Comprehensive income 767 767
       
       
Consolidated Cash Flow Statement        
Profit after tax 2,610 4 2,615
Other non-cash income and expenses – 3 – 4 – 7
Net cash flows from operating activities 2,696 2,696
1
Not defined by International Financial Reporting Standards (IFRSs).
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Group
€ million
2017
as reported IFRS 5 adjustment adjusted
Reconciliation of EBIT1 to EBITDA pre1        
Operating result (EBIT)1 2,525 – 102 2,423
Depreciation/amortization/impairment losses/reversals of impairments 1,758 – 17 1,741
EBITDA1 4,282 – 118 4,164
Restructuring expenses 84 – 23 61
Integration expenses/IT expenses 189 – 1 188
Gains (+)/losses (–) on the divestment of businesses – 310 – 310
Acquisition-related adjustments 63 63
Other adjustments 106 – 26 81
EBITDA pre1 4,414 – 168 4,246
       
Business free cash flow1        
EBITDA pre1 4,414 – 168 4,246
Investments in property, plant and equipment, software as well as advance payments for intangible assets – 1,047 35 – 1,012
Changes in inventories – 23 5 – 18
Changes in trade accounts receivable as well as receivables from royalties and licenses – 24 2 – 22
Elimination first-time consolidation of BioControl Systems – 2 – 2
Business free cash flow1 3,318 – 125 3,193
1
Not defined by International Financial Reporting Standards (IFRSs).
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Healthcare
€ million
2017
as reported IFRS 5 adjustment adjusted
Financial performance
Net sales 6,999 –809 6,190
Cost of sales – 1,587 248 – 1,340
Gross profit 5,412 – 562 4,850
 
Marketing and selling expenses – 2,722 349 – 2,373
Administration expenses – 299 28 – 271
Research and development costs – 1,632 32 – 1,600
Other operating income and expenses 688 43 731
Operating result (EBIT)1 1,447 – 111 1,337
 
Depreciation/amortization/impairment losses/reversals of impairments 708 – 17 691
EBITDA1 2,155 – 127 2,028
 
Restructuring expenses 40 – 23 17
Integration expenses/IT expenses 28 27
Gains (+)/losses (–) on the divestment of businesses – 316 – 316
Acquisition-related adjustments
Other adjustments 42 – 26 16
EBITDA pre1 1,949 – 177 1,773
 
Business free cash flow1
EBITDA pre1 1,949 – 177 1,773
Investments in property, plant and equipment, software as well as advance payments for intangible assets – 411 35 – 375
Changes in inventories – 39 5 – 34
Changes in trade accounts receivable as well as receivables from royalties and licenses – 51 2 – 49
Business Free Cash Flow1 1,448 – 134 1,314
1
Not defined by International Financial Reporting Standards (IFRSs).

(50) Measurement policies

The main assets and liabilities disclosed in the consolidated balance sheet are measured as follows:

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Balance sheet item Measurement principle
Assets
Goodwill Amortized cost (subsequent measurement: impairment-only approach)
Other intangible assets
With finite useful life Amortized cost
With indefinite useful life or not yet available for use Amortized cost (subsequent measurement: impairment-only approach)
Property, plant and equipment Amortized cost
Financial assets (current/non-current)1
Equity instruments Fair value
Debt instruments Amortized cost or fair value, depending on the business model
(see Note (60) "Financial assets")
Derivative assets (financial transactions) Fair value
Other assets (current/non-current)
Other receivables (financial instruments)1 Amortized cost
Derivative assets (operative)1 Fair value
Non-financial items Amortized cost
Deferred tax assets Undiscounted measurement based on tax rates that are expected to apply to the period when the asset is realized or the liability is settled
Inventories Lower of cost and net realizable value
Trade accounts receivable (without lease receivables)1 Amortized cost
Lease receivables According to IAS 17 (see Note (59) "Leasing")
Income tax receivables Expected tax refunds based on tax rates that have been enacted or substantively enacted by the end of the reporting period
Cash and cash equivalents1 Amortized cost
Assets held for sale Lower of carrying amount and fair value less costs to sell
1
As from January 1, 2018, in accordance with IFRS 9; see (49) ‟Effects from new accounting standards and other presentation and measurement changes” ‟Effects from new accounting standards and other presentation and measurement changes”.
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Balance sheet item Measurement principle
Equity and liabilities
Provisions for pensions and other post-employment benefits Projected unit credit method
Other provisions (current /non-current) Present value of the expenditures expected to be required to settle the obligation
Financial liabilities (current/non-current)
Bonds and commercial paper Amortized cost
Bank loans Amortized cost
Liabilities to related parties Amortized cost
Loans from third parties and other financial liabilities Amortized cost
Liabilities from derivatives (financial transactions)1 Fair value
Finance lease liabilities Amortized cost
Other liabilities (current/non-current)
Liabilities from derivatives (operative)1 Fair value
Liabilities from non-income related taxes Settlement amount
Other liabilities Settlement amount
Deferred tax liabilities Undiscounted measurement based on tax rates that are expected to apply to the period when the asset is realized or the liability is settled
Trade accounts payable Amortized cost
Refund liabilities Expected reimbursement amount
Income tax liabilities Expected tax payments based on tax rates that have been enacted or substantively enacted by the end of the reporting period
Liabilities directy related to assets held for sale Fair value
1
As from January 1, 2018, in accordance with IFRS 9; see (49) ‟Effects from new accounting standards and other presentation and measurement changes” ‟Effects from new accounting standards and other presentation and measurement changes”.

(51) Consolidation methods

The consolidated financial statements are based on the single-entity financial statements of the consolidated companies as of the balance sheet date, which were prepared applying consistent accounting policies in accordance with IFRSs.

Acquisitions were accounted for using the purchase method in accordance with IFRS 3. In cases where a company was not acquired in full, non-controlling interests were measured using the fair value of the proportionate share of net assets. The option to measure non-controlling interests at fair value on the date of their acquisition (full goodwill method) was not utilized.

When additional shares in non-controlling interests are acquired, the purchase price amount that exceeds the carrying amount of this interest was offset directly in equity.

IFRS 11 was applied for joint arrangements. A joint arrangement exists when, on the basis of a contractual arrangement, the Group and third parties jointly control business activities. Joint control means that decisions about the relevant activities require unanimous consent. Joint arrangements are either joint operations or joint ventures. Revenues and expenses as well as assets and liabilities from joint operations were included in the consolidated financial statements in accordance with the Group’s rights and obligations. By contrast, interests in joint ventures as well as in material associates over which the Group has significant influence were recognized in accordance with IAS 28 using the equity method of accounting.

Intragroup sales, expenses and income, as well as all receivables and payables between the consolidated companies, are eliminated. The effects of intragroup deliveries reported under non-current assets and inventories are adjusted by eliminating any intragroup profits. In accordance with IAS 12, deferred taxes are applied to these consolidation measures.

(52) Currency translation

The functional currency concept applies to the translation of financial statements of consolidated companies prepared in foreign currencies. The subsidiaries of the Group generally conduct their operations independently. The functional currency of these companies is normally the respective local currency. Assets and liabilities are measured at the closing rate, and income and expenses are measured at weighted average annual rates in euros, the reporting currency. Any currency translation differences arising during consolidation of Group companies are recognized in equity. If Group companies are deconsolidated, existing currency differences are reversed and reclassified to profit or loss.

When the financial statements of consolidated companies are prepared, business transactions that are conducted in currencies other than the functional currency are disclosed using the current exchange rate on the date of the transaction. Foreign currency monetary items (cash and cash equivalents, receivables and payables) in the year-end financial statements of the consolidated companies prepared in the functional currency are translated at the respective closing rates. Exchange differences from the translation of monetary items are recognized in the income statement with the exception of net investments in a foreign operation.

Currency translation was based on the following key exchange rates:

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€ 1 = Average annual rate Closing rate
2018 2017 Dec. 31, 2018 Dec. 31, 2017
Chinese renminbi (CNY) 7.815 7.621 7.869 7.791
Japanese yen (JPY) 130.372 126.921 126.131 134.669
Swiss franc (CHF) 1.153 1.112 1.128 1.168
South Korean won (KRW) 1,294.331 1,275.143 1,271.164 1,275.923
Taiwan dollar (TWD) 35.544 34.398 34.958 35.538
U.S. dollar (USD) 1.181 1.130 1.144 1.195

Since July 2018, Argentina’s economy has been classified as hyperinflationary in accordance with IAS 29 ‟Financial Reporting in Hyperinflationary Economies”. Accordingly, the Group’s business activities in Argentina were no longer disclosed at historical cost, but were restated retrospectively for the entire reporting year, adjusted for inflation. For this purpose, the Group used a dedicated index combining the wholesale index IPIM (Índice de precios internos al por mayor) and the consumer price index IPC (Índice de precios al consumidor). As of the balance sheet date, the Group’s dedicated index stood at 2,462.1 (January 1, 2018: 1,656.6).

(53) Recognition of net sales and other income

Depending on the business sector, the Group uses various distribution channels to provide its products. In the Healthcare business sector, pharmaceutical prescription products are often sold to specialized wholesalers and distributors, and to a lesser extent directly to pharmacies, physicians or hospitals. In the Life Science and Performance Materials business sectors, products are largely sold to business customers, and to a lesser extent to distributors.

Net sales and other income are recognized when (or as) the customer obtains control of the asset. In the case of product sales, the customer usually obtains control as soon as delivery is made, given that the customer is generally not able to obtain any benefits from the asset before that point in time. To a lesser extent, the Group generates net sales from the sale of goods based on bill-and-hold arrangements. In these cases, net sales are recognized before the goods are delivered to the customer, i.e. as soon as the Group has invoiced the respective products and the additional criteria laid out in IFRS 15.B81 are fulfilled. In the case of sales of hardware and equipment in the Life Science business sector, the revenue recognition criteria are only met after installation has been successfully completed – to the extent that the installation requires specialized knowledge, does not represent a clear ancillary service and the relevant equipment can only be used by the customer once successfully set up.

In addition to revenue from the sale of goods, net sales also include commission income, profit-sharing participations, revenue from services, and – in the Life Science business sector – license income, but the volume involved is insignificant.

For service contracts, and customer-specific equipment construction contracts, revenue is recognized over time, based on the progress towards complete satisfaction of the performance obligation, provided that the Group has an enforceable right to payment for performance completed to date. The progress is mostly determined according to the cost-to-cost method, and the milestones achieved as at the reporting date.

In the Healthcare and Life Science business sectors, a limited number of contracts provide for the out-licensing of intellectual property. In the Healthcare business sector, out-licensing agreements are usually not part of ordinary activities, meaning that the corresponding income is not presented within net sales, but within other operating income. If the license represents a separate performance obligation, it must be determined whether a right-to-use asset (recognition of revenue at a point in time), or an access right (recognition over a period of time), is transferred to the customer. Irrespective of the classification of licenses, sales- or usage-based royalties are recognized only after the customer makes the corresponding disposals, or uses the corresponding intellectual property.

Net sales from contracts comprising several separate performance obligations (particularly sales of goods in combination with services) are recognized when the respective obligation has been fulfilled. Therefore, the transaction price is allocated beforehand to each performance obligation identified in the contract on a relative stand-alone selling price basis. To a limited extent, there are multiple-element contracts in the Life Science business sector.

Dividend income is recognized when the right of dividend payment is established, when it is considered probable that the economic benefit attributable to the dividend payment will flow to the Group, and when the dividend payment can be measured reliably.

Net sales are recognized net of sales-related taxes and sales deductions. When net sales are recognized, estimated amounts are taken into account for sales deductions, for example rebates, discounts and returns. Payments to customers are generally recognized as sales deductions, unless the payments are made for distinct goods or services provided by the customer, provided that their value does not exceed the fair value of the goods or services received by the Group.

Sales deductions, such as discounts provided on the invoice as price-reducing items, which will likely be applied by customers when making the respective payments, are recognized in the consolidated balance sheet as reductions of trade accounts receivable. Expected refunds, such as bonus payments, reimbursements for returns, or rebates from health plans and programs, are recognized in the separate item ‟refund liabilities” in the consolidated balance sheet (see Note (30) ‟refund liabilities”).

Given that the Group generates the large majority of its revenue via sales transactions with simple structures, the company usually has an enforceable right to payment after the performance obligation has been fulfilled. The payment targets contractually agreed between the Group and its customers usually range between 30 and 60 days. For some service contracts, the company receives the contractually agreed consideration before the service is delivered; in such cases, the consideration received is presented as a contract liability in the consolidated balance sheet until revenue is recognized. A contract asset is recognized for an over-time realization of sales of services and customer-specific equipment/hardware if the Group does not have an unconditional right to payment until complete fulfillment of the contractual services.

The Group uses the following practical expedients of IFRS 15:

  • The promised amount of consideration is not adjusted for the effects of a significant financing component if the period between the fulfillment of a performance obligation and the payment by the customer amounts to up to one year.
  • Expected revenue from contracts with customers is not disclosed for contracts with a term of up to one year.

Please refer to the Annual Report 2017 for further information on the accounting and measurement principles applied in the previous year with regard to the recognition of net sales and other income.

(54) Collaboration agreements, in-licensing and out-licensing in the Healthcare business sector

In the Healthcare business sector, the Group regularly enters into collaboration agreements, as well as in-licensing and out-licensing contracts, in particular with research institutions, pharmaceutical and biotechnology companies. In the majority of cases, the Group acquires rights to the intellectual property of the respective contract parties against the provision of upfront payments, regulatory or commercial milestone payments, or license fees. The portion of the consideration paid by the Group to acquire intellectual property is recognized as an intangible asset. If additional service is acquired from the contract party – besides intellectual property – an appropriate portion of the consideration is allocated to research and development costs in line with the service performance of the contract party.

In individual cases, the Group enters into collaboration agreements with other pharmaceutical and biotechnology companies whereby both contract parties develop drug candidates on a collaborative basis; in case of regulatory approval, such drugs will be commercialized by both contract parties. As a general rule, such collaboration agreements comprise the granting of rights to intellectual property as well as additional goods or services promised by the Group, such as the provision of development activities or production services. For these activities and services, the Group usually receives consideration from its contract parties, such as upfront payments, or regulatory and commercial milestone payments and license fees (see Note (63) ‟Contingent consideration”). Furthermore, specific income and expense items are commonly carried collectively amongst the contract parties. When entering into this kind of collaboration agreements, the Group must determine whether the individual promised goods or services are separate performance obligations, or whether they instead must be combined with other performance obligations. Given that the collaboration partner is usually not able to obtain any benefit from the license alone, or from the license in combination with other readily available resources, and considering, moreover, that the individual promised goods or services are invariably not distinct in the context of the contract, the performance obligations are often integrated into bundles, income from which is recognized in this case in other operating income during the period where the material development activities are provided.

Furthermore, collaboration agreements in the pharmaceutical area typically allocate the revenue generated in specific markets, or with specific products, to individual collaboration partners; simultaneously, specific income and expense items are carried by the collaboration partners according to predefined allocation ratios. The Group recognizes the revenue from the sale of products to third-party customers, if it is the principal within the meaning of IFRS 15. Expenses resulting from payments made to collaboration partners in connection with profit-sharing agreements are recognized in other operating expenses. Reimbursements of research and developments costs made between the collaboration partners are recognized in research and development costs. The Group’s most important collaboration agreement is the strategic alliance with Pfizer Inc., United States, in the immuno-oncology area (see Note (6) ‟Collaboration agreements of material significance”).

(55) Research and development costs

Research and development costs comprise the costs of research and development departments, the expenses incurred as a result of research and development collaborations as well as the costs of clinical trials in the Healthcare business sector (both before and after approval is granted).

The costs of research cannot be capitalized and are expensed in full in the period in which they are incurred. As internally generated intangible assets, it is necessary to capitalize development expenses if the cost of the internally generated intangible asset can be reliably determined and the asset can be expected to lead to future economic benefits. The condition for this is that the necessary resources are available for the development of the asset, technical feasibility of the asset is given, its completion and use are intended, and marketability is given. Owing to the high risks up to the time that pharmaceutical products are approved, these criteria are not met in the Healthcare business sector regarding the development of drug candidates. Costs incurred after regulatory approval were insignificant and were therefore not recognized as intangible assets. In the Life Science and Performance Materials business sectors, development expenses are capitalized as soon as the aforementioned criteria have been met. Provided the relevant criteria set forth in IAS 38 are fulfilled, software development costs are capitalized.

Reimbursements for R&D are offset against research and development costs.

(56) Goodwill

Goodwill is recognized on the acquisition date in the course of business combinations. Goodwill is measured at cost, and is defined as the excess amount of the purchase price paid for the company shares over the value of the acquired portion of net assets. Net assets are defined as the net balance of the fair values of the acquired identifiable assets, and the assumed liabilities and contingent liabilities.

Goodwill is allocated to cash-generating units or groups of cash-generating units and tested for impairment either annually or if there are indications of impairment. The carrying amounts of the cash-generating units or groups of cash-generating units are compared with their recoverable amounts and impairme

(57) Other intangible assets

Acquired intangible assets are capitalized at cost. Self-developed intangible assets are only capitalized if the requirements specified by IAS 38 have been met. Intangible assets acquired in the course of business combinations are recognized at fair value on the acquisition date. If the development of intangible assets takes a substantial period of time, the directly attributable borrowing costs incurred up until completion are capitalized as part of the costs.

Intangible assets with indefinite useful lives and intangible assets not yet available for use

Intangible assets with indefinite useful lives and intangible assets not yet available for use are not amortized; however they are tested for impairment when a triggering event arises or at least once a year. Here, the respective carrying amounts are compared with the recoverable amount and impairments are recognized as required. Impairment losses recognized on indefinite-life intangible assets and intangible assets not yet available for use are reversed if the original reasons for impairment no longer apply.

The marketing authorizations, patents, licenses and similar rights, and other items not yet available for use primarily relate to rights that the Group acquired for active ingredients, products or technologies that are still in development stages. Amortization begins when the product reaches market approval, and is charged on a straight-line basis over the shorter of the patent or contract term and the estimated useful life.

Intangible assets with finite useful lives

Intangible assets with a finite useful life are amortized using the straight-line method. The useful lives of customer relationships, brand names and trademarks as well as marketing authorizations, acquired patents, licenses and similar rights, and software are between three and 24 years. Amortization of intangible assets and software is allocated to the functional costs in the consolidated income statement. An impairment test is performed if there are indications of impairment. Impairment losses are determined using the same methodology as for indefinite-life intangible assets. Impairment losses are reversed if the original reasons for impairment no longer apply.

(58) Property, plant and equipment

Property, plant and equipment is measured at cost less depreciation and impairments plus reversals of impairments. The component approach is applied here in accordance with IAS 16. Subsequent costs are only capitalized if it is probable that future economic benefits will arise for the Group and the cost of the asset can be measured reliably. The cost of self-constructed property, plant and equipment is calculated on the basis of the directly attributable unit costs and an appropriate share of overheads. If the construction of property, plant and equipment takes a substantial period of time, the attributable borrowing costs incurred up until completion are capitalized as part of the costs. In accordance with IAS 20, costs are reduced by the amount of government grants in those cases where government grants or subsidies have been paid for the acquisition or manufacture of assets (grants related to assets). Grants related to expenses which no longer offset future expenses are recognized in profit or loss. Property, plant and equipment is depreciated using the straight-line method over the useful life of the asset concerned. Depreciation of property, plant and equipment is based on the following useful lives:

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USEFUL LIFE OF PROPERTY, PLANT AND EQUIPMENT

Useful life
Production buildings maximum of 33 years
Administration buildings maximum of 40 years
Plant and machinery 6 to 25 years
Operating and office equipment; other facilities 3 to 10 years

The useful lives of the assets are reviewed regularly and adjusted if necessary. If indications of a decline in value exist, an impairment test is performed. If the reasons for an impairment loss no longer exist, a reversal of the impairment loss recognized in prior periods is recognized.

(59) Leasing

Where non-current assets are leased and economic ownership lies with the Group (finance lease), the asset is recognized at the present value of the minimum lease payments or the lower fair value in accordance with IAS 17 and depreciated over its useful life. The corresponding payment obligations from future lease payments are recognized as liabilities. If an operating lease is concerned, the associated expenses are recognized in the period in which they are incurred.

(60) Financial assets

Classification

Since January 1, 2018, the classification and measurement of financial assets are determined by the business model of the company and the characteristics of the cash flows of the respective financial asset in accordance with IFRS 9. Upon initial recognition, a financial asset is designated either as ‟at amortized cost”, as ‟at fair value through other comprehensive income” or as ‟at fair value through profit or loss”.

Financial assets are recognized as at the settlement date. Debt instruments are reclassified only if the business model used to manage such assets has changed. Financial assets with embedded derivatives are considered as one item, provided that the respective cash flows are solely payments of principal and interest.

Measurement

At initial recognition, the Group recognizes financial assets at fair value, plus any transaction costs directly attributable to the acquisition of such assets – provided the financial assets are subsequently not measured at fair value through profit or loss. However, trade accounts receivable without significant financing components are exempted from this general rule and measured at their transaction price. Transaction costs of assets measured at fair value through profit or loss are recognized as expenses in the consolidated income statement. Trade accounts receivable that are potentially designated to be sold on account of a factoring agreement are measured at fair value through other comprehensive income. Provided that the trade accounts receivable are sold, the factoring fees previously recognized directly in equity are recycled through the operating result upon derecognition of the trade accounts receivable sold.

Debt instruments

The following table provides details on the measurement effects of debt instruments on the consolidated income statement:

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Category Asset type Impairment losses/reversals of impairment losses Net gain (or loss) on disposal/value adjustments Foreign currency gains or losses Interest income or expenses
Subsequent measurement at amortized cost Operative Impairment losses, and reversals of impairment losses on financial assets (net) Other operating income or other operating expenses Other operating income or other operating expenses Financial result (applying the effective interest method)
Financial Financial result Financial result Financial result
Subsequent measurement at fair value through other comprehensive income Operative Impairment losses, and reversals of impairment losses on financial assets (net)
  • Results recognized directly in equity (value adjustment)
  • Recycling of the cumulative results previously recognized directly in equity through the operating result (derecognition) when asset is disposed
Other operating income or other operating expenses Financial result (applying the effective interest method)
Financial Financial result
  • Results recognized directly in equity (value adjustment)
  • Recycling of the cumulative results previously recognized directly in equity through the operating result (derecognition) when asset is disposed
Financial result
Subsequent measurement at fair value through profit or loss Operative Other operating income or other operating expenses Other operating income or other operating expenses Financial result (applying the effective interest method)
Financial Financial result Financial result

Depending on the category of debt instrument, at initial recognition the Group recognizes either the credit losses expected to occur over the entire lifetime or the 12-month expected credit losses. Except debt instruments with subsequent measurement through profit or loss, the impairment model of IFRS 9 is applied to all debt instruments.

The Group uses the simplified impairment model for trade accounts receivable and contract assets pursuant to which any credit losses expected to occur over the entire lifetime of an asset are taken into account. In order to measure expected credit risks, the assets are grouped on the basis of the existing credit risk structure and the respective maturity structure. The customer groups with comparable default risks to be taken into account are determined at the Group in accordance with the business sectors and location of the respective customers. The default rates used in the simplified impairment model are derived on the basis of historical experience and current macroeconomic expectations by taking into account country-specific ratings. These country ratings are aggregated to three separate rating groups. In this context, historical default rates generally also represent the best approximation for future expected defaults to the extent that a country’s rating remains unchanged. Accordingly, when a country’s rating changes, the historical default rates of the rating group to which the respective country has been re-allocated have to be applied, rather than the historical default rates of the previous rating group. Further information on the impairment of financial assets can be found in Note (38) ‟Management of financial risks”.

Provided that the Group expects default risk to be low, the impairments of all other debt instruments are limited to the 12-month expected credit losses. If the default risk has increased significantly since initial recognition, impairments are increased to the amount of credit losses expected to occur over the entire lifetime of the respective asset. The Group considers default risk to be low if the risk of non-performance is remote and the contract party is able to fulfill its payment obligations at short notice at any time. The probabilities used to establish 12-month expected credit losses, or lifetime expected credit losses, are based on historical default rates, taking current credit ratings into consideration.

Equity instruments

Equity instruments are subsequently measured at fair value.

For equity instruments not held for trading, the Group has uniformly exercised the option of recognizing future changes in fair value in other comprehensive income in the consolidated statement of comprehensive income and thus to retain them in consolidated equity upon disposal of the financial instrument.

Changes in the fair value of equity instruments held for trading are recognized through profit or loss (other operating income/expenses).

Dividend income from equity instruments of both categories is recognized in the consolidated income statement in other operating income. Impairments and impairment reversals of equity instruments are disclosed together with other fair value changes.

Derecognition

The Group derecognizes financial assets if there is no reasonable expectation that the contract party will fulfill its contractual obligations. In this context, the Group takes individual discretionary decisions in order to evaluate whether contract fulfillment can be reasonably expected.

Accounting and measurement principles applied in the previous year (IAS 39)

For further information on the accounting and measurement principles applied in the previous year (IAS 39 ‟Financial instruments: recognition and measurement”), please refer to the Annual Report 2017.

(61) Financial liabilities

Other financial liabilities

Except for contingent consideration, which only occurs in the context of business combinations in accordance with IFRS 3, and derivatives with negative market values, all financial liabilities are subsequently measured at amortized cost using the effective rate method. The Group primarily assigns financial liabilities such as issued bonds and bank loans, trade payables, and non-derivative current and non-current liabilities to this category.

Liabilities subsequently measured at fair value through profit or loss

Contingent consideration, as well as derivatives with negative market values, are subsequently measured at fair value. Value changes are recognized through profit or loss.

(62) Derivatives and hedge accounting

The Group applied the hedge accounting provisions of IFRS 9 effective January 1, 2018, and did not opt for the option to continue to apply IAS 39. The existing hedging relationships were continued, even after the first-time application of IFRS 9.

The Group uses derivatives solely to economically hedge recognized assets or liabilities and forecast transactions. The Group applied the hedge accounting rules exclusively to forecast cash flow hedges. Hedging transactions were entered into for highly probable forecast transactions in foreign currencies. Cash flow hedge accounting for forecasted transactions in foreign currency will lead to the hedged item being recognized at a fixed exchange rate on a net basis – instead of being recognized at the spot exchange rate at the transaction date.

Depending on the nature of the hedged item, changes in the fair values of derivatives used for hedging purposes are recognized in the consolidated income statement either in the operating result or in the financial result.

The Group currently only uses derivatives as hedging instruments. The hedging relationship must be effective at all times, i.e. the change in fair value of the hedging instrument almost fully offsets changes in the fair value of the hedged item. The Group uses the dollar offset method as well as regression analyses to measure hedge effectiveness. Hedging ineffectiveness may occur when the forecast cash flows are made/received, or if hedged items are dissolved. Derivatives that do not or no longer meet the documentation or effectiveness requirements for hedge accounting, whose hedged item no longer exists, or for which hedge accounting rules are not applied are classified as ‟financial assets and liabilities at fair value through profit or loss”.

In the case of hedging relationships where the Group uses options as hedging instruments, only the intrinsic value of options has been designated as the hedging instrument since the first-time application of IFRS 9. Changes in the fair value of the time value component of options that are used for hedge accounting have to be recognized in other comprehensive income and in a new reserve for cost of hedging within equity. The subsequent accounting of these amounts depends on the type of the hedged transaction.

In the case of hedging relationships where the Group uses forward contracts as hedging instruments, only the spot element is designated as the hedging instrument. Changes in the fair value of the forward element in forward contracts are initially recognized in a new reserve for hedging costs within equity. The subsequent accounting of these amounts depends on the type of the hedged transaction.

Reclassifications of cash flow hedge reserve to profit or loss are recognized in the operating result, while reclassifications of the cost of cash flow hedge reserve are recognized in the financial result.

(63) Contingent consideration

For contingent consideration that was contractually agreed with the acquirer or seller within the context of the disposal or the acquisition of businesses within the meaning of IFRS 3, the fair value of the claims or obligations as at the transaction date is recognized as a financial asset or financial liability. The subsequent measurement is at fair value through profit or loss. Contingent consideration in connection with the purchase of individual assets outside of business combinations is recognized as a financial liability only when the consideration is contingent upon future events that are beyond the Group’s control. In cases where the payment of contingent consideration is within the Group’s control, the liability is recognized only as from the date when a non-contingent obligation arises. Contingent consideration linked to the purchase of individual assets primarily relates to future milestone payments in connection with in-licensed intellectual property in the Healthcare business sector.

Changes in the fair value of financial assets and financial liabilities from contingent consideration are recognized as other operating income or other operating expenses, except for changes due to interest rate fluctuations and the effect from unwinding discounts. Interest rate effects from unwinding of discounts as well as changes due to interest rate fluctuations are recognized in financial income or financial expenses.

(64) Other non-financial assets and liabilities

Other non-financial assets are carried at amortized cost. Impairments are recognized for any credit risks. Long-term non-interest bearing and low-interest receivables and liabilities are carried at their present value. Other non-financial liabilities are carried at their repayment amount.

(65) Deferred taxes

Deferred tax assets and liabilities result from temporary differences between the carrying amount of an asset or liability in the IFRS and tax balance sheets of consolidated companies as well as from consolidation activities, insofar as the reversal of these differences will occur in the future.

Deferred taxes are recognized through profit or loss, except when they relate to items recognized in equity; in the latter case, deferred taxes are recognized either in gains/losses recognized in equity, or in consolidated equity.

Deferred tax assets resulting from deductible temporary differences, tax credits as well as tax loss (and interest) carryforwards, are recognized if it is considered probable that taxable profit will be available in the future to apply such tax assets. Deferred tax liabilities are recognized for temporary differences subject to tax in the future. Our calculations are based on the expected prevailing tax rates in the respective countries as at the date the tax will be due. As a rule, our tax projections are based on the statutory regulations applicable, or endorsed, at the balance sheet date. Deferred tax assets and liabilities are offset, provided they relate to the same tax authority, and provided that the Group has an enforceable right to offset tax. Material effects on deferred tax assets and liabilities resulting from changes of tax rates, or amendments of tax laws, are usually recognized in the period in which the legislative procedure is completed. As a rule, these effects are recognized through profit or loss. In case of deferred tax items recognized in equity, such effects are recognized either in the consolidated statement of comprehensive income (gains/losses recognized in equity), or in consolidated equity.

Deferred tax liabilities are recognized for projected dividend payments of subsidiaries. If no dividend payments are projected in the foreseeable future, no deferred tax liability is recognized for the difference between proportional equity in line with IFRSs and the investment value determined for tax purposes.

(66) Inventories

Inventories are carried at the lower of cost or net realizable value. When determining cost, the ‟first-in, first-out” (FIFO) and weighted average cost formulas are used. In addition to directly attributable unit costs, manufacturing costs also include overheads attributable to the production process, which are determined on the basis of normal capacity utilization of the production facilities.

Inventories are written down if the net realizable value is lower than the acquisition or manufacturing cost carried in the balance sheet.

Since inventories are for the most part not manufactured within the scope of long-term production processes, the manufacturing costs do not include any borrowing costs.

Inventory prepayments are recognized under other current assets.

(67) Provisions for pensions and other post-employment benefits

Provisions for pensions and other post-employment benefits are recognized in accordance with IAS 19. The obligations under defined benefit plans are measured using the projected unit credit method. Under the projected unit credit method, dynamic parameters are taken into account in calculating the expected benefit payments after an insured event occurs; these payments are spread over the entire period of service of the participating employees. Annual actuarial opinions are prepared for this purpose. Actuarial gains and losses resulting from changes in actuarial assumptions and/or experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred) are recognized immediately in equity as soon as they are incurred, taking deferred taxes into account. Consequently, the consolidated balance sheet provides – after deduction of the plan assets – the full scope of the obligations while avoiding the fluctuations in expenses that can result especially when the calculation parameters change. The actuarial gains and losses recognized in the respective reporting period are disclosed separately in the consolidated statement of comprehensive income.

(68) Other provisions and contingent liabilities

Provisions are recognized if it is more likely than not that an outflow of resources will be required to settle the obligation and the amount of the obligation can be measured reliably. The carrying amount of other provisions takes into account the amounts required to cover future payment obligations, recognizable risks and uncertain obligations of the Group to third parties.

Measurement of other provisions is based on the settlement amount with the highest probability or, if a large number of similar cases exist with respect to the provision being measured, it is based on the expected value of the settlement amounts. Long-term provisions are discounted and carried at their present value as of the balance sheet date if the discount rate effect is material. To the extent that reimbursement claims exist as defined in IAS 37, they are recognized as an asset – separately from provisions – if their realization is virtually certain and the asset recognition criteria have been met. Restructuring provisions are recognized after detailed restructuring plans have been established and disclosed.

Contingent liabilities comprise not only possible obligations arising from past events and whose existence is subject to the occurrence of uncertain future events, but also present obligations arising from past events where an outflow of resources embodying economic benefits is not probable or where the amount of the obligation cannot be measured reliably. Contingent liabilities that were not assumed within the context of a business combination are not recognized in the consolidated balance sheet. Unless the possibility of an outflow of resources embodying economic benefits is remote, information on the relevant contingent liabilities is disclosed in the notes. In this context, the present value of the future settlement amount is used as the basis for measurement. The settlement amount is determined in accordance with the rules set out in IAS 37 and is based on the best estimate.

(69) Share-based compensation programs

Provisions have been set up for obligations from long-term variable compensation programs (Long-Term Incentive Plan of the Group). These share-based compensation programs with cash settlement are aligned not only with target achievement based on key performance indicators, but above all with the long-term performance of shares of Merck KGaA, Darmstadt, Germany. Certain executives and employees could be eligible to receive a certain number of virtual shares – Share Units of Merck KGaA, Darmstadt, Germany (MSUs) – at the end of a three-year performance cycle. The number of MSUs that could be received depends on the individual grant defined for the respective person and the average closing price of shares of Merck KGaA, Darmstadt, Germany, in Xetra® trading during the last 60 trading days prior to January 1 of the respective performance cycle (reference price). In order for members of top management to receive payment for the 2016 tranche, they must personally own an investment in shares of Merck KGaA, Darmstadt, Germany, dependent on their respective fixed annual compensation. For the 2017 and 2018 tranches, an obligatory personal investment is not a precondition to receive payments. Since 2017, the personal investment for top management is defined in a separate Share Ownership Guideline (SOG). When the three-year performance cycle ends, the number of MSUs to then be granted is determined based on the development of defined key performance indicators (KPIs).

For the 2016 tranche, these are on the one hand the performance of the share price of Merck KGaA, Darmstadt, Germany, compared to the performance of the DAX® with a weighting of 70%, and on the other hand the development of the EBITDA pre margin during the performance cycle as a proportion of a defined target value with a weighting of 30%.

As of fiscal 2017, the program conditions were modified. For the 2017 and 2018 tranches, the performance of the share price of Merck KGaA, Darmstadt, Germany, relative to the performance of the DAX® is considered with a weighting of 50%, and the development of the EBITDA pre margin during the performance cycle as a proportion of a defined target value with a weighting of 25%. The development of organic sales growth as a proportion of a defined target value with a weighting of 25% is a new key performance indicator now taken into account.

Depending on the development of the KPIs, at the end of the respective performance cycle the eligible participants are granted between 0% and 150% of the MSUs they could be eligible to receive. Based on the MSUs granted, the eligible participants receive a cash payment at a specified point in time in the year after the three-year performance cycle has ended. The value of a granted MSU, which is relevant for payment, corresponds to the average closing price of shares of Merck KGaA, Darmstadt, Germany, in Xetra® trading during the last 60 trading days prior to January 1 after the performance cycle. Whereas the payout for the 2016 tranche is limited to two times the reference price, the payout for the 2017 and 2018 tranches is limited to two and a half times the individual grant.

The fair value of the obligations is recalculated by an external expert using a Monte Carlo simulation based on the previously described KPIs on each balance sheet date. The expected volatilities are based on the implicit volatility of shares of Merck KGaA, Darmstadt, Germany, and the DAX® in accordance with the remaining term of the respective tranche. The dividend payments incorporated into the valuation model are based on medium-term dividend expectations. Changes of the intrinsic value of share-based compensation programs are allocated to the respective functional costs according to the causation principle. Fair value changes are recognized in financial income or financial expenses.

The Executive Board members have their own Long-Term Incentive Plan, the conditions of which largely correspond to the Long-Term Incentive Plan described here. A description of the plan for the Executive Board can be found in the compensation report, which is part of the Statement on Corporate Governance.

On the occasion of the 350th anniversary of the company in 2018, every employee in Germany was granted shares of Merck KGaA, Darmstadt, Germany, worth € 350. For the granted shares of Merck KGaA, Darmstadt, Germany, the required shares were purchased on the stock market by a third party on behalf of the Group and then transferred to the eligible employees.