Financial Management Book 2020 PDF

University of St.
Gallen
School of Management, Economics, Law and Social Sciences (HSG)
Principles of
Financial Management
A practice-oriented Introduction
Prof. Dr. Dirk Schäfer

Institute for Accounting, Control and Audit
www.aca.unisg.ch
[email protected]
Foreword I
Foreword
With this new edition, the duties and responsibilities of the CFO are in the focus, leading to a broader spectrum
covered by the book. CEO and CFO, with their respective roles and perspectives onto the company, must work as a
close team and ensure long-term success. Oftentimes, the CFO validates and secures implementation, financing and
assessment of growth initiatives initiated by the CEO. Complementing CEO and CFO as sparing partners, business
analysts take the role of business partners in operating units, instead of being number-crunchers only and hardly ever
looking further than excel spreadsheets. The top responsibilities of the CFO function include discussions about the
course of the business, price calculations, discount levels, and scenarios regarding market developments. The
recurring mandatory services include financial reporting.
The interest in financial reporting of companies enjoys continuous increase, despite extensive online news. While
scandals regarding financial reporting led to significant confusion around the turn of the century, and stock
exchange authorities, standard setters, as well as governments of various countries set out new rules and regulations,
the importance of audited information has become a cornerstone thereof. The more important it has become to know
and understand the rules, mechanisms and context of financial management.
Using the information from financial reporting, management accounting and performance measurement prepares
analysis, which are used by line managers for making decisions und steering of their divisions. Deviation analysis
show where new measures are required to achieve objectives, scenario analysis disclose how financial ratios change
if key facts of the business, like sales or personnel cost come under pressure, and internal and external analysis help
for location decision. But all this requires to not compare apples with oranges, but disclose facts that are
comparable, are built on identical norms and principles, and commented for decision making. Which business
partner is solid enough to engage in strategic projects together? Which investment suggest a risk-adequate return?
Which company has enough cash reserves, also during difficult times to not be highly dependent on banks?
A further responsibility of the CFO is liquidity management, which is done by the treasurer and the treasury
department, being responsible that sufficient cash is available at any point in time to fulfill all financial obligations.
Respective decisions include strategic decisions regarding the structure of liabilities in the statement of financial
position: what financing shall apply, what should be the ratio between equity and liabilities?
Questions like these will be discussed in this book, with practical examples, with focus on essentials, imparting
knowledge, arouse interest and with fascinating examples also entertain along.
Target audience
As every market offer, we also want to focus on our target customers, hoping to meet their expectations more
tailored then with a general sweeping swipe. So we choose the perspective of an student hungry for education,
thirsty for knowledge regarding the most important aspects of financial management, including their application.
Looking as full-time as well as executive students, this practical-oriented book with many examples aims serving
both these demanding target groups.
Foreword II
Structure
The book is structured into four parts. Part A introduction to financial management shows the overall frame and
integrates financial management into the overall management and leadership of companies. The frame used is the St.
Gallen Management Model serving as orientation for organizational searing.
Part B looking outside – external financial management discusses the mandatory parts of annual reports as well
as other aspects of financial reporting in seven chapters. The frame used are financial reporting standards such as
IFRS, Swiss GAAP FER and US-GAAP, including looking at respective differences.
Part C looking inside – internal financial management shows how costs develop and may be influenced. This
information is then used for decision support through financial ratios and ratio systems through comprehensive
presentation and interpretation.
Part D looking forward – strategic planning concerns questions around financing and how credit ratings may
influence the cost for financing. A further discussion is around M&A projects, serving for organizational growth.
Analyzing and deciding on effects on financing structure, financial ratios and possibilities for synergies are
responsibilities of the CFO.
Thanks
Books are oftentimes team efforts, with roots dating back far into previous years. As the lecture developed, a
comprehensive rework of the book was inevitable. First and far most I would like to thank Florian Hohmann and
Daniel Tinner for their efforts. The chapters were reworked and new chapters were added, to achieve the extended
objectives. Without their engagement, this result would not have been possible.
PS:
Dear students, you hold a print-fresh new edition of this book in your hand. We appreciate your feedback
([email protected]) – please share with us any mistakes you may find. Thank you very much and make sure to
have fun as well as gain interesting insights while reading!
Summary of Contents III
Summary of Contents
Foreword I
Summary of Contents............................................................................................................................... III
Table of Contents ........................................................................................................................................ V
List of Figures .......................................................................................................................................... XII
List of Charts ........................................................................................................................................ XVII
List of Abbreviations ..............................................................................................................................XIX
Part A Introduction to Financial Management ........................................................................................ 1
Introduction ............................................................................................................................. 2
Embedding of Financial Management into the St. Gallen Management Model (SGMM)6
Part B: Looking outside – External Financial Management ................................................................. 26
Objectives and Principles of Financial Reporting ............................................................. 27
Statement of Financial Position ........................................................................................... 69
Statement of Profit or Loss ................................................................................................ 124
Statement of Cash Flows .................................................................................................... 145
Notes and Audit Report ...................................................................................................... 161
Corporate Governance and Other Reports ...................................................................... 175
Group Reporting ................................................................................................................. 187
Part C: Looking inside – Internal Financial Management ................................................................. 203
Introduction to Management Accounting ........................................................................ 204
Performance Measurement ................................................................................................ 226
Part D: Looking forward – Strategic Planning .................................................................................... 265
Financing ............................................................................................................................. 266
Principles of Financial Management – a practice-oriented introduction

Summary of Contents IV
Credit Rating ....................................................................................................................... 286
Mergers & Acquisitions ...................................................................................................... 313
Bibliography ............................................................................................................................................. 339
List of Internet sources ........................................................................................................................... 341

Table of Contents V
Table of Contents
Foreword I
Summary of Contents............................................................................................................................... III
Table of Contents ........................................................................................................................................ V
List of Figures .......................................................................................................................................... XII
List of Charts ........................................................................................................................................ XVII
List of Abbreviations ..............................................................................................................................XIX
Part A Introduction to Financial Management ........................................................................................ 1
Introduction ............................................................................................................................. 2
1.1 Introduction to Financial Management........................................................................... 2
1.2 Book Structure and Work Methodology ........................................................................ 3
1.3 Symbols and Explanations.............................................................................................. 4
Embedding of Financial Management into the St. Gallen Management Model (SGMM)6
2.1 Introductory Example from Nestlé ................................................................................. 6
2.2 Managerial Finance and the St. Gallen Management Model ......................................... 7
2.3 Financial Management as an essential management task ............................................. 10
2.4 Financial Management in the task perspective ............................................................. 11
2.4.1 Environmental spheres ..................................................................................... 11
2.4.2 Stakeholder ....................................................................................................... 13
2.4.3 Interaction issues .............................................................................................. 15
2.4.4 Processes and Value Creation .......................................................................... 16
2.4.5 Governance as element of order ....................................................................... 18
2.5 Financial Management in the praxis perspective ......................................................... 20
2.5.1 Decision-making praxis.................................................................................... 21
2.5.2 Frame of orientation ......................................................................................... 21
2.5.3 Management praxis .......................................................................................... 22
2.5.4 Executive management .................................................................................... 23
2.6 Summary ....................................................................................................................... 24
2.7 Additional Literature .................................................................................................... 25
Part B: Looking outside – External Financial Management ................................................................. 26
Objectives and Principles of Financial Reporting ............................................................. 27

3.1 Introductory Example from PubliGroupe ..................................................................... 27
3.2 Objectives of Financial Reporting ................................................................................ 28
3.3 Framework Conditions and Accounting Standards ...................................................... 31

Table of Contents VI
3.3.1 Swiss Code of Obligations ............................................................................... 32

3.3.2 Listing on the SIX Swiss Exchange ................................................................. 33
3.3.3 Swiss GAAP FER ............................................................................................ 34
3.3.4 International Financial Reporting Standards (IFRS) ........................................ 36
3.3.4.1 Organization ..................................................................................... 36
3.3.4.2 Procedure for Establishing New Standards (Standard Setting) ........ 38
3.3.4.3 IFRS for SMEs ................................................................................. 39
3.3.5 US GAAP ......................................................................................................... 40
3.3.6 IFRS versus Swiss GAAP FER ........................................................................ 41
3.3.7 Allocation of Standards to Positions in the Financial Statements.................... 43
3.4 Fundamentals of Financial Management ...................................................................... 44
3.4.1 Basic Assumptions of Financial Reporting ...................................................... 47
3.4.2 Primary Principles and Secondary Principles of Financial Reporting ............. 50
3.5 Dimensions of Reporting .............................................................................................. 54
3.5.1 Components of Financial Reporting ................................................................ 54
3.5.2 Timing of Reports ............................................................................................ 57
3.5.3 Industry Affiliation of the Reporting Company ............................................... 58
3.5.4 Scope of the Annual Report ............................................................................. 64
3.6 Summary ....................................................................................................................... 66
3.7 Additional Literature .................................................................................................... 68
Statement of Financial Position ........................................................................................... 69
4.1 Introductory Example from Alpiq ................................................................................ 69

4.2 Statement of Financial Position Structure, Definitions and Accounting Principles ..... 70
4.2.1 Asset side.......................................................................................................... 71
4.2.2 Definition and Recognition Criteria for Assets ................................................ 73
4.2.3 Liability and Equity side .................................................................................. 75
4.2.4 Definition and Recognition Criteria for Liabilities .......................................... 78
4.2.5 Valuation Approaches ...................................................................................... 79
4.3 Valuation of selected Current Assets positions ............................................................ 82
4.3.1 Inventories ........................................................................................................ 83
4.3.2 Receivables of Current Assets.......................................................................... 87
4.3.3 Securities and Investments in Current Assets .................................................. 90
4.4 Valuation of Non-Current Asset positions ................................................................... 93
4.4.1 Property, Plant and Equipment......................................................................... 94
4.4.2 Investments....................................................................................................... 99
4.4.3 Intangible Assets ............................................................................................ 100
4.4.3.1 Patents, trademarks, and R&D-expenses ....................................... 103
4.4.3.2 Goodwill ......................................................................................... 104
4.4.3.3 Personnel, Know-how, Customer Lists .......................................... 108
4.5 Valuation of selected Liability Positions .................................................................... 109
4.5.1 Liabilities ........................................................................................................ 109
4.5.2 Provisions ....................................................................................................... 111
4.6 Valuation of Equity Positions ..................................................................................... 116
4.6.1 Earned Capital and Reserves .......................................................................... 117
4.6.2 Statement of Changes in Equity ..................................................................... 119
4.7 Summary ..................................................................................................................... 121
4.8 Additional Literature .................................................................................................. 122
Statement of Profit or Loss ................................................................................................ 124

5.1 Introductory Example from Looser ............................................................................ 124

Table of Contents VII
5.2 Definition and Content of the Statement of Profit or Loss versus the Statement of
Comprehensive Income ........................................................................................................ 125
5.2.1 Difference between the Statement of Profit or Loss and the Statement of Other
Comprehensive Income ................................................................................. 126
5.2.2 Background on “Other Comprehensive Income”........................................... 127
5.2.3 Presentation of the Statement of Profit or Loss and Other Comprehensive
Income ........................................................................................................... 128
5.3 Cost of Goods Sold and Total Cost Methods ............................................................. 130
5.3.1 Cost of Goods Sold Method ........................................................................... 130
5.3.2 Total Cost Method .......................................................................................... 132
5.4 Margins of Discretion in the Statement of Profit or Loss........................................... 133
5.4.1 Revenue Recognition ..................................................................................... 133
5.4.2 Cost of Materials and Personnel Expenses .................................................... 136
5.4.3 Effects of Statement of Financial Position Valuations onto the Statement of
Profit or Loss ................................................................................................. 138
5.5 Segment Reporting ..................................................................................................... 139
5.5.1 Defining Business Segments .......................................................................... 140
5.5.2 Reporting ........................................................................................................ 141
5.6 Summary ..................................................................................................................... 143
Statement of Cash Flows .................................................................................................... 145

6.1 Introductory Example from Petroplus ........................................................................ 145
6.2 Purpose and Structure of the Statement of Cash Flows.............................................. 146
6.2.1 Delimitation of Funds..................................................................................... 148
6.2.2 Structure and Preparation ............................................................................... 149
6.3 Cash Flow from Operating Activities ......................................................................... 150
6.3.1 Direct Method ................................................................................................ 150
6.3.2 Indirect Method .............................................................................................. 151
6.4 Cash Flow from Investing Activities .......................................................................... 154
6.5 Cash Flow from Financing Activities ......................................................................... 155
6.6 Statement of Financial Resources and Decision-Making Basis ................................. 157
6.7 Summary ..................................................................................................................... 159
Notes and Audit Report ...................................................................................................... 161

7.1 Introductory Example from Jomed and EMTS .......................................................... 161
7.2 Purpose and Scope of the Notes ................................................................................. 162
7.2.1 Interpretation Function ................................................................................... 164
7.2.2 Ratification and Explanation Function........................................................... 165
7.2.3 Supplementation Function.............................................................................. 166
7.2.4 Correction Function........................................................................................ 166
7.3 Select Components of the Notes ................................................................................. 167
7.3.1 Transactions with Related Parties .................................................................. 168
7.3.2 Off-Balance-Sheet Transactions .................................................................... 168
7.3.3 Events Occurring After the Reporting Date ................................................... 168
7.3.4 Information about Financial Risks and Management of Capital.................... 169
7.3.5 Risk Evaluation .............................................................................................. 169
7.3.6 Further Information ........................................................................................ 169
7.4 Audit Report ............................................................................................................... 170
7.4.1 Legal Fundamentals ....................................................................................... 170

Table of Contents VIII
7.4.2 Scope of the Audit .......................................................................................... 170

7.4.3 Negative Net Worth and Over-indebtedness .................................................. 171
7.5 Summary ..................................................................................................................... 173
Corporate Governance and Other Reports ...................................................................... 175

8.1 Introductory Example from Hilcona........................................................................... 175
8.2 Other Reports in the Annual Report ........................................................................... 176
8.3 Management Report ................................................................................................... 177
8.3.1 Law and Financial Reporting ......................................................................... 178
8.3.2 Corporate Governance and Management Report ........................................... 178
8.3.3 Liability .......................................................................................................... 179
8.4 Corporate Governance ................................................................................................ 179
8.4.1 SIX Directives ................................................................................................ 180
8.4.2 Corporate Governance – Company Comparison ........................................... 181
8.5 Corporate Responsibility ............................................................................................ 181
8.5.2 Corporate Responsibility – Company Comparison ........................................ 182
8.6 Value Added Statement .............................................................................................. 183
8.7 Summary ..................................................................................................................... 185
Group Reporting ................................................................................................................. 187

9.1 Introductory Example from Volkswagen and Porsche ............................................... 187
9.2 Fundamentals .............................................................................................................. 188
9.2.2 Preconditions for and Information in Consolidated Financial Statement ...... 193
9.3 Consolidation Methods ............................................................................................... 194
9.3.1 Full Consolidation .......................................................................................... 197
9.3.2 Equity method ................................................................................................ 199
9.4 Summary ..................................................................................................................... 201
Part C: Looking inside – Internal Financial Management ................................................................. 203
Introduction to Management Accounting ........................................................................ 204

10.1 Introductory example ThyssenKrupp ......................................................................... 204
10.2 Fundamentals and distinction ..................................................................................... 205
10.2.1 Distinction between internal and external accounting ................................... 206
10.2.2 The performance management function in the company ............................... 207
10.3 Cost concepts .............................................................................................................. 208
10.3.1 Chargeability of costs ..................................................................................... 208
10.3.1.1 Fixed costs ...................................................................................... 209
10.3.1.2 Variable costs ................................................................................. 209
10.3.1.3 Learning and experience curve and economies of scale ................ 210
10.3.1.4 Total and unit costs......................................................................... 210
10.3.2 Attributability of costs .................................................................................... 211
10.3.2.1 Allocation of indirect costs............................................................. 212
10.3.2.2 Cost accounting .............................................................................. 213
10.3.2.3 Cost distribution sheet .................................................................... 214

Table of Contents IX
10.4 Break-Even Analysis .................................................................................................. 216

10.4.1 Interaction of costs, sales volume and profit .................................................. 216
10.4.1.1 Calculation of break-even item ...................................................... 217
10.4.1.2 Break-even item for target profit .................................................... 218
10.4.1.3 Calculation of the break-even revenue ........................................... 218
10.4.1.4 Break-even revenue for target profit .............................................. 219
10.4.2 Coefficient of safety ....................................................................................... 220
10.4.3 Break-even analysis as a decision-making and planning instrument ............. 220
10.4.4 Break-even analysis in the case of multiple products .................................... 221
10.5 Further aspects of performance management ............................................................. 221
10.5.1 Budgeting ....................................................................................................... 222
10.5.2 Variance analyses ........................................................................................... 222
10.5.3 Process costing and Activity-Based Costing .................................................. 223
10.6 Summary ..................................................................................................................... 224
10.7 Additional literature .................................................................................................... 225
Performance Measurement ................................................................................................ 226
11.1 Introductory Example from Schindler ........................................................................ 226

11.2 Fundamentals of Financial Statement Analysis and Key Performance Indicators ..... 227
11.2.1 Objectives and Limits of the Financial Statement Analysis .......................... 229
11.2.2 Preparation and Evaluation Methods of the Financial Statement Analysis ... 230
11.2.3 Fundamentals and Overview of Key Performance Indicators ....................... 232
11.3 Financial Statement Analysis using Geberit ............................................................... 235
11.4 Key Liquidity Indicators ............................................................................................. 238
11.4.1 Cash Ratio ...................................................................................................... 238
11.4.2 Quick Ratio .................................................................................................... 239
11.4.3 Current Ratio .................................................................................................. 239
11.4.4 Accounts Receivable Turnover and Days of Sales Outstanding .................... 240
11.4.5 Inventory Turnover and Days Inventory Held ............................................... 241
11.4.6 Non-Current Assets to Total Assets Ratio ..................................................... 242
11.4.7 Free Cash Flow (FCF) .................................................................................... 243
11.4.8 Amortization Duration / Debt Factor ............................................................. 244
11.4.9 Times Interest Earned..................................................................................... 244
11.4.10 Cash Flow Ratio ............................................................................................. 245
11.4.11 Cash Burn Rate............................................................................................... 245
11.5 Key Leverage Indicators ............................................................................................. 246
11.5.1 Equity Ratio.................................................................................................... 246
11.5.2 Self-Financing Ratio ...................................................................................... 247
11.5.3 Debt-to-Equity Ratio and Gearing ................................................................. 248
11.5.4 Equity and Long-Term Debt to Non-Current Asset Ratio ............................. 249
11.6 Key Profitability Indicators ........................................................................................ 250
11.6.1 Return on Equity (ROE) ................................................................................. 250
11.6.2 Return on Investment (ROI) ........................................................................... 251
11.6.3 Return on Invested Capital (ROIC) ................................................................ 252
11.6.4 Return on Sales (Margin) ............................................................................... 253
11.7 Summary Financial Ratio development at Geberit..................................................... 255
11.8 Key Performance Indicator Systems .......................................................................... 256
11.8.1 DuPont Analysis............................................................................................. 256
11.8.2 Economic Value Added (EVA)...................................................................... 258
11.8.3 Balanced Scorecard (BSC) ............................................................................. 259
11.8.4 Working Capital Management ....................................................................... 260
11.9 Summary ..................................................................................................................... 262
Table of Contents X
Part D: Looking forward – Strategic Planning .................................................................................... 265
Financing ............................................................................................................................. 266

12.1 Introductory example Startups.................................................................................... 266
12.2 Fundamentals of company financing .......................................................................... 267
12.3 Inside financing .......................................................................................................... 268
12.3.1 Financing with provisions .............................................................................. 268
12.3.2 Self-financing ................................................................................................. 269
12.3.2.1 Plowback ratio ................................................................................ 271
12.3.2.2 Internal growth rate and long-term financeable growth ................. 272
12.4 Outside financing ........................................................................................................ 273
12.4.1 Credit financing .............................................................................................. 273
12.4.1.1 Bonds .............................................................................................. 274
12.4.1.2 Commercial papers ......................................................................... 276
12.4.1.3 Bank loans and open credit ............................................................ 277
12.4.1.4 Supplier credits ............................................................................... 277
12.4.2 Mezzanine capital ........................................................................................... 277
12.4.3 Equity financing ............................................................................................. 278
12.5 The optimal capital structure ...................................................................................... 279
12.5.1 Pecking order theory ...................................................................................... 280
12.5.2 Capital structure and cost of capital ............................................................... 281
12.6 Summary ..................................................................................................................... 284
Credit Rating ....................................................................................................................... 286

13.1 Introductory example Schmolz + Bickenbach AG ..................................................... 286
13.2 The basis of ratings ..................................................................................................... 287
13.2.1 Definition of credit rating and loan default .................................................... 289
13.2.2 History ............................................................................................................ 291
13.2.3 Types of credit rating ..................................................................................... 291
13.3 External credit ratings ................................................................................................. 294
13.3.1 Relevance of ratings ....................................................................................... 295
13.3.2 Rating agencies .............................................................................................. 298
13.3.3 Use of ratings ................................................................................................. 299
13.3.4 Process of preparing an issuer rating.............................................................. 301
13.3.5 The process of preparing issue ratings ........................................................... 306
13.3.6 Timeliness of external ratings ........................................................................ 306
13.3.7 Criticism of external ratings ........................................................................... 308
13.4 Summary ..................................................................................................................... 310
Mergers & Acquisitions ...................................................................................................... 313

14.1 Introductory example Liechtensteinische Landesbank ............................................... 313
14.2 Introduction Mergers & Acquisitions ......................................................................... 314
14.2.1 Fundamentals and terminology of M&A ....................................................... 314
14.2.2 Reasons for M&A .......................................................................................... 318
14.2.2.1 Reasons for buying companies ....................................................... 318
14.2.2.2 Reasons for selling companies ....................................................... 320
14.2.3 Reasons for the failure of M&A ..................................................................... 320
14.3 Due Diligence ............................................................................................................. 321
14.4 Company valuation ..................................................................................................... 323
Table of Contents XI
14.4.1
Net asset value method ................................................................................... 324
14.4.2
Practitioner method ........................................................................................ 325
14.4.3
DCF method ................................................................................................... 325
14.4.4
EVA method ................................................................................................... 330
14.4.5
Multiplier method ........................................................................................... 332
14.4.5.1 Entity multiples .............................................................................. 333
14.4.5.2 Equity multiples ............................................................................. 333
14.4.6 Example of company valuation from a fairness opinion................................ 334
14.5 Execution and post-merger integration....................................................................... 335
14.5.1 Asset deal vs. share deal ................................................................................. 335
14.5.2 Signing & closing ........................................................................................... 335
14.5.3 Post-merger integration .................................................................................. 336
14.6 Summary ..................................................................................................................... 337
Bibliography ............................................................................................................................................. 339
List of Internet sources ........................................................................................................................... 341

List of Figures XII
List of Figures
Figure 1: Goal triangle of Financial Management......................................................................................... 8
Figure 2: Financial Management Processes .................................................................................................. 9
Figure 3: SGMM task perspective ............................................................................................................... 11
Figure 4: Goal Triangle of Financial Reporting .......................................................................................... 12
Figure 5: Objectives of Investor Relations .................................................................................................. 14
Figure 6: Agency Model in Financial Reporting ......................................................................................... 19
Figure 7: SGMM praxis perspective ........................................................................................................... 20
Figure 8: Goals of Financial Reporting ....................................................................................................... 31
Figure 9: Framework Conditions in Financial Reporting............................................................................ 32
Figure 10: An Overview of Swiss GAAP FER ........................................................................................... 35
Figure 11: IFRS Organization ..................................................................................................................... 37
Figure 12: Overview of IFRS ...................................................................................................................... 38
Figure 13: Typical Structure of a Standard (IFRS/IAS) .............................................................................. 39
Figure 14: Allocation of Standards to Positions in the Statement of Financial Position ............................ 43
Figure 15: Allocation of Standards to Positions of the Financial Statement ............................................... 44
Figure 16: Principles of accounting as foundation ...................................................................................... 44
Figure 17: Hierarchy of the Financial Reporting Provisions....................................................................... 45
Figure 18: Basic Concept of the IFRS Fundamentals ................................................................................. 46
Figure 19: Dimensions of Financial Reporting ........................................................................................... 54
Figure 20: Scope of Financial Reporting..................................................................................................... 55
Figure 21: Components of an Annual Report.............................................................................................. 56
Figure 22: Interaction of the Mandatory Components ................................................................................ 57
Figure 23: Disclosure of Assets, Liabilities and Equity in the Statement of Financial Position ................. 71
Figure 24: Structure of the Statement of Financial Position ....................................................................... 71
Figure 25: Nestlé Example: Asset Side of the Statement of Financial Position.......................................... 73
Figure 26: Structure of Liabilities and Equity ............................................................................................. 76
Figure 27: Equity as Residual Value ........................................................................................................... 77
Figure 28: Nestlé Example: Liabilities and Equity Side ............................................................................. 78
Figure 29: Minimum Classification of the Statement of Financial Position pursuant to IAS 1 .................. 79
Figure 30: Valuation Approaches ................................................................................................................ 80
Figure 31: Acquisition Cost and Cost of Conversion .................................................................................. 84
Figure 32: Nestlé Example: Inventory Explanations................................................................................... 85
Figure 33: Nestlé Example: Inventories ...................................................................................................... 86
Figure 34: Nestlé Example: Explanations Regarding Receivables and Loans ............................................ 88
Figure 35: Amortized Cost .......................................................................................................................... 88

List of Figures XIII
Figure 36: Nestlé Example: Trade Receivables .......................................................................................... 89

Figure 37: Impact of Risks on the Impairment of Receivables ................................................................... 90
Figure 38: Classification and Valuation of Financial Assets Pursuant to IFRS 9 ....................................... 91
Figure 39: Classification of financial liabilities, derivatives and equity instruments ................................. 92
Figure 40: Classification and Valuation of Financial Assets Pursuant to IAS 39 ....................................... 92
Figure 41: Nestlé Example: Statement of Asset Additions and Disposals .................................................. 95
Figure 42: Initial Valuation of Property, Plant and Equipment ................................................................... 96
Figure 43: Nestlé Example: Recognition of Property, Plant and Equipment .............................................. 97
Figure 44: Subsequent Valuation of Property, Plant and Equipment .......................................................... 98
Figure 45: Nestlé Example: Intangible Assets .......................................................................................... 101
Figure 46: Initial Valuation of internally generated Intangible Assets ..................................................... 102
Figure 47: Nestlé Example: Recognition of Research and Development ................................................. 103
Figure 48: Geberit Example: Goodwill ..................................................................................................... 107
Figure 49: Classification and Valuation of Financial Liabilities Pursuant to IFRS 9 ............................... 110
Figure 50: Nestlé Example: Provisions, Contingent Liabilities and Contingent Assets ........................... 112
Figure 51: Decision Tree for the Recognition of Provisions ..................................................................... 113
Figure 52: Composition of Equity ............................................................................................................. 117
Figure 53: Nestlé Example: Statement of Changes in Equity ................................................................... 119
Figure 54: Composition of Equity ............................................................................................................. 120
Figure 55: Nestlé Example: OCI ............................................................................................................... 120
Figure 56: Nestlé Example: Statement of Other Comprehensive Income................................................. 127
Figure 57: Classification of Other Comprehensive Income ...................................................................... 128
Figure 58: Minimum Classification of the Statement of Other Comprehensive Income .......................... 128
Figure 59: Sub classification of Income in the Statement of Profit or Loss.............................................. 129
Figure 60: Cost of Goods Sold Method, Classification ............................................................................. 131
Figure 61: Nestlé Example: Cost of Goods Sold Method ......................................................................... 131
Figure 62: Example: Cost of Goods Sold Method .................................................................................... 132
Figure 63: Total Cost Method, Classification ........................................................................................... 132
Figure 64: Example: Total Cost Method ................................................................................................... 133
Figure 65: Nestlé Example: Revenue Recognition.................................................................................... 135
Figure 66: Revenue Recognition model IFRS 15...................................................................................... 135
Figure 67: Segment Reporting................................................................................................................... 140
Figure 68: Nestlé Example: Segment Information for the Business Segments......................................... 141
Figure 69: Nestlé Example: Company-wide Information of the Business Segments ............................... 142
Figure 70: Relationship between Statement of Financial Position, Statement of Profit or Loss, and
Statement of Cash Flows ........................................................................................................................... 147
Figure 71: Structure of the Statement of Cash Flows................................................................................ 149
Figure 72: Distinction between Cash-Effective and Non-Cash-Effective................................................. 152
Figure 73: Nestlé Example: Cash Flow from Operating Activities........................................................... 153
List of Figures XIV
Figure 74: Nestlé Example: Cash Flow from Investing Activities............................................................ 155
Figure 75: Nestlé Example: Cash Flow from Financing Activities .......................................................... 156
Figure 76: Nestlé Example: Statement of Financial Resources ................................................................ 158
Figure 77: Statement of Cash Flows as a Basis for Decision-Making ...................................................... 158
Figure 78: Nestlé Example: Applied Financial Reporting Principles ....................................................... 164
Figure 79: Nestlé Example: Taxes ............................................................................................................ 165
Figure 80: Nestlé Example: Earnings per Share........................................................................................ 166
Figure 81: Types of Negative Net Worth .................................................................................................. 171
Figure 82: Nestlé Example: Corporate Governance Introduction ............................................................. 180
Figure 83: Value Added Statement ........................................................................................................... 184
Figure 84: Case Study: Swisscom Value Added Statement ...................................................................... 185
Figure 85: Nestlé Example: Group of Consolidated Companies .............................................................. 189
Figure 86: Categories of Participating Interests ........................................................................................ 190
Figure 87: Nestlé Example: Consolidated Companies .............................................................................. 195
Figure 88: Decision as to Consolidation Method Pursuant to IFRS ......................................................... 195
Figure 89: Nestlé Example: Companies of the Nestlé Group ................................................................... 196
Figure 90: Full Consolidation Pursuant to IFRS 10 .................................................................................. 197
Figure 91: Volkswagen Group structure ................................................................................................... 207
Figure 92: Fixed costs ............................................................................................................................... 209
Figure 93: Level-fixed costs ...................................................................................................................... 209
Figure 94: Variable costs ........................................................................................................................... 210
Figure 95: Variable costs taking into account learning, experience and economies of scale.................... 210
Figure 96: Mixed costs .............................................................................................................................. 210
Figure 97: Attributability of direct and indirect costs ............................................................................... 211
Figure 98: Example of a cost distribution sheet ........................................................................................ 214
Figure 99: Example of a cost distribution sheet ........................................................................................ 215
Figure 100: Watering can principle of the break-even calculation ........................................................... 216
Figure 101: Break-even analysis ............................................................................................................... 217
Figure 102: Contribution margin ratio and variable cost ratio .................................................................. 219
Figure 103: Traditional overhead calculation............................................................................................ 223
Figure 104: Process and activity-based overhead calculation ................................................................... 223
Figure 105: Analysis of the Framework Conditions and Financial Statement Analysis ........................... 228
Figure 106: Preparatory Steps for the Financial Statement Analysis ........................................................ 230
Figure 107: Objectives of Financial Management and Its Key Performance Indicators........................... 232
Figure 108: Data Basis of Key Performance Indicators ............................................................................ 233
Figure 109: Data Basis of Key Performance Indicators ............................................................................ 233
Figure 110: Geberit Key Performance Indicators (Statement of Profit or Loss and Other Comprehensive
Income, and Statement of Cash Flows) ..................................................................................................... 236
Figure 111: Geberit Key Performance Indicators (Statement of Financial Position)................................ 237
List of Figures XV
Figure 112: Geberit Revenue by Division and Region 2015 and 2014 ..................................................... 237
Figure 113: Invested Capital and Operating Assets .................................................................................. 253
Figure 114: DuPont Analysis (ROI) .......................................................................................................... 257
Figure 115: EVA ....................................................................................................................................... 259
Figure 116: Balanced Scorecard ................................................................................................................ 260
Figure 117: Net Working Capital .............................................................................................................. 260
Figure 118: Cash Conversion Cycle .......................................................................................................... 261
Figure 119: Overview of financing options available to a company......................................................... 268
Figure 120: Nestlé Example: Provisions ................................................................................................... 269
Figure 121: Nestlé example: Self-financing .............................................................................................. 270
Figure 122: Market capitalization of SMI companies and Apple cash holdings....................................... 270
Figure 123: Market capitalization of DAX companies and Apple cash holdings ..................................... 270
Figure 124: Nestlé example: Plowback Ratio ........................................................................................... 271
Figure 125 Instruments of debt capital financing ...................................................................................... 273
Figure 126: Nestlé example: Credit financing........................................................................................... 274
Figure 127: Example of a bond ................................................................................................................. 275
Figure 128: Nestlé example: Outstanding bonds....................................................................................... 276
Figure 129: Nestlé example: Maturity structure ........................................................................................ 276
Figure 130: Nestlé example: Equity financing .......................................................................................... 278
Figure 131: Procedure of an ordinary capital increase .............................................................................. 279
Figure 132: Early phases of company financing ....................................................................................... 280
Figure 133: Debt ratios in the USA ........................................................................................................... 283
Figure 134: Influence on a company's creditworthiness ........................................................................... 290
Figure 135: Types of rating ....................................................................................................................... 291
Figure 136: Nestlé example: Management of credit risks ......................................................................... 293
Figure 137: Example: Management of counterparty risks ........................................................................ 293
Figure 138: Rating categories used by Moody’s, S&P and Fitch ............................................................. 295
Figure 139: Distribution of defaults by S&P-rating before default ........................................................... 296
Figure 140: Change in the probabilities of default .................................................................................... 297
Figure 141: Nestlé example: Credit rating for financial assets ................................................................. 300
Figure 142: Use of ratings ......................................................................................................................... 301
Figure 143: Ideal typical procedure for preparing a rating........................................................................ 302
Figure 144: Categories and criteria in preparing a rating .......................................................................... 303
Figure 145: S&P's process for preparing a rating ...................................................................................... 304
Figure 146: Average development of ratings prior to default ................................................................... 308
Figure 147: Phases of the M&A process ................................................................................................... 314
Figure 148: Global M&A activity ............................................................................................................. 315
Figure 149: M&A activity in Switzerland ................................................................................................. 315

List of Figures XVI
Figure 150: M&A by industry (number of transactions, globally, since 1985) ........................................ 316
Figure 151: The largest business transactions of all time.......................................................................... 316
Figure 152: Ideal-typical M&A process .................................................................................................... 321
Figure 153: Main areas of due diligence ................................................................................................... 322
Figure 154: Pricing in the M&A process .................................................................................................. 324
Figure 155: Net asset value method .......................................................................................................... 324
Figure 156: Free cash flow DCF method .................................................................................................. 325
Figure 157: Tax-adjusted WACC as discount factor for DCF method ..................................................... 326
Figure 158: DCF method with Terminal Value ........................................................................................ 326
Figure 159: Calculation of net company value using the DCF method .................................................... 326
Figure 160: DCF calculation of gross and net company value.................................................................. 327
Figure 161: initial situation DCF calculation (zero growth after detailed planning period) ..................... 328
Figure 162: Discounting of detailed planning periods .............................................................................. 328
Figure 163: Calculation of Terminal Value............................................................................................... 329
Figure 164: Discounting Terminal Value .................................................................................................. 329
Figure 165: EVA approach ........................................................................................................................ 330
Figure 166: Calculation of company value using the EVA method .......................................................... 330
Figure 167: Example of company valuation using the EVA method ........................................................ 331
Figure 168: Comparison of EVA and DCF methods ................................................................................ 332
Figure 169: European industry multiples in November 2018 ................................................................... 334
Figure 170: Processes of Post-Merger Integration .................................................................................... 336

List of Charts XVII
List of Charts
Table 1: Overview of Book Chapters ............................................................................................................ 3
Table 2: Audience of Annual Report........................................................................................................... 13
Table 3: Example of Investor Relations ...................................................................................................... 15
Table 4: IFRS for SMEs versus Swiss GAAP FER .................................................................................... 39
Table 5: IFRS versus Swiss GAAP FER [1] ............................................................................................... 41
Table 8: Comparison of the Basic Assumptions and Swiss Accounting Principles (GoR) ........................ 46
Table 9: Discontinued Parts of the Company Tamedia ............................................................................... 49
Table 10: Industry Characteristics in the Financial Statement .................................................................... 58
Table 11: Scope and Assessment of Annual Report.................................................................................... 66
Table 12: Components of Current Assets .................................................................................................... 72
Table 13: Components of Non-Current Assets ........................................................................................... 73
Table 14: Mini Case: Capitalization of an Asset ......................................................................................... 74
Table 15: Example: Borussia Dortmund ..................................................................................................... 75
Table 16: Components of Liabilities and Equity ......................................................................................... 77
Table 17: Valuation Approaches Pursuant to the IFRS Conceptual Framework ........................................ 80
Table 18: Valuation Terms .......................................................................................................................... 81
Table 19: Mini Case: Inventory Impairment ............................................................................................... 86
Table 20: Mini Case: Depreciation Method ................................................................................................ 98
Table 21: Mini Case: Treatment of Goodwill ........................................................................................... 106
Table 22: Mini Case: Comparison Full Goodwill and Partial Goodwill methods .................................... 108
Table 23: Sonova Provisions for Legal Disputes ...................................................................................... 114
Table 24: Mini Case: Establishing Provisions........................................................................................... 116
Table 25: Time when earnings are recognized .......................................................................................... 134
Table 26: Classification of Employee Benefits ......................................................................................... 137
Table 27: Definitions of Liquid Funds ...................................................................................................... 148
Table 28: Definition of Funds Pursuant to IAS 7 ...................................................................................... 149
Table 29: Direct Calculation of Cash Flow from Operating Activities ..................................................... 150
Table 30: Indirect Calculation of Cash Flow from Operating Activities .................................................. 151
Table 31: Mini Case: Cash Flow from Operating Activities ..................................................................... 153
Table 32: Calculation of Cash Flow from Investing Activities ................................................................. 154
Table 33: Mini Case: Cash Flow from Investing Activities ...................................................................... 155
Table 34: Calculation of Cash Flow from Financing Activities................................................................ 156
Table 35: Mini Case: Cash Flow from Financing Activities ..................................................................... 157
Table 36: Statement of Financial Resources ............................................................................................. 157
List of Charts XVIII
Table 37: Typical Content of the Notes..................................................................................................... 163

Table 38: Functions of the Notes............................................................................................................... 167
Table 39: Bankruptcy of Mindset Holding AG ......................................................................................... 172
Table 40: Bankruptcy of Jomed ................................................................................................................ 172
Table 41: Bankruptcy of Swissair ............................................................................................................. 172
Table 42: SIX Corporate Governance Directives ...................................................................................... 180
Table 43: Case Study: Corporate Governance – Company Comparison .................................................. 181
Table 44: Case Study: CR, CSR and Sustainability in Comparison ......................................................... 183
Table 45: Swissair Error in Group of Consolidated Companies ............................................................... 197
Table 46: Mini Case: Elimination of Group-Internal Events .................................................................... 198
Table 47: Mini Case: Capital Consolidation ............................................................................................. 199
Table 48: Mini Case: Equity Method ........................................................................................................ 200
Table 49: Comparison of internal and external accounting....................................................................... 206
Table 50: Cost attributability and chargeability ........................................................................................ 208
Table 51: Development of Unit Costs with increasing production Quantity ............................................ 211
Table 52: Company Comparison of Automobile Manufacturers .............................................................. 231
Table 53: Key Performance Indicators Compared by Sector .................................................................... 235
Table 54: Geberit financial ratios 2014 to 2018 ........................................................................................ 255
Table 55: Case Study: Diverse use of the term “rating”............................................................................ 288
Table 56: S&P CICRA .............................................................................................................................. 304
Table 57: S&P Business Risk Profile ........................................................................................................ 305
Table 58: S&P Financial Risk Profile ....................................................................................................... 305
Table 59: S&P Anchor Rating ................................................................................................................... 306
Table 60: Instruments used for monitoring ratings ................................................................................... 307
Table 61: Criticism of rating agencies....................................................................................................... 309
Table 62 Entity Multiples .......................................................................................................................... 333
Table 63: Equity Multiples ........................................................................................................................ 333

List of Abbreviations XIX
List of Abbreviations
AC Acquisition cost
AG Aktiengesellschaft (limited share company)
AP Accounts Payable
BSC Balanced Scorecard
CA Current assets
CC Cost of conversion
CEO Chief Executive Officer
CF Cash Flow
CFfin Cash Flow from financing activities
CFinv Cash Flow from investing activities
CFR Conceptual framework
CFO Chief Financial Officer
CFop Cash Flow from operating activities
CG Corporate governance
CH Switzerland
CHF Swiss francs
CICRA Corporate Industry and Country Risk Assessment
CO Swiss Federal Code of Obligations (Schweizerisches Obligationenrecht)
COGS Costs of Goods Sold
COO Chief Operating Officer
CR Corporate responsibility
CSR Corporate social responsibility
CTO Capital Turnover
DCF Discounted Cash Flow
DIH Days Inventory Held
DP Discussion paper
DPO Days Payables Outstanding
DSO Days Sales outstanding
E Equity
e.g. exempli gratia
EBI Earnings before interests
EBIT Earnings before interests and taxes
EBITDA Earnings before interests, taxes, depreciation and amortization
ED Exposure draft
EU European Union

List of Abbreviations XX
EUR Euro
EV Enterprise Value
EVA Economic Value Added
f. and the following
FCF Free cash flow
FCFop Free cash flow from operating activities
FER Fachempfehlungen der Rechnungslegung (professional financial reporting recommendation)
ff. and the following
FFO Funds from Operations
FVTOCI Fair value through other comprehensive income
FVTPL Fair value through profit and loss
GAAP Generally accepted accounting principles
GoB Grundsätze ordnungsmässiger Buchführung (bookkeeping principles)
GoR Grundsätze ordnungsmässiger Rechnungslegung (accounting principles)
i.e. id est
IAS International Accounting Standard
IASB International Accounting Standards Board
IASC International Accounting Standards Committee
IC Invested Capital
IFRIC International Financial Reporting Interpretations Committee
IFRS International Financial Reporting Standard
L Liabilities
L&E Liabilities and Equity
M&A Management & Acquisition
NCA Non-current assets
NOA Net Operating Assets
NOPAT Net Operating Profit after Taxes
NWC Net working capital
OCI Other comprehensive income
OR Schweizerisches Obligationenrecht (Swiss Federal Code of Obligations)
p. page
P/B Price-Book ratio
P/E Price-Earning ratio
pp. pages
RFID radio frequency identification
ROA Return on Assets
ROCE Return on Capital Employed

List of Abbreviations XXI
ROE Return on Equity

ROI Return on Investment
ROIC Return on Invested Capital
RONOA Return on Net Operating Assets
ROS Return on Sales
SCBP Swiss Code of Best Practice
SGMM St. Gallen Management Model
TV terminal value
US-GAAP United States Generally Accepted Accounting Principles
USD United States Dollars
WACC Weighted Average Cost of Capital
WC Working capital

Part A
Introduction to Financial Management 1
Part A
Introduction to
Financial
Management

Chapter 1:
Introduction 2
Introduction
1.1 Introduction to Financial Management

Financial management is a multi-faceted and broad area of application. In bigger organizations, the CFO is
responsible for all aspects of financial management. This book is written from the perspective of a CFO, aiming to
describe the respective duties, responsibilities, as well as practical examples.
The core topic of financial management is securing and presenting success of a company. In order to make
economic decisions, various information is needed as a foundation. For decisions, the internal and the external
perspective must be considered differently. For the internal perspective, the CFO is responsible to provide the right
decision information at the right time in the right quality in order to use financial means objective-oriented and
value-increasing. Strategic options are evaluated and investments and acquisitions are assessed with the CEO. For
the external perspective, the CFO is responsible for Financial reporting and ensures the right capital structure.
In connection with financial management, information regarding the financial position of a company is the most
important, along with the need for information of potential internal and external recipients of this information. The
required financial information about companies is generally derived primarily from internal and external financial
data, i.e. from management accounting and from financial accounting. Looking at the internal perspective,
appropriate managerial decisions can only be made if financial information as well as financial and economic
relationships are known, correctly recorded, assessed and edited. Managers need information to, among other,
formulate strategies, communicate and implement decisions on product design, production and marketing (Datar &
Rajan, 2018, p. 22). For the external perspective, the main objective of financial management is using financial
reporting to inform various stakeholders about the asset, finance and income situation of the company. The
information shall be useful for a broad range of addressees for economic decision. While financial reporting
addresses investors as a priority, because they provide the company with financial resources, addressees also include
suppliers, customers and the state. The following examples help illustrate the necessity for financial reporting.
Investors: You have heard that investment in a company yields a higher return than that of your savings
account. Imagine that you would like to invest a portion of your savings in a company, as you don't need
this portion for a certain period of time. In which company should you invest your savings?
Large orders: Imagine that you have a medium-sized landscaping company and a nationally renowned real
estate firm approaches you with a large order. Because this order means committing some of your
company's human and cash resources and thus signifies a considerable risk, you would like to thoroughly
research the real estate firm. What information do you gather in order to scrutinize the real estate company?

Chapter 1:
Introduction 3
Customers: You are part of the executive management of a company and are having a discussion with one
of your most important customers. Due to the poor economic situation, the customer is worried about the
long-term orders that you have been commissioned to fulfill. What information could you refer to in order
to convince the customer that your company is financially stable?
All three examples comprise a search for information with the aim of making an economic decision. There are many
other external interest groups which, as in these examples, expect information about the economic position of a
company with respect to making their decision.
This book explains financial management first from the external perspective, then from the internal perspective.
With regard to relationships outside of the company, financial reporting within the context of financial statements
plays a key role here. Financial statements are the result of financial accounting, which is also discussed as part of
the external perspective. As many public corporations now apply the “International Financial Reporting Standard”
(IFRS), this book focuses on financial reporting according to IFRS. For the following internal perspective,
management accounting, financing as well as mergers and acquisitions will be discussed.
1.2 Book Structure and Work Methodology

Part A – introduction to financial management discusses the role of financial management in the context of
organizational management and leadership. Part B – looking outside introduces financial reporting, while Part C –
looking inside management accounting and performance measurement describes. Finally, part D – looking forward
introduces strategic decisions of financial management such as financing, capital structure and growth. The
following figure provides a graphical summary.
Table 1: Overview of Book Chapters
Part A: Introduction to Financial Management

Chapter 1 Introduction
Chapter 2 Embedding of Financial Management into the St. Gallen Management Model (SGMM)
Part B: Looking outside – external Financial Management
Chapter 3 Objectives and Principles of Financial Reporting
Chapter 4 Statement of Financial Position
Chapter 5 Statement of Profit or Loss
Chapter 6 Statement of Cash Flows
Chapter 7 Notes and Audit Report
Chapter 8 Corporate Governance and Other Reports
Chapter 9 Group reporting
Part C: Looking inside – internal Financial Management
Chapter 10 Introduction to Management Accounting
Chapter 11 Performance Measurement
Part D: Looking forward – Strategic Planning
Chapter 12 Financing
Chapter 13 Credit Rating
Chapter 14 Mergers & Acquisitions (M&A)
Note. Own depiction.

Chapter 1:
Introduction 4
1.3 Symbols and Explanations

Throughout the book, the same symbols and info boxes will be repeatedly shown. These should assist in the
understanding and classification of the contents.
The annual financial statement of Nestlé group will be employed as an example

throughout the entire “Annual Report” topic in Part B. For this reason, we recommend
using the 2018 Nestlé group annual report as supplemental reading material.
The annual financial statement of Geberit will be employed as an example throughout the
entire “Introduction to Financial Statement Analysis” topic in Part C. Here too, we
recommend using Geberit's annual reports as supplemental reading material.
At the beginning of each chapter, you will find an article from a newspaper or professional journal or a company
press release as an introductory example. The introductory examples should establish the practical relevance and
simultaneously introduce the topic of the respective chapter. Alongside the introductory example, you will find
various symbols and info boxes in all chapters. These are introduced and explained below.
“INTRODUCTORY EXAMPLE” introduces the topic and illustrates, using an example, the practical application of
the chapter topic.
INTRODUCTION: CONSOLIDATED FINANCIAL STATEMENTS
Volkswagen to take over Porsche in August

The two car manufacturers Volkswagen and Porsche are merging sooner than planned. Volkswagen is to acquire
Porsche's automotive business for EUR 4.46 billion. (See chapter 9 for complete example.)
“LEARNING OBJECTIVES” describe the topics explained in the chapter and the knowledge conveyed.
LEARNING OBJECTIVES
This chapter should convey the following knowledge:
• Understanding of the fundamental principles of group financial reporting
“IFRS BOX” displays an IFRS standard in a brief and clear manner.
BOX: IFRS 9 Financial Instruments

Chapter 1:
Introduction 5
“Nestlé EXAMPLE” shows examples from the Nestlé Group annual financial statement and thus clarifies the
theoretical content by means of a continuous practical example.
EXAMPLE
Nestlé
From: Consolidated Financial Statements of the Nestlé Group 2018 p. 77.
“MINI CASE” shows fictional examples of how the theory is implemented.
ALLOWANCE ON INVENTORY
Market value comes under pressure:

MINI CASE 1
“CASE STUDY” is a short practical example that illuminates the topic from another, practice-oriented side. Case
studies can be found in the individual chapters.
SWISSAIR GROUP OF CONSOLIDATED COMPANIES
Ernst & Young findings in review of Swissair

CASE STUDY
Not only the separate and consolidated annual financial statement for 1999 but also, to a much greater extent, the
separate and consolidated annual financial statement for 2000 did not properly depict the economic and financial
situation of the Swissair Group. The Swissair Group consolidated financial statements for 1999 and 2000
exhibited, among other things, fundamental consolidation errors.
(See chapter 9 for the complete case study.)

Chapter 2:
Embedding of Financial Management into the St. Gallen Management Model (SGMM) 6
Embedding of Financial Management into the

St. Gallen Management Model (SGMM)
Financial management is one of the most important management

tasks. But what does financial management actually mean? Which
processes does it consist of? What are the objectives of financial
management and why is this management task so important for
companies? The following chapter answers these and alike
questions by mapping financial management into the St. Gallen
Management Model (SGMM, Rüegg-Stürm & Grand, 2019) and
with the illustration of the following, recent practical example.
2.1 Introductory Example from Nestlé
INTRODUCTION: EMBEDDING OF FINANCIAL MANAGEMENT
Medicine instead of chocolate

The nutrition giant Nestlé strengthens its health business and invests in the biotech company Seres Therapeutics Nestlé
aims to develop and market a medicine against digestion sicknesses.
The nutrition giant Nestlé strengthens its high-margin health business with a multi-billion dollar cooperation. The division
Nestlé Health Science invests an initial 120 million dollars in the biotech company Seres Therapeutics.
With this investment Nestlé wants to develop and later market a medicine against
digestion sicknesses, as the company explained on Monday. Overall the partnership has a
volume of 1.9 billion dollar. As soon as Seres Therapeutics meets the defined
development and marketing targets, Nestlé will pay additional fees for milestones and
license.
The group, headquartered at Vevey focuses on health business since several years, which typically contributes higher margins
than the traditional divisions of chocolate bars, coffee, and convenience food products. “This is a significant step” says Greg
Bahar, managing director of the Nestlé Health Science division. The new medicine shall be marketed as a pill and it might be
available within a few years already.

Chapter 2:
In addition to such cooperation, Nestlé plans to also grow through acquisitions. “We are also investigating some
supplementing acquisitions. We pursue different opportunities” says Bahar. Acquisition opportunities also include food
business for elderly people.
Article has been modified. From: Handelsblatt (January 11, 2016).
Reflective questions
1. Why is Nestlé considering investments in the health business?
2. Following which criteria did Nestlé decide the required investment amount?
3. Where does the required financial resources come from to finance such investments?
4. How are investors going to be informed about the future financial success of such investments?
5. What persons and audiences do have an interest regarding financial information of Nestlé and what are their expectations?
6. What problems do you see concerning financial information and expectations?
2.2 Managerial Finance and the St. Gallen Management Model

There is no universally valid definition for financial management, nor are there predefined processes for financial
management. Financial management as a management task as well as its processes are specific to each company.
The SGMM sees the external processes of financial management primarily as support process, as mainly financial
reporting plays a significant role in creating managerial opportunities by ensuring financial resources. Financial
resources are relevant for the survival of the company as they ensure organizational capacity to act. The processes of
internal financial management, mainly the processes of management accounting, are largely management processes
of the SGMM. Activities like budgeting, multi-year financial planning, evaluation of investments, or structuring of
M&A activities are typical examples of management processes, as they concern the “reflexive design and
development of organizational value creation” (Rüegg-Stürm & Grand, 2017, p. 145).
Attempt at a Financial management is one of the most important responsibilities of management. Mastering the
definition of modern instruments of financial management contributes to the overall company success. Financial
financial accounting, management accounting, finance […] contribute concretely to increase value for customers,
management shareholders and employees (University of St. Gallen, 2005, 4. edition)
In order to satisfy the overall aim for allocation of financial resources, financial management follows three main
goals: profit, risk and liquidity. In financial management, a company is always shifting between these goal
categories, whereby the focus can vary widely. Typically, not all three goals can be attained to the same extent, as
they compete with each other, and therefore the goals are oftentimes displayed as goal triangle (see figure 3). For
example, the decision not to reinvest the bank balance in the company leads to a high level of liquidity. As a result,
however, the returns generated are diminished, as the company is not employing this capital. On the other hand, the
company can invest the capital in a new business division that has the potential of earning high returns. By doing
this, however, the company incurs a risk, as the success of the new division is uncertain. The company will not be
successful in business and financially if it focuses on only one of the three goals. All three goals must be monitored.

Chapter 2:
These goals are measured by various performance data that is defined by management. The following diagram with
the goal triangle illustrates how financial decisions affect goals.
Figure 1: Goal triangle of Financial Management
Note. Own depiction
In the area of financial management, there are various opportunities to influence financial performance data.
Financial management sub-processes reveal these opportunities and provide the basis for evaluating the financial
goals of liquidity, risk and return. In principle, the following sub-processes can be distinguished:
1. Financial reporting
2. Management accounting
3. Corporate finance and risk management
4. Growth and M&A
(Modeled after Dubs, Euler, Rüegg-Stürm & Wyss, 2009, p. 118 & 244.)
The sub-processes of financial management of a company can be understood as pyramid. The foundation of any
financial information, internal as well as external, is book keeping and accounting. On the basis of the booking
entries, the financial reporting is compiled, which summarizes the financial development of a period and presents it
to external stakeholders. Also internal financial management, i.e. management accounting, uses booking
transactions as basis. However, internal information must be more detailed then external financial reporting in order
to support managers’ decisions. Such detailed internal reports are further aggregated into financial ratios and ratio
systems, as part of the performance management, to support interpretation and decision-usefulness of the internal
data. Internal financial management helps managers to quickly decide if results of products, divisions, or
geographical units meet expectations and intentions, and to derive operational as well as strategic actions.
Each company implements the above-mentioned processes in a slightly modified form and with a different focus.
The two main areas of financial management are financial reporting (external financial management) and
management accounting (internal financial management). Management accounting is also referred to as operational
accounting or performance measurement. Financial reporting is the result of financial accounting.
Each company implements the above-mentioned processes in a slightly modified form and with a different focus.
The two main areas of financial management are financial reporting (external financial management) and
management accounting (internal financial management). Management accounting is also referred to as operational
accounting or performance measurement. Financial reporting is the result of financial accounting.

Chapter 2:
Figure 2: Financial Management Processes
Decreasing number of transactions
st
Op egic
ra
t
er pl
at an
in n
g in
Increasing value creation
Strategic
Increasing uncertainty
& g
Decisions
(capital structure / M&A / investment)
Fi
Operating Decisions
na
(Pricing / Make-or-buy / increase efficiency )
nc
in ma
ia
te na
l
rn g
Performance Measurement
al em Fin
(Financial ratios / ratio systems / BSC)
en an
Management Accounting
t
ex ma
ci
Financial Reporting
al
te na
rn g
al em
Financial Accounting
(booking of individual transactions in accordance with local laws and accounting & reporting standards
en
t
Note. Own depiction
Financial reporting uses bookkeeping and financial accounting as as basis, which is not discussed in this book.
Financial reporting is carried out with regard to a company or group (several companies). The assessment of the
economic and financial position of the company or group is the focus. Financial reporting should provide
information regarding the asset, earnings and financing of a company. The preparation and representation of this
information takes place according to various accounting standards. This data is normally made available on a
quarterly basis (quarterly reports). The information should serve as a basis for decision-making for management as
well as external stakeholders, in particular concerning financing questions (corporate finance), transactions with
other firms (mergers and acquisitions), development of asset positions or the course of business. Within the context
of financial reporting, a reduction of the information asymmetry between management and owners also takes place,
as public auditors examine the financial statements. Financial reporting is discussed in part B of this book.
2. Management accounting and performance measurement

Management accounting makes business information available as the basis for decision-making for the management
team. Management accounting is also called cost management, costing, or operational accounting. It comprises
detailed operational information that is used internally only and, depending on the company, is provided frequently
(i.e., daily cash reports or weekly revenue figures). The basis for this information is the recording and monitoring of
all business processes of a company. The company is then typically divided into different segments, departments,
cost centers, products, customers, regions, etc. Different performance data is collected and analyzed during
management accounting according to the characteristics of these units. Cost drivers and cost centers are defined in
order to gauge cost behavior in the company as accurately as possible. Budgets and deviation analyses are also
created based on this information. Performance measurement uses such information for comprehensive analysis,
oftentimes using financial ratio and ratio systems, to quantify the strengths and weaknesses of the company. These
analysis help the management team taking the necessary operating and strategic decisions. Typically, operational
decisions may include, for example, price adjustments for products, decisions concerning inventory levels, make-or-
buy decisions (whether to produce in-house or outsource), etc. The fundamentals of management accounting and
performance measurement as well as the decisions derived from them will be discussed in part C of this book.

Chapter 2:
3. Financing and M&A

Two of the most important strategic decisions for companies, which are taken upon information from internal
financial management, are financing and M&A transactions. More specifically, financing is typically understood to
secure sufficient financial means for the current operation as well as strategic and long-term investments. M&A
concerns any type of company transactions combining or spinning-off business activities.
Financing current operations is oriented towards the short and medium term and mostly concerns operating
decisions. Examples include the provision of liquidity for upcoming payments and smaller investments or in
connection with currency translation when importing or exporting. Financing current operations is also designated
as working capital management. In contrast, comprehensive capital budget analyses with multiple scenarios are
created for strategic investments and those involving larger amounts. Such larger investment projects, and typically
for M&A transactions, oftentimes required involving external investors. As such, questions and decisions regarding
financing are closely linked to growth and M&A. And using the analysis from management accounting and
performance measurement, the management team may decide for which operations adding or spinning-off business
activities may prove successful and which financing approach suites the specifics of the decisions. Strategic options
regarding financing and M&A will be discussed in part D of this book.
2.3 Financial Management as an essential management task

Financial resources are one of the most important resources for an enterprise. Without financial resources, an
enterprise cannot pursue its business praxis and make investments. In the introductory example in chapter 2.1, it is
mentioned that in 2016, Nestlé has invested $120 million in the biotech firm Seres Therapeutics while planning a
total investment in this area, as well as other future acquisitions, of up to $1.9 billion. In order to make such
investments, an enterprise requires capital. This can be provided, on the one hand, by an enterprise itself (for
example, through retained earnings) or by external investors (for example, banks or shareholders). External
investors are therefore important stakeholders in an enterprise. In order for Nestlé to be able to access as a resource
the financial means of external investors, their expectations, concerns, interests, and perspectives must be taken into
account. It is here that financial management provides an essential contribution. External investors would like to
know about the economic situation of an enterprise before they make available these financial means as a resource.
Therefore, in the context of financial management, information on the situation of assets, finances, and income of an
enterprise are prepared and made available.
The decision to invest significantly into the health industry is a strategic decision, resulting from a critical relaxion
of the environment. And performance measurement plays an important role: long-term financial planning allows
assessing investment amounts as well as businesses to invest in in regard to expected added values.
Because financial management is an essential management task, the following chapters will map financial
management into the SGMM. They follow the latest edition of the SGMM which distinguishes between a task
perspective, which follows business considerations, and a praxis perspective, which follows social and cultural
considerations. The main focus is on the task perspective, however for completeness also some elements of the
praxis perspective are introduced.

Chapter 2:
2.4 Financial Management in the task perspective

How financial management is represented in the task perspective of the SGMM will be discussed using the
introductory example from chapter 2.1.
Figure 3: SGMM task perspective
Note: Rüegg-Stürm & Grand (2019). p. 43
2.4.1 Environmental spheres
In the SGMM, the environment is understood as a landscape of possibilities for organizational value creation
(Rüegg-Stürm & Grand, 2019, p. 26). Financial reporting as a support process should thereby contribute to
developing such possibilities from the enterprise’s existence-relevant environment and to making the specific value
creation usable. When an enterprise like Nestlé attempts to develop financial means from external investors as a
resource, it moves into the environmental sphere of "economy". “The focus here is on optimal allocation of
resources for the efficient production of goods and services" (Rüegg-Stürm & Grand, 2017, p. 76). Such an
allocation is done by the usual procedures of the market. Decisions are therefore based on evaluation criteria such as
"cost-benefit analysis, efficiency and productivity, or profit and loss" (Rüegg-Stürm & Grand, 2017, p. 76).
Management must know these evaluation criteria. An evaluation criterion for banks is, for example, the
creditworthiness of an enterprise (see chapter 13), which is judged by the probability that the interest on a loan can
be paid and the loan can be repaid in full at the end of its term. For this purpose, particularly information regarding
the liquidity of an enterprise is required. It is financial reporting, a sub-process of financial management, that
ensures the bank getting access to the information it needs. Through financial reporting, information (such as the
liquidity of an enterprise) is prepared, provided to the addressee (such as banks), and should help these in making a
decision (granting a loan?). This can be represented by the goal triangle of financial reporting (see figure below).
However, in order for information to be useful for making decisions, the information must fulfill some
preconditions. Information is only useful for decisions if it enables the consideration of alternative courses of action
(Behr & Leibfried, 2014, p. 27). To permit a comparison with the previous year's figures or with another company,

Chapter 2:
financial information must meet certain minimum requirements, such as, for example, comparability (between
different companies) and consistency (comparison with previous year). These requirements are designated as basic
accounting principles (GoR) and are described in more detail in chapter 3. Only through the use of rules that must be
adhered to does financial reporting become useful in decision-making. These rules comprise the law and the
accounting standards described in chapter 3.
Figure 4: Goal Triangle of Financial Reporting
Note. Based on: Behr & Leibfried, 2014, p. 48.
As needs for information change, the accounting standards and financial reporting in the form of financial
statements are also undergoing a constant process of change. An annual report looks different today than it did five
or ten years ago. Ten years ago management strove to satisfy, first and foremost, investors' needs for information;
today's financial reporting also includes financial figures referring to ecological sustainability, for example. In
addition, legislators and those setting accounting standards modify reporting norms. As per January 31, 2013, for
example, financial accounting was changed in the Swiss Code of Obligations in order to integrate current needs for
information. At the same time, the annual report has also undergone a massive transformation over the last five
years (See case study: Uses of Corporate Reporting in chapter 2.3).
With regard to the introductory example, it can be summarized that Nestlé has, in the allocation of financial
resources, moved into the environmental sphere of "economy". In this environment sphere, there exist certain
evaluation criteria, as with creditworthiness in the case of the bank granting a loan. If Nestlé would like to procure
capital from banks, it must prepare the relevant information and make it available to financial institutions in a
standardized format so that they can make a decision on lending. While the environmental sphere of "economy"
remains the primary focus of financial reporting, there has been a development in recent years where the focus is
also increasingly directed to communicatively enacting other environmental spheres. The annual report as the
central means of financial reporting has been changing for years. Previously, the annual report mainly consisted of
an annual account with the financial results and an almost exclusive focus on the environmental sphere of
"economy". Over time, ever more information on the executive management and controlling or corporate
governance has been included in the annual report. Thus, focus is also placed on the communicative enactment of
the interaction topics “norms & values", in which evaluation criteria are recognized that are less profit-oriented and
more measures of value, such as justice and fairness (Rüegg-Stürm & Grand, 2017, p. 79). Likewise, content about
social responsibility and sustainability of an enterprise have been added to the annual report. These are directed
toward the responsibility of the enterprise arising from the interaction of the environmental spheres, stakeholders,
and interaction topics.

Chapter 2:
2.4.2 Stakeholder
Although investors or capital providers are often cited as the main addressee of the annual report or financial
reporting in general, there are significantly more stakeholders who interact with the processes of financial
management. In particular, there is broad interest in the financial results that are a product of reporting. However,
the level of interest and also the influence of the various stakeholders on reporting vary greatly. Some addressees
can obtain the information that is most important to them directly and in great detail. For example, management and
important capital providers such as banks have special access to financial information from Nestlé group. Also, tax
authorities may request the information they want directly from the enterprise. Other stakeholders, however, as
suppliers or NGOs, can only rely on the information provided by the enterprise, and they have little opportunity to
demand additional or supplementary information. The following table summarizes the different information needs of
the key stakeholders (what?) and for what kind of decision they are required (for what?). It must be noted that the
decision-making and the information needs of the different stakeholders are not exhaustive.
Table 2: Audience of Annual Report
Stakeholder* Subgroup Decision (why) Need for information (what)
Internal Management Planning Financial position, future

Employees
recipients Employees Workplace Continuity
Shareholders Buy/sell Return, financial position
Investors Creditors Creditworthiness Liquidity
Potential investors Investment decision Return, products, future
- Continuation of customer Financial position, problems, future

Customers
relationship
Tax authorities Tax assessment Profit, equity
Government
Regulatory agencies Approval revocation Equity, liquidity
External Media Financial press Reporting Background information, problems, future

recipients - Creditworthiness Liquidity, earnings
Suppliers
NGOs - Influence of the company General information
Educational - Collaboration Financial position, background information,

institutions problems
Rating agencies Assessment of creditworthiness Liquidity, financial position, future
Financial analysts Investment recommendation Management, future, earnings

Others
General public Influence of the company General information
Trade unions Wage negotiations Financial position
* based on the St. Gallen Management Model

Note. Based on Behr & Leibfried (2014), p. 53. Own depiction.
The management board and other internal stakeholder have access to information from internal financial
management. The respective objective is to support the management team with achieving the self-imposed targets,
while the external financial management communicates the company’s financial situation “true and fair” to external
stakeholders. While the external financial management is bound to generally accepted accounting and reporting
standards, the internal financial management follows internal requirements and guidelines and respective
information is typically less aggregated and more future-oriented.

Chapter 2:
A key instrument of coverage of external financial reporting for enterprises is the annual report (see chapter 3.5.).
The modern annual report has become, over time, a means of information for all stakeholders of the enterprise that
provides information about the business activities and their effects, both financial and non-financial, in a reporting
period. Ultimately, however, reporting must take the needs of all stakeholders into account. For this, a common
denominator must be found that incorporates the needs of external persons who are unable to directly procure or
request the desired information (Behr & Leibfried, 2014, p. 53). Despite the search for the common denominator
and taking into account the different types of interest, financial reporting is increasingly geared towards one specific
type of stakeholder, namely investors. The reasoning behind this is that investors' need for information is so
extensive that it largely covers the broad interests of the majority of other recipients. Financial analysts and financial
media, for example, report primarily from the perspective of investors in any case. (Behr & Leibfried, 2014, p. 69.)
The focus on investors as special and important stakeholders becomes apparent through “investor relations” activity
in a company. Investor relations encompasses the maintenance of contact, communication and collaboration with
investors, analysts and the financial media. These three stakeholders are also referred to as the financial community.
The three target groups, however, have differing previous knowledge, objectives and expectations of the company.
Investor relations aims to provide the financial community with all required information so that the development of
the company value may be assessed and confidence in the company maintained. The purpose of this relationship
management is an increase in the share price, which is of interest to the financial community and the company.
Figure 5: Objectives of Investor Relations
Nestlé actively maintains the relationship with investors. There is an Investor Relations Department to satisfy the
needs of this stakeholder group. Relevant information, such as the investment in Seres Therapeutics, is published
immediately. This helps Nestlé in developing the financial resources that can ultimately be used for investment, as
in the introductory example. Despite the importance of investors, to which reporting is primarily geared, Nestlé does
not neglect the information needs of other stakeholders. In addition to the annual report, for example, published
annually is the report "Nestlé in Society", which deals with the societal responsibility of the enterprise.

Chapter 2:
Table 3: Example of Investor Relations
INVESTOR RELATIONS
Excerpt from the Nestlé homepage Announcement of a divestment

CASE STUDY
concerning investor relations Reason for the announcement:

• Publications and presentations about the company,
the markets it serves, executive management, etc. • To prevent speculation and rumors
• Announcements and news (see example on right)
• To establish a feeling of security among impacted
• Information regarding business results, brand as employees
well as research and development
Source: www.nestle.com/investors/presentations
2.4.3 Interaction issues
The organizational landscape of possibilities and the established production and linking of resources in an
organization-specific configuration of resources is often taken for granted but can be questioned. Different
communication and exchange relations exist between an organization and its stakeholders (Rüegg-Stürm & Grand
2019: p. 56). The subjects of such exchange may be, for example, customer expectations, or expectations regarding
employment security. The SGMM calls such exchanges interaction issues, defined as «what is brought to the
organization’s attention by stakeholders, offered to it for the value creation, or is disputed» (Rüegg-Stürm & Grand
2019: p. 56).
Interaction issues can therefore also have a significant impact on how enterprises interact in the area of financial
management with its stakeholders within the various environmental spheres. One example of their influence is the
level of change regarding the structure and content of financial reporting: what was earlier seen almost exclusively
as a communication tool with the environmental sphere "economy" aimed at the stakeholder group of investors,
today considers significantly more environmental spheres and the interests of a wide range of stakeholders. An
example is the controversy surrounding the concept of "sustainability", which has been ignited by various issues
(subjects of controversy). Dramatic events (such as the VW emissions scandal) and unfavorable developments (like
climate change) mean that the issue of "sustainability" has been the subject of controversial discussion, especially in
Chapter 2:
the media. This has also had a great influence on communications with stakeholders in terms of financial
management. The existing focus of reporting to the investors and the publication of almost exclusively financial
information came into question because this alone could no longer be counted on to satisfy the expectations of
stakeholders. The appropriate allocation of relevant resources could no longer be adequately ensured by referring
exclusively to the environmental sphere of "economy" as critical arguments in the environmental spheres of
"society" and "nature" gained greater relevance and stakeholders such as NGOs or the public have increased in
importance. This led to increased demand for enterprises to publish information on the topic of sustainability in
addition to financial information, and they have responded, with most enterprises newly including a sustainability
report in the annual report.
The situation is similar with the concept of transparency. Again, various incidents (for example, discussions about
the payment of huge bonuses linked to the banking crisis) have ensured that the issue has been the subject of
controversial discussions. Enterprises in the field of financial management have taken these facts into account by
adding a corporate governance report in the annual report.
In summary, it can be noted that, as presented in the introductory example, investors are essential to enterprises like
Nestle so that investments can be made; however, evolvements regarding interaction issues can shift this focus and
place into question the established routinized processes for the allocation of financial resources as a resource.
Therefore, it is also enormously important in the area of financial management to keep an eye on the organization-
specific environment, examine it in greater detail, and to react to changing demands in the different environmental
spheres. So, even as Nestlé continues to place a great focus on investors in its reporting, it also takes into account the
increased interest of other stakeholders on the topics of sustainability and transparency by publishing sustainability
reports and corporate governance reports. Ignoring new stakeholder requests and therewith information
requirements may have a massive impact also on the allocation of financial resources.
2.4.4 Processes and Value Creation
The starting point of all processes of financial management is the enterprise as an economic entity, namely the
organization. Financial reporting as an instrument of interaction of the enterprise with the environment and as
support process has its origins therefore in the organization itself (Dubs, Euler, Rüegg-Stürm & Wyss, 2009. p. 112).
According to Rüegg-Stürm and Grand (2019, pp. 27f), six types of organizations can be distinguished: private
companies, state-owned companies, public organizations, non-governmental organizations (NGOs), nonprofit
organizations (NPOs), and pluralistic organizations. The focus of this book is primarily on private companies, which
is characterized by most of the value creation being achieved in the environmental sphere of "economy", being
privately held (mostly by shareholders), and having the goal of generating enhanced value creation for its owners
(Rüegg-Stürm & Grand, 2019, p. 27). The fourth generation of SGMM understands organizations, according to
Rüegg-Stürm and Grand (2017), as "value-creation systems that generate collaborative value creation for their
environment from an organization-specific configuration of resources" (p. 118). In generating this value creation,
there is often a multitude of decision-making imperatives that needs to be carefully processed, using routinized
processing in order to establish a stable and bearing decision-making praxis. This decision-making process is
oriented on an organization-specific frame of orientation.

Chapter 2:
Value creation is defined in SGMM according to two different perspectives: Considered in terms of results, value
creation refers mainly to the products ultimately manufactured or services provided by an organization. From a
process-oriented perspective, the term refers to the activities that contribute to the creation of the results of value
creation, such as the invention, development, manufacture, or sale of products and services (Rüegg-Stürm & Grand,
2019 p. 22). From a process perspective, the SGMM describes the value creation processes to be differentiated, i.e.
using division of labor and bundling different activities to sub-systems, which require special expertise to fulfill
(Rüegg-Stürm & Grand, 2019 pp. 22ff). To achieve a homogeneous value creation despite this differentiation,
processes integrate the different activities within the organization (Rüegg-Stürm & Grand, 2019 pp. 60ff).
The subprocesses of financial management are partly support processes, partly management processes. According to
the SGMM, financial reporting is a support process which uses routinized communication with the existence-
relevant environment in order to facilitate allocation of financial resources, and it leads to managerial flexibility and
reflexivity. Consequently, the processes of financial reporting as support processes concern the efficient resource
configuration such as securing sufficient liquidity (Rüegg-Stürm & Grand, 2019 p. 70). In contrast, performance
management is a management process, which supplies financial data, which is essential for operational decision
making as well as for strategy work. Future-oriented activities such as budgeting or financial multi-year planning do
support and condition organizational reflexivity. Organizational planning processes may for example lead to
question and re-position the status quo of organizational value creation (Rüegg-Stürm & Grand, 2019 p. 71).
According to Rüegg-Stürm and Grand (2019), support processes mainly support “the establishment and
development of organization specific resource configuration” (p. 69). Financial reporting serves this purpose with
allocation of financial resources. Management accounting serves as management process, which according to
Rüegg-Stürm and Grand (2019) “repeatedly executed tasks which concern the reflexive design and development of
the organizational value creation” (p. 65). Some aspects of management accounting, such as budgeting or financial
planning, allows the executive team reflexive contention with the current as well as in the future expected financial
development.
Also the design of the financial reporting itself is reflected in the process oriented design of the organizational value
creation and division of labor. As described in chapter 5.3, organizations have two options to choose from regarding
how they want to disclose the statement of profit or loss. Companies like Nestlé, which choose the cost-of-goods-
sold method, disclose the expenditures of the business year by functional units. So the positions in the statement of
Nestlé are “Sales- and Distribution”, “Marketing and Administration”, and “Research and Development” (see
chapter 5.3.1). This mirrors the influence of the process-oriented perspective and the internal differentiation of the
organization as the expenditures of the overall value creation are allocated to certain sub-systems. At the same time,
an integration of the individual sub-systems applies to an overall value creation perspective with disclosing the total
profit for the overall organization.
The view of value creation is also considered in the financial reporting and is disclosed in the so-called segment
reporting (see chapter 5.5). Segments are seen as diversifiable subunits of an economic entity and mirror the
orientation of the enterprise according to target market or customer and product or service groups. Enterprises
publish important financial information (for example, revenue, profits, assets, liabilities, etc.) on the individual
segments. Based on the introductory example, it can be seen that Nestlé, through its investments, is increasingly
directing its focus to the production of products in the healthcare market. This development in the value creation of

Chapter 2:
Nestlé can also be seen in the segment reporting. While the proportion of the product segment "Nutrition Products
and Health Science" to total group sales was continuously increased from 11.7% (2012) to 17.7% in the year 2018
(see chapter 5.5.2).
2.4.5 Governance as element of order
According to the understanding of the SGMM, (corporate) governance is a function that "creates the basic premises
for the impact of management praxis as a whole, and specifically for executive management" by ensuring the basic
legitimacy “that empowers effective management praxis for the benefit of the owners"(Rüegg-Stürm & Grand,
2019, p. 75). Thus, corporate governance embeds and shapes ideas, expectations, and standards for the value
creation of an enterprise, which serves the management as orientation (Rüegg-Stürm & Grand, 2017, p. 233).
An example of the effect of corporate governance "is the reflexive design of the relationship of an organization to its
owners" (Rüegg-Stürm & Grand, 2019, p. 75). On the one hand, the owners make important resources available for
an enterprise (see chapter 2.2.1) while, on the other hand, they also can have an influence on the value creation of
the enterprise (Rüegg-Stürm & Grand, 2017, p. 223). It is here that financial management provides an important
contribution. Examples include the discussion of relevant information provided to a broad group of stakeholders in
the corporate government reports. In addition, financial reporting also contributes significantly to helping reduce the
existing information asymmetry between owners and the organization itself as well as ensure greater transparency.
Compared to external stakeholders such as investors, internal stakeholders like management or executive employees
have better access to more information about the company. In this context, people speak of information asymmetry,
as internal persons know more about the enterprise than external persons. This is where financial reporting comes in,
as it should reduce this information asymmetry. Financial reporting makes comprehensive information concerning
the course of business at a company available to external stakeholders. At the same time, accounting standards and
financial reporting should prevent, through strict and clearly defined rules, abuse by executives who are comparably
better informed. Management could, for example, deliberately forgo depreciations that are due in order to increase
profit in a specific year and thereby be rewarded with a higher salary. In the theory surrounding information
asymmetry, this abuse is termed moral hazard. In financial reporting, this explains why the margin of discretion is
kept deliberately narrow and why in many circumstances detailed rules must be followed. Financial reporting and its
rules were also established within this context and are constantly being developed further in order to adapt to current
realities. Financial reporting rules are designated as generally accepted accounting principles (GAAP) and are
covered in greater detail in the following chapters. (Dubs, Euler, Rüegg-Stürm & Wyss, 2009, p. 176)
The principal-agency-model describes how such information asymmetry evolves between internal and external
stakeholders. The origin of this theory or model concerns the conflict of interest between two groups of persons.
Small companies are often managed by the owners or partners of the company. In large enterprises, however, this is
rarely the case. Large enterprises normally have management that, in Switzerland, comprises the executive
management and the board of directors. Participation by this management in the capital of the company is generally
limited to a small percentage. The largest investors or shareholders are other natural and legal persons that are not
simultaneously part of the management of a company. Although both parties are interested in the company's
successful development and positive results, there are nevertheless significant differences in the specific interests of
the individual parties. While the investor or shareholder expects a high return as well as assurance concerning

Chapter 2:
repayment of their capital, management may harbor other plans. For example, management may be intending to
expand and thus reinvests instead of distributing a portion of the profits. Another example would be if management
were to intentionally postpone investments in order to report higher profits and, as a result, obtain a higher
remuneration. This potential for tension between the investors or shareholders, referred to as the principal, and
executive management, known as the agent, is defined as the principal-agent theory.
Figure 6: Agency Model in Financial Reporting
(2)
Auditing
commissions
Management
Investor (principal) Asymmetric information
(agent)
performs
(1)
Annual report
Statm. of fin. pos. Management report

statements
Descriptive
Statm. of profit or los & OCI Corporate Governance
Financial
reports
Statm. of cash flows Sustainability
Statm. of chang. in equity Value adding
Notes Additional reports
(1) Reduction of
asymmetric information (2) Reduction of
Reporting on asymmetric information
• Information Verification of adherence to
• Control policies
• Release
Information asymmetry exists between the agent and the principal, as the agent has more information than the
principal. There is a disconnection between ownership (principal) and utilization of ownership (agent). This
disconnection creates the danger of capital not being allocated according to the priorities of the investors (principal).
It can also lead to problems in raising capital if the principal shows no trust. Opportunistic behavior on the part of
the agent is described as moral hazard in the principal-agent theory. This refers to the moral risk that the agent may
exploit insider information to benefit him and therefore potentially act in opposition to the interest of the principal.
Financial reporting standards (GAAP) define the exchange of information in detail and thereby help bridge the
information asymmetry. However, because even the best rules are ineffective if they are not adhered to, an
independent authority was established in order to examine the compliance with the standards and the law. Not only
investors and other external stakeholders but also internal personnel belonging to management possess the need for
compliance with standards and laws. The independent authority confirms that the company has complied with the
rules, which also exonerates management personnel. Certified accountants or public auditors perform this
independent inspection. (Behr & Leibfried, 2014, pp. 65ff).
The primary task of the external audit as an institution is to reduce information asymmetry between investors and
management by means of an independent inspection. The public auditing company is commissioned and paid by the
company itself. However, the public auditing company is supervised by the government, which also grants
permission for the performance of audits. In Switzerland, this is governed by the Revisionsaufsichtsgesetz (law on

Chapter 2:
audit supervision). The largest public auditors in Switzerland and the world are termed the Big Four and are PwC,
Ernst & Young (EY), KPMG and Deloitte. The public auditor receives the order from the company to examine the
information presented in the financial reports and to certify its flawless quality in accordance with the rules. During
the inspection, particular attention is paid to whether the financial statement correctly and fairly reflect the profit and
loss, financial and asset position, whether the predefined standards are adhered to, and whether the economic
situation of the company is thus accurately represented in the financial statement. This is denoted by fair
presentation (see next chapter). Depending on the company, the public auditor is required to cover all levels of
complexity. It is not possible, however, to check every detail of the applied financial reporting in the external audit.
Therefore the audit is performed through random sampling and by focusing on materiality. The auditors execute
their inspection work with the help of various procedures. The audit procedure is adapted to the situation specific to
the company in a risk-oriented manner, which is why it is termed the risk-oriented audit approach. The results of the
inspection work are assessed based on materiality. Materiality predicates whether a circumstance changes the
representation of a company's economic situation in a material manner. Financial management therefore plays and
important role regarding corporate governance, because it supports bridging the information asymmetry between
investors and managers and support transparency.
Financial management therefore, has an important role to play in the area of corporate governance. Trough financial
reporting, it can contribute to the dismantling of the information asymmetry between investors and the acting
individuals of an enterprise and the strengthening of transparency.
2.5 Financial Management in the praxis perspective

The SGMM task perspective discussed in the previous chapters does not take into account that the «functioning of
an organization and the effectiveness of its management praxis» cannot always be taken for granted (Rüegg-Stürm
& Grand, p. 110). Therefore, the focus of the praxis perspective are the «manifold preconditions and the socio-
cultural practices» which eventually establish the effectiveness of management (Rüegg-Stürm & Grand, p. 140). The
following chapters discuss exemplary some aspect of the praxis perspective in relation with financial management.
Figure 7: SGMM praxis perspective
Note: Rüegg-Stürm & Grand (2019). p. 143

Chapter 2:
2.5.1 Decision-making praxis
In the task perspective, processes are presumably stable (Rüegg-Stürm & Grand, 2019, p. 164). However, in the
reality of processes for organizational value creation, the need to make decisions continually arises from ongoing
changes in the environment. These decisions are not made by individuals, but achieved in collective communication
processes. In the SGMM such communication processes are understood under the term "decision-making praxis",
which shall stabilize the organizational value creation as well as its innovative further development (Rüegg-Stürm &
Grand, 2019, p. 164).
The decision-making imperatives, with which enterprises are continually confronted, include especially questions
concerning the continued development of the enterprise – for example, what products services should be provided
for the environment in the future, toward which stakeholders the value creation should be oriented, how the value-
creation processes should be configured, etc. (Rüegg-Stürm & Grand, 2017, p. 166). Therefore decision-making
imperatives within an organization play a big role for the financial management, as a reciprocal relationship exists:
On the one hand, decision-making imperatives have an influence on the processes of financial management while,
on the other hand, these processes influence the decisions to be made. In the example, it can be seen that Nestlé has
made the (strategic) decision to expand its healthcare business through investments and a stronger focus on the area
of health science. Such strategic decision are impossible without information from the internal financial
management and respective analysis and forecasts. In addition, development of value adding services such as
building up health science for Nestlé typically required financial investment, which requires allocation of financial
resources, and therefore external financial management significantly supports investment and therewith the
development of the company’s value adding services. For strategic decisions such as investment or M&A, internal
and external financial management jointly provide the necessary information and decision basis.
Strategic decisions are not only influenced by processes of financial management, instead they also influence them.
As an example, after an investment, Nestlé potentially needs to adapt its financial reporting to focus more on
addressing stakeholders from the health sector, which could eventually lead to changes in the content. In the case of
an enterprise focusing on new geographic areas or products, as already mentioned, need to perform segment
reporting, starting at a certain size. Such decisions, as in the case of Nestlé, always have an impact on the
configuration of resources, which needs to be adjusted or developed further (Rüegg-Stürm & Grand, 2017, p. 166).
Last but not least, decision-making imperatives also continuously arise for the sub-process of financial management
as a management task. This can be illustrated particularly well in performance measurement (see chapter 11). Key
Performance Indicators don’t simply exist, they are not objective facts, and instead they must be constructed,
defined, and compiled. The constructed data must be interpreted and evaluated by management; connected to this is
an effort of communicative sense making. Management must deal with uncertainty in the interpretation of various
indicators. Organization-specific routinized decision-making practices and forms of decision processing support
developing and defining which indicators will be seen as particularly important and how they will be interpreted.
2.5.2 Frame of orientation
In order that any decisions can be made within an organization, an organization-specific frame of reference and
orientation is required. This serves as a "collectively relevant framework of meaning and orientation" and consists of

Chapter 2:
the shared "self-evidently accepted as relevant and valid and principally unchallenged points of reference”, values
and ideas of success (Rüegg-Stürm & Grand, 2017, p. 178; Rüegg-Stürm & Grand, 2019, p. 185). The frame of
orientation consists of three orientations, each focusing on different critical aspects (Rüegg-Stürm & Grand, 2019, p.
185), and influences the processes of financial management, and is at the same time influenced by it.
The frame of orientation of an enterprise, which the SGMM describes to exist of normative, strategic and
operational orientation, always has an influence on the processes of financial management and at the same time
financial management influences the frame of reference. The influence of the frame of orientation of an organization
onto the financial management is expressed in the financial reporting, as the organization-specific normative,
strategic and operational orientation the content and structure of the financial reporting guides. Thus the normative
perspective of Nestlé influences, for example, the scope and thematic focus of corporate governance and the
sustainability report. Compliance with the true and fair view principle (see chapter 3) is also derived from the
normative orientation of the enterprise, i.e. from its fundamental ideals and moral concept. The strategic orientation
specifies which stakeholders in particular are to be addressed by the reporting. Furthermore, the strategic orientation
influences the content-related focus of narrative elements of reporting, such as the management report (see chapter
8.3).
The internal financial management and respective decisions relate to the organization’s frame of orientation.
Decisions about the financing structure (see chapter 12) are guided by the normative orientation. Management
accounting (see chapter 11), and the targets and performance indicators for value creation (such as sales, profit
contribution, margin, etc.), must be adapted to the ideas and criteria of success of the operational orientation. In
addition, the organization-specific operational orientation guides questions regarding securing short-term liquidity.
Besides being influenced by the frame of orientation, the processes of financial management also influence the
frame of orientation of an organization. As an example, aggressive financial objectives (such as sales or profit
targets) as part of management accounting and performance measurement decisions guide the normative orientation
of the organization. Employees feeling pressured to meet the targets may be tempted to enter agreements and
transactions that are not compatible with the prior moral concept of the organization.
2.5.3 Management praxis
According Rüegg-Stürm and Grand (2017), management practices are "those practices that are suitable for the
reflexive design of organizational value creation and the associated challenges and opportunities" (p. 216). This
definition allows financial management to also be classified in the area of management practices. If the
organizational value creation is reflected within the scope of management, it is fundamentally a question of the
extent to which it shall be maintained or further developed or adapted in a certain area (Rüegg-Stürm & Grand,
2019, p. 216). The processes of financial management provide an important contribution to this kind of reflection.
For example, if the management accounting, in the preparation of financial information, observes unsatisfactory
results, profit margins or returns are being generated in one business segment, consequences for the enterprise must
be interpreted and assessed based on this information. This can also be illustrated with the example of Nestlé. In the
article, it says that Nestlé is continuously building its health business because it tends to yield "higher revenues than
the traditional range of chocolate bars, coffee or finished products". Here the contribution of financial management
to reflecting the value creation at Nestlé becomes abundantly clear. The internal preparation of the financial

Chapter 2:
information for the various product segments has the revealed that the health business is more profitable for Nestlé
than the traditional food business. In fact, it can be recognized on the basis of the segment reporting at Nestlé that
the area "Nutrition Products and Health Care", along with “beverages in liquid and powder form", yields the highest
profit margin in the operating activities (see chapter 5.5.2). This information from financial management has
contributed to reflexivity about Nestlé’s organizational value creation and led to increased investments being made
in the health business.
2.5.4 Executive management
In contrast to corporate governance – in which, as described in the previous section, the focus is on embedding an
enterprise in its environment – executive management deals mainly with the conditions for an effective design of the
overall system (Rüegg-Stürm & Grand, 2019, p. 249). The main task is to «design the management platforms in
such a way, that the value creation and the subsequently required decision-making praxis can be further developed
successfully» (Rüegg-Stürm & Grand, 2019, p. 249). In this way, executive management can define and realize the
framework conditions prescribed by corporate governance (Rüegg-Stürm & Grand, 2019, p. 249).
An important sub-area of executive management is to define and implement relevant ideas of success for an
enterprise. In this way financial management as a management task again makes a significant contribution. If ideas
of success can be defined in the course of executive management, evaluation criteria can be set, upon which success
can be measured (Rüegg-Stürm & Grand, 2017, p. 227). These evaluation criteria often conform to data that are
processed and published in the course of the processes of internal financial management. Many enterprises use as
evaluation criteria specific indicators such as return on equity, debt ratio or free cash flow (see chapter 11) that can
be assigned to the three target categories of financial management, return, risk, and liquidity (see chapter 2.2), and
can be calculated based on the processed data. An ambition level can be assigned to each of these evaluation criteria,
upon which success can be measured in concrete terms. This ambition level can be of a quantitative (such as "ROE
of min. 20%”) or qualitative ("an improvement in the ROE") nature (Rüegg-Stürm & Grand, 2017, p. 247).
It could be that, in the example, failing to reach a defined ambition level led the executive management to critically
reflect on Nestlé’s primary value creation, and it was decided in the name of development to invest more in the
health business. In fact, the net profit margin of Nestlé group fell from 11.9% in 2012 to 11.3% in 2013 before
significantly increasing to 16.3% in fiscal 2014. Undoubtedly, this increase is not only due to investments in
profitable healthcare business; nevertheless, it is possible that a falling net profit margin at an enterprise and group
like Nestlé group led management to critically reflect on the primary value creation and developments in the
relevant environment, coming to the conclusion that larger parts of the value creation should be aligned in the future
to the promising health care market.

Chapter 2:
2.6 Summary
A definition of financial management must encompass various sub-disciplines, which themselves require company
specific definitions and weighting. Generally speaking, financial management can be split into external financial
management and internal financial management, preparing and communicating financial information to external
stakeholders (primarily investors) and internal stakeholders (primarily management) respectively, allowing them
taking economic decisions. Financial reporting is a part of external financial management, constituting a support
process communicating to investors and therewith securing and allocating financial resources. Management
accounting and performance measurement are important management processes, preparing and analyzing internal
financial information, allowing critical reflection on value adding and value chains. The reflections shall lead to
operating and strategic decisions, namely regarding financing and growth / M&A. In summary, financial
management consists of the following sub-processes:
2. Performance management and management accounting
3. Financing and risk management
4. Growth / M&A
Financial management is one of the most important tasks of management. It is therefore necessary and reasonable to
present and classify the various processes of financial management on the basis of SGMM. The SGMM consists of
the three key categories environment, organization, and management.
In the area of environment, financial management influences the decision of resource allocation. Consequently,
financial reporting addresses various environmental spheres and satisfies the divergent information needs of a broad
group of stakeholders. At the same time, the relevant environmental spheres and stakeholders and their information
needs continuously change. Information from the internal financial management help with reflecting on
environmental changes and subsequently enacting the environment.
Financial reporting and management accounting as instruments of interactions of the enterprise with the
environment have its origin in the organization itself. The different ways of looking at organizational value creation
(whether from the view of it as a result- or process-oriented perspective) are also found in the reporting, such as
when, for example, enterprises present financial information of different subunits (product groups, geographical
entities, etc.) separately in segment reporting or when the expenses of the whole company are divided among
different functional areas in the income statement. Also decision-making praxis within an organization has an
impact on financial management and is, at the same time, also affected by it. For example, on the one hand, the
decision to invest in a new business brings with it a change in the configuration of the financial reporting while, on
the other hand, the success of financial management in the allocation of financial resources, as well as analyses and
projections derived from management accounting, significantly influence the scope and direction of possible
investments. Finally, with regard to the organization-specific frame of orientation, there is a reciprocal relationship
between the organization and financial management that influences the concrete design of financial reporting on the
one hand, financial management on the other hand, and also delivers important target measures and performance
indicators for directing the value creation, and therewith it influences the design of the frame of orientation.

Chapter 2:
Reflexivity about organizational value creation and its development are important aspects of management. Here,
too, the processes of financial management contribute significantly. In executive management, evaluation criteria for
ideas of success are used, based on information from management accounting and performance measurement.
Continuously missing a set ambition level can result in a realignment of the organizational value creation. In the
area of corporate governance, which represents the basis of legitimacy for the management praxis, financial
management and financial reporting contribute to helping reduce the information asymmetry between investors and
management. In this context, audits also play a central role. Auditing firms are commissioned by enterprises to
examine the information presented in the financial reporting and to certify its irreproachable quality in accordance
with regulations. This independent check also helps to further lower information asymmetry between investors and
management.
2.7 Additional Literature

Achleitner, A-K., Behr G. & Schäfer, D. (2009). Internationale Rechnungslegung: Grundlagen, Einzelfragen und
Praxisanwendungen (4. Vollständig überarbeitete und erweiterte Auflage). München: Vahlen.
Duffé, A. (2005). Creditor Relations. Frauenfeld: Huber.
Behr, G. & Leibfried P. (2014). Rechnungslegung (4. aktualisierte und überarbeitete Auflage). Zürich: Versus.
Baumann, R. (2014). Finanzielle Führung – Management Basiskompetenz: theoretische Grundlagen und Methoden
mit Beispielen, Repetitionsfragen und Antworten. (4. Überarbeitete Auflage) Zürich: Compendio
Bildungsmedien.
Boemle, M. (2008). Der Jahresabschluss: Bilanz, Erfolgsrechnung, Geldflussrechnung, Anhang. Zürich: Verlag
SKV.
Dubs, R., Euler, D. Rüegg-Stürm, J. & Wyss, C. (Hrsg). (2009). Einführung in die Managementlehre. Bern: Haupt.
KPMG Deutsche Treuhand-Gesellschaft (Hrsg.). (2003). International Financial Reporting Standards: eine
Einführung in die Rechnungslegung nach den Grundsätzen des IASB. (2. Überarbeitete Auflage). Stuttgart
Schaeffer-Poeschel.
KPMG AG Wirtschaftsprüfungsgesellschaft. (Hrsg.). (2014). IFRS visuell. Die IFRS in strukturierten Übersichten.
(6. überarbeitete Auflage). Stuttgart: Schaeffer-Poeschel.
Lingnau, V. (2010) Studienbuch Finanzbuchhaltung. Ebersdorf 1-2-Buch.

Rüegg-Stürm, J. & Grand, S. (2017). The St. Galler Management-Modell. Bern: Haupt.
Rüegg-Stürm, J. & Grand, S. (2019). The St. Galler Management-Modell: management in a complex world. Bern:
Haupt.
Schellenberg, A. C. (2010). Rechnungswesen: Grundlagen, Zusammenhänge, Interpretationen (4. überarbeitete und
erweiterte Auflage). Zürich: Versus.

Part B:
Looking outside – External Financial Management 26
Part B:
Looking outside –
External Financial
Management

Chapter 3:
Objectives and Principles of Financial Reporting 27
Objectives and Principles of Financial

Reporting
The framework conditions of

financial reporting encompass all
relevant rules that a company must
take into account in financial
reporting. These establish the
manner and content of reporting
concerning the past, the present and
prospects. The law itself provides
guidelines here.
However, there are also recognized financial reporting standards that specify which circumstances and business
transactions must be financially measured as well as recorded in the statement of financial position, and therefore
included in the reporting. The framework conditions of financial reporting also establish which components must be
exhibited in the financial statements, when reporting must take place, and the scope and structure of the individual
components. It becomes apparent that overall financial reporting does not deal with the simple presentation of
financial figures but is a representation of past business activities.
3.1 Introductory Example from PubliGroupe
INTRODUCTION: SPECTRUM OF REPORTING
PubliGroupe: Figures Reported Incorrectly?

PubliGroupe to be sanctioned by the Swiss stock exchange
supervisory authority. The marketing company allegedly violated
financial reporting regulations.
The marketing company PubliGroupe allegedly violated provisions

relating to financial reporting in its annual and half-year financial
statements. These breaches by the company have been brought forward
by SIX Exchange Regulation, the stock exchange supervisory authority,
which has lodged a sanction request.
After completion of its examination, SIX Exchange Regulation contends that PubliGroupe AG violated provisions of the
applicable financial reporting standards in its 2011 annual financial statement as well as its 2012 half-year financial statement,
the Swiss exchange supervisory body announced on Wednesday.

Chapter 3:
Specifically, the supervisory authority is charging PubliGroupe with insufficient fulfillment of certain reporting requirements
concerning sales revenue as well as interim reporting and of thus having infringed regulations. According to Wednesday's
statement, the duration of the proceedings is uncertain.
PubliGroupe switched its financial reporting standard from IFRS (International Financial Reporting Standards) to the Swiss
GAAP FER standard as of the fiscal year 2012. In a press release, PubliGroupe AG denied the allegations of the stock
exchange supervisory authority.
Article has been modified. From: Handelszeitung (March 20, 2013).
1. Which framework conditions apply for PubliGroupe with respect to financial reporting? Which institutions define these
framework conditions?
2. Why is the Swiss exchange SIX interested in financial reporting?
3. What could have motivated PubliGroupe to switch to Swiss GAAP FER and what are the potential effects of such a switch?
3.2 Objectives of Financial Reporting
LEARNING OBJECTIVES
• Understanding the derivation of the objectives of financial reporting

• Recognizing the factors influencing the objectives of financial reporting
• Understanding the concept of financial reporting and accounting standards
• Recognizing areas of information
Financial reporting cannot be free from subjective influences. As seen in the previous chapters, there are numerous
different needs for information, stakeholders and environmental spheres that all exert an influence on financial
reporting. These also help change the objectives of financial reporting over time. Even areas of information have
altered over the course of the years. The statement of cash flows, for example, was for a long time not mandatory in
the Swiss Code of Obligations but is today an essential component of an informative annual report. Nevertheless, it
is possible, in principle, to establish objective goals for financial reporting or the preparation of financial statements.
Financial reporting aims to make a company's economic activities transparent by presenting them in a quantitative
manner. In doing so, financial reporting serves to satisfy different interested parties' need for information. The
supply of information has the purpose of supporting the decision-making process by delivering decision-relevant
data (decision usefulness). The objectives of financial reporting can therefore be summarized as:
§ the provision of information concerning the asset, financial and earnings positions of a company,
§ which should be useful for the widest possible circle of recipients
§ in order to make economic decisions.
Objective of financial The goal of financial statements is to provide information regarding the asset, financial and earnings
reporting according to position as well as changes in the asset and financial position of a company that is useful for the
IFRS economic decisions of a wide circle of recipients. (IFRS Conceptual Framework Sec. 12)

Chapter 3:
In order to satisfy needs for information and make the correct supply of information available, the company must
know recipients' needs for information and comply with laws and accounting standards. The industry in which the
company is active, the capital markets as well as the legal structure of the company also influence the disclosed
information. In this context, history itself delivers a good example of how needs for information have influenced
laws and financial reporting. Banks were and are still the most important source of financing in continental Europe.
As a result, this engendered a pronounced orientation towards the creditor in the laws concerning financial reporting
in continental Europe. The creditor orientation was thereby characterized by the protection of creditors and the
resulting conservative presentation of the financial position. In Switzerland, it was then legally easily possible, under
the guise of being “conservative,” to represent the asset and earnings position of a company in a manner that made it
appear relatively worse than it actually was. Due to internationalization and the developments in understanding the
importance of informative financial reporting and satisfying all possible needs for information, the principles of a
true and fair view or fair presentation have now become established. They should guarantee an accurate picture of
the economic situation of a company. As a result, the orientation towards the interests of the creditors and therefore
the protection of creditors is no longer the primary objective of financial reporting.
This historical example illustrates that the objective of financial reporting will always be the reflection of a
weighting of interests (Behr & Leibfried, 2009, p. 61). The principles of a true and fair view or fair presentation
are, basically, also an attempt at conveying a proper picture of the economic situation of a company, while
considering and weighting all significant interests. Subjective perceptions play an influential role here too. How,
then, are the objectives achieved? This is where the concept of financial reporting comes in. Through the creation of
principles and norms regarding the representation of financial circumstances, framework conditions concerning
scope, quantity and quality are established that help to provide a picture of the actual economic situation that is as
clearly defined as possible. These accounting norms or accounting standards are designated as generally accepted
accounting principles (GAAP). Statutory regulations may also contain accounting norms. Independent auditing
ensures compliance with the principles and norms. A company attains the desired true and fair view by taking into
account the following points:
§ Consistent application of an accounting standard, which provides clear guidelines regarding the balancing
of accounts and the disclosure of circumstances (norms)
§ Presentation of financial results according to the norms of the accounting standard
§ Inspection of the application and representation of the financial circumstances and results by an
independent auditing body (external audit)
Civil or commercial laws normally specify minimum financial reporting requirements. In particular, Art. 957a of the
Swiss Code of Obligations (CO) stipulates bookkeeping as the basis for financial reporting. At the same time, the
Swiss bookkeeping principles (GoB) are defined. Building on this, the goals of financial reporting are defined in
Art. 958 of the Swiss Code of Obligations.

Chapter 3:
Art. 957a CO Bookkeeping
B. Bookkeeping
1
Bookkeeping is the foundation for financial reporting. It encompasses those business transactions and circumstances that
are necessary for the representation of the asset, financing and earnings position of the company (economic situation).
2
It complies with the Swiss bookkeeping principles. In particular, attention should be paid to:
1. complete, true and systematic recognition of business transactions and circumstances;

2. documentary proof of the individual accounting entries;
3. clarity;
4. usefulness with respect to the type and size of the company;
5. verifiability.
3
Accounting records are considered all written records on paper or in electronic or equivalent form that are required to
identify details regarding the business transactions or circumstances behind an accounting entry.
4
Bookkeeping ensues in the local currency or in the currency relevant to the business activities.
5
Bookkeeping ensues in the local language or in English. Entries can be made in writing, electronically or in an equivalent
manner.
Art. 958 CO Financial reporting
C. Financial reporting
I. Purpose and components
1
Financial reporting should represent the economic situation of the company in such a manner that third parties can form a
reliable opinion.
2
Financial reporting ensues via the annual report. The annual report includes the financial statement (separate financial
statement) consisting of the statement of financial position, the statement of profit or loss and the notes. The provisions for
larger companies and groups remain reserved.
3
The annual report must be created within six months after the fiscal year ends and submitted to the responsible body or the
responsible person for approval. It must be signed by the chairman of the top management or administrative body and the
person responsible for financial reporting within the company.
In addition to the law, independent institutions may also define financial reporting norms (so-called financial
reporting standards). Provisions regarding financial reporting typically divide the needs for information of
stakeholders into four areas of information. This division of information is defined in the different modern financial
reporting standards (e.g. IFRS, US GAAP or Swiss GAAP FER) in a relatively congruent manner, which is why this
book also focuses on these four areas in particular:
a) Asset position: is represented by the statement of financial position

b) Earnings situation: is represented by the statement of profit or loss and other comprehensive income
c) Financial position: is represented by the statement of cash flows
d) Equity: is represented by the statement of changes in equity

Chapter 3:
Figure 8: Goals of Financial Reporting
3.3 Framework Conditions and Accounting Standards
LEARNING OBJECTIVES

• Understanding the different framework conditions of financial reporting
• Being able to evaluate the influence of the statutory framework conditions
• Understanding and being able to evaluate the relevance of the individual financial reporting standards
As seen in chapter 2, there are different stakeholders with respect to financial reporting. Financial reporting defines
the manner in which information concerning a reporting period (e.g. fiscal year or quarter under review) must be
prepared and presented. In this context, it is important to know how financial reporting is designed, what framework
conditions exist in financial reporting, and what the scope of reporting is. A distinction can be made between the
framework conditions of the legal system, the framework conditions of the financial reporting standards as well as
additional framework conditions. The statutory framework conditions must be contemplated first, whereby
jurisdiction is not only determined by the location of the company's registered office; for international companies,
the local laws of the countries in which the company conducts transactions must also be considered. In Switzerland,
the Swiss Code of Obligations (CO) regulates statutory financial reporting. The CO stipulates the fundamental
principles and establishes the functions and duties of financial reporting. In addition to the CO, the tax laws of the
individual cantons (StG per canton) as well as the Swiss Federal Income Tax Act (DBG) regulate specific
circumstances in financial reporting with respect to tax assessment. Swiss companies are always confronted with the

Chapter 3:
statutory framework conditions. In contrast, companies have a certain freedom of choice regarding financial
reporting standards. Different systems of financial reporting standards and therefore different associated principles
and methods in the implementation of financial reporting exist. In an international context, two systems have
prevailed over time and, in recent years, become increasingly congruent. These systems are the International
Financial Reporting Standards (IFRS) as well as the United States Generally Accepted Accounting Principles (US
GAAP). On a national level in Switzerland, the standards consist of the professional recommendations for financial
reporting (FER). These are also called Swiss GAAP FER. The focus of Swiss GAAP FER is on SMEs and national
large companies. These systems are designated as financial reporting standards. There are additional framework
conditions that need to be considered in combination with financial reporting. Typically, companies listed on the
stock exchange are of special interest and therefore stock exchanges and exchange supervisory authorities seek to
influence the financial reporting of such public corporations. In Switzerland, SIX Swiss Exchange in particular has
established directives and recommendations for financial accounting and financial reporting. A Swiss company,
depending on its size, is therefore confronted with the following framework conditions in financial reporting:
Figure 9: Framework Conditions in Financial Reporting
3.3.1 Swiss Code of Obligations
Title 32 of the Swiss Code of Obligations, entitled “Commercial Accounting and Financial Reporting,” regulates
financial reporting for Swiss companies. Art. 958 CO describes the functions and duties of financial reporting (see
chapter 3.2). Furthermore, the CO explains the fundamental concepts of the basic accounting principles (GoR) (see
chapter 3.4). The CO also stipulates when the company is subject to financial accounting regulations:
Art. 957 CO Bookkeeping and Accounting Obligation
1
Subject to the bookkeeping and accounting obligation, pursuant to the following conditions, are:
1. sole proprietorships and partnerships with sales revenues of at least CHF 500 000 in the last fiscal year;
2. legal entities.
In addition to the general fundamental principles, Art. 959 et seq. CO also provides clear details concerning the
scope and structure of the financial statement (see chapter 3.5). Art. 961 CO requires large companies disclosing
additional information in the notes, prepare a statement of cash flows and provide a management report. In the same
context, Art. 962 CO defines whether a company must additionally prepare the financial statements according to a
recognized standard of financial reporting. Recognized standards are Swiss GAAP FER, US GAAP and IFRS.

Chapter 3:
Art. 962 CO Financial Statements Pursuant to Recognized Financial Reporting Standards
1
According to this title, the following must prepare a financial statement pursuant to a recognized standard of financial
reporting:
1. companies whose equity securities are listed on an exchange, if so required by the stock exchange;
2. cooperatives with at least 2000 cooperative members;
3. foundations subject by law to regular audits.
Art. 963 CO provides particular regulations in connection with the preparation and design of financial statements of
groups of companies; these are covered in chapter 9.
In addition to the tasks and duties named above, the CO also establishes other tasks and functions with respect to
financial reporting:
§ Signatory obligation: Art. 958, 3 CO stipulates that the annual report must be signed by the chairperson of
the top management or administrative body and by the person responsible for financial reporting within the
company.
§ Safekeeping obligation: pursuant to Art. 958f CO.
§ Disclosure obligation: pursuant to Art. 958e CO.
§ Publicity obligation: pursuant to Art. 697 CO and Art. 958e CO.
§ Profit determination function and distribution regulation: pursuant to Art. 671f CO.
§ Establishment of capital loss and over-indebtedness: pursuant to Art. 725 CO.
§ Additional obligations associated with financial reporting: in addition to the mentioned duties and tasks,
further obligations exist – such as the deadlines for reporting or the length of the accounting period – that
will not be covered here but are explained in the reference
literature.
3.3.2 Listing on the SIX Swiss Exchange
If a company intends to issue or list bonds or equity securities on the SIX Swiss Exchange stock market, it is subject
to particular financial accounting and reporting requirements. As soon as equity or debt securities are traded on the
stock market, the company must comply with the SIX directive concerning financial reporting (RLR). This
stipulates which financial reporting standards are recognized and may be implemented, how interim reporting must
be structured, and how reports as well as other information must be publicly disclosed. Investment and real estate
companies are subject to additional special conditions with respect to financial accounting and reporting.
Art. 1 RLR General Provisions
By establishing corresponding financial reporting requirements, this directive aims at permitting investors to assess the
quality of the issuers (Art. 8, 2 Swiss Stock Exchange Act (BEHG)).
Specific criteria must be satisfied in order to list equity or debt securities on the Swiss Exchange. SIX thereby
differentiates between four regulatory standards: main standard, standard for investment companies, standard for
real estate companies as well as the domestic standard. These regulatory SIX standards also mandate the possible
financial reporting standards. For example, a real estate company domiciled in Switzerland is not permitted to
submit its annual report pursuant to US GAAP. For companies domiciled in Switzerland, SIX provides the
following regulations in Art. 6 RLR:

Chapter 3:
I) Issuers Incorporated in Switzerland
IFRS US GAAP Swiss GAAP FER

Issuers of equity securities
Main standard x x
Standard for investment companies x x
Standard for real estate companies x x
Domestic standard x x x
Issuers of debt securities only x x x

Note. From: SIX Swiss Exchange (undated).
3.3.3 Swiss GAAP FER
Swiss GAAP FER is the recognized financial reporting standard with an origin
in and focus on Switzerland. The Foundation for Accounting Recommendations
was founded on March 20, 1984, in Switzerland and is a professional
commission that, according to the excerpt from the commercial register, has the
following purpose:
Purpose The foundation aims to achieve the creation of a “professional commission for recommendations for financial
reporting” of at most 30 members comprising business leaders, auditing and accounting professionals, members
of employer and employee organizations, persons from universities, representatives from the public sector and
other groups of persons interested in financial reporting. The professional commission has the task of
developing recommendations regarding financial reporting, which take into account Swiss conditions and
present companies with feasible approaches. (Excerpt from the commercial register entry of the Foundation for
Accounting Recommendations. Version shortened by author.)
In line with the purpose, the professional commission issued the “Swiss GAAP FER” accounting principles.
According to statements by the professional commission, Swiss GAAP FER focuses on the financial reporting of
small and medium-sized organizations and groups of companies with a national character. Other users are non-profit
organizations, pension plans, insurance companies, and building and health insurers. These companies are provided
with a suitable framework for informative financial reporting that conveys an accurate picture of the asset, financial
and earnings positions (true and fair view). A further goal is the advancement of communication with investors,
banks and other interested groups of persons. At the same time, comparability of the financial statements between
companies as well as over time is made simpler. (Foundation for Accounting Recommendations, undated.)
The Swiss GAAP FER concept is constructed in a modular manner and consists of the conceptual framework, which
can be considered the basis, as well as individual standards, which can be divided into core FER, additional FER,
industry-specific standards as well as consolidated financial statements and exchange listing.
The conceptual framework (CFR) mandatory for all companies comprises the fundamentals and principles that
provide the basis for financial reporting pursuant to Swiss GAAP FER. In addition to the fundamentals regarding
purpose, objective, valuation concepts and qualitative requirements, the CFR elucidates the relationship to tax law.
Furthermore, the CFR is relevant when individual standards do not contain sufficiently detailed information. In this
case, the CFR is then enlisted and used to fill the “gaps” in individual standards in a practical manner.

Chapter 3:
Figure 10: An Overview of Swiss GAAP FER
Note. Own depiction. Based on: Meyer (May 2008), p. 290.
Swiss GAAP FER is equipped for the application of a customized selection of professional recommendations; this
selection provides a suitable basis for financial reporting and simultaneously offers the option for subsequent
application of Swiss GAAP FER in its entirety. Appropriate application of the financial reporting standards varies
according to the size of the company, measured by the total assets, annual sales volume and number of full-time
employees. Small companies have the option of implementing the conceptual framework as well as selected key
professional recommendations (core FER). A small company may limit itself to core FER as long as two of the
following criteria are not exceeded in two consecutive years:
§ Total assets of CHF 10 million;

§ Annual sales volume of CHF 20 million;
§ 50 full-time employees on an annual average.
Medium-sized companies must comply with core FER and additional FER recommendations. FER 31, “Additional
Professional Recommendations for Listed Companies,” is also mandatory for listed companies. Furthermore, Swiss
GAAP FER 30, “Consolidated Financial Statements,” exists for the economic presentation of entire groups of
companies as well as industry-specific standards.

Chapter 3:
3.3.4 International Financial Reporting Standards (IFRS)
The International Financial Reporting Standards (IFRS) are international

financial reporting provisions issued by the International Accounting Standards Board (IASB). The IASB emerged
from the International Accounting Standards Committee (IASC), which was founded in London on June 29, 1973,
as a private-law association of national professional organizations of accountants and auditors. The IASC, however,
lived in the shadows for many years until 2000, when the European Union decided to collaborate with the IASC in
the further development of European financial reporting provisions. In 2001, the IASC was then restructured and
renamed the IASB. Up until this point in time, financial reporting standards were issued as International Accounting
Standards (IAS). These continue to be partially in effect today and are being modified or substituted by new
standards (IFRS) by the IASB to the present day. The new financial reporting standards developed by the IASB are
called IFRS standards and are consecutively numbered, in line with the IAS (e.g. “IFRS 3 Business Combinations”
regulates the presentation of acquisitions and mergers). In January 2010, the IASC Foundation was renamed the
IFRS Foundation in order to maintain consistency in naming. (IASB, 2013, & KPMG Deutsche Treuhand-
Gesellschaft, 2003, p. 2 et seq.)
3.3.4.1 Organization
The IFRS Foundation is the legal organization under whose authority the IASB operates. 22 trustees lead the
Foundation. The IASB is the executive body and consists of 16 full-time experts who are responsible for the
development and publication of IFRS (a book published each year featuring all currently valid regulations) as well
as IFRS for SMEs (simplified regulations that target the particularities of SMEs). The trustees of the IFRS
Foundation appoint the members of the IASB. The authority of the IASB can be summarized as follows:
§ Discussion of accounting problems and, where applicable, development of an exposure draft (ED);
§ Consultation and publishing of exposure drafts;
§ Adoption of new IFRS standards and interpretations by the IFRS Interpretations Committee;
§ Revision or repeal of existing IFRS standards
The Standing Interpretations Committee (SIC) was formed in order to promote the correct interpretation of the
standards; it has the tasks of answering questions from IFRS users as well as issuing interpretations for users
concerning specific cases of implementation. In the meantime, the SIC was renamed the International Financial
Reporting Interpretations Committee (IFRIC) and is today called the IFRS Interpretations Committee. Due to the
IFRS Interpretations Committee's experience with implementation problems, it also submits proposals for improving
individual standards to the IASB. The IFRS Interpretations Committee consists of 14 members.
In addition to the executive (IASB) and the interpretation (IFRS Interpretations Committee) bodies, there is also the
supervisory and controlling body. The trustees of the IFRS Foundation assume this function. The 22 trustees of the
IFRS Foundation are not involved in the development and adoption of financial reporting standards. In order to
ensure a broad international basis, six trustees must be selected from North America, six from Europe, six from
Asia/Oceania, one from Africa, one from South America and two from the rest of the world (IASB, 2013, & KPMG
Deutsche Treuhand-Gesellschaft, 2003, p. 2 et seq.).
The following diagram illustrates the interaction between the three bodies.

Chapter 3:
Figure 11: IFRS Organization
Note. From: IASB (2013).
Objective and Concept:
Objective Development of a uniform set of high quality, understandable, enforceable and globally accepted financial
reporting standards that are based on clearly formulated principles (IASB, 2013.)
In order to attain the objective, the IASB lists the following success factors:
§ An independent standardization committee that is supervised by a geographically and professionally

diverse group of trustees. The trustees are accountable to a Monitoring Board, whose members are
representatives of the public capital market authorities.
§ Support through an external IFRS Advisory Council and an IFRS Interpretations Committee, which
formulate guidelines for the specific practical implementation of the standards.
§ A thorough, open, participatory and transparent formal approach.
§ Dialogue with investors, regulators, business leaders and the global accountancy profession during each
phase of the process.
§ Worldwide collaboration with other standard-setting bodies.
The objective, pursuant to IFRS, is that financial statements provide information regarding the asset, financial and
earnings position as well as changes in the asset and financial position of a company in a manner that is useful for
the economic decisions of a broad group of recipients The IFRS standards are primarily geared towards investors'
need for information. According to IFRS, the essential requirement of the financial statement is “fair presentation.”
Like Swiss GAAP FER, IFRS has a conceptual framework (CFR), which is termed framework and contains all
IFRS fundamentals and principles. Similar to Swiss GAAP FER, the standards build on this CFR. However, in
contrast to Swiss GAAP FER, the standards are not categorized (core FER, industry-specific FER, etc.). Instead,
IFRS standards are consecutively numbered. New IAS standards are no longer being created; instead, existing IAS

Chapter 3:
are being amended as well as gradually replaced by IFRS standards. Each company that carries out financial
reporting pursuant to IFRS must comply with the CFR as well as all standards relevant to its business activities. In
addition to the standards, interpretations also exist, which help in the application of the individual standards. The
IFRS concept can be depicted as follows.
Figure 12: Overview of IFRS
Note: Own depiction.
3.3.4.2 Procedure for Establishing New Standards (Standard Setting)
Provisions are made for a formalized due process before the draft of a new IFRS or the amendment of an existing
IAS or IFRS. The process is an international consultation procedure that involves the interests of persons and
organizations from around the world. IFRS divides the process into six points:
1. Setting the agenda

2. Planning the project
3. Developing and publishing the discussion paper
4. Developing and publishing the exposure draft
5. Developing and publishing the standards
6. After the standard is issued
At the beginning of this standardization process, a draft statement of principles (DP) is utilized as a discussion
paper. This discussion paper is openly debated for at least four months. During this period, the interested
professional public has the opportunity to submit an opinion by means of a comment letter. The publication of a DP
is not a required step in the development process, but it is generally implemented by the IASB. On the basis of the
opinions received, an exposure draft (ED) – a draft of the subsequent standard – is compiled, which is then also
published for comment. Only after evaluation and examination of the opinions received concerning the ED is the
final version of the standard then adopted. In the case of strong opposition to the ED, an amended draft (re-
exposure) may be published before the final version of the standard is adopted. After a standard has been adopted,
sessions and meetings concerning the new standard continue to take place regularly between IASB members and
other interested parties in order to provide support during implementation, monitor that the standard is proven in
practice, and, if necessary, clarify problems as they arise (IFRS website, undated.).

Chapter 3:
The first IAS standard was published by the IASB in June 1975. This was “IAS 1 Disclosure,” and it is still in effect
today, after having been revised in 1997, 2001 and 2008 and also being renamed to “IAS 1 Presentation of Financial
Statements.” In the meantime, numerous IFRS have been newly created and existing IFRS/IAS modified. In the
course of this, the structure of the standard always follows a certain scheme in order to simplify understanding and
implementation by the reader and user. The typical structure of a standard is depicted in the following diagram.
Figure 13: Typical Structure of a Standard (IFRS/IAS)
Note. From: KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 8.
3.3.4.3 IFRS for SMEs
In July 2009, IFRS for SMEs was launched as an independent accounting concept. The objective of the IASB is to
make financial reporting provisions available that are suitable for non-listed small to medium-sized companies. The
financial reporting provisions are based on IFRS, which were developed primarily for listed companies. With this
step, IFRS became increasingly competitive with Swiss GAAP FER, which is commonly used in Switzerland. To
date, however, there are no indications that IFRS for SME is likely to supplant Swiss GAAP FER as the dominant
financial reporting standard in Switzerland. The most important differences between Swiss GAAP FER and IFRS
for SMEs are listed below. The analysis was created by OBT and is reproduced here without changes.
Table 4: IFRS for SMEs versus Swiss GAAP FER
Swiss GAAP FER IFRS for SMEs

Target group SMEs, also for companies listed in the ancillary Companies not subject to mandatory public disclosure
segment of the SIX Swiss Exchange, non-profit
organizations and pension plans
Acceptance Recognized and established in Switzerland International orientation
Scope/ Few detailed regulations – conceptual Contains detailed regulations, approx. 200 pages and
regulation framework often has to fill gaps, approx. 130 several references to IFRS, which comprises 2 800
density pages pages
Constancy Most recently thoroughly revised in 2007 and Revised every three years
this version should remain valid for the coming
years; revisions as needed
Goodwill - Goodwill must be written down periodically, § Goodwill must be written down periodically
accounting generally over 5 years, in justified cases up to § If useful life cannot be reliably determined,
20 years depreciation over 10 years
- Offsetting against equity at time of § Offsetting against equity not permitted
acquisition permitted, effects of capitalization
must be disclosed in the notes

Chapter 3:
Pension plan Basis is financial statement of the pension plan § Open whether additional expert opinions from
liability pursuant to Swiss GAAP FER 26 insurance experts are required for Swiss standards
Corresponding economic payable/credit § Compared to full IFRS, simplification regarding
recognized as liability/asset parameters to be considered
§ Pension plan liability recognized in statement of
profit or loss and other comprehensive income
Presentation/ Extraordinary positions are permitted. No extraordinary positions permitted.
classification No regulation for discontinued operations and It regulates the presentation of discontinued
assets held for sale operations and assets held for sale
Financial Financial instruments (exception: derivatives) Detailed regulation, financial instruments mostly
instruments to be treated on the basis of general valuation, included in statement of financial position at fair
classification and disclosure provisions value; detailed information to be disclosed in the
notes
Information Breakdown of (net) revenues by geographic No disclosure obligation
on segments market and business segments
Note. From: Schweizer & Zahno (2010), p. 2.
3.3.5 US GAAP
As the second international standard alongside IFRS, the United States Generally Accepted Accounting Principles
play a significant role in the financial reporting of large corporations. In contrast to IFRS and Swiss GAAP FER, US
GAAP is not an explicitly developed set of rules but instead grew historically over a considerable period of time and
now consists of a comprehensive collection of standards that have been developed by different organizations and
originate from different sources. As contradictions may surface between the existing financial reporting principles
due to the historical development, US public auditors created a hierarchical system that is known as the House of
GAAP. The House of GAAP can be divided into GAAP in a narrower sense and GAAP in a broader sense. GAAP
in a narrower sense encompasses the following regulations:
§ FASB Statements: Financial Accounting Standard Board (FASB) issues the Statements of Financial
Accounting Standards (SFAS) (like the IASB and IFRS)
§ FASB Interpretations: interpretations of SFAS (like the IFRS interpretations)
§ APB Opinions: the Accounting Principles Board (APB) was supplanted by the FASB in 1972, but its
opinions (explanations concerning the regulations) remain in effect, provided the APB have not been
superseded by new standards
In addition to GAAP in a narrower sense, there are other GAAP sources (GAAP in a broader sense) as well as the
US Congress, the US Securities and Exchange Commission (SEC), which are both permitted to establish financial
reporting provisions. The financial reporting standard is therefore very comprehensive and allows little leeway for
interpretation. US GAAP has a pronounced focus on US investors. In contrast to IFRS and Swiss GAAP, US GAAP
also features more industry-specific provisions. Compared to Swiss GAAP FER with its approx. 200 pages and
IFRS with approx. 2 400 pages, US GAAP, with approx. 6 000 pages, is extensive. The numerous implementation
and detailed provisions lead to practical supplements and amendments being issued on a weekly basis.
Although US GAAP is very relevant internationally, the last initial public offering on a stock market by a company
using US GAAP was in 2005 in the EU. The reason for this is that EU stock exchanges require the mandatory
application of IFRS. In Switzerland, the SIX Swiss Exchange (i.e. the stock market in Zurich) still permits listing on
the exchange with US GAAP as the financial reporting norm. Through continuous internationalization and
globalization, IFRS and US GAAP have become increasingly congruent over recent years.
Because this book focuses on IFRS, US GAAP will not be explained in more detail here.

Chapter 3:
3.3.6 IFRS versus Swiss GAAP FER
To what extent a company has a tendency to decide in favor of IFRS or Swiss GAAP FER as its financial reporting
standard has already been covered in chapter 3.3. Ultimately, each company decides for itself which standard is
most suitable for the company. Nevertheless, the decision has been increasingly discussed in the media since the
financial crisis. Three relevant articles are reproduced below.
Table 5: IFRS versus Swiss GAAP FER [1]
IFRS VERSUS SWISS GAAP FER [1]
Swatch Group Tired of IFRS

CASE STUDY
Increasingly elaborate provisions lead to frustration – large corporations also considering

switch to Swiss GAAP FER
The increasingly complex provisions of the International Financial Reporting Standard (IFRS) are generating irritation
among the CEOs of many Swiss companies. The new regulations concerning pension plan obligations are particularly
bewildering. A standard coming into effect in 2013 will lead to a significant reduction in equity at many companies.
Additional radical amendments from IFRS are looming. Many small companies have already switched their financial
reporting to Swiss GAAP FER in recent years, and now global companies are also toying with the idea. Among them is
the world's largest watch corporation. “Swatch Group is pondering whether to return to the Swiss GAAP FER standard,”
Nick Hayek stated in a conversation with [Swiss business magazine] Finanz und Wirtschaft. The CEO is annoyed with
the continually new and increasingly complex provisions: “For industrial companies acting in an entrepreneurial
manner, this over-regulation madness, which we feel is becoming more and more apparent with the IFRS standard, is
catastrophic. These standards originate from an Anglo-Saxon financial industry philosophy.” Since 2008, around twenty
mostly smaller companies have moved from IFRS to the less strongly regulated Swiss GAAP FER standard.
Like the Swatch Group, other companies are also rethinking their reporting. Swisscom, for example, evaluated the
impact of a switch. “We came to the conclusion, however, that IFRS is still the right standard,” says Peter Burkhalter,
Head of Group Accounting at Swisscom. Implenia is also undertaking a review. “We are constantly monitoring the
effects of the IFRS directives. A switch to Swiss GAAP FER is not on Implenia's agenda but cannot be ruled out
entirely for the future,” declared Roland Dubach, Head of Finance and Controlling.
The EMS Group also recognizes the “IFRS trend toward increasingly elaborate, complex and therefore also costly
provisions. Especially and increasingly for small and medium-sized companies, they represent a burden without any
corresponding operational benefit.” At this time, however, EMS Chemicals still prefers the IFRS standard. IFRS is
“under constant review” at electrical engineering company Burkhalter too. Depending on additional amendments, “a
switch may become a possibility,” states Burkhalter CEO Marco Syfrig.
But there is the other camp: A switch is not under debate at, for example, Schindler, Forbo and Belimo. Walter Meier
Holding and Barry Callebaut have also settled on and back IFRS, whereby they specify the advantages in connection
with financing via the international stock markets. […]
The Swiss exchange, however, is unwilling to accept that large corporations move away from IFRS. Every company
essentially has the freedom of choice regarding financial reporting, but companies are required to request approval from
the exchange before making a switch, explains SIX spokesman Alain Bichsel. “We could intervene if we have
misgivings,” he says. Swiss GAAP FER is not intended for large corporations.
Note. From: Bürgler (2012). Version shortened by author.

Chapter 3:
Swiss Financial Reporting Regulation Just As Good As IFRS Norm

CASE STUDY
The Swiss financial reporting norm Swiss GAAP FER results in an accurate picture of the asset and earnings position or
a so-called true and fair view, says Daniel Sauter, which is understood and accepted by debt investors and financial
reporting specialists outside of this country. He is a partner at PricewaterhouseCoopers and a leading member of the
Foundation for Accounting Recommendations, which developed the Generally Accepted Accounting Principles, in
particular those concerning the issues facing small and medium-sized companies.
Significant differences to IFRS exist in three areas. The FER rules continue to permit immediate or progressive
depreciation of goodwill. Pension plan deficits must be stated in the statement of financial position of consolidated
financial statements only in the case of concluded or imminent restructuring measures. Only revenue information is
required in segment reporting. According to Sauter, companies that switch from IFRS to FER often maintain a level of
detail that exceeds the minimum. Auditing costs for this type of handling are equivalent for both accounting standards.
For listed companies – with the exception of the largest and those with a pronounced international orientation – the FER
standard is simpler and not so overwhelming, says Werner Schiesser, CEO of public auditor BDO: “A reliable insight
into the well-being of the company is provided nonetheless.” He also refers to the fact that FER is being continuously
developed. Issues currently being reviewed include a refinement of segment reporting and the regulation of share-based
remuneration, as Reto Ebene, a KPMG partner and FER leading member, explains. In this way, points that have been
criticized by financial analysts will be improved.
Note. From: Bürgler (2012). Version shortened by author.
IFRS Versus Swiss GAAP FER

CASE STUDY
The Swiss professional recommendations concerning financial reporting (Swiss GAAP FER) are currently experiencing
a renaissance at non-listed companies as well as – and this is making people sit up – at companies listed on the stock
exchange that, up to now, had implemented the international financial reporting norms (International Financial
Reporting Standards – IFRS). This year, for example, Bossard, Gurit, Cham Paper, Hügli and Datacolor have announced
that they will switch from IFRS to Swiss GAAP FER, despite the consequence that a switch also means moving from
the main standard to the domestic standard at the SIX Swiss Exchange.
Back in 2005, when SIX first required companies listed on the main standard to apply either US GAAP or IFRS, many
companies using Swiss GAAP FER at the time decided to convert to IFRS. What is motivating the companies to now
move in the opposite direction? […]
Many claim that, from the perspective of companies, IFRS has become too complex and that the constant amendments
are resulting in internal and external work and costs that can no longer be justified with greater benefits. For small and
medium-sized companies, it is decidedly more difficult to provide the required resources than for large, multinational
corporations. This makes Swiss GAAP FER attractive to medium-sized companies, as it was conceived precisely for
this target group and simultaneously takes unique Swiss circumstances into consideration, such as the simplified
calculation and booking of pension obligations. […]
Furthermore, Swiss GAAP FER offers financial reporting provisions that are modified to Swiss conditions and
recognized in Switzerland. Whether a switch is an option depends on the concrete circumstances and the environment of
the enterprise.
Note. From: Neininger & Schmid (2009). Version shortened by author.

Chapter 3:
3.3.7 Allocation of Standards to Positions in the Financial Statements
LEARNING OBJECTIVES

• Understanding the allocation of the standards to the positions in the financial statements
• Understanding the difference in allocation between Swiss GAAP and IFRS
In the following two diagrams, the Swiss GAAP and IFRS standards are assigned to the individual positions in the
statement of financial position, statement of profit or loss and other comprehensive income as well as the statement
of cash flows. The overview illustrates the relevance of the individual standards for the individual positions of the
financial statement. Swiss GAAP FER is short compared to IFRS. In Swiss GAAP FER, not all specific
circumstances have their own standards; instead, the general, superordinate standards should be used to assess a
concrete circumstance. Financial instruments, for example, are regulated in IFRS in the specific individual standards
IAS 39, IFRS 7 and IFRS 9. In contrast, Swiss GAAP FER does not have a standard for financial instruments,
which is why valuation should ensue pursuant to the general FER 2 standard. IFRS contains more individual
standards that regulate specific circumstances. This is also apparent when comparing the number of superordinate
standards of Swiss GAAP FER and IFRS. Despite having a fraction of the scope of IFRS, Swiss GAAP FER has a
relatively large number of general standards.
Figure 14: Allocation of Standards to Positions in the Statement of Financial Position
Note. Based on: KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 3-6 & Feller (2011), p. 9.

Chapter 3:
Figure 15: Allocation of Standards to Positions of the Financial Statement
Note. Based on: KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 3-6 & Feller (2011), p. 9.
3.4 Fundamentals of Financial Management
LEARNING OBJECTIVES
• Understanding the creation, structure and hierarchy of the fundamentals of financial reporting
• Understanding the relationship between basic assumptions, primary and secondary principles and individual norms
• Recognizing the differences between the CO, Swiss GAAP FER and IFRS regarding the basic assumptions and GoR
Figure 16: Principles of accounting as foundation

Statement of profit or
Statement of financial Statement of Statement of changes
loss and other
position cash flows in equity
comprehensive income
Notes
Annual report
Laws / Policies / Standards / Statements
How do investors and other readers of the annual report know that the figures are comparable with the previous
years’ figures? How do readers know that the annual report shows all important business transactions? How is a
manufacturing contract which spans over multiple years reflected in the statement of financial position and the
Chapter 3:
statement of profit or loss of any given year? To what extend may annual reports of different companies be
compared with one another? Such questions are addressed with the principles of financial accounting. They define
content and quality of information presented in the annual report, and they serve as foundation and primary pillars of
financial reporting. Thank to this standard foundation and pillars, readers can concentrate on what is important tot
hem, the analysis and interpretation of facts and figures.
In order to achieve the primary objective of reporting that reflects a true and fair view (see chapter 3.2) and of
preparing informative financial reports, the framework conditions mentioned in chapter 3.3 must be implemented.
Basic assumptions (premises) and principles must be defined when establishing the fundamentals of financial
reporting. Often, in professional literature, legislation and financial reporting norms, no distinction is made between
basic assumptions and principles of financial reporting (Boemle, 2008, p. 105). Basic assumptions and principles are
repeatedly summarized and jointly referred to as accounting principles (GoR). The GoR build on the bookkeeping
principles (GoB). The GoB and GoR constitute general rules concerning recognizing accounting transactions and
presenting them in the financial statement (Boemle 2008, p. 101). In Swiss legislation, GoR and GoB can be found
in Art. 958b and c CO. The basic assumptions (premises) must first be defined in order to determine and understand
the accounting principles (GoR). In addition to the basic assumptions and GoR, which are very general, norms have
also been established. The norms (also called individual norms or financial reporting norms) regulate specific
activities such as the valuation and reporting in the financial statement of the acquisition of a machine as an addition
to the equipment of a company. The fundamentals of financial reporting are therefore a hierarchical concept,
whereas the basic assumptions (premises) constitute the foundation upon which the general principles (GoR) are
built. The individual norms for the specific activities come afterwards. IFRS and Swiss GAAP FER designate the
basic assumptions and GoR as the conceptual framework, which forms the basis for the individual norms.
Figure 17: Hierarchy of the Financial Reporting Provisions

Chapter 3
Objective
True and fair view / Fair presentation
Art 960ff, OR
Chapters 4-9
Individual norms Swiss GAAP FER 1-14

From general to specific
IFRS IAS 1-41 and IFRS 1-17
Art 958ff, OR
Swiss accounting principles (GoR)
Swiss GAAP FER conceptual
Chapter 3
framework
(Basic) assumptions (premises) IFRS framework
Reference in
Hierarchy Fundamentals this book
The basic assumptions (premises) and GoR are defined in the conceptual framework (CFR) in IFRS as well as in
Swiss GAAP FER. IFRS refers to the conceptual framework as “framework.” In connection with the basic
assumptions and GoR – IFRS, the Swiss Code of Obligations and Swiss GAAP FER have become more and more
similar in recent years and are now practically congruent, whereby the main difference lies in the terms used.
Because this book is focused on IFRS, chapters 3.4.1 and 3.4.2 will examine the IFRS set of rules more closely. The
IFRS conceptual framework defines two basic assumptions (underlying assumptions): the accrual principle and the

Chapter 3:
going-concern principle. The basic assumptions provide the foundation for four primary principles (qualitative
characteristics), which in some cases include secondary principles. The basic concept of the IFRS fundamentals is
illustrated in figure 20.
Figure 18: Basic Concept of the IFRS Fundamentals
While the CO and IFRS discuss basic assumptions, these are termed “fundamentals” in Swiss GAAP FER. Also in
contrast to the CO and IFRS, Swiss GAAP FER lists five as opposed to two basic assumptions. The three additional
basic assumptions in Swiss GAAP FER – namely the gross presentation method, the concept of substance over form
as well as the principle of prudence – can also be found in the IFRS and the CO.
Table 8: Comparison of the Basic Assumptions and Swiss Accounting Principles (GoR)
Swiss Code of Obligations (CO) Swiss GAAP FER IFRS

Basic Art. 958a and b CO FER CFR 9-14 IFRS-F 22-23
Assumptions § Going-concern assumption § Going concern § Going concern
(OR and IFRS)
§ Accrual principle § Accrual principle § Accrual basis
Fundamentals § Gross presentation method
(Swiss GAAP
§ Substance over form
FER)
§ Principle of prudence
Qualitative Art. 958 c, 1 CO FER CFR IFRS-F 24-42

Requirements 1. Clarity and understandability 1.Clarity 1. Understandability
(GoR)
2. Completeness 2.Reliability 2. Relevance
3. Reliability 3.Materiality a. Materiality
4. Materiality 4.Consistency 3. Reliability
5. Prudence 5.Comparability a. Faithful representation
6. Comparability b. Substance over form
7. Offsetting prohibition c. Neutrality

d. Prudence
e. Completeness
4. Comparability

Chapter 3:
The concept of substance over form and the principle of prudence are mentioned in an identical manner as
qualitative requirements in IFRS, i.e. as accounting principles (GoR). In the CO, the legislative body has stipulated
substance over form as an objective in Art. 958, 1 CO, and not as a GoR (Art. 958c, 1 CO). The gross presentation
method, defined as a basic assumption in Swiss GAAP FER, is also stated in an identical manner as an offsetting
prohibition in the CO as well as a secondary principle of completeness in IFRS. This principle states that positions
must be reported as a gross value whenever possible so that the calculated net value is comprehensible. Offsetting
positions is permitted only if this does not result in misleading presentation and it is circumstantially justifiable. The
basic assumptions as well as qualitative requirements (GoR) of the three financial reporting norms are thus, for the
most part, identical and are explained in detail using the IFRS logic in the following chapters 3.4.1 and 3.4.2.
3.4.1 Basic Assumptions of Financial Reporting
The basic assumptions of financial reporting are modeled after IFRS and constitute the accrual principle and the
going-concern principle. These two principles are mandatory and disclosure of any deviation is compulsory.
1. Accrual Principle and Matching Principle
For many economic activities, a transaction can be defined as an exchange of cash. Therefore, a simple income and
expenses statement suffices for many small operations such as a small law office. However, when there are
numerous different types of transactions and this results in increased complexity, it is no longer sufficient to
recognize a transaction when income is received and expenses are paid. Modern financial reporting therefore
enables matching of costs with revenues in the appropriate period. An important assumption of IFRS is thus the
principle of accrual accounting. According to this principle, transactions are not recognized in the statement of profit
or loss when cash is exchanged, but instead they are allocated to the period in which the economic cause occurred
(Behr & Leibfried, 2009, p. 73 & IFRS, p. 23). Expenses are reported as costs at the time when the circumstantially
matching income is realized in the form of revenue. The matching of costs and revenue in the appropriate period
therefore leads to the allocation of all costs of one period to the corresponding revenue. Derived from this, for
example, is the cost-of-sales method of presenting the statement of profit or loss, according to which only those
costs (cost of goods sold) are shown that were incurred in connection with the sales (in contrast of the full cost
method which discloses full cost and changes in inventory). In IAS 1, this period matching is termed the accrual
basis of accounting (Behr & Leibfried, 2009, p. 75). In addition to the accrual principle, the matching principle
stipulates a material matching of earnings and expenses, i.e. income is disclosed as earnings by the time when it is
highly probable and when the associated expenses have been incurred (see matching principle in chapter 5.4.1).
A statement of profit or loss for the period pursuant to the accrual principle compares the usage of goods and
services (costs) with the receipt of goods and services designated as income (revenue) during a defined period of
time (Boemle, 2008, p. 116). The biggest related challenge is to match the correct costs and revenue of an
accounting period. The demarcation between the periods also always signifies a separation between the operational
and economic events and processes. The period-appropriate matching of costs and revenue is only possible with the
consistent recognition of transactions and circumstances, irrespective of when cash is exchanged. If a machine is
purchased as an addition to the equipment of a company, for example, and the acquisition price is immediately paid
in full, there are no future cash outflows in the years following the purchase. However, because the machine is used
in production, this results in annual revenue from the sale of the produced goods. According to the accrual principle,
the costs that correlate, in a purely mathematical manner, to the revenue from the sale of the produced goods are
Chapter 3:
presented, so that the machines can be continuously replaced and kept up to date. If this expense is not estimated for
each applicable period(i.e. year, quarter and/or month), the company would report years of profit without expenses
and then, at the point in time when the machine would have to be replaced, high expenses with, presumably,
substantial losses. In the financial reporting, i.e. in the financial statement, this expense is disclosed as depreciation
position (see chapter 4.2.5) (Behr & Leibfried, 2009, p. 75.).
In order to allocate costs and revenue to the periods, the economic cause alone is decisive, as this demonstrates the
success of a company in the reporting period.
2. Going Concern Principle
In the preparation of the financial statement, it is fundamentally significant whether the company applying financial
reporting will continue to exist as an economic entity in the future and perform its economic activities indefinitely,
or whether its activities will be temporarily suspended in part or in whole or terminated. With the going-concern
principle, IFRS essentially assumes that the company will continue to perform its business activities. Therefore,
when preparing the financial statement, it is necessary to examine whether the going-concern assumption is realistic.
Indications that the company as a going concern is threatened:
§ Over-indebtedness or negative working capital

§ Approaching due dates of liabilities with fixed maturities, without a realistic prospect of prolongation or
repayment
§ Excessive use of short-term loans to finance non-current assets
§ Repeated operational cash drains (negative cash flow)
§ Inability to pay supplier obligations and other obligations as they become due (insolvency)
§ Inability to meet terms of credit agreements
§ Inability to procure financial resources needed for important product developments or other important
investments
§ Departure of key personnel, for whom there are no suitable replacements
§ Loss of an important market, franchise, license or supplier
(Boemle, 2008, p. 115.)
Provided that there are no indications that the company as a going concern is at risk, the going-concern assumption
is adopted. The background of the adoption of the going-concern assumption is reflected in the overall valuation of
the company and, therefore, in the statement of financial position. In the event of the future relinquishment of some
or all business activities or in the event of bankruptcy, all of the manufactured products and operating equipment
must be sold at liquidation prices. In such situations, the disposal and liquidation prices are much lower than the
normal market prices. A statement of financial position comprised of liquidation values thus often reports values
that are significantly lower than a statement of financial position comprised of going-concern values. Lower
valuations or lower prices may arise from the following reasons (Behr & Leibfried, 2009, p. 77):
§ Lack of guarantees or future service maintenance for these products from the company under liquidation
§ Time pressure in disposal of goods to be liquidated
§ Operating equipment can often be used by third parties only with considerable additional outlay
§ Unfinished products and services (goods in production or semi-finished products)

Chapter 3:
If the question of going concern can no longer be answered positively for a part of the company, valuation for this
part must ensue according to liquidation or disposal values. Assets with a potentially large difference between their
going-concern value and the liquidation value are also known as hot air assets. Hot air assets constitute, for example:
§ Capitalized intangible assets (e.g. brands, research and development costs, goodwill)
§ Capitalized pension surplus
§ Deferred tax assets, the valuation of which is determined by whether there will be future profits
In individual cases, the liquidation values may be higher than those reported to date in the statement of financial
position. Real estate is often cited as an example. The value of immovable property held over a long period of time
could have risen sharply due to the increase in prices for building land, which then results in the liquidation and
disposal value being higher than the book value in the statement of financial position, for example.
Due to the fact that it is often not easy to recognize a going-concern deviation and that the reporting period may last
up to a year, the going-concern assumption must be examined in a critical manner following even small indications
of a risk to the company as a going concern in the next 12 months. The adoption of the going-concern assumption is
generally not mentioned specifically in the financial statement. In contrast, any deviation from the going-concern
assumption must be disclosed.
Table 9: Discontinued Parts of the Company Tamedia
DISCONTINUED PARTS OF THE COMPANY TAMEDIA

CASE STUDY

Chapter 3:
CASE STUDY
Note. From: Tamedia Annual Report 2012, pages 36, 38 & 69.
3.4.2 Primary Principles and Secondary Principles of Financial Reporting
The accounting principles (GoR) ensure the fulfillment of the qualitative requirements and objectives of financial
reporting. GoR are designated as qualitative requirements because they constitute characteristics through which
information disclosed in the financial statement becomes useful to the recipients. The CO stipulates that financial
accounting should be organized according to seven prevailing principles. The GoR pursuant to the CO are as
follows:
Art. 958c CO Swiss accounting principles
III. Swiss accounting principles

1
For financial accounting, the following principles are particularly decisive:
1. It must be clear and understandable.
2. It must be complete.
3. It must be reliable.
4. It must contain material information.
5. It must be prudent.
6. The same benchmarks must always be implemented for presentation and valuation.
7. Offsetting assets and liabilities as well as costs and revenue is not permitted.
2
The amounts of the individual positions in the statement of financial position and the notes must be substantiated by an
inventory or in another manner.
3
While complying with the statutory minimum content, financial accounting must be adjusted to accommodate features
particular to the company and the industry.
According to IFRS conceptual framework 24-42, there are four principles and six additional secondary principles.
The abovementioned GoR pursuant to the CO are essentially included in the IFRS principles (see chapter 3.4). For
this reason, the primary and secondary IFRS principles are explained below.
1. Understandability
In order to make optimal use of the information presented in the financial statement, it must be easily understood by
the recipients. The assumption may be made, however, that the recipients possess reasonable knowledge of business
and economic activities and of financial reporting. It can also be expected that the information will be read with
appropriate diligence. Information concerning complex topics may not be omitted with the reasoning that certain
recipients may find it difficult to understand; instead, the information must be prepared and presented in such a

Chapter 3:
manner that it is understandable for a knowledgeable third party. The objective of this principle is therefore that all
decision-relevant transactions and circumstances are presented such that they can be comprehended and evaluated
by a knowledgeable third party.
2. Relevance
The information in the financial statement must be relevant for economic decisions. Information is deemed relevant
if it influences the economic decisions of the recipients. This means that the disclosure or the omission of disclosure
influences the economic decisions of the recipients. This concerns the assessment of past, current or future events as
well as the confirmation or correction of past assessments. Decision-relevant information is not only associated with
the present and the future but also encompasses comparison data from the past. For this reason, the development of
key figures is generally presented in a multi-year comparative format (last five or more years) and not only disclosed
in comparison to the previous year. The expanding flood of information and therefore also the growing scope of the
annual report confirm the increasing importance of the principle of relevance (Behr & Leibfried, 2009, p. 81). The
precondition for the relevance of information is its materiality, which is simultaneously a secondary principle.
a) Materiality
Financial reporting was conceived as a qualitative instrument for the presentation of financial elements,
relationships and changes. In financial reporting, the accuracy of the bookkeeping is limited by the inaccuracy
of estimates and valuation approaches. For example, estimates are necessary in connection with the positions
inventory, trademarks and goodwill, and often their value is significant. Financial reporting is therefore an
approximate calculation that identifies and presents transactions and circumstances to the effect that they are
material to recipients' decision-making. Information is material if it significantly influences the valuation and
the presentation of the financial reporting or individual positions such that this may cause a change in the
assessment and decision-making of the recipients. Materiality is dependent on the magnitude of the position or
the error that occurs based on the particular circumstances of the omission or incorrect presentation.
Correspondingly, materiality is a threshold or a limit value. In the practical application of the principle of
materiality, the benchmark implemented in the calculation of the threshold or limit value plays a central role.
The benchmark is a reference value for potential deviations (e.g. +/- 3%). This measure must always be
assessed from the point of view of the recipients. Thus, from a quantitative perspective, materiality is
dependent on a reference value and deviations that are to be defined. Three important reference values, for
example, are equity, profit for the period and cash flow from business activities. This is due to the simple
reason that investors incorporate these three reference values in their economic decisions. If, for example, the
omission of a certain position influences equity by more than the defined deviation (e.g. +/- 3%), then this
position is classified as material. In the determination of materiality, different reference values are relevant (for
example, revenue can be used for individual positions, equity for others). There are various methods to
determine the deviation percentage rate, but deviations of more than five or ten percent of a reference value
determined in an individual case can always be considered material. Irrespective of the magnitude (deviation in
percent of the reference value), a circumstance may have a material influence on the decision-making of
recipients for other reasons. The circumstance must be disclosed in this case as well, even though the limit
value is not exceeded. For example, transactions with related persons may have a decisive influence on the
decision-making of investors, even if the transactions are relatively insignificant amount-wise (Behr &
Leibfried, 2009, p. 79-80.).

Chapter 3:
3. Reliability
Despite being material, information could be unreliable and therefore misleading. Information is only useful if it is
also reliable. Information is reliable if it does not contain material errors and is free of bias. Recipients must have
confidence that the information is presented in a credible manner and that it actually presents the contents that it
aspires to present as well as what can be reasonably expected. Estimates, as a material valuation approach of
financial reporting, are not subject to the reliability requirement of the financial statement, provided that the
approaches used in establishing the estimates are disclosed. In order to meet the reliability requirement, financial
reporting must fulfill five secondary principles, which are described as follows.
a) Credible Presentation
In order for information to be reliable, the financial statement must present the business transactions and
economic circumstances in a credible manner. This principle refers in particular to presentation, and requires
above all a transparent structure as well as a clearly appropriate description of the individual positions. The
statement of financial position must therefore, for example, present all business transactions and circumstances
in such a manner that they reflect, in an economically correctly manner, the assets, debts and equity on the
reporting date of the financial statement.
b) Substance over Form

The principle of substance over form relates to the decision between legal and economic embodiment. There
may be a discrepancy between the economic and legal (formal) embodiment of business transactions. For
example, company A sells an asset to another party B so that the title is legally transferred to party B. At the
same time, the two parties (A and B) agree that company A will continue to be the recipient of the future
economic benefits. In this example, reporting the sale would not be credible, even though party B holds the
legal title. Substance over form stipulates that the asset should remain on the statement of financial position of
company A because the economic benefits of the asset continue to flow to company A. In substance over form
the economic significance of a transaction is decisive, not its formal configuration. This principle is important
particularly with respect to the inclusion of lease agreements in the statement of financial position.
c) Neutrality
Information must be neutral and thus free of bias. If the specific selection or presentation of information
influences a decision or assessment in order to achieve a predefined result or outcome, the information and
therefore the financial statement is not neutral. The information in the financial statement must be free of
influence from particular interests and impartial.
d) Prudence
Those persons involved in the preparation of the financial statement (bookkeeping, management accounting,
executive management, public auditors, etc.) must deal with uncertainties. For example, they must forecast the
probability of collecting doubtful receivables, estimate the likely useful life of technical equipment as well as
project the number of warranty cases that might occur. The secondary principle of prudence requires a cautious
approach to handling such uncertainties. The assessment of risks should ensue in a relatively extensive manner,
while opportunities are to be assessed relatively strictly (Boemle, 2008, p. 138). Therefore prudence means that
a certain degree of diligence must be exercised when performing assessments needed for the estimates and
when there are uncertainties. As a result, assets or profit will not be overstated and debts or expenses will not
Chapter 3:
be understated. So when two possible values are determined in cases of uncertain assessment, the more
prudently established value should be adopted (Boemle, 2008, p. 138). In connection with the principle of
prudence, however, it is not permitted to accumulate hidden reserves, overstate provisions or use the
deliberately understated recognition of asset or revenue valuation or the deliberately overstated recognition of
debts or expenses. This would violate the principle of neutrality and reliability.
e) Completeness
Subject to the limits of materiality and costs, information must be complete in order for it to be reliable. In this
respect, all information specifically relevant for the assessment of a company's economic situation must be
disclosed. This principle is a central aspect particularly for public auditors, as they are required to ensure
complete recognition of all obligations on an accrual basis and the disclosure of additional obligations in the
notes within the context of the audit (Behr & Leibfried, 2009, p. 83). Therefore the secondary principle is also
of central importance to the recipients, as it is very difficult to determine compliance from an external
perspective. This also concerns the disclosure of off-statement obligations in particular, which may be
overlooked.
4. Comparability
With the goal of enabling the recipient to recognize developments in the asset, financial and earnings position and
thus support the decision-making process, the financial statement of a company must be comparable over time.
Comparability can be assessed according to formal or substantive aspects. Formally, the structure and format of the
presentation in the reporting period must correspond to those of the previous period. Substantively, application of
the selected valuation and disclosure principles must be uniform. Only formal and substantive consistency allows
comparability over time. However, under certain circumstances deviations from the previous period are permitted
and even necessary. An adjustment is necessary if the circumstance in connection with GoR can be presented in a
better manner or fulfillment of the principles is improved (e.g. more reliable and relevant presentation). Such
deviations compared to the previous period, regardless of whether they are formal or substantive, have to be
disclosed. The recipients must be able to understand the differences in the statement of financial position and
valuation methods. This includes quantification of the deviation so that the recipients can assess the impact. In order
to adhere to the principle of comparability, past financial statements must also be modified or supplemented after an
adjustment in the valuation method, in order to permit a comparison over time.
Note Concerning the Gross Presentation Method / Offsetting Prohibition

In contrast to IFRS, the gross presentation method or the offsetting prohibition is listed as a separate GoR in the CO
and Swiss GAAP FER. The gross presentation method can be classified in IFRS under the principles of
understandability and reliability in the conceptual framework. IFRS discusses the topic explicitly, however, in IAS
1.32 of the “IAS 1 Presentation of Financial Statements” individual norm, which establishes the offsetting
prohibition as in the CO and Swiss GAAP FER. According to IFRS, the CO and Swiss GAAP FER, the gross
presentation method prohibits the grouping of different positions (or transactions) into a single position (or
transaction). Assets and liabilities, revenue and costs are not allowed to be offset; individual positions must be
reported separately. Offsetting is permitted only in circumstantially justified cases and if this does not lead to
misleading presentation. Circumstantially justified cases could include, for example, a regulation in a specific
individual norm.

Chapter 3:
3.5 Dimensions of Reporting
LEARNING OBJECTIVES

• Recognizing and assessing the three relevant dimensions of reporting
• Understanding the components of the three dimensions
Different dimensions must be taken into account to ensure financial reporting in a comprehensive manner. These are
the components of financial reporting, the time and the industry affiliation. Reporting according to the three
dimensions contributes to reducing information asymmetry and mitigating issues related to insider information
(Dubs, Euler, Rüegg-Stürm & Wyss, 2009, p. 162.).
Figure 19: Dimensions of Financial Reporting
Note. Based on: Dubs, Euler, Rüegg-Stürm & Wyss (2009), p. 162.
3.5.1 Components of Financial Reporting
The annual report is created once a year and, according to modern financial reporting, comprises the management
report, the financial statements, and additional information regarding corporate governance, corporate social
responsibility, or sustainability (individual parts of this information may be mandatory, depending on the financial
reporting standard selected or on supplemental provisions such as those from the stock exchange supervisory
authority). The financial statements are often designated as the financial section of the annual report. In the financial
statements, a distinction must be made between consolidated financial statements and separate financial statements,
i.e. reporting for an economic entity consisting of at least two legal entities (such as parent company and subsidiary)
or reporting for an individual legal entity. The mandatory components of the financial statements, encompass:
The statement of financial position conveys a picture of the asset and financial position
Statement of financial position
of a company at the end of a reporting period (reporting date).
The statement of profit or loss should convey information concerning the magnitude and
Statement of profit or loss and sources of the company's revenue or performance over a period. The statement of other
other comprehensive income comprehensive income shows the other income positions (not affecting net profit),
derived from the net profit from the statement of profit or loss,
The statement of cash flows supplies information concerning how the company
Statement of cash flows
generated and employed liquid assets.

Chapter 3:
The statement of changes in equity shows the change in equity over the period. It serves
Statement of changes in equity
as an indicator of the company's future ability to undertake distributions or repay capital.
Notes The notes increase the information content for recipients by providing additional details.
The management report presents, in report form, the manner in which business has developed in the past, in
particular over the last year. It is not examined by the public auditors but may not contradict the inspected and
certified financial statement. The supplemental, optional components contain additional details concerning the
corresponding aspects; for example, the corporate governance report discloses detailed information about how the
executive management of the company works and what internal controls must be complied with while performing
these activities. If the annual report is augmented by the obligations of ad hoc publicity and interim reports, this can
then be regarded as financial reporting in the broader sense (Dubs, Euler, Rüegg-Stürm & Wyss, 2009, p. 120-121).
The following figure summarizes the components of reporting.
Figure 20: Scope of Financial Reporting
Financial reporting
Ad hoc publication Pro-forma reports Interim reporting Annual report
Financial statements Reports
Company or consolidated financial statements Management report
Mandatory components of financial statements Corporate Governance report
Statement of Statement of profit or loss

financial position and other comp. income Corporate Responsibility report / Sustainability report
Statement of Statement of
cash flows changes in equity Value adding report
Notes etc.
Note. Based on Dubs, Euler, Rüegg-Stürm & Wyss (2009), p. 120.
In addition to the annual report, the scope of financial reporting also includes interim reporting, ad hoc publication,
and pro forma reporting. Interim reporting requires disclosure of simplified financial statements on a quarterly or
half-year basis. Ad hoc publicity means immediate and proactive distribution of information that is relevant for
stock prices (i.e. that could affect the share price) in order to prevent insider knowledge and insider trading. The
requirements and conditions regarding ad hoc publicity are defined by the stock exchange guidelines and are
therefore dependent on the stock exchange that a company is listed with. Pro forma reports are required at capital
market transactions and by the stock exchange guidelines. It is a simplified financial statement prepared prior to a
merger, spin-off, or acquisition, reporting the new to-be economical entity.
With respect to chapter 3.3, there are defined regulations that must be adhered to concerning the scope and structure
of the financial statements. In addition to determining which components are mandatory or optional, the laws as well
as the financial reporting standards stipulate the content and structure of the mandatory components. Art. 959 et seq.
CO specifies the scope and structure of the financial statement in detail, but these will not be examined here as this
is covered in the regulations pursuant to IFRS and Swiss GAAP FER in a more in-depth manner. This is also
reflected in Art. 963b CO, which states that the consolidated financial statements for groups of companies must be
created pursuant to a recognized standard of financial reporting.

Chapter 3:
BOX: IAS 1 Presentation of Financial Statements
Content: Basic provisions for the preparation and presentation of financial statement
Core tenets: Financial statement consists of a statement of financial position, a statement of profit or loss and other
comprehensive income, a statement of cash flows, a statement of changes in equity and notes.
Financial statement must present the asset, financial and earnings position as well as the cash flow of a
company in a true and fair manner.
The mandatory components of the financial statement are the statement of financial position, the statement of profit
or loss and other comprehensive income, the statement of cash flows, the statement of changes in equity and the
notes. Despite the considerable congruence between IFRS, Swiss GAAP FER and CO, a distinction regarding
classification into mandatory and optional components must be pointed out. The management report, also called
director's report or management commentary, is listed under Swiss GAAP FER as well as in CO as a mandatory
component. In contrast, IFRS mentions the management report in IAS 1-13 as being an optional component. The
IASB has nevertheless issued a directive concerning the content, scope and presentation of a management report. In
addition to the mandatory components, there are optional components such as corporate social responsibility /
sustainability reports or a value added statement. The following diagram provides an overview of the division of the
components of an annual report.
Figure 21: Components of an Annual Report
Components of annual report
Annual report
Statement of
financial positions
Financial statements
Statement of profit or loss

and other comp. income
Mandatory Swiss GAAP FER
Statement of
Mandatory IFRS
changes in equity
Statement of
cash flows
Notes
Additional reports
Management report
components
Environmental and/or
sustainability report
Optional
Value added statement
Note. Based on: Dubs, Euler, Rüegg-Stürm & Wyss (2009), p. 120 & Feller (2011) p. 12
& KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 12.
The individual mandatory components are not independent of each other; instead, the business circumstances are
typically reflected in several components at the same time. There are corresponding connections and
interdependencies between the components. The sale of a product, for example, which is recognized in the statement
of profit or loss as revenue, also influences the statement of financial position, as a new receivable is created and
inventory is reduced. Additionally, the notes disclose more information about this transaction. The following
overview displays these dependencies graphically.

Chapter 3:
Figure 22: Interaction of the Mandatory Components
1a
5
Statement of profit or loss
Notes
1b
Statement of oth. comp. inc.
Explanations
Expenses
Details Revenue Profit
Other comprehensive income

Profit
Comprehensive income
2
4
Statement of cash flows Statement of ch. in equity
Cash flow from operating Comprehensive income

activities
Cash flow from investing Transactions with shareholders
activities
Cash flow from financing
activities Change in equity
3
Statement of financial position
Change in cash
Cash
Liabilities
Change in equity
Other assets
Equity
This chapter examines only the scope but not the defined content of the components. The details of the individual
components of an annual report are presented in the following chapters:
Book chapter Mandatory components pursuant to IAS 1

Chapter 4 Statement of financial position
Chapter 4.6 Statement of changes in equity
Chapter 5 Statement of profit or loss and other comprehensive income
Chapter 6 Statement of cash flows
Chapter 7 Notes
Chapter 8.3 Management report
Chapter 8 Optional components
3.5.2 Timing of Reports
As mentioned, in addition to the annual report, financial reporting includes additional aspects:
§ Ad hoc publicity: disclosure of information material to the share price

§ Interim reports: half-yearly and quarterly reports
§ Pro forma reports: reporting about capital market transactions
The ongoing need for information regarding the economic situation of a company on behalf of investors, analysts
and media leads to the annually issued financial statement being supplemented by interim reports and ad hoc
information as current, ongoing disclosure. The dimension of time is therefore an important factor in reporting. In
addition to financial reporting, analyst conferences and media information complement the interaction and
disclosure to investors and media. (Dubs, Euler, Rüegg-Stürm & Wyss, 2009, p. 121 & 162)

Chapter 3:
3.5.3 Industry Affiliation of the Reporting Company
In addition to the components and the timing of the reports, industry affiliation can be mentioned the third
dimension of reporting. Depending on the industry in which the company is active, specific peculiarities must be
considered and implemented. This is naturally reflected in the reporting and therefore also the financial statement.
Generally, six industry types can be distinguished:
§ Commercial firms
§ Industrial companies
§ Banks
§ Insurance companies
§ Other service companies
§ Non-profit organizations
These industry types are differentiated according to their characteristics and subsequently illustrated in practical
examples:
Table 10: Industry Characteristics in the Financial Statement
Characteristics of the statement of profit Characteristics of the statement of financial position

or loss and other comprehensive income
Commercial § High sales and high material costs § Inventory (merchandise)
firms § Tendency to low margin
§ Tendency to high sales § Property, plant and equipment (production machinery)
Industrial § Tendency to high cost of goods sold are a large part of total assets
companies
§ Disclosure of gross profit
Three main sources of income: § Assets: assets for proprietary trading and loans granted
§ Lending activities (interest rate spread: granting § Liabilities: significant portion of financing from client
loans and administering savings accounts) (savings) deposits
Banks § Commission and service activities (commission
from trading of client funds)
§ Proprietary trading
Two main sources of income: § Assets: income with disbursement still outstanding is
§ Premium income invested in capital market (and other markets)
Insurance § Profits from accumulated income, i.e. profit from § Liabilities: single largest position in the statement of
companies capital investments financial position of an insurance company: provisions
Main expenses: for the payment of future claim benefits
§ Payment of insurance benefits
Main position: Main position:
§ Depending on the business/services significant
Other service § Typically personnel expenses
property, plant and equipment may be required (and
companies
respective liabilities and equity)
§ High receivables and payables
§ Income and expenses are shown according to § Assets: sustainable support requires multi-year projects,
source, in the notes also according to purpose or which lead to considerable future obligations for which
projects sufficient funds must be retained
Non-profit § Profits must be allocated to a restricted fund or to § Liabilities: equity can be divided into organizational
organizations the organizational capital (and therefore the capital (organization is free to stipulate deployment)
reported annual profit is zero) and restricted fund capital, i.e. the capital has already
been earmarked and there is an obligation of
corresponding payments

Chapter 3:
Industrial company, example: BMW
Source: BMW Group Annual Report 2018, p. 111

Chapter 3:
Source: BMW Group Annual Report 2018, p. 110
Bank, example: UBS
Source: UBS Group Annual Report 2018, p. 323

Chapter 3:

Chapter 3:
Insurance company, example: Bâloise
Source: Bâloise Group Annual Report 2018, p. 118f

Chapter 3:
Source: Bâloise Group Annual Report 2018, p. 120
Non-profit organization example: Caritas

Chapter 3:
Caritas Switzerland Annual Report 2018, p. 30
3.5.4 Scope of the Annual Report
The preparation of the annual report offers a good opportunity to present a positive image of the company and to
address and maintain relationships not only with investors (investor relations) but also all other stakeholders and
interest groups. The scope of the annual report, in particular in the case of public companies, is therefore not only
geared towards investors' need for information in the context of the principal-agent theory (chapter 2.2.3). The
management report and additional reports have been developed to the point that they are now often similar in size to,
and frequently more comprehensive than, the financial statement. It is not only the number of pages that is decisive
with respect to the scope but also the manner in which information is made available. For example, annual reports
are increasingly being published on the internet in an interactive manner, so that interested parties can immerse
themselves in the flood of information, undertake a targeted and efficient search, and also access additional links.
The trend is moving more and more towards integrated reporting. The content of the supplemental, optional
components in particular highlights the social responsibility of the companies vis-à-vis the population, society and
the environment. In the respective disclosures, companies demonstrate how they have embraced this responsibility
and how it can be evaluated in terms of their business activities. In contrast to financial statement, however, these
reports are not certified but only inspected occasionally by the statutory auditors to ascertain whether they contradict
the financial statement. Correspondingly, such reports may be strongly biased towards the perspective of the
Chapter 3:
reporting company. They are also partially used as marketing instruments. In chapter 8, the content of some of these
reports as well as the question of the responsibility of large corporations will be covered in greater detail.
Since 2002, a research team at the University of Applied Sciences and Arts Northwestern Switzerland (FHNW) has
been taking a closer look at company reporting. Every year it investigates the reporting practices of the 250 largest
Swiss companies as well as a number of selected SMEs with a focus on the integration of ecological and social
aspects. Its research activities, spanning a period of more than ten years, revealed some interesting findings. The
following cites three findings from the FHNW study entitled Die Zukunft der Geschäftsberichterstattung. Analysen
und Trends [The Future of Financial Reporting: Analyses and Trends] by Professor Claus-Heinrich Daub, PhD.
I. Today's modern annual reports or financial statement increasingly constitute several sections – or the
reporting is integrated. The following shows a model of modern reporting according to Daub:
(From: Daub, 2013, p. 13, translated)
II. The Internet is progressively supplementing printed reporting – and sometimes replacing it.
Clariant Homepage. Annual report 2017
III. Integrated annual reports are published not only by large corporations but also by SMEs, municipal utility
companies and non-profit organizations.
(From: Daub, 2013, p. 19, translated)

Chapter 3:
Table 11: Scope and Assessment of Annual Report
SCOPE AND ASSESSMENT OF ANNUAL REPORTS
Article from Handelszeitung

CASE STUDY
FHNW: Geberit Submits Best Annual Report

Zurich (awp) – Geberit's 2009 annual report was voted best annual report by the University of Applied Sciences and
Arts Northwestern Switzerland (FHNW), which had judged a selection of annual reports of Swiss companies. Ranked
second and third were Georg Fischer and Bank Coop. The list of those ranked in the top ten includes Sulzer, Post,
Knecht & Müller, Coop, Roche, Migros and ABB. The three bottom spots were occupied by Schwyzer Kantonalbank,
Swiss Life and Nationale Suisse.
The assessment of the annual reports was performed by a team led by Claus-Heinrich
Daub, which has been analyzing the annual reports of the 250 largest Swiss
corporations as well as a number of selected SMEs on an annual basis since 2002. The university stated on Tuesday that,
in addition to the economic elements, the social and ecological aspects of corporate management were also considered.
With respect to content, the analysis was oriented towards the international reporting standard of the Global Reporting
Initiative and placed particular importance on transparency. This year's assessment comprised 69 annual reports
(previous year 57) selected via a multi-stage procedure and each inspected in great detail by two independent analysts.
Note. From: Handelszeitung (2010).
3.6 Summary
Objective of Financial Reporting
The objectives of financial reporting can be summarized as:
§ Providing information regarding financial assets, capital and income of a company

§ that is useful to a broad audience
§ for making economic decisions.
Framework Conditions:
In Switzerland, the Swiss Code of Obligations (CO) addresses financial reporting through the establishment of
general fundamental principles as well as required details in terms of the scope and structure of the financial
statement. Financial reporting standards define the principles and methods of implementing financial reporting. The
CO stipulates which companies must apply a recognized financial reporting standard. There are two internationally
recognized concepts with respect to financial reporting standards. These are the International Financial Reporting
Standards (IFRS) as well as the United States Generally Accepted Accounting Principles (US GAAP). In
Switzerland, Swiss GAAP FER exists as well. FER stands for Fachempfehlung zur Rechnungslegung [Swiss
professional recommendations concerning financial reporting].
Swiss GAAP FER focuses on small and medium-sized organizations and groups of companies with a national
character. Swiss GAAP FER follows the principle of a true and fair view. This constitutes conveying a
comprehensive and accurate picture of the earnings, asset and financial position. Swiss GAAP FER can be divided
into a conceptual framework, core FER standards and additional standards. IFRS is issued by the International
Accounting Standards Board (IASB). In the past, these standards were called International Accounting Standards
(IAS), which are still effective today. The new standards are designated as IFRS and are consecutively numbered.
The issuance of new standards occurs pursuant to a predefined process. There is a conceptual framework that
defines the principles and assumptions. IFRS also has a stand-alone set of rules for small and medium-sized

Chapter 3:
companies that is called IFRS for SME and competes directly with Swiss GAAP FER. The US counterpart to the
European IFRS are the United States Generally Accepted Accounting Principles (US GAAP). These have grown
historically over time and today constitute a collection of various organizations and sources. A hierarchical system
was established, which is known as the House of GAAP. However, maintaining an overview with respect to US
GAAP is difficult.
To guarantee the comparability and quality of financial reporting, the Swiss stock market SIX Swiss Exchange
issues its own directives and recommendations for financial reporting and disclosure. SIX has established different
trading segments. For the international Main Standard, the financial statement must be completed according to IFRS
or US GAAP. Swiss GAAP FER is permitted for the national Domestic Standard.
Fundamentals of Financial Reporting

In financial reporting, basic assumptions (premises) and accounting principles (GoR) are defined in order to achieve
the objective of reporting that reflects a true and fair view. These are listed in the conceptual framework of Swiss
GAAP FER and IFRS. Basic assumptions and GoR can also be found in CO legislation. The IFRS, CO and Swiss
GAAP FER basic assumptions and GoR have become increasingly congruent in recent years. IFRS defines two
basic assumptions (underlying assumptions): the accrual principle and the going-concern principle. Four primary
principles (qualitative characteristics) are based on the basic assumptions and in some cases include secondary
principles.
The recognition of revenue and costs in the period in which they occur is known as the accrual principle and
encompasses the concept of period-appropriate matching of costs with revenues. This principle stipulates that
income and expenses are not recognized in the statement of profit or loss and other comprehensive income when
cash is exchanged but instead are allocated to the periods in which the economic cause occurred. The matching
principle supplements the accrual principle. The second principle assumes that the company will continue to
perform its economic activities and is designated as the going-concern principle. It is necessary to always closely
examine reports in order to ascertain whether the going-concern assumption is expected for the future, i.e. whether
the company will continue to exist as an economic entity and perform its economic activities indefinitely or if there
are indications of a potential bankruptcy or split-up (i.e. divesting or asset stripping).
Similar to the basic assumptions, the accounting principles of IFRS, Swiss GAAP FER and the CO are for the most
part congruent, but there are differences in the terms and the distinction between basic assumptions and GoR.
According to the IFRS conceptual framework, there are four principles and six additional secondary principles.
1. Understandability
2. Relevance
o Materiality
3. Reliability
o Credible presentation
o Substance over form
o Neutrality
o Prudence
o Completeness
4. Comparability

Chapter 3:
Dimensions of Reporting:
Reporting can be divided into components, timing and industry affiliation. The annual report is also termed the
financial statement and generally encompasses the management report, the financial statement (financial section) as
well as information concerning corporate governance and, if needed, corporate social responsibility and
sustainability. The financial statement comprises the statement of financial position, the statement of profit or loss
and other comprehensive income, the statement of cash flows, the statement of changes in equity and the notes. The
annual report is prepared once a year. In addition, there are also half-yearly and quarterly reports, which are
designated as interim reports, as well as ad hoc publicity. Depending on industry affiliation, there are particularities
and industry characteristics that must be taken into account in the financial statement. Notable differences exist
between commercial firms, industrial companies, banks, insurance companies, other service companies and non-
profit organizations. The annual report is undergoing constant transformation, and, in addition to the financial
section, more and more information about the activities of a company is being included.

Behr, G. & Leibfried P. (2014). Rechnungslegung (4. aktualisiere und überarbeitete Auflage). Zürich: Versus.
mit Beispielen, Repetitinsfragen und Antworten. (4. überarbeitete Auflage). Zürich: Compendio
Bildungsmedien.
SKV.
Daub, C.-H. (2013). Die Zukunft der Geschäftsberichterstattung: Analysen und Trends. Gefunden am 07.08.2013
auf http://web.fhnw.ch/plattformen/hsw/news/news-2012/schweizer-geschaeftsberichte/PraesDaub-GB-
Studie-12_Fin.pdf/view?searchterm=None
Feller, C. (2011). Swiss GAAP FER: strukturierte Übersicht mit Fallbeispielen. Zürich: Orell Füssli.
Schaeffer-Poeschel.
Lingnau, V. (2010). Studienbuch Finanzbuchhaltung. Ebersdorf 1-2-Buch.
Meyer. C. (2008, Mai). Grundlagen zu Swiss GAAP FER: Massgeschneidertes Konzept für aussagekräftigen Ab-
schluss nach True and Fair View. In: Der Schweizer Treuhänder, 2008/5. Gefunden am 07.07.2013
http://www.fer.ch/fileadmin/downloads/news/Grundlagen_Swiss_GAAP_FER.pdf.
Pellens, B. Fülbier, R.U., Gassen, J. & Sellhorn, T. (2014). Internationale Rechnungslegung (9. überarbeitete
Auflage). Stuttgart: Schaeffer-Poeschel.
Schellenberg, A. C. (2010). Rechnungswesen: Grundlagen, Zusammenhänge, Interpretationen (4. überarbeitete
Auflage). Zürich: Versus.

Chapter 4:
Statement of Financial Position 69
Statement of Financial Position
In order to make economic decisions with respect to a

company, information concerning the assets of the
company is of particular interest. In financial reporting,
this is conveyed primarily by means of the statement of
financial position. However, the other parts of the
financial statement offer supplemental information about
the assets, liabilities and equity. Particularly useful are
the notes, which disclose further explanations
concerning the development of the financial position,
and the statement of changes in equity, which discloses Note. Own depiction.
the changes in equity in details.
4.1 Introductory Example from Alpiq
INTRODUCTION: STATEMENT OF FINANCIAL POSITION AND CHANGES IN EQUITY
Alqip with More Than a Billion in Losses

Following the losses of the previous year, Alqip needs to strengthen its
capital base. For this, Alqip intends to take out new loans. The energy
company sustained losses of CHF 1.086 billion in the previous fiscal year.
The loss can be ascribed to impairment losses and extraordinary aspects,
as the company revealed on Tuesday. The company had expected a loss
and mentioned the prospect of implementing measures last November,
without specifying these in concrete terms. The company has now announced that it will take out a subordinated loan of
between CHF 800 million and CHF 1 billion in order to strengthen its capital base.
Earnings before extraordinary aspects amounted to CHF 220 million – 14.7 percent less than in the previous year. Revenue
dropped 9.1 percent to CHF 12.71 billion. The Group is not providing a forecast for the current year. The divestment program
would be continued in 2013, the company stated.
Alpiq began restructuring back in November 2011. Among other measures, 450 jobs were cut, 170 of these in Switzerland.
The number of employees sank from 11 208 to 7 926 at the end of 2012 – a drop of almost 30 percent.
Article has been modified. From: Handelszeitung (March 12, 2013).

Chapter 4:
1. Without looking at the statement of financial position, which substantial positions could Alpiq report?
2. Will Alpiq report a large or small level of non-current assets?
3. Why might an impairment have such a significant effect on Alpiq?
4. Which statement of financial position positions could be impacted by the impairments?
4.2 Statement of Financial Position Structure, Definitions and Accounting

Principles
LEARNING OBJECTIVES

• Recognizing an overview of classification of positions disclosed in the statement of financial position
• Recognizing the definitions of positions disclosed in the statement of financial position
• Being able to apply the principles concerning statement of financial position and recognition of assets, liabilities, and
equity
• Reviewing and deepening knowledge of the accounting principles for the statement of financial position
The financial position of a company encompasses not only the assets but also the receivables and debt obligations.
The statement of financial position merges these two perspectives and presents a comparison of assets and capital.
The structure of the statement of financial position is comprised of two superordinate concepts, one being assets, the
other being liabilities and equity. As per the reporting date of the financial statement, the statement of financial
position shows a snapshot of all past asset-relevant events as well as all already concluded future transactions
(Schellenberg 2000, p. 47). The statement of financial position is static in nature and only shows changes compared
to previous years' figures.
Definition The statement of financial position is the clearly structured depiction of all assets and liabilities and equity, i.e.
Statement assets and obligations of a company, on a specific reporting date. It shows the financial position of a company
of financial by means of a presentation of the type, magnitude and composition of the assets, debt and equity capital.
position (Schellenberg 2000, p. 47)
In principle, this raises the question of what has to be disclosed as assets and obligations, as well as at what point in
time these are disclosed in the statement of financial position. For this purpose, the financial reporting standards
include established definition criteria for the individual accounting positions, which identify and classify individual
assets and obligations. In addition to these definition criteria, recognition criteria are also defined in the norms,
which establish whether positions may be included in the statement of financial position. It is possible that an asset
or an obligation fulfills the definition criteria but not the recognition criteria, meaning that it is therefore not
included in the statement of financial position. Such circumstances may, however, have to be disclosed in the notes.
The following decision tree summarizes in principle the individual steps in the assessment of whether or not a
position must be included.

Chapter 4:
Figure 23: Disclosure of Assets, Liabilities and Equity in the Statement of Financial Position
IAS 1 Presentation of Financial Statements

(see chapter 3.5.1)
In order to compare statement of financial positions of different companies, legislation and the financial reporting
standards prescribe a minimum classification. The legal provisions regarding the classification of positions in the
statement of financial position pursuant to Art. 959 et seq. CO constitute the minimum requirements from a business
perspective (see chapter 3.3.1). The minimum classification according to IAS 1 stipulates a detailed presentation that
exceeds the legal minimum (see chapter 3.5.1). The structure is in principle organized according to maturities,
unless classification according to liquidity provides more relevant information. In contrast, at financial institutions
classifications generally always ensue according to liquidity. The IAS 1 financial reporting standard lays down the
guidelines concerning allocation by maturity for assets as well as liabilities and also provides information on
reporting equity.
The IFRS conceptual framework distinguishes between three components of the statement of financial position:
assets, liabilities (obligations or debt) and equity. Assets include all asset positions; liabilities and equity encompass
all obligations and equity. In the following sections, assets, liabilities and equity will be described in more detail and
their definition and recognition criteria will be discussed.
4.2.1 Asset side
Figure 24: Structure of the Statement of Financial Position

Chapter 4:
Assets comprise all asset positions such as existing goods, cash and cash equivalents as well as future inflows of
goods and cash and cash equivalents without further counter-performance. Investments are depicted on the assets
side. Correspondingly, the assets side shows how the available capital is deployed. In other words, it shows how the
resources that are available to the company are utilized or committed. The different assets on the assets side are
presented according to the asset's convertibility into cash. Correspondingly, assets are divided into current assets and
non-current assets.
Current assets is the short-term portion of the assets and includes assets that can be realized immediately or within
12 months of the reporting date, i.e. that can be converted into liquidity. This comprises all goods that are acquired
or produced for the purpose of resale or subsequent disposal (Schellenberg 2000, p. 54). The term current assets
arose from the fact that these asset positions are constantly being converted and are therefore in current circulation.
The most important components of current assets are the following:
Table 12: Components of Current Assets
Cash and cash § Cash on hand

equivalents § Bank balance (incl. post office savings bank)
§ Checks
Securities § Money market instruments held for liquidity purposes
§ Non-strategic listed securities
Receivables § Trade receivables (accounts receivable)

§ Unfulfilled but legally valid claims against third parties
§ Advance payments to suppliers
§ Loans granted with maturities of less than 12 months
§ Advances and prepayments
Value adjustments § Adjustments for accounts receivable

for receivable § Impairments on receivables
Inventories § Raw materials and operating supplies

§ Unfinished goods, unfinished services
§ Finished goods
Prepaid expenses § Items of the period-appropriate accruals and deferrals

= accrued income § Expenses paid in the previous year but that first affect profit in the following year
§ Payments anticipated for the following year that affect profit in the current year
An asset is deemed as being a current asset if it fulfills one of the following points:
§ It can be expected that the asset will be converted or used for the purpose of disposal or consumption in
the production process within the normal business cycle of the company.
§ The asset is held for the purpose of trading or for a short period, whereby conversion is anticipated within
12 months of the reporting date.
§ The asset is cash or cash equivalent has not been appropriated.

Chapter 4:
Figure 25: Nestlé Example: Asset Side of the Statement of Financial Position
Nestlé EXAMPLE
From: Consolidated Financial Statements of the Nestlé Group 2018 p. 67
Non-current assets represents the medium-term to long-term portion of the assets. The positions belonging to non-
current assets can usually not be converted into cash within a year and are thus available for the company over a
medium-term to long-term period of time. The most important positions in non-current assets are the following:
Table 13: Components of Non-Current Assets
Property, plant § Land with and without construction, buildings

and equipment § Technical facilities and machines
§ Operating and business equipment
Intangible § Patents
assets § Concessions
§ Brands
§ Goodwill
Investments § Participating interests

§ Loans granted with maturities exceeding 12 months
§ Securities held for strategic reasons
4.2.2 Definition and Recognition Criteria for Assets
IFRS Conceptual Framework
The IFRS conceptual framework (see chapter 3.3.4) stipulates the definition and recognition criteria for assets. The
definition establishes whether a value may actually be designated as an asset and guarantees comparability of the
assets reported in the financial statement. In addition to objects such as goods in stock or machines, rights (e.g.

Chapter 4:
patents or other intangible positions) can also be considered assets. According to the IFRS conceptual framework, an
asset is defined as:
§ A resource at the disposal of the company (control over this resource)

§ The resource is the result of past business transactions (past event)
§ The asset possesses the potential of future economic benefits (future inflow of economic benefits)
If a circumstance fulfills all three of these definition criteria, then it is deemed to be eligible for capitalization or
disclosure in the statement of financial position. For intangible assets, the following three criteria must all be
fulfilled in addition: (i) they must be identifiable, (ii) they may not be of a monetary nature (iii) and they may not be
physically existent. IFRS defines clear preconditions with respect to capitalization criteria as well. An asset is
required to be recognized and therefore disclosed in the statement of financial position if:
§ it is probable that future economic benefits associated with the asset will flow to the company (probability
of economic benefit) and
§ its cost or its value can be determined in a reliable manner (valuation).
If these recognition criteria are fulfilled, the asset must be shown in the statement of financial position, i.e.
capitalization or disclosure in the statement of financial position is mandatory. If the recognition criteria are not
fulfilled, the circumstance may not be capitalized.
Table 14: Mini Case: Capitalization of an Asset
CAPITALIZATION OF AN ASSET
MINI CASE
1 Initial situation:
FC Zurich (FCZ) succeeds in signing the FC Barcelona (FCB) player Ramon Goal. FCZ pays
FCB a transfer fee of CHF 10 million. How is the transfer fee treated in the financial statement?
2 Definition criteria:
§ Does FCZ have authority to dispose of the resource (control)?
- According to the existing contract / UEFA transfer regulations, FCZ may transfer the player to another team at any
time in exchange for an appropriate transfer fee.
§ Result from events in the past?

- Contract signing lies in the past
- Proper transfer
§ Inflow of future economic benefits?
- Further transfer possible
- Anticipated income from television, trophy money and viewer spending (sporting success)
- Superstar attracts new sponsors
- Part of operational business

Chapter 4:
3 Recognition criteria:
§ Probability of economic benefit?
- Economic benefit from resale (risk of injury can be insured); the signing is expected to lead to the significant
strengthening of the team
- Age of the player is important (young/old)
§ Reliable determination of the acquisition costs

- The payments made to the old team in the amount of CHF 10 million can be regarded as “reliable” (market price)
- Possible devaluation?
4 Conclusion:
Capitalization of the transfer fee in the statement of financial position, i.e. no accounting entry as a direct expense
Table 15: Example: Borussia Dortmund

Borussia Dortmund EXAMPLE
From: Annual Report

2018/2019 KGaA Group.
Borussia Dortmund, p. 82
4.2.3 Liability and Equity side
The liabilities and equity show the current obligations that will result in future resource outflows without
performance in kind. For example, these are outstanding supplier invoices, loans from banks and capital from
company owners (equity). The liabilities and equity side of the statement of financial position shows the available
financial resources according to their origin. In doing so, there is a distinction in the legal status of the obligation:

Chapter 4:
Obligations vis-à-vis third parties are assigned to liabilities; obligations vis-à-vis partners (e.g. shareholders) and
retained, i.e. not distributed, profits are allocated to equity (whereby, from a legal perspective, only obligations vis-
à-vis the debt investors/lenders of capital are claimable; equity suppliers have co-determination rights and duties). A
determining factor for dividing the liabilities and equity side is the date of repayment. Because there are different
stakeholders with respect to capital, these expect repayment at different points in time. Each stakeholder also has a
different contractual relationship with the company. The liabilities and equity side is therefore also divided
according to legal criteria. In accordance with the legal form, debt investors are referred to as creditors, and equity
suppliers as owners of the company. The liabilities and equity side therefore reveals information regarding the origin
of the resources. As in the case of assets, the dimension of time plays a central role in the presentation of the
liabilities and equity. In principle, a distinction is made between short-term and long-term liabilities including
equity. The presentation of liabilities and equity takes place according to ascending time to maturity, whereby equity
is specified at the end as it is accepted without maturity.
Figure 26: Structure of Liabilities and Equity
The reasons for the origin of liabilities and thus debt investors are diverse. For example, a wholesaler becomes a
creditor by supplying raw material, a bank by extending credit or a customer by providing an advance payment. All
of these creditors are external to the company, and generally a specific deadline for payment, repayment or delivery
is agreed. The fulfillment of the obligation by the company may be regarded as the primary interest of the creditors.
Equity can have different origins, such as, for example, the issuance of shares (due to incorporation or capital
increase), the retention of earnings, revaluations, or currency translation reserves. Equity suppliers are always
owners, however, and their primary interest lies in the continued existence of the company. Another difference
between liabilities and equity is the interest-bearing characteristic. While medium-term and long-term liabilities are
often interest bearing, there is usually a prohibition on paying interest on equity. The sole exceptions are general and
limited partnerships [Kollektiv- und Kommanditgesellschaft], which permit contractual agreements regarding
interest payment. Depending on the legal form, the owners participate in the profit or loss of the company in a
limited or unlimited, primary or subsidiary manner (Schellenberg 2000, p. 60). Further differences in the legal form
of companies are with regard to the co-determination rights and duties of the owners or founders and to the
designation of the equity capital. The most important terms for equity capital are:
§ Sole proprietorship: equity

§ General partnership: capital (separated by partner)
§ Limited partnership: limited partner's share (limited partner) and capital (fully liable partner)

Chapter 4:
§ Limited liability company : common stock capital

§ Stock corporation: share capital
§ Association: association capital
§ Foundation: organization capital
Because equity cannot be considered a liability due to its lack of maturity, it is described separately in the IFRS
conceptual framework. Equity can be interpreted in two ways, which mathematically, however, lead to the same
result. On the one hand, equity encompasses the resources made available to the company by its owners, which flow
to the company by being supplied from outside or by foregoing earnings distribution internally. Equity is increased
through profit or a higher revaluation1 of assets, and it is decreased through losses or lower valuations. On the othe
rhand, equity can alternatively be defined as the difference between assets and liabilities. Therefore equity is the
residual amount of the assets of the company after deduction of all debts (residual value).
Figure 27: Equity as Residual Value
The most prevalent components of liabilities and equity are introduced in the following:
Table 16: Components of Liabilities and Equity
Short-term liabilities § Trade payables (accounts payable or payables for goods and services)
§ Unfulfilled but legally valid claims from third parties arising from trade
Advance payments § Advance payments from customers that establish a obligation on the part of the company
from customers
Financial liabilities § Debts vis-à-vis banking institutions

§ Short-term forms: overdraft facility
§ Medium-term to long-term forms: fixed loans and credit (rollover)
Other short-term § Liabilities that are not trade payables (other accounts payable)
liabilities § Unfulfilled but legally valid claims from third parties not arising from trade
Accrued expenses = § Items of the period-appropriate accruals and deferrals

§ Income earned in the previous year that, from an economic perspective, should have been
deferred
recognized in the following year
income/credits § Services received in the previous year that lead to expenses only in the following year
Provisions § Anticipated or imminent obligations vis-à-vis third parties

§ Probability of occurrence and amount are uncertain
§ May be short-term or long-term
Equity capital § Company equity capital with voting right

§ Disclosure in the statement of financial position at nominal value
1
Apart from the valuation of assets in foreign currencies (i.e. currency translation), asset revaluation may only be carried out in exceptional
cases, for instance for investment properties (i.e. for properties that are held exclusively to generate returns, in other words renting, and not for
own use) or in the event of discontinued operations.

Chapter 4:
§ Varies according to legal form

§ Own share of equity capital (e.g. own equity shares), as offsetting position
Valuation reserves § Revaluation reserves as unrealized but already reportable gains from an appreciation in non-
current assets
§ Currency translation reserves
Disclosed reserves § Accumulated retained earnings not distributed to shareholders

§ Types: legal, statutory, voluntary or agreed reserves
Profit carried over § Reserves auxiliary account

§ Net earnings from previous year that were neither distributed nor added to reserves and are
available for profit distribution
§ “Residual position”
Note. Own depiction. Based on Schellenberg, p. 59.
Figure 28: Nestlé Example: Liabilities and Equity Side

Nestlé EXAMPLE
From: Consolidated Financial Statements of the Nestlé Group 2018, p. 69
4.2.4 Definition and Recognition Criteria for Liabilities
On the liabilities and equity side, the IFRS conceptual framework defines liability or debt and establishes
recognition criteria that must be applied in the assessment of whether circumstances must be carried as liabilities. A
liability can be regarded as the “mirror image” of an asset (Pellens, 2008, p. 121). According to IFRS, the definition
of a liability is:
Chapter 4:
§ Current obligation of the company
§ Result of past business transactions
§ Settlement of the obligation is expected to lead to an outflow of resources that constitute economic
benefits for the company
A liability may and must be recognized and disclosed in the statement of financial position, however, only if
§ the outflow of resources with economic benefits is probable and
§ its value can be determined in a reliable manner.
Figure 29: Minimum Classification of the Statement of Financial Position pursuant to IAS 1
Modern financial reporting dictates that it is not only current book values of assets that must be reported but also the
historical acquisition cost or cost of conversion in addition to the corresponding accumulated depreciation and
impairments as separate negative positions. In doing so, the company is free to choose whether to specify these
details directly in the statement of financial position or to show only the current book value in the statement of
financial position and disclose the details in the notes. Non-current assets must usually also be disclosed in a
statement of asset additions and disposals in the notes, which provides detailed information regarding the
development of the acquisition cost or cost of conversion.
4.2.5 Valuation Approaches
According to the definition and recognition criteria for assets and obligations, the key question concerns the amount
at which the positions must or may be included in the statement of financial position. A position may only be
recognized if it is possible to determine its value in a reliable manner. Here too, the IFRS conceptual framework
stipulates the fundamental valuation methods and types to determine the values included in the statement of
financial position. In valuation, a compulsory distinction is made between the initial valuation, i.e. determination of
the acquisition cost or cost of conversion, and the subsequent valuation, i.e. calculation of depreciation and
impairments.

Chapter 4:
Figure 30: Valuation Approaches
In addition to the general regulation of initial and subsequent valuation, IFRS specifies different valuation
fundamentals in various forms and different combinations for certain circumstances (IAS/IFRS texts, p. 26). In the
IFRS conceptual framework, the following four fundamental valuation approaches are defined:
Table 17: Valuation Approaches Pursuant to the IFRS Conceptual Framework
Historical acquisition cost Asset: Obligation:

or cost of conversion amount paid in cash or cash equivalents for the amount that the carrying party (i.e. the party
acquisition of the asset or the fair value of the that carries the amount it the statement of
performance in kind at the acquisition date financial position) would receive in exchange
for the liability
Current cost Asset: Obligation:

(replacement costs) amount paid in cash or cash equivalents for the amount in cash or cash equivalents that would
acquisition of an asset at the current date be required for the settlement of the obligation
at the current date
Disposal value Asset: Obligation:

(settlement value) amount in cash or cash equivalents that would amount in cash or cash equivalents that would
be recoverable for the sale of the asset at the be required for the settlement of the liability in
current date the ordinary course of business
Present value Asset: Obligation:

amount of the discounted future net cash amount of discounted future net cash outflows
inflows expected in the ordinary course of required for the settlement of the liability in
business the ordinary course of business
Own depiction. Based on Pellens, p. 126 and IAS/IFRS texts, p. 26.
The valuation approaches illustrated above are not exhaustive in the IFRS rules. Individual IAS and IFRS standards
contain additional valuation approaches. For example, IAS 16 specifies the fair value or market value and the
recoverable amount for the valuation of property, plant and equipment. These IAS 16 valuation approaches cannot
be allocated to the four basic approaches named in the IFRS conceptual framework. Other standards partially
provide an explicit right to choose the valuation approach.
As a rule, the first disclosure of assets and liabilities in the statement of financial position usually ensues at the
current cost, i.e. at the current acquisition cost or cost of conversion. In principle, purchased assets are valued at the
current acquisition costs (for example, market value) and in-house manufactured assets at the actual cost of
conversion. Initial valuation at the acquisition cost or cost of conversion is referred to as initial valuation at
historical costs, as today's acquisition cost or cost of conversion become historical costs in the following period. The
valuation approach using historical acquisition cost or cost of conversion stipulates that depreciation and
impairments are undertaken on assets and liabilities in the subsequent periods, i.e. they are adjusted for systematic
depreciation and nonrecurring effects on value.
The other valuation approaches are typically applied in the event of special circumstances or exceptions, such as for
investments held for a brief period or for investment properties (i.e. land and building owned for the purpose of
lease income). The current value is also used, for example, as the subsequent valuation for these circumstances and

Chapter 4:
exceptions. In this case, the subsequent valuation corresponds to the current market values that are referred to in the
IFRS conceptual framework as replacement or current cost. However, the conceptual framework does not provide
for any specific allocation of the valuation criteria to individual assets or liabilities, to certain circumstances or to
special situations. This allocation ensues in the respective standards and will be examined in the next chapters. In
conclusion and in order to aid understanding, the most important valuation terms are listed.
Table 18: Valuation Terms
Book value Value reported in the statement of financial position (i.e. “in the books”) Book value
Residual value Planned value at the end of the useful life, i.e. after all systematic Residual value
depreciation have been deducted
Market value Current value that could be recovered on the open market Market value
Net asset value Current market value after all attributable debt has been deducted Net asset value
Discounted future Value of all future economic benefits (usually monetary inflows, the future Discounted future
cash flows are generally discounted) earnings
earnings
Disposal value Value that could be recovered in a sale Disposal value
With the subsequent valuation of assets, a distinction must be made between three approaches: depreciation,
impairment and market valuation. The primary function of depreciation is to revise earnings so that the current value
reflects the depreciation or use of the asset. The value of the asset is adjusted by the depreciation (asset value
adjustment). The depreciation amount is disclosed in the statement of profit or loss and other comprehensive income
as affecting profit, but it is not a cash expense (adjustment to profit), as cash is not affected by a depreciation
transaction. The cause of depreciation is use, obsolescence or shifts in demand. There are different depreciation
methods, whereby they all constitute systematic methods that include accounting entries distributed over several
years. The different depreciation methods will be covered in more detail in chapter 4.4.
In contrast to depreciation, impairments are snapshot value adjustments (usually impairment losses) that have a
nonrecurring instead of a systematic character. An impairment test is generally administered in the event of
indications of a change in asset value. The test consists of comparing the book value with the recoverable value. The
recoverable value pursuant to IFRS 36 is defined as either fair value minus sales costs or the value in use; whichever
one is the greater value. The value in use comprises the discounted net cash flows generated by the asset in the
future (i.e. discounted future earnings). If the calculated recoverable value is lower than the book value, this
difference must be recognized as an impairment loss affecting profit. It is also possible for an impairment to be
positive, meaning an appreciation, as a maximum typically only up to the original amount though.
Similar to impairment, market valuation is snapshot-based, but it is performed periodically like depreciation
(generally annually). In market valuations, the current market value is recognized as the new value (current cost, see
chapter 4.2.5) and the difference between the new and old values is disclosed in the statement of profit or loss and
other comprehensive income. Market valuation is applied selectively for specific assets only. In particular, these are
briefly held investments and investment properties.
BOX: IAS 36 Impairment of Assets
Content: Definition and recognition of impairment losses of assets in the statement of financial position.

Chapter 4:
Core tenets: At each reporting date, the assets must be evaluated for indications of impairment losses. If indications
exist, an impairment test is performed. The test examines whether the book value is greater than the
recoverable amount. The recoverable amount is the greater value of fair value minus sales costs or value
in use. The value in use comprises the discounted net cash flows.
Delimitation: In particular, IAS 36 regulates impairment losses of intangible assets as well as property, plant and
equipment. Other impairment losses are regulated in the corresponding standards, e.g. IAS 2 for
inventories, IFRS 9 for deferred tax assets and financial assets, etc.
Note. Based on KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 30.
As introduced in the chapter 3, IFRS, Swiss GAAP FER, as well as CO follow the prudence principle. The
following three therefrom derived sub-principles may significantly influence the subsequent valuation of assets:
§ Lower of cost or market principle: If the net disposal value of inventories is lower than the book value
(historical costs), an impairment must be executed, which is disclosed in the statement of profit or loss
and other comprehensive income as affecting profit. This is referred to as an extraordinary value
adjustment. The net disposal value is calculated based on the estimated sales proceeds (market price)
attainable in the ordinary course of business. Costs yet to be incurred, such as the estimated costs of
completion as well as the estimated selling costs, are deducted from the market price. The essential
difference to market valuation is that inventories are valued at historic cost (i.e. acquisition cost or cost of
conversion), without systematic depreciation, but as soon as the market price falls below this historic cost
the market valuation applies.
§ Realization principle: Income is not recognized until it is actually realized. Therefore, surplus value of
immovable property, investments held over the long term, and the like, (i.e. increase in market prices, e.g.
for land) cannot be disclosed in the statement of financial position and therefore the surplus can neither be
disclosed in the statement of profit or loss and other comprehensive income. Such surpluses can only be
disclosed when an asset is sold. For example, a property on Zurich's Bahnhofstrasse, purchased for a few
thousand francs decades ago and, according to the expert opinion or insurance valuation, worth millions
today. The difference between book value and market value would have to be realized by a sale. Simple
realization, as it is possible for securities, is sufficient to comply with the realization principle.
§ Imparity principle: In contrast to the realization principle, impairments on positions in the statement of
financial position must be recognized in the statement of financial position and in the statement of profit
or loss at an early stage. Therefore losses must be taken into account when they are discernible (loss
anticipation). This unequal treatment (imparity) is derived from creditor protection.
4.3 Valuation of selected Current Assets positions
LEARNING OBJECTIVES
• Recognizing the definition and valuation of inventories, receivables, securities, and financial assets.

Chapter 4:
As explained in chapter 2.4.1, current assets encompass liquid resources and assets that have a short-term character,
i.e. they are usually used (or exchanged or sold) within one fiscal year. The following considers the most important
fundamentals of valuation for short-term assets.
4.3.1 Inventories
BOX: IAS 2 Inventories
Content: Definition of initial and subsequent valuation of inventories as well as determination of how acquisition
cost and cost of conversion are calculated. Furthermore, the methods of simplifying valuation are
defined.
Core tenets: Inventories should be valued according to the acquisition cost or cost of conversion, or a lower net
disposal value. The FIFO (First In, First Out) method as well as the average cost method are permitted as
valuation simplification methods. In the subsequent periods, it must be examined whether additional
impairment losses exist.
Delimitation: The recognition criteria of inventories are not specified in IAS 2; correspondingly, the regulations
pursuant to the IFRS conceptual framework apply.
Inventories generally encompass goods that are made available for sale during the ordinary course of business
(incl. work-in-progress goods/products) or goods that are used to manufacture such goods or to provide such
services. Rendered but not yet invoiced services are also recorded as inventories. Inventories are usually divided into
the following categories:
§ Raw materials
§ Semi-finished products, unfinished goods, work in progress or not yet invoiced services
§ Finished products, incl. commodities, as well as down payments made
Depending on the business model of the company, only one or several categories may be relevant. For example, a
commercial firm may report its goods as commodities, whereas a production company may report raw material,
semi-finished and finished products in the classical manner.
Initial valuation:
The initial valuation of inventories usually ensues according to acquisition cost or cost of conversion. In doing so,
the acquisition cost or cost of conversion are, in principle, individually allocated to the individual assets in the
inventory. Within the context of the subsequent valuation, the lower of cost or market principle must be observed,
i.e. the lower value of historical costs or market value must always be recognized. Acquired components of the
inventories are valued at the current acquisition costs (market value, for example). In contrast, inventories
manufactured in-house are valued at the current cost of conversion.

Chapter 4:
§ Acquisition costs: comprise the purchase costs incurred in association with procurement, including
costs for transportation, quality assurance and the like (i.e. incidental acquisition costs), minus any
price reductions such as rebates or discounts (i.e. purchase price reductions). The acquisition costs
thus include all expenses paid in order to transform the asset into an operation-ready state.
§ Cost of conversion: comprise the costs of converting the assets manufactured in-house, including
acquisition costs for the used raw materials as well as all other costs incurred to transform the asset
into its current state. The value of the products manufactured in-house that is determined in this
manner is also referred to as the cost price. In accordance with the calculation structure, the cost of
conversion can be divided into direct costs, material overhead costs and production overhead costs. In
contrast, administrative overhead costs should not be included in the valuation. This also applies to
selling expenses, as these have not been incurred yet.
IAS 23 Borrowing Costs
In determining acquisition cost and cost of conversion, borrowing costs pursuant to IAS 23 are also taken into
account. Borrowing costs are recognized, together with the acquisition cost or cost of conversion, in the statement
of financial position if these can be directly attributed to the acquisition, construction or manufacture of the asset
and it is probable that the asset will generate an economic benefit (Pellens p. 368). The following overview
summarizes the components of the acquisition cost and cost of conversion that must be considered in valuation.
Figure 31: Acquisition Cost and Cost of Conversion

Acquisition costs Cost of conversion
Purchase price (net acquisition price) Direct material and production costs
+ Incidental acquisition costs + Production-related overhead costs

(directly attributable costs)
Fixed and variable
Import duties Determination based on normal capacity
utilization
Transportation costs incl. transportation
insurance Production-related administrative expenses
Packaging
+ Other costs necessary to convey the products
Taxes, inasmuch as they are non-refundable to their present location and present condition
Handling costs + Financial expenses (IAS 23)*
Others
- Acquisition price reductions Not included: (prohibited)

• Idle capacity costs
Discounts
• Inventory costs, inasmuch as they are not
required as part of the production process
Other types of rebates and refunds
• Administrative overhead costs (not related to
+ Financial expenses (IAS 23)* production)
• Distribution costs
* see explanation of IAS 23 above
Note. Own depiction. Based on KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 20.
With large quantities of inventories in the warehouse, it can sometimes be difficult to directly allocate the actually
paid price (cost) to the respective assets. Individual allocation is therefore unsuitable with certain inventories. For
reasons of economy and simplification, streamlined valuation approaches are applied in these cases, which allow the
collective valuation of similar inventory positions (a so-called group valuation approach). The valuation
simplification methods are only permitted for interchangeable goods and with respect to large quantities of
inventory positions. For goods of different types or uses, different methods may be selected accordingly. Pursuant to

Chapter 4:
IAS 2, in addition to the standard cost method and retail method, the two fictional sequences of consumption
methods (FIFO and average cost) are also accepted as valuation simplification methods.
§ Standard cost method: Standard costs are calculated on the basis of planned prices and normalized material
consumption, normalized labor input, normalized performance and capacity utilization rates of machines.
These target parameters should be reviewed regularly pursuant to IAS 2 and, if necessary, adjusted to current
circumstances. The method prevents an overvaluation of the inventories as it is based on the assumption of a
normal state of business operations. If the actual level of activity exceeds the normal level of activity, the
actually incurred costs constitute the upper valuation limit of this method. The method may be implemented if
the determined costs correspond approximately to the actual costs (Pellens p. 376, KPMG IFRS p. 96.).
§ Retail method: Costs are determined by subtracting a percentage gross profit margin from the sales proceeds
(at sales prices). In doing so, it is important to consider that the gross margin may be different depending on
the article and that the actual margin must regularly be re-determined so that no theoretical margins are
included in the valuation. According to IAS 2, average gross profit margins may be used for an entire group of
goods. This method is often applied in commercial firms in particular, as these have large inventory quantities
with similar gross profit margins and high turnover. Periodic reviews of costs take place here as well.
§ FIFO method: This method constitutes a sequence of consumption method. The First In, First Out method
assumes that the inventory positions purchased or produced first (i.e. the oldest) are sold first. Consequently,
inventory positions remaining at the end of the reporting period are those purchased or produced directly
beforehand. The final inventory balance will thus contain the most recently acquired or produced assets.
§ Average cost method: The average cost method entails taking into account the average cost prices in the
valuation of the stock or cost of goods sold. The sum of the initial inventory value and the total cost price for
all additions of the period is divided by the quantity of all period purchases. This average value per article can
be calculated at regular intervals, for example monthly. Depending on the circumstances of the company, the
average can be calculated on a reporting period basis (weighted average) or with each additionally received
delivery (moving average).
Figure 32: Nestlé Example: Inventory Explanations

Nestlé EXAMPLE
Initial valuation
Valuation simplification method
Lower of cost or market principle
Subsequent valuation:

Chapter 4:
In the subsequent valuation of inventories, the lower of cost or market principle or the net disposal value is
applied. International and Swiss accounting practices stipulate that an impairment must ensue as soon as the net
disposal value is lower than the book value. A review must take place in the following period in order to examine
whether the cause for the impairment loss still exists. If the net disposal value increases again, a positive impairment
must follow (impairment reversal rule). Appreciation is only permitted up to a maximum of the historic (original)
acquisition cost or cost of conversion value. The conversion or acquisition costs constitute the upper valuation limit.
The impairment of inventories must usually take place as individual impairments. Similar or related inventories may
be lumped together, if they originate from the same product line, serve similar purposes, are used in similar ways,
are produced as well as distributed in the same region, and if distinguishability from other products of the product
line is difficult or not possible. A lump-sum devaluation of all inventories is not permitted, however (KPMG IFRS
Introduction, p. 99.).
Table 19: Mini Case: Inventory Impairment
INVENTORY IMPAIRMENT
MINI CASE
Market value comes under pressure:
Note. Own depiction.If a commodity’s cost price sinks instead of its net disposal value, it becomes necessary to examine
whether this reduction is accompanied by a change on the sales side and therefore also in the net disposal value. For
raw materials such as crude oil or components, however, a change in the cost price is usually crucial, as these could
be resold on the market or simply replaced by new acquisitions. The replacement costs of raw materials are
therefore often the best benchmark for their net disposal value. In all other cases, an assessment of whether falling
cost prices could lead to a reduction in sales prices is required.
The valuation simplification methods explained in the previous subchapter may also be implemented in
subsequent valuation. Regardless of the choice of valuation simplification method, the resulting valuation must
always be compared with the net disposal value, and the lower of the two values must be recognized. The
simplification methods therefore do not contradict the lower of cost or market principle. In contrast, it is prohibited
to apply different valuation approaches for inventories similar in nature and use; instead, the same valuation
approach must be applied to similar inventories. (Pellens p. 381.)
Figure 33: Nestlé Example: Inventories

EXAMPLE
Nestlé

Chapter 4:
4.3.2 Receivables of Current Assets
BOX: IFRS 9 Financial Instruments: Financial Assets
Initial situation: 2009 saw the beginning of an overhaul of the valuation of financial instruments due to the financial crisis
of 2008. In the same year, the IASB published the first draft of IFRS 9. On July 24, 2014, the IASB
disclosed the final standard for IFRS 9, which now finally defines the new rules regarding disclosure of
impairment as well as the change in classifications and valuation of financial assets. IFRS 9 applies for
business year starting at or after January 1, 2018 and therewith it replaced IAS 39 as of January 2018.
Content: Valuation of financial assets and financial liabilities and disclosure in the statement of financial position.
Core tenets: Financial assets are, in principle, classified on the basis of the business model of the company and the
properties of the financial asset. Financial assets that are held within the context of a business model with
the goal of holding the assets and with the sole transactions being principal and interest payments belong
to the class of “at amortized costs.” All other assets are required to belong to the class of “at fair value.”
Assets in the first class are recognized and reported based on historical costs, while assets in the second
class are recognized and reported according to current market prices.
Delimitation: IFRS 7 regulates the notes information with respect to financial instruments.
Receivables are monetary claims arising from mutual agreements. The company carrying the position in its
statement of financial position has already executed its part of the performance; the counter-performance is still
outstanding, however. Trade receivables encompass claims for monetary payments for the delivery of goods or for
rendered services (e.g. for consulting, architectural services, transportation services or other freelance services).
Other receivables are claims not arising from a delivery or service but from a previous monetary commitment, e.g.
interest payments due from loans granted. Loans with short-term maturities, such as the final year of a granted loan
or an upcoming repayment of principal, are not reported as investments but also under other receivables. Because
the assets are realizable or will be realized in the short term, the loans with short-term maturities must be recognized
in the statement of financial position under other receivables. In the area of receivables and loans, receivables from
affiliated companies within the group of affiliated companies are also reported. In the consolidated statement of
financial position, these receivables between companies of the group are offset (see chapter 9.3.3), and are thus
visible only in the separate financial statements. Receivables are included under financial assets and are therefore
subject to disclosure in the statement of financial position and valuation according to the regulations of IFRS 9.
IFRS 9 replaced IAS 39 as per January 1, 2018. Under IFRS 9 financial instruments are first classified and, based
on the classification, the initial and subsequent valuation are determined. IFRS 9 includes comprehensive rules
regarding complex and derivative financial instruments. IFRS 9 as well as its concept are presented in the following.
Initial valuation:
IFRS 9 distinguishes between two types of assets for classification purposes: “at amortized cost” and “at fair
value” (see chapter 4.3.5). IFRS 9 requires receivables to be classified at amortized cost because these arise in
connection with the business model that is practiced. Initial valuation recognizes receivables at the fair value of the

Chapter 4:
performance in kind, plus transaction costs. The fair value corresponds to the transaction price. Example: if a
company sells a product to a customer for CHF 100.-, plus CHF 10.- for transportation, the initial valuation of the
receivable that the company now has towards the customer is at the total transaction price, i.e. CHF 110.-.
Figure 34: Nestlé Example: Explanations Regarding Receivables and Loans

Nestlé EXAMPLE
In the subsequent valuation, receivables are disclosed in the statement of financial position according to the
amortized cost approach. In doing so, gains and losses from the amortization of acquisition costs, impairment
losses, reclassifications and the disposal of the asset are taken into account. Systematic depreciation does not apply
for receivables. Amortized cost comprises the following positions:
Figure 35: Amortized Cost
In the subsequent valuation, potential risks also have to be taken into account and disclosed in the notes pursuant to
IFRS 7. The most important risks relate to the following:
§ Receipt of payment (default risk of the debtor)

§ Warranty risk (claims regarding purchase price reduction or guarantee deductions)
§ Currency risks

Chapter 4:
The risks usually lead to a devaluation of the outstanding receivables and therefore to an impairment. At each
reporting date, it is necessary to examine whether indications of an impairment loss exist. An impairment loss exists
if there is an objective indication of a permanent impairment loss that is based on a past event that occurred after the
initial recognition and that has an effect on future cash flows. The examination of the receivables ensues within the
context of an assessment of creditworthiness on the reporting date (or, for the external auditors, at the time of the
audit).
Since 2019, IFRS 9 stipulated that the Expected Credit Loss (ECL) must be calculated for all financial instruments
applicable to the new valuation model as per initial valuation of the asset. IFRS 9 is mainly tailored at banks,
industrial companies may use a simplified method to calculation of the expected losses because the implementation
of IFRS is very complex.
Figure 36: Nestlé Example: Trade Receivables

Nestlé EXAMPLE
In order to report an impairment, a distinction must be made between risks that have actually occurred and risks
that are likely to occur. The former lead to a direct adjustment (impairment) or a loss of receivables. With probable
risks, an indirect adjustment via a lump sum (collection risk, impairment for future losses on receivables, etc.) can
be made. Direct impairments can be recorded for risks that can be attributed to individual amounts. In Swiss circles,
lump-sum adjustments to receivables are referred to as value adjustment for receivables. In IFRS, value adjustment
for receivables is not expressly mentioned, but the corresponding concept is established. According to IFRS, value
adjustments are usually reported in the notes, and the statement of financial position only shows the adjusted
receivables value. It is permitted, however, to report value adjustments in the statement of financial position.

Chapter 4:
As in the case of inventories, the principle of individual impairments is also valid for impairments of receivables.
For simplification purposes, lump-sum impairments are also possible if these are based on sufficient experience
with respect to the risks involved (default risk, etc.). For this, the amount of the allowance for doubtful accounts
receivable is estimated and the impairment or the value adjustment for receivables created. For the estimation of the
lump-sum impairment, three methods are generally used:
§ Percentage rate of goods sold (percentage of sales)

§ Percentage rate of outstanding receivables (percentage of accounts receivable)
§ Age structure of the outstanding receivables (see Nestlé example) (aging of accounts receivable)
Figure 37: Impact of Risks on the Impairment of Receivables
In contrast to Swiss GAAP FER, IFRS permits lump-sum impairments only in a very restrictive manner, and lump-
sum impairments on total accounts receivable (percentage of accounts receivable) are prohibited according to IFRS
(Behr & Leibfried, 2009, p. 291). Swiss tax legislation permits the application of lump-sum impairments in addition
to the individual impairments, usually in the amount of 5% of domestic receivables and 10% of foreign receivables.
In the United States, such accounts receivable adjustments on the basis of concrete experience, i.e. based on
receivables losses sustained by the corresponding company over a certain period of time, are permitted.
4.3.3 Securities and Investments in Current Assets
IFRS 9 Financial Instruments: Financial Assets

(see chapter 4.3.2)
Companies typically name two reasons for investing liquid resources in financial investment instruments in the short
term: (i) as a material component of the business model or (ii) to invest resources not needed at the moment in a
profitable manner. These financial investments range from classic financial instruments such as shares, bonds and
investment funds to derivatives (for example options, swaps, forward contracts, etc.). Securities in current assets
have a maturity date of within 12 months. This is why this position in the statement of financial position often shows
short-term money market instruments and time deposits, fiduciary investments or currency investments at banks, as
well as short-term shares and bonds. Regardless of whether they are short-term or long-term, all securities and
investments must be disclosed in the statement of financial position in compliance with the IFRS 9 standard
introduced in the previous chapter. Customarily, short-term investments in current assets are designated as
securities and long-term investments in non-current assets as investments. Types of long-term investments in non-
current assets (holding period >12 months) are covered in chapter 4.4.2.
Chapter 4:
As already introduced in the previous chapter, IFRS 9 distinguishes between two categories of assets:
§ Assets at amortized cost
§ Assets at fair value
The classification is important as it is used as a basis for valuation. The following overview summarizes the criteria
for classification and the resulting valuation and disclosed in the statement of financial position. If disclosure applies
at fair value, income and expenses can be either disclosed as profit of the period (at fair value through profit or loss,
FVTPL) or as other comprehensive income (at fair value through other comprehensive income, FVTOCI). The
classification of financial assets into the respective categories impacts the initial as well as the subsequent valuation.
Figure 38: Classification and Valuation of Financial Assets Pursuant to IFRS 9
Financial assets
Amortized cost Fair value

Classification
All financial assets that

• are held within the context of a business model
that has the objective of holding the assets, and All other financial assets
• represent only payments of principal and interest
at certain points in time.
(1)
Amortized cost Fair value
Valuation and balance sheet
(2)
inclusion
Profits and losses from

• amortization of costs
Fair value through OCI
Fair value through profit or loss
(FVTOCI)
• impairment losses (FVTPL)
• reclassifications All fair-value adjustments must
All fair-value adjustments must be
be recorded in other
• disposal of the asset recorded as profit or loss
comprehensive income (OCI)
must be recorded in profit or loss
(1) Fair-value option:

(2) OCI option:
• Choice per asset
• Choice per asset
• Prerequisite: There is a
significant reduction in • Only for equity capital
balance sheet or valuation instruments not held for
inconsistency through the trading purposes
reclassification
For classification of financial assets, IFRS distinguishes between liabilities (e.g. bonds) and equity (e.g. shares). For
the classification of liabilities, the following two tests exist. If the liability successfully passes both tests, it is
discloses at amortized costs, otherwise at fair value. Both tests apply at initial valuation.
§ Business model-test: looking from the perspective of the business model, are the liabilities hold for the
financial return at the date of maturity or are they hold for changes in market prices?
§ Cash flow-test: does the contract of the financial assets define specific cash flows (interests and
repayment) as per defined dates?
If the financial assets is valued at fair value according to theses test, then subsequent tests apply to assess if the
changes in values are profit effective (i.e. FVTPL approach) or not (i.e. FVTOCI approach). Again, a business
model as well as a cash flow test applies. If both tests are passed successfully, FVTOCI applies, if not FVTPL.

Chapter 4:
§ Business model-test: looking from the perspective of the business model, are liabilities hold for both,
receiving the predefined cash flows as well as they are sold for benefitting from changed market prices?
§ Cash flow-Test: does the contract of the financial assets define specific cash flows (interests and
repayment) as per defined dates?
Despite amortized cost or FVTOCI classification, disclosure at FVTPL, i.e. Fair value-Option, is still possible but
only if the disclosure at FVTPL eliminates or significantly reduces a disclosure or valuation inconsistency.
For equity instruments or derivative financial instruments, classification is less complex. They must be disclosed at
fair values and changes in values are profit effective (i.e. FVTPL approach). Only equity instruments that are not
held for trading purposes, and consequently they are disclosed as non-current assets, allow for a FVTOCI-option.
At initial valuation and disclosure, a company can choose FVTOCI instead of FVTPL. Using FVTOCI, only
dividend payments are disclosed as profit effective. The following figure summarizes the classification of different
financial assets.
Figure 39: Classification of financial liabilities, derivatives and equity instruments
Liability instrument Derivative instrument Equity instrument
Cash flow-test
Passed Failed
Business model-test Held for trading

No
Scenario 1: Scenario 2: Scenario 3:
Held for Held for Neither Yes
contractual contractual scenario 1 nor
cash flows cash flows and scenario 2
for trading
Using fair value Using FVTOCI

option? Yes option?
No
No No Yes
Amortized costs FVTOCI FVTPL FVTOCI
Note. Based on Ernst & Young (2015). p. 9.
Figure 40: Classification and Valuation of Financial Assets Pursuant to IAS 39

Chapter 4:
In contrast to the IFRS 9 standard, its “predecessor” standard IAS 39 (valid until 2017) divided financial instruments
into four categories. Because IAS 39 is still relevant for the analysis of old annual reports, the following overview
aims to help demonstrate the differences.
Initial valuation:
Regardless of the classification into “amortized cost” or “fair value,” all financial assets must be initially
recognized at fair value. A difference between assets at amortized cost and at fair value is that transaction costs must
be taken into account under “amortized cost.” While disclosure at FVTPL requires initial valuation at fair value,
disclosure at amortized costs as well as FVTOCI do also include transaction costs for the initial valuation.
Profits and losses from financial instruments at “amortized cost” are disclosed in the statement of profit or loss and
other comprehensive income. Changes originate from the following circumstances:
§ Amortization of costs
§ Impairment losses
§ Reclassification
§ Disposal of the asset
Upon indications of loss in value, a profit-effective value adjustment is required. If the value of the financial
instrument increases again in later periods, an increase in value applies, up to initial purchasing value. Valuation
increases above the initial purchasing value are not allowed. In contrast, financial instruments that are disclosed at
fair value, record all increases and decreases in valuation as profit/loss or as other comprehensive income.
4.4 Valuation of Non-Current Asset positions
LEARNING OBJECTIVES

• Recognizing the meaning, structure and composition of non-current assets
• Being able to apply the definition and valuation of property, plant and equipment as well as financial and
intangible assets

Chapter 4:
Non-current assets comprise assets with a long-term character, which are usually held or used for longer than a year
(see chapter 4.2). The following considers the most important fundamentals of valuation for long-term assets.
4.4.1 Property, Plant and Equipment
BOX: IAS 16 Property, Plant and Equipment
Content: Determination of capitalization, definition of initial and subsequent valuation of property, plant and
equipment, as well as establishment of how acquisition/conversion cost is calculated.
Core tenets: Property, plant and equipment that fulfill the three definition criteria (control, past event and future
benefits) are capitalized if the inflow of future benefits is likely and the costs can be reliably determined.
The acquisition cost or cost of conversion is recognized in the initial valuation of property, plant and
equipment. The subsequent valuation may follow amortized costs or fair value. If amortized costs apply,
systematic depreciation as well as impairment losses or appreciation upon the appearance of the
corresponding indications must apply. In the revaluation model, property, plant and equipment are valued
according to fair value at each reporting date.
Delimitation: Impairment losses or appreciation are defined in IAS 36.
Property, plant and equipment (tangible, long-lived assets) are physical and can be manufactured in-house or
acquired for the production of goods, the performance of services or investment purposes. Key features of property,
plant and equipment are therefore their tangibility and a useful life of more than one period.
Given that the three definition criteria are fulfilled (control, past event and future benefits), property, plant and
equipment must be capitalized if the following two recognition criteria are both met:
§ It is probable that future benefits associated with the asset will flow to the company.
§ The acquisition cost or cost of conversion of the asset can be determined in a reliable manner.
The following categories of property, plant and equipment are reported at least in the statement of financial position
or the notes:
§ Property and buildings

§ Technical facilities and machines
§ Tools, operations and office equipment (furniture)
§ Vehicles
§ Property, plant and equipment under construction
§ Other property, plant and equipment
The useful life of an asset reveals the estimated length of time for which the asset will be used by the company and
is decisive for subsequent valuation in particular. Furthermore, identification of the individual assets in property,
plant and equipment is important, as certain assets are comprised of various components that have varying useful
life durations. IAS 16 stipulates that such assets are subject to component accounting. In this process, the
individual components of an asset are reported separately and treated differently from an accounting perspective.
The components may be written down and impaired in different ways. One example of the application of component
accounting is the reporting of airplanes: The airplane and the engines are disclosed in the statement of financial
position and reported as separate and independent assets.

Chapter 4:
Figure 41: Nestlé Example: Statement of Asset Additions and Disposals
Nestlé EXAMPLE
The overview of the development of the individual asset classes of property, plant and equipment is summarized in
the so-called statement of asset additions and disposals. The statement of asset additions and disposals provides
detailed information regarding the development and division of property, plant and equipment, and is part of the
notes (see chapter 7.2). The statement of asset additions and disposals often presents the gross amounts, i.e. divided
according to the original acquisition costs and the accumulated depreciation and impairments. This helps to follow
the development better. Changes in the group of consolidated companies (acquisition or sales of subsidiaries),
investments, disposals (sales, removal), depreciation, impairments and the influence of conversion gains/losses are
reported separately. Investments and divestments can be compared with the statement of cash flows. In doing so,
however, transactions not affecting liquidity, such as exchange deals and leasing, as well as profits and losses from
asset disposals must be eliminated (KPMG: Reading and understanding ARs, p. 23).

Chapter 4:
In addition to the customary property, plant and equipment that are disclosed in the statement of financial position
and valued according to IAS 16 as explained in this chapter, there are special categories of property, plant and
equipment that are subject to different treatment pursuant to IFRS and Swiss GAAP FER. These are:
§ Property, plant and equipment intended for sale (IFRS 5)

§ Property held for purpose of generating a return or as financial investments (investment properties, IAS 40)
§ Leasing (IAS 17/IFRS 16)
Although these assets have the characteristics of property, plant and equipment, specific considerations arise
concerning their disclosure in the statement of financial position and valuation (e.g. delimitation of legal and
economic ownership in leasing). The additional literature provides more information on this matter.
Initial evaluation:
For acquired assets, capitalization ensues at the acquisition costs in principle. The acquisition costs encompass the
purchase price as well as the incidental acquisition costs and purchase price reductions that are directly attributable
to the asset. Directly attributable incidental costs are, for example, import duties. Directly attributable purchase price
reductions encompass rebates, bonuses, discounts and similar positions.
Figure 42: Initial Valuation of Property, Plant and Equipment
Note. Own depiction. Modeled on KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 40.

* see explanations regarding IAS 23 in chapter 4.3.1 Inventories
With goods manufactured in-house, the costs of conversion are recognized as for inventories (IAS 2). The
acquisition of certain assets may lead to the creation of an obligation, which may give rise to costs in later
accounting periods. For example, the closure of a plant may bring about restoration costs if the property must be
returned to its original condition or restored at the end of the plant's useful life. If this factor is already known at the

Chapter 4:
time of acquisition and if provisions must be established for this purpose pursuant to IAS 37, these future costs must
be recognized as well. Provisions pursuant to IAS 37 are covered in chapter 4.2.3.
Figure 43: Nestlé Example: Recognition of Property, Plant and Equipment

Nestlé EXAMPLE
Property, plant and equipment are valued at amortized costs, for selected items, such as marketable securities held
for a short period of time and investment properties, the revaluation model applies. The amortized costs approach
uses the acquisition cost or cost of conversion, from which the systematic depreciation as well as impairment losses
are deducted. The revaluation model uses the fair value at the time of revaluation. Revaluation must be executed
regularly, every three to five years, and more frequently with volatile property, plant and equipment. Until the next
revaluation takes place, systematic depreciation must take place. If the revaluation leads to an appreciation vis-à-vis
the book value, this appreciation must be recorded as part of the revaluation reserves position in equity, i.e. it does
not affect profit. Later impairment losses are then offset to such revaluation reserves of the same asset; impairment
losses that exceed such revaluation reserves are disclosed as expenses in the statement of profit or loss and other
comprehensive income. The precondition for the selection of the revaluation model is that the fair value of the asset
can be reliably determined. The decision for the valuation approach must be taken upon purchase of an asset and it
must be applied in a coherent manner for all assets of a asset class. Most companies apply amortized cost valuation.

Chapter 4:
Figure 44: Subsequent Valuation of Property, Plant and Equipment
Amortized costs Revaluation model
Valuation at acquisition/conversion costs less Valuation at fair value less interim depreciation
depreciation and impairments and impairments
Depreciation Revaluation
Depreciation method Every 3-5 years (more frequently forvolatile

assets)
Systematic method that best reflects
usage The entire class of assets must be revalued
in case of revaluation
Depreciation duration
Recording of value adjustments
Estimated company-specific useful life Appreciation: in other comprehensive

income (exception: reversals of previous
impairments)
depreciation volume / residual value
Devaluation: profit or loss (exception:
reversals of previous appreciations)
depreciation volume = acquisition/
conversion costs less residual value
Systematic depreciation
Impairments/appreciations (analogous to amortized costs approach)
Pursuant to IAS 36 Impairments/appreciations

(analogous to amortized costs approach)
Note. Own depiction. Modeled on KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 40.
Table 20: Mini Case: Depreciation Method
DEPRECIATION METHOD
Purchase price: TCHF 500

MINI CASE
Residual value after 5 years: CHF 0

Company-specific useful life: 5 years (= depreciation period)
Hours of operation: 10
Year Straight Declining balance Activity-based Combination

line
TCHF 40% of the CHF 50 60% straight line
100 p.a. book value per hour 40% activity-based
Depr. Depr. BV Hours Depr. Fixed Hours Variable Depr.
1 100 200 300 1.8 90 60 1.8 36 96
2 100 120 180 2 100 60 2 40 100
3 100 72 108 2.2 110 60 2.2 44 104
4 100 43 65 2.1 105 60 2.1 42 102
5 100 26 39 1.9 95 60 1.9 38 98
Total 500 461 10 500 300 10 200 500
Depreciation reflects the systematic method to consider the asset's usage. A distinction is made between three basic
calculation methods: straight-line method, declining balance method, and activity-based. The straight-line as
well as the declining balance methods are time-based depreciation methods. The depreciation period reflects the
expected useful life during which a company uses the asset. The company-specific useful life may be shorter than
the economic life of the asset. The depreciable amount shows the total financial value scheduled to be written down
over the expected useful life. Usually, the depreciable amount is defined as the difference between the initial
valuation (acquisition cost or cost of conversion) and the residual value. The residual value is the estimated value of
the asset after expiration of the company-specific useful life.

Chapter 4:
With the straight-line method, the depreciable amount is equally distributed over the company-specific useful life.
With the declining balance method, a depreciable amount is established as a fixed percentage rate based on the
most recent book value. The activity-based method is a performance-related method and calculates the
depreciation amount based on the performance provided during the period (in hours, watts, etc.). In rare cases, the
methods may also be combined. The different depreciation methods and the interaction between useful life and
residual value are illustrated in the example below.
4.4.2 Investments
IFRS 9 Financial Instruments

(see chapter 4.3.2)
As already described in chapter 4.3.3, financial assets are divided on the assets side into securities as part of current
assets (short-term) and investments as part of non-current assets (medium-term to long-term). The classification for
short-term financial instruments pursuant to IFRS 9 already seen is also valid for medium-term or long-term
financial instruments, which is why the classification pursuant to IFRS 9 is repeated here:
§ Assets at amortized costs
§ Assets at fair value
As introduced in chapter 4.3.3, decisive for the classification as well as the initial and subsequent valuation of
financial instruments are the business model and the intentions of the company carrying the position in the statement
of financial position. In financial reporting of large corporations, three groups of investments are disclosed in the
assets. The first group encompasses minority shareholdings (that are not traded on a stock exchange). If the
company has a participating interest of less than 20%, it is usually not consolidated but rather reported as investment
assets (see chapter 4.5), provided that there is no intention to sell the shares in the short term.
A second group within investments consists of granted and received loans, provided that these have a maturity of
longer than one year. Loans and receivables are non-derivative financial instruments with fixed or determinable
payments that are not traded on an active market. They are created when the group makes money, goods or services
directly available to a debtor without the intention of trading the resulting receivable. Valuation is in principle based
on the nominal amount (acquisition costs).
The third group encompasses marketable financial instruments with maturities longer than one year (or with no
maturity, such as in the case of shares) and where the intention is to hold the assets until maturity or on a longer-
term basis for strategic purposes. If the business model and cash flow tests pursuant to IFRS 9 are fulfilled (see
chapter 4.3.3), these are disclosed in the statement of financial position and valued at amortized cost.
In addition to these three groups, there are many more financial instruments or different intentions of companies
with long-term financial assets. Marketable financial instruments, being a subset of financial instruments, follow the
classification and disclosure of financial instruments as described in chapter 4.3.2.

Chapter 4:
4.4.3 Intangible Assets
BOX: IFRS 16 Intangible Assets
Content: Determination of the definition and recognition criteria as well as the initial and subsequent valuation of
intangible assets.
Core tenets: Intangible assets are capitalized if they generate future benefits and the costs can be reliably determined.
Acquired intangible assets must be capitalized and must be valued differently according to their form of
acquisition. Internally manufactured intangible assets are capitalized only if these concern development
costs and they meet precisely defined preconditions. For disclosure in the statement of financial position,
there is the choice between the acquisition/conversion cost model or the revaluation model (as for IAS 16
Property, Plant and Equipment).
Delimitation: Certain intangible assets are covered directly in the corresponding IFRS standard:
• IAS 2 Intangible assets in inventories (for example contract research for third parties)
• IAS 12: Intangible assets through deferred tax assets
• IFRS 3: Intangible assets from company acquisitions (derivative goodwill)
• IFRS 4: Intangible assets from insurance policies
• IFRS 9: Intangible assets from financial instruments
Note. Modeled on KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 105.
Intangible assets constitute circumstances that are identifiable, not of a monetary nature and have no physical
existence. Intangible assets are very significant for companies. For example, groups invest large sums in the
establishment or acquisition of brands, in the development of products or processes, in the acquisition of licenses,
patents and concessions, or in takeovers of other companies. Because intangible assets have no physical existence,
the question of disclosure is a particular challenge and must be well documented. An intangible asset must be
disclosed in the statement of financial position if it fulfills all of the following three criteria:
§ Fulfills the definition of an intangible asset: in addition to the three general definition criteria for assets,
intangible assets are identifiable, not monetary, and without physical substance.
§ Complies with the recognition criteria for intangible assets. These correspond to the general recognition
criteria for capitalization but require more extensive documentation.
§ Not excluded from recognition by special provisions.
IAS 38 states that a circumstance is an intangible asset if it fulfills all six of the following definition criteria:
§ Identifiable
§ Non-monetary
§ Without physical existence
§ Control (authority over its disposal lies with the company)
§ Past event
§ Future economic benefit
The second step comprises fulfilling all of the recognition criteria for assets:
§ It is probable that the economic benefits associated with the intangible asset will flow to the company.
§ The acquisition cost or cost of conversion can be reliably determined.
The third step consists of examining the special provisions. The most important are:
§ Brands created in-house are not allowed to be capitalized; only brands acquired in a derivative manner may
be capitalized.

Chapter 4:
§ Customer lists are not allowed to be capitalized (regardless of whether they were created in-house or are a
derivative acquisition).
§ Research costs are not allowed to be capitalized; development costs are allowed to be capitalized if the six
additional recognition criteria are fulfilled (see later part of this chapter).
Figure 45: Nestlé Example: Intangible Assets

Nestlé EXAMPLE
Initial valuation:
For intangible assets that fulfill the definition and recognition criteria, the valuation is also dependent on the type of
acquisition: derivative and original acquisition. A derivative acquisition is usually a purchase from a third party
and can be divided into individual acquisitions, acquisitions within the context of a business combination,
acquisitions generated by public funds or acquisitions generated through an exchange. Derivatively acquired
intangible assets are often capitalized at acquisition costs, unless capitalization is excluded in compliance with
special provisions, such as for customer lists. Mergers and acquisition (i.e. purchase of a company or a unit of
company) constitute special cases: for each of the acquired assets, including intangible assets, the specific individual
value must be determined at current fair values. Typically the price that must be paid for the purchase of the
company or unit is higher than the sum of the individual fair values of all assets. This difference between the

Chapter 4:
individual values and their sum is called “goodwill” (see chapter 4.4.3.2). The original acquisition of intangible
assets refers to internally created assets, such as, for example, brands created in-house, results of research and
development, or patents that originated in-house. While brands created in-house are not allowed to be capitalized
(IFRS specifically stipulates such a prohibition), own patents are allowed to be capitalized at the cost of conversion,
i.e. customarily at the costs of the patent application. For the assessment of the reporting of the original
circumstances concerning research and development, IFRS provides clear definitions of the two terms. IFRS
defines research to mean independent and scheduled studies in order to attain new, scientific and technological
knowledge. In contrast, development is understood to mean the application of research results and other knowledge
for the production planning or design of new or considerably improved materials, devices, products, processes,
systems or services, provided that application ensues before the start of commercial manufacturing or internal use.
Internally created assets are often not capitalized but instead disclosed as expenses in the statement of profit or loss
and other comprehensive income. Expenses in the research area are not allowed to be capitalized as it is assumed
that these cannot fulfill the recognition criteria for intangible assets. Expenses for development, on the other hand,
may be capitalized as intangible assets if it can be proven that all six specific preconditions are fulfilled.
Figure 46: Initial Valuation of internally generated Intangible Assets
Original acquisition
Internally generated
intangible assets
acquisition
Type of
Internally generated Costs of the research Costs of the

synergy effects phase development phase
Special prerequisites
Special prerequisites
cumulatively not
cumulatively fulfilled
fulfilled
Valuation
Capitalization of the
Expenditures through
directly attributable
income statement
costs
Note. Modeled on KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 106-107.
The specific preconditions for capitalizing development costs are as follows:
1. Technical feasibility
2. The intention to develop the intangible asset further and use it internally or sell it
3. The ability to use the intangible asset internally or sell it
4. Demonstration of how the intangible asset will generate future economic benefits
5. The availability of adequate technical, financial and other resources to complete the development
6. Reliable attribution of costs incurred during development
If one of these preconditions is not fulfilled, the expenses for this development performance are not permitted to be
capitalized but must instead be reported as expenses affecting profit in the statement of profit or loss and other
comprehensive income.

Chapter 4:
Valuation
Initial valuation Subsequent valuation
Acquisition cost or Deprecia- Impair-

cost of conversion tion ments
As with property, plant and equipment (IAS 16), intangible assets may be valued in the subsequent periods
according to two different methods. There is a choice per class of intangible assets to perform subsequent valuation
according to acquisition/conversion cost (ACC) or according to fair value (fair value – revaluation model). As
there is often no active market for intangible assets, the ACC model plays a more significant role. Essentially,
subsequent valuation ensues as for property, plant and equipment (see chapter 4.4.1). In contrast to the tangible
assets, intangible assets often have an indefinite useful life. This makes depreciation impossible for intangible assets.
Instead, classification with respect to the subsequent valuation model (ACC or revaluation model) as well as the
useful life (definite or indefinite) of the intangible asset is newly assessed each year and modified if necessary.
4.4.3.1 Patents, trademarks, and R&D-expenses
Patents, trademarks, concessions and the like are rights that are usually subject to intellectual property rights
legislation and are protected based on registration. All of these rights may be disclosed in the statement of financial
position provided that they were acquired in a derivative manner. The purchase price (acquisition costs) minus
appropriate depreciation constitutes the upper valuation limit. In determining depreciation with respect to a loss in
value due to application or use of an object, the so-called protection period constitutes the upper limit for the
depreciation period for rights with a limited protection period (e.g. expiration of patent protection). For brands, there
are strong arguments against systematic depreciation over a defined period, as an indefinite useful life is expected.
Similar to the maintenance costs for immovable property, brands incur expenses through brand maintenance
(advertising, PR, etc.); for the preservation or increase of brand value.
Some intangible non-current assets manufactured or compiled in-house, in the sense of property rights, are eligible
for disclosure in the statement of financial position (for example, own inventions protected by patents). In this case,
only the cost of conversion may be capitalized. With an originally acquired patent, these are the costs for patent
registration and attaining patent protection. In contrast, neither future anticipated cash flows arising from own use or
the sale of the patent (discounted future earnings) nor the expenses for the development of the products or
technologies protected by the patent are allowed to be capitalized (see above for disclosure of development costs).
Figure 47: Nestlé Example: Recognition of Research and Development

Nestlé EXAMPLE

Chapter 4:
4.4.3.2 Goodwill
BOX: IFRS 3 Business Combinations
Content: Definition of the different types, the presentation and recognition of business combinations.
Core tenets: A business combination is a transaction or another event through which an acquirer attains control over
one or several businesses.
On the acquisition date, all identifiable acquired assets and debts must be valued at fair value. The
difference between the transferred performance in kind for the company acquisition and the net asset
volume of the acquired company must be capitalized as goodwill.
Delimitation: • Impairment losses of goodwill are regulated in IAS 36. This includes the regular impairment tests.
• Joint ventures are included in IAS 31.

The price that the acquiring company is prepared to pay for purchasing the company (also referred to as “the object”
or “target”) does not simply correspond to the difference between the assets and the liabilities of the relevant
business activities or parts thereof. Instead, the price is significantly influenced by the revenue that can be expected
from the two companies combined, on a long-term basis (i.e. “synergies”). As an example, one might imagine a
young start-up company that has developed innovative search technology for social networks. However, due to a
lack of resources or experience, marketing the technology may prove difficult. In this situation, a possible merger
with a company like Google may enable the marketing of new products and market services in a way that would not
be possible for one of the two companies on their own. IFRS stipulates that the first step for the financial disclosure
of acquisition is the revaluation of all assumed assets and liabilities of the acquired company (i.e. target), including
provisions. This revaluation must ensue from the perspective of the newly merged company, according to the new,
merged business activities. This perspective may lead to different results compared to assessments made according
to the business activities prior to the merger for assets like brands and R&D expenses. Through the acquisition, the
original brands of the acquired company are now transformed into brands acquired in a derivative manner by the
acquiring company and may therefore be disclosed at purchase value. Following the example of innovative search
technology for social networks, the precondition of sufficient financial resources is fulfilled after the acquisition by
Google, and therewith all criteria for disclosing of development costs are met. The assets and liabilities revalued
pursuant to IFRS guidelines (also called “revalued net assets”) are then offset against the acquisition price. This
acquisition price is usually determined by the value that the acquiring company expects in return for the acquisition.
This value encompasses not only the value of the net assets but typically also the anticipated future revenue
expected to result from synergies. The difference between the purchase price and the revalued net assets is called
goodwill. IFRS specifies that this goodwill must be disclosed as non-current asset. If the purchase price is lower
than the net assets revalued according to the IFRS guidelines, this is referred to as badwill. IFRS stipulates the
obligation to recognize and disclose badwill as a liability.
Goodwill and badwill originate through the purchase of a company or a unit of another company (i.e. independently
viable business activity). In such a transaction, the acquiring company acquires more than 50% ownership of the
company through purchasing of its shares, or of the unit through purchasing its assets. In the first scenario, all
contracts, rights and obligations of the company being acquired remain in place, and the acquiring company (i.e. the
new parent) has full or decisive control over the acquired company and its assets and liabilities. For example, the

Chapter 4:
fact that Google, according to December 2013 press announcements, intends to acquire the majority of the shares of
the robotics company Boston Dynamics does not influence the respective existing service and delivery agreements
with the American military.2 Through this acquisition, the acquired company becomes a subsidiary of the acquiring
company (Boston Dynamics becomes a daughter company of Google). Later the acquired company may be
dissolved as a legal company and its business activities may be integrated into the existing departments of the parent
company (or into affiliated companies). Even in the case of such restructuring, the parent company continues to be
the legal successor of the previously acquired company. Correspondingly, when acquiring a company the new
parent assumes all of the rights and obligations of that company3. If, instead of the acquisition of an entire company,
only a business area is taken over, all assets and liabilities associated with the business area are assumed. The assets
and liabilities may encompass entire companies in addition to individual assets. An example of an acquisition of
individual assets is Swiss International Airlines after the grounding of Swissair. Swiss International Airlines
acquired Swissair's airplanes, for example, and offered to maintain the employment contracts of the flight and cabin
crew personnel. It did not assume Swissair's legal obligations, i.e. the flight and cabin crew employment contracts
were not transferred to Swiss International Airlines. Instead, the employment contracts with Swissair were
terminated and new ones were signed with Swiss International Airlines. This acquisition of assets (instead of
acquisition of a legal entity) also lead to the fact that e.g. the identification of “SR” could not be assumed, so Swiss
International Airlines flies using the identification “LX”.
An example of an acquisition of an entire company as a separate legal entity is the sale of a business area for the
preparation and treatment of municipal and industrial water and sewage, including the associated service activities,
which Siemens announced in November 2012. This sale also comprised the legally separate production and
distribution companies in North America (the primary market of this business area at the time), which were in the
possession of Siemens.
In contrast to derivative acquired goodwill, it is prohibited to disclose any alike surplus value in the statement of
financial position for business activities that was created internally. The disclosure prohibition results from the fact
that there is no market-based valuation available for the original surplus value (i.e. no acquisition price) and
therefore also no reference point regarding how much a third party would reasonably agree to pay for the original
surplus value. Reasons for the payment of a premium or surplus value for the purchase of another company are
diverse. There are, however, some often mentioned and recurring reasons:
§ The expected revenues exceed the normal interest rate earned on equity.
§ Assets that are not eligible for inclusion on separate or consolidated financial statements (e.g. efficient
organization, good management, reputation, etc.).
§ Strategic price.
§ Remuneration paid for the possession of an acquired company as such (e.g. for the fact that the company is
no longer a competitor).
§ Synergy effects resulting from a particularly efficient combination of assets.
2
Google did, however, announce that it would assess medium-term cooperation with the military in the area of robotics. Contracts that contain a
so-called “change of control” clause are an exception. This means that special conditions are stipulated in the contract in case the control of a
contractual partner changes, which occurs in the event of a change in ownership, for instance.
3
While the new mother company is the legal successor and therewith steps into all contracts and agreements, they may contain a CoC-clause, i.e.
a “change of control”-clause. Such clauses define the status of the contract if the ownership structure of one of the contractual partners changes. It
serves that a company may limit e.g. obligations to buy goods from its main supplier after this main supplier has been taken over by the main
competitor. Typically CoC-clauses allow that in such cases, contracts and agreements may be terminated on short notice.

Chapter 4:
From another perspective, goodwill is a surplus value and basically the present value of future expected revenues
that exceed the anticipated earned interest rate on an investment. In this process, concepts such as the economic
value added model (EVA) are applied. This represents the capitalized future surplus profits (= economic value
added), in other words earnings that exceed the costs. In the determination of costs, a weighted interest rate made up
of the liabilities and equity interest rate is applied. This weighted interest rate is referred to as the weighted average
cost of capital (WACC). EVA and WACC are explained as part of key ratios in more detail (see chapter 11).
Table 21: Mini Case: Treatment of Goodwill
TREATMENT OF GOODWILL
Capitalization of Goodwill:
MINI CASE 1
0 Initial situation: Parent Ltd. buys 100% of the subsidiary Ltd. and pays 130 in cash
In the first step, the assets of the subsidiary Ltd. are revalued
1 Possible revaluations thereby increase the assets and, correspondingly, equity
Parent Ltd. Subsidiary Ltd. Subsidiary Ltd. (revalued)

Current assets Liabilities Current assets Liabilities Current assets Liabilities
100 200 100 90 150 90
Equity
Non-current assets Non-current assets
60 Equity
300 Equity 50
110
Non-current assets
200
50
Revaluation in current assets of the subsidiary Ltd.:

inventories and revaluation reserves 50
2 Calculation of balance sheet items of the parent Ltd. (new)
a) Goodwill:
Subtract the acquired equity of subsidiary Ltd. Purchase price 130
(revalued) from the purchase ./. Equity of subsidiary Ltd. (revalued) -110
Goodwill 20
b) Liabilities:
Add liabilities of the parent Ltd. and sub. Ltd. (revalued) 200 + 90 = 290 Parent Ltd. (new)
Current assets Liabilities
c) Current assets:
120 290
Add CA of the parent Ltd. and sub. Ltd. (revalued) 100 + 150 – 130 = 120
and adjust using the purchase price Non-current assets
350
d) Non-current assets: 300 + 50 + 20 = 370
Equity
Add NCA of the parent Ltd. and sub. Ltd. (revalued),
200
and include goodwill as an intangible asset
Goodwill 20
(Part of NCA)
e) Equity: residual value (must correspond to the original equity of the parent Ltd.)
Impairment Test:
MINI CASE 2
a) Definition: Sum of future cash flows 125

Impairment test = examining the value of goodwill ./. Subsidiary Ltd. equity (revalued) 110
Fair value of goodwill 15
b) Execution:
At least once a year or if indications appear that goodwill no longer has a certain value
Parent Ltd. (new)
c) Procedure: Current assets Liabilities
Valuation of the future economic benefit of the assumed assets and liabilities/equity 120 290
(valued at present value, i.e. discounted)
Non-current assets
d) Example: year following takeover of subsidiary Ltd.: 350
• Market environment of subsidiary Ltd. worsens Equity
• The sum of future cash flows (as a measure of economic benefit) is estimated at 125
195
• New fair value = future cash flows 125 less subsidiary Ltd. equity (new) 110 = 15
Goodwill 15
• New goodwill fair value of 15 is less than balance sheet goodwill of 20 (Part of NCA)
• Impairment of 5 is necessary, whereby goodwill is reduced to 15 and equity to 195
Note. Own depiction
Pursuant to IAS 36, a so-called impairment test must be performed on goodwill annually or more often in the event
of indications of depreciation (e.g. market changes or a decline in sales), which may result in an impairment of

Chapter 4:
goodwill if necessary. In contrast to many other non-current asset positions, goodwill is not subject to a depreciation
schedule but is instead subject only to impairments where necessary. During the impairment test, an assessment is
made as to whether the present value of the assets of the previously acquired company corresponds to or exceeds the
amount capitalized as goodwill. In order to determine the present value of the assets, the future cash flows of the
acquired company are usually estimated and subsequently discounted using the WACC (see EVA and WACC). The
new present value of the assets corresponds to the new fair value of the goodwill. If this new value falls short of the
goodwill disclosed for this company in the statement of financial position, an impairment must be carried out and
the book value of the goodwill reduced to the level of the lower fair value. However, if the new fair value of the
goodwill exceeds the book value in the following period, appreciation is not permitted. There is a ban on impairment
reversals for goodwill.
The purchase of Sanitec Group by Geberit in February 2015 for around CHF 1.2 billion is one of the many examples
where a goodwill is paid for expected synergy effects (details see chapter 11.3). As the following excerpt from the
annual report 2015 shows, the difference between the price paid and the value of the net assets acquired was around
CHF billion 0.9. Therewith, goodwill accounted for around three-quarters of the price paid. Geberit reasons this high
goodwill expected synergy potentials with cost efficiencies, expanded product portfolio, and accessing new
geographical markets.
Figure 48: Geberit Example: Goodwill
Goodwill paid by Geberit when acquiring Sanitec Group

Geberit Goodwill EXAMPLE
From: Geberit Group Annual Report 2015, pp. 97f

Chapter 4:
For a 100% acquisition, the goodwill is calculated by deducting revaluated net assets from the purchase price as
discussed above. If however the target company is not acquired by 100%, i.e. and the acquisition is only between
50% and 100% of the shares from the target company, the goodwill calculation requires further considerations. IFRS
3 requires choosing either the Full Goodwill method or the Partial Goodwill method. Using the Full Goodwill
method, also the minority shares are considered for the calculation of the goodwill. The Partial Goodwill method
in contrast allows disclosing only the goodwill that is applicable to the owner that is preparing the consolidated
financial statement. So the Full Goodwill method calculates the purchase price that would have to been paid for
acquiring 100% of the new subsidiary (in the example below 180 is paid for a 60% share in the new subsidiary, so
the purchase price for 100% of the subsidiary would be 300). Then the total revaluated equity of the subsidiary is
subtracted from the 100% purchase price to calculate the goodwill. The Partial Goodwill method uses the effective
purchase price (for the e.g. 60% share in the subsidiary) and deducts the respective revaluated equity (e.g. 60%) to
calculate the goodwill. While IFRS allows choosing either of the methods for each individual acquisition, US-
GAAP only allows the Full Goodwill method. The following examples introduce the respective calculations.
Table 22: Mini Case: Comparison Full Goodwill and Partial Goodwill methods
Full Goodwill and Partial Goodwill methods

MINI CASE 1
0 Initial situation: Parent Ltd. buys 60% of the subsidiary Ltd. and pays 180 in cash.
The revalued net assets of the subsidiary Ltd. are 200
a)  Full Goodwill method: Purchase price (for 60%) 180

1
Calculate the 100% price of the subsidiary Ltd. by + price for minority share (for 40%) 120
including the minority value and deduct the full - equity of subsidiary Ltd. (revalued) -200
(revalued) equity of subsidiary Ltd. Goodwill 100
b)  Partial Goodwill method: Purchase price (for 60%) 180

deduct the acquired (partial) (revalued) equity from - share in equity of subsidiary Ltd. (revalued) -120
the purchase price Goodwill 60
Note. Own depiction
4.4.3.3 Personnel, Know-how, Customer Lists
Every company has specially trained personnel and/or specific know-how (which is not patentable and is therefore
customarily bound to individual key performers) and/or an existing customer base that loyally consumes the
company's goods or services, as well as other particular intangible assets that are important for success on the
market (e.g. image, reputation, etc.). None of these intangible assets can be capitalized and are therefore not
reflected in financial reporting. These assets may not be reported under non-current assets. Customarily,
capitalization is not allowed because the recognition criterion “control/authority to dispose” is unsatisfied. For
example, due to the voluntary nature of contracts and their right of termination, a company only has limited control
over employees and customers. Indirect capitalization is possible, however, if a premium (goodwill) is paid for such
know-how or the customer base by the acquiring company within the context of a takeover. The goodwill must be
reported in this case. Goodwill should not, however, be interpreted as an asset position for know-how; instead,
goodwill must be interpreted as the sum of all reasons for the premium paid. In the case of business combinations as
well, personnel-specific know-how or customer lists may not be separately disclosed in the statement of financial
position as intangible assets. While the capitalization of customer lists is prohibited according to IFRS, key
customers must be disclosed within the framework of segment reporting (see chapter 5.5). The company may choose
to voluntarily disclose information regarding know-how, personnel and customer lists in the management report.

Chapter 4:
4.5 Valuation of selected Liability Positions
LEARNING OBJECTIVES

• Recognizing the meaning, structure and composition of liabilities
• Recognizing the definition and disclosure in the statement of financial position of existing liabilities and
provisions
Liabilities reveal the extent to which the company is dependent on financing through third parties and the scope of
future expected charges required to service this external funding. The structure of liabilities provides interested
parties with information concerning the maturity of the liabilities. The following examines the most important
fundamentals of the valuation of liabilities.
In the statement of financial position, the structure of liabilities is most often based on two criteria: maturity on the
one hand (short-term and long-term liabilities), and the question of whether the liabilities position is interest bearing
or not on the other. However, it is possible for one and the same liability to be reported as non-current and have a
part simultaneously recognized as a short-term liability. This is the case with loans that are paid back over a certain
number of years. The loan amount not due in the following twelve months appears under long-term liabilities, while
the next payment installment comes under short-term liabilities.
Liabilities are divided into debt and provisions. Debt represents existing contracts with suppliers and investors.
Provisions are obligations that are expected but the exact timing as well as exact amount of which are uncertain, i.e.
they are liabilities that have a certain uncertainty with respect to time and amount.
4.5.1 Liabilities
BOX: IFRS 9 Financial Instruments: Financial Liabilities
Initial situation: 2009 saw the beginning of an overhaul of the valuation of financial instruments due to the financial crisis of
2008. In the same year, the IASB published the first draft of IFRS 9. On July 24, 2014, the IASB disclosed
the final standard for IFRS 9, which now finally defines the new rules regarding disclosure of impairment
as well as the change in classifications and valuation of financial assets. IFRS 9 applies for business year
starting at or after January 1, 2018 and therewith it replaces IAS 39 as of 2018.
Content: Disclosure in the statement of financial position and valuation of financial assets and liabilities.
Core tenets: § Financial liabilities held for trading purposes must be valued at fair value. Value adjustments must
be recognized on the statement of profit or loss and other comprehensive income.
§ All other financial liabilities not belonging to a special category are to be valued at amortized cost.
§ There are specific regulations for the following special categories: obligations from continuing
involvement, financial guarantees and low-interest loan commitments.
Delimitation: IFRS 7 stipulates disclosure regarding financial instruments in the notes.

Chapter 4:
Financial liabilities are disclosed in the statement of financial position according to IFRS 9 (prior to 2018, the
applicable standard was IAS 39). The procedure for determining the recognition and valuation methodologies is
identical to their determination for financial assets (see chapters 4.3.3 and 4.4.2). To start with, the liability is
classified and then correspondingly valued. Customarily, financial liabilities held for trading purposes and other
financial liabilities comprise the largest portion of liabilities. Financial liabilities held for trading purposes also
include liabilities entered into with the intention of short-term payment, such as trade payables. The following
overview presents the classification and corresponding valuation methodology.
Figure 49: Classification and Valuation of Financial Liabilities Pursuant to IFRS 9
Financial liabilities
All financial liabilities not Financial liabilities held for Payables Financial guarantees Obligations to grant
included in another trading purposes: low-interest loans
• from financial assets
category • acquired with the intention transferred but not written
Classification
of short-term disposal, off, and

• part of a portfolio that is • from continuing
managed together and is to involvement
be sold in the short term, or
• derivatives (not part of a
hedge)
(1)
Valuation
Fair value through profit Consideration and/or net Fair value – transaction costs
Amortized cost
and loss book value (IAS 37 / IAS 18)
(1) Fair-value option:

• Choice per liability
• Prerequisite: There is a
significant reduction in balance
sheet or valuation
inconsistency through the
reclassification
The most important liabilities positions and their accounting treatment are as follows:
§ Trade Payables
Liabilities with suppliers and trade payables (accounts payable) are disclosed in the statement of financial
position in the same way as trade receivables (assets side). For more information, see chapter 4.3.2. Separate
reporting of obligations vis-à-vis affiliated companies (parent companies, subsidiaries and affiliated
companies) is important. Reporting takes place analogous to the comparable asset positions.
§ Non-Current Financial Liabilities

Non-current financial liabilities are usually interest-bearing liabilities with a specific term or maturity of
more than one year. The interest-bearing debt of a company plays a central role in the further analysis of the
statement of financial position (see chapter 11). Non-current financial liabilities can be divided into
instruments traded on the stock exchange and those not eligible to be traded on an exchange.

Chapter 4:
Financial liabilities traded on a stock exchange include straight bonds, convertible bonds, zero-coupon bonds,
variable-rate instruments (floaters), etc. Analogous to investments, financial liabilities traded on an exchange
are disclosed in the statement of financial position pursuant to IFRS 9 (see chapter 4.3.3), whereby the
business background behind the holding of the instrument is of key importance for its accounting treatment.
Financial liabilities not eligible to be traded on an exchange, such as bilateral financial liabilities between a
financial institution and the company, are recognized at their nominal value. Mortgages fall into this category
but are usually legally terminable at short notice (within three to six months), unless the mortgage in question
is a fixed long-term mortgage. However, the substance over form principle stipulates that all mortgages,
regardless of termination, are disclosed as long-term liabilities.
Financial liabilities usually have a common characteristic of interest being owed to capital providers
(investors or banks) for the capital made available. The interest expense or financial expense is recognized in
the statement of profit or loss and other comprehensive income or on an accrual basis (accrued expenses) in
the statement of financial position if the accrued interest expense has not yet been paid at the reporting date.
Partial payment of the debt during its term is referred to as amortization and the payment of the entire debt at
the end of the term as repayment.
§ Accrued Expenses
With accrued expenses, accounting doctrine differentiates between anticipated liabilities and accrued
expenses in a narrower sense. Anticipated liabilities arise from having already received a service without the
corresponding performance in kind being due yet. Accrued interest on bonds is an example of this. Accrued
expenses in the narrower sense arise from payments already received without having delivered the
corresponding service yet. Examples of this are advance payments from tenants or from insurance policy
holders to the company carrying the position in the statement of financial position. Accrued expenses are
usually disclosed in the statement of financial position at their pro-rated nominal value.
4.5.2 Provisions
BOX: IAS 37 Provisions, Contingent Liabilities and Contingent Assets
Content: Determination of capitalization, definition of the valuation of provisions, contingent liabilities and
contingent assets.
Core tenets: Provisions are defined as current legal or constructive obligations arising from a past event that are
associated with a probable outflow of resources and the amount of which can be reliably estimated.
Valuation ensues according to the “best estimate” concept. This means recording the liability using the
best possible estimate of the resource outflow required to settle the obligation on the reporting date. The
obligation must be discounted using a market interest rate congruent with the due date, if this effect is
assessed as material. Future events that could influence the settlement amount must be taken into account
as soon as objective substantial indications of these appear.
Contingent liabilities and contingent assets are only to be presented in the notes.
Delimitation: Individual details and stipulations can be found in the specific IFRS / IAS standards.
Provisions are obligations that the company is exposed to on the reporting date, but their exact timing and amount
are vague, but rather certain (i.e. a certainty/probability above 50%). This unpredictability of provisions repeatedly

Chapter 4:
leads to the need of additional disclosure. In addition to the general definition and recognition criteria that apply to
all liabilities, IFRS has defined additional criteria regarding at what point in time, at what value and at what level of
detail the provision are disclosed in the statement of financial position and/or in the notes. In IAS 37, the probability
of the resource outflow as well as the probability of the amount of the resource outflow primarily determine whether
a provision must be recognized. If the resource outflow is probable but the amount cannot be reliably estimated, the
obligation must be mentioned as a contingent obligation in the notes. If the obligation exists but the probability of an
outflow of resources is low, no disclosure of any kind is required.
If a circumstance fulfills the definition criteria but not the recognition criteria for being disclosed as a liability in the
statement of financial position, an additional check on recognition as a provision is required. In order to be reported
as a provision, all three of the following preconditions must be met:
§ The company has a present obligation of a legal or constructive nature that arose from a past event
§ The probability of a resource outflow in order to settle the obligation
§ Reliable estimation of the obligation amount is possible
Correspondingly, provisions are characterized by uncertainty concerning whether the performance obligation will
occur at all and concerning its scope or timing. The resource outflow is deemed probable if there is more reason to
expect it than not, i.e. the probability of it occurring is more than 50%. The amount of the resource outflow is
deemed reliably estimable if it can be determined with a probability of more than 50%.
Provisions are clearly established circumstances in financial reporting and can be distinguished from the following
three terms:
§ Reserves: reserves that are a component of equity

§ Impairments: in the sense of valuation adjustments for assets, even if these impairments are reported on
the liabilities and equity side and are not deducted directly from the relevant asset
§ Accrued and deferred positions: see previous chapter
Figure 50: Nestlé Example: Provisions, Contingent Liabilities and Contingent Assets
Nestlé EXAMPLE

Chapter 4:
With these three positions of the statement of financial position, it has already been established that the liabilities
and equity position justifiably exists, and the amount and maturity are certain. In addition, provisions may not be
confused with future operating losses. Future operating losses from ordinary business activities are not allowed to be
recognized as provisions.
In order to achieve appropriate accounting recognition of current obligations and future risks, provisions are checked
according to the following decision tree.
Figure 51: Decision Tree for the Recognition of Provisions
Present obligation due to

No No
the occurrence of a
Possible obligation?
mandatory event in the
past
Yes
Probable economic No Probability of economic Yes

benefit? benefit is negligible?
Yes
Obligation amount can be No (infrequent)

reliably estimated?
Yes
Provision: Contingent liability:

a) Recognition in the a) No recognition in the
No disclosure
statement of financial position statement of financial position
b) Explanation in the notes b) Explanation in the notes
If disclosure of the provision as a liability in the statement of financial position fails because one or several of the
above criteria are not fulfilled, it must be tested whether, at most, a contingent liability exists. A contingent liability
is not disclosed in the statement of financial position as a liability. Instead, there is an obligation for disclosure in the
notes (see chapter 7.3). Provisions can be divided into different subcategories. The designation is up to the company.
The most frequent division of provisions comprises warranty provisions, provisions for pending transactions,
provisions for restructuring measures and provisions for legal disputes.
Warranty Provisions
Warranty provisions are established to satisfy a guarantee obligation (warranty obligation or obligation for correct
delivery, particularly with regard to quality) for products and/or services arising from statutory requirements,
general business terms and conditions, or contractual requirements. Such provisions are, on the one hand, necessary
wherever warranty expenses are significant in order to meet legal business requirements; on the other hand, they are
also interesting from a tax perspective, provided that the tax authorities allow provisions to be claimed as
deductions. The best method is to effect the calculation based on fundamentals that have been valid for a long time,
for example on the average value of the last X years or with declining percentage rates for the last one to three years,
for instance. In this case, for example, 3% of sales would be calculated as the general warranty provision amount for
the reporting period, 2% for the prior year, and 1% for the year before that.

Chapter 4:
Provisions for Pending Transactions

Provisions for pending transactions are often hedging transactions, such as raw materials contracts for cotton. In the
textile industry, cotton is often purchased long before via contracts in order to secure pricing. But because prices are
quoted in US dollars and cotton as a commodity is subject to market price fluctuations (supply and demand are
partially influenced by the harvest), price levels may be extremely volatile. If a contract (purchase) is entered into
for termination in 12 months and if the price is significantly lower at the reporting date (which is for example 8
months after the contract has been entered into and 4 months prior to maturity), the transaction must be valued as
loss-free, i.e. the difference in price must be reported as a provision. Whether the price is actually higher or lower in
4 months at the maturity date than at the reporting date is unknown.
Provisions for Restructuring Measures

Provisions for restructuring measures usually originate from various restructuring projects within a firm. These
could comprise, for example, plans for more efficient utilization of industrial production capacities through the
closure or consolidation of production sites. Restructuring measures also encompass optimizations of existing
production facilities or services that include significant reorganization (for example, changes in the management
structure). Because restructuring changes existing business processes and organizations, provisions represent the
anticipated resource outflows lasting until the end of the restructuring measures, when higher resource inflows
should be forthcoming. In order for restructuring measures to be recognized, there must be a formal plan that
describes in detail the relevant business area and the effects (persons, costs, location, facilities, etc.), implementation
of the plan must have been initiated before the reporting date, and those affected must already be informed.
Provisions for Legal Disputes
Table 23: Sonova Provisions for Legal Disputes
SONOVA PROVISIONS FOR LEGAL DISPUTES

CASE STUDY
MEDIA ANNOUNCEMENT
April 26, 2013
Implant Provisions
Sonova Announces Threat of Profit Decline
Swiss hearing aid manufacturer Sonova is bracing itself against claims for damages associated with faulty inner-ear
implants. The global market leader is putting an additional CHF 198 million aside for lawsuits against subsidiary
Advanced Bionics. The provisions will be booked in the 2012/13 fiscal year, Sonova announced on Friday. Until now,
analysts had expected a profit of CHF 325 million for the 2012/13 fiscal year ending March 31.
A US court last week awarded a plaintiff unexpectedly high damages of USD 7.25 million. Sonova intends to appeal
against the judgment. Nevertheless, the company is increasing its provisions to a total of CHF 250 million for further
lawsuits in connection with the implants.
More than 4000 devices were implanted between 2003 and 2006. A faulty outsourced component prompted Sonova to
initiate a product recall in 2006. Sonova estimates that approximately half of the devices could malfunction. To date,
around one third of the implants have been replaced. In numerous other cases, Sonova was able to reach a settlement with
the patient. “At the moment, 27 cases are pending, but this number may vary on a daily basis,” stated CEO Lukas
Braunschweiler. He does not foresee class-action lawsuits. Nonetheless, Sonova is preparing for legal disputes that may
last a long time. “This may keep us or our legal bodies occupied for the next four to eight years,” the CEO explained.
Note. From: NZZ (April 26, 2013). http://www.nzz.ch/aktuell/wirtschaft/wirtschaftsnachrichten/sonova-warnt-wegen-implantat-rueckstellung-
vor-gewinneinbruch-1.18071683

Chapter 4:
Provisions for legal disputes encompass disputes arising from tax, legal and administrative proceedings that occur
during the ordinary course of business. Provisions for legal disputes are also referred to as litigation provisions,
among other terms. Litigation provisions primarily comprise provisions for product liability cases and general
liability cases in connection with large accidents. For example, litigation provisions were established for the Prestige
tanker accident in Portugal in November 2002 and the Costa Concordia cruise ship accident off the coast of Italy in
January 2012.
Pension Provisions
Pension provisions are also important provisions. IFRS and Swiss GAAP FER distinguish in principle between
defined benefit and defined contribution pension plans. The provisions show the obligation of the company for
future pension payments to current and former employees. All companies must disclose any commitments and
obligations related to defined benefit pension plans in the statement of financial position (see chapter 5.4.2). Due to
legal stipulations, companies in Switzerland must outsource pension planning and management to independent
foundations or cooperatives (pension funds). Because Swiss companies, regardless of the selected pension plan
(defined benefit or defined contribution), generally have a constructive obligation vis-à-vis these foundations or
cooperatives (see chapter 5.4.2), the net obligations (difference between assets and expected obligations) are
reported in the consolidated financial statements of the group according to IFRS. In Switzerland, the actuarial
mathematical reserves (calculated based on life expectancy, mortality tables, etc.) or provisions are therefore
established in the pension funds and not in the statement of financial position of the companies. In its financial
reporting, a company shows only the period-relevant costs for the pension plans (pension expenses), the recognition
on an accrual basis of these contributions at the reporting date, and the debts and receivables vis-à-vis the pension
fund. By contrast, in Germany, companies have the option of paying retirement pensions directly. Consequently, the
corresponding provision requirement must be disclosed in the statement of financial position of the company. When
analyzing companies with pension provisions, the pension fund system on which the provisions are based must be
taken into account. Only then can conclusions be drawn from the pension provisions. In this context, additional
information must be disclosed in the notes concerning the type of pension fund involved and how it is funded (see
chapter 7.3). The reference literature provides additional information regarding pension plans.
The notes reveal a great deal of information concerning all provisions. Analogous to the statement of asset additions
and disposals for property, plant and equipment (chapter 4.4.1), the provisions table in the notes presents an
overview of the provisions subcategories. For each category of provisions, formation, utilization (which does not
affect profit) and reversal (which is recognized on the statement of profit or loss and other comprehensive income)
in the reporting period are shown. A larger amount of reversals of provisions that are no longer needed may indicate
inaccuracies in previously established provisions or unanticipated positive developments. If the reversals have a
significant effect on the profit, these are explained in the provisions table in the notes. The notes also include
information concerning the underlying assumptions of the uncertainties associated with the provisions (KPMG:
Reading and understanding ARs, p. 23.).

Chapter 4:
Table 24: Mini Case: Establishing Provisions
ESTABLISHING PROVISIONS
MINI CASE
1 Initial situation
L-Tech AG sells computer keyboards manufactured in-house and provides a one-year warranty. The warranty includes
free repairs of the keyboards. Experience shows that 10% of the keyboards exhibit faults within the first year and are
returned to L-Tech AG for repair. The repairs cost CHF 7 per unit. In total, L-Tech AG sold 600 000 units in the last
fiscal year. How is this circumstance disclosed in the statement of financial position?
2 Recognition criteria
§ Does the company have a present obligation of a legal or constructive nature from a past event?
Yes, the company guarantees the functionality of the keyboard for one year. The warranty leads to an obligation.
§ Is a resource outflow in order to settle the obligation probable?

Yes, the company incurs personnel and material costs in performing the warranty repairs.
§ Is a reliable estimation of the obligation amount possible?
Yes, the company has data based on experience from past years.
3 Valuation
§ Estimation of the obligation amount:
The provision amount is determined based on the data from the company's experience.
Sold keyboards 500 000
Defective keyboards 500 000 x 10% = 50 000
Repair costs 50 000 x CHF 7 = CHF 350 000
4 Conclusion
Capitalization of a provision in the amount of CHF 350 000 for warranty repairs.
4.6 Valuation of Equity Positions
LEARNING OBJECTIVES

• Recognizing the meaning, structure and composition of equity
• Understanding the statement of changes in equity
• Understanding the definition of share capital, interest capital and cooperative capital, legal and voluntary
reserves as well as profit carried over
Equity reveals to what extent the company is financed by the owners and by retained earnings. It also provides
information concerning what amount was contributed by the owners (paid-in capital) and what amount has been
earned and retained by the company itself over time (retained earnings). As already explained in chapter 4.2.3,
equity is defined in IFRS as the difference between assets and liabilities and may correspondingly be interpreted as
the residual value.

Chapter 4:
Equity usually comprises subscribed or nominal equity capital and earned reserves. In the case of a stock
corporation, the subscribed capital is referred to as share capital, which includes shares (embody proprietary rights
and co-determination rights) and participation capital (only proprietary rights). The equity capital can be modified
by capital increases or capital reductions. Different options for capital increases for stock companies according to
Swiss law will be discussed in chapter 12.4.3.
The law in Switzerland stipulates a minimum amount of CHF 100 000 for share capital (Art. 621 CO), 20% of
which (a minimum of CHF 50 000, however) must be paid-in (Art. 632 CO). Payments that exceed the nominal
value are designated as a premium (paid-in surplus). Pursuant to Art. 622 CO, the shares may be issued as bearer
shares or registered shares (minimum nominal value 1 centime); whereby many firms issue two or more groups
with, for example, different nominal values (e.g. series A, series B) for the same category, e.g. for registered shares.
Participation capital is interesting primarily because it is not associated with voting rights and the nominal value can
be freely selected. Participation certificates without nominal value are referred to as participatory notes.
Figure 52: Composition of Equity
4.6.1 Earned Capital and Reserves
Reserves are an additional component of equity, whereby these can be differentiated according to the origin of the
resources. These reserves are disclosed in the statement of other comprehensive income (see chapter 5.2).
Retained Earnings
The Swiss Code of Obligations states that retained earnings may be divided into legal, statutory, voluntary and
resolution-related reserves. Retained earnings are formed through the allocation of the earned profit in a period.
Allocations to voluntary and resolution-related reserves are determined by the company itself in every period. Profit
carried over is profit from the previous period that has not been paid out in the form of dividends or distributed and
is also reported as a component of retained earnings. Retained earnings are an important instrument for financing of
enterprises and will be discussed in chapter 12.3.2.

Chapter 4:
With legal and statutory reserves, established percentages of the profit are allocated to the reserves. The law
regulates reserves to the extent that certain allocations from the profits to a so-called legal reserve (“reserve fund”)
must be performed. These allocations to the legal reserves must ensue only until the reserve has reached a
designated percentage of the share capital. The corresponding rules are formulated in Art. 671 CO and require the
following:
§ The allocation of 5% of profit until a legal reserve of 20% of the share capital has been reached.
§ Allocation of the premium from capital transactions as well as 10% of those dividends, etc., that are
distributed and exceed the amount of 5% of the equity capital. This allocation is necessary only until the
legal reserve has reached 50% of the equity capital.
Modified regulations apply for holding companies.
Currency Translation Reserves

With the consolidation of foreign companies, the separate financial statements prepared in local currencies are
converted into the functional currency of the parent company. The currency translation differences generated by this
conversion from the local currency to the functional currency of the parent company are reported separately in
equity and are not disclosed in the statement of profit or loss and other comprehensive income. The currency
translation reserves continue to be reported, but are not disclosed in the statement of profit or loss and other
comprehensive income, until the foreign company has left the group. With the exit from the group of consolidated
companies, the reserves are dissolved and disclosed in the statement of profit or loss and other comprehensive
income (Pellens p. 488.).
Revaluation Reserves
The revaluation method of asset valuation was explained in chapter 4.4. In the revaluation method, value
adjustments in subsequent valuations of property, plant and equipment or intangible assets are recorded in
revaluation reserves in equity in a manner not affecting profit. All value adjustments are accumulated as differences
to the fair value (revaluation method) in the revaluation reserves, or impairment losses lead to a reversal of the
revaluation reserves in a manner not affecting profit (Pellens p. 488.).
Reserves from the Valuation of Financial Instruments

The timely valuation of designated financial instruments leads to reserves from financial instruments, analogous to
the revaluation reserves of assets. IFRS 9 stipulates that gains and losses from value adjustments of assets to fair
value through OCI are not permitted to be presented in a manner affecting profit. The respective value adjustments
as differences to fair value are accumulated in the reserves from the valuation of financial instruments. (Pellens p.
488.)
Actuarial Gains / Losses from Pension Obligations

Pension plan obligations of a company vis-à-vis its employees are very complex and are determined by means of
mathematical calculations. In doing so, life expectancy rates and other factors are incorporated. A change in the
actuarial assumptions as well as the difference between the actuarial assumptions and the actual events generate
actuarial gains or losses. These are in part directly disclosed in the statement of profit or loss and other
comprehensive income and in part disclosed as equity, thus not affecting profit (Pellens p. 488.).

Chapter 4:
4.6.2 Statement of Changes in Equity Ne pas lire

The IFRS conceptual framework defines the statement of changes in equity as one of the five mandatory
components (in addition to the statement of financial position, statement of profit or loss and other comprehensive
income, statement of cash flows and notes). The Swiss Code of Obligations also stipulates the disclosure of changes
in equity. The purpose of the statement of changes in equity is the presentation of changes in equity between two
reporting dates or changes in the net assets of the company pursuant to the applied standards. Various transactions
can change equity without these appearing in one of the other mandatory components, for example transactions with
the owners such as increase in stock capital. A detailed presentation of these changes is therefore of essential
importance to shareholders.
Figure 53: Nestlé Example: Statement of Changes in Equity

Nestlé EXAMPLE
Profits for the year Comp.

Other comp. income income
Transactions with
shareholders

(see chapter 3.5)
The changes in equity can, in principle, be divided into six components, which are explained below:
§ Results from ordinary business activities (component of profit or loss for the year)
§ Extraordinary results (component of profit or loss for the year)4
§ Other comprehensive income
§ Capital increases
§ Capital decrease
§ Capital distribution
For illustration purposes, the components are presented in dark blue in the following diagram.
4
According to IFRS, extraordinary results, i.e. extraordinary income and expenses, only apply in exceptional cases for events that occur outside
of the influence of the company, e.g. natural disasters.

Chapter 4:
Figure 54: Composition of Equity
Change in equity
Comprehensive income as per statement of profit or loss and

Transactions with shareholders
other comprehensive income (comprehensive income)
Net profit or loss as per statement of profit Capital Capital Capital

Other comprehensive income
or loss and other comprehensive income increases decreases distributions
Income from
Extraordinary
ordinary business
activities income
Other Comprehensive Income

OCI encompasses profit components that do not affect net profit as they are offset directly with equity. In particular,
currency translation differences from consolidation, revaluations of assets and financial instruments, and actuarial
gains/losses are to be cited here. These transactions have already been discussed in the previous chapter. Many of
these revenues and costs are recorded at a later point in time, for example at their conversion, in the statement of
profit or loss and other comprehensive income in a manner affecting profit.
Figure 55: Nestlé Example: OCI

Nestlé EXAMPLE

Chapter 4:
Transactions with Shareholders

These transactions are reflected in the paid-in capital of equity. Transactions with shareholders encompass capital
increases, capital reductions and distributions. The types of capital increases were explained in the previous chapter.
The best-known form of distribution and also the proper procedure for distributing earned capital is the dividend.
Dividends are first taken into account in the year in which they are paid (i.e. after the reporting period).
Correspondingly, the financial statement shows a financial presentation before profit distribution. In determining the
dividend, the possible uses for the reserves must be considered. As already mentioned, there are different types of
reserves. The appropriation possibilities for the legal reserves are restricted. Appropriation of the free as well as the
legal reserves is decided on exclusively through resolutions of the shareholders' meeting. All retained earnings not
allocated to the legal or free reserve positions (or those marked with similar designations) are posted to the profit
carried over. The profit carried forward is increased by the profit of the period at the behest of the shareholders'
meeting (effectively the profit of the period that is not decided for distribution to the shareholders).
Extraordinary Results/Income
This component summarizes all revenues and costs not associated with the actual business activities of the company.
For example, sales of assets or reversals of provisions that are no longer needed are reported here.
Income from Ordinary Business Activities

This component of the statement of changes in equity is taken directly from the statement of profit or loss and other
comprehensive income and is computed from all revenues and costs arising from within the context of ordinary
business activities.
The change in equity is closely linked to the statement of profit or loss and other comprehensive income. The
income from ordinary business activities and extraordinary result are identical with the profit of the period from the
statement of profit or loss (see chapter 5.2), and adding the other comprehensive income (OCI) equals the result of
the statement of profit or loss and other comprehensive income.
4.7 Summary
The statement of financial position provides decision-makers with important information concerning the financial
and asset position of a company. While the assets side reveals the resource commitment and thereby differentiates
between non-current and current assets, the liabilities and equity side shows the financing of the company through
liabilities and equity.
Definition, Recognition and Valuation

With regard to disclosure of individual positions in the statement of financial position, the three-part initial question
applies, in principle: definition, recognition (disclosure in the statement of financial position) and valuation. The
question of definition examines whether the circumstance fulfills the criteria of an asset or a liability. For this, the
definition criteria for assets, liabilities, provisions and equity are relevant. In contrast, recognition (via the
recognition criteria) questions whether such a circumstance should be disclosed in the statement of financial

Chapter 4:
position. If both previous questions were answered positively, the valuation question clarifies what amount will be
disclosed in the statement of financial position for the asset, liability or equity.
Assets
The most important positions are inventories, receivables and loans, short-term and long-term investments, property,
plant and equipment and intangible assets. In principle, assets are disclosed in the statement of financial position at
their acquisition cost or cost of conversion at the initial valuation. Investments, however, are categorized into
valuation at amortized cost or at fair value. In the subsequent valuation of inventories, valuation simplification
methods such as FIFO or the standard cost method may be applied in order to execute valuation more quickly and
easily. For the subsequent valuation of property, plant and equipment, there are the acquisition/conversion cost
model and the revaluation model. Trade receivables and loans are customarily disclosed in the statement of financial
position at their nominal value. Trade receivables and loans must undergo impairment tests. These impairments for
trade receivables are referred to as value adjustment for receivables. In the subsequent valuation, the wear,
depreciation and development of market prices must be considered for all assets. The lower of cost or market
principle stipulates that, in the event of numerous available values, the lowest value must be recognized.
Liabilities and Equity

The liabilities and equity side of the statement of financial position provides stakeholders with valuable information
concerning the origins of the resources. In principle, the liabilities and equity side is organized by liabilities and
equity. Equity shows the financing of the company with its own capital, while liabilities show the financing of the
company with resources made available by third parties. The most important positions are trade payables, provisions
as well as long-term financial debt. Trade payables are recognized analogous to receivables. With provisions,
specific preconditions must be fulfilled before they are permitted to be disclosed in the statement of financial
position. It is also essential to understand that equity represents the residual interest of assets minus debt.
Furthermore, equity can be divided into paid-in and earned capital. Other comprehensive income also plays an
important role as an equity component, as certain transactions lead to recognition that does not affect profit and is
not disclosed in the statement of profit or loss and other comprehensive income.

mit Beispielen, Repetitinsfragen und Antworten. (4. überarbeitete Auflage). Zürich: Compendio
Bildungsmedien.
SKV.

Chapter 4:
Schaeffer-Poeschel.

Chapter 5:
Statement of Profit or Loss 124
Statement of Profit or Loss
Information about a company's profitability is provided

through periodical financial reporting in the statement of
profit or loss and other comprehensive income. This
contains information about an entity's entrepreneurial
performance and the efficiency of its economic
activities, as it compares output and input in the
reporting period. According to the IFRS conceptual
framework, the statement of profit or loss is an integral
part of the statement of other comprehensive income. Notes. Own depiction.
5.1 Introductory Example from Looser
INTRODUCTION: STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
Looser Steps up Sales with Doors

The industrial group Looser has posted rising sales for 2012.
While the door business thrived, cranes were not so popular. In
2012 the industrial group Looser from Arbon, Thurgau,
increased sales by 3.9 percent to CHF 472.9 million. The
company has announced that both temperature control and
doors showed pleasing growth. The other segments trailed
behind.
After adjustment for the effects of currency changes, additional

purchases and divestment, sales growth reached 4.2 percent.
The coatings division was not left unscathed by the effects of the downturn in Western Europe and the growing weakness in
Asia. This resulted in adjusted sales growth of 0.4 percent. In the industrial business, trade in cranes and space systems was
down, which caused a decline in sales of 2.3 percent after currency adjustment.
Temperature Control and Doors

The temperature control sector, on the other hand, was able to benefit from the heavy demand from the German home market,
export countries and the semi-conductor industry. Sales grew by 20.2 percent after currency adjustment. The doors segment
grew by 7.4 percent on this basis. This was mainly fuelled by favorable conditions for new buildings and renovations in

Chapter 5:
Germany. After adjustment for one-off effects of CHF 9.2 million from the previous year's results, Looser expects a higher
operating profit in 2012. The company publishes its financial statement on March 20.
Article has been modified. From: Handelszeitung (April 28, 2012).
1. What does the development of sales tell us about the company?
2. What figures from the statement of profit or loss and other comprehensive income, besides sales, are particularly interesting
for the assessment of the earnings position?
3. Why is a segment report or division according to segments important? What needs to be taken into account here?
5.2 Definition and Content of the Statement of Profit or Loss versus the
Statement of Comprehensive Income
LEARNING OBJECTIVES

• Knowing the definition of the statement of profit or loss versus the statement of comprehensive income
• Understanding the content and the classification of the statement of profit or loss
The main function of the statement of profit or loss and other comprehensive income is to disclose information
regarding an entity's success or lack of success. “Success” is used here as a neutral designation for profit and loss.
As the statement of profit or loss and other comprehensive income always presents the relevant business activities
during a certain period (unlike the statement of financial position, which shows the situation on a certain cut-off
date) and “success” must therefore be seen in relation to a certain period, we speak of the “result for the period.”
This chapter initially discusses the statement of profit or loss and other comprehensive income and then explains the
difference between the statement of profit or loss and the statement of other comprehensive income.
In principle, all income and expense positions in the reporting period have to be taken into account when
determining the profit or loss for the year (result for the period). As already explained in chapter 4.6.2, this covers
ordinary business activities and extraordinary profits or losses. In a similar way to the statement of financial
position, which compares assets and liabilities, the statement of profit or loss and other comprehensive income
compares income and expenses. Income accrues when an asset rises in value or a liability falls in value. At the same
time, income is recorded by adjusting the statement of financial positions’ position in question. Upon the sale of a
product, for instance, a customer receivable is created on the statement of financial position, and in the statement of
profit or loss and other comprehensive income the income is posted as revenue. Expenses arise when an asset falls in
value or a liability rises in value. This happens, for instance, when various materials have to be purchased in order to
manufacture a product. On the statement of financial position this purchase results in a liability towards suppliers. In
the statement of profit or loss and other comprehensive income it appears as expenses (cost of goods).
The comparison of income and expenses in the statement of profit or loss and other comprehensive income has the
purpose of calculating the “correct” result for the period and is therefore based on the accrual principle in
accordance with the IFRS conceptual framework. The period of time plays a role in apportioning income and
Chapter 5:
expenses into certain slices of time. Due to this appointment, a new statement of profit or loss and other
comprehensive income is started for each defined accounting period (such as a quarter, a half-year or a year). So
income and expense accounts, unlike statement of financial position accounts, have no opening balance. The
statement of profit or loss and other comprehensive income can also be defined as a list of adds and outs of cash,
goods and services that affect income, with the purpose of presenting a result generated within a certain period of
time.
Definition of The statement of profit or loss is a clear list of all expenses and earnings during an accounting period, with
statement of the purpose of accounting for the business activities and calculating the result for the period as profit or loss
profit or loss from the difference between income and expenses (Schellenberg 2000, p. 69.).
In order to present overall business success during a period, it is also necessary to take account of matters that
influence an entity's equity but that are not reported as affecting profit in the statement of profit or loss and other
comprehensive income. These changes in equity not affecting profit may be due to the translation of positions from
the financial statement which are in foreign currencies into a reporting currency, for instance. Exchange rate
fluctuations from period to period also affect equity, independently of the result for the period. These changes in
equity that do not affect income are referred to as “other comprehensive income” and are also part of the content of
the statement of other comprehensive income, in addition to the result for the period (see also chapter 4.6.2). The
accrual principle, which we have already come across, and the period analysis apply in the same way in relation to
other comprehensive income and in the statement of other comprehensive income.
Definition of statement The statement of other comprehensive income is a list of the annual profit or loss from ordinary
of other comprehensive business activities (statement of profit or loss) and other comprehensive income from matters not
income affecting profit.
5.2.1 Difference between the Statement of Profit or Loss and the Statement of Other
Comprehensive Income
IAS 1 Presentation of Financial IFRS Conceptual Framework

Statements
(see chapter 3.5.1)
In the IFRS conceptual framework and in IAS 1, the statement of profit or loss does not appear as an independent
part of the financial statements. Instead it is part of the statement of profit or loss and other comprehensive income,
which according to IFRS is the main statement for information regarding earning positions. The statement of other
comprehensive income encompasses the statement of profit or loss, called Erfolgsrechnung in Switzerland and in
the Swiss Code of Obligations (CO). The CO only uses the term statement of profit or loss (Erfolgsrechnung) (Art.
959b of the Code of Obligations (CO)). The statement of profit or loss generally reports the profit for a period as the
balance of income and expenses affecting profit. This is also the reason why IFRS makes a distinction between a
statement of other comprehensive income and a statement of profit or loss. In the statement of other comprehensive
income, “other comprehensive income” (OCI) is reported separately. Therefore the statement of other
comprehensive income also includes additions and disposals of cash, goods and services that do not affect profit. As
already mentioned in chapter 4.6.2, transactions that do not affect profit are initially recognized in equity and do not

Chapter 5:
appear in the statement of profit or loss, but it is likely that the transactions will affect profit at a later point in time
and then they are disclosed in the statement of profit or loss. The statement of other comprehensive income therefore
shows relevant changes in value due to market developments (e.g. differences arising from foreign currency
translation).
Figure 56: Nestlé Example: Statement of Other Comprehensive Income

Nestlé EXAMPLE
5.2.2 Background on “Other Comprehensive Income”
“Other comprehensive income” has not been part of IFRS financial reporting for very long, which is why its history
is so important in order to understand it. In recent years it has increasingly been found that changes in valuation
approaches and market conditions have had a strong influence on certain statement of financial position and
transactions, thus causing a great deal of volatility of annual profit or loss. Many of these matters were not
accounted for in detail in financial reporting before the statement of other comprehensive income was introduced. In
order, on the one hand, to limit this volatility and not to mix valuation transactions too much with the ordinary profit
or loss for a year, as well as to increase transparency in relation to volatility, “other comprehensive income,” modern
financial reporting uses the statement of other comprehensive income as an addition to the statement of profit or
loss. This means that matters and transactions relevant for valuation can be recognized in “other comprehensive
income” without affecting profit, and without influencing the profit or loss for a year. The following figure shows
how other comprehensive income is classified in the statement of profit or loss and other comprehensive income.

Chapter 5:
Figure 57: Classification of Other Comprehensive Income
Change in equity
Comprehensive income as per statement of profit or loss and

Transactions with shareholders
other comprehensive income (comprehensive income)
Net profit or loss as per statement of profit Capital Capital Capital

Other comprehensive income increases decreases distributions
or loss and other comprehensive income
Income from
ordinary business Extraordinary
income
activities
Other comprehensive income is explained in greater detail in chapter 4.6.2, Statement of Changes in Equity. The
connection between other comprehensive income and the obligatory components of financial reporting is shown in
Figure 19 in chapter 3.5.1.
5.2.3 Presentation of the Statement of Profit or Loss and Other Comprehensive Income
According to IAS 1, the statement of other comprehensive income can either be presented as a single statement or
split into two statements. An entity that prepares its financial statements in accordance with IFRS accounting
standards has a choice in relation to the presentation of the statement of other comprehensive income.
Figure 58: Minimum Classification of the Statement of Other Comprehensive Income
Minimum classification of the statement of

Presentation in one statement Presentation in two statements
•  Sales revenue •  Sales revenue

•  Operational expenses •  Operational expenses
•  Other operational income and expenses •  Other operational income and expenses
•  Financial expenses •  Financial expenses
Statement of
profit or loss
•  Profit and loss attributable to equity valuation •  Profit and loss attributable to equity valuation
(consolidation) (consolidation)
Statement of profit or loss and
other comprehensive income
•  Tax expenses •  Tax expenses

•  Post-tax result from discontinued operations •  Post-tax result from discontinued operations
= Profit or loss = Profit or loss
•  Profit or loss
•  Components of other comprehensive income: •  Components of other comprehensive income:
– Currency translation differences – Currency translation differences

Statement of other
– Fair value changes of available-for-sale – Fair value changes of available-for-sale

financial assets financial assets
– Fair value changes of cash flow hedges – Fair value changes of cash flow hedges
– Revaluations – Revaluations
– Actuarial profits/losses – Actuarial profits/losses
– Equity valuation – Equity valuation
= Comprehensive income = Comprehensive income
Division into two statements breaks down a company's financial performance into a statement of profit or loss,
representing the result (i.e. profit or loss) for a certain period, and a second statement with the elements of other
comprehensive income (OCI). At the same time, it defines the minimum information that the statements must
contain. It must be noted that both IFRS and the Swiss Code of Obligations require further positions or sub-

Chapter 5:
classifications: IFRS in individual standards and the Swiss Code of Obligations (CO) if this is material for the
evaluation of the earnings position by third parties or if usual due to the type of activities that the entity engages in
(Art. 959b (5) CO).
In addition to the minimum classification shown above, a multi-level form of presentation has established itself for
the statement of other comprehensive income. Interim results are formed comprising certain income and expense
positions in order to give the reader of the statement of financial position a quick overview of an entity's financial
performance. Frequent positions reported are EBIT (earnings before interest and tax) and EBT (earnings before tax).
If a group does not hold 100% of the shares in all subsidiaries, this produces so-called minority interests. So the total
profit or the total income cannot accrue entirely to the shareholders of the group's parent company. In the financial
statements, these minority interests are reported separately, as shown in the figure above. The Nestlé Example:
Statement of other comprehensive income (figure 58) in chapter 5.2.1 also shows these minority interests.
Figure 59: Sub classification of Income in the Statement of Profit or Loss
Sales revenue
Total cost method Cost of goods sold method
+ Other operating revenue

- Cost of goods sold (COGS)
+/- Changes in inventories of finished goods and
= Gross profit
unfinished goods
- Costs of raw materials and supplies
- Costs of employee benefits - Distribution costs
- Costs of depreciation - Administrative expenses
- Other expenses - Other expenses
+/- Income from discontinued operations
Operating Income (EBIT)
+/- Financial income and expenses

Financial
result
+ Income from investments in equity companies (consolidation)
Earnings before taxes (EBT)
- Taxes Taxes
Profit of the period
+/- Events not related to income, recorded as other comprehensive income OCI
Comprehensive income
Income attributable to shareholders of the parent Minority interests
In order to obtain a rapid overview of an entity's financial performance, it is helpful to take a look at the following
interim results. While they originate from the statement of profit or loss and other comprehensive income, they are
oftentimes used throughout the annual report as they illustrate the company’s business success very well.
(1) Revenue
(2) Gross profit = sales less cost of sales (only in the case of the cost of goods sold method)
(3) Operating result = EBIT (earnings before interest and tax)
(4) Pre-tax profit = EBT (earnings before tax)
(5) Profit of the year

Chapter 5:
5.3 Cost of Goods Sold and Total Cost Methods
LEARNING OBJECTIVES

• Knowing the difference between the cost of goods sold and the total cost methods
• Understanding the effects of the two different forms of presentation
The statement of profit or loss and other comprehensive income is usually presented in a vertical format. In the case
of productive enterprises, the number of goods produced in a period does not usually match the number of goods
sold in the same period. If more goods are produced than sold, they are stored in the warehouse and increase
inventories of finished products. If more goods are sold than produced, the shortfall is removed from the warehouse.
These changes in inventories must be accurately reflected in the statement of profit or loss and other comprehensive
income – i.e. sales should be compared with the production costs of the goods sold, regardless of the production
costs effectively incurred (i.e. the costs of the effectively produced goods). According to IFRS standards (IAS
1.102) and also the Swiss Code of Obligations (Art. 959b CO), there are two ways of classifying elements of
financial performance in order to reflect changes in inventories. These are the cost of goods sold method (also
known as the “function of expense” method) and the total cost method (also known as the aggregate cost or nature
of expense method). The cost of goods sold method classifies expenses on the basis of business functions, while the
total cost method is based on types of expense. An entity generally has the right to choose between the two methods.
In principle, however, it should choose the method that offers the best overall view of the value creation process.
Depending on which method is selected, different information has to be provided in the statement of profit or loss
and other comprehensive income as well as in the notes.
5.3.1 Cost of Goods Sold Method
The cost of goods sold method analyses earnings from sales (goods and services sold) and allocates to them the
expenses incurred in relation to them, namely the cost of goods sold (COGS). The cost of goods sold only includes
costs incurred in connection with the products sold in the reporting period. The cost of goods sold can be interpreted
as the costs incurred by the production department for the products and services sold. If the cost of goods sold is
deducted from sales, the gross profit can be calculated. The distribution and administration costs are then deducted
from the gross profit (and revenue from discontinued operations is added) in order to calculate the EBIT. As the cost
of goods sold, distribution expenses and administration expenses can be interpreted as the costs of the departments,
or costs of functional units (production, sales and administration), we speak of a functional allocation of expenses in
the case of a statement of profit or loss and other comprehensive income prepared according to the cost of goods
sold method. The central point is that the increase in inventories and own work capitalized5 are not reported as part
of sales, and their costs (on the expenses side) are not included in the cost of goods sold. The classification
suggested by the IASB is shown below (IAS 1.102).
5
Own work capitalized means products and services produced and used by the entity in question. If a furniture producer, for instance, uses its
own furniture in its sales and administration offices, this sale in itself is not shown as revenue in the statement of profit or loss and other
comprehensive income but as own work capitalized.

Chapter 5:
Figure 60: Cost of Goods Sold Method, Classification
Sales revenue
Expenses Revenue
- Cost of goods sold (COGS)
Cost of goods sold
Gross profit (COGS)
Other costs (presented Sales revenue

- Distribution expenses
by cost department)
- Administrative expenses EBIT
- Other expenses
EBIT
Note. Based on Hoffmann & Lüdenbach (2009), p. 49.
An entity that uses the cost of goods sold method also has to disclose information concerning the type of expenses,
including the expense of depreciation and impairment as well as employee benefits.
Figure 61: Nestlé Example: Cost of Goods Sold Method

Nestlé EXAMPLE

Chapter 5:
Figure 62: Example: Cost of Goods Sold Method
Cost of Goods Sold Method EXAMPLE
From: LafargeHolcim Group, Annual Report 2018, p. 162
5.3.2 Total Cost Method
The total cost method is also known as the aggregate cost or nature of expense method and, unlike the cost of goods
sold method, shows changes in inventories as part of operating performance. In order to nevertheless achieve the
required balance between income and expenses, the expenses for the period show the cost of the goods produced,
i.e. not only the goods sold but also the goods and services stored in the warehouse. With this method, increases and
reductions in inventories of unfinished and finished products are added to or deducted from revenue. This method
affects the statement of profit or loss and other comprehensive income by “lengthening” it in comparison with the
cost of goods sold method. The classification suggested by the IASB is shown below (IAS 1.102).
Figure 63: Total Cost Method, Classification
Sales revenues
+ Increase in inventories of finished goods and

Expenses Revenue
unfinished goods
- Decrease in inventories of finished goods and
unfinished goods Total costs for the
period Sales revenue
+ Goods and services on own account
(presented by cost
type)
- Expenses for raw materials and supplies
Inventory increase
- Expenses for employee benefits EBIT
- Depreciation
- Other expenses
EBIT
Note. Based on Hoffmann & Lüdenbach (2009), p. 49.

Chapter 5:
Figure 64: Example: Total Cost Method
Aggregate Cost Method EXAMPLE
From: Swatch Group 2018 Annual Report, p. 173
5.4 Margins of Discretion in the Statement of Profit or Loss
LEARNING OBJECTIVES
• Knowing when revenue or income is recognized in the statement of profit or loss and other comprehensive income
• Knowing how extraordinary income and expenses are treated
• Understanding the connection between the statement of financial position and the statement of profit or loss and other
Accounting standards also give guidelines for the statement of profit or loss and other comprehensive income,
similar to those for the statement of financial position, indicating whether and in what cases a position has to be
reported and how this is to be done. The reporting entity has various margins of discretion here.
5.4.1 Revenue Recognition
BOX: IAS 18 Revenue
Content: Recording earnings and revenue in the statement of profit or loss and other comprehensive income.
Core tenets: IFRS distinguishes between general and special preconditions for earnings/revenue. In general it must be
possible to reliably calculate the amount of income earned and it must be probable that the economic
benefit from the business activity in question will accrue to the respective entity. In addition, there are

Chapter 5:
also special preconditions for the various categories of income/revenue – such as the sale of goods, the
provision of services, etc. – that have to be fulfilled in order for income/revenue to be disclosed in the
statement of profit or loss and other comprehensive income.
Delimitation: Revenue from leases (IAS 17/IFRS 16), changes in the fair value of financial instruments in accordance
with IAS 39/IFRS 9 and further specific income from non-ordinary activities are dealt with in the
appropriate IFRS standards and not in IAS 18.
Revenue, or earnings, is the first position in the statement of profit or loss and other comprehensive income.
Revenue is generated in the course of the company's ordinary business activities. Depending on the business model,
this is where income from the sale of goods, the provision of services, from interest, dividends or royalties is listed.
This leads to the question of at what point revenue or income may be recognized as such. In financial reporting we
use the term “revenue recognition,” which fixes the point in time when revenue or income is recognized as having
accrued. Revenue recognition determines the time of transfer of the main benefits and burdens. This means the
economic benefits and burdens and not the transfer of legal title (see chapter 4.4, “substance over form”). So, in the
individual case, it must be ascertained whether any special reservation of title for the seller – special rights of
warranty, conversion rights or similar – stand in the way of revenue being recognized. It must be noted that earnings
can only be recognized if the actual amount earned can be reliably determined and if it is probable that the benefits
and burdens from the underlying transaction really will accrue.
In addition to these general preconditions for the recognition of earnings in the statement of profit or loss and other
comprehensive income, IFRS makes additional requirements in connection with the different types of earnings
(goods, services, interest, etc.) that have to be fulfilled before revenue or earnings can be reported in the statement of
profit or loss and other comprehensive income. The following table shows at what time earnings are recognized.
Table 25: Time when earnings are recognized

For all earnings § The amount of the earnings can be reliably calculated.
§ It is probable that the benefit from the sale/transaction will accrue to the entity in question.
In addition, there are special rules for the following types of income:
Sale of goods § The main economic benefits and burdens have passed to the buyer.
§ The seller has retained no rights to dispose of the goods and has no effective power to do so.
§ The costs incurred or yet to be incurred on the sale of the goods can be reliably calculated.
Rendering § The stage of completion for the transaction can be reliably calculated on the reporting date.
(providing) of a
§ The costs incurred or yet to be incurred can be reliably calculated.
service
Interest § Recorded pro rata temporal taking account of the effective rate of interest paid on the asset.
Royalties § Recorded in relation to the appropriate period in accordance with the underlying contract.
Dividends § Recorded at the time when the legal right to the payment of the dividend arises.

Chapter 5:
Figure 65: Nestlé Example: Revenue Recognition
Nestlé EXAMPLE
Earnings are generally measured at the fair value of the consideration received or to be received. Despite these
detailed guidelines, the reporting entity still has quite a significant margin of discretion as regards the recognition of
earnings in the statement of profit or loss and other comprehensive income, which is shown in the Nestlé example
by the use of the terms “mainly” and “substantially” as well as in IAS 18 by the term “probable.” These margins of
discretion offer the entity the option of developing a statement of financial position policy, i.e. the possibility of
exerting a certain amount of influence on the recognition and presentation of business matters in its reporting.
For all reporting periods starting on or after January 1, 2018, IFRS 15 applies for revenue recognition, now called
“Revenues from contracts with customers” (before January 1, 2018, the standard IAS 18 applied). The two core
principles are first that revenues shall be recognized when the power of disposition for the respective goods and
services is transferred, and secondly the value of the revenue shall be in the amount of the expected return
obligation. For assessing these two aspects, IFRS newly introduces a five step revenue recognition model (see figure
75).
Figure 66: Revenue Recognition model IFRS 15
Step 1 Step 2 Step 3 Step 4 Step 5
Recognize
Identify the Define the Allocate the
Identify the contract revenues
obligation in transaction price to the
with a customer and fulfill
the contract price obligations
obligations
Note. Based on Deloitte (2014)
Following the revenue recognition model of IFRS 15, the first steps identifies if actually a contract was entered with
a customer or not, using various criteria laid out in IFRS 15.9. The second step is to then assess what goods and
services were contractually agreed with the customer and therewith the company identifies its exact obligation. In
the third step the transaction price, which the company may expect from the customer for the agreed goods and
services, must be identified and defined. If a contract consists of multiple obligations, then step four allocates the
value of the contract to the different obligations based on the individual market prices of each obligation (IFRS
15.74). Only after completing steps one to four, revenue recognition may apply. Recognition applies upon transfer
of the power of disposition for the respective goods and services. Power of disposition is defined as possibility to
receive economic benefit from an asset and to influence its future use. The transfer of power of disposition may be
at a certain point in time, or alternatively over a certain time period if the following conditions are met:

Chapter 5:
1. With fulfillment by the company, the customer receives the economic benefit from the goods or services
and uses it at the exact same time (this is typically the case for services).
2. With its goods or services, the company creates or improves an asset, which was already under the
customer’s power of disposition during the creation or improvement (e.g. construction on the customers’
land).
3. With its goods or services, the company creates an asset which the company cannot use in any other way
(than for this customer); and it has the right for (partial) payments for the goods and services already
delivered or rendered; and it is expected that the contract will be fulfilled as expected (e.g. specific service
agreements such as education of office staff for changing from Windows to Apple).
For the transfer of power of disposition at a certain point in time, the following considerations apply:
• The company currently has the right for being paid for the asset
• The customer has legal ownership for the asset
• The company has physically transferred the asset (property has been assigned to the customer)
• The main opportunities and risks associated with ownership of the assets are with the customer
• The customer has received and accepted the asset.
With IFRS 15, the contractual obligations are the asset and are therewith recognized in the statement of financial
positions, no longer the contract (which used to be the asset under IAS 18). For obligations that are fulfilled by
transferring the power of disposition at a certain point in time (supplying trading goods, consumer good, etc.), no
significant changes exist for the revenue recognition according to IFRS 15 and IAS 18. Changes in revenue
recognition apply for transferring power of disposition over a time period: under IAS 18 partial revenue recognition
parallel to the progress of delivering goods or rendering services was only possible for customer specific
commissioned production (which was ruled by IAS 11, being also replaced by IFRS 15, see chapter 5.4.3). With
IFRS 15, such partial revenue recognition is also possible for contracts of work and labor or similar service
agreements (Deloitte, 2014).
5.4.2 Cost of Materials and Personnel Expenses
The cost of materials and personnel expenses can be subsumed under the term “business expenses.” As a rule, these
expenses are directly related to the entity's rendering and provision of services and are therefore directly related to
revenue.
IAS 2 Inventories IFRS 9 Financial Instruments

(see chapter 4.3.1) (see chapter 4.3.2)
The cost of materials is often referred to as production expense in a production operation or as the cost of goods in
the case of a trading operation. In the statement of financial position, the cost of materials is counterbalanced by the
positions “trade payables” or “other liabilities” as well as “inventories” in the case of production and trading

Chapter 5:
operations. These positions are explained in chapter 4.3. The cost of materials therefore reflects the costs of goods
and services used in connection with the provision of services.
BOX: IAS 19 Employee Benefits
Content: Reporting of employee benefits.
Core tenets: The recognition and valuation of employee benefits depends on their classification into four categories:
short-term benefits, post-employment benefits, other long-term benefits and termination benefits.
The category “post-employment benefits” includes pension commitments that the entity has to its former
employees. The standard explains the distinction between defined contribution and defined benefit plans
and the calculation of pension provisions to meet future pension commitments.
Delimitation: Share-based payment is explained in IFRS 2.
Personnel expenses are also part of the rendering and provision of services, but they have to be looked at in two
groups. The larger group in terms of amount is usually accounted for by the wages and similar paid to employees.
These are short-term benefits for employees that are reported as expenses in the statement of profit or loss and other
comprehensive income and paid out to the employees by bank transfer. These short-term benefits are not usually
counterbalanced by directly allocable assets or liabilities. The second group comprises the three categories: long-
term benefits, post-employment benefits and termination benefits. Typically positions such as liabilities in
connection with pension commitments to existing and former employees apply for this group. The following table
shows the two groups and gives examples of the four categories of employee benefits according to IFRS standards.
Table 26: Classification of Employee Benefits

Benefits due in the § Wages, salaries
Short-term
short term § Profit-sharing and bonus plans
benefits § Cash value of non-cash benefits (e.g. company cars)
for employees
§ Benefits from occupational pension schemes

Post-employment
§ Other benefits to be paid after the end of the employment relationship (such as
benefits healthcare)
Long-term
benefits § Anniversary money
Other long-term § Long-term disability benefits
benefits for employees § Profit-sharing and bonus plans that become due more than 12 months after the end of
and
the period when the service was provided
post-employment § End of the employee's contract of employment prior to normal retirement age due to a
benefits decision by the company
Termination benefits § Offer of premature retirement by the company to the employee
§ These obligations require the company to have a detailed and formal plan (number of
employees, benefits, time of implementation, etc.)
Pension commitments may have quite a significant influence on the statement of financial position and statement of
profit or loss and other comprehensive income. Pension commitments are obligations, typically disclosed as pension
provisions (see also chapter 4.5.1). The recognition and valuation of pension commitments can be very complex and
country specific. Their calculation is typically based on actuarial assumptions and calculations. In principle, the
entity's future obligations to pay benefits to retired employees are discounted at an actuarial interest rate appropriate
to the maturity of the obligation, and the resulting net obligation is accounted for as a pension provision. For
detailed information about the recognition and margins of discretion for pension commitments, please refer to the

Chapter 5:
reference literature. In principle, IFRS and Swiss GAAP FER make a distinction between defined benefit and
defined contribution plans. The main difference lies in the investment risk, as defined contribution plans require the
employee to pay a fixed amount into a fund and to bear both the actuarial risk and the investment risk. In the case of
defined benefit plans, money is paid into a pension fund (it is either paid by the employee or by the employer, or by
the employee through the employer; the fund may be with a separate legal entity or within the company), but the
manager of the fund guarantees a defined benefit. This means that the fund bears a significant portion of both the
actuarial risk and the investment risk. In principle, most enterprises in Switzerland have been using defined
contribution plans for a number of years. Unlike in other countries however, in Switzerland there is still often a de
facto obligation for the employer to make up for any gaps in pension provision. This results in a benefit-based
component. Switzerland is a good example of a country where pension obligations are influenced by national
policies and the country's culture. This is the case in most countries, which is why pension plans cannot always be
strictly classified as defined benefit or defined contribution plans. This example also hints the difficulties for
harmonizing the different country-specific schemes into a single approach for the consolidated financial statement.
5.4.3 Effects of Statement of Financial Position Valuations onto the Statement of Profit or
Loss
Besides the recognition of revenue, the cost of materials and personnel expenses, the statement of profit or loss and
other comprehensive income is particularly influenced by the valuation of the positions in the statement of financial
position. So the assessment of transactions in relation to their recognition in the statement of financial position also
has a significant influence on the statement of profit or loss and other comprehensive income. The effect of positions
from the statement of financial position onto the statement of profit or loss and other comprehensive income is an
important aspect of modern financial reporting. Examples are depreciations of tangible assets, which result from the
subsequent valuation of non-current assets, yet are of relevance to income. The valuation of assets and liabilities is
strongly influenced by the following three well-known principles (see chapter 4.2.5) and they are therefore reflected
in the statement of profit or loss and other comprehensive income (such as in the case of impairment):
§ The lower of cost or market principle

§ The recognition principle
§ The imparity principle
Important positions in the statement of profit or loss and other comprehensive income in connection with these
principles are depreciation and impairments resulting from the assets in the statement of financial position.
Depreciation and impairments lead to a reduction in the value of the asset and thus to an expense in the statement of
profit or loss and other comprehensive income. These transactions, however, do not affect liquidity, as there is no
cash flow from these transactions. Impairments of assets arise externally from and in addition to systematic
depreciation, so they can be referred to as unscheduled, and they reflect certain developments. Impairments are
ascertained by means of impairment tests, which have to be performed at least once a year and if there are certain
indications (such as significant changes in market dynamics). When performing an impairment test, the reporting
entity has a relatively large de facto margin of discretion, as the entity is responsible for estimating the fair value.
Impairments of receivables may also have effects on the statement of profit or loss and other comprehensive income.
This leads to the question of the recoverability of the receivables on the statement of financial position. As chapter

Chapter 5:
4.3.2 discusses, general bad-debt allowances (del credere) may also be made for the impairment of accounts
receivable. However, if there is an effective default, the receivable is eliminated entirely in the statement of profit or
loss and other comprehensive income. The reporting entity therefore gives itself a margin of discretion here, as it has
to be decided in the individual case when a receivable can be objectively considered to be irrecoverable.
IAS 11 Construction Contracts

(not dealt with in detail in this book)
Long-term contracts are a special case in accounting. Some entities work on the production or execution of orders
that take longer than one year to complete, in other words longer than a reporting period. In order for these contracts
to still appear on the statement of financial position and in the statement of profit or loss and other comprehensive
income, the principle of revenue recognition is breached (see chapter 5.4.1). This means that the progress of the
work to date is reported in the financial statement before the main economic benefits and burdens arising from the
contract pass from one party to another. The percentage of completion method is used on the reporting date. This
method calculates the profit on a pro rata basis, after taking account of all future costs to be incurred. In addition, the
possible risks must also be taken into account and disclosed. In order for construction contracts to be accounted for
and for the principle of revenue recognition to be breached, a number of preconditions must be fulfilled. In the case
of long-term contracts, questions regarding accrual and their valuation arise, which open up margins of discretion
for the reporting entity. IFRS addresses the subject of long-term construction contracts in a separate standard, IAS
11. The details regarding the recognition and valuation of long-term construction contracts, especially the way that
the percentage of completion is determined, will not be discussed any further in this book. Please consult the
reference literature. Starting on January 1, 2018, IFRS 15 replaces IAS 11 as well as IAS 18 and therewith long-term
construction contracts fall under contractual obligations provided over a period of time (see chapter 5.4.1).
5.5 Segment Reporting
LEARNING OBJECTIVES

• Recognizing the purpose and significance of business segments
• Understanding the format of the segment account
BOX: IFRS 8 Operating Segments
Content: Segment reporting.

Core tenets: Segments are defined on the basis of the internally reported business segments. This is known as the
management approach. If sales, profits or assets of a business segment account for more than 10% of the
total for all business segments, these have to be disclosed individually as reportable business segments.
Each reportable segment has to disclose its profits or losses. All figures disclosed must be in accordance
with the internally reported valuation methods. In order to close the gap between these internal valuation
methods and those used for the statement of financial position, and statement of profit or loss published
for external use, a reconciliation statement has to be disclosed for certain positions.
Furthermore, it is necessary to (a) break down income according to individual products and services or
groups, (b) subdivide income and certain long-term assets according to countries and (c) disclose income
accounted for by important customers.

Chapter 5:
The segment report is a specification of the statement of financial position and the statement of profit or loss and
other comprehensive income. It presents important positions for individual segments, i.e. parts of the economic
entity. The segment report is typically found in the notes. Modern financial reporting stipulates in detail what is to
be understood by segments and how these are defined and formed, and what information has to be disclosed for
these segments. According to IFRS, segments are understood as isolable sub-units within a diversified economic
entity. Segments typically reflect an entity's orientation in terms of target markets, customers and groups of products
or services, while also revealing the corporate strategy. The information should come directly from the internal
reporting system. In this way, segment reporting makes it possible to evaluate the corporate strategy, to assess
individual divisions of the entity,m and to review the management strategy.
Figure 67: Segment Reporting
Note. Own depiction. Based on KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 161-164.
Segment reporting comprises the following information:
§ Information for business segments (also known as operating segments)

§ Information per product group or service
§ Information per country or geographical unit
§ Information regarding important customers (without mentioning names)
For operating segments, a broad range of information must be disclosed. In contrast, disclosure for company-wide
information, i.e. details by product/service, by geographical area, and by customer, is limited.
5.5.1 Defining Business Segments
Reportable segments are usually determined according to a two-stage procedure. First of all, the business segments
are defined. The business segments are formed according to the management approach. This means adopting the
entity's internal point of view. The following criteria serve to define the business segments:
§ The financial figures of the operating unit are periodically checked and controlled by senior management.
§ The operating unit generates income and is accountable for expenses.
§ The operating unit delivers separate financial figures.

Chapter 5:
§ Activities that do not generate earnings are grouped together separately as “other activities.”
As a second step, reportability is determined: the business segment qualifies as reportable segment, i.e. it must be
included in the segment reporting if one of the following criteria is fulfilled:
§ The sales (external and internal) of the business segment account for at least 10% of total revenue.
§ The profits of the business segment account for at least 10% of total profits.
§ The assets of the business segment account for at least 10% of all assets (or total assets).
It is also possible to have segments that only supply or serve other internal business units. If none of the above
criteria apply, the business segments can be grouped together until one of the criteria has been met or grouped
together and reported as “other segments.” However, it is only possible and permissible for business segments to be
grouped together under certain preconditions.
5.5.2 Reporting
IFRS requires two kinds of presentation, business (or operating) segment reporting and company-wide reporting.
Figure 68: Nestlé Example: Segment Information for the Business Segments
BEISPIEL Nestlé
The first form of presentation involves information on business segments. This first form of presentation specifically
requires information on sales to third parties and to other segments, income from interest, depreciation and

Chapter 5:
amortization, taxes, assets, and liabilities of the individual segments. However, at least one performance indicator
(such as earnings before interest and tax) and the corresponding assets or liabilities have to be reported. This
information is known as segment information. As this information originates from internal reporting, a
reconciliation statement usually has to be prepared between the total from the reportable segments and the
corresponding amount in the statement of financial position or statement of profit or loss and other comprehensive
income. The reconciliation statement gives an insight into any differences between the valuation principles used for
internal reporting and those used for the financial statements (prepared in accordance with IFRS or Swiss GAAP
FER standards).
Figure 69: Nestlé Example: Company-wide Information of the Business Segments

Nestlé EXAMPLE
From: Consolidated Financial Statements of the Nestlé Group 2018, p. 87)
The second form of presentation requires the separate reporting of sales and assets for the required company-wide
information (products/services, geographical area, and customers). This means sales according to the main products
and services, sales and assets according to the main geographical areas, and also sales to the most important
customers have to be disclosed. Only sales to third parties (without segment-internal sales) have to be presented as
sales; the assets are long-term assets without financial assets, deferred taxes or assets from defined benefit pension

Chapter 5:
plans. For sales according to customers, the 10% rule is used – i.e. only customers that account for more than 10%
of total revenue have to be disclosed. The names of the customers do not need to be disclosed.
5.6 Summary
The statement of profit or loss and other comprehensive income reflects a company's earnings situation during a
certain reporting period. The statement of profit or loss and other comprehensive income compares the income
generated with the associated expenses. It not only presents revenue as well as the cost of materials and personnel
expenses but also transactions stemming from changes in the statement of financial position, such as the impairment
of assets. There is therefore a close connection between the statement of financial position and the statement of
profit or loss and other comprehensive income.
Format
The statement of profit or loss and other comprehensive income primarily has the task of giving a clear picture of a
company's financial performance. Meaningful assessments can be made on the basis of the following interim results:
(1) Revenue
(2) Gross profit (only in the case of the cost of goods sold method)
(3) Result from ordinary activities
(4) Operating result = EBIT (earnings before interest and tax)
(5) Pre-tax profit = EBT (earnings before tax)
(6) Profit of the year
The Cost of Goods Sold and Aggregate Cost Methods

Depending on the business model, an entity has a choice between two ways of presenting the statement of profit or
loss and other comprehensive income. The cost of goods sold method (also known as the “function of expense”
method) classifies according to functions, revenue and the associated costs. The aggregate cost method (also known
as the “nature of expense” method) classifies according to types of expense.
Segment Reporting
A further form of presenting an entity's financial performance is segment reporting, which is a requirement in
modern financial reporting. Business segments are formed from independent operating units, and their income and
assets are reported separately. Furthermore, segment reporting provides information about products/services,
geographical markets and important customers.
Margins of Discretion
There are de facto margins of discretion with regard to the presentation and content of the statement of profit or loss
and other comprehensive income. The reporting entity particularly has a margin of discretion in its financial
statements in relation to the following positions:
§ Revenue recognition
§ Impairment of intangible assets
§ Recoverability of receivables
§ Long-term construction contracts

Chapter 5:

Achleitner, A-K. & Behr G. (2003). International Accounting Standards – Ein Lehrbuch zur Internationalen
Rechnungslegung (3. Auflage). München: Vahlen.
Behr, G. & Leibfried P. (2014). Rechnungslegung (4. aktualisiertte und überarbeitete Auflage). Zürich: Versus.
mit Beispielen, Repetitinsfragen und Antworten. (4. Überarbeitete Auflage). Zürich: Compendio
Bildungsmedien.
SKV.
Schaeffer-Poeschel.

Chapter 6:
Statement of Cash Flows 145
Statement of Cash Flows
Investors are very interested in financial strength and the

development of liquidity. Liquidity is referred to as the
“oxygen” of the company. Without sufficient liquidity,
the company is no longer able to service its liabilities,
which results in legal consequences and thus restricts the
entrepreneurial freedom of the company. Early detection
of problems in financial strength and liquidity is
therefore paramount. The statement of cash flows makes
this information available.
6.1 Introductory Example from Petroplus
INTRODUCTION: STATEMENT OF CASH FLOWS
Petroplus Intends to Lower Breakeven Point and Become Cash Neutral

Refinery operator Petroplus presented details of its strategic three-year plan through
to 2012 at a recent analyst event. The company aims to lower its breakeven point
and become cash neutral at the very least […].
Acquisitions to help expand the manufacturing infrastructure are still on the

horizon. Purchases must be congruent with the strategy, contribute to profits, earn a
positive cash flow and improve the statement of financial position as well as the
financial flexibility of Petroplus, the refinery operator explained. According to the information provided, the equipment
contained in the portfolio up to now exhibits large differences in reliability, cost structure and energy efficiency due to its
varied history. Petroplus itself rates the 2009 fiscal year results as below average. Refinery utilization rates were at 70%, and
USD 300 million in liquid funds were consumed.
As part of its three-year plan, the company intends to improve efficiency. In the presentation, the company promised to
increase profits by more than one US dollar per barrel in total. Areas in which the company seeks improvement include the
gross margin, energy efficiency, operating outflows as well as general and administrative costs. The investments in the
efficiency program are projected at approximately USD 120 million, and initial resources have been spent already in 2010.
The company stated that the strikes in France have influenced profits in the fourth quarter of 2010 only marginally.

Chapter 6:
Meanwhile, credit agreements for the so-called revolving credit facility (RCF) should be achieved in this time period,
Petroplus announced. The adjusted EBITDA is projected to be USD 120 million for the fourth quarter and USD 476 million
for the fiscal year 2010.
For 2011, Petroplus estimates utilization rates of 81%, after anticipated rates of 78% for the current fiscal year. As recently
communicated during the announcement of the results for the third quarter, investments for 2011 should amount to USD 315
million and operating outflows to USD 665 million. […]
Article has been modified. From: Handelszeitung (December 9, 2010).
Petroplus on the Brink of Bankruptcy

After termination of a USD 1 billion credit line, refinery operator Petroplus is struggling to stay afloat. One analyst has
designated this a “grave situation.” The company is currently hoping for successful negotiations with the banks and help from
the French government. “The situation is very grave. The company needed USD 1.5 billion at the end of the third quarter to
maintain its daily operating activities; at the moment it only has USD 1.1 billion at its disposal” […].
It is, however, unclear where the company stands exactly and how high its liquidity requirements are at the moment […].
“With production cuts, halts in investments and the postponement of supplier payments, the company can attempt to make end
meet over the next few weeks” […].
Article has been modified. From: Tagesanzeiger (December 29, 2011).
1. Which component of the financial statement provides information concerning the need for USD 1.5 billion for maintaining
daily operating activities? What is this control parameter called?
2. Apart from in the statement of cash flows, where in the financial statement is it possible to read about investments?
3. Petroplus: How does one go from liquid funds that have been reduced by CHF 300 million to the EBITDA?
4. Petroplus: Are investments of USD 120 million a large amount for Petroplus?
5. Petroplus: To what extent is credit such as the revolving credit facility shown on the statement of cash flows?
6.2 Purpose and Structure of the Statement of Cash Flows
LEARNING OBJECTIVES

• Recognizing the significance of the statement of cash flows for information
• Understanding the composition of a statement of cash flows
• Being able to perform an analysis of a statement of cash flows
The effects of business transactions on liquidity are not revealed in the statement of profit or loss and other
comprehensive income, as not all recognized revenues and expenses affect liquidity. The statement of profit or loss
and other comprehensive income therefore lacks a presentation of the flow of funds into and out of a company
during a period. In contrast to revenues and expenses, the terms “inflows” (payments received) and “outflows”
(payments made) always refer to business transactions that affect liquidity.
In addition to the presentation of assets and liabilities as reporting date values in the statement of financial position
as well as revenues and expenses as period calculations in the statement of profit or loss and other comprehensive
Chapter 6:
income, the statement of cash flows represents the incoming and outgoing payments in the period under review. The
statement of cash flows is an instrument for the documentation of the development, source and appropriation of
funds. It has been a mandatory component of relevant regulations concerning the financial statement for years
(IFRS, US-GAAP, Swiss GAAP FER and CO). The statement of cash flows is also less commonly referred to as a
flow of funds statement. The terms are synonymous.
Definition of Statement The statement of cash flows provides information regarding the source of funds as well as funds
of Cash Flows appropriation and reveals the change in cash funds (Baumann, 2005, p. 31.).
BOX: IAS 7 Statement of Cash Flows
Content: Preparation and presentation of statement of cash flows.

Core tenets: The statement of cash flows is a separate component of the financial statement and explains the change in
the funds level on the basis of the source and appropriation of funds.
In addition to cash funds and demand deposits, funds also encompass highly liquid cash equivalents that
can be converted into cash at any time.
The statement of cash flows is divided into cash flow from operating activities, from investing activities
(investing cash flow) and from financing activities (financing cash flow). The cash flow from operating
activities can be calculated directly or indirectly. Unrealized gains/losses are transactions that are in
principle not cash relevant. Interest, dividends and income taxes are permitted to be allocated to any of
the three cash flows. However, the allocation must be consistent.
Figure 70: Relationship between Statement of Financial Position, Statement of Profit or Loss, and Statement of Cash Flows
The benefit of cash flow information lies in the possibility of better gauging the ability of the company to earn cash
and cash equivalents and therefore analyzing the development of liquidity. In addition, cash flow is the basis for
company valuation models and, due to its robustness vis-à-vis changes or differences in applied accounting policies,
is ideal for the comparison of companies as well as for the projection of future cash flows. The statement of cash
flows permits less options and margins of discretion than the statement of financial position as well as the statement
of profit or loss and other comprehensive income. Cash flow can thus be interpreted from a financial perspective and
from an income perspective in connection with the statement of profit or loss and other comprehensive income.
Cash flow and the statements of cash flows are also useful instruments for management, as they are indispensable in
a planning context as a link between the statement of financial position and the statement of profit or loss and other
Chapter 6:
comprehensive income that ensures the objective integration of profit and liquidity. The examination of cash flows
allows the reader of financial statements to realistically assess business performance and permits conclusions to be
drawn about specific strategic decisions (for example, investing activities over a longer period of time in a
comparison over several years).
As the name reveals, the statement of cash flows shows the development or movement of liquidity over a period.
The statement of cash flows, designed as a movement calculation, primarily aims to improve the presentation of the
financial position. The main objective of the statement of cash flows is the detailed disclosure of cash flows in order
to provide company management, creditors, investors and the public with information regarding:
§ The ability to earn cash flow surpluses

§ Future financing requirements
§ The ability to service liabilities and pay dividends
§ The risk of insolvency within the context of credit checks
§ Divergence between the annual result and the associated cash flows
§ The effects of cash-relevant and non-cash-relevant investing and financing transactions on the financial
position of the company
The statement of cash flows is therefore interesting for all stakeholders financially involved with the company, as
dividends and interest are paid, debt is serviced and investments are made from cash flow surpluses.
6.2.1 Delimitation of Funds
The statement of cash flows exhibits the changes in funds between two reporting dates as well as the sources of the
changes. The funds represent the initial starting point of each statement of cash flows. They are also referred to as
financial funds or liquid funds and are a compilation of various positions from the statement of financial position. In
Switzerland, the following funds can be found:
Table 27: Definitions of Liquid Funds
Cash (cash on hand and the like) + Demand deposits (bank and post office account
Cash
balances)
Cash and cash equivalents Cash + Cash equivalents
Net cash and cash equivalents Cash and cash equivalents - Short-term financial liabilities
Working capital Current assets - Short-term liabilities

Depending on the choice of financial funds, the significance of the statement of cash flows can be interpreted
differently. In order to achieve comparability in financial statements, IFRS stipulates use of “net cash and cash
equivalents” for liquid funds. Pursuant to IAS 7, these funds comprise the following positions:
Cash and cash equivalents should only encompass positions that secure the company's ability to service liabilities in
the short term, but no positions held for the purpose of medium-term to long-term investment. Equity participations
usually do not constitute cash equivalents. Cash equivalents are convertible to cash within three months and include,

Chapter 6:
for example, call deposits, time deposits as well as money market instruments with maturities of less than three
months. Securities such as shares with significant risk of changes in value do not count as cash equivalents.
Table 28: Definition of Funds Pursuant to IAS 7
§ Cash (cash on hand and the like)

+ Cash
§ Demand deposits (bank and post office account balances)
§ Must be readily convertible to known amounts of cash

+ Cash equivalents § Are subject to an insignificant risk of changes in value
§ Maturity from the time of acquisition must be less than three months
§ Liabilities vis-à-vis banks must be deducted if these are liabilities that are repayable
- Current financial liabilities at any time and represent an integral component of the cash management of the
company (for example, overdraft facilities)
6.2.2 Structure and Preparation
In order to present the information in a concise and clear manner, the statement of cash flows is divided into three
parts, according to funds appropriation and source: cash flow from operating activities, investing activities and
financing activities. There are inflows and outflows of funds for each cash flow type.
Figure 71: Structure of the Statement of Cash Flows
In addition to the cash flow types listed in the diagram above, free cash flow is also often reported in the financial
statement. Free cash flow can be defined in different ways, but in practice free cash flow is usually understood to be
the sum of cash flow from operating activities less customary replacement investments and customary dividends
(customary replacement investments and customary dividends are deducted because these must be paid in order to
secure ordinary business operations in the medium term). The free cash flow allows the reader of the financial
statements to immediately see what portion of the funds is available for additional investments, additional dividends
or for repayments – i.e. it represents the earned financial funds that the company has at its free disposal. If investing
activities consumed more funds than operating activities generated, the reader of the financial statements sees this
gap, and the cash flow from financing activities shows how this gap was financed. Furthermore, free cash flow in a
comparison over several years is useful as it provides a comprehensive picture of the company's ability to generate
funds and its investment strategy.

Chapter 6:
6.3 Cash Flow from Operating Activities
LEARNING OBJECTIVES

• Recognizing the importance of cash flow from operating activities
• Calculation of cash flow from operating activities
• Understanding and being able to apply direct and indirect calculation methods
Cash flow from operating activities provides information on the progress of the core business. In this process, the
focus is on operating activities; the ordinary activities or operating results. The cash flows stem from the sales
activities of the company (purchasing, production, sales, maintenance, services, etc.). According to this definition,
cash flow from operating activities therefore shows the internal financing strength of the company. In other words, it
shows the level of funds that the company is able to independently earn based on its own activities. Cash flow from
operating activities comprises the following business transactions, for example:
§ Payment receipts from the sale of goods or the provision of services

§ Payments to suppliers
§ Wage and salary payments
§ Outgoing and incoming payments from the sale/acquisition of financial instruments for the trading portfolio
Two approaches exist for calculating the cash flow from operating activities, which are also established in IAS 7 and
Swiss GAAP FER 4. The company is free to choose which method it uses. First, there is the original preparation
approach, also referred to as the direct method, which considers all cash-effective events (expenses and revenues).
The second approach is derivative preparation or the indirect method, which starts with the results for the period and
adjusts them by the non-cash-effective expenses and revenues. Both methods are explained below.
6.3.1 Direct Method
Table 29: Direct Calculation of Cash Flow from Operating Activities

+ Payment receipts from the sale of goods or the provision of services
+ Cash revenue + Payment receipts from usage remuneration, fees, commission and other earnings
+ Payment receipts from the sale of financial instruments from the trading portfolio
./. Payments to suppliers (cost of goods sold)

./. Payments to and for employees (wage and salary payments, personnel expenses)
- Cash expenses
./. Payments associated with other operating expenses
./. Payments for the acquisition of financial instruments for the trading portfolio
Option: interest, + Payment receipts from interests and dividends

dividends, taxes ./. Payment for interests, dividends and taxes
= Cash flow from operating activities (direct)
When using the direct method, cash inflows and outflows from operating activities are presented in a direct manner.
The direct method thus represents a type of “function of expenses” method showing the effect on liquid resources.
As the name suggests, the purpose of the cash flow from operating activities becomes apparent in the direct method.

Chapter 6:
Cash revenues are compared to the cash expenses. For received and paid interests and dividend there is an option,
following IAS 7.31, to disclose them as cash flow from operating, investing or financing activities. Tax payments
are, following IAS 7.35, to be disclosed as cash flow from operating activities unless they are directly linked to
specific investments or financing.
If possible, the direct method should be applied for calculating the cash flow from operating activities as it provides
the greatest amount of information. In order to use this method, however, cash flows must be separately recorded,
which normally does not occur within the context of financial reporting and is therefore associated with considerable
effort. As already explained in the introductory chapter on cash flow, the cash flows cannot be deciphered directly
from the statement of financial position and statement of profit or loss and other comprehensive income. To prepare
the cash flow from operating activities pursuant to the direct method, all business transactions must, for example, be
assigned an account key signaling whether the transaction is cash-effective as a whole or in part or how much is not
cash-effective. This account key identifies all transactions that are cash-effective and those that are not. Based on
this, a second step involves constructing a flow-of-funds analysis, from which the statement of cash flows is
prepared as a last step. This elaborate calculation is also the reason why most companies choose the indirect method.
With the indirect method, the accounting information of the company can be utilized without having to prepare a
separate flow-of-funds analysis.
6.3.2 Indirect Method
In contrast to the direct method, the indirect method starts with earnings before interest and taxes (EBIT) as reported
in the statement of profit or loss and other comprehensive income. Subsequently, the changes not affecting cash are
taken into account, i.e. changes of the corresponding positions (from the statement of financial position) during the
reporting period are added or deducted from this number. In this way, the indirect (derived) statement of cash flows
is in principle prepared on the basis of two successive financial statements. This approach can be performed
externally or from within the company.
Table 30: Indirect Calculation of Cash Flow from Operating Activities

EBIT: Earning before interest and taxes (profit/loss)
+ Depreciation and Impairments

+ Non-cash + Increase in provisions
expenses + Losses from impairments
+ Other non-cash expenses
./. Extraordinary sales gain (e.g. income from disposals of property, plant and equipment)
- Non-cash
./. Dissolution of provisions
revenue
./. Other non-cash revenues
+/- Changes in Consideration of changes in inventories, receivables and liabilities:

operating ./. Increase in accounts receivable (funds commitment) or + Decrease in accounts receivable (release of funds)
working ./. Increase in inventories (funds commitment) or + Decrease in inventories (release of funds)
capital (WC) + Increase in accounts payable (source of funds) or - Decrease in accounts payable (use of funds)
Option: interest, + Payment receipts from interests and dividends

= Cash flow from operating activities (indirect)

Chapter 6:
The first step involves identifying all non-cash-effective business transactions and adding the non-cash-effective
costs to the reporting period results or deducting the non-cash-effective revenues from the reporting period results.
As non-cash-effective business transactions could also arise from investing and financing activities, these must be
subtracted in order to calculate the cash flow from operating activities. The identification of non-cash-effective
business transactions can take place by comparing the amounts of the two financial statements under consideration.
This leads to the creation of a flow-of-funds analysis that must be regarded in conjunction with the statement of
profit or loss and other comprehensive income. With the aid of the flow-of-funds analysis and the statement of profit
or loss and other comprehensive income, the non-cash-effective business transactions can be identified and
quantified. The following, significantly simplified presentation should be helpful in the allocation of cash-effective
and non-cash-effective business transactions.
Figure 72: Distinction between Cash-Effective and Non-Cash-Effective
Because IFRS and Swiss GAAP FER use net cash and cash equivalents as financial funds (see chapter 6.2.1), a third
part must be taken into account when determining cash flow from operating activities using the indirect method.
This concerns operating working capital (operating current assets less operating short-term liabilities). As this
change parameter influences the level of liquid funds significantly, the three positions trade receivables, inventories
and trade payables must be taken into account when calculating cash flow from operating activities. The logic of the
impact of operating working capital on cash flow is simple. If accounts receivable or inventories increased during
the period, then cash and cash equivalents are committed that are not currently available to the company; therefore,
the increase in trade receivable or inventories is deducted from cash flow from operating activities. On the other
hand, an increase in trade payables reflects an increase in liquid funds, as the supplier will be paid later and this cash
may be used for the company's own operating activities. In this case, this is simply credit granted by the supplier.
The following three key words, which will be analyzed in greater detail in the statement of financial position
analysis (see chapter 11.8.4), aim to improve cash flow from operating activities:
§ Collect early: The sooner the customer pays the outstanding trade receivables, the earlier the company has
liquid resources available. This increases the cash flow from operating activities.
§ Pay late: The later any outstanding payables vis-à-vis suppliers are paid, the longer the company has
liquid resources available (also referred to as supplier's credit). This increases the cash flow
from operating activities.
§ Just in time: The fewer cash and cash equivalents are tied up in inventories and the shorter the period,
the longer the company has these resources available for other business activities. For this
reason, principles such as “just-in-time” deliveries or other inventory management

Chapter 6:
strategies were developed and implemented. With the just-in-time principle, the lowest
possible level of inventory is held in stock and is directly supplied “in time” according to
demand.
The option described in chapter 6.3.1 for interests, dividends and taxes also applies for the indirect method. The
indirect method is simpler to apply than the direct method, which requires the recording of all cash-effective
transactions. This is due primarily to the fact that information concerning non-cash-effective transactions is already
included in the existing statement of financial position and statement of profit or loss and other comprehensive
income, and calculations are made based on the existing accounting system.
Figure 73: Nestlé Example: Cash Flow from Operating Activities

Nestlé EXAMPLE
Table 31: Mini Case: Cash Flow from Operating Activities
PRESENTATION OF CASH FLOW FROM OPERATING ACTIVITIES
The following business transactions were recorded in Cash flow from operating activities based on business
MINI CASE
20X3: transactions in 20X3:
§ Depreciation of machines 30 Operating result 130

§ Depreciation of mobile assets 10
+ Non-cash expenses
§ Dissolution of provisions 20 Depreciation 40
§ Goods sold on credit 340
- Non-cash revenue
§ Goods purchased on credit 350
Dissolution of provisions -20
§ Bank transfers to our suppliers 110
§ Bank transfers from our customers 120 Change in WC
- Increase in accounts receivable 220
§ Profit according to the statement of profit or loss
and other comprehensive income 130 + Decrease in inventories 40
+ Increase in accounts payable 240
§ Decrease in inventories 40
Cash flow from operating activities 210

Chapter 6:
6.4 Cash Flow from Investing Activities
LEARNING OBJECTIVES
• Understanding the importance and calculation of cash flow from investing activities
Reporting changes in funds from investing activities aims to provide information regarding the use of resources for
future earnings potential and the associated anticipated future profit and surplus income. The cash flow from
investing activities is also called investing cash flow. The investing activities of a company are reflected in the non-
current assets on the statement of financial position or on the statement of asset additions and disposals. In addition
to intangible assets and property, plant and equipment, investments are also affected by the investing activities of a
company if they comprise investments and divestments in loans or other debt or equity instruments. Cash inflows
and outflows from the purchase or sale of current assets (securities) are, however, usually allocated to cash flows
from operating activities and are not taken into account in the investing cash flow. The difference between the
definition and recognition in the statement of financial position of securities and investments is explained in chapters
4.3.3 and 4.4.2. Cash flow from investing activities is calculated based on the direct method. Analogous to
calculating the cash flow from operating activities, additional information regarding investment and divestment
amounts is required that cannot be derived from the statement of financial position and the statement of profit or loss
and other comprehensive income.
Table 32: Calculation of Cash Flow from Investing Activities

+ Payment receipts from sales of property, plant and equipment, intangible and other long-term assets from
+ Divestments of non-current assets
non-current + Payment receipts from the sale of subsidiaries (less relinquished cash and cash equivalents)
assets
+ Payment receipts from other investments
./. Payments for the acquisition of property, plant and equipment, intangible and other long-term assets from
non-current assets
- Investments in
./. Payments for the acquisition of subsidiaries (less cash and cash equivalents acquired)
non-current
./. Payments for other investments
assets
./. Choice: interest, dividends and income tax payments (may also be captured in operating and financing
activities)
Option: interests, + Payment receipts from interests and dividends

= Cash flow from investing activities
Reporting changes in funds from investing activities aims to provide information regarding the use of resources for
future earnings potential and the associated anticipated future profit and surplus income. The cash flow from
investing activities is also called investing cash flow. The investing activities of a company are reflected in the non-
current assets on the statement of financial position or on the statement of asset additions and disposals. In addition
to intangible assets and property, plant and equipment, investments are also affected by the investing activities of a
company if they comprise investments and divestments in loans or other debt or equity instruments. Cash inflows
and outflows from the purchase or sale of current assets (securities) are, however, usually allocated to cash flows
from operating activities and are not taken into account in the investing cash flow. The difference between the

Chapter 6:
definition and recognition in the statement of financial position of securities and investments is explained in chapters
4.3.3 and 4.4.2. Cash flow from investing activities is calculated based on the direct method. Analogous to
calculating the cash flow from operating activities, additional information regarding investment and divestment
amounts is required that cannot be derived from the statement of financial position and the statement of profit or loss
and other comprehensive income.
Figure 74: Nestlé Example: Cash Flow from Investing Activities

BEISPIEL Nestlé
In order to calculate the cash flow from investing activities, one starts with the initial and final balance of the asset
positions. The difference between these values must then be carefully examined. There are usually four transaction
types during the year that give rise to changes in the balances: inflows (investments), outflows (divestments),
depreciation and impairment losses or appreciations (IAS 26). All transactions can only be presented using all three
components of the financial statements (statement of financial position, statement of profit or loss and other
comprehensive income as well as statement of cash flows).
Table 33: Mini Case: Cash Flow from Investing Activities
PRESENTATION OF INVESTING CASH FLOW
The following business transactions were recorded in Cash flow from investing activities based on the business
MINI CASE
20X3: transactions in 20X3:
§ Depreciation of machines 30 - Investments in non-current assets

Investments in property, plant and equipment -100
§ Depreciation of mobile assets 10
Investments in real estate -200
§ Purchase of a machine 100
+ Divestments in non-current assets
§ Purchase of property of 200 with mortgage 140 Divestments in property, plant and equipment +40
§ Sale of furnishings with book value 38 for cash 40 Cash flow from investing activities -260
Depreciation is not relevant for investing activities.

6.5 Cash Flow from Financing Activities
LEARNING OBJECTIVES
• Understanding the importance and calculation of financing cash flow
The third area of the statement of cash flows is the area of financing activities. Cash flow from financing activities
can also be called financing cash flow. The purpose of this area is to financially balance out deficits from the
operating and investing activities areas. As the name suggests, financing activities make it apparent how investments
are financed externally, if the cash flow from operating activities is not sufficient to cover the investing activities. It
also becomes apparent whether an increase in funds is associated with financing or external resource procurement.

Chapter 6:
In the financing area, changes in funds are therefore captured based on changes in equity or liabilities. Cash flow
from financing activities is thus a reflection of long-term financial debt and equity. In this context, cash flow from
financing activities aims to facilitate the estimation of future claims of the investors vis-à-vis the company. From the
third part of the statement of cash flows, the investor can see the potential size of his or her claim and obtain
valuable insights regarding coming periods and distributions to owners in these periods by comparing statement of
cash flows over several years. It must be mentioned that, pursuant to IFRS, there is a choice as to how interest
payments, dividends and income tax payments are captured. In contrast, Swiss GAAP FER stipulates that dividends
or distributions to equity owners belong in financing activities. Despite the choice allowed in IFRS, the common
practice is to report distributions to equity owners in financing activities, analogous to Swiss GAAP FER. Income
tax payments, however, are often accounted for in cash flow from operating activities.
Table 34: Calculation of Cash Flow from Financing Activities
+ Increase in financial liabilities and + Payment receipts from the issuance of equity instruments
equity + Payment receipts from the assumption of financial liabilities
./. Outflows for the repayment of financial liabilities

./. Outflows for the repayment of capital to shareholders (equity instruments)
./. Reduction in financial liabilities and
./. Outflows for the payment of liabilities from financial leasing liabilities
equity
./. Payments for changes in shareholding proportions in subsidiaries not stemming from
the attainment or loss of control
+ Payment receipts from interests and dividends

Option: interests, dividends, taxes
./. Payment for interests, dividends and taxes
= Cash flow from financing activities
Figure 75: Nestlé Example: Cash Flow from Financing Activities

Nestlé EXAMPLE

Chapter 6:
Table 35: Mini Case: Cash Flow from Financing Activities
PRESENTATION OF CASH FLOW FROM FINANCING ACTIVITIES
The following business transactions were recorded in 20x3:

MINI CASE
§ Capital increase of 200 with premium of 40 + Increase in financial liabilities / equity

Increase in share capital with premium 240
§ Amortization of a loan 120
Inflows from increase in bank loan 100
§ Shareholders receive dividends of 60 Inflows from new mortgage 140
§ Increase of long-term bank loan 100
- Reduction in financial liabilities / equity
§ Purchase of property of 200 with mortgage 140 Outflows from loan repayments -120
- Distributions
What is the cash flow from financing activities based Dividend -60
on these transactions?
Cash flow from financing activities 300
6.6 Statement of Financial Resources and Decision-Making Basis
LEARNING OBJECTIVES
• Recognizing the importance and calculation of the statement of financial resources
• Understanding the importance of the statement of cash flows as a basis for decision-making
Finally, the statement of cash flows confirms the change in cash and cash equivalents with the three cash flows and
currency conversion differences. By summing up of the inflows and outflows from operating, investing and
financing activities, the level of financial resources or funds is transferred from the initial balance to the final
balance for the period under review. In doing so, currency conversion differences that arose from the use of different
currency exchange rates must be taken into account. Cash and cash equivalents from foreign subsidiaries are usually
in the corresponding foreign currency and not in the functional currency of the group, which is why these must be
converted. The initial balance of the cash and cash equivalents of the foreign subsidiaries is converted using the
exchange rate valid on the reporting date at the end of the preceding reporting year. The cash and cash equivalents
of the foreign subsidiaries reported at the end of the current year are, however, converted using the exchange rate of
the new reporting date. The subsidiaries' transactions (operating, investing and financing activities) recognized on
the consolidated statement of cash flows are converted using the average exchange rate of the reporting period,
however. This results in three different currency translations for the same currency pair. Ultimately, the differences
reflect indirect or unrealized gains or losses due to currency fluctuations. This conversion risk involving recognizing
assets of foreign subsidiaries in the group is also referred to as translation risk.
Table 36: Statement of Financial Resources

Initial funds balance (net cash and cash equivalents) Beginning of the year or end of preceding reporting year
+ Cash flow from operating activities
+ Cash flow from investing activities (usually a negative amount)
+ Cash flow from financing activities
+/- Conversion differences from exchange rate influences
= Final funds balance (net cash and cash equivalents) End of the current reporting year

Chapter 6:
The consolidation of the cash flows and consideration of the conversion differences can also be regarded as
accounting reconciliation, as the reported and certified changes in liquid resources according to the statement of
financial position must correspond with the sum of the funds changes from operating, investing and financing
activities.
Figure 76: Nestlé Example: Statement of Financial Resources
EXAMPLE
Nestlé
From: Consolidated Financial Statements of the Nestlé Group 2018, p. 70.
A comprehensive approach to analyzing the statement of cash flows reveals how individual decisions are related and
that the three areas should not be regarded in isolation. The statement of cash flows in its entirety divulges a great
deal concerning the decisions made by the management. The fundamental logic is summarized in the following
diagram. Further analysis of the statement of cash flows can be found under statement of financial position analysis
in chapter 11.
Figure 77: Statement of Cash Flows as a Basis for Decision-Making
Initial situation:
positive
Free Cash Flow
Yes No
Decisions: Decisions:
• Repayment of debt?
• Investment in new businesses?
• Increase equity?
• Buyback of shares?
• New debt?
• Increase dividends?
• Increase cash ("war chest")?
Decision apparent:
Cash flow from financing activities
If a company generates more cash flow from operation then it uses for investments, it has excess cash that the
company can use freely, after considering a minimum dividend (typically shareholders only accept a lower dividend
during difficult times or ahead of a big project). If the cash flow from operation is lower than the investment
requirement, additional cash is required and the company must search for additional equity or debt, or it must
finance the investment from the cash reserves (i.e. from the “war chest”).

Chapter 6:
6.7 Summary
Purpose and Structure of the Statement of Cash Flows
As a mandatory component of financial statement, the statement of cash flows presents a comparison of the
incoming and outgoing payments of the period under review. Cash-effective business transactions are referred to as
inflows and outflows. Statements of cash flows document the development, source and appropriation of funds. Cash
flow as a result of the statement of cash flows is often used due to its robustness vis-à-vis changes or differences in
applied accounting policies.
The statement of cash flows exhibits the changes in funds between two reporting dates as well as the sources of the
changes. The funds balance (financial funds or liquid funds) must first be defined and comprises various statement
of financial positions. Free cash flow is usually the sum of cash flow from operating activities less customary
investment outflows and customary dividend payments.
Cash Flow from Operating Activities

Cash flow from operating activities provides information on the progress of the core business. The cash flows arise
as a result of the sales activities of the company. There are two methods to calculate the cash flow from operating
activities:
Direct method: + Cash revenue (e.g. payment receipts from the sale of goods)
- Cash expenses (e.g. payments to suppliers)
= Cash flow from operating activities:
Indirect method: EBIT

+ Non-cash expenses (e.g. depreciation)
- Non-cash revenues (e.g. dissolution of provisions)
+/- Changes in operating working capital (WC) (e.g. increase in accounts receivable)
= Cash flow from operating activities
Cash Flow from Investing Activities

The investing activities of a company are reflected in the non-current assets on the statement of financial position or
statement of asset additions and disposals (intangible assets, property, plant and equipment, long-term investments).
+ Divestments in non-current assets (e.g. payments received from sale of property, plant and equipment)
- Investments in non-current assets (e.g. payments for the acquisition of property, plant and equipment)
= Cash flow from investing activities

Chapter 6:
Cash Flow from Financing Activities

Financing activities reflect the financial compensation if capital must be procured or if repayments of existing
financial liabilities are undertaken. Cash flow from financing activities is thus a reflection of long-term financial
debt and equity.
+ Increase in financial liabilities and equity (e.g. capital increase)

- Reduction in financial liabilities and equity (e.g. repayment of financial debt)
- Distributions of interest (choice: recognition in operating or investing cash flow)
= Cash flow from financing activities
Statement of Financial Resources and Decision-Making Basis
The statement of financial resources or the statement of changes in financial resources is the sum of the inflows and
outflows from operating, investing and financing activities. The funds balance is transferred from the initial balance
of the period under review to the final balance. During this process, currency conversion differences must be taken
into account. Because of the three cash flow calculations (operating, investing and financing cash flow) as well as
the statement of financial resources, the statement of cash flows in its entirety allows conclusions to be drawn
regarding decisions made by management, making it suitable as a decision-making basis for a broad range of
decisions.

SKV.
Schaeffer-Poeschel.

Chapter 7:
Notes and Audit Report 161
Notes and Audit Report
The notes to the financial statements are in many cases

the most important element for detailed analyses.
Additional details emerge, since a company's financial
and economic position cannot be depicted solely by the
components of the financial statements In the notes,
which are also a mandatory component of the financial
statements, the reader finds detailed information with
respect to selected positions in the statement of
financial position, the statement of profit or loss and
other comprehensive income, the statement of cash
flows, as well as the statement of changes in equity.
The notes also provide guidance about the underlying accounting principles and present further information, such
as on management of capital, scope of consolidation and events after the reporting date. Independent public
auditors certify in the audit report, which is also to be found in all financial reports, whether all principles were
complied with and whether disclosures were implemented in full.
7.1 Introductory Example from Jomed and EMTS
INTRODUCTION: NOTES AND AUDIT REPORT
Companies on the Brink

The reporting season brings to light the fact that further companies are at risk of bankruptcy in
Switzerland. Auditors are cast in an unfavorable light. At some companies, the auditors simply ignored the
warning signs.
Following the admission by Jomed concerning improper bookings, EMTS is now also having its books audited again.
Although the managing director of EMTS's auditor Deloitte & Touche reported to an Austrian newspaper that only minor
changes were necessary, the mobile phone repair provider will nevertheless be in a mess. Business is poor: During the first
nine months of the past year, the company annihilated EUR 7 million in cash at operational level. Cash reserves amounted to
just EUR 11.3 million as of the end of September. The Austrians were therefore planning to obtain approval for a capital
increase in the next few days.
False Bookings
However, depending on the extent of the false bookings, this is now at risk. And if EMTS is unable to quickly arrange for
refinancing, the company is on the brink: The most pressing problem is not the EUR 22.5 million in long-term borrowed

Chapter 7:
capital. […] Rather, it is the EUR 33.6 million in short-term liabilities, mostly supplier credits, posted by EMTS at the end of
September.
When creditors begin to have doubts about a customer's solvency, they restrict the amount and duration of credit and want to
see cash. And for EMTS, this can quickly become a matter of
life or death: If the position “Short-term liabilities” were to
fall by a mere third, the company would be left high and dry.
As early as 2001, EMTS's books had a number of flaws: Half
of the statement of financial position is composed of goodwill
and intangible assets. Accounts receivable rose by nearly
240% and inventories by 160%. Revenue grew by 60%, but it
lagged behind the growth in current assets. Particularly
because the quality of EMTS's customers is good – 95% of
the receivables balance in 2001 was attributable to Nokia, Sony-Ericsson, and Motorola, which are not known to have a poor
attitude about payment – Deloitte & Touche could have asked itself whether revenues and profits were properly booked.
As auditors of Jomed, Arthur Andersen should also have seen a host of warning signs. The discrepancy between the medical
technology company's operating profit (EUR 26 million) and operational cash flow (EUR 18 million) was too high. The
difference of EUR 43 million went in full toward inventory and accounts receivable.
Warning Signs in the Statements of Financial Position

How can a CFO artificially inflate revenues and profits? The simplest way is by booking income against the asset positions
“Inventory” and “Receivables.” At a bare minimum, the auditors should have insisted on a comment in the annual report that
outstanding accounts receivable of EUR 70 million (with total annual revenue of 165 million) constitute a significant credit
risk. With Card Guard, which collapsed due to defective accounts receivable management, PricewaterhouseCoopers was at
least successful in making mention in the notes of the risks of high accounts receivable, albeit with convoluted wording.
The situation was completely different with the software company Day: KMPG Fides wrote that there was substantial doubt
about whether the company could ensure its continued existence. This was not written in small print in the notes but rather
directly in the auditors' report. Similarly, a warning was made in convoluted language in the annual report of Von Roll.
Depicted article has been modified. From: Handelszeitung. (January 29, 2003)
1. Why did the auditing companies not look good?
2. What is the main duty of an auditor? Which auditing firms were mentioned in the article, and how does their business look
today?
2. Which mandatory component of the financial statements is used to present further information about positions in the
statement of financial position or the statement of profit or loss and other comprehensive income? Why?
3. Which mandatory component of the financial statements presents the quality of accounts receivable?
7.2 Purpose and Scope of the Notes
LEARNING OBJECTIVES
• Recognizing and understanding the functions and meaning of the notes

• Recognizing rules regarding content and structure

Chapter 7:
The notes are an integral component of the financial statements. They supplement, explain and expand the
information provided by other components of the financial statements. For the purposes of clarity and materiality,
certain information is intentionally not depicted in the statement of financial position, the statement of profit or loss
and other comprehensive income, the statement of cash flows or the statement of changes in equity but instead is
disclosed in the notes. In addition, there is also information that is not presented in the other components of the
financial statements because, in terms of content, it cannot be allocated to these parts. As explained in chapter 3,
reporting in connection with financial reporting must follow certain rules, i.e. the accounting standards. It is due to
this consistent ascertainment of the information depicted in connection with periodic financial statements as well as
through the preparation of financial statements according to uniform rules that the recipients of the reporting can be
sure that information relevant to decision-making is presented to them in accordance with a true and fair view.
Information concerning the applied accounting standards and principles, particularly how explicit voting rights are
interpreted, and concerning the examination of accounting standards and principles is one of the central tasks of the
notes.
Table 37: Typical Content of the Notes

Component Explanations
Overview of the applied accounting principles, in particular new rules and rules that no longer need to be
this chapter (chapter 7.2)
considered
Explanations and breakdowns of individual positions from the statement of financial position, the
statement of profit or loss and other comprehensive income, the statement of cash flows, and the this chapter (chapter 7.2)
statement of changes in equity (in some cases required by relevant standards)
Segment reporting see chapter 5.5
Explanations about the statement of cash flows see chapter 6
Transactions with related parties this chapter (chapter 7.3)
Other information about matters not subject to accounting

• Events occurring after the reporting date
• Discretionary decisions
• Uncertainties in estimates this chapter (chapter 7.3)
• Information about financial risks

• Management of capital
• Various other information
Note. Own depiction. Modeled on KPMG AG Wirtschaftsprüfungsgesellschaft. (2012). P. 7.
The notes thus contain a wealth of information that serves to round out the other components of the financial
statements and, above all, to evaluate the risks to a company or group. Accordingly, the notes enable recipients of
the financial statements to obtain an in-depth insight into the financial situation and business of a company or group.
The objective of financial reporting – making the information necessary for a comprehensive evaluation of the
financial and economic position of a company available to recipients – can therefore be achieved only by means of
the interplay of all five mandatory components of the financial statements (the statement of financial position, the
statement of profit or loss and other comprehensive income, the statement of cash flows, the statement of changes in
equity and the notes). The following table shows the typical content of the notes, from which companies usually do
not deviate materially.

Chapter 7:
Definition The notes contain additional information about the financial report in the financial statements. This is not
of notes depicted, or only incompletely depicted, in the statement of financial position, the statement of profit or loss
and other comprehensive income, the statement of cash flows or the statement of changes in equity. As a fifth
mandatory component of the financial statements, the notes serve a number of functions: interpretation,
ratification, explanation, supplementation and correction.

(see chapter 3.5.1)
Whereas the Swiss Code of Obligations dedicates a separate statutory article and Swiss GAAP FER dedicates a
separate standard to dealing with the content of the notes, they are not dealt with under IFRS in one single relevant
standard. In the Swiss Code of Obligations, disclosure is dealt with in Art. 959c CO; under Swiss GAAP FER, it is
Swiss GAAP FER 6 that describes the details with respect to the structure and content of the notes. Under IFRS, the
notes are mentioned in IAS 1, the general standard that describes the depiction of all components of the financial
statements (see chapter 3.5). In addition to these standards, under both IFRS and Swiss GAAP FER the relevant
standards for the corresponding topics (e.g. leasing, IAS 17) deal with additional explanations and breakdowns for
individual positions that have to be disclosed in the notes. Since the notes contain a multitude of information, they
also serve a number of functions:
§ Interpretation function § Supplementation function

§ Ratification and explanation function § Correction function
7.2.1 Interpretation Function

Figure 78: Nestlé Example: Applied Financial Reporting Principles
Nestlé EXAMPLE
The recipients of reporting can make decisions based on information depicted in the annual report only if they are
able to fully understand and correctly interpret the information. Therefore the notes have an important interpretation
function with the depiction of the accounting principles and policies that are being applied. The information about
accounting policies comprises the approaches and methods explained in chapter 4 to 7, which are briefly explained
to the reader in the notes in order to provide him or her with sufficient understanding of the accounting basis. Only

Chapter 7:
when a recipient knows how a company applies accounting standards can he or she correctly evaluate the company's
financial position as it relates to his or her decision and draw comparisons with other companies. In addition, with
consolidated financial statements, the consolidation principles and the scope of consolidation must be set forth in the
notes. In connection with the interpretation function, the notes in particular cover information with regard to:
§ Definitions of cash and cash equivalents

§ Inventory valuation procedure
§ Amortization/depreciation procedure and the underlying useful lives of assets
§ Fair-value calculation procedure
§ Consolidation principles
7.2.2 Ratification and Explanation Function
The notes also have a ratification and explanation function. Although certain transactions and basic conditions are
shown in one of the four mandatory components (statement of financial position, statement of profit or loss and
other comprehensive income, statement of cash flows and statement of changes in equity), they are not explained in
detail. For example, certain positions are aggregated in collective positions. Here, the notes serve an important
function by breaking down such positions and supplementing them with a detailed list. With the aid of such lists, the
reader understands the exact composition of the positions and how the figures came about. In this regard, the most
important lists are in connection with the following positions from the statement of financial position:
§ Inventories (see chapter 4.3.1)

§ Trade receivables (see chapter 4.3.2)
§ Property, plant and equipment: statement of changes in non-current assets (see chapter 4.4.1)
§ Goodwill and intangible assets (see chapter 4.4.3)
§ Employee benefits (see chapter 5.4.2)
§ Financial assets and financial liabilities (see chapter 4.4.2 and chapter 4.5.1)
§ Provisions and contingent liabilities (see chapter 4.5.2)
§ Taxes
Figure 79: Nestlé Example: Taxes
Nestlé EXAMPLE

Chapter 7:
7.2.3 Supplementation Function
Various information that is not reflected in matters subject to accounting but that is relevant for the evaluation of
assets, the financial position and the earnings situation may be set forth only in the notes. Therefore the notes have a
supplementation function, since information can be seen in the notes that is not set forth in the other mandatory
components. The most important headings in this connection are:
§ Transactions with related organizations and persons

§ Off-balance sheet transactions
§ Earnings per share
§ Risk assessment
§ Joint ventures and collaborations in project consortiums with a profit participation of less than 50%
§ Holdings in other companies (associated companies)
§ Group companies
§ Guaranties
§ Transactions with related parties
§ Events after the reporting date
Figure 80: Nestlé Example: Earnings per Share
BEISPIEL Nestlé
7.2.4 Correction Function
Despite the principle of consistency, there are always changes in the depiction of the financial statements and with
regard to valuation fundamentals. In order to ensure that the financial statements are comparable with prior years
(time) and with other companies (inter-company), qualitative and, where possible, quantitative information has to be
provided in the notes about the changes made. The notes thus have a correction function. (Boemle, 2008, p. 408)
The following table summarizes the four most important functions of the notes, along with the questions of the
recipient in this connection and the content for addressing this question.

Chapter 7:
Table 38: Functions of the Notes
Function Question Content in the notes
§ How do positions in the statement of
financial position and the statement of
§ Overview of the applied financial reporting
profit or loss and other comprehensive
Interpretation function principles
income have to be interpreted?
§ Which principles are used and how were
values calculated?
§ How did the aggregated figures in the § Detailed explanations and breakdowns of
Ratification and statement of financial position, statement individual positions from the statement of financial
of profit or loss and other comprehensive position, statement of profit or loss and other
explanation function income and statement of cash flows arise comprehensive income, and statement of cash
and what are they composed of? flows
Supplementation § What information relevant to the financial

§ Other information about matters not subject to
statements is not contained in any of the
function accounting
three mandatory components?
§ Is there an interruption in the consistency § Information about the changes made to the form of
Correction function of the applied form of depiction or the depiction of the financial statements and the
applied valuation fundamentals? applied valuation fundamentals
7.3 Select Components of the Notes
LEARNING OBJECTIVES
• Recognizing the correlation between the individual mandatory components (statement of financial position, statement
of profit or loss and other comprehensive income, statement of cash flows, statement of changes in equity and the
notes)
• Recognizing supplemental information that is not accounted for
In order to satisfy the interpretation as well as ratification and explanation function, each position from the statement
of financial position, statement of profit or loss and other comprehensive income, statement of cash flows and
statement of changes in equity must show a cross-reference to all related information in the notes. The extent to
which the individual positions from the statement of financial position, statement of profit or loss and other
comprehensive income, statement of cash flows and statement of changes in equity are disclosed in the notes is
generally dealt with in the relevant accounting standards. The information to be provided was therefore already
discussed in chapter 4 to chapter 7. In connection to this, table 40 in chapter 7.2 shows the chapters in this book that
handle the extent of disclosure. For example, property, plant and equipment and the associated statement of changes
in non-current assets in the notes are discussed in chapter 4.4.1. In particular, lists such as the statement of changes
in non-current assets and overviews about reserves and financial liabilities are very important and were explained in
chapter 4. For this reason, this chapter addresses the information in the notes that has a supplementation function
and is not contained in the other mandatory components (statement of financial position, statement of profit or loss
and other comprehensive income, statement of cash flows and statement of changes in equity). However, the
following aspects of disclosure are not to be viewed as exhaustive.

Chapter 7:
7.3.1 Transactions with Related Parties
Parties who can directly or indirectly exercise significant influence over the company's financial or operational
decisions are called a related party (parties over which the company can exercise significant influence were
addressed in connection with consolidation, see chapter 9). Such a party may be a natural or legal person. All
transactions with related parties are not comparable to arm's-length transactions between unrelated parties (third
parties), since arm's-length terms and conditions are not necessarily used as a result of the special relationship and
the interests. For this reason, transactions and outstanding balances with related parties are disclosed in the notes. In
many cases, the remuneration paid to group management and the board of directors is also listed under this same
heading. Under IFRS, as well as for listed companies under the Swiss Code of Obligations, this disclosure is
mandatory (Amstutz, Eberle, Haas, Haas & Hallauer, 2013, p. 22).
7.3.2 Off-Balance-Sheet Transactions
Summarized under off-balance-sheet transactions are transactions and risks that are not yet reflected in the statement
of financial position, statement of profit or loss and other comprehensive income, statement of cash flows or
statement of changes in equity, or perhaps never will be, but are nevertheless important for an overall assessment of
the economic position. Only if the reader of the annual report is aware of these transactions and risks can he or she
make the correct decisions. Off-balance-sheet transactions include, but are not limited to, the following transactions
and factors (Amstutz, Eberle, Haas, Haas & Hallauer, 2013, p. 22):
§ Legal disputes (that are not booked as provisions)

§ Pledging of shares (for a loan or other transactions)
§ Contingent liabilities (guaranties, joint and several pledges as well as other contingent liabilities)
§ Long-term operating leases
§ Capital commitments
7.3.3 Events Occurring After the Reporting Date
Week or months pass between the reporting date, which is often December 31 or June 30, and publication of the
annual report. For this reason, it may be that, between the date of the financial statements and their publication,
material events occur that could influence the financial statements for the prior fiscal year or reporting period. In
general, a distinction is made between two types of events:
§ Events after the reporting date that are required to be taken into account are events that provide additional
substantive indications about circumstances that were already present on the reporting date (e.g. events that
already indicate impairment as of the reporting date)
§ Events after the reporting date that do not need to be taken into account are events that indicate
circumstances that only occurred after the reporting date (e.g. change in market value due to market
changes)
In the former case, the amount is adjusted in the financial statements. In the latter case, the amount is not adjusted in
the financial statements, but information is provided in the notes about the nature and estimated amount where the
event is of particular importance (KPMG AG Wirtschaftsprüfungsgesellschaft, 2012, p. 32).

Chapter 7:
7.3.4 Information about Financial Risks and Management of Capital
The notes should mention relevant financial risks and how these are being addressed. In particular, this has to do
with loan, liquidity and market risks in connection with financial instruments (trade receivables, financial assets,
etc.). This information is important because financial instruments often make up a significant share of total assets
and thus can have a material influence on the company's future development. Market risks primarily consist of
currency and interest rate risks, which are evaluated using sensitivity analyses. Liquidity risk primarily has to do
with temporal components and thus with contractual maturities of financial liabilities. In contrast, credit risk consists
of the risk of counterparty default and thus covers such issues as concentration risk on the counterparty level.
Related to financial risks is the management of capital, which is intended, among other things, to meet these risks
and is characterized depending on the company's effective risks. Under Swiss GAAP FER, information about
financial risk and/or management of capital does not have to be disclosed (Amstutz, Eberle, Haas, Haas & Hallauer,
2013, p. 25).
7.3.5 Risk Evaluation
In addition to evaluating financial risks, the Swiss Code of Obligations (Art. 663b (12) CO) requires a risk
evaluation for the group as a whole, with special consideration of such issues as industry affiliation, technological
developments, labor market trends, external influences, internal organization, etc. However, the law does not require
any specific form of depiction and content, for which reason companies are at liberty in this respect. As a result,
annual reports range from describing the processes of risk evaluation to depicting material risks (Amstutz, Eberle,
Haas, Haas & Hallauer, 2013, p. 25). For the recipients of the financial statements, it is important to know whether
risks have a material influence on the company's business – and if so to what extent – and thus on financial reporting
(Boemle, 2008, p. 444).
7.3.6 Further Information
Pensions and financial liabilities are among the largest liability positions, and they also contain a great deal of
complex information. For this reason, comprehensive information about these two positions in the statement of
financial position is disclosed in the notes.
Pensions:
As explained in chapter 4.5.2 in connection with provisions for pensions and in chapter 5.4.2 with respect to pension
expenses for the current period, a group has a statutory and/or contractual duty to provide benefits to its employees
or other beneficiaries for old age or in the event of death or disability. The disclosure in the notes with respect to
pensions covers surpluses or shortages in the pension fund ascertained according to uniform criteria, as well as the
components of pension costs and the change in the group's pension liabilities or credits. As explained in the chapters
cited, there is a duty to account where there are defined benefit pension plans. With defined benefit plans, the
employer bears the actuarial risk. Surpluses or shortages can be ascertained by comparing the present value of
pension obligations with the market value of plan assets (KPMG – Reading and understanding ARs. p. 24).
Financial Liabilities:
Using details about financial liabilities, conclusions can be drawn about future cash outflows from financing
activities and the liquidity position. The reader is primarily interested in long-term debts. The notes disclose not only

Chapter 7:
the breakdown of financial debts by amount but also the maturity structure, while the terms and conditions are
normally shown as well. There is no duty to disclose open, unused limits, but many companies provide these figures
and thus disclose information about financing latitude.
7.4 Audit Report
LEARNING OBJECTIVES

• Recognizing legal fundamentals
• Being able to explain the scope of the audit
• Being able to distinguish between negative net worth and over-indebtedness
On behalf of the shareholders' meeting, the auditors examine whether the annual and consolidated financial
statements are in conformity with the provisions of law, the articles of association and the stipulated accounting
standards. As an independent part of the annual report, the audit report constitutes a relatively brief yet very
important section. In the often one- to two-page audit report, it is revealed in standardized form whether financial
reporting accurately depicts the economic position of the audited company and whether this was depicted pursuant
to the applicable accounting standards and statutory provisions. The auditors can audit only in terms of risk. This
means that the auditors may not make any statements about the economic performance of the audited company and
its prospects for the future. In the event of deviation from the applicable accounting standards or the statutory
provisions, the auditors may note so-called reservations or limitations with respect to compliance with provisions. In
such a case, a limited opinion is issued.
7.4.1 Legal Fundamentals
The audit report is included in the Swiss Code of Obligations and is dependent on various aspects, such as revenue,
number of employees, etc. (see chapter 9.2). The Swiss Code of Obligations recognizes two types of audits: the
ordinary audit and the limited audit. Large companies and groups that apply IFRS, as well as international groups
that account using Swiss GAAP FER, are subject to ordinary audits, for which reason the limited audit will not be
addressed in detail here. With the ordinary audit under Art. 728a CO, the auditors examine the following issues:
§ Whether the financial statements and, where applicable, the consolidated financial statements comply with
legal provisions, the articles of association and the chosen accounting standard
§ Whether the motion presented by the board of directors to the shareholders' meeting on the allocation of the
statement of financial position profit complies with legal provisions and the articles of association
§ Whether there is an internal system of control
7.4.2 Scope of the Audit
In Switzerland, an ordinary audit is performed according to the Swiss Auditing Standards. Established principles for
proper performance ensure the quality of the audit by the public auditors. The Auditing Standards are binding on
public auditors. The audit process is therefore highly formalized, and stipulated audit strategies and programs are
applied. The auditing firm takes into account the company's business and environment, as well as its accounting
system and internal system of control, in the customized audit program. As mentioned above, the audit approach is

Chapter 7:
risk-oriented. Therefore the definition of materiality plays a key role. The public auditors focus on positions in the
financial statements for which there is a possibility of material errors or where the risk would be greatest.
Information is material if its omission or flawed depiction may influence the economic decisions of recipients made
on the basis of the financial statements. If the consolidated financial statements are prepared according to an
international accounting standard, corresponding auditing standards are likewise applied. In connection with IFRS
these are the International Standards on Auditing (ISA), and for US GAAP they are the US Generally Accepted
Auditing Standards (US GAAS)
7.4.3 Negative Net Worth and Over-indebtedness
The situation of negative net worth has special significance for a company. Under the Swiss Code of Obligations,
negative net worth exists where a company shows a loss carried forward or a statement of financial position loss for
the current period. In other words, assets no longer fully cover equity. Negative net worth occurs in the event of
losses (for a newly formed company) or in the event of repeated losses that exceed the reserves in equity (for
companies with profits in prior years).
Figure 81: Types of Negative Net Worth
Note. Own depiction. Modeled on Carlen, Gianini & Riniker 2005. P. 85.
From a Swiss commercial law standpoint, there are three cases of negative net worth:
§ Negative net worth without legal consequences

There are no legal consequences if the assets still cover liabilities and at least half of the share capital and
statutory reserves. In the case of negative net worth, pursuant to Art. 671, 3 CO, general reserves may be
used to cover losses.
§ Negative net worth with legal consequences: Capital loss
Art. 725, 1 CO refers to a capital loss where one half of equity capital and statutory reserves is no longer
covered. In this case, the board of directors is obligated to immediately convene a shareholders' meeting
and propose restructuring measures.
§ Negative net worth with legal consequences: Over-indebtedness (pursuant to Art. 725, 2 CO)
Over-indebtedness exists where assets no longer fully cover liabilities (i.e. losses from prior years exceed
equity capital). According to Art. 725 2 CO, in this case an interim statement of financial position is to be
drawn up at going-concern and liquidation values and then submitted to the auditors. If under both
scenarios liabilities are not fully covered, the board of directors must notify the court, unless creditors
subordinate their claims.

Chapter 7:
In the audit report, negative net worth with legal consequences is mentioned in order to point out the company's
endangered condition (Based on Carlen, Gianini & Riniker. 2005. Höhere Finanzbuchhaltung. P. 83-85).
Table 39: Bankruptcy of Mindset Holding AG
MINDSET BANKRUPTCY
CASE STUDY
PRESS RELEASE
Pfäffikon SZ, August 31, 2012
Mindset Holding AG gives notice of its over indebtedness and insolvency

and applies for the opening of bankruptcy proceedings
At its meeting yesterday, the board of directors of Mindset Holding AG resolved

to request the local court in Hofei SZ to open bankruptcy proceedings. This
decision became unavoidable after Mindset was unsuccessful over recent months
and years in securing financing to cover series production of the electric vehicle.
A series of negotiations with industry partners and financial investors was unsuccessful. The restructuring efforts have to be termed a
failure. The board of directors greatly regrets this step and would like to thank the shareholders for the trust that they have shown. We
are disappointed to state that, in the current stock exchange environment, conventional forms of investment are preferred to a highly
innovative project.
MINDSET HOLDING AG is the quoted parent company of Mindset AG. The mindset is a new type of automobile that differs
dramatically, both technologically and aesthetically, from traditional vehicle concepts. The Mindset was from the very outset designed to
be an electric automobile for everyday use. The development and marketing of the mindset constitutes the company's core business.
Note. From: Mindset (2012). Excerpt from press release.
Table 40: Bankruptcy of Jomed
BANKRUPTCY OF JOMED
CASE STUDY
What Investors Can Learn from the Jomed Bankruptcy

In January, the share price of the medical technology company Jomed collapsed by more than
80% in several days. “Today, we look more closely,” say analysts. They recommend that small
investors today exercise great restraint.
The Jomed story sounds unbelievable. The CFO had no qualms about resorting to tricks and booking revenues that were completely
unearned. The aim was to create a slightly better impression for the capital markets, which had a favorable view of the company anyway.
Did the company's CEO [...], who himself had a significant stake in the firm and was therefore interested in a high stock price, cover up
for his CFO? Or was the boss so incompetent that he had no idea about the company's revenues?
The highly paid public auditors of the now defunct auditing firm Arthur Andersen accepted the accounting and signed off. Now it has
become known that at least four Jomed employees deliberately made incorrect bookings, thereby creating problems for the company. It
is unclear whether the auditors were aware of this.
When word got out, very embarrassed faces were to be seen on all sides. Resignations, apologies – and application to the bankruptcy
court just one week later. Within hours, the stock, formerly hyped by the financial media and analysts, went into free-fall, drawing other,
totally uninvolved companies down with it into the morass. The flagship company, once valued at more than 2.5 billion on the Swiss
exchange SWX, is currently worth just CHF 40 million. For cheated investors, nothing short of a fiasco.
Now, some are starting to ask: “How could it come to this?” […] It is no great leap to make an analogy to the considerably more
spectacular cases in the US, like Enron and WorldCom.
For […], an analyst at the bank Julius Bär, there were “no signs” of such a catastrophe. “We have to be able to rely on the audited
financial statements,” says the qualified biochemist, who has been tracking the company for some time. [...] Even in retrospect, he says:
“The figures submitted to us seemed plausible.”
And much that Jomed promised is also true [...] “The control mechanisms would have been there,” says [...], an analyst at the Geneva
private bank Lombard Odier Darier Hentsch. But in this case, they wouldn't have worked. […] But at Lombard Odier at least they've
been warned: “Today, we look more closely and verify at many companies who's handling the audit and whether the auditing firm has
been changed […].”
Note. From: Strohm (2009). Article modified.
Table 41: Bankruptcy of Swissair

Chapter 7:
SWISSAIR GROUP BANKRUPTCY

CASE STUDY
Ernst & Young Findings in Review of Swissair
On behalf of the trustee, we here present a findings summary from our examination of the Swissair matter.
Over indebtedness and Endangered Continued Existence
At the holding level (separate financial statements of the SAirGroup), proper accounting would have revealed a capital loss in the
financial statements for the year 2000. If the principle of prudence had been applied as required, the SAirGroup would almost certainly
have been over indebted as of December 31, 2000, because, among other things, the investment in SAirLines was overvalued by roughly
CHF 1.0-1.5 billion. As of December 31, 2000, there was at least a justified concern of over indebtedness. Furthermore, a statement of
financial position prepared at liquidation values probably would not have eliminated the over indebtedness, since liquidation values in
such situations are inevitably lower than going-concern values.
Both at the time of preparation of the separate financial statements for 2000 for the SAirGroup and the consolidated financial statements
for 2000 for the Swissair Group (formally approved by the board of directors on March 30, 2001) and at the time of
publication/presentation (statement of financial position press conference on April 2, 2001, and shareholders' meeting on April 25,
2001), the continued existence of the SAirGroup was seriously endangered.
Note. From: Ernst & Young. 2003, p. 3. Excerpt from the examination findings.
7.5 Summary
Purpose and Scope of the Notes:
The notes are an integral component of the financial statements. The notes provide information that the other
components are unable to provide or provide only to a limited extent. They are intended to supplement, explain and
expand the information provided by the other components. In this way, the notes provide deeper insights into a
group's financial situation and business. The notes comprise the following content:
§ Overview of the applied financial reporting principles

§ Explanations and breakdowns of individual positions from the statement of financial position, the statement
of profit or loss and other comprehensive income, the statement of cash flows and the statement of changes
in equity (in some cases required by relevant standards)
§ Segment reporting
§ Transactions with related parties
§ Off-balance-sheet transactions
§ Other information about matters not subject to accounting
The notes have the following four functions:

§ Interpretation function: information about accounting policies
§ Ratification and explanation function: many positions are broken down and explained with a detailed list
§ Supplementation function: additional information that is not reflected in matters subject to
accounting
§ Correction function: changes in the depiction of the financial statements and in
valuation fundamentals are depicted.
Selected Components of the Notes:
§ Relevant transactions with related parties are not comparable to arm's-length transactions between
unrelated parties (third parties) and must therefore be listed in the notes.
§ Off-balance-sheet transactions are transactions that are not yet reflected in the statement of financial
position or perhaps never will be (e.g. legal disputes, pledges, contingent liabilities, etc.).

Chapter 7:
§ Since weeks or months pass between the reporting date and publication of the annual report, so-called
“events occurring after the reporting date” may arise that would have a material impact on results.
§ The notes should mention relevant financial risks and how these are being addressed. In particular, this has
to do with loan, liquidity and market risks in connection with financial instruments.
§ The notes contain a risk evaluation for the group as a whole, with such issues as industry affiliation,
technological developments, labor market trends, external influences, internal organization, etc.
Audit Report:
The auditors examine whether the annual and consolidated financial statements are in conformity with the
provisions of law and the articles of association, whether financial reporting accurately depicts the economic
position of the audited company, and whether this was depicted pursuant to the applicable financial reporting
standards.

Behr, G. & Leibfried P. (2014). Rechnungslegung (4. Aktualisierte und überarbeitete Auflage). Zürich: Versus.
mit Beispielen, Repetitinsfragen und Antworten. Zürich: Compendio Bildungsmedien.
SKV.
Carlen, F., Gianini, F. & Riniker, A. (2005). Höhere Finanzbuchhaltung. Zürich: Verlag SKV.
Schaeffer-Poeschel.

Chapter 8:
Corporate Governance and Other Reports 175
Corporate Governance and Other Reports
Despite the extensive numerical information contained

in the mandatory components of financial reporting,
recipients require additional information about the
company and its activities. In addition to business
development in connection with a management report,
stakeholders are also increasingly interested in remarks
about management, market cultivation, strategic
decisions and the approach to the environment. In
addition to established corporate governance with
information about the direction of the company, an
increasing number of other reports and analyses have
started to be published in recent years.
8.1 Introductory Example from Hilcona
INTRODUCTION: CORPORATE GOVERNANCE AND OTHER REPORTS
Hilcona AG Takes Over Gastro Star AG

Hilcona is reinforcing its position in the category of fresh convenience food: The range of products – sandwiches, pizzas,
pasta, fresh meals, sauces, soups and muesli – that is already well established on the market will now be expanded with ultra-
fresh products from Gastro Star. These products include kitchen-ready salads, fruits, vegetables and vegetable mixes. With a
daily production of 30-40 tons of fresh products, Gastro Star is an up-and-coming company of ultra-fresh convenience. […]
Jobs and Locations Remain

The 530 jobs at Gastro Star in Dällikon (canton of Zurich) and the roughly 110 positions at the subsidiary Schwarz Viva AG
in Villigen (canton of Aargau) will be maintained. […] Established production and distribution locations will be continued.
Hilcona Bolsters Market Position

By taking this step, Hilcona is bolstering its presence in the rapidly growing area of fresh convenience. The goal of growing
faster than the market is in line with the company's long-term, clearly defined strategy. The synergies arising from this
merger of Hilcona and Gastro Star will be used to bolster Hilcona's performance, sustainable profitability and market
position. The Hilcona Group has approximately 1 300 employees.
Gastro Star with New Opportunities

Hilcona's acquisition of Gastro Star provides them both with new opportunities. Access to Hilcona's distribution channels
will provide fresh growth momentum for both companies. The sale of the company, which was founded in 1972 […], also
ensures continuity in connection with the desired successor arrangement.
Customers Get Everything From One Source

Chapter 8:
Hilcona AG focuses on food retailing, the discount channel, the impulse purchase area and the hotel, restaurant and catering
sector in its home country of Switzerland and the neighboring EU. With Gastro Star AG, additional product lines for retail
business, gas stations and gastronomy will now be added. Larger, more extensive fresh-product ranges and services from one
source, delivered fresh daily, make shopping much easier for customers.
About Hilcona
Hilcona has developed from being Switzerland's largest preserved-foods manufacturer into a pioneer in fresh convenience in
Switzerland and surrounding EU countries. Hilcona serves all major retail and gastro food channels in Switzerland and
surrounding countries. Hilcona is the leader in most of the offered product lines. In Germany, Hilcona is the most well-
known brand for “fresh pasta.”
• Range of products: sandwiches, pasta, salads, fresh meals, pizzas, sauces and soups, as well as fruit, potato and
vegetable products and more
• Four locations: Schaan (headquarters), Orbe, Schafisheim and Lupfig
• Number of employees to date: approximately 1 300; main focus: German, Austrian and Swiss markets for food
retail, impulse and discount area, gastronomy and food industry
• Toni Hilti Familientreuhänderschaft holds 51% of Hilcona, while Bell AG holds 49%
• Revenue for 2011: approximately CHF 400 million
Adapted corporate announcement. From: Hilcona. (May 9, 2012).
1. Is all of the information in the corporate announcement also contained in Hilcona's annual report?
2. In which components of Hilcona's annual report can the following information be found?
• Announcement and orientation about company take-over
• Information about strategy pursued with the take-over
• Information about Hilcona (range of products, locations, employees, revenue)
• Shareholdings of Hilcona's owners (Toni Hilti Familientreuhänderschaft and Bell)
8.2 Other Reports in the Annual Report
LEARNING OBJECTIVES

• Recognizing the components of the annual report
In addition to the components of the financial statement that are certified by auditors, a number of additional reports
can be found in the annual report that provide information about the company. Examples of additional reports are:
§ Management report (directors' report / letter of the CEO / letter of the board of directors)
§ Information about corporate social responsibility
§ Information about corporate governance
§ Information about the business model and markets served
§ Value added statement
§ Environmental records
Many publicly traded companies in Switzerland now publish a very comprehensive annual report. For some of these
companies, the annual report is so extensive that the companies separate the financial statements from the

Chapter 8:
management report and other reports. However, the term “annual report” is still considered to comprise the entirety
of all of these reporting elements. The aforementioned additional reports are often set against the financial part
(financial statement) as the reporting part. Analogous to the notes, the reports are intended to provide additional
information to complement the figures in the financial part and to highlight other backgrounds. In addition, these
reports provide an estimate of the company's near future and information about company management (executive
committee and board of directors), and they are also designed to show the impact of economic activity on the
environmental sphere (see St. Gallen management model in chapter 2). Since the supplemental reports in the
financial statement as well as in the annual report are not audited, companies have some latitude in their
presentation. A presentation by management that glosses over certain factors can lead to legal disputes if the
company develops differently than depicted in the additional reports and the share price falls, for example. These
reports are thus interesting in connection with prospectus liability.
8.3 Management Report
LEARNING OBJECTIVES

• Recognizing the tasks and content of the management report
• Being able to show the relation to corporate governance
The management report is required by law and provides a summarizing view of all mandatory components of the
financial statement and in addition provides further information. In particular, it has to do with the company's
business performance, which is only indirectly apparent from the financial statement. Accordingly, the management
report, which is formulated as a textual report, complements the financial statement with the aim of providing a
better understanding of financial and economic correlations. The financial statement lacks information such as
incoming orders, order portfolio, important transactions and the composition of the customer base. For readers of the
financial statement, the numerical material is usually only fully comprehensible with an explanation such as that
provided by the management report. Moreover, the management report provides in-depth insight into the assessment
regarding the business development by the company's senior management. Although the management report has
different names, it usually includes the same type of information. Synonyms include the directors' report,
management discussion, and discussion and analysis by management. Since in the management report the aspects to
be addressed are primarily those that are not directly apparent from the financial statement, the management report
normally comprises the following information:
§ Key financial indicators for the past year

§ Trends in and commentary about business performance, broken down by company area
§ Trends in relevant markets
§ Degree of capacity utilization
§ Investment and production activity
§ Extraordinary events
§ Risk management
§ Employees
§ Strategies and prospects for the upcoming year

Chapter 8:
The management report encompasses the significant characteristics of the asset, financial and revenue situation of
the company and combines these with qualitative and strategic implementations of the past fiscal year, informs
about the most important elements of uncertainty and offers an outlook for the immediate future.
8.3.1 Law and Financial Reporting
A management report is explicitly required by law, but the company drawing up the accounts has a great deal of
freedom in structuring it. Under Art. 961c CO, larger companies and, in particular, publicly traded companies are
required to prepare a management report. In the article, the definition and the content are stipulated as follows.
Art. 961c CO Management Report
1
The management report presents the business performance and the economic position of the company and, if applicable, of
the corporate group at the end of the financial year from points of view not covered in the financial statement.
2
The management report must in particular provide information on:
1. the number of full-time positions on average for the year;
2. the execution of a risk assessment;
3. orders and assignments;
4. research and development activities;
5. extraordinary events;
6. future prospects.
Neither IFRS nor US GAAP requires a management report as a mandatory component. However, IFRS in IAS 10.11
mentions the management report, with rudimentary information about what it contains, and indicates that many
companies prepare one. In contrast to IFRS, Swiss GAAP FER requires that a management report be published, and
it defines a framework concept with the following minimum substantive information:
§ Environment: summary of the economic environment in the past year (e.g. market and sector trends,
competition, relevant framework conditions such as economic climate, statutory changes) and future
expectations with respect to the economic environment.
§ Fiscal year: discussion of the components of the financial statement using key financial indicators from the
statement of financial position and the statement of profit or loss and other comprehensive income, as well
as their development.
§ Outlook: discussion of the further development of the organization, particularly for the coming fiscal year,
above all also with respect to risks and opportunities.
8.3.2 Corporate Governance and Management Report
Corporate governance and all additional information about company management are sometimes included in the
management report. This is for historical reasons, since corporate governance as a separate component of the annual
report first became significant in the last decade. Because of the increased significance, it is more frequently being
presented as a separate part of the report and the management report is dedicated, as the name implies, solely to
economic developments in the past year.

Chapter 8:
8.3.3 Liability
The management report has implications for liability because a company's management ventures to offer an outlook
and a business forecast. The expectations that this engenders may result in legal disputes. Despite this risk,
companies are practically forced to publish a management report, since investors today expect extensive information
about business performance and prospects for success.
8.4 Corporate Governance
LEARNING OBJECTIVES

• Being able to explain corporate governance in connection with the annual report
• Recognizing the (legal) bases for reporting about corporate governance
As explained in the preceding chapter, corporate governance6 is often presented in connection with the management
report. However, in contrast to the management report, IFRS, Swiss GAAP FER or the Swiss Code of Obligations
does not stipulate a reporting disclosure about corporate governance. As a result, it comes as no surprise that there is
no universally valid definition for the term “corporate governance.” Although to date a uniform definition of
corporate governance has not emerged, reporting about corporate governance does not differ significantly between
entities. Consequently, the corporate governance report depicts the framework of rules and the principles of the
company's direction. Although the corporate governance report is not a component of IFRS, there are other
directives that require such a corporate governance report:
§ Germany: Corporate Governance Code

§ Switzerland: Swiss Code of Best Practice, SIX Transparency Directive
§ US: Sarbanes-Oxley Act
In Switzerland, there are essentially no obligatory principles. The Swiss Code of Best Practice (SCBP) has the
character of a recommendation. However, in the case of listing on the SIX (Swiss stock exchange), the SIX
Transparency Directives have to be satisfied, which require, among other things, disclosures about corporate
governance. Exceptions to these directives have to be cogently substantiated. Under the SCBP, corporate
governance is defined as follows:
Corporate Toward a definition:

Governance (CG) The term “corporate governance” is understood to encompass the full range of principles directed
towards shareholders' interests, seeking transparency and a good balance between direction and control
at the top company level while maintaining decision-making capacity and efficiency. (SCBP)
Corporate governance is particularly concerned with the disclosure of the structures of company management in
order to create transparency and control through this. In Switzerland, the following three issues are discussed in
connection with corporate governance in particular:
6
Governance = act, fact, manner of governing, control.

Chapter 8:
§ Reasonableness of the remuneration of members of the board of directors and the executive committee and
its disclosure.
§ Responsibility as CEO and chair of the board of directors falling to one person
§ Composition of the board of directors and the executive committee, taking into account so-called “diversity
aspects” (with respect to knowledge, experience, gender, age, origin, etc. of members of the board of
directors and executives)
(KPMG, undated)
Figure 82: Nestlé Example: Corporate Governance Introduction

Nestlé EXAMPLE
From: Nestlé Group 2018 Management Report. p. 58
8.4.1 SIX Directives
Since many large Swiss companies are listed on the stock exchange, SIX directives are very important for large
Swiss companies. SIX has broken down corporate governance into nine areas for which the company must provide
information. Table 51 lists the topics and their sub-chapters.
Table 42: SIX Corporate Governance Directives
1.1. Description of the operational group structure
SIX Corporate Governance Directives
1. Group structure and

1.2. Scope of consolidation and cross-shareholdings
shareholders
1.3. Significant shareholders
2.1. Capital: authorized and conditional capital in particular
2.2. Changes in capital
2. Capital structure 2.3. Shares, participation certificates and participatory notes
2.4. Limitations on transferability and nominee registrations
2.5. Convertible bonds and options
3.1. Members of the board of directors as well as other activities and vested interests
3.2. Elections and terms of office
3. Board of directors
3.3. Internal organizational structure and definition of areas of responsibility
3.4. Information and control instruments vis-à-vis the executive committee
4.1. Members of the executive committee as well as other activities and vested interests
4. Executive committee
4.2. Management contracts
5.1. Content and method of determining the remuneration and the shareholding programs
5. Remuneration,
shareholdings and loans 5.2. Transparency of remuneration, shareholdings and loans pertaining to issuers with registered
offices outside Switzerland
6.1. Voting right restriction and representation as well as statutory quorums
6. Shareholders'
6.2. Convocation of the shareholders' meeting and inclusion of topics on the agenda
participation
6.3. Entries into the share register
7. Changes of control and 7.1. Duty to make an offer
defense measures 7.2. Clauses on changes of control
8.1. Duration of the mandate and term of office of the lead auditor
8. Auditing body 8.2. Auditing fees as well as additional fees
8.3. Information instruments pertaining to an external audit
9. Information policy
From: SIX (October 29, 2008)

Chapter 8:
8.4.2 Corporate Governance – Company Comparison
The table below lists the corporate governance principles of various companies as examples from practice.
Table 43: Case Study: Corporate Governance – Company Comparison
CORPORATE GOVERNANCE OF VARIOUS COMPANIES

O
The corporate governance principles of UBS are designed to lead the firm towards sustainable growth and
CASE STUDY
to protect the interests of its shareholders as well as to create value for shareholders and stakeholders.
We strive to act with integrity, responsibility, fairness, transparency and discretion at all times in order to
secure the trust of all stakeholders.
Sulzer is committed to the principles of good corporate governance. They ensure a sound balance of power
and support the company in creating sustainable value for its different stakeholders.
Corporate governance puts the focus not only on business risks and the company's reputation, but also on
corporate social responsibility towards all our stakeholders. As a responsible business, we recognize the
significance of effective corporate governance. We show respect for society and the environment,
communicate in an open and transparent manner, and act in accordance with legal, corporate and ethical
guidelines. To underline this, a Code of Conduct binding for the entire Group has been added to the
mission statement.
Geberit's corporate governance practices are based on the principles and rules of the “Swiss Code of Best
Practice” of economiesuisse as well as the directives issued by the SIX Swiss exchange. An account of
them is provided every year in the annual report. The central elements are laid down in the articles of
incorporation and in the regulations of the board. Furthermore, the board explores the issue of corporate
governance on a regular basis and initiates appropriate improvements as required.
The corporate governance of Syngenta is aligned with international standards and practice. The company
complies with the “Swiss Code of Best Practice” and meets the rules of the New York Stock Exchange
(NYSE) as applicable for foreign companies. Syngenta is in compliance with the applicable requirements
of the US Sarbanes-Oxley Act of 2002, including the certification of the annual report prescribed by the
US Securities and Exchange Commission (so-called Form 20-F) by the CEO and the CFO and the report
of the external auditors on the assessment of internal control of financial reporting by management.
Note. From: websites (About us à Corporate governance) of UBS, CS, Sulzer, Holcim, Geberit and Syngenta.
8.5 Corporate Responsibility
LEARNING OBJECTIVES
• Being able to explain corporate responsibility in connection with the annual report
• Recognizing the background to reporting about corporate responsibility
Reporting, which has traditionally been aimed at capital providers, is often supplemented by social reporting known
as corporate responsibility (CR). It describes the impact of corporate activities on society and the various
environmental spheres of a company. CR comprises the components corporate social responsibility (CSR),
corporate governance (CG) and sustainability business. CSR focuses on the impact of corporate activity on society
and the environment. In contrast, sustainability reporting focuses primarily on the sustainability of business in all of
the company's environmental spheres. The third component of CR, corporate governance, focuses on company
management (see preceding section). However, the terms are not used with precision in theory and practice; as with
corporate governance, there are no universally valid definitions. The terms have for years been familiar

Chapter 8:
internationally in companies, associations, politics and interest groups, but there are very different attempts at
definitions and these are often established on a discretionary, image promoting or occasionally misleading basis.
Corporate Attempt at a definition:

Responsibility (CR) Corporate responsibility is a broad term describing every influence that corporate activity has on
society and the environment.
http://www.nachhaltigkeit.info/artikel/abgrenzung_cs_csr_cc_1501.htm?sid=7a183f42cff592e17e07a2c844b558b0
Corporate Social Attempt at a definition:

Responsibility (CSR) Corporate social responsibility is understood to mean the social responsibility of companies as a
part of sustainable business.
http://www.nachhaltigkeit.info/artikel/abgrenzung_cs_csr_cc_1501.htm?sid=7a183f42cff592e17e07a2c844b558b0
Sustainability Attempt at a definition:

Business Sustainability means meeting today's needs without limiting the options and resources available to
future generations. Specifically, the objective is to combine economic growth and long-term
business success with environmentally friendly and social conduct. (Geberit)
http://www.geberit.com/master/content/media/global_media/group/unternehmen/nachhaltigkeit/Sustainability_Strate
gy_2013_en.pdf
CR, CSR and sustainability reporting are becoming increasingly important, particularly in view of the globalization
and development of large companies, since large, multinational groups have gained social and economic power.
Social reporting, which combines CR, CSR and sustainability reports, arose in response to criticism from NGOs and
NPOs. A social report presents the objectives, measures and achievements of social activities and their effects. The
aim of social reporting is to show a company's positive contribution to all stakeholders and promote dialogue
between the company and stakeholders.
Analogous to corporate governance, there are no legal fundamentals for the topic of social reporting. In contrast to
CG, however, there are also no recommendations by sector organizations or associations that provide guidelines.
Social reporting is based on a voluntary decision by management. Since strategy and reporting in connection with
CR, CSR and sustainability are just as different as the definitions by individual companies, there are a variety of
different social reports.
8.5.2 Corporate Responsibility – Company Comparison
The table below lists various examples from practice of CR, CSR and sustainability strategies. As part of the
growing importance of CR and, in particular, of reporting about environmental impact and sustainability, companies
and their reporting in this regard are evaluated using different indicators and by various areas. For example, the
Global Reporting Initiative (GRI) has created its own standard that stipulates GRI indicators for evaluating reporting
about sustainable development. In the Swiss environment, studies on the issue of sustainability reporting are
regularly conducted by the Institute for Sustainable Management (IFSM) at the University of Applied Sciences and
Arts Northwestern Switzerland. Other universities, such as the Chair for Sustainability Management at the
University of St. Gallen, also researches and publishes in the area of sustainability reporting.

Chapter 8:
Table 44: Case Study: CR, CSR and Sustainability in Comparison
CR, CSR AND SUSTAINABILITY OF VARIOUS COMPANIES

O
CASE STUDY
UBS is firmly committed to corporate responsibility and actively strives to understand, assess, weigh
and address the concerns and expectations of its stakeholders. This process supports UBS in its efforts
CR
to safeguard and advance the firm's reputation for responsible corporate conduct. Responsible
corporate conduct helps directly to create sustainable value for the company.
As well as complying with the professional standards and ethical values set out in our Code of
Conduct, we strive to assume our corporate responsibilities in every aspect of our work. We do so
CR based on our broad understanding of our duties as a financial services provider, member of society and
employer. Our approach also reflects our commitment to the environment and dialogue with our
stakeholders.
Sulzer wants to be a recognized responsible company for all of its employees and other relevant
stakeholders. Our core values of customer partnership, operational excellence, and committed people
Sustainability
function as an inner compass, which guides us in our behavior.

Sulzer wants to produce eco-efficient solutions and technologies with processes that have a minimum
impact on the environment. Sulzer aspires for leadership in energy efficiency solutions that assist its
customers in shaping new ways and markets, building a more sustainable economy.
Holcim aims to build capacity of people and organizations through investment and engagement, which
goes beyond the act of corporate donation. All Group companies have integrated this strategic
CSR
approach in their business plan to meet local needs. The result is a rich diversity of projects and
initiatives.
Sustainability
With our social projects, we aim to make a sustainable contribution towards enhancing quality of life
– by helping to provide people in developing regions all over the world with better basic sanitary
services and, therefore, with important foundations for life.
Corporate responsibility (CR) is part of everything we do – from developing innovative products that
CR
help farmers grow more from less to controlling the environmental impact of our operations.
Note. From: websites (About us àCorporate governance) of UBS, CS, Sulzer, Holcim, Geberit and Syngenta.
8.6 Value Added Statement
LEARNING OBJECTIVES

• Being able to explain the background to the value added statement
• Recognizing the components of the value added statement
In addition to corporate responsibility, the value added statement also plays an important role in connection with the
effects of corporate activity. In order to evaluate a company's effective performance as compared with other
companies, revenue and other key financial indicators in the financial statement fall short. For example, the high
division of labor for today's production steps results in companies procuring more and more components instead of
producing them themselves. This reduces vertical integration and thus also the value that a company adds. The
company makes these make-or-buy decisions in connection with management accounting and controlling, which
provide the data basis for them. By reducing vertical integration and value addition, companies focus on their core
expertise, thus freeing up resources, since fewer facilities, personnel and other property, plant and equipment are
needed. In order to account for this production based on division of labor, the value added statement eliminates the

Chapter 8:
added value that is procured from other companies in the form of input services, thereby showing the performance
and value effectively contributed by the company. The concept of added value is also used by value added tax
(VAT), which taxes only the value added by the relevant company (Behr & Leibfried, 2009, p. 681).
Third-party input services are deducted from revenue. Input services include third-party services and purchases of
goods from third parties, as well as energy supplies. The calculation can be divided into gross and net value added.
Gross value added arises from the deduction of third-party input services. Net value added is calculated as gross
value added less depreciation, amortization and participating interests (calculated using the equity method). Since
property, plant and equipment are manufactured by third parties, depreciation of property, plant and equipment
reflects the depreciation of an input service. For this reason, depreciation must be deducted in order to arrive at the
net value added. (Behr & Leibfried, 2009, p. 682) The gross and net value added statement can be considered the
production output statement.
Figure 83: Value Added Statement
Production output statement Allocation statement
Advance payments
Write-downs
Sales
Employees
Gross
value added Government
Net value added Debt provider
Equity provider
Company
The calculated net value added shows the proceeds that do not have to be paid to third parties out of revenue as
compensation for input services. Various groups of persons raise corresponding claims to this net value added. The
allocation statement shows this allocation of added value to these groups. With personnel expenses, employees are
usually the largest group. Other groups include lenders (interest and dividends) and the state (levies and taxes).
As with corporate responsibility and sustainability reporting, there are no recommendations, guidelines or binding
legal fundamentals for the disclosure of a value added statement or information about added value. The company is
thus at liberty to choose whether to prepare a value added statement and, if so, what content to depict and how.

Chapter 8:
Figure 84: Case Study: Swisscom Value Added Statement
SWISSCOM VALUE ADDED STATEMENT

O
CASE STUDY
Note. From: Swisscom 2018 Annual Report, p. 55
8.7 Summary
Other Reports in the Annual Report:
The annual report can be divided into a financial part (financial statement) and a reporting part. The reporting part
consists of other reports with additional information and backgrounds as to how the figures in the financial part
came about. These other reports comprise information about senior company management and the impact of
business on environmental spheres and estimates by management, and provide a projection about the company's
near future.
Management Report:
The management report covers all essential features of the company's assets, financial position and earnings
originating from the financial statement. These are combined with qualitative and strategic remarks about the past

Chapter 8:
fiscal year by the company's senior management. In addition, the management report provides information about the
most important uncertainty factors and offers an outlook for the near future. The management report, which is
formulated as a textual report, complements the financial statement. A management report is required by law, but
the company drawing up the accounts has a large amount of options regarding its content and structure. In addition,
the management report has implications for liability.
Corporate Governance (CG):

Corporate governance is designed to provide additional information about the nature of company management. In
doing so, the focus is on shareholder interests in order to achieve transparency and a balanced relationship between
management and control. SIX requires a variety of information about group structure, shareholders, board of
directors, executive committee, remuneration, shareholders' participation rights, shareholdings, etc. for all
companies listed on the SIX. Apart from the rules of stock exchanges and exchange supervisory authorities,
reporting with respect to corporate governance is not set down either in law or in an accounting standard.
Corporate Responsibility (CR):

Corporate responsibility (CR) is social reporting consisting of corporate social responsibility (CSR), corporate
governance (CG) and sustainability business. It depicts the impact of corporate activities on society and the
environment as well as the various environmental spheres of a company. CSR addresses, in particular, social
responsibility. Sustainability business means sustainability through which present needs are satisfied without
limiting opportunities and resources for future generations.
Value Added Statement:

The idea of value added assumes that input services from other companies are eliminated in order to show what
performance and value was contributed by the company. A production output and allocation statement is prepared in
the process.

Behr, G. & Leibfried P. (2014). Rechnungslegung (2. Überarbeitete und erweiterte Auflage). Zürich: Versus.
mit Beispielen. (4. überarbeitete Auflage). Zürich: Compendio Bildungsmedien.
SKV.
Carlen F., Gianini F. & Riniker A. (2005). Höhere Finanzbuchhaltung. S. 83-85
auf http://web.fhnw.ch/plattformen/hsw/news/news-2012/schweizer-geschaeftsberichte/PraesDaub-GB-
Chapter 9:
Group Reporting 187
Group Reporting
To customers, suppliers and also investors, Nestlé, Volkswagen, ABB,

Novartis and many other large corporations appear to have the market
presence of one company. Often, however, such large corporations are a
group of multiple companies. In particular, international companies that
are globally active have legally separate subsidiaries in the domestic
country and abroad. Because investors but also other stakeholders are
mainly interested in the financial position of the group as a whole, not all
separate financial statements of the companies in the group are published;
instead, a joint presentation of the economic entity, i.e. consolidated
financial statement, is prepared. This presents all entities of the group, i.e.
all direct and indirect participating interests (subsidiaries) of a parent
company, considered from one comprehensive economic viewpoint.
9.1 Introductory Example from Volkswagen and Porsche
INTRODUCTION: CONSOLIDATED FINANCIAL STATEMENT
Volkswagen to take over Porsche in August

The two car manufacturers Volkswagen (VW) and Porsche are merging sooner than planned. Volkswagen is to acquire
Porsche's automotive business for EUR 4.46 billion. The companies announced on Wednesday evening that Volkswagen
wants to take over Porsche's automotive business on August 1. Ferdinand Piech, Chairman of the VW Supervisory Board, is
thus marking another milestone on the road to creating the world's largest car manufacturer.
Close Cooperation

Chapter 9:
Group Reporting 188
The close cooperation between the Group's future twelve brands is projected to reduce costs significantly. “Through the
merger of business operations, Volkswagen and Porsche will grow even stronger in the future – financially and strategically”
[…]. Porsche Holding – which, in addition to sports car manufacturer Porsche AG, had owned approximately half of the
Volkswagen ordinary shares – will receive the purchase price of EUR 4.46 billion and one ordinary share from Volkswagen.
The heavily indebted Porsche Holding is thus able to reduce its liabilities and has cash to spare for new investments, which,
after amendments to the articles of incorporation, are now permitted to include wind turbines. In return, Volkswagen is
increasing its participating interest in car manufacturer Porsche AG to 100%, from a current 49.9% share. The Porsche brand
will become an “integral part” of the VW Group […]. The Wolfsburg-based Group and Porsche Holding expect savings of
approximately EUR 320 million through accelerated integration, a sum that both companies are willing to share in a fraternal
manner.
First Takeover Attempt Failed
Originally, VW and Porsche SE intended to merge via a stock swap; however, this attempt failed due to litigation risks in the
billions in the wake of the ultimately unsuccessful takeover attempt of VW by Porsche in 2009.
The full consolidation of the Porsche automotive business will have a positive effect on Volkswagen's 2012 consolidated
profit, VW stated. However, impairment of the purchase price allocation will diminish this effect in terms of operating
performance. VW's 2012 financial result will increase by in excess of EUR 9 billion, while net liquid assets are expected to
shrink by EUR 7 billion: As of August and in addition to the purchase price, VW will also assume responsibility for Porsche
AG debts amounting to EUR 2.5 billion. Porsche Holding explained that it will, to start with, use the sales proceeds to redeem
EUR 2 billion of existing bank liabilities. The predominant portion of the remaining liquidity will be utilized to acquire
strategic participating interests with a focus on the automotive supply chain. Special distributions to shareholders of Porsche
SE are not planned. […]
Article has been modified. From: NZZ online (July 5, 2012).

Picture from HAZ (Undated).
1. What reasons are given for the takeover of Porsche by VW?
2. VW held a 49.9% share in Porsche before the transaction. Why had the VW consolidated financial statements not reported
Porsche in a fully consolidated manner (full consolidation) previously?
3. Why are the new Group's net liquid assets shrinking after the transaction?
4. To what extent does the full consolidation have a positive effect on the performance of the new Group?
9.2 Fundamentals
LEARNING OBJECTIVES

• Understanding the fundamental principles of consolidated financial reporting
• Being able to explain the most important terms in connection with consolidation
• Being able to apply the preconditions for consolidation
A group is a combination of several legally separate companies that are affiliated by means of ownership or control.
This construction is also referred to as an economic entity, as the affiliated companies pursue a common strategy

Chapter 9:
Group Reporting 189
and the operating profits are deployed for the achievement of this strategy. Similarly, the existence of
interdependencies requires common economic actions. Furthermore, a group is characterized by its uniform control
system. If a company can be influenced by another company, a decision must be made as to whether or not the
influencing company should integrate the other company into its group of consolidated companies. The group of
consolidated companies is a designation for all companies that are summarized or consolidated in the consolidated
financial statement. Correspondingly, the consolidated financial statement is a summarized presentation of all
separate financial statements of the legally separate companies, which, however, constitute one entity on an
economic basis and are controlled by a superordinate company. Each company in the group continues to prepare its
own separate financial statement.
Figure 85: Nestlé Example: Group of Consolidated Companies

Nestlé EXAMPLE
The controlling company is often referred to as the parent company and the companies being controlled as the
subsidiary companies. Ownership interest describes the percentage of voting rights that the parent company has in
the subsidiary and that may be exercised at the shareholders' meeting. The ownership interest is customarily
expressed as a percentage and is identical to the ownership relationship. The ownership relationship is generally also
decisive for the degree of control, i.e. the extent of the influence that the parent company is permitted to exercise
over the subsidiary. However, aspects such as membership in the executive management of the subsidiary may also
shift control in favor of the parent company. The subsidiaries may be described in different ways, depending on the
ownership interest or the degree of control. The percentage share determines the five categories of participating
interest. A company that is 100% controlled by the parent company can be referred to as an affiliated company. The
designation of “affiliated company with minority interests” is used if the subsidiary is controlled by the parent
company to a degree of at least 51% but less than 100%. Joint venture is the term used for companies that are
controlled by two different parent companies that each control 50%. Associated companies exhibit participating
interests of between 20% and 50%, with participating interests of less than 20% designated as minority
shareholdings. The diagram below summarizes the different designations and participating interests with respect to
the level of control.

Chapter 9:
Group Reporting 190
Figure 86: Categories of Participating Interests
Consolidated financial
statements
Group
Separate financial statements
100% Affiliated company
51-99% Affiliated company with minority interests
50% Joint venture

20-49% Associated company

<20% Minority shareholding
The individual categories of participating interests are valued and presented in different ways in the consolidated
financial statement. However, they are all included in the group of consolidated companies, i.e. they are all taken
into account in the consolidated financial statement. The criteria for determining the group of consolidated
companies according to IFRS, Swiss GAAP FER and the CO are largely similar. The Swiss Code of Obligations
mentions the consolidation of companies that are controlled by parent companies in Art. 963 CO (see next chapter).
Swiss GAAP FER 30 defines the group of consolidated companies based on voting rights, control or common
management. According to the new IFRS 10, establishment of the group of consolidated companies ensues through
the principle of control. For this purpose, the IASB issued a new definition of control in 2013. In the superseded IAS
27 financial reporting standard, the term “control” was used exclusively, implying a direct or indirect majority of
voting rights in the shareholders' meeting, as in Art. 963 CO. In the new IFRS 10 standard, “control” is replaced by
the phrase “power over the investee” to indicate control with respect to the opportunity to exert influence. Control
and the exertion of influence can be attained, for example, through the composition of the board of directors.
Control without ownership, however, is referred to solely if there is significant opportunity for the influencing
company (parent company) to exert influence over the activities of the company being influenced (subsidiary).
To be able to assess the economic situation of a group, neither the sums of the financial statement of all companies
nor the separate financial statement of the parent company will reveal the necessary information (Schellenberg,
2000, p. 209). Instead, a consolidated financial statement must be prepared, which encompasses the financial
information of all companies of a group and make corrections for group-internal transactions. Participatory
relationships, mutual debt and deliveries of goods need to be corrected in particular. It then becomes possible to
imagine the group as one large company, and the consolidated financial statement shows the statement of financial
position, statement of profit or loss and other comprehensive income, statement of cash flows, statement of changes
in equity and notes of this large group. Correspondingly, the reporting of a group reveals only the financial effects,
analogous to that of a large company. The consolidated financial statement neither replaces nor influences the
separate financial statements.
The consolidated presentation of a group in the consolidated financial statement provides two essential advantages.
By offsetting the mutual group-internal receivables and liabilities, the consolidated financial statement shows an
adjusted financial overview of the group. This helps to prevent financial distortions and avoid misinterpretation.
Another advantage is that misleading conclusions concerning profit in the reporting period can be avoided due to the

Chapter 9:
Group Reporting 191
fact that all internal sales transactions (e.g.: group-internal sales of goods) are netted against each other.
Consolidated financial statements also have some disadvantages, however. The consolidated common perspective
may lead to a partial or complete suppression of individual business areas (branches, divisions). Furthermore,
comparability of different groups is impeded, in particular for multinational groups and conglomerates – i.e. groups
that include companies with different business activities and industry affiliation. This factor can be mitigated by
looking at segment reporting, however (see chapter 5.5).
BOX: IFRS 10 Consolidated Financial Statement
Initial situation: The regulation concerning consolidated financial statement was amended with effect from January 1, 2013;
the previous IAS 27 regulations were superseded by the newly created IFRS 10 standard. Furthermore, the
IFRS 12 standard was also issued, which regulates disclosure in the notes.
Content: Preparation and presentation of consolidated financial statement as well as inclusion in the statement of
financial position and valuation of investments in subsidiaries, jointly controlled entities and associated
companies.
Core tenets: A company is required to prepare a consolidated financial statement if it has at least one subsidiary. The
company is referred to as the parent company. Under certain preconditions, a company that is a parent
company in a subgroup may be exempt from the obligation to prepare a consolidated financial statement.
Subsidiaries are companies that are subject to the control of another company. Control is the ability to
determine the financial and business policies of a company in order to obtain benefits from its activities.
Control arises primarily by possessing a majority of the voting rights. However, IFRS 10 defines
numerous other circumstances that could lead to a control relationship.
In the consolidated financial statement, all financial statement positions of the parent company and of all
of the subsidiaries – whereby positions are recorded in the statements of financial position using uniform
methods – are added and group-internal positions are offset.
Delimitation: § IAS 28 regulates the inclusion on the statement of financial position and the valuation of investments in
associated companies and joint ventures.
§ IFRS 11 regulates the inclusion on the statement of financial position of joint agreements.
§ IFRS 12 regulates the disclosure of investments in other companies in the notes.
Based on: KPMG AG Wirtschaftsprüfungsgesellschaft (2012), p. 173.
The legal fundamentals for groups headquartered in Switzerland are regulated by the Swiss Code of Obligations
(CO). Because the CO only mentions groups in one paragraph of Art. 963 CO, Switzerland lacks any real statute law
for groups. The CO defines a group as being a collection of several legally separate companies under common
economic management. The following lists the most important points for consolidated financial statements from the
CO.
Art. 963 CO Obligation to Prepare Consolidated Financial Statement
According to Art. 963 CO, each legal entity is required to prepare a consolidated financial statement if the following
points are met in a cumulative manner:
• Subject to the financial reporting obligation (see Art. 727 CO)

• Controls one or more companies subject to the financial reporting obligation
Art. 963, 2 CO Control of Another Company

Chapter 9:
Group Reporting 192
The control of another company is defined in Art. 963, 2 CO as follows:
2
A legal entity controls another company if it:
1. directly or indirectly has the majority of the votes in the governing body;
2. directly or indirectly has the right to appoint or dismiss the majority of the members of the top management or
administrative body; or
3. is capable of exercising a controlling influence due to the articles of incorporation, the deed of foundation, an
agreement or an equivalent instrument.
Art. 963a CO Exemption from the Preparation of Consolidated Financial Statement
According to Art. 963a, 1 CO, however, a legal entity is exempt from the obligation to prepare a consolidated
financial statement if two of the three following parameters are not achieved in two consecutive fiscal years:
• total liabilities and equity of CHF 20 million

• sales revenue of CHF 40 million
• 250 full-time employees on an annual average
Regardless of whether the above criteria are met, consolidated financial statements must be prepared in any case
(Art. 963a, 2 CO) if
• they are necessary for the most reliable assessment of the economic situation;
• they are requested by shareholders with at least 20% of the share capital; or
• they are requested by a majority shareholder or a shareholder with contribution liability.
In connection with the preparation of the consolidated financial statement, additional special regulations apply for
associations, foundations and similar organizations. For more information see Art. 963a, 2 CO.
Art. 963b CO Recognized Financial Reporting Standards
In order to adequately meet the needs of the recipients of the financial statement, pursuant to Art. 963b CO, certain
groups are subject to mandatory application of a recognized financial reporting standard such as IFRS or Swiss
GAAP FER. Groups must apply recognized financial reporting standard if one of the following points is fulfilled:
• companies with equity securities listed on an exchange, if so required by the stock exchange
• cooperatives with at least 2000 cooperative members
• foundations subject by law to regular audits
Likewise, a consolidated financial statement must be prepared according to a recognized standard if one of the
following circumstances exists:
• if it is requested by shareholders who represent at least 20% of the equity capital or 10% of the cooperative
members or 20% of the association members
• if it is requested by a shareholder or an association member who is personally liable or subject to
contribution liability
• if it is requested by the foundation supervisory authority
If none of the listed circumstances exist, the Swiss accounting principles (Art. 958 CO) apply (see chapter 3).

Chapter 9:
Group Reporting 193
Art. 727 CO Audit/Examination of the Consolidated Financial Statement
The CO also regulates when a public auditor must be appointed to perform an ordinary audit of the group.
According to Art. 727 CO, the following companies must have their financial statement audited:
• Public companies, i.e.:

o equity securities listed on an exchange;
o bonds outstanding; or
o investments in corresponding subsidiaries exceeding 20% of the assets or the sales revenue.
• Companies where two of the three following parameters are achieved in two consecutive fiscal years:
o total liabilities and equity of CHF 20 million
o sales revenue of CHF 40 million
o 250 full-time employees on an annual average
• Companies subject to the obligation to prepare consolidated financial statements

• If so requested by shareholders with 10% of the share capital
• If mandatory under the articles of incorporation
If the criteria mentioned above are not met, the group may choose between performing a limited audit according to
Art. 727a CO or, if the conditions pursuant to Art. 727a, 2 et seq. CO are fulfilled, dispensing with an audit entirely.
It is customary for groups to undergo ordinary audits, however.
9.2.2 Preconditions for and Information in Consolidated Financial Statement
If the consolidated presentation of the financial statement of all companies belonging to the group is to accurately
present the economic situation, the separate financial statements must be harmonized and based on identical
regulations. The harmonization of the separate financial statements is a compulsory and necessary precondition for
consolidated financial statement. It encompasses the following points:
• Uniform reporting date

• Uniform system of accounts
• Similar accounting procedures
• Uniform account assignment guidelines
• Uniform valuation
Modern financial reporting standards such as IFRS, US GAAP or Swiss GAAP FER provide for this harmonization.
The financial reporting to be applied and the associated principles have to be disclosed in the notes of the
consolidated financial statement.
Information Pursuant to Swiss GAAP FER:

Swiss GAAP FER regulates consolidated financial statement in the FER 30 standard and names the following
preconditions for harmonization, which must also be disclosed in the notes:
• Group of consolidated companies

• Principles of consolidation

Chapter 9:
Group Reporting 194
• Valuation fundamentals and principles

• Additional circumstances subject to disclosure pursuant to this or other professional recommendations
The information concerning the group of consolidated companies must contain the following:
a) Treatment of the organization in the consolidated financial statement
b) Name and headquarters of the included organizations
c) Share in capital of these organizations
d) Changes in the group of consolidated companies compared to the previous year
e) Deviations from the reporting date of the group
The information concerning the principles of consolidation contains:

a) Method of consolidation, in particular with respect to capital consolidation
b) Currency conversion method as well as treatment of the conversion gains/losses
c) Treatment of associated organizations and joint ventures
d) Treatment of group-internal profit (intercompany profit)
(PwC, 2013, p. 26.)
Consolidated Financial Statements Pursuant to IFRS:

IFRS 12, which defines disclosure with respect to the consolidated financial statement in the notes, requires more
comprehensive minimum information than Swiss GAAP FER. In principle, IFRS 12 requires extensive disclosure of
information regarding the following circumstances:
• Information about material discretionary decisions and assumptions that were made concerning
inclusion of the participating interest in the group of consolidated companies, as well as its classification
(type of participating interest).
• Information regarding each category of types of participating interests (subsidiary, joint venture and
associated companies) about the type of relationship, the associated risks and the influence on the financial
statement.
• Type, scope and risks of the investments in other, non-consolidated structured companies (special-
purpose entities)
(KPMG AG Wirtschaftsprüfungsgesellschaft, 2012, p. 185 & IASB 2011, p. 5.)
9.3 Consolidation Methods
LEARNING OBJECTIVES
• Recognizing group financial reporting methods in a general manner
• Understanding differences between the consolidation methods

Chapter 9:
Group Reporting 195
Financial reporting provides three consolidation or valuation methods for the presentation of subsidiaries and
participating interests in the consolidated financial statement:
§ Full consolidation
§ Equity method
§ Reporting as a financial asset
Before the introduction of IFRS 11 Joint Arrangements (which include joint ventures) as of January 1, 2013, IFRS
stipulated proportionate consolidation for joint ventures. IFRS 11 now prescribes the equity method for joint
ventures, thereby abolishing without replacement proportionate consolidation as a consolidation method. This
reform stipulates an adjustment in the valuation and reporting of joint ventures in the consolidated financial
statement, and in particular their disclosure in the notes.
Figure 87: Nestlé Example: Consolidated Companies

EXAMPLE
Nestlé
According to the definition in IFRS 10, if one company has complete control over another company, full
consolidation is applicable. If the level of control is significant but not complete, the full-consolidation method must
also be applied, but the non-controlled interest must be reported as a minority interest. Joint ventures, in which two
companies exert joint control to the same extent (i.e. 50% control each), are recorded in the statement of financial
position using the equity method.
Figure 88: Decision as to Consolidation Method Pursuant to IFRS
Note. From: Ernst & Young, 2012, p. 9

Chapter 9:
Group Reporting 196
Figure 89: Nestlé Example: Companies of the Nestlé Group
Nestlé EXAMPLE
From: Consolidated Financial Statements of the Nestlé Group 2018, 168
Joint operations7 will not be covered in this book but are explained in the reference literature. The equity method is
also applicable if a material but not a controlling influence is exerted, i.e. if the participating interest lies between
20% and 49%. If there is no material exertion of influence over the other company, the participating interest of the
parent company in the subsidiary is recorded in the statement of financial position as a financial asset. Generally,
participating interests of less than 20% control are not consolidated and are reported as financial asset or
investments. IFRS 9 Financial Instruments is applicable for reporting as investments (see chapter 4.4.2).
Subsidiaries are generally only referred to as such if there is a significant influence (i.e. control of more than 50%);
investments of up to 50% are typically referred to as participating interests. The full-consolidation and equity
methods are explained in more detail in the next two chapters. The following overview aids in the decision as to
which consolidation method is applicable.
7
Alongside joint ventures, IFRS 11 also recognizes joint operations, for which assets, debt, expenses and earnings are disclosed in the statement
of financial position. In contrast to joint ventures, which are independent legal entities (with two mother companies), joint operations may be
structures as legally belonging to one of the “mother-“companies, or as a partnership (without its own legal entity).

Chapter 9:
Group Reporting 197
Table 45: Swissair Error in Group of Consolidated Companies
SWISSAIR GROUP OF CONSOLIDATED COMPANIES
Ernst & Young Findings in Review of Swissair

CASE STUDY
On behalf of the trustee, we present a findings summary from our examination of the Swissair matter.
Financial Reporting
Not only the separate and consolidated financial statement for 1999 but also, to a much greater extent, the separate and consolidated
financial statement for 2000 did not properly depict the economic and financial situation of the SAirGroup.
The 1999 and 2000 consolidated financial statements of the Swissair Group exhibited, among others things, fundamental consolidation
errors, whereby the French companies and the LTU were not fully consolidated, even though the economic benefits and the economic
risks were borne entirely by the SAirGroup. Sabena was not fully consolidated either, even though actual control likewise existed (at
the latest as of July 2000). Among other things, material off-statement of financial position transactions were reported incorrectly and
in an incomplete manner in the consolidated financial statement for both 1999 and 2000 as well as in the separate financial statement
for the SAirGroup dated December 31, 1999, and December 31, 2000.
Note. From: Ernst & Young (2003), p. 3. Excerpt from the examination findings.
9.3.1 Full Consolidation
If the parent company has complete control over the subsidiary (100%), full consolidation is applicable. With
significant control (greater than 50% but less than 100%), full consolidation is applied and the minority interests are
reported. Therefore, full consolidation may be appropriate even if the parent company is not the sole investor in the
subsidiary. In order for full consolidation pursuant to IFRS 10 to take effect, three conditions must be fulfilled in a
cumulative manner: “power over the investee,” “exposure to variability in returns” and “link between power and
returns.” In this case, control is achieved. The following diagram explains the conditions in more detail.
Figure 90: Full Consolidation Pursuant to IFRS 10
Based on: KPMG (2011), p. 1–3.
As a first step, the uniform recognition and valuation provisions must be followed so that full consolidation may be
implemented. The exertion of control enables the enforcement of this uniformity. Accordingly, all assets,
liabilities/equity, expenses and revenue from the separate financial statements of the subsidiaries are transferred at
full value (100%) into the consolidated financial statement. This step is also called summation the financial
statement positions into the aggregated financial statement. In the third step, group-internal events and transactions
are eliminated. This occurs in connection with the entity concept in consolidated financial statement. The
elimination encompasses the following incremental steps:
• Capital consolidation: Offsetting participating interests at the parent company against equity at the
subsidiaries.
• Debt consolidation: Offsetting balances from the parent company (for financing loans) or from affiliated
companies (for receivables generated by supply or service) against the corresponding debts of the
subsidiaries or affiliated companies.

Chapter 9:
Group Reporting 198
• Elimination of intercompany profit: Services between subsidiaries (e.g. production site in China supplies to
sales organization in Switzerland) are typically rendered at market prices, thus generating intercompany
profit (e.g. at the production site in China). These profits are netted against expenses incurred by the
counterparty (e.g. purchasing expenses of the sales organization in Switzerland).
• Elimination of group-internal revenue and expenses: In addition to intercompany profit, all transactions
concerning the exchange of goods or services between the companies of a group must be eliminated as
well. This applies in particular to license fees paid to group-internal research enterprises, rental fees
charged by the real estate subgroup or management fees payable to the holding company.
Technically, all consolidation and eliminations are expressed as booking entries. These booking entries lead to the
consolidated financial statement. So the consolidated financial statement results from first a summation of all
financial statements of each company, followed by secondly the consolidation and elimination booking entries.
Table 46: Mini Case: Elimination of Group-Internal Events
ELIMINATION OF GROUP-INTERNAL EVENTS

MINI CASE 1
The parent reports a loan of CHF 400 000 to its subsidiary in its statement of financial position (6% interest). The same
amount is reported as a liability to the parent in the statement of financial position of the subsidiary.
Set of accounting entries to correct the aggregate statement of financial position and aggregate statement of profit or
loss and other comprehensive income:
• Loan subsidiary to Loan parent 400 000
• Interest revenue parent to Interest expenses subsidiary 24 000

MINI CASE 2
Last year, the subsidiary supplied the parent with goods valued at CHF 720 000.
Set of accounting entries to correct the aggregate statement of profit or loss and other comprehensive income:
• Goods revenue subsidiary to Goods expenses parent 720 000
If a subsidiary is only controlled in a significant manner (i.e. control by the parent company is greater than 50% but
less than 100%), this automatically means that minority shareholders with control of less than 50% also exist. In
order to reflect this fact, their investment shares of the equity and profit for the period of the corresponding
subsidiary are calculated using the scope of control. The sums of these amounts for all subsidiaries are reported in
the consolidated statement of financial position and consolidated statement of profit or loss and other comprehensive
income as the non-controlled share of the group equity and as the non-controlled share of the attributable profit of
the period. These sums are generally designated as minority interests.

Chapter 9:
Group Reporting 199
Table 47: Mini Case: Capital Consolidation
CAPITAL CONSOLIDATION
MINI CASE 1
Full consolidation of a subsidiary in the 100% ownership of the parent company
Set of accounting entries to correct the aggregate statement of financial position:

• Equity to Participation in IC 20
Full consolidation of a subsidiary in the 80% ownership of the parent company

MINI CASE 2
Set of accounting entries to correct the aggregate statement of financial position:

• Equity to Participation in IC 20
• Equity to Minority interests 5
9.3.2 Equity method
The equity method is applicable if the parent company is able to exercise material influence over the activities of the
company invested in but sole control does not exist. Typically, a participating interest between 20% and 50% is
considered material influence. Further aspects of control, such as having a seat on the board of directors, play a
secondary role as such aspects are intended to achieve a level of significant influence, i.e. of greater than 50%,
thereby leading to the application of full consolidation. Companies that are subject to the potential material
influence of a parent company are referred to as associated companies (20%-50% participating interest) or joint
ventures (50% participating interest). The equity method can be interpreted as a partial consolidation procedure or
valuation procedure. At the time of purchase, the participating interest is capitalized as an asset in the statement of
financial position at the cost of purchase. In the following periods, the value of the participating interest is adjusted
in the statement of financial position of the parent company based on the development of the proportionate share of
the equity of the company invested in. If the company in which the parent company has invested earns a profit,

Chapter 9:
Group Reporting 200
retains this profit and this then leads to an increase in equity, the value of the participating interest must be
increased, proportionate to the share of the parent company in the company invested in. In the event of a loss, the
accounting entry must be made on the other side. The equity value therefore always correlates to the percentage of
control over the equity of the company in the corresponding currency. The difference in the cost of purchase of the
participating interest and the equity value are entered in the statement of financial position of the parent company as
follows:
§ If the company in which the parent company has invested earns a profit:
Participating interest to Revenue from non-
consolidated participating interest
§ If the company in which the parent company has invested earns a loss:
Expenses from non- to Participating interest
consolidated participating interest
Table 48: Mini Case: Equity Method
EQUITY METHOD
MINI CASE
Note. Own depiction

Chapter 9:
Group Reporting 201
9.4 Summary
Fundamentals:
A group is a combination of several legally separate companies and is also termed an economic entity. Adjusted for
group-internal transactions, the consolidated financial statement, also called group financial statement, is a summary
of the separate financial statements of these legally separate entities, which are, however, economically controlled
by a superordinate company. The superordinate company is referred to as the parent company and companies in
which shares are held as subsidiaries. The level of control, i.e. the amount of influence exerted by the superordinate
parent company over the subordinate subsidiaries, is expressed in percentages. This percentage share also
determines the different designations of the subsidiaries and participating interests:
§ 100% Affiliated company

§ 51-99% Affiliated company with minority interests
§ 50% Joint venture
§ 20-49% Associated company
§ <20% Minority shareholding
The CO stipulates when it is mandatory to prepare consolidated financial statement, apply a recognized financial
reporting standard, and perform an audit or examination of the consolidated financial statement. In order for
consolidated financial statement to be prepared, the following preconditions must be fulfilled:
§ Uniform reporting date

§ Uniform system of accounts
§ Similar accounting procedures
§ Uniform account assignment guidelines
§ Uniform valuation
Likewise, information concerning the group of consolidated companies, consolidation principles, valuation
fundamentals, and additional information must be disclosed in the notes.
Consolidation Methods:
With full consolidation, the key question is whether the influence that one company is able to exert over another is
significant. IFRS introduced the concept of control. If the parent company has control over the subsidiary, full
consolidation is applicable. Pursuant to IFRS, certain conditions must be met in a cumulative manner in order to
constitute the circumstance of control. In order to execute full consolidation, the preconditions for consolidated
financial statement must first be fulfilled. Subsequently, all positions of the separate financial statements of all
subsidiaries to be consolidated are summed up and, thirdly, group-internal events are eliminated or offset.
The equity method is applicable if the parent company is able to exercise material influence over the activities of the
company invested in but no actual control exists. This is customarily the case with participating interests of between
20% and 50%. The participating interests are referred to as associated companies (20% to 50% participating
interest) as well as joint ventures (50% participating interest). The equity method is a partial consolidation
procedure. This means that the participating interest is capitalized as an asset on the statement of financial position
of the parent company at the time of purchase at the cost of purchase and that in the following periods it is adjusted
based on the development of the proportionate share of the equity of the company invested in.

Chapter 9:
Group Reporting 202

SKV.
Schaeffer-Poeschel.

Part C:
Looking inside – Internal Financial Management 203
Part C:
Looking inside –
Internal Financial
Management

Chapter 10:
Introduction to Management Accounting 204
Introduction to Management Accounting

After the sub-process of financial reporting was examined in
detail in the previous chapters, the focus is now on the sub-
process of management accounting and performance
management, also called as cost management, costing, cost
accounting or operational accounting. It is an essential support
and management process for companies. A survey of insolvency
administrators showed that 79% regarded a lack of performance
management as the most frequent cause of insolvency (Euler
Hermes / ZIS University of Mannheim, 2006, p. 7).
10.1 Introductory example ThyssenKrupp
INTRODUCTION: MANAGEMENT ACCOUNTING
Being Alan Hippe

When Alan Hippe took over as CFO of ThyssenKrupp in 2009, the steel group still believed in the success of its billion
dollar U.S. investments. Hippe couldn't turn the tide, but he couldn't officially bury the dream either.
When Alan Hippe took office as CFO of ThyssenKrupp in April 2009, everyone around him is on edge: Steel production has
collapsed, billion-euro investments in Brazil and the U.S. are on the brink of collapse, and the Supervisory Board has just fired
Karl-Ulrich Köhler and Jürgen Fechter, the responsible member Executive Board and project manager for the Steel Americas
plants. ThyssenKrupp is plagued by a mixture of bad luck, mismanagement and chaos.
Nevertheless — and this is how it was presented outwardly — Hippe meets with those in charge who still believe in the
success of the billion-dollar investments in Brazil and Alabama. For the ambitious Hippe, who at the time was just 42 years
old and had been mentioned to possibly become CFO of Deutsche Post and Deutsche Telekom, this is a challenge entirely to
his liking. ThyssenKrupp is his chance to prove himself for the next step on the career ladder: the leap to CEO.
Hippe encounters established, sometimes encrusted structures in his area of responsibility. Many of his employees are loyal to
his predecessor, Ulrich Middelmann. They only see Hippe as a newcomer from outside the Group who has come in to disrupt
the usual processes.
Hippe throws himself into work, and he isn’t looking to make friends: He turns financial management at ThyssenKrupp
around completely and sees the potential for improvement in some areas. With these measures, he quickly finds his way to
investors. The capital market was where he felt most comfortable during his previous positions at Fraport and Continental.
Internally — as former employees would say in the media — Hippe lacks empathy for his employees. In this way, he does not
succeed in building up a management culture that makes it possible to address problems.
The new CFO gradually familiarizes himself with the Steel Americas project: He learns that all the experts considered the
decision to build a steel mill in Rio de Janeiro in 2005 and a processing plant in Alabama in 2007 to be the right one and that
ThyssenKrupp's strategy was logical: Thanks to a proximity to raw materials, low ore prices and low labor costs, the company
can produce slabs cheaply in Brazil. It exports these to Alabama and processes them into flat steel products for the then-

Chapter 10:
booming U.S. market. ThyssenKrupp is expected to outperform its competitors there because of its low purchasing costs. That
must have sounded quite promising indeed.
However, Hippe also learns that both plants will be significantly more expensive than planned due to poor project
management and that the opening will be delayed. He can hardly intervene in April 2009, and the Supervisory Board has
already reacted with various dismissals. The only decision he can still influence now is whether ThyssenKrupp will
nevertheless continue the project. Yes, I am in favor, he decides: There is no turning back; otherwise the money already
invested will be gone. And once the plants are up and running, they will be profitable.
The full extent of the costs would not become apparent until the end of 2010, after both plants have started up: They came out
to 12 billion euros — the plant in Brazil alone cost 3.3 billion euros, far exceeding the originally approved investment budget
of 1.9 billion euros. Instead of 2008, the first slab did not roll off the production line in Brazil until June 2010. The plant in
Alabama opens its doors in December 2010.
Even worse, in the months after the facitilies come online, the entire business model of Steel Americas proves to be seriously
misguided. The framework conditions on which the business case was based end up being significantly different from those in
the planning phase in 2004 and 2005 — and from what Alan Hippe apparently believed. There is much to suggest that the
company was aware of the risks from the outset. In their reports, two independent consultants certify to the Supervisory Board
that they had, already in 2005, pointed out the dependence of the Steel Americas project on the development of Brazilian labor
costs, the real/dollar exchange rate, iron ore prices and demand in the U.S. steel market. The risks were identified but lost sight
of and underestimated during the course of the project.
In terms of risk management and internal performance management, all signals should have pointed to alarm. But that's
exactly what obviously didn't happen. In December 2010, the Executive Board informed the Supervisory Board that
ThyssenKrupp would break even with Steel Americas in fiscal 2011/2012.
What became of these forecasts is known: After ThyssenKrupp wrote off 2.1 billion euros on the steel mills in fiscal
2010/2011, another impairment charge of 3.6 billion euros followed in 2011/2012, resulting in an EBIT loss of 4.4 billion
euros for the Group. Legally, the Executive Board acted correctly at the time — as attested by an expert opinion from the
commercial law firm of Hengeler Müller. The lawyers found no evidence that the Executive Board did not act to the best of its
knowledge or belief or even lied to the Supervisory Board. According to the report, the incorrect decisions and assessments
are covered by the Business Judgement Rule. In the meantime, Hippe was already on to greener pastures: At the end of March
2011, he stepped down as CFO of ThyssenKrupp and joined the Swiss pharmaceutical giant Roche as CFO.
Article based on: Finance Magazine (2013, 21 February).
Reflection questions
1. Where were the problems at ThyssenKrupp based?
2. Could the developments have been recognized earlier with better performance management?
10.2 Fundamentals and distinction
LEARNING OBJECTIVES
The chapter is intended to convey the following knowledge:

• Knowing and understanding the differences between internal and external accounting
• Being able to describe the role of performance management in financial management
• Understanding the embedding of the performance management function in the financial organization of a company

Chapter 10:
10.2.1 Distinction between internal and external accounting
The expectations and requirements of internal stakeholders are naturally only fulfilled to a limited extent by external
reporting: The objective of (external) accounting, as discussed in Chapter 3, is to provide information about the
financial position and performance of an enterprise that is useful to the broadest possible audience of economic
decision-makers. However, management requires for its decisions information that is more detailed and wider in
scope, beyond what would be provided in the aggregated form of external reporting (keyword materiality).
Managers need information in order to, for example, formulate, communicate and implement strategies and make
product design, production and marketing decisions (Datar & Rajan, 2018, p. 22).
Table 49: Comparison of internal and external accounting
External Financial Management Internal Financial Management

Information Communication of financial situation to Support of the management team achieving the
investors, banks, and other stakeholders envisioned targets
Addressees Mainly external stakeholders, mainly investors Different management hierarchies within the
organization
Leeway in Strictly regulated (IFRS, US-GAAP, Swiss Any application is possible
application GAAP FER, tax law), Adherence to rules
testified by an external auditor
Temporal focus Historical orientation: presenting historical Future-oriented: using data for projections such as
expenses and performance budgets and product calculations
Period of reporting Defined reporting periods, typically annually or Flexible, depending on requirement (decision
quarterly necessity)
Type of reports Aggregated reports, one statement for the Detailed reports, showing the exact specific
whole group information for the respective decision
Own illustration. Based on Datar & Rajan (2018, S. 23)
Performance management therefore aims to provide internal stakeholders with information so that they can make
informed decisions in the interests of the company. Managers use this information to manage the activities or
functions for which they are responsible and to coordinate those activities or functions across the enterprise. While
the aggregated external reporting represents essential information, internal reports can be available in various forms.
This information is individually tailored to the needs of management or the company and can answer very specific
questions, in contrast to the principle of materiality in external accounting. For example, a regional sales unit
manager needs a very detailed report, while a global sales unit manager prefers reports with a higher degree of
aggregation. This is operational information that is only used internally and, depending on the company, is provided
frequently (for example, daily cash reports, weekly sales reports or ad hoc reports due to specific events). Such
management decisions may include price adjustments for own products, decisions on stockholding or make-or-buy
decisions (if products are produced or purchased).
Many attempts to define the activities of performance management exist. These include, for example, the definition
by Fischer et al. (2015, p. 29), which takes up some of the points mentioned above:
Definition of Performance management can be defined as "goal-oriented management based on information, planning,
Performance control and coordination. It uses an information-provision and -processing system. It has the role of analyzing
Management and aligning all business decisions and actions in a goal-oriented manner. In other words: Performance
management should ensure the realization of business goals (management support) by supporting decision-
making and guiding behavior. Accordingly, performance management is considered a ‘support function of
management’” (Fischer et al., 2015, p. 29).

Chapter 10:
In addition to the academic consideration, the practice perspective should also be considered here. For example, the
mission statement of the International Association of Controllers (ICV) can be used for this purpose. It describes the
role of the controller as a partner of management as well as outlining specific activities:
"As partners of management, controllers make a significant contribution to the sustainable success of the
ICV mission
organization. Controllers ...
statement
1. design and accompany the management process of defining goals, planning and management control
so that every decision-maker can act in accordance with agreed objectives.
2. ensure the conscious preoccupation with the future and thus make it possible to take advantage of
opportunities and manage risks.
3. integrate an organization’s goals and plans into a cohesive whole.
4. develop and maintain all management control systems. They ensure the quality of data and provide
decision-relevant information.
5. are the economic conscience and thus committed to the good of an organization as a whole.”
(International Association of Controllers ICV, 2019)
10.2.2 The performance management function in the company
The Chief Financial Officer (CFO) monitors the financial interests of a company. These include (but are not limited
to) performance management, accounting, taxes, treasury and risk management, as well as, in some companies
investor relations or strategic planning. The performance management function generally reports to the CFO, along
with accounting and other functions. This is clearly illustrated by the example of the Volkswagen Group:
Figure 91: Volkswagen Group structure
Chief Executive Officer (CEO)

EXAMPLE Volkswagen
Research & Sourcing & Production & Accountign & Sales & Marketing Human Resources &
Development Procurement Operations (COO) Finance (CFO) (CMO) Organization
Group Accounnting Group Performance

Tax and Customs Group Treasury
and Reporting Management
Accounting PM brand and PM value adding

Group Reporting Investor relations Financial planning PM Operations
subsidiaries projects processes
Own illustration. Based on Fischer et al., 2015, p. 10.
In principle, it should be noted that specialization in individual departments and functions increases with the size of
a company. For example, in a small company, one person or department can be responsible for all these tasks, while
in a large corporation these tasks are performed by different departments.

Chapter 10:
10.3 Cost concepts
LEARNING OBJECTIVS

• Understanding the difference between attributability and chargeability of costs
• Being able to characterize and describe fixed and variable costs
• Knowing different approaches to allocating direct and indirect costs to cost objects
As the analysis of costs represents an essential task, performance management is sometimes referred to as cost
management. The data available for internal accounting comes from accounting; however, its structure (labor costs,
transport costs, energy costs...) differs the decisions to be made: Cost accounting converts this data into decision-
relevant data (what costs are incurred in the production of a product, what are the marginal costs of a new employee,
what contribution margin is achieved by a certain location, ...). Costs incurred by the company can be differentiated
according to various criteria (Eisele et al., 2011, pp. 799ff):
§ Attributability of costs
§ Dependency on employment
§ Type of cost recording
§ Type of source of cost items
§ Operational function
§ Liquidity effect of costs
§ Origin of cost goods
It is thereby important to understand that costs in internal financial management may differ from expenses in
external financial management. For example, the costs of a marketing campaign must be recognized as an expense
in accordance with accounting standards but can be capitalized for internal accounting purposes and amortized over
a longer period of time if it is considered that this more accurately reflects the company's actual profits (Datar &
Rajan, 2018, p. 33).
The following section deals with the differentiation of costs according to their chargeability to changes of output
(i.e. dependency on employment, i.e. fixed and variable costs) and their attributability to goods and services (direct
and indirect costs). The analysis of unit (direct) and overhead (indirect) costs in relation to goods and services is also
called full cost accounting, while the analysis of variable and fixed costs is also called partial cost accounting.
The relationship between cost chargeability and attributability is shown in the following table:
Table 50: Cost attributability and chargeability
Overhead costs Direct costs

Fixed Fixed overhead costs
costs (administration, interest, depreciation, rent)
Variable Variable overhead costs Variable unit costs
costs (energy, water, small parts, supplies) (materials, production wages, third-party services)
Own illustration. Based on Controlling-Blog (2019)
10.3.1 Chargeability of costs
When considering dependency on employment, a distinction is made between fixed and variable costs. The
distinction is made on the basis of the influence of the cost driver. Variable costs can be described as a function of a

Chapter 10:
cost driver, such as the quantity of items (goods and services) produced: As production quantity increases, variable
costs also increase. Fixed costs, on the other hand, are constant and independent of the cost driver (at least in the
short term, within a certain observation interval).
10.3.1.1 Fixed costs
Fixed costs are costs that are constant and independent of a cost driver for a specific period of time. Examples
include rents, leasing payments, salaries for administrative personnel, or insurance premiums, which generate fixed
costs regardless of the quantity produced, i.e. the number of goods and services produced. Another example is a
production machine that generates fixed costs independent of the quantity produced. The fixed costs per unit
decrease with increasing production quantity, as these can be spread across more units.
A production machine for glass bottles costs CHF 100 000. That cost is not affected by the number of bottles produced:
EXAMPLE Fixed costs
Figure 92: Fixed costs
Cost
Y=100 0000
Number of produced items
Own illustration
Fixed costs are to be understood as fixed for only a certain period and a certain analysis interval. In the long term,
for example, a company can sell a production machine that is not required, which then no longer generates fixed
costs. In addition, a machine has capacity limits. If production exceeds the capacity limit, an additional machine
must be purchased. These are so-called level-fixed costs (also known as interval-fixed costs).
A bottling company may add as many machines as required. For a production of up to 1 million bottles, the machine costs
EXAMPLE Level-fixed costs
are CHF 100 000, for a production of between 1 and 2 million bottles CHF 200 000, and so on.
Figure 93: Level-fixed costs
Cost
Y=300 000
Y=200 000
Y=100 000

1 million 2 million 3 million
Own illustration
10.3.1.2 Variable costs
Variable costs depend on a cost driver. For example, materials costs are variable costs that depend on the quantity
produced. Each additional unit produced incurs materials costs in this amount. This can be represented graphically
as a linear function that depends on the quantity produced:

Chapter 10:
Materials costs per produced glass bottle amount to CHF 0.05. For each additional bottle produced, the materials costs
EXAMPLE Variable costs
also increase by CHF 0.05.
Figure 94: Variable costs
Cost
Y=100 0000
Own illustration
10.3.1.3 Learning and experience curve and economies of scale
In practice, the learning and experience curve and economies of scale play an important role. The learning and
experience curve was first described in aircraft construction (Wright, 1936, pp. 122-128) and states that, with each
doubling of the cumulative production quantity, unit costs decrease by a certain percentage. This is due to learning
effects, such as less working time has to be invested per product or less waste per product. With each doubling of
the cumulative production quantity, unit costs decrease by about 20 to 30 percent due to efficiency gains.
With increasing size, companies can also benefit from economies of scale, e.g. their market power allows them to
negotiate lower purchase prices. But transaction costs (search costs, negotiation of purchase prices, transport costs),
which for example influence materials and purchase prices, can also be reduced per unit. Together with the learning
and experience curve, this leads to the fact that the variable costs in reality are a curve with a decreasing slope:
Figure 95: Variable costs taking into account learning, experience and economies of scale
Learning and scale
Cost
Own illustration.
10.3.1.4 Total and unit costs
Combining variable costs and fixed costs leads to the total costs. As they have a variable as well as a fixed
component, they are characterized as mixed costs.
The production of glass bottles generates mixed costs: On the one hand, a machine is needed (fixed costs), on the other
EXAMPLE Total costs
hand materials for the production (variable costs). This cost function can be described (≤ 1 million bottles) as
Y = 100 000 + 0.05x.
Figure 96: Mixed costs
Cost
Total cost :
Y = 100 000 + 0.05x
Variable cost: Y = 0.05x
Fixed cost: Y = 100 000
Own illustration

Chapter 10:
Having the total costs, cost per unit can be calculated as average costs. It is advisable to always keep an eye on total
costs and not only unit costs. If the quantity being produced changes, unit costs also change, since the fixed costs
must be distributed to different production quantity:
Table 51: Development of Unit Costs with increasing production Quantity
Quantity Var. costs/unit Total var. costs Fixed costs Total costs Unit costs
200 000 0.05 10 000 100 000 110 000 0.55
400 000 0.05 20 000 100 000 120 000 0.30
600 000 0.05 30 000 100 000 130 000 0.22
800 000 0.05 40 000 100 000 140 000 0.18
1 000 000 0.05 50 000 100 000 150 000 0.15
Own illustration.
10.3.2 Attributability of costs
In determining the attributability of costs, the distinction is no longer made between variable and fixed costs but
between direct and indirect costs. The attributability of costs includes the consideration of unit costs as direct costs
and overhead costs as indirect costs. The focus is on distributing the costs incurred to cost centers and cost units in
the company in order to obtain transparency about costs:
§ Direct costs (or unit costs) can be assigned directly to a cost object. Examples of cost objects are products,
services, activities, processes or customers. Typically, materials costs are direct costs because they can be
assigned to the individual products produced with very little effort.
§ Indirect costs (or overhead costs), on the other hand, cannot easily be assigned to a cost object. For
example, if different products are produced in a factory, costs such as rent, electricity, etc., must be
allocated to the different products.
Figure 97: Attributability of direct and indirect costs
Direct
costs
Product
Overhead
Allocation of indirect cost to products using cost rates,
costs
surcharge rates or disperse rates
(Indirect cost)
Own illustration
The classification into direct and indirect costs is not always clear. Depending on technical possibilities and
relevance of costs, they can either be recorded directly or allocated to an object as indirect costs. The distinction
between direct and indirect costs depends on various factors (cf. Datar & Rajan, 2018, p. 51):
Materiality Even if it is technically feasible, costs are not necessarily allocated directly to products, as cost tracking
can be costly. The more significant the costs, the more directly they are charged.
Availability of Technological developments such as RFID chips make it possible to record costs as direct costs without
great effort.
information
Design of If certain parts of the production (e.g., a production site) are used exclusively for a single product, costs
processes incurred there can be allocated to the cost object as direct costs.

Chapter 10:
10.3.2.1 Allocation of indirect costs
The indirect costs incurred must be allocated to individual products in order to achieve transparency about which
product has generated which costs in the company. One possible approach is to calculate the overhead rate (indirect
costs are also referred to as overhead costs) on the basis of budgeted production:
Overhead rate 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡𝑠

Overhead rate =
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
If you know the overhead rate, you can calculate the total manufacturing costs for a product. In this simple case,
there is a company-wide, uniform overhead rate that is used for all products. The example of glass bottle production,
which is already familiar, is also intended to illustrate this:
Example The overhead costs for the production machine are CHF 100 000 per year, and a production of 1 000 000
bottles is budgeted for the current year. As a reminder, the material costs for each bottle is CHF 0.05.
Calculation The overhead rate is therefore calculated as follows:
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡𝑠 𝐶𝐻𝐹 100 000

Overhead rate = = = 𝐶𝐻𝐹 0.10
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 1 000 000
Interpretation
§ The production costs for a glass bottle are therefore CHF 0.05 + CHF 0.10 (for a production run of
1 000 000 bottles).
§ The sales price must therefore be higher than CHF 0.15 in order to make a profit.
§ If the quantity produced differs from the budgeted quantity, this calculation is only conditionally
valid: If production is lower than budgeted, too few overhead costs are allocated to the product, so if
you sell at this price, you incur a loss!
This example already shows that this very simple calculation does not meet the requirements of practice in many
cases. It is only valid if the quantity produced corresponds to the budgeted quantity. In addition, the simple
calculation can cause false incentives in the company, as there is no transparency about overhead costs. In the case
of multiple products, this simple calculation also falls short because different products incur different overhead
costs.
The overhead costs incurred must be allocated to individual products as far as possible according to their source, in
order to obtain transparency about manufacturing costs on the one hand and to be able to determine the ideal sales
price on the other. Cost rates, surcharge rates or disperse rates are used to allocate overhead costs (Winiger &
Prochinig, 2014, p. 45).
Allocation Description & prerequisite Example

Cost rate A cost center produces an output A production machine run 6 000 hours per year and the machine‘s
that can be clearly and easily annual expenses are CHF 600 0000.
measured. Machine cost rate = CHF 100 / h
Surcharge rate There is a relation between the The expenses for storage room (e.g. rent) are related to the material
cost of a cost center and the cost purchased (and added to inventory). The storage expenses are CHF:
type. Surcharge rate of 10% on direct materials costs
Disperse rate Calculating costs using a disperse The total cost for a building (e.g. rent, electricity, etc.) are allocated
rate to different cost centers (production, marketing, administration, etc.)
based on square meters (m2) of each cost center (in this example:
only allocation to other cost center, not to cost object).

Chapter 10:
Using the rates determined in this way for the allocation of costs, you can determine the original costs for a product.
This is illustrated in the following example:
Example § Direct materials costs are CHF 600 for product X and CHF 250 for product Y.
§ Direct wage costs are CHF 150 for product X and CHF 100 for product Y.
§ Materials overhead costs amount to 25% of direct materials costs.
§ Production overhead costs amount to 190% of direct wage costs.
§ Administrative and sales overhead costs amount to 30% of manufacturing costs.
Calculation Product X Product Y

Direct materials costs 600.00 250.00
Direct wage costs 150.00 100.00
Materials overhead costs 150.00 62.50
Production overhead costs 285.00 190.00
Manufacturing costs 1 185.00 602.50
Overhead costs for administration/sales 355.50 180.75
Original costs 1 540.50 783.25
10.3.2.2 Cost accounting
Cost accounting is used to provide information for operational planning. It includes information on costs and
revenues as well as their analysis and comparison of actual figures with planned and target values.
Cost accounting is based on the values entered by financial accounting. In a first step, the expenses and income
incurred must be adjusted. This eliminates non-periodic and one-time expenses and income. Any imputed costs,
such as imputed interest or imputed depreciation, must also be taken into account to the extent their amounts are
disclosed at too low of a level. Since cost accounting is a tool of operational accounting, companies are not bound
by any rules and are free to design their own – the decisive factor here is that the costs actually incurred for
production are taken into account in order to achieve a true representation. For example, hidden reserves created by
excessive depreciation must be reversed.
Cost types
The cost type calculation examines which costs are incurred by the company. Different cost types are, for example,
personnel costs, materials costs or depreciation. The costs incurred must then be divided into direct and overhead
costs so that the overhead costs that cannot be directly assigned to a product can be distributed to the individual cost
centers.
Cost centers
The cost centers calculation clarifies where costs are incurred. To do this, overhead costs incurred are broken down
into various cost centers. The cost centers can be defined according to various criteria. For example, common
breakdowns are organizational (one department or unit in the company corresponds to a cost center) or a functional
(materials, production, sales, administration, ...). The cost centers enable internal cost allocation of overhead costs
and are the link between cost type calculation and cost unit calculation (Fischer et al, 2015, p. 16). A distinction
must be made between main cost centers (e.g. materials, production, sales and administration) and pre cost centers
(e.g. buildings), with the costs of the latter being broken down and allocated to the main cost centers.

Chapter 10:
Since a specific allocation approach is used for each cost centers, the resulting costs per product are more detailed
and precise, i.e. they can be analyzed more closely than if all overhead costs were allocated to the products at a
single, company-wide rate. A single rate can cause disincentives, such as pricing, because it is not transparent
regarding i.e. where costs are incurred and how costs per product change in case of changing production processes.
Cost unit
The cost unit calculation provides information on what costs were incurred for. A typical cost unit is a finished
product: the original costs for a product are calculated with the cost unit calculation while total costs for a specific
period and their allocation to cost units are determined with the cost unit time calculation (Schweitzer & Küpper,
2011, p. 158).
Cost-of-sales method
Excursion
Cost of sales accounting shows sales in terms of corresponding costs (COGS). The cost of sales is thereby
shown according to the cost centers where the costs were incurred: manufacturing costs, sales costs, etc.
Total cost method

In the total cost method, the increase in inventories and depreciation expenses are shown in the income
statement. The expense is presented according to cost type: purchases of goods and raw materials, personnel
expenses, and so on.
10.3.2.3 Cost distribution sheet
The cost types, cost centers and cost unit calculation can be combined in the cost distribution sheet to determine the
costs incurred per cost center and the original costs for a product, i.e. the total costs for one product (Coenenberg et
al., 2009, p. 104):
Figure 98: Example of a cost distribution sheet

EXAMPLE Cost distribution sheet
From Fischer et al., 2015, p. 17.

Introduction to Management Accounting

Chapter 10:
EXAMPLE Cost distribution sheet
Figure 99: Example of a cost distribution sheet

4
5
Own illustration.
11. Expenses and revenues that are one-time or from other accounting periods, as well as costing adjustments for interest & depreciation
22. Direct costs can be allocated to cost units directly
33. Overhead costs are allocated to cost centers
44. Costs of pre cost centers are allocated to cost centers
55. Allocation of material- and production-overhead costs to cost centers
66. Surplus of administrative- and sales-overhead costs to cost units
215
Chapter 10:
10.4 Break-Even Analysis
LEARNING OBJECTIVES

• Understanding and describing the influences of cost behavior and volume produced on profit.
• Calculating the break-even point of a company.
• Calculating the coefficient of safety with respect to possible volume decrease up to the break-even point.
A company's profits depend on its revenues and costs. These, in turn, are driven by the number of products produced
and the number of products sold. A central question for companies is therefore how many products have to be sold
at what price in order to make a profit. A company can only make profits after it has covered its fixed costs with the
contribution margins of the products sold.
Contribution margin Contribution margin = Revenue − Variable costs
Contribution margin per unit Contribution margin per unit = Preis − Variable costes per unit
Of particular interest is the profit threshold, i.e. the point at which all fixed costs are covered and profits can be
booked. Reaching this threshold is called break-even and can be calculated if variable costs, fixed costs and the sales
price are known.
The difference between revenues and variable costs is referred to as the contribution margin (Schweitzer & Küpper,
2011, p. 467). The contribution margin is needed to cover the fixed costs. After all fixed costs have been covered, a
profit is generated. The following figure illustrates this with the watering can principle:
Figure 100: Watering can principle of the break-even calculation

Price per item
(sales price)
Variable cost
per item
Contribution margin per item
Fixed cost
Profit
From Shank, & Govindarajan, 1989, p. 27
10.4.1 Interaction of costs, sales volume and profit
The interaction of sales volume and costs as well as the effects on profit can be shown in a graph. The break-even
point is where a company has not yet made a profit, i.e. where the total costs are the same as the revenue. This is the
case graphically where the two lines intersect. If the total revenue is greater than the total costs, a company makes a
profit. This is the case to the right of the break-even items.

Chapter 10:
Figure 101: Break-even analysis
Revenue :
Y = 0.15x
$
Total cost :
Y = 100 000 + 0.05x
Break Even Revenue Variable cost: Y = 0.05x
Fixed cost: Y = 100 000

Break Even items
Own illustration
The graph can also be used to discuss various effects. In the example, a sales price of CHF 0.15 is assumed. The
sales price determines the slope of the revenue curve. If a higher sales price can be achieved, it becomes steeper and
therefore intersects with the total cost curve earlier, which reduces the break-even items. Falling sales prices, on the
other hand, would make the revenue curve flatter, shifting the intersection point and consequently the break-even
point to the right.
The cost curve has two components, variable costs and fixed costs. Fixed costs determine the starting point of the
total cost curve on the Y axis. If fixed costs increase, the straight line moves upward, which shifts the intersection to
the right. Increasing fixed costs mean that more products have to be sold to cover them. Falling fixed costs move the
cost curve down, resulting in an earlier break-even.
The slope of the cost curve is dependent on variable costs. The higher these are, the steeper the cost curve is and
further to the right it meets the revenue curve. This can be explained by the fact that the contribution margin per unit
decreases at the same sales price, and more products have to be sold in order to reach the break-even point.
10.4.1.1 Calculation of break-even item
Profit can be expressed as a function of sales revenue and variable and fixed costs:
Meaning The profit of a company is calculated from the sales revenue reduced by variable and fixed costs.
Calculation 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠 − 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
Example Continuing the example with glass bottles (fixed costs = 100 000, variable costs = 0.05 CHF), if the sales
price per bottle is set at 0.15 CHF, the profit is calculated as follows:
𝑃𝑟𝑜𝑓𝑖𝑡 = 0.15 − 0.05𝑥 − 100 000
To calculate the break-even item, calculate the quantity of products sold for which a profit of 0 is made. To do this,
fixed costs are compared with the contribution margin per unit:
Meaning Break-even item is defined as the quantity at which a company makes neither a profit nor a loss. This
point is also referred to as the profit threshold.
Calculation 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠

𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦[\]^_àb]c = =
𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛
Example Fixed costs CHF 100 000, sales price CHF 0.15, variable costs CHF 0.05:
100 000
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦[\]^_àb]c = = 1 000 000
0.15 − 0.05

Chapter 10:
Interpretation § The difference between the sales price and variable costs is used to cover fixed costs.
§ Consequently, the price minus the variable costs corresponds to the contribution margin.
§ The formula for calculating the break-even items can therefore also be written as:
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦[\]^_àb]c =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
The break-even item is the quantity that leads to a profit of 0. Therefore (ceteris paribus) a loss is made under this
quantity (if a fewer number of products is sold), a profit is made over this quantity (if a higher number of products is
sold). This quantity graphically corresponds to the intersection of the total cost curve with the revenue curve.
10.4.1.2 Break-even item for target profit
To calculate a target profit, the target profit can be added to the fixed costs. The contribution margins of all products
must cover the fixed costs. Once the fixed costs are covered, profits are generated on the basis of the contribution
margins. The contribution margins of the quantity sold must therefore cover the fixed costs and the desired profit:
Meaning The target profit formula is used to calculate the amount that must be sold to achieve a specific target
profit. If a target profit is to be achieved, it must be added to the fixed costs in the formula.
Calculation 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡

𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦e^\f]g h\ijkg = =
𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛
Example Fixed costs CHF 100 000, sales price CHF 0.15, variable costs CHF 0.05, target profit 1 000
101 000
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑖𝑦e^\f]g h\ijkg = = 1 010 000
0.15 − 0.05
Interpretation § If the fixed costs are covered, a profit is achieved thanks to the difference between the sales price and
the variable costs.
In reality, profits are taxed. The target profit must therefore be corrected for this taxation. In other words,
contribution margins must include fixed costs, taxes and the target profit after taxes. For the calculation, the target
profit is increased by the tax burden in order to be able to use a target profit after taxes in the formula:
Example Fixed costs CHF 100 000, sales price CHF 0.15, variable costs CHF 0.05, target profit 1 000 (target net
profit), tax rate 20%.
First the gross profit must be calculated:

n]g h\ijkg o qqq
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 = = 1 250
o`g^p \^g] o`q.r
101 250
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦[\]^_àb]c = = 1 012 500
0.15 − 0.05
Interpretation § In comparison to the case without taxes, 2 500 more bottles have to be sold in order to achieve the
same profit.
§ Profit taxes have no influence on the calculation of break-even item.
10.4.1.3 Calculation of the break-even revenue
Up to this point, the quantity that must be sold to reach the break-even was calculated. This procedure can be
converted into a calculation of the break-even revenue. To calculate the profit threshold as a function of revenue, the
variable costs are not defined as an amount per unit sold but as a percentage of revenue. The contribution margin
ratio is the portion of revenue that is available to cover fixed costs and generate profit.

Chapter 10:
Figure 102: Contribution margin ratio and variable cost ratio
40
Variable costs 40 / 100 covering
Variable costs ratio 40% variable
costs
100
Revenue 60
Contribution
Contribution margin 60 / 100
margin
Contribution margin ratio 60%
to cover
fixed costs
Own illustration
The formula that was used before for the calculation of profit can be switched to revenue to create the formula for
the break-even revenue, which is:
Derivation 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠 − 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − (𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑒 ∗ 𝑟𝑒𝑣𝑒𝑛𝑢𝑒) − 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 ∗ (1 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑒) − 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 ∗ 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑖𝑜 − 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
0 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 ∗ 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑖𝑜 − 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝑅𝑒𝑣𝑒𝑛𝑢𝑒[\]^_àb]c =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑖𝑜
𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛
𝑤ℎ𝑒𝑟𝑒 𝑡ℎ𝑒 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑖𝑜 = =
𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒
Example Sales price CHF 400, variable costs CHF 240, fixed costs CHF 1 200 000
yqq`ryq
The contribution margin ratio is calculated as: = 40 %
yqq
o rqq qqq
Break-even revenue is calculated as: = 3 000 000
q.y
Interpretation § The company reaches the profit threshold as soon as revenue of CHF 3 000 000 is achieved.
§ The break-even items of 7 500 can be derived from the break-even revenue.
§ The contribution margin is 160; multiplied by 7 500 units, the fixed costs of 1 200 000 are covered.
10.4.1.4 Break-even revenue for target profit
You can add a target profit to the formula for the break-even revenue in the same way as for the calculation of the
break-even item:
Formula 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑇𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡

𝑅𝑒𝑣𝑒𝑛𝑢𝑒e^\f]g }\ijkg =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑖𝑜
•^€]• }\k‚]`b^\k^ƒ€] ‚i•g• „icg\kƒ…gkic †^\fkc
𝑤ℎ𝑒𝑟𝑒 𝑡ℎ𝑒 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑖𝑜 = •^€]• }\k‚]
= •^€]• }\k‚]
Example Sales price CHF 400, variable costs CHF 240, fixed costs CHF 1 200 000, target profit CHF 240 000
yqq`ryq
The contribution margin ratio is calculated as: = 40 %
yqq
o rqq qqq‡ryq qqq
The revenue for a target profit is calculated as: = = 3 600 000
q.y
Interpretation § If revenues of CHF 3 000 000 are achieved, the company reaches the profit threshold.
§ From the revenue of 3 600 000, the amount of 9 000 units can be derived.
§ The contribution margin is 160, so when multiplied by 7 500 units the fixed costs of
1 200 000 are covered — the target profit is achieved with the remaining 1 500 units.

Chapter 10:
10.4.2 Coefficient of safety
For companies in matured or declining markets, the break-even analysis may not focus on how many units need to
be sold to make that profit. More interesting could be the question of the degree to which the quantity sold may
decrease until a loss is made, i.e. what the safety buffer is. This coefficient of safety can be calculated as follows:
Meaning The coefficient of safety indicates the maximum extent to which the utilization rate may be reduced
without suffering a loss:
Calculation 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦‚…\\]cg − 𝐼𝑡𝑒𝑚 [\]^_àb]c

𝐶𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑠𝑎𝑓𝑒𝑡𝑦 =
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦‚…\\]cg
Calculation Break-even item 1 000 000, current quantity 1 250 000

o rŠq qqq` o qqq qqq
𝐶𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑠𝑎𝑓𝑒𝑡𝑦 = = 20 %
o rŠq qqq
Interpretation § The higher the coefficient of safety, the better the company is protected against a possible loss.
§ A coefficient of safety of 20% means that production can be reduced by 20% before no profit is made.
§ This 20% corresponds to 250 000 units in this case: If these units are subtracted from the current
quantity, exactly the break-even item is achieved.
10.4.3 Break-even analysis as a decision-making and planning instrument
Break-even analysis can not only be used to calculate the profit threshold, but also serves management as a basis for
strategic decisions. Should a marketing strategy that increases fixed costs be implemented, since contribution
margins from additionally sold units are higher and profit is increased as a result? Should the price be increased
because the additional contribution margin more than compensate for the reduced sales volume? Should the price be
reduced, since a smaller contribution margin per product could accepted while the quantity effect is greater?
These and other questions can be dealt with using the concepts presented in this chapter in order to enable decision-
makers to make well-founded decisions. In addition, strategic decisions regarding cost structures must also be made.
For example, fixed costs, such as in sales, can be replaced by performance-related wage components, depending on
the number of products sold. These measures would increase the variable costs per product and reduce the
company's fixed costs at the same time. The cost structure of a company can be expressed through operating
leverage (see Datar & Rajan, p. 103):
Operating 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 =
leverage 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 − 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
Option A: Contribution margin per product 80, fixed costs 2 000

Option B: Contribution margin per product 50, fixed costs 800
Example By selling 40 products, both companies achieve a profit of 1 200. However, the operating leverage differs:
40 ∗ 80 40 ∗ 50
𝑂𝑝𝑡𝑖𝑜𝑛 𝐴 = = 2.67% 𝑂𝑝𝑡𝑖𝑜𝑛 𝐵 = = 1.67%
40 ∗ 80 − 2000 40 ∗ 50 − 800
§ Operating leverage indicates how strongly a change in the volume sold affects profit: An increase in
revenue by 1% increases profit according to operating leverage, i.e. by 2.67% for option A and by
1.67% for option B.
§ A change in the volume sold changes the operating leverage.
Interpretation § A higher operating leverage indicates a higher proportion of fixed costs and is therefore associated
with more risk.
§ A company without fixed costs has an operating leverage of 1%.
§ These considerations only apply in the area where a company makes a profit.

Chapter 10:
Operating leverage can therefore be used to express the risk in a company's cost structure. With higher fixed costs,
the company is exposed to a higher risk of loss, which is compensated for in the profit zone by stronger profit
increases from a higher volume sold. Companies must consciously design their cost structures as high operating
leverage can lead to financial problems in economically weaker times. A company that can no longer cover its fixed
costs becomes insolvent. If the operating leverage of two companies is compared, it must be ensured that they
operate in the same industry, as the industry can have a strong influence on the cost structure. By their very nature,
manufacturing companies have higher fixed costs than service companies.
10.4.4 Break-even analysis in the case of multiple products
The previous examples were each based on a single product. However, break-even analysis can also be performed
for multiple products. The procedure is described below using an example:
TV Radio Total
EXAMPLE Multi-product case
Budgeted sales 60 40 100

Revenue (200 per TV, 100 per Radio) 12 000 4 000 16 000
Variable costs (120 per TV, 70 per Radio) 7 200 2 800 10 000
Contribution margin (80 per TV, 30 per Radio) 4 800 1 200 6 000
Fixed costs 4 500
Profit 1 500
In order to calculate the break-even threshold, it is assumed that sales are made in accordance with the budgeted ratio (i.e.,
3:2) and that so-called bundles are used (even if these are not physically sold as a bundle). The contribution margin can be
calculated for this bundle in a ratio of 3:2:
® 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝐵𝑢𝑛𝑑𝑙𝑒 = 3 ∗ 80 + 2 ∗ 30 = 300
Now the number of bundles for the break-even can be calculated analogously to the case with a product:
‘kp]’ ‚i•g• yŠqq

® 𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 = „icg\kƒ…gkic †^\fkc }]\ […c’€] = = 15 𝐵𝑢𝑛𝑑𝑙𝑒𝑠
“qq
® Each bundle contains three TVs and two radios, so the break-even items are 45 TVs and 30 radios (or any other
combination of TVs and radios that leads to a total contribution margin of 4 500).
From Datar & Rajan, p. 105-106 (slightly adapted).
10.5 Further aspects of performance management
LEARNING OBJECTIVES

• Knowing other tasks of the performance management function in the company
• Understanding budgeting and its different approaches
• Understanding the advantages of Activity-Based Costing
In addition to recording and analyzing costs, performance management has other central tasks. These include
budgeting and the associated analysis of budget variances. Budgeting will be dealt with briefly below, as will
process cost accounting, which eliminates the weaknesses of cost and performance accounting already presented.

Chapter 10:
Performance management can also be described as a performance management function — in this function, key
figure systems such as Balanced Scorecard play an important role, as do questions of management incentives. This
subarea will be examined in the next chapter.
10.5.1 Budgeting
The long-term framework for company activities is defined by the corporate strategy. Medium-term planning, which
typically has a horizon of five years, is derived from this. Medium-term planning describes how strategic goals can
be achieved operationally. The budget, which has a time horizon of one year and is typically prepared in the fourth
quarter of the fiscal year for the new year, is much more detailed than the medium-term planning. The purposes of
the budget make it an important coordination and control instrument for companies (Friedl et al, 2014, p. 512f.):
§ Budgets translate the company strategy and goals into clearly defined financial targets for the entire
organization and its subunits.
§ The budgeting process forces managers to deal with the future and make their plans transparent.
§ Future activities can be better coordinated by coordinating sub-budgets, and communication within the
organization (between departments and across hierarchies) is also encouraged.
§ The budget or the degree to which it is complied with often serves as a basis for assessing the performance
of a unit when comparing planned and effectively achieved results. The budget can therefore also serve as a
basis for motivating managers to make efficient use of resources by means of incentives.
The planning flow structure can be either top-down (from the top hierarchical level down) or bottom-up, while
against-the-flow describes a combination of these two variants (Rieg, 2008, p. 21):
Top-down Bottom-up Against-the-flow

§ Retrograde planning: Derivation § Progressive planning: Derivation § Combination of both methods:
from top to bottom. from bottom to top Derivation in several planning
rounds
§ Goals of company management § Lower hierarchy levels work out
are to be concretized on the plans for the following year, § Starts with Top-Down Planning.
following levels. which are condensed until an
overall plan is created. § Targets are commented on at
§ Advantages lie in the relatively lower levels, and adjustments are
rapid preparation and the fact § Advantage is that the plans are encouraged.
that all subplans are geared to more realistic.
the goal set from above. § Aggregation of proposals and
§ Disadvantages are that plans are adjustments.
§ Disadvantages lie in the fact that more uncoordinated.
the feasibility is not necessarily § Company management adapts
considered, as the focus lies on § The plans may also not be guidelines based on feedback
what is desired. ambitious enough if they are to from individual hierarchy levels.
serve as a target value and basis
§ The new guidelines are again
§ Knowledge about the feasibility for incentive payments.
of goals lies at the lower levels. handed down and made more
§ Useful for strongly growing concrete.
§ Useful for small companies or in markets or strongly decentralized
times of crisis. conglomerates.
10.5.2 Variance analyses
The values budgeted in this way can be compared with the actual values during the fiscal year in order to identify
variances. Variances can have different causes, which is why they have to be analyzed. Based on this analysis,
measures can then be defined so that these variances can be corrected.

Chapter 10:
If, for example, the material cost budget is exceeded, it must be examined whether this is due to increased prices or
inefficient use in the company (scrap). In most cases, these variances cannot be reduced to a single cause (Friedl et
al., 2014, p. 528). For example, a larger production volume due to higher demand may be the cause of exceeding the
material cost budget. This is remedied by so-called flexible budgets, which do not plan with fixed sales and
production quantities, but are corrected to the quantity actually produced before the analysis.
10.5.3 Process costing and Activity-Based Costing
If the share of overhead costs in the finished product is very high, this can lead to a product variant being assigned
too high or too low overhead costs (Fischer et al., 2015, p. 239). Since costs are allocated on the basis of direct costs,
products with higher costs are also allocated a larger proportion of overhead costs, which may not reflect reality:
Figure 103: Traditional overhead calculation
Surcharge for Product 1 is

significantly higher because of
higher direct product cost
Product 1 Product 2
Direct Product Cost Surcharge (80%)
Own illustration
A more cause-based allocation of overhead costs than with the cost accounting sheet is possible with process-
oriented calculations. These include Activity Based Costing (ABC) process costing. The allocation is based on the
required activities or processes. It results in a "fairer" distribution of overhead costs to various products:
Figure 104: Process and activity-based overhead calculation
Surcharges based on
effectively consumed
process steps
Product 1 Product 2 Product 3

Direct Product Cost Surcharge Standard Version
Surcharge Special Model Surcharge Small Batch
Own illustration
The ABC approach was developed in American accounting, as overhead costs in administration have risen sharply.
The aim is to no longer allocate the overheads to the cost units on the basis of wage hours but to actually performed
activities (Fischer et al., 2015, p. 240f.). Process costing, on the other hand, is based on the German system and is
adapted to the conditions of the German-speaking environment (Fischer et al., 2015, p. 241). The two methods are
closely related: ABC looks at individual activities, while process costing takes into account "process flows spanning
cost centers" and thus entire corporate processes (Horváth & Mayer, 2011, p. 5).

Chapter 10:
10.6 Summary
In contrast to external financial management, internal financial management (also performance management,
operational accounting, cost accounting or management accounting) tries to satisfy the information needs of internal
stakeholders. In contrast to external financial management, internal financial management offers many options for
how it can be best designed and organized. Business activities are analyzed in order to create a decision-making
basis for the management. The performance management function is usually part of a company's finance department
and reports to the CFO.
One of the most important tasks is the analysis of costs incurred in the company, which is why performance
management can also be called cost management. Costs can be categorized according to their behavior:
§ Fixed costs
§ Variable costs
§ Mixed costs
Another central task is cost allocation. The costs incurred must be allocated to the party responsible in the enterprise.
The different types of costs incurred by the company are subdivided into cost types. These are passed on to cost
centers (places in the company where costs were incurred, such as production). Finally, the cost unit is the product
for which the costs were incurred. The cost allocation can be represented schematically in the operational
accounting sheet.
Direct costs can be allocated directly to a cost object, whereas the indirect costs must be dispersed. This allocation
can take place using a global overhead rate, for example. If a more exact allocation is required, different cost rates,
surcharge rates and dispersion rates can be used.
If revenue is analyzed as well as costs, the break-even point can be calculated. If all fixed costs are covered by the
contribution margins (sales price – variable costs), the company reaches the profit threshold. The coefficient of
safety refers to a margin within the framework of break-even analysis: How much may the sales volume fall before
the company will be making a loss? Break-even analysis can be performed not only for a single product but also in
the case of multiple products.
In addition to cost and revenue accounting, performance management has other central tasks in the company. These
include, for example, budgeting or variance analyses.

Chapter 10:
10.7 Additional literature

Becker, W. & Ulrich, P. (2016). Handbuch Controlling. Wiesbaden: Springer Fachmedien.
Behringer, S. (2018). Controlling. Wiesbaden: Springer Fachmedien.
Coenenberg, A. G., Fischer, T. M. & Günther, T. (2009). Kostenrechnung und Kostenanalyse (7. Aufl.). Stuttgart:
Schäffer-Poeschel.
Controlling-Blog (2019). Gemeinkosten. Gefunden am 16. Januar 2019 unter https://www.controlling-
blog.de/gemeinkosten/
Datar, M. D. & Rajan, M. V. (2018). Horngren’s Cost Accounting: A Managerial Emphasis (16th Ed.). Harlow, UK:
Pearson.
Eisele W. & Knobloch, A. P. (2011). Technik des betrieblichen Rechnungswesens: Buchführung und Bilanzierung,
Kosten- und Leistungsrechnung, Sonderbilanzen (8. Aufl.). München: Vahlen.
Euler Hermes / ZIS Universität Mannheim (2006). Ursachen von Insolvenzen: Gründe für
Unternehmensinsolvenzen aus der Sicht von Insolvenzverwaltern. Wirtschaft Konkret Nr. 414.
Finance Magazin (2013, 02. Februar). Being Alan Hippe. Gefunden am 07. November 2018 unter
https://www.finance-magazin.de/cfo/fuehrung-karriere/being-alan-hippe-1250591/
Fischer, T. M., Möller, K., & Schultze, W. (2015). Controlling: Grundlagen, Instrumente und
Entwicklungsperspektiven (2. Aufl.). Stuttgart: Schäffer-Poeschel.
Friedl, G., Hofmann, C. & Pedell, B. (2014). Kostenrechnung. München: Vahlen.
Gleich, R. (2014). Controlling und Big Data. Freiburg: Haufe.
Horsch, J. (2018). Kostenrechnung: Klassische und neue Methoden in der Unternehmenspraxis (3. Aufl.).
Wiesbaden: Springer Fachmedien.
Horváth, P. (2012). Controlling (12. Aufl.). München: Vahlen.
Horváth, P., & Mayer, R. (2011). Was ist aus der Prozesskostenrechnung geworden? Controlling & Management,
55(2), 5-10.
Internationaler Controller Verein ICV (2019). Das Controller-Leitbild der IGC. Gefunden am 07. Januar 2019 unter
https://www.icv-controlling.com/fileadmin/Verein/Verein_Dateien/Sonstiges/Das_Controller-Leitbild.pdf.
Rieg, R. (2008). Planung und Budgetierung: Was wirklich funktioniert. Wiesbaden: Gabler.
Schweitzer, M. & Küpper, H.-U. (2011). Systeme der Kosten- und Erlösrechnung (10. Aufl.). München: Vahlen.
Shank, J. K. & Govindarajan, V. (1989). Strategic Cost Analysis: The Evolution from Managerial to Strategic
Accounting. Homewood, Illinois: Irwin.
Winiger, A. & Prochinig, U. (2014). Kostenrechnung (3. Aufl.). Zürich: SKV.
Wright, T. P. (1936). Factors Affecting the Cost of Airplanes. Journal of the Aeronautical Sciences, 3(4), 122-128.

Chapter 11:
Performance Measurement 226
Performance Measurement
Development of sales
As discussed in the previous chapter 10, management

accounting provides detailed internal reports to the
management with granular information about products,
business units, or geographical units. In order to derive
operating and strategic decisions from this information,
performance measurement as subdomain of internal Cash ratio
120,000 = 50%
240,000
financial management uses various financial ratios and Quick ratio

265,000
240,000
= 110%
387,000
ratio systems to quantify strengths and weaknesses of a Current ratio
240,000 = 161%
Level of accounts receivable
company. Simple financial ratios are often calculated Concentration risks
20% 25%
with information from the external financial reports. 40%
60% 80% 75%
Ratio systems however require internal data, oftentimes

also non-financial information (customer satisfaction,
waste ratio, etc.). This chapter introduces established
financial ratios and ratio systems, as well as decisions
that are typically taken based on their results.
11.1 Introductory Example from Schindler
INTRODUCTION:
More Profit with Less Revenue – 2009 Profit of CHF 600 Million
In the current economic crisis, Schindler Holding AG is holding its own, boosting
profit with declining revenue. Although the elevator and escalator manufacturer
experienced a decline in revenue of 11.4% to CHF 9 092 million and incoming
orders were down 16.6% to CHF 9 214 million, operating profit at the EBIT level
rose by 12.7% to CHF 746 million in the first nine months of the 2009 fiscal year.
Net profit before minority holdings increased by 6.3% to CHF 505 million and
after minority holdings to CHF 481 million, the company announced on Tuesday.
The Group generated CHF 846 million of cash flow from operating activities. The results had a positive effect on the key
performance indicators in the statement of financial position: As of September 30, 2009, cash amounted to CHF 1 757 million
(as of December 31, 2008: 1 540 million). The equity ratio was 33.0% (as of December 31, 2008: 29.7%).
With the announced figures, Schindler exceeded analysts' expectations. The AWP consensus for revenue was 9 013 million,
for EBIT 714 million, and for net profit before minority holdings CHF 464 million. Due to the high order portfolio at the start
of the year, capacity adjustments introduced early on, savings in material costs and process improvements, the company was
able to boost both its operating profit and group profit. In the core elevator business, the poor economic outlook in most
regions of the world led to a decline in incoming orders and in operating revenue. Incoming orders amounted to CHF 6 202

Chapter 11:
million, constituting a decline of 13.7% (in local currencies: -9.7%). Operating revenue fell by 5.4% to CHF 6 097 million (in
local currencies: -1.1%), according to the company.
In several markets, the difficult economic circumstances led to a significant decline in construction work. In the first nine
months, the demand in new equipment business was significantly below the prior-year level, particularly in Spain, the US,
Great Britain, Australia and several markets in Eastern Europe. Compared with the prior-year period, a decline of 28% (in
local currencies: -24.4%) was recorded in new equipment business.
Depicted article has been modified. From: Handelszeitung. (October 27, 2009)
1. Which components of the financial statement formed part of this article?
2. How is EBIT calculated and what information does it provide?
3. How is cash flow from operating activities related to cash and equity?
4. From which component of the financial statement does the information in the bottom three sections come?
11.2 Fundamentals of Financial Statement Analysis and Key Performance

Indicators
LEARNING OBJECTIVES

• Recognizing the distinction between external and internal viewpoints of financial statement analyses
• Understanding the challenges in financial statement analyses and in using key performance indicators
• Calculation and interpretation of important financial ratios
• Taking decisions based on financial ratios
In order to better understand and assess annual reports and information resulting from internal financial
management, typically financial ratio and ratio systems apply. Analysis, evaluation and assessments may be
prepared by internal personnel or by external stakeholders such as investors or suppliers. Evaluation and analysis is
not only carried out by the company itself but rather by many third parties, such as investors or suppliers,
concluding insights about a company's assets, financial position and earnings. These findings serve the internal and
external stakeholders for taking economic decisions such as starting or continuing a business relationship, evaluating
creditworthiness, monitoring targets, or different investment options. The internal analysis prepared by the company
itself forms part of the management accounting. The internal analysis involves management's handling of financial
matters, using financial data and information that are not available to the public. (Boemle, 2008, p. 673)
The external evaluation of the financial statement faces the challenge of analyzing the extensive data in the annual
report8. The first step in a financial statement analysis is thus to systematically prepare financial information for the
purpose of the analysis, e.g. proportionalities are calculated, and comparisons are made. Financial reporting can be
viewed as the data basis for a comprehensive analysis. Thanks to clearly defined financial reporting standards (e.g.
8
In this chapter, financial ratios are calculated from the perspective of an external stakeholder, as all respective information is broadly, easily and
freely available through annual reports. Internal stakeholders have access to significantly more information, which allows more detailed and
comprehensive analyses (e.g. monthly or for specific products). However, the following discussions apply for internal and external stakeholders.

Chapter 11:
IFRS), identical positions are found in the statement of financial position, the statement of profit or loss and other
comprehensive income, the statement of cash flows, the statement of changes in equity and the notes of various
companies, including over the course of time. This is made possible by the application of the “true and fair view” of
accounting standards and supports the analysis (see chapter 10.2.3), since a analysis is always only as good as the
underlying data. In order to achieve systematic preparation and condense financial information, key performance
indicators (KPIs) and respective systems are used. Technical opportunities have made the task of calculating KPIs
simple and rapid. As a result, the number of KPIs has consistently grown in professional literature. Any analysis
should be prepared with the focus on the most meaningful KPIs with respect to the decision to be made rather than
as many KPIs as possible. The choice of KPIs must still be made with the specific company in mind. Just as
important as the choice of KPIs is understanding how a figure was generated. If readers do not know what the
figures mean and how they came about, they will not be able to correctly interpret the results.
Figure 105: Analysis of the Framework Conditions and Financial Statement Analysis
However, a comprehensive financial statement analysis includes more than just the calculation of KPIs. In addition
to the first step involving their quantitative calculation, the KPIs not only have to be evaluated, they also have to be
assessed in the specific context. This requires, as a second step in a financial statement analysis, the inclusion of the
economic environment, the markets served and the attractiveness of the sector. The second part of the analysis
necessitates information from the management report, the annual report, the corporate governance report and the
broader sector environment. Also necessary is a comparison of the competition from a qualitative standpoint as well
as a comparison of KPIs. Important remarks in the notes, such as those concerning financial risk management, must
be included in the qualitative analysis as well. The extent to which a sector analysis (such as Porter's Five Forces) or
other strategic analyses (such as the BCG Matrix) are included essentially depends on the scope of the financial
statement analysis. As in the analysis of KPIs, it is not quantity but rather quality that is essential for the qualitative
analysis. A few central, meaningful statements are more valuable than a lengthy analysis lacking any coherence.
The financial statement analysis therefore summarizes all data components in the financial statement as well as
qualitative information in the other components of the annual report and formulates statements based on them.

Chapter 11:
11.2.1 Objectives and Limits of the Financial Statement Analysis
The financial statement analysis is a process of condensing and gaining information about a company's assets,
financial position and earnings. Two issues are at the core of the financial statement analysis:
§ To what extent is the company capable of generating a cash surplus in the future (cash earning power)?
§ To what extent can the company meet its payment obligations on time (estimate of illiquidity risk)?
For this reason, the financial statement analysis forms the basis for all economic decisions in connection with the
analyzed company. In particular, the following points are in the foreground:
For this reason, the financial statement analysis forms the basis for all economic decisions in connection with the
analyzed company. In particular, the following points are in the foreground:
§ Evaluation of the company's assets, financial position and earnings

§ The company's statement of financial position policy
§ Self-financing power
§ Margin trends in the business model
§ Estimate of the company's creditworthiness
§ Starting or continuing business relationships with the company
§ Investment decisions (buy or sell shares) for publicly traded companies
§ Tax and corporate consulting
§ Medium- and long-term company development
§ Continue or discontinue selected business units
§ Company valuation or stock analysis for publicly traded companies (not included in this book)
In contrast to audited financial statement, analysis are not based on general principles and guidelines. The analysis is
always dependent on the party preparing it, or the decisions to be made. Both in the quantitative part with KPIs and
in the qualitative part describing the business model and the sector environment, the party preparing a financial
statement analysis may be biased. Also of great importance is which KPIs are used and how these and other
information from the annual report are weighted. Users and readers of financial statement analyses must always be
aware that a financial statement analysis is nothing more than condensing and summarizing of existing information.
The financial statement itself constitutes an effort to depict business reality. This involves an approximation on
which the financial statement analysis relies. The following problem areas result from the analysis:
§ Limits with regard to the meaningfulness of a financial statement analysis: Condensed information is
dependent on the party preparing the analysis.
§ Meaningfulness of a key performance indicator: Although a key performance indicator already

condenses figures, a key performance indicator should never be viewed in isolation but instead be put in
context with other figures and key performance indicators.
§ Choice of suitable key performance indicators: Depending on the issue or the decision-making situation,
different figures are chosen. There are unfortunately different formulas for a number of key performance
indicators in both practice and in the literature,. The ones that are correct for the respective company must
be decided on a case-by-case basis.

Chapter 11:
§ Sector and time comparisons of key performance indicators: Comparison with other companies or with
other periods (e.g. prior year) of the same company.
§ Data and numerical information: Availability and proper preparation (possibly adjustment) of data and
numerical material.
§ Inability to predict the future: With backward-looking financial information, it is impossible to predict
the company's future; key performance indicators can at most depict trends.
11.2.2 Preparation and Evaluation Methods of the Financial Statement Analysis

Figure 106: Preparatory Steps for the Financial Statement Analysis

Step 1: Data Selection
First, the data material has to be explored. The annual report has to be on hand for each year that is being analyzed.
Even though each annual report contains the prior-year figures, the latter cannot be definitively analyzed, since the
information in the notes and other comments are lacking. It is only possible to find all of the relevant data and notes
needed in the annual report of the year to be analyzed (Boemle, 2008, p. 677). In other words, the last three annual
reports are required at a minimum in order to prepare a reliable multi-year analysis.
All large companies normally have subsidiaries, each having a specific purpose, which usually does not cover the
group's entire business model but rather only a sub-activity. Comprehensive consideration and analysis is therefore
possible only at group level, which is why the consolidated financial statements are normally used for the purpose of
the financial statement analysis. It is important to note here that many large companies have a holding company as
the uppermost entity. This company's separate financial statements should not be confused with the consolidated
financial statements. Like a subsidiary, a holding company is only one company and reflects its own business
activity, normally the holding of participating interests in subsidiaries. Accordingly, an analysis of a holding
company's financial statements serves no useful purpose if the group is to be evaluated as a single economic entity.
Step 2: Preparation
Once the numerical and data material in the consolidated financial statements is available, the closure of the
financial statement analysis has to be prepared. This preparation covers formal criticism of the financial statement in
terms of the superficial form of the financial statement. The following points are to be implemented (based on
Boemle, 2008, p. 679):
1. Formal review:
§ Review of whether preparation of the financial statement conforms to the rules (in accordance with
statutory provisions and the chosen financial reporting standards)
§ Consideration of any reservations, indications or addenda in the audit report
§ Clarification of the designation and content of individual positions using information in the notes
§ Consideration of additional information in the notes

Chapter 11:
2. Formal adjustment
§ Clarification about the exploitation of accounting options (harmonize use of leeway)
§ Book profit distribution (recognition of dividends as short-term liabilities)
3. Adjustment of the classification

§ Adjustment of classifications by grouping individual positions (formation of groups) into meaningful
subtotals including those necessary for calculating key performance indicators (e.g. grouping of
machinery and cumulative depreciation on machinery)
Step 3: Selection of Analysis Method

In order to obtain a meaningful financial statement analysis, a suitable analysis method has to be used. Normally, a
calculated key performance indicator alone is not meaningful unless a comparison is made. There are in principle
three different methods for making a comparison using the key performance indicator in this regard:
§ Time comparison: This is also called an internal company comparison or period comparison and compares
the company's key performance indicators over a certain time period. The advantage of this method is that
extraordinary events and trends are quickly revealed.
§ Industry or company comparison: This is also termed an inter-company comparison and compares key
performance indicators with those of a competitor (company comparison) or of the same economic sector
(industry comparison). The advantage of this method is that the competition can be compared and
competitiveness evaluated. However, the challenge is finding a suitable competitor that has the same
business activities, since many large companies are diversified and have a number of business fields.
§ Normative comparison: This compares key performance indicators with target, benchmark and projected
values. This method of comparison may also be understood as typical benchmarking, since the company
defines projected values itself or uses target, benchmark and projected values accepted in the sector.
Thanks to a variety of analyses by corporate consulting firms and to research work at universities and
colleges, corresponding benchmarks are publicly available.
Table 52: Company Comparison of Automobile Manufacturers
COMPANY COMPARISON OF AUTOMOBILE MANUFACTURERS
Thanks to Weak Yen, Japanese Overtake Germans

CASE STUDY
Japanese automobile manufacturers are in the fast lane. On average, they overtook their German competitors in
terms of operating margin in the first quarter. The primary reason for this is the weak yen.
[…] On average, they overtook their German competitors in terms of operating margin in the first quarter. While the
profitability of carmakers from the Land of the Rising Sun rose by 2.7 percentage points to 6.9%, that of the competition
from Europe's largest economy fell by nearly two percentage points to 5.9%. This was the result reached by the corporate
consultants of Ernst & Young in connection with an analysis of the statements of financial position of the world's 17
largest automobile manufacturers, in which the groups use different accounting standards. Among individual companies,
BMW continues to hold the top position, with a margin of 11.6%. The two other German representatives Volkswagen
(5.0%) and Daimler (3.5%) suffered marked losses in profitability, whereas Toyota (8.6%) and Mazda (5.1%) doubled
their margins and Honda (5.0%) and Nissan (6.1%) achieved slight increases.
Note. From: Rasch. (June 5, 2013).

Chapter 11:
11.2.3 Fundamentals and Overview of Key Performance Indicators
KPIs are calculated with relatively simple formulas, e.g. revenue is compared to the number of customers, resulting
in average revenue per customer, or equity is compared to total assets, resulting in the equity ratio. With KPIs, a
company can be evaluated more easily. There are a number of key performance indicator methods:
§ Classification or structural figures: e.g. equity ratio or key performance indicators by segment
§ Relationship figures: e.g. return on equity or inventory turnover
§ Index figures: growth
§ Key performance indicator systems: return on investment or economic value added
The use of key performance indicators has advantages as well as disadvantages (ControllingPortal, 2019):
Advantages
§ Identification of deviations and weak points
§ Preparation of critical key performance indicator values as target metrics for sub-areas
§ Simplification of control processes
§ Quantitatively precise operationalization of targets
Disadvantages
§ The party preparing the analysis can selectively choose the key performance indicators and interpretations
that best correspond to their objectives.
§ If the entrepreneurial process is aligned only according to key performance indicators, this threatens to
sacrifice long-term profits in favor of short-term gains.
§ Critical key performance indicator values can also be perceived as ambitious.
§ One-sided viewpoint oriented to financial targets (for example, corporate social responsibility, employee
satisfaction, etc. are not taken into account).
Figure 107: Objectives of Financial Management and Its Key Performance Indicators
While a variety of key performance indicators are proposed in the literature, this book considers only the
fundamental most-often-used key performance indicators that have typical formulas that are sector- and company-
neutral. These are typically associated with the magic triangle introduced in chapter 2. This results in three groups of

Chapter 11:
key performance indicators that are connected with the three objectives of financial management. The three groups
of key performance indicators can in turn be allocated to the mandatory components of the financial statement.
However, note information has to be considered for all three groups of key performance indicators.
Figure 108: Data Basis of Key Performance Indicators
In order to be able to calculate and compare key performance indicators, positions have to be summarized and
certain terms and valuation approaches have to be used. The following overview shows the designations and
classifications relevant in the calculation of key performance indicators.
Figure 109: Data Basis of Key Performance Indicators
The most frequently used key performance indicators are given below in brief with formulas but without any
explanation. Key performance indicators are discussed in the following chapters using the example of Geberit
annual report 2014. Despite the general validity and prominence of key performance indicators, there are always
slightly different approaches to the calculation of key performance indicators. The decision whether to include or
exclude a certain position in the calculation necessarily leads to different key performance indicators. As explained
in the above section 11.2.1, the decision depends on the party preparing the analysis. Ultimately, however, the
calculation difference for the same key performance indicator should not be too broad.
Finally, KPIs must be considered sector-dependently. Benchmark values are illustrative expected values and have to
be adjusted to meet the current application, particularly the company's specific situation, the current economic
position and thus expected returns, and the special features of the sector.

Chapter 11:
Chapter 11:
Table 53: Key Performance Indicators Compared by Sector
Key performance indicator Bank Retail Wholesale Automotive Plant Benchmark

construction
Cash ratio X X X 80%
Quick ratio X X >100%
Current ratio X X X 150%
Free cash flow X X X X X >0
Amortization duration X 2-5 years

Days of sales outstanding X X X 40 days
Days inventory held X X X 10-180 days
Return on assets X X >7%
Return on equity X X X 10-15%
Return on net operating assets X X 10%

Return on sales X X 1-10%
Equity ratio X X X X 25-50%
Debt ratio X X X X 50-75%

Debt-to-equity ratio X X 100-230%
Asset coverage ratio 2 X X X >100%
11.3 Financial Statement Analysis using Geberit

Geberit is a leading Swiss industrial company that prepares its accounting according to IFRS. The most important
key performance indicators in the financial statement analysis will be calculated and interpreted in the next chapters
using Geberit's financial statement as of December 31, 2013, and December 31, 2014. A multi-year comparison of
individual key performance indicators has intentionally been dispensed with, since the primary interest is in the
calculation logic, application and meaningfulness of key performance indicators. In order to begin with the
calculation and interpretation of key performance indicators, the company itself and its business model must first be
understood. For this purpose, Geberit's business model and development, as well as the markets and countries it
serves, will be explained briefly in the following.
The Geberit Group is the European market leader in sanitary technology and has a global orientation. From the time
of its establishment in 1874, the company has always been a pioneer in the sector, consistently setting new trends
with its comprehensive system solutions. Geberit has representatives in more than 40 countries. Sales activities are
concentrated on the major European markets, with growth opportunities in Central and Eastern Europe, France,
Great Britain, the Nordic countries, North America, China, India and Southeast Asia. Geberit supplies markets in
Asia and North America with products specifically designed to suit regional needs. To serve these markets, local
competence centers have been built up in Shanghai (China) and Chicago (US). The company has 35 production
sites, six of them in the Asia Pacific region. The main production sites are located in Switzerland, Germany, and
Austria. Geberit's range of products is designed for use in new buildings as well as renovation and modernization
projects. It comprises the product lines sanitary systems (installation systems, cisterns and mechanisms, faucets and
flushing systems, waste fittings and traps) and piping systems (building drainage systems, supply systems, and

Chapter 11:
ceramics). Geberit brand-name products are innovative, durable and ecologically efficient, providing high benefits
for retailers, plumbers and end users alike. The Geberit Group generated a sales volume of CHF 2.6 billion in 2015
and employs more than 12 000 people worldwide. Geberit is headquartered in Switzerland in Jona and has been
listed on the Swiss stock exchange since 1999; in 2012 the Geberit share was included in the SMI (Swiss Market
Index). (Information from www.geberit.ch) Acquisitions are typically transaction that significantly influence and
change the business of companies, and therewith also significantly influence financial management and financial
reporting, more so if the acquired company is big, offers complementing products, services, markets, and customers,
and if the price being paid is high. The acquisition of the Finnish Sanitec group, the leading sanitation ceramics
player in Europe, is such an example for Geberit. Geberit paid CHF billion 1.2, it complemented its sanitation
product line all the way to ceramics, and it strengthened its market position in Scandinavia, France, UK, as well as
Eastern Europe. In February 2015, Geberit bought 99.7% of the shares of Sanitec and the purchase was finances
with existing cash, new bank loans, and issuing of bonds. An acquisition of the size of Sanitec has a significant
influence onto the financial ratios of Geberit Group. Therefore the Geberit group financial reports of 2014 and 2015
serve discussing such changes using financial ratios. The following charts provide information about trends in the
most important aggregation metrics in the statement of profit or loss and other comprehensive income (e.g. EBIT)
and statement of cash flows (e.g. free cash flow) as well as the most important positions (e.g. financial liabilities).
All information about metrics in the charts and in the following chapters is in CHF million.
Figure 110: Geberit Key Performance Indicators (Statement of Profit or Loss and Other Comprehensive Income, and Statement of Cash Flows)
Note: https://annualreport.geberit.com/reports/geberit/annual/2018/gb/English/2020/geberit-key-figures.html

Chapter 11:
Figure 111: Geberit Key Performance Indicators (Statement of Financial Position)
Note: https://annualreport.geberit.com/reports/geberit/annual/2018/gb/English/2020/geberit-key-figures.html
Figure 112: Geberit Revenue by Division and Region 2015 and 2014
Note. Geberit annual report 2014, pp. 29f; annual report 2015, pp. 25f
The Graphs, indicating the development of key indicators, disclose the significance of the Sanitec Group acquisition
without calculation of the financial ratio. Sales and assets, mainly goodwill, increase significantly with acquisition,
while equity ratio and available cash decrease. The expected synergies regarding products and markets, as discussed
in chapter 4.4.3.2, are already indicated in the charts showing regional development and product portfolio
development of sales. The importance of the main markets Switzerland and Germany is decreasing, while the
Nordics, Central and Eastern Europe, France and UK show higher shares of sales. The Sanitec product “ceramics”
has already reached sales share of one-quarter in the first year.

Chapter 11:
2015 FINANCIAL STATEMENTS OF GEBERIT IN THE BUSINESS PRESS

Slightly higher margins
CASE STUDY
The result of the sanitary technology group Geberit has convinces investors. After the presentation of the Q1 results, the
share price increased by 2.9%. Sales increased by 13%, which includes the sales from the Sanitec business that were not
included in the January 2015 numbers. Corrected by effects from acquisition and currency translation, the sales increased
by 3.1%. The improved margin results from higher sales volume, lower raw material prices, and synergies from the
Sanitec acquisition. The executive team expects further positive markets in Germany, with 30% share the most important
market of Geberit. Business was weak in the gulf region and in China.
Note. From: NZZ online (April 23, 2016)
11.4 Key Liquidity Indicators
LEARNING OBJECTIVES

• Being able to recognize and calculate the most common key liquidity indicators
• Being able to interpret key liquidity indicators
Liquidity can be called a company's oxygen. Illiquidity is the top reason for bankruptcy in Switzerland. Having a
sufficient amount of cash and cash equivalents and thus liquidity is therefore a necessary prerequisite for a
company's survival. In this regard, the amount of cash and cash equivalents must be evaluated in relation to financial
liabilities. The analysis must consider the maturity congruity of assets and liabilities and their effects. In addition,
net debt shows the ratio of cash and cash equivalents to financial liabilities. Cash flow is likewise of central
importance for evaluating a company's liquidity situation.
11.4.1 Cash Ratio
Meaning
Ratio of cash and cash equivalents to liabilities that have to be settled in the short term
Calculation Cash and cash equivalents

Short term liabilities
Information basis
Cash and cash equivalents = all cash and means of payment with high liquidity, such as: cash on hand,
bank account balances, post office account balances, cash equivalents
(e.g. call money available within 24 or 48 hours) and securities available
for sale in the short term
Short term liabilities = payables for goods and services, other short term liabilities, short term
provisions, deferred liabilities
Interpretation § The cash ratio describes the relationship between the amount of cash and cash equivalents and short-
term liabilities that have to be serviced.
§ The cash ratio is often less than 100%, i.e. the amount of cash and cash equivalents (liquidity) is
maintained at a fairly low level for the sake of profitability.
§ Companies that employ large numbers of staff often define the minimum amount of cash and cash
equivalents in relation to wage payments (e.g. the amount of cash and cash equivalents needs to at
least cover personnel costs for the next three months).
Target ratio Not relevant

Chapter 11:
Example from Geberit

Geberit 2014 749.7
= 202%
370.8
Geberit 2015 459.6
= 98.6%
466.3
Interpretation § The cash ratio was very high in the past and is rather unusual for an industrial company.
§ Because of the acquisition of Sanitec, the cash ratio decreased significantly, which indicates a
significant use of cash for the acquisition and increase of short-term liability for financing.
11.4.2 Quick Ratio
Meaning
Ratio of cash and cash equivalents, including short-term receivables, to short-term liabilities
Calculation Cash and cash equivalents + receivables

Short-term liabilities
Information basis
Receivables = trade receivables (less provisions for bad debt) + other receivables
Interpretation § Receivables should flow to the company in the short term as cash (customers pay open invoices) and
then be available to cover short-term liabilities. Accordingly, the quick ratio can be interpreted as the
probability of whether short-term liabilities can be serviced.
§ The quick ratio is less conservative than the cash ratio, and it takes into account the fact that
receivables and short-term liabilities have the same maturities.
§ The inflow of receivables is relatively certain (other than during times of crisis), since provisions for
bad debt (impairment on receivables) have already been deducted.
Target ratio 100%

Geberit 2014 749.7 + 125.3
= 236%
370.8
Geberit 2015 459.6 + 130.6
= 126.6%
466.3
Interpretation § Due to the high amount of cash and cash equivalents, the quick ratio, like the cash ratio, showed a
high value in the past and is now significantly reduced because of the acquisition of Sanitec. The
current level seems more typical for production companies
§ Despite the acquisition, all obligations can be served (as of Dec 31, 2015).
11.4.3 Current Ratio
Meaning
Ratio of assets with short-term availability to short-term liabilities
Calculation Current assets

Information basis Current assets = cash and cash equivalents + receivables + inventories + other current assets
Interpretation § The current ratio shows the extent to which short-term liabilities can be serviced in a best-case
scenario (i.e. if all customers pay and all inventories can be sold and these customers have also paid).
§ A value of 100% means that liabilities becoming due in the short term can be covered with resources
available in the short term and thus on time. Maturity congruity exists at >100%.
§ A current ratio of less than 100% indicates a massive liquidity problem, since not all short-term
debts can be settled from short-term assets.

Chapter 11:
§ Transformation of inventories into cash and cash equivalents may require some time (e.g. ice cream
is produced in the winter but mainly sold in the summer). This means that the expected value of the
current ratio should normally be well above 100%.
§ Just-in-time production reduces inventories, but this also means that selling accumulating inventories
may be difficult or require high discounts or rebates, especially during times of crisis.
Target ratio At least 100%

Geberit 2014 1 136.6
= 307%
370.8
Geberit 2015 960.8
= 206.0%
466.3
Interpretation § With a current ratio over 100%, maturity congruity exists. Thus, as of the reporting date of
December 31, 2015, all of Geberit's short-term liabilities can be paid from short-term resources.
11.4.4 Accounts Receivable Turnover and Days of Sales Outstanding
Meaning Accounts receivable turnover:

Tally of how often accounts receivable are turned over in a given year (only sales on credit).
Days of sales outstanding (DSO) or collection period:
Relationship between accounts receivable and credit sales, i.e. the average duration between invoicing
and receipt of payment.
Calculation Sales on credit Ø Accounts receivable

x 365
Ø Accounts receivable Sales on credit
Information basis Sales on credit = revenue, not including cash sales; alternatively, revenue can be used
Ø Accounts receivable (customer balances) = (opening amount + closing amount) / 2
Interpretation
Accounts receivable turnover and days of sales outstanding:
§ Both key performance indicators show how long capital is tied up as trade receivables. High
accounts receivable turnover leads to fewer days of sales outstanding, since customers pay more
quickly.
§ In order to make a meaningful statement, the agreed payment deadlines and countries need to be
taken into account. In Germany, Austria and Switzerland, invoices are usually payable within 30
days. In France and Italy, receivables are payable in 90 days.
§ Defaulted-on receivables (bankruptcies, etc.) may not form part of the calculation and have to be
deducted.
§ The static value is hard to interpret. On the other hand, changes between two years can shed light on
changed customer behavior, the outsourcing of business activities to countries with different
payment customs or shifting business activities and practices.
§ Using the same formulas as for accounts receivable turnover and days of sales outstanding, it is also
possible to calculate accounts payable turnover and days of payables outstanding. Accounts
payable are used instead of accounts receivable, and cost of goods sold is used instead of sales on
credit. With the days of payables outstanding, the payment terms used by the company become
apparent. If possible, the days of payables outstanding should be longer than the days of sales
outstanding, such that the company first receives money and then pays thereafter. This gives rise to a
so-called supplier credit, since the company waits until its own customers have paid before paying
suppliers. Suppliers thereby give the company a credit until customers pay.
§ Accounts payable turnover: Days of payables outstanding:

Chapter 11:
Cost of goods sold Ø Accounts payable

x 365
Ø Accounts payable Cost of goods sold
§ The average accounts receivable is required, since a reporting date metric is compared with a
period-related metric from the statement of profit or loss and other comprehensive income
(through the formation of the average, accounts receivable are also transformed into a period-
related metric).

Geberit 2014 Accounts receivable turnover: Days of sales outstanding:
2 089.1 (125.3 + 114.8)/2 * 365
= 17.4 = 21.0 days
(125.3 + 114.8)/2 2 089.1
Geberit 2015 Accounts receivable turnover: Days of sales outstanding:
2 593.7 (130.6 + 125.3)/2 * 365
= 20.3 = 18.0 days
(130.6 + 125.3)/2 2 593.7
Interpretation § First, the customer basis should be made clear. Who is behind the customers owing receivables?
Geberit's customers range from large construction firms to small sanitary installers. And the markets,
e.g. typical payment days in Germany and Eastern Europe, are very different. Therefore, the average
calculated number of days of sales outstanding must be interpreted with caution.
§ Geberit's customers pay their invoices on the average in 18 days, which can be considered very good
in the construction industry and the serviced countries.
§ Accounts receivables turnover improved in 2015. So Sanitec seems to have better payment terms, or
during the integration the customer contracts were increased.
11.4.5 Inventory Turnover and Days Inventory Held
Meaning Inventory turnover:

Tally of how often inventory is turned over in a given year at cost of goods sold.
Days inventory held (DIH) or duration of storage:
Relationship between amount of inventory and cost of goods sold in inventory.
Calculation Inventory turnover: Days inventory held:
Cost of goods sold Average inventories

x 365
Average inventories Cost of goods sold
Information basis Ø inventories = Ø stock level = (opening amount + closing amount) / 2

Cost of goods sold = COGS (or material expenses)
Interpretation Inventory turnover and days inventory held:

§ High turnover leads to a low figure for days inventory held, meaning that inventory is quickly
reduced without becoming too large.
§ Days inventory held reflects the period in which inventories are sold (converted to revenue).
§ A high figure for days inventory held has the following advantages:
+ high supply readiness leads to customer satisfaction (customer does not have to wait long)
+ flexibility for customer orders
+ can be an advantage over the competition
+ purchasing volumes rise, which means more negotiating power (i.e. lower purchasing prices)
§ A high figure for days inventory held has the following disadvantages:
- resources tied up in large inventories (opportunity costs)
- unproductive goods as long as they are in inventory
- ageing of goods in inventory

Chapter 11:
§ In general, a low figure for days inventory held and thus fewer tied-up resources are to be desired. In
certain sectors, inventory availability and thus days inventory held are very important, which is why
the evaluation depends on the type of products, distribution, supply policies, logistics, etc.
§ If days inventory held has increased in recent years, the reasons need to be clarified:
- difficulties in selling certain products (this is a problematic situation)
- increase in the sale of certain products (this is a positive situation and initially an inventory
increase is often unavoidable, but in the medium term the amount of inventory should be able to be
reduced again to its original level)
- preparation of a product launch (in this situation, it is mandatory that inventory be increased prior
to the launch)
Target ratio Sector-dependent: for inventory turnover

§ Industrial operation: about 2-4 times
§ Retail operation: about 4-6 times

Geberit 2014 Inventory turnover: Days inventory held:
604.2 (205.7 + 170.9)/2 * 365
= 3.2 = 113.8 days
(205.7 + 170.9)/2 604.2
Geberit 2015 Inventory turnover: Days inventory held:
784.4 (279.9 + 205.7)/2 * 365
= 3.2 = 113.0 days
(279.9 + 205.7)/2 784.4
Interpretation § With an inventory turnover of 3.2, Geberit is in the upper average for industrial companies. High
turnover is important for Geberit, since the company considers itself to be highly innovative. Low
turnover might be an indication that products no longer meet market requirements
§ In connection with the positive trends in the construction industry, the high days inventory held of
more than 100 days is positive. This enables Geberit to avoid supply shortages.
§ Because of high amounts of cash on hand, Geberit can easily tie up resources in inventory.
11.4.6 Non-Current Assets to Total Assets Ratio
Meaning
Ratio of non-current assets to total assets
Calculation Non-current assets

Total assets
Information basis Total assets = statement of financial position total
Interpretation § High non-current assets reveal risks in the area of impairments. If there is a high intangible value,
impairment can more rapidly degrade a company's financial position.
§ A high non-current assets to total assets ratio can lead to economies of scale, but at the same time it
harbors the risk of lower flexibility (with respect to changed customer needs, production methods or
materials). For this reason, companies with high non-current assets in particular must monitor trends
in the non-current assets to total assets ratio over time and critically review them.
§ Due to large differences between sectors, the non-current assets to total assets ratio is not very
suitable for comparing different companies, but is used instead to compare various time periods.
Target ratio Sector-dependent

Chapter 11:

Geberit 2014 1 294.9
= 53.3%
2 431.5
Geberit 2015 2 593.0
= 73.0%
3 553.8
Interpretation § Relatively high non-current assets are to be expected with an industrial company like Geberit.
§ The significant increase is mainly because of the goodwill resulting from the acquisition of Sanitec
group (see chapter 4.4.3.2). High goodwill includes the risk of impairments. If the synergy effects of
the two businesses should not be realized, the resulting impairments would significantly jeopardize
the financial situation of Geberit group.
11.4.7 Free Cash Flow (FCF)
Meaning Money that is “freely” available to the company from operating activities, after deduction the payments
for investments and after paying interest on debt and dividends to shareholders.
Calculation Free cash flow =

Cash flow from operating activities
+ cash flow from investing activities
./. minimum dividend
Information basis Minimum dividend = dividend that is expected from the shareholders in minimum. Proxies: dividend
paid last year (see statement of cash flow) or the profit distribution suggestion for the current year (to
be found in the annual report of the mother company)
Interpretation § FCF should be very positive in the long term, i.e. the company must be capable of generating a
surplus in cash and cash equivalents.
§ FCF is available to pay financial debts and to make special disbursements or repayments to
shareholders.
§ FCF that is negative once is not negative if it is cumulatively positive over several years. Negative
FCF can arise through high investments.
§ Caution is advised when using the FCF key performance indicator, since countless definitions of this
key performance indicator are found in practice. In particular, interest on liabilities is handled in a
variety of ways, which is why different FCFs can be calculated.
Target ratio Cumulatively over several years, FCF must be positive.

Geberit 2014 and 2015 2014
2015 Cash flow from operating activities 612.1 575.5
+ Cash flow from investing activities -1 325.2 -26.3
./. Minimum dividend* -310.7 -282.0
Free cash flow -1 023.8 267.2
*dividend paid this year, from last year’s profit
Interpretation § Operational cash flow increased, which is to be considered as very positive.

§ The very negative Free Cash Flow is expected with an acquisition like the Sanitec group. If the Free
Cash Flow of the coming years increases again, and it remains positive over a longer period, there
shall be no concern for the liquidity situation of Geberit.

Chapter 11:
11.4.8 Amortization Duration / Debt Factor
Meaning
Relationship between financial debts subject to repayment and freely available financial resources that
have been generated.
Calculation Net financial debt

Free cash flow
Information basis Net financial debt = financial liabilities (liabilities with interest due) ./. cash and cash equivalents ./.
securities in current assets
Interpretation § The amortization duration or debt factor indicates the number of years in which, all other things
being equal, full amortization of net financial debt would be possible from generated free cash flow.
§ Insolvency indicator: If the debt factor rises continuously over several years, under certain
circumstances in spite of strategic projects for realignment, turnaround or even reorganization
having been undertaken, this increase is an early indicator of impending insolvency.
§ Amortization duration is very important to debt holders since it provides an indication of when they
can expect repayment.
Target ratio 1-3 years: very good

4-6 years: satisfactory to good
7 years: unsatisfactory
10 years: financial debts have the character of equity or venture capital
Geberit 2014 and § Because of very low financial liabilities, Geberit did not have net financial debt as of December 31,
2015 2014. Only with the acquisition of Sanitec group, financial debt started to apply.
11.4.9 Times Interest Earned
Meaning Ratio of cash flow from operating activities to the amount of interest that has to be paid on debt
(liabilities)
Calculation Cash flow from operating activities before interest on debt

Interest expenses
Information basis Interest expenses = financial expenses
Interpretation § Insolvency indicator

§ The interest coverage ratio shows how well interest on debt can be paid from operating activities.
§ In contrast to the debt factor (amortization duration), the focus is not on the financial debt but rather
on the contractually stipulated, recurring interest on debt.
§ The interest coverage ratio shows the charge caused by leverage.
§ If interest on debt is unable to be paid, this causes liquidity problems.

Geberit 2014 575.5 – 4.0
= 144.9
4.0
Geberit 2015 612.1 – 20.1
= 31.5
20.1
Interpretation § Geberit can easily cover the interest for financial dept.
§ The ratio decreased despite increased cash flow from operating activities as Geberit did finance the
acquisition of Sanitec to a large extend with liabilities (bank loans and bonds).

Chapter 11:
11.4.10 Cash Flow Ratio
Meaning
Ratio of cash flow from operating activities to debt.
Calculation Cash flow from operating activities

Information basis Short-term liabilities = short-term debt
Interpretation § The key performance indicator shows the extent to which short-term liabilities can be settled through
cash flow from operating activities.
§ The cash flow ratio is more meaningful and more comparable than the three liquidity degrees (I, II
and III) because receivables and inventories can be influenced relatively simply as of the reporting
date (which is possible for cash flow only with much greater effort).
§ Dividend: The cash flow ratio can also be calculated under the assumption that a minimum dividend
has to be paid (analogous to the calculation of free cash flow). Accordingly, cash flow from
operating activities must be reduced by the amount of this dividend.

Geberit 2014 575.5
= 155.2%
370.8
Geberit 2015 612.1
= 131.3%
466.3
Interpretation § Because of increasing short-term liabilities, the cash flow ratio continued sinking. Still, all short-
term liabilities can be paid with the cash flow from operating activities.
§ Even taking into account a minimum dividend (see FCF calculation), short-term liabilities would
still not be fully covered.
11.4.11 Cash Burn Rate
Meaning Number of years until cash and cash equivalents are consumed by negative cash flow.
Calculation Cash and cash equivalents

Cash drain
Information basis Cash drain = negative cash flow from operating activities
Interpretation § Insolvency indicator

§ The cash burn rate shows the amount of time until the company, if there is no change in the earnings
and cash flow position, uses up its cash, thereby becomes insolvent and has to file for bankruptcy.
§ The key performance indicator is used primarily for start-ups and companies with high initial
investments but with little or no earnings, since the previously discussed key liquidity indicators are
not meaningful for these companies and are thus of little assistance in making decisions.

Geberit 2014 and Geberit's cash burn ratio is not relevant because positive cash flow was generated in 2014 and 2015. If
2015 the cash flow from operating activities was negative for Geberit, this would be a sign of serious
business problems.

Chapter 11:
11.5 Key Leverage Indicators
LEARNING OBJECTIVES

• Being able to recognize and calculate the most common key leverage indicators
• Being able to interpret key leverage indicators
Key leverage indicators aim in particular at balanced financing and a balanced asset financing structure. Key
performance indicators concerning asset structure (assets) primarily provide valuable information about the existing
business model. A further analysis of the capital structure (liabilities) provides information about expected cash
outflows to debt holders and shareholders. A company's leverage is essentially dependent on the ratio of equity to
liabilities and equity. Financing as a link between assets and capital also enables an important insight into a
company's ability to survive in the long term. Analogous to the cash ratio, quick ratio and current ratio, maturity
congruity is a central point that has to be complied with for financing.
11.5.1 Equity Ratio
Meaning Ratio of equity to liabilities and equity.

Calculation Equity
Liabilities and equity
Information basis Liabilities and equity = statement of financial position total

Equity = paid-in equity (capital stock)
+ generated equity (retained earnings)
Interpretation In contrast to debt (liabilities), which has to be repaid in full, equity may bear entrepreneurial risk.
For reasons of security and stability, the highest possible equity ratio should be striven for.
Debt is associated with dependence on debt holders. For instance, debt holders can demand
collateral or agree contractual restrictions with the company. Contractually stipulated restrictions in
connection with granting liabilities are called covenants and are often used by banks. There are a
variety of covenants, which can in turn be subdivided into various types.
The following covenants are often seen: No new debt holders without the consent of the existing
debt holders. Equal collateral or no collateral for all debt holders.
Once certain key performance indicators (normally interest coverage and debt factor as well as
gearing) deteriorate, the company must inform the debt holders, and when certain values are
exceeded, the loan agreement becomes due and the debt has to be repaid. Because of the higher risk
associated with equity, shareholders demand a higher return than debt holders, meaning that equity is
more expensive than debt. For reasons of return, the lowest possible equity ratio should therefore be
striven for (leverage effect).
See debt-to-equity ratio and gearing.
The decision about the equity ratio is also a decision about who should bear the risk. Where equity
ratio is high, the company itself can bear more risk. But where it is low, more risk will have to be
borne by debt holders because the likelihood of a credit default is higher. For this reason, the risk
aversion of shareholders and debt holders likewise plays a role. In order to make a low equity ratio
plausible, it must always be investigated whether this can be improved through “economic equity.”
Economic equity includes shareholder loans (subordinated or not) and subordinated bonds. While
subordinated shareholder loans and subordinated bonds have the character of debt, they are to be

Chapter 11:
settled after other debt holders in the event of bankruptcy. Unsubordinated shareholder loans
likewise have a special position because in the event that the company experiences trouble
shareholders tend to refrain from calling the loan and thus waive repayment. These debt instruments
accordingly have the character of equity, which is why they can be included in economic equity.
These instruments are also called mezzanine instruments, i.e. financing instruments whose
character lies between traditional equity and traditional debt.
Analogous metric: debt ratio

Liabilities
Liabilities and equity

Geberit 2014 1 717.1
= 70.6%
2 431.5
Geberit 2015 1 482.2
= 41.7%
3 553.8
Interpretation § In the past, the equity ratio was very high, for similar companies values of >50% are seldom.
§ The acquisition of Sanitec was primarily financed with additional liabilities, so the equity ratio
decreased significantly. While such a financing approach decreases the equity ratio, it is the
preferred option from a profitability perspective.
§ Rising new outside capital (bank loans and bonds) was no problem for Geberit, also thanks to the
high equity ratio in the past.
11.5.2 Self-Financing Ratio
Meaning
Ratio of retained earnings to equity, i.e. the amount of self-generated resources kept in the company.
Calculation Retained earnings

Equity
Information basis Retained earnings = profit reserves

Equity = capital stock (e.g. share capital) + retained earnings
Interpretation § The self-financing ratio provides information about the composition of equity and its changes.
§ A high amount of equity and a high equity ratio can come about for a variety of reasons. For
example, increases of capital or a high premium in connection with the issue of shares can result in a
higher amount of equity. Alternatively, equity increases through retention of self-generated
resources. This is the portion of equity on which the self-financing ratio is focused.
§ A high self-financing ratio permits the conclusion to be drawn that positive cash flow was generated
and that the shareholders are prepared to leave a large part of it within the company instead of
distributing it as a dividend. But it is also conceivable that the company lacks good access to new
shareholders and must therefore finance itself, i.e. from self-generated resources.
§ The self-financing ratio can also be viewed as a measurement metric for the willingness of
shareholders to retain earnings in the company. This is also called profit retention.

Chapter 11:
Geberit 2014 and Retained earnings are not shown in the 2014 and 2015 financial statement, which is why Geberit's self-
2015 financing ratio cannot be definitively calculated.
Interpretation § Because of the very high amount of capital reserves of CHF 1 912.5 million (2014: 1 994 million) in
comparison to equity of CHF 1 482.2 million (2014: 1 717 million) and share capital of CHF 3.8
million (2014: 3.8 million), it can be assumed that the self-financing ratio is very high.
11.5.3 Debt-to-Equity Ratio and Gearing
Meaning Debt-to-equity ratio:

Ratio of debt to equity
Gearing:
Ratio of net financial debt to equity
Calculation Debt-to-equity ratio: Gearing:
Debt Debt-bearing interest – cash and cash equivalents
Equity Equity
Information basis Debt bearing interest has to be deduced from the notes (non-interest-bearing debt includes, for
example, payables for goods and services or provisions for pensions).
Net financial debt = debt bearing interest - cash and cash equivalents (see definition chapter 11.4.1)
Interpretation
Debt-to-equity ratio and gearing:
§ Insolvency indicators: Losses reduce equity and diminish the ability to raise additional equity, i.e.
the share of debt tends to rise. Accordingly, a debt-to-equity ratio that increases over several years
can be an early indicator of an impending reorganization or insolvency.
§ The debt-to-equity ratio is also called leverage, i.e. the ratio of financial debt (or liabilities) to equity.
§ A rising debt-to-equity ratio means the growing influence of and dependence on debt holders.
§ The company's debt holders and creditors use the debt-to-equity ratio or gearing in order to estimate
their risk (creditor risk). The lower the debt-to-equity ratio (and thus the higher the equity ratio), the
lower the creditor risk.
§ The debt-to-equity ratio and gearing provide indications about a company's debt situation and,
analogous to the equity ratio, shows the risk of over indebtedness.
§ The difference between the debt-to-equity ratio and gearing is that the debt-to-equity ratio places all
debt in relation to equity, whereas gearing uses only the portion that was taken on as financing with
counter-performance (i.e. in exchange for payment of interest), less cash and cash equivalents, i.e.
the portion of debt that could be directly repaid.
§ A high debt-to-equity ratio and gearing points to a lack of financial maneuvering room.
Leverage effect:
Growing leverage (Debt/Equity) results in a higher return on equity (𝑟EK) (although interest expenses
increase and profit decreases with more debt, the tax burden is also lower, and overall somewhat lower
profit is divided among far less equity, which leads to a higher return). Above a certain level of
leverage, return on equity declines again (for example, when interest for additional debt is very high
because equity is comparatively very low).
§ As long as the return on investment (return on equity and debt) is higher than the debt interest rate,
the return on the invested equity increases as the debt-to-equity ratio (leverage) increases.
§ Assumption: Debt interest rates remain unchanged, which is unrealistic since higher indebtedness
generally leads to higher debt interest rates.
Debt
𝑟e = 𝑟le + x (𝑟le – 𝑟e)
Equity
𝑟l = Interest on debt
𝑟le = Return on liabilities and equity
𝑟e = Return on equity

Chapter 11:

Geberit 2014 Debt-to-equity ratio:
714.4
= 41.6%
1 717.1
Geberit 2015 Debt-to-equity ratio:
2 071.6
= 139.8%
1 482.2
Interpretation § Parallel to the decrease of equity ratio, also the debt-to-equity ratio increased because the acquisition
of Sanitec was heavily financed with additional liabilities.
11.5.4 Equity and Long-Term Debt to Non-Current Asset Ratio
Meaning Equity to non-current asset ratio: Equity and long-term debt to non-current
asset ratio:
Ratio of equity to non-current assets. Ratio of equity and long-term debt to
non-current assets.
Calculation Equity to non-current asset ratio: Equity and long-term debt to non-current
asset ratio:
Equity Equity + long-term debt
Non-current assets Non-current assets
Information basis Solely metrics of the statement of financial position (i.e. metrics as of the reporting date)
Interpretation Equity to non-current asset ratio:

§ Shows the portion of non-current assets financed with equity.
§ Suitable for statements about the risk congruity of the financing: high-risk assets should be covered
by risk-bearing capital (e.g. start-up).
§ Financing of low-risk non-current assets with equity is expensive.
§ Financing of high-risk assets (e.g. new, untested production method) with debt is risky: when loans
become due, assets necessary for operations might be lost, and the power of debt holders increases.
Equity and long-term debt to non-current asset ratio:
§ Shows the portion of non-current assets financed with equity and/or long-term debt.
§ Golden rule of statements of financial position = maturity congruity: this means long-term assets
(non-current assets) should be financed with long-term capital (equity and non-current debt).
§ The golden rule of statements of financial position applies irrespective of the company's risk and
irrespective of country or sector.
Target ratio Equity and long-term debt to non-current asset ratio: at least 100%

Geberit 2014 Equity to non-current asset ratio: Equity and long-term debt to non-current asset ratio:
1717.1 1 717.1 + 343.6
= 132.6% = 159.1%
1 294.9 1 294.9
Geberit 2015 Equity to non-current asset ratio: Equity and long-term debt to non-current asset ratio:
1 482.2 1 482.2 + 1 605.3
= 57.2% = 119.1%
2 593.0 2 593.0
Interpretation § Matching maturities is still fulfilled with the equity and long-term debt to non-current asset ratio
being higher than 100%: 119.1%.
§ The equity to non-current asset ratio has decreased significantly because of the enormous increase of
non-current assets with the acquisition of the Sanitec group. The decrease of the equity and long-
term debt to non-current asset ratio is not as significant, the increase in non-current assets is to a
certain extend compensated by the increase of long-term debt because the acquisition was
significantly financed with bank loans and bonds.

Chapter 11:
11.6 Key Profitability Indicators
LEARNING OBJECTIVES

• Being able to recognize and calculate the most frequent key profitability indicators
• Being able to interpret key profitability indicators
Key profitability indicators relate outputs to inputs that are relevant to achieving results. This comparison between
inputs and outputs is at the center of all economic action and above all serves to evaluate the extent to which a
company is capable of generating profits. (Boemle, 2008, p. 682). Key profitability indicators can be divided into
two types. First, earnings position (EBIT, gross profit, profit, cash flow from operating activities, etc.) can be
compared with invested or existing capital (return on investment). Second, measurement metrics for the earnings
position (EBIT, gross profit, profit, cash flow, etc.) are compared with revenue (return on sales).
In order to better understand a company's profitability and derive the correct decisions therefrom, a brief analysis of
earnings and expenses should be prepared prior to calculating key profitability indicators. This ensures that the
business model has been understood and that a company's earning power can be roughly estimated.
Elements of the Expenses Analysis:

§ Trends in total expenses over several years
§ Trends in individual types of expenses
§ Ratio of a given type of expense to total expenses
§ Ratio of a given type of expense to (gross) revenue
§ Further analysis of expense positions
Elements of the Earnings Analysis:

§ Trends in total revenue over several years
§ Trends in individual revenue groups (look at segment accounting)
§ Trends in market shares
§ Revenue per employee
§ Revenue per m2 of sales space (for retail operations)
§ Further analysis of earning positions
11.6.1 Return on Equity (ROE)
Meaning Ratio of profit to invested equity.
Calculation
Profit
Average equity
Alternative:
Profit Sales Liabilities and equity
x x
Sales Average liabilities and equity Average equity

Chapter 11:
(Return on sales) x (Capital turnover) x (Leverage)
Information basis Not necessary to aggregate statement of financial position / income positions
Proper depiction in the statement of financial position or the notes
Ø equity = (opening amount + closing amount) / 2
Interpretation § Debt holders are compensated with the payment of interest in exchange for the capital made
available. The profit should compensate shareholders in the medium term for making equity
available.
§ Equity is risk capital and is repaid last in the event of the dissolution of the company (e.g.
bankruptcy).
§ Return on equity should be significantly higher than interest paid on debt in order to compensate
shareholders for the additional risk borne by equity.
§ With a relatively low share of equity (and a high share of debt), the return on equity expected by
investors is correspondingly higher. (Leverage effect: see 10.5.3 Gearing)
Target ratio Roughly 5-10% higher than interest on debt (depending on risk, e.g. sector, etc.)

Geberit 2014 498.6
= 29.5%
(1 717.1 + 1 664.1) / 2
Geberit 2015 422.4
= 26.4%
(1 482.2 + 1 717.1) / 2
Interpretation § Geberit has a very good return on equity at 26.4%.
§ The high level of the return on equity must also be seen in the context of the low interest rate
environment (Switzerland and the EU), with negative interests in Switzerland. The five-year CHF swap
stands at -0.56% and the ten-year CHF swap at -0.30%.
11.6.2 Return on Investment (ROI)
Meaning Ratio of profit plus interest paid to liabilities and equity.
Calculation
Profit + interest on debt
Average liabilities and equity
Alternative:
EBI Sales
x
Sales Average liabilities and equity
(EBI margin) x (Capital turnover)
Information basis EBI = Profit + interest on debt (earnings before interest)

Proper depiction in the statement of financial position or the notes
Interpretation § The return on investment (ROI) is a metric that measures performance in a way that is neutral as to
capital structure, showing the interest on invested capital.
§ ROI is indifferent as to the debt-to-equity ratio because financing effects are not taken into account
with EBI. In this way, financing costs (interest on debt) have no influence on ROI.
§ ROI depends on details of current assets and non-current assets. For example, a high amount of non-
current assets that have been depreciated very little leads to a lower ROI. By contrast, older non-
current assets that have been largely depreciated lead to a higher ROI, since less capital is tied up.
§ Return on investment is suitable for the (financing-neutral) evaluation of investment alternatives
because equity and debt (liabilities) are taken into account.
§ Is mathematically identical to return on assets (ROA). However, ROA is calculated as profit +
interest on debt over current assets and non-current assets. Thus ROA measures the deployment of
assets and their efficiency, and the analysis addresses in particular the share of current assets and

Chapter 11:
non-current assets, their amount and changes to them.

§ Capital turnover (CTO) measures how quickly capital is turned over. CTO has an influence on the
return on investment. Capital-intensive companies have a low CTO.
Sales Sales
or
Average liabilities and equity Average equity + interest bearing debt
Target ratio Capital turnover: Industry: 0.9 to 1.3 times

Retail: 1.7 to 3.0 times

Geberit 2014 Capital turnover: Return on investment:
2 089.1 498.6 + 4.0
= 0.9 = 21.6%
(2 431.5 + 2 226) / 2 (2 431.5 + 2 226) / 2
Geberit 2015 Capital turnover: Return on investment:
2 593.7 422.4 + 20.1
= 0.9 = 14.8%
(3 553.8 + 2 431.5) / 2 (3 553.8 + 2 431.5) / 2
Interpretation § Capital turnover is well within the sector average. Due to an industrial company's capital intensity, a
CTO above 1.3 is rare for industrial companies.
§ The return on investment has decreased with the acquisition. But still, a value of 14.8% is still very
good. And if the expected synergy effects materialize, return on investment is expected to increase
again.
11.6.3 Return on Invested Capital (ROIC)
Meaning Ratio of operating profit to invested net operating assets.
Calculation ROIC: RONOA:

NOPAT NOPAT
Ø invested capital Ø NOA
ROCE:
EBIT
Ø capital employed
Information basis
EBIT = earnings before interest and taxes
NOPAT = net operating profit after tax = EBIT ./. taxes
Capital employed
= Liabilities and equity less interest-free short-term debt
Net operating assets
= operating assets less interest-free operating debt
= operating assets (not including, for example, real estate not used for operations) less trade
payables, other liabilities, accrued expenses and provisions (not including provisions for
pensions, since these usually accrue interest)
Invested capital
= Liabilities and equity less interest-free debt
Interpretation § ROIC is an operational return that is neutral as to capital structure.
§ ROIC can also be interpreted as the capital turnover rate.
§ RONOA measures the efficiency with which management invests operating assets and therefore
constitutes a key performance indicator for evaluating operational business.
§ The differences between ROIC, RONOA and ROCE are usually minor except for certain situations,
e.g. restructuring (which parts of the company will be necessary for operations in the future, which

Chapter 11:
financing can be relinquished), are very decisive in order to be able to make these specific decisions
on a solid basis. Since ROIC, RONOA and ROCE were already preceded by other calculations (e.g.
the calculation of invested capital is already a key performance indicator), these calculations also
need to be known in detail before ROIC, RONOA or ROCE can be correctly interpreted.

Geberit 2014 500.3
= 24.9% Pension liabilities are not included as interest-
(2 056.8 + 1 942.5) / 2 bearing debt because Geberit consolidated the
Geberit 2015 pension fund and, as a result, there is a high
445.9
= 20.4% pension fund liability that is not related to
(2 631.5 + 1 733.1) / 2 operations.
Interpretation § Return on invested capital can be deemed very good. While it decreased slightly because of
shrinking profit and increased capital, it is still very high.
Figure 113: Invested Capital and Operating Assets
Assets Liabilities and equity
Cash & cash equivalents Creditors
Receivables Other payables Current

Current liabilities
Inventories Accrued expenses
assets
Other receivables Interest-bearing liabilities
Prepaid expenses
Interest-bearing liabilities
Non-current
Provisions
liabilities
Fixed
Non- Pension provisions
current
assets
Intangible Share capital
Equity
Capital increase
Assumption: only operating values
Net operating assets Invested capital

= Operating assets = Interest-bearing liabilities
- Non-interest-bearing liabilities + Equity
11.6.4 Return on Sales (Margin)
Meaning
Profit margin (ROS) = ratio of profit to total revenue
EBIT margin = ratio of EBIT to total revenue
EBITDA margin = ratio of EBITDA to total revenue
Gross profit margin = ratio of gross profit to total revenue
Calculation Profit margin (ROS): Gross profit margin:

Profit Gross profit
Net sales Net sales
EBIT margin: EBITDA margin:
EBIT EBITDA
Net sales Net sales
Information basis
Net sales = sales – sales reductions (rebates, discounts, etc.)

Chapter 11:
Interpretation Depending on the financial metric selected in relation to sales, it is possible to see a different level of
efficiency and profitability.
Profit margin (return on sales, ROS):

§ Return on sales is the ratio of the annual result to net sales revenues for the reporting period and thus
depicts the efficiency of the business as a whole.
§ Return on sales is sector-specific and depends on the market situation.
§ The ROS for retail operations is usually lower than that for investment-intensive production
operations.
EBIT margin:
§ The EBIT margin is the ratio of EBIT (operating result) to net sales revenues for the reporting period
and thus depicts the efficiency of operational business.
§ In contrast to ROS, the EBIT margin does not take into account extraordinary effects, the result from
equity and minority participations, interest income or taxes.
§ The EBIT margin permits a statement to be made irrespective of the financing structure.
EBITDA margin:
§ In contrast to the EBIT margin, EBITDA is compared to net sales revenues.
§ The EBITDA margin considers operating efficiency without taking depreciation and amortization
into account. Depreciation and amortization depend on how investment-intensive a sector is.
Gross profit margin:
§ Gross profit is sales less cost of sales, and it reveals a great deal about the attractiveness and
profitability of the sector and the products and services sold. Gross profit is prior to deduction of all
overheads, such as personnel and other operating expenses, which are highly company-specific and
thus may vary in efficiency.
§ The gross profit margin as the ratio between revenue and gross profit is also called the trading
margin.
§ A high gross profit margin indicates the high profitability of the sector or the markets serviced and
the products sold.

Geberit 2014 ROS: EBIT margin:
498.6 576.9
= 23.9% = 27.6%
2 089.1 2 089.1
Geberit 2015 ROS: EBIT margin:
422.4 498.3
= 16.3% = 19.2%
2 593.7 2 593.7
Interpretation § Margins have deceased, but are still very strong.
§ While revenues increased because of the acquisition, profit and EBIT decreased. The reason is the
low profit and EBIT margin of Sanitec. If the integration of Sanitec is successful and the synergies
materialize, margins will increase again.
§ With a group that operates in several countries and in various product and/or service lines, segment
accounting always has to be looked at as well. What does revenue consist of? Which country or
which product/service is sold the most?

Chapter 11:
11.7 Summary Financial Ratio development at Geberit
The above analysis of financial ratios for Geberit shows that the acquisition of Sanitec by Geberit had a significant
influence onto all financial ratios for 2015 versus 2014, which is expected for such a significant acquisition. To
summarize the financial analysis of Geberit, the table below also shows the financial ratios until 2018.
Table 54: Geberit financial ratios 2014 to 2018
Financial ratio 2014 2015 2016 2017 2018

Cash Ratio 202.2% 98.6% 94.8% 72.2% 42.7%
Quick Ratio 236.0% 126.6% 127.2% 107.5% 72.5%
Current Ratio 306.5% 206.0% 199.1% 183.7% 134.9%
Days of sales outstanding 21.0 days 18.0 days 19.8 days 23.6 days 23.7 days
Days inventory held 113.8 days 113.0 days 130.8 days 129.5 days 126.3 days
Non-current assets to total assets ratio 53.3% 73% 70.3% 71.9% 74.5%
Free cash flow (CHF) 267.2 m -1 023.8 m 306.2 m 124.2 m 210.1 m
Times interest earned 142.9 29.5 52.0 50.3 43.2
Cash flow Ratio 155.2% 131.3% 133.0% 112.1% 113.1%
Equity ratio 70.6% 41.7% 45.4% 49.1% 49.8%
Debt to equity ratio 41.6% 139.8% 120.2% 103.7% 100.6%
Equity to non-current asset ratio 136.2% 57.2% 64.6% 68.2% 66.9%
Equity and long-term debt to non-current asset ratio 159.1% 119.1% 121.1% 117.8% 108.8%
Return on Equity 29.5% 26.4% 35.2% 30.4% 33.3%
Return on Assets 21.6% 14.8% 15.7% 14.7% 17.0%
ROIC 29.3% 20.4% 21.2% 20.0% 23.2%
EBIT margin 27.6% 19.2% 22.8% 21.4% 23.0%
After the significant changes in financial ratios from 2014 to 2015, because of the acquisition of Sanitec, the
changes in recent years are again smaller. Positive are the improvements of profitability ratios, partly because the
profitability of the acquired Sanitec group was lower than the profitability of Geberit. This difference in
profitability, together with extraordinary expenses for the integration in 2015 lead to a decrease in EBIT (-13.6%)
and profit (-15.3%), despite increase in sales (+24.2%) and assets (+46.2%). It seems that the expected synergy
effects already materialized in 2016, EBIT (+28.5%) and profit (+29.8%) increased significantly. The return on
equity of 35.2% is exceedingly high. In the year 2017, ROE decreased, because of the increase in Equity ratio, as
Geberit is paying back debts required for the acquisition of Sanitec (self-financing, see chapter 12.3). In 2018,
Geberit reduced long-term liabilities (through paying back) as well as equity (through share buy-back). Both of
which reduce the availability of cash and therewith lower the liquidity ratios.
While negative free cash flows are expected in years with significant investments, Geberit manages to return back to
a positive free cash flow one year after the acquisition already, being even significantly higher than the free cash
flow in 2014. This is mainly owed to the improved cash flow from operating activities (+16.8%). This is again a
clear indication that the synergy effects from the acquisition of Sanitec group have already started to materialize.
Geberit uses the free cash flow to pay back the debt that were necessary to finance the acquisition. The lower free
Chapter 11:
cash flow in 2017 results from higher investments, higher dividends, and slightly lower cash flow from operations.
In 2018 the Free Cash Flow increased significantly, mainly because of increased cash flow from operating activities.
11.8 Key Performance Indicator Systems
LEARNING OBJECTIVES
• Recognizing key performance indicator systems and understanding their significance

• Being able to understand and apply interrelationships between key performance indicators
Despite the fact that several figures are compiled from the statement of financial position, statement of profit or loss
and other comprehensive income, statement of cash flows, statement of changes in equity and the notes, a key
performance indicator always reflects only one sub-aspect of the company's assets, financial position and earnings.
Key performance indicators are influenced by a variety of determinants and may also show different results
depending on the calculation. Key performance indicators should never be viewed on their own, in isolation.
Instead, a variety of key performance indicators must be chosen from all three areas of liquidity, leverage and
profitability and considered as a whole. This is also where key performance indicator systems are effective. Key
performance indicator systems are designed to provide an overall view of a company's financial position. In the
process, they put individual key performance indicators and their calculation bases in an overall systematic context.
The systematic structure enables the reader to recognize the interrelationships between key performance indicators
and their elements and to derive appropriate interpretations and decisions.
11.8.1 DuPont Analysis
One of the most well-known key performance indicator systems is the DuPont analysis (also called the DuPont
model and the DuPont method). The DuPont analysis was developed in 1913 by the eponymous chemical company.
DuPont is one of the world's largest groups in the chemical industry. Using a number of complementary key
performance indicators, the DuPont analysis ascertains the return on investment (ROI) as the top-level key
performance indicator. On the level beneath it, ROI is determined by the two key performance indicators capital
turnover and return on sales. These two key performance indicators are in turn determined by corresponding detailed
key performance indicators.
In this way, ROI is broken down over several levels to the volume and success metrics from the statement of
financial position and the statement of profit or loss and other comprehensive income. This shows the influence that
the individual components have on ROI. Each element influences the next value and, indirectly, ROI.
ROI is a good metric for measuring the company's success. In the process, not only does ROI come about from
return on sales, but it is also placed in relation to invested capital. The ROI analysis shows that there are two levers
for increasing ROI. These two influencing factors are the ratio of profit to revenue (return on sales) and the ratio of
revenue to invested capital (capital turnover). Independently of the company's sector, the measures for achieving an
increase in the return on investment can be divided into one of the two influencing factors. (Baumann, 2005, p. 74)

Chapter 11:
Figure 114: DuPont Analysis (ROI)
Note. Based on Baumann (2005) p. 74.
Increasing the Return on Sales:

Increasing the return on sales is the first thought and the classic approach for increasing the return on investment.
With higher revenue and stable or less sharply rising costs, the return on sales can be increased. Alternatively, lower
costs also increase the return on sales. However, the following factors have to be taken into consideration in
attempting to increase revenue and reduce costs:
§ Normally, increases in revenue cannot be achieved without additional effort and costs (market cultivation,
advertising, campaigns, etc.). (Baumann, 2005, p. 75) The question is how high the added costs are in the
case of an expansion and whether the added revenue is, in relative terms, higher than before, or whether a
higher margin can be achieved. Increasing the margin by growing revenue is possible if the existing
infrastructure and processes can be used more intensely. Conceivable in the long term are venturing into
markets and developing products and services with higher margins, though this is difficult to quantify.
Accordingly, , increasing revenue is an approach that does not easily attain an increase in the return on
sales in the short term and is difficult to quantify in the long term.
§ Measures to reduce costs must always be reviewed for their efficiency. Cost reductions that result in a
lower quality of products or services and thus in lower revenue must be avoided. Cost reduction can only
be carried out if this does not interfere with the company's performance. (Baumann, 2005, p. 75)
Improved Capital Use:

If the same revenue can be generated with less capital, then capital turnover and thus ROI increases. Efficient use of
capital has a positive effect on the return on investment, and it can be achieved through the following approaches:

Chapter 11:
§ More efficient current assets through better management of liquidity, receivables, payables and inventory
by means of reduced holdings in current assets. Improvements in this subject area can also be termed
working capital management. Getting customers to pay more quickly by means of an efficient dunning
system, shortening inventory duration (e.g. just in time) and exploiting supplier credits can reduce working
capital and thus current assets.
§ More efficient use of non-current assets (machinery, buildings, etc.) and dispensing with non-operational
assets. (Baumann, 2005, p. 75)
The DuPont analysis is a good example of how small, individual steps can improve key performance indicators on
lower levels and thus lead directly to improved profitability. The elements of ROI first become clearly visible only
after the linkage of key performance indicators. The DuPont analysis has been adopted by many companies and
modified or enhanced to suit their own purposes and needs.
11.8.2 Economic Value Added (EVA)
Although not a classic key performance indicator system, economic value added (EVA) is a very well-known
concept in the context of an overarching key performance indicator. Developed by the corporate consulting firm
Stern Stewart & Co, EVA is used in many areas of the economy particularly for the purposes of evaluating the
advantageousness of an investment. In principle, EVA depicts residual profit or loss by deducting the cost of capital
from net operating profit after taxes (NOPAT).
However, EVA can be calculated not only as the difference between NOPAT and the cost of capital, but also by
using value spreads (ROCE and WACC). This involves the excess return that emerges as the difference between
ROCE and the weighted average cost of capital, multiplied by the value of existing invested assets. (Stewart, 1991,
p. 136) A positive EVA value means added economic value and accordingly is to be strived for by the company or
with respect to a planned investment. If the realized return (ROCE) is larger than the capital cost rate, this results in
excess return and the objective is achieved. On the other hand, a loss is created if the cost of capital is higher than
ROCE, and value is destroyed. In this regard, the capital cost rate is calculated with WACC. WACC (weighted
average cost of capital) is the weighted average cost with weighting according to equity and debt. In principle,
WACC makes a statement with respect to the costs that typically result from equity and debt for comparable
companies (i.e. same sector and similar with respect to activity, risk, size, internationalization, etc.). For a stable
company with good annual results, WACC can be calculated from the annual report as follows:

Chapter 11:
WACC = ( LiabilitiesDebtand equity x Interest on debt ) + (LiabilitiesEquity

and equity
x Return on equity )
Since EVA is added value, this can be depicted in a manner analogous to the DuPont analysis. EVA is determined
on the second-highest level by two key performance indicators. These are NOPAT and the cost of capital. These are
in turn determined on the next level by two influencing factors each. Thus, analogous to the DuPont analysis, EVA
is broken down into individual influencing factors, and corresponding potential for optimization is revealed.
Figure 115: EVA
Note. Modeled on: Stewart (1991).
11.8.3 Balanced Scorecard (BSC)
In the 1990’s, non-financial information became more dominant in performance measurement, in addition to
financial management. The Balanced Scorecard is one of the most dominant concepts how to combine the various
sources of information. The financial ratios used are derived directly from the company’s strategy. The numbers of
ratios used shall be lower than 20 (“twenty is plenty”) and they should be useful to assess and evaluate the
implementation progress of the company’s strategy.
The Balance Scorecard uses four dimensions to categorize the ratios and consequently analyze the company’s
strategic development (Kaplan & Norton, 1997, pp. 47-134):
§ Financial perspective: uses the traditional financial ratios and looks at the company’s overall financial
performance. It may also be understood as overarching perspective, because the other three perspectives
and their ratios shall (if selected and defined right) ultimately influence the financial ratios positively.

Chapter 11:
§ Customer perspective: uses ratios like customer satisfaction or customer profitability. Presumably, higher
customer satisfaction leads to higher market share and higher customer profitability, all of which again lead
to improved financial ratios in the financial perspective.
§ Process perspective: uses ratios on quality, productivity and efficiency, as well as net working capital
(efficiency of using capital). Positive ratios improve customer ratios (e.g. customer satisfaction), as well as
directly and indirectly financial ratios.
§ Capacity perspective: it comprises employees, their potential and motivation, as well as information
technology and systems. These aspects are seen as basis for long-term successful business activities.
Figure 116: Balanced Scorecard
Note. On the basis of Kaplan & Norton (1997, S. 8)
11.8.4 Working Capital Management
As discussed in chapter 4, net working capital shall remain low as it requires financing, i.e. capital and consequently
financing costs, i.e. cost for capital. The net working capital consists of receivables from goods and services and
inventory, minus payables for goods and services. Receivables can be seen as loan to customers, payables as loan
from suppliers, so increased receivables requires additional capital, whereas increased payables reduces capital
required and can be seen as a source of financing.
Figure 117: Net Working Capital
Management accounting is responsible to provide and supervise ratios regarding inventory levels, receivable
payments and payables conditions, and if necessary take measures for improvement. Improvements of net working
capital result from the following areas with the following rules of thumb:
§ Receivables from goods and services: collect early! The sooner due receivables are paid by the customer,
the earlier respective financial means are available to the company. If payment are significantly later than
expected or than average, counter-measure are required to collect receivables early.

Chapter 11:
§ Payables for goods and services: pay late! The later due payables to suppliers are paid, the longer
respective financial means are available to the company (also known as supplier loan). From a financial
perspective, using and maybe stretching suppliers’ payment terms is advisable, however strategic reasons,
such as long-term supplier relationship, may suggest differently.
§ Inventories: Just-In-Time! The few and the shorter inventory levels are, the longer respective financial
means are available to the company. This is one of the reason why supply-chain and inventory strategies
such as “just-in-time” have evolved and are implemented: inventories are as small as possible, material is
supplied as needed, i.e. “in time” when production processes require them. Again, strategic reasons may
support minimum inventory levels.
The success of Net Working Capital management can be measured with the cash conversion cycle. This cycles looks
at the duration between cash outflow (i.e. payment for investment or for products) and cash inflow (i.e. receives
money from customers). Using the example of a trading company, it orders goods on day 0, and pays the invoice
after 30 days. 40 days after ordering, the products are sold to a customer, against invoice. 20 days later the customer
pays the invoice. For this example, the cash conversion cycle is 30 days, because the customer payment arrives 30
days after the company pays the supplier. The following graph shows these days graphically.
Figure 118: Cash Conversion Cycle
Companies try to keep the Cash Conversion Cycle as short as possible. The specific success depends on a number of
factors, such as industry (retail companies with sales locations have longer cycles than just-in-time production
companies), geographical focus (payment terms depend significantly by countries), or negotiation power (e.g.
relationship with suppliers). Big online retailers such as Amazon may even achieve negative cash conversion cycles
for certain goods as they pay the supplier only after it has received the customer payment (i.e. it only forwards the
money to the supplier according to what and when the customer paid).
Meaning
Duration from payment of supplier until payment from customer.
Calculation Days inventory held (DIH)

+ Days sales outstanding (DSO)
– Days payables outstanding (DPO)
Interpretation
§ The ratio calculates, how many days it takes for the money, which is used to purchase material,
flows back to the company.

Chapter 11:

Geberit 2018 Days Payables Outstanding (DPO):
(94.8+126.1) / 2* 365
= 45.1 days
893,2
Days Sales Outstanding (DSO): 23.7 days (see summary Geberit financial ratio above)
Days Inventory Held (DIH): 126.3 days (see summary Geberit financial ratio above)
CCC = 126.3 days + 23.7 days − 45.1 days = 104.9 days
Geberit 2017 Days Payables Outstanding (DPO):
(126.1+112.3) / 2* 365
= 52.4 days
829.8
Days Sales Outstanding (DSO):23.6 days (see summary Geberit financial ratio above)
Days Inventory Held (DIH): 129.5 days (see summary Geberit financial ratio above)
CCC = 129.5 days + 23.6 days − 52.4 days = 100.7 days
Interpretation § Days Inventory Held at Geberit is rather high, because of its quality orientation and promise to
deliver spare parts fast.
§ Days Payables Outstanding is higher/longer than Days Sales Outstanding, which means that Geberit
gets money from customers faster than it pays suppliers. This difference in payment term and
behavior is possible because of the Geberit’s power and dominance in the market.
§ The Cash Conversion Cycle of Geberit is around 100 days, which is normal for an industrial
company like Geberit. It has a relatively high Days Inventory Held, however a relatively favorable
situation for Days Payables Outstanding and Days Sales Outstanding, which indicate high priority of
receivables and payables management.
11.9 Summary
Fundamentals:
Performance measurement is a method for internal processing information. In so doing, the underlying numerical
information from management accounting and maybe financial statements from one or more years and from one or
more companies is evaluated and compared. Depending on interests, different objectives are pursued with the ratio
and ratio system analysis. By processing numerical information, grouping figures and condensing to produce key
performance indicators, performance measurement creates additional information. However, performance
measurement and analysis does not end with the identification of key performance indicators. Key performance
indicators have to be interpreted in order to achieve a significant gain in information. In addition, basic conditions
have to be included in a analysis, evaluation and interpretation. A meaningful analysis of company figures is
possible only in the market and sector context.
Procedure:
A well-grounded performance measurement can be broken down into the following steps:
1) Selection of data: financial statements, internal data, other sources
2) Preparation: formal review and adjustment, modification of the classification
3) Evaluation methods: time, company and/or sector comparison, selection of key performance indicators
4) Evaluation: calculation of key performance indicators, analysis of basic conditions, assessment

Chapter 11:
Key Performance Indicators:

With respect to the use of key performance indicators, there are no generally applicable standards or principles,
which is why a variety of different key performance indicators exist and the same key performance indicators are
calculated differently. Accordingly, when discussing key performance indicators, it must always be understood how
the figure was calculated in detail. Categorization should be divided along the triangle of financial management into
key leverage, profitability and liquidity indicators. If several key performance indicators are considered from each of
these three categories, a comprehensive analysis and evaluation of the company can be prepared. The following key
performance indicators are most frequently used:
Key Liquidity Indicators Key Leverage Indicators Key Profitability Indicators

§ Quick ratio § Equity ratio § Return on equity (ROE)
§ Days of sales and payables § Debt-to-equity ratio / gearing § Return on investment (ROI)
outstanding § Return on EBITDA
§ Free cash flow
§ Debt-to-equity ratio
§ Interest coverage ratio
Key Performance Indicator Systems:

Key performance indicator systems group together several key performance indicators and therefore enable a quick
overview of a company's financial condition. In the process, they place individual key performance indicators and
their calculation bases in a systematic context. The systematic structure makes it possible to recognize
interrelationships between key performance indicators and their elements and to derive appropriate interpretations.
For overall company evaluation and steering, analysis from internal financial management and ratios systems are
oftentimes used. Widely used ratio systems are the “DuPont scheme (ROI tree)”, the “Economic Value Added
(EVA)”, the “Balanced Scorecard (BSC)”, and the “Cash Conversion Cycle”.

Chapter 11:

Behr, G. & Leibfried P. (2014). Rechnungslegung (2. Überarbeitete und erweiterte Auflage). Zürich: Versus.
mit Beispielen, Repetitinsfragen und Antworten. (4. Überarbeitete Auflage). Zürich: Compendio
Bildungsmedien.
SKV.
ControllingPortal (2019). Bilanzkennzahlen zur Bilanzanalyse (Kennzahlenkatalog): Umfangreiche Kennzahlen-
Übersicht mit Beispielberechnungen und Online-Rechner. Gefunden am 07. Januar 2019
unterhttp://www.controllingportal.de/Fachinfo/Kennzahlen/Bilanzkennzahlen-zur-Bilanzanalyse.html
Fischer, T. M., Möller, K. & Schultze, W. (2012). Controlling: Grundlagen, Instrumente und
Entwicklungsperspektiven. Stuttgart: Schäffer-Poeschel.
Gladen, W. (2011). Performance Measurement: Controlling mit Kennzahlen (5. Aufl.). Wiesbaden: Gabler.
Gleich, R. (2011). Performance Measurement: Konzepte, Fallstudien und Grundschema für die Praxis (2. Aufl.).
München: Vahlen.
Horváth, P. (2011). Controlling (12. Aufl.). München: Vahlen.
Kaplan, R. S. & Norton, D. P. (1997). Balanced Scorecard – Strategien erfolgreich umsetzen. Stuttgart: Schäffer-
Poeschel.
Stewart, G. B. (1991). The Quest for Value - The EVA Management Guide. New York: Harper Business.
Weber, J. (2004). Einführung in das Controlling (10. Aufl.). Stuttgart: Schöffer-Poeschel.

Part D:
Looking forward – Strategic Planning 265
Part D:
Looking forward –
Strategic Planning

Chapter 12:
Financing 266
Financing
"Valuable resources are, for example, financial resources, technological

infrastructures, manufacturing processes, knowledge structures [...].
Such resources are not simply a given. Rather, most often they must first
be identified, analyzed and mobilized, i.e., made into a resource for
organizational value creation." (Rüegg-Stürm & Grand, 2017, p. 68)
One of the main tasks of financial management is the financing of the

company. Without capital available for new investments, companies
cannot survive. A survey of insolvency administrators showed that
financing gaps are regarded as the second most frequent cause of
insolvency by 76% of those surveyed (Euler Hermes / ZIS University
Mannheim, 2006, p. 7).
12.1 Introductory example Startups
INTRODUCTION: FINANCING
Swiss startup policy needs new priorities
The financing of young companies has long been a political issue. Much has changed in recent years. The forgotten
concerns of startups now deserve more attention.
Rich Switzerland is letting startups die of thirst financially: This accusation has been heard many times in recent years. The
argument is that, although it is relatively easy for young companies to find funding at an early stage, there is a "valley of
death" waiting for them not long afterward, often at financing rounds of between CHF 5 million and 20 million.
In order to fill the financing gap, Switzerland has one group of investors that is considered particularly suitable: pension funds.
In the second pillar, a great deal of savings have accumulated. Pension funds manage over CHF 800 billion. At the same time,
they invest only a fraction of this amount in young companies — estimates are less than one percent. If this proportion were
increased even slightly, the "valley of death" could be filled in.
More money available
As a result, various large-scale projects have been launched to help Switzerland obtain more venture capital. In order to
convince potential investors such as pension funds, promoters have relied on an aggressive marketing strategy and have been
quite hard to miss as they loudly announcing new investment vehicles to great fanfare. However, despite some high-profile
announcements, not a single franc has yet flowed into any Swiss startup. At the same time, small and medium-sized venture
capitalists have steadily increased their silent commitment. Even though growth has slowed somewhat, more money is being
invested in Swiss startups year after year. The "valley of death" is also a gap in the market. Where there is so little capital,

Chapter 12:
Financing 267
high returns are tempting.
The fact that politicians are not forcing the hand of pension funds is to be welcomed. After all, we are talking about Swiss
pension assets. Economic criteria should determine how these are invested, not political desires. However, it is surprising how
little the pension funds themselves invest in alternative investments such as private equity and venture capital for startups.
Clearly, such investments are illiquid, which means that the funds will be tied up for years to come. It would seem that, for
pension funds in particular, which tend to have quite a long-term investment horizon, it is exactly this stronger commitment
that could be desirable — not out of the love of startups but for the return on investment. The fact that more private capital is
flowing into startups suggests that an economic calculation can legitimize such investments.
Taking other worries seriously
The private initiatives show that the need for political action in the area of venture capital has decreased. This will be all the
more true when one or another major project launches. However, it cannot be inferred from this that policymakers can sit back
on the subject of startups.
Bureaucratic nightmares such as complicated customs clearance procedures, paper wars in administrative procedures or
laborious VAT settlements have plagued young Swiss companies for years. That startups with such complaints point to a real
problem is shown in the World Bank's Ease-of-Doing Business Indicator. Switzerland slipped from 11th place in 2004 to 33rd.
The goal here is to stand up for Switzerland as a startup country. However, politicians have known these problems for a long
time. Unfortunately, however, solving them involves a lot of work, which, to make matters worse, is difficult to market. But
perhaps the skillful approach of the venture capital pioneers serves as inspiration — with good marketing and catchphrases
like the "valley of death", they have finally managed to make a dry but important issue heard.
Article adapted from NZZ (Commentary by Jürg Müller, 2018, 12 July)
1. Why are startups having a hard time financing themselves?
2. What options do companies have for financing?
3. Why do companies need capital?
12.2 Fundamentals of company financing
LEARNING OBJECTIVES

• Understanding the need for company financing
• Knowing different types of company financing
In principle, a company can finance itself from inside or outside. Inside financing means financing through retained
profits or provisions. External financing can take the form credit, the contribution of equity capital or a mixed form
(mezzanine capital). These financing options can also be subdivided into equity and debt capital financing, which
describes the legal rights and obligations of the capital or investor (see following illustration). The optimal ratio of
equity and debt capital is also an important aspect of financing, as both financing options have advantages and
disadvantages. This is also referred to as the optimal capital structure of a company.

Chapter 12:
Financing 268
Figure 119: Overview of financing options available to a company
Financing options
Inside Financing Outside Financing
Financing with
Credit financing
provisions
Debt capital
financing
“Mezzanine”
financing
Equity capital
financing Self-financing Equity financing
Own illustration. Based on Volkart & Wagner (2014, p. 571)
In the following, the financing instruments of inside financing are first examined in more detail, followed by the
instruments of outside financing. This chapter concludes with some remarks on the optimal capital structure.
12.3 Inside financing
LEARNING OBJECTIVES

• Knowing the different instruments of inside financing
• Understanding the advantages and disadvantages of inside financing instruments
• Learning to calculate the Plowback Ratio and sustainably financeable growth
Inside financing refers to the generation of financial resources from operating activities (Volkart & Wagner, 2014, p.
578). As already mentioned in the introduction, inside financing is mainly carried out through provisions and
retained earnings. The portion of profit that is not distributed and consequently used for inside financing is often
referred to as the plowback ratio. In practice, internal financing is much more important than external financing, but
it also requires sufficient earning power and consequently the generation of sufficient financial resources (Boemle &
Stolz, 2010, p. 26).
12.3.1 Financing with provisions
Provisions are characterized by the fact that it is uncertain whether the obligation to perform will arise at all or to
what extent or at what time. Provisions can be divided into different subcategories: The most common subcategories
are guarantee provisions, provisions for pending transactions, provisions for restructuring and provisions from legal
disputes (as well as pension provisions in some countries such as Germany).
Provisions are therefore an obligation that currently does not result in any cash outflow. These liquid funds can
therefore be used for company financing: If a company generates sales of CHF 10 million and cash expenses of
CHF 7 million, the company received CHF 3 million. If provisions for any guarantees amounting to CHF 1 million
are accrued in the same period, the profit for the period amounts to CHF 2 million. However, the effective inflow of
financial resources still amounts to CHF 3 million: The provision of CHF 1 million can be used for inside financing.
However, this is only the case as long as the provision obligations must not be paid out yet, or as long as the
payments are lower than the provisions formed. Since these funds belong to third parties and not to the company
itself, provisions are an instrument of inside financing that can be allocated to debt capital financing.

Chapter 12:
Financing 269
However, it is important to note that provisions may or must only be formed if the prerequisites are fulfilled (cf.
chapter 4.5.2). That means that for financing with provisions no real choices exists — that is, one cannot form these
simply because one would like to use this source of financing. Instead, provisions must be formed as respective
obligations occur, i.e. in compliance with the corresponding accounting regulations. Provisions never the less
represent a source of financing up to the point at which they are to be claimed (or dissolved).
Figure 120: Nestlé Example: Provisions

EXAMPLE Nestlé
From: Consolidated Financial Statements Nestlé 2018, p. 69.
12.3.2 Self-financing
Self-financing represents a much more important instrument of inside financing than provisions. A company can
finance itself through the retention of profits. Large companies in particular cover their capital requirements
primarily through self-financing instruments (Boemle & Stolz, 2010, p. 26).
There are various reasons in favor of self-financing. Short innovation cycles lead to shorter investment cycles and
consequently to a steadily growing need for capital, i.e., more frequent need for new and replacement investments.
Especially in times of increased volatility on the financial markets, the capital generated by the company itself plays
an important role as it enables companies to ensure their independence from investors. Particularly in difficult times
(when a company urgently needs capital), access to capital can be restricted or associated with higher costs. In order
to compensate for the increased risk, higher interest rates are incurred. Or to put it in the words of Bob Hope: "A
bank is a place that will lend you money if you can prove that you don't need it". In addition, raising capital on the
financial markets involves transaction costs. A further advantage of self-financing is that the reserves thus created
do not result in fixed (such as with interest payments or repayment of a bond) or expected payments (such as is the
case with provisions).
In the case of corporations, self-financing is reflected in the balance sheet by means of retained earnings and to a
certain extent is also required by law. Please refer to section 4.6.1 for further details.
The Nestlé Annual Report shows an increase in retained earnings in 2017 of CHF 1.3 billion. The annual profit was
not fully distributed to the owners, as can be seen in the profit distribution or the change in retained earnings.

Chapter 12:
Financing 270
Figure 121: Nestlé example: Self-financing
EXAMPLE Nestlé
From: Consolidated Financial Statements Nestlé 2018, pp. 69-72.
In some cases, self-financing is reflected not only in the balance sheet but also in free cash and cash equivalents.
This observation can be made in particular with technology giants such as Apple or Google. Apple is the most
prominent example: At the end of September 2018, cash and cash equivalents amounted to around $66.3 billion and
$74.2 billion at the end of September 2017 (Apple, 2018). Comparing this cash level with the market capitalization
of the 20 biggest companies from the SMI and DAX index reveals how exceedingly high this cash level is.
Figure 122: Market capitalization of SMI companies and Apple cash holdings
Market capitalization in million CHF Apple's cash level

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Figure 123: Market capitalization of DAX companies and Apple cash holdings
Market capitalization in million CHF Apple's cash level

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Own illustration (data from https://www.finanzen.ch/index/marktkapitalisierung/dax; as of end of November 2018).

Chapter 12:
Financing 271
Apple has generated immense financial resources through the instrument of self-financing, as can be seen in the two
figures above. Theoretically, Apple could buy companies such as UBS, ABB, Daimler or BMW with its cash
reserves alone. This phenomenon of very high cash reserves is not unusual for technology companies. Nevertheless,
Apple is an exception here due to the amount of cash at hand.
12.3.2.1 Plowback ratio
The plowback ratio indicates the portion of the profit that is retained in the company, i.e. the self-financing ratio.
Meaning Share of retained earnings in total profit.
Calculation 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑃𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 = 1 − 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 = 1 −
𝑃𝑟𝑜𝑓𝑖𝑡 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Basis of Dividend per share and profit per share. As a rule, companies report these separately in their financial
information statements.
Interpretation § The payout ratio is the percentage of a company's profits that is distributed to its shareholders.
§ The plowback ratio is the exact opposite of the payout ratio and shows the percentage of a
company's profit will be retained.
§ Thus, the plowback ratio shows the degree of self-financing of companies.
Using Nestlé as an example, the plowback ratio is calculated and subsequently interpreted:
Figure 124: Nestlé example: Plowback Ratio

EXAMPLE Nestlé
From: Consolidated Financial Statements Nestlé 2018, p. 66, 147.
Calculation 2.45 2.35

2018: 1 − = 27.1 % 2017: 1 − = −0.01 %
3.36 2.32
Interpretation
§ Nestlé had a low plowback ratio for many years (industry average: 52.36%, source: Reuters).
§ In general, too low a plowback ratio is seen as an unsustainable dividend policy, as self-financing
suffers as a result.
§ However, Nestlé, as a very successful company for a long time, has already accumulated very
high retained earnings and can afford such a dividend policy.

Chapter 12:
Financing 272
12.3.2.2 Internal growth rate and long-term financeable growth
The internal growth rate is the growth that a company can sustain thanks to self-financing. The internal growth rate
is calculated as follows:
Internal Growth = 𝑃𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 ∗ 𝑅𝑒𝑡𝑢𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 ∗ 𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔

Rate
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑝𝑟𝑜𝑓𝑖𝑡 𝐸𝑞𝑢𝑖𝑡𝑦
= ∗ ∗
𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑝𝑟𝑜𝑓𝑖𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
The long-term growth rate, on the other hand, shows how strongly the company can grow through self- and debt
capital financing without having to change its capital structure. The long-term growth rate is calculated as follows:
Long-term = 𝑃𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 ∗ 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦

Growth Rate
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑝𝑟𝑜𝑓𝑖𝑡
= ∗
𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑝𝑟𝑜𝑓𝑖𝑡 𝐸𝑞𝑢𝑖𝑡𝑦
The two key figures are illustrated using the following example:
Net current assets 800 Financial debts 600

MINI CASE
Fixed assets 1 200 Equity 1 400

2 000 2 000
Budgeted sales growth 10%, net profit 192, Plowback Ratio 33.33%
˜y o™r oyqq ˜y o™r

Internal growth rate = o™r ∗ oyqq ∗ rqqq = 3.2% / Sustainable Growth Rate = o™r ∗ oyqq = 4.6 %
The calculations can be interpreted as follows:

§ Sales growth of up to 3.2% can be achieved without outside financing (using self-financing), whereby growth
financing leads to a higher level of equity capital financing.
§ At sales growth of between 3.2% and 4.6%, the company can finance itself through a mixture of equity and debt
capital financing without increasing debt. Depending on the additional debt capital financing, the influence of self-
financing on the capital structure is compensated. With a 4.6% increase in debt capital (from 600 to 627), the limit of
leverage-neutral growth financing has been reached.
§ If sales growth is higher than 4.6% and the company does not/cannot finance with equity financing, debt capital
financing must overcompensate for self-financing, which increases leverage and reduces the equity capital financing
ratio.
§ The budgeted sales growth means that outside financing is also necessary to achieve this.
The following options exist for increasing the internal or sustainable growth rate:
§ Increasing the plowback ratio by changing the dividend policy: In the example, the sustainable growth rate increases
to 10.3% and the internal growth rate to 7.2% if the plowback ratio is increased to 75%
§ Increase the return on sales
§ Increase the turnover rate of assets
§ An increase in the leverage ratio only affects the sustainable growth rate.
From: Boemle & Stolz, 2010, pp. 462-463 (adapted slightly).

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12.4 Outside financing
LEARNING OBJECTIVES

• Knowing the various instruments of external financing
• Understanding the advantages and disadvantages of outside financing instruments
As described in the introduction to this chapter, in addition to inside financing, a company can consider outside
financing through the instruments of credit financing, equity financing and the hybrid form of mezzanine financing.
The special features of these instruments are described below.
12.4.1 Credit financing
As already explained in detail in section 4.5.1 , the debt capital of a company can be divided into operating liabilities
and interest-bearing debt capital. Operating liabilities are a by-product of actual business activities, such as trade
payables or provisions. These could also be described as non-interest-bearing liabilities. There is also interest-
bearing debt, which companies can borrow within the framework of credit financing from lenders or the utilization
of lines of credit with banks.
Lenders are characterized by the fact that, in contrast to shareholders, they have no right of participation in the
management of the company. While shareholders make their capital available indefinitely and without entitlement to
regular, fixed remuneration, lenders have a legal claim to repayment of the amount granted at the contractually
agreed time and a claim to fixed remuneration in the form of interest. The interest to be paid depends on various
factors, such as the creditworthiness of the company or the terms of the contract, but also the current situation on the
financial markets (interest rate level, volatility, etc.). For the assessment of creditworthiness, for example, ratings are
used, which will be discussed in detail at a later date.
In practice, there are also special forms that can deviate from this norm, such as a zero bond, where no regular
interest is paid but the bond can be purchased at a discount. There are also forms of financing that have both equity
and debt capital components, which would allow lenders to also have a say (see section on mezzanine capital).
Credit financing offers a wide range of possibilities. These can be categorized, for example, on the basis of the
duration/maturity and capital market segment dimensions:
Figure 125 Instruments of debt capital financing

long
Bank loan Bond

Duration
Open credit Commercial

Papers
short
Credit market Capital market
Capital Market Segment
Own illustration.

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Financing 274
The Nestlé example shows the different types of debt and credit financing and their change over a period. The main
influences are inflows from newly issued bonds and the redemption of matured securities.
Figure 126: Nestlé example: Credit financing

EXAMPLE Nestlé
From: Consolidated Financial Statements Nestlé 2018, p. 69, 124
12.4.1.1 Bonds
A bond is a debt obligation in which different investors act as creditors on the same terms. Bonds are generally
issued publicly on capital markets or, in some cases, placed directly with institutional investors (e.g., pension funds).
The bond debtor (issuer) owes the buyer (investor) of the bond the agreed periodic interest payments (coupon) and
the redemption amount to be repaid at the end of the term. Bonds are also referred to as obligations, notes or
annuities. In practice, there are many different forms of bonds:
Classic Straight Bond Classic example of a bond. Fixed, constant coupons are paid out over the entire term, which is
contractually limited. At the end of the term, the investor also is also repaid the par value of the
bond.
Zero Coupon Bond The zero coupon bond does not pay out coupons but is issued under par (or repaid under par).
The coupon is thus not paid out annually but accumulates over the term. This may have tax
advantages under certain circumstances.

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Perpetuals A perpetual has no maturity date and therefore pays the coupon "forever". These are usually
issued by governments, the advantage being that nations have no refinancing costs (as with a
maturing bond).
Floater A floater has an interest rate fixed to an index (such as LIBOR). For this reason, they are
always traded (close to) the par value. The term is usually two to three years.
Callable Bond In the case of a callable bond, the issuing companies can call the bond (the bond owners are in
the short position) but pay a higher interest rate for this right.
Inflation Linked Bonds Inflation linked bonds guarantee an effective coupon rate (inflation-adjusted interest rate).
Figure 127: Example of a bond

EXAMPLE
Company X would like to raise CHF 50 million in fresh debt capital. Bonds with a denomination of
CHF 5 000 per bond will be issued in 2019. The bond has a coupon of 5% and is due in 2024.
pay CHF 5 000 for each bond to company X
Company X CHF 50 million

… Investors
Can be sold on
capital markets
10 000 Bonds
pays CHF 250 interest per bond p.a., and CHF 5 000 per bond after 5 years
Investors
Own illustration
A large company will generally have several bonds outstanding at the same time, as can be seen from the example
of Nestlé, having issued bonds in excess of one billion Swiss francs in 2018:
Nestle revitalizes bond exchange with billion-franc issues

The world's largest food company has gathered 1.5 billion francs with two bonds. A six-year bond with a 0.25 percent coupon
brought in 900 million francs, and a further CHF 600 million was attributable to a 10-year, 0.75% interest bearing paper. The
risk premiums against the swap level are nine and 14 basis points, respectively. The funds will be used for general business
purposes, Nestlé told Reuters.
Demand was very good, according to traders. Nestlé had originally targeted amounts of 500 and 350 million Swiss francs,
respectively. "Nestlé is a name that pulls. The group has few outstanding bonds and doesn't issue them very often," one trader
said. Its credit rating of "AA" is very high, and the yield is significantly better than that of bonds issued by the Swiss
Confederation or other issuers.
Article adapted in illustration. From: Cash (2018, 7 June).

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Figure 128: Nestlé example: Outstanding bonds
EXAMPLE Nestlé
From: Consolidated Financial Statements Nestlé 2018, p. 125
12.4.1.2 Commercial papers
Commercial papers are money market papers issued by non-financial companies with the highest credit rating. In
contrast to bonds, these money market papers have a very short maturity (usually 30 to 270 days) and are therefore
issued to cover short-term liquidity requirements. Interest is charged on a discount basis. In practice, the
simultaneous and complementary use of bonds and commercial papers can be found:
Figure 129: Nestlé example: Maturity structure

EXAMPLE Nestlé
From: Consolidated Financial Statements Nestlé 2018, p. 129

Chapter 12:
Financing 277
12.4.1.3 Bank loans and open credit
In addition to issuing bonds, companies also have the classic bank loan at their disposal. These are particularly
relevant for smaller companies that do not have access to capital markets. Bank loans can essentially be divided into
four types (Boemle & Stolz, 2010, p. 514ff.):
§ Open credit: Could also be described as a "classic" bank loan and is suitable where there is a recurring
need. Within the framework of the agreement, a limit is negotiated with the bank up to which the current
account can be overdrawn. Open credit is characterized by an alternating debt and credit relationship with
the bank. The advantage is that the interest only has to be paid on the actual amount to which the limit is
exceeded.
§ Bank loan: A loan that must be repaid at a certain point in time (also known as a fixed advance).
§ Discount credit: The sale of receivables to the bank (or an unconditional payment order from the issuer to
the bank). In the past, these exchanges were very common but have become rare in Switzerland.
§ Deposit credit: The bank acts as guarantor of the borrower. In return, the borrower pays a deposit
commission to the bank.
Some large corporations have an in-house bank that procures money on the capital market by means of bonds in the
name of the group and makes it available to the group companies in its role as a group bank by means of loans. This
procedure can also have tax advantages.
12.4.1.4 Supplier credits
The increase in trade payables represents an increase in financial resources, as the supplier is paid later and this
money is used for the company's own operations. In this case, nothing else but a loan is granted by the supplier.
These supplier credits represent another source of credit financing: This is an interest-free open credit.
12.4.2 Mezzanine capital
Mezzanine financing or mezzanine capital refers to financing instruments that contain elements of both equity and
debt capital. Mezzanine capital is subordinated to debt capital. This means that, in the event of bankruptcy, the debt
capital providers are served first and only then the mezzanine capital providers. In practice, the design of these
mixed instruments takes various forms:
Options bond In the case of options bonds, the buyer acquires a call option on shares of the issuing company in
(bond financing with addition to the bond. The value of the additional option on the shares is usually not added to the
equity character) issue price but offset by a lower interest rate.
Convertible bond Convertibles include the additional right for the buyer to convert the acquired bond into shares of
(bond financing with the issuer. Unlike an options bond, it is therefore not possible to acquire shares in the company in
equity character) question in addition to the bond, but the bond expires when it is converted into shares. If the
buyer exercises his right to conversion, the issuer transfers the bond from debt to equity.
Subordinated loan Subordinated loans are part of the debt of the borrowing company. For the borrower, however,
(loan financing with the subordinated loan means that, in the event of liquidation or insolvency, the subordinated loan
equity character) is subordinated to other claims against the debtor company.
Participation certificate Participation certificates are similar to shares but are non-voting.
(equity financing with
debt character)
In the course of the financial crisis, so-called contingent convertible bonds, or CoCos for short, gained in popularity.
If the bank's equity ratio (CET 1, Tier 1) falls below a certain limit, the outstanding CoCos are converted into equity
in order to improve the bank's financial situation.
Chapter 12:
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12.4.3 Equity financing
The options for equity financing depend strongly on the legal form of a company. The focus of this book is on the
stock corporation and therefore on equity financing through the issuance of shares. Under Swiss law, there are three
possibilities for capital increases:
Ordinary OR 650: "The ordinary capital increase is decided by the General Meeting and must be carried out within
capital increase three months by the Board of Directors".
Approved OR 651: "The General Meeting may authorize the Board of Directors to increase the share capital within
capital increase a maximum period of two years by amending the Articles of Incorporation.”
® This option offers more flexibility to be able to react quickly in case of need and not have to
convene a General Meeting first.
Conditional OR 653: "The General Meeting may decide on a conditional capital increase by granting the creditors of
capital increase new bonds or similar debt instruments vis-à-vis the Company or its group companies and the employees’
rights to subscribe for new shares (conversion or option rights) in the Articles of Incorporation.”
Figure 130: Nestlé example: Equity financing

EXAMPLE Nestlé
From: Consolidated Financial Statements Nestlé 2018, p. 69, 143.
While companies can generally finance continuous growth by reinvesting accumulated profits, this is not the case
with rapid or erratic development. There is an additional capital requirement which can be met by credit financing or
equity financing. If the General Meeting has not approved a conditional capital increase, a capital increase is a
protracted process (see the description of the capital increase procedure on the next page), which is not effective in
the event of an immediate need for capital. It is therefore not uncommon for a capital increase to serve as a short-
term replacement for borrowed capital, e.g. bank loans (Boemle & Stolz, 2010, p. 347).
Considerations regarding the optimal capital structure (see following chapter) also play a role in the financing of
companies. With increasing indebtedness, it also becomes more demanding or more expensive for a company to
procure outside capital. An increase in equity capital can therefore also take place with the aim of increasing the
debt potential (Boemle & Stolz, 2010, p. 347).
In many cases of an equity increase, there is not necessarily a concrete capital requirement; in these cases, one
speaks of a procurement of stock liquidity. The rationale behind this is to raise capital in favorable market and
environment conditions, whereas this can be more difficult to impossible in times of concrete capital requirements
or during times of crisis (Boemle & Stolz, 2010, p. 347).

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Other reasons may lead companies to increase their equity base. Especially the capital adequacy regulations for
banks (e.g., EU Capital Requirements Regulation CRR, Basel III) require banks to have sufficient capital to avoid
the risk of default. But capital increases can also occur in the context of corporate transactions to be financed in part
with own shares.
Figure 131: Procedure of an ordinary capital increase
Publicly authenticated decision
Capital increase procedure

by general assembly
CO 650II, cf. 1-9

Content:
• Nominal value of increase • Start of dividend right
• Percentage of payment • Types capital contribution
• Number, type and nominal • Rights / advantages
value of new share • Details of buying options
Potential delegation to the board: CO 650II, cf. 3

• Definition of initial offering price
CO 652c, 633 CO 652c, 634 CO 652d CO 653e, cf. 2

Payment in Payment in Payment with Payment by
cash kind equity offsetting
CO 652e CO 652f
Board’s Report on increase in Board’s Report on increase in
capital without auditor’s certificate capital with auditor’s certificate
CO 652g
Publicly authenticated board decisions
Entry in the company register within CO 650III

three months of general assembly decision
Publication of change in statute
From: Böemle & Stolz, 2010, p. 351.
12.5 The optimal capital structure
LEARNING OBJECTIVES

• Knowing the Myers pecking order theory
• Calculating the average cost of capital of a company
For a company, the question now arises of how it should ideally finance itself or what an optimal capital structure
looks like. Operationally successful companies finance themselves primarily through the cash flows from business
activities, i.e. through self-financing, while individual peaks in demand are satisfied through short-term credit
financing. For larger growth ambitions, long-term bonds or even further equity financing should be considered
(Volkart & Wagner, 2014, p. 583).

Chapter 12:
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12.5.1 Pecking order theory
The pecking order theory postulated by Myers (1984) states that companies prefer self-financing, followed by credit
financing. Equity financing is the least favored, while mezzanine financing, by its nature, takes the place in between.
If self-financing is not sufficient, companies resort to credit financing. There are several reasons for this: For
example, transaction costs for debt capital (costs for issuing bonds) are generally lower than the costs for raising
new company capital: Raising additional equity capital dilutes the shares of existing shareholders, and raising equity
capital is more time-consuming and complex than issuing bonds. Tax reasons can also be cited, as interest, unlike
dividends, can be deducted as business expenses and thus reduce the tax burden (tax shield). In addition, lenders
expect less return than equity investors, as they receive their money back before the shareholders in the event of
bankruptcy and thus bear less risk.
In addition to these direct costs, there are also indirect costs of raising capital, such as signaling effects. An issue of
debt capital instead of equity capital signals that the shares are undervalued, while an issue of equity capital signals
an overvaluation. Conversely, the announcement of a share buyback by a company, for example, signals an
undervaluation of shares and usually has a positive effect on the share price.
Excursion, Startup financing
In the early stages of a startup, the focus is on equity financing through business angels, private equity and
venture capital. Due to the high risk involved, lenders are not prepared to provide capital (or only at very
unfavorable conditions). Business angels, on the other hand, accept this high risk and are compensated with
shares in the company. If the company is successful in the future, these shares can become very valuable. As a
rule, these venture capitalists have a portfolio of investments, so that a successful investment can offset the
total losses from other investments. At a later point in time, these companies also take on debt capital:
Figure 132: Early phases of company financing
Early stage financing Later stage financing

Founding phase Growth phase Maturity phase
Seed Start up First stage Second stage Third stage Transition/change Exit
Fundamentals: Mature production: Production Market Market Crisis: • IPO (initial

• Concept • Founding and market penetration expansion: • Turnaround public offering)
• Market analysis • Production introduction • growth • Restructuring • MBO
• Product versions (R&D) • Succession • MBI
development • MBI (management • Trade sale
(R&D) buy in) • Secondary
• MBO (management buy-out
buy out)
Equity of founder and owners

Financing options
Family, friends and fools
Business angels
Government (public support)
Venture capital
Private equity
(long term) bank loans
From: Zademach & Baumeister, 2014, p. 124.

Chapter 12:
Financing 281
12.5.2 Capital structure and cost of capital
The cost of capital of a company is calculated as a weighted average of the cost of debt and the cost of equity. This
weighted average cost of capital is known as WACC:
Calculation FK EK
WACC = k •ž × + k £ž ×
GK GK
Example Equity ratio 35%, average cost of debt 3%, average cost of equity 8%
˜Š % “Š %
WACC = 3 % × oqq % + 8 % × oqq % = 4.75 %
Interpretation § Under current conditions, the company has an average cost of capital of 4.75%.
§ Theoretically, this could be further reduced by raising additional debt.
§ Higher debt increases risk, which is why equity investors will demand a higher return (dividend):
Example of Equity ratio 20%, average cost of debt 3%, average cost of equity 11.75%
greater level of ¥q % rq %
WACC = 3 % × oqq % + 11.75 % × oqq % = 4.75 %
debt
§ According to Modigliani & Miller (1958), in an efficient market without friction, the company
cannot control the cost of capital through the capital structure, since an increase in borrowed capital
increases risk for the equity providers.
§ The equity providers want to be compensated for this additional risk.
§ Therefore, according to Modigliani and Miller (1958), the cost of capital and the value of the
company are independent of the capital structure.
However, in the previous instances, taxes have not been taken into account. As a result, borrowing is worthwhile to
a certain extent. The increase in value based on the tax deductibility of interest is known as the tax shield. Despite
rising equity capital costs, the cost of capital falls:
Calculation with FK EK
WACC = k •ž × (1 − Steuersatz) × + k £ž ×
tax GK GK
Example Equity ratio 20%, average cost of debt 3%, average cost of equity 11.75%, tax rate 30%
¥q % rq %
WACC = 3 % × (1 − 0.3) × oqq % + 11.75 % × oqq % = 4.03 %
Interpretation § Taxes mean that borrowing has a positive effect on the cost of capital
§ With increasing indebtedness, however, the risk of creditors also increases, which is why an increase
in indebtedness is only worthwhile to a certain extent.
In addition to the tax shield, there is another effect that makes borrowing worthwhile for companies to a certain
extent, namely the leverage effect. The leverage effect is based on the fact that debt capital is cheaper than equity
capital. If a project achieves a higher return than the cost of debt capital, the return on equity and thus the enterprise
value can be increased. The leverage effect can be well illustrated using a simple example:
Initial situation A company has equity of CHF 1 million and generates an annual profit of CHF 100 000. The return on
equity is therefore 10%. There is the option of a further project, which also generates a return of CHF
100 000 and requires capital of CHF 1 million. The company has the option of financing this additional
project either with equity or with a loan (interest rate = 5%).
Financing with Financing with equity: A profit of CHF 200 000 is achieved:
equity 𝑃𝑟𝑜𝑓𝑖𝑡 = 200 000
= 10% 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
𝐸𝑞𝑢𝑖𝑡𝑦 = 2 000 000
Financing with Financing with debt: Income of CHF 200 000 is generated, of which CHF 50 000 must be paid as
debt interest. A profit of CHF 150 000 remains:
𝑃𝑟𝑜𝑓𝑖𝑡 = 150 000
= 15% 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
𝐸𝑞𝑢𝑖𝑡𝑦 = 1 000 000
Interpretation § If the return on an additional project is higher than the interest payable on borrowed capital, this

Chapter 12:
Financing 282
can increase the return on equity (leading to an increase in the value of the company).
§ However, the higher debt ratio also increases the risk for the equity investors because the interest
must also be paid if the desired success is not achieved:
Profit drops Due to the weak market environment, profits drop from 200 000 to 60 000:
60 000
𝐹c…\ aª = = 3 % 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
2 000 000
60 000 − 50 000
𝐹aª …c’ ‘ª = = 1% 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
1 000 000
This simple example illustrates that borrowing can increase the return for owners. This is where the name comes
from, leverage. By using leverage, effects are amplified and in both directions. As a result of leverage, the volatility
of the return on equity increases. This higher return, however, is needed to compensate for the higher risk, since in
the event of a worse result, the return on equity also drops disproportionately. The increase in leverage therefore
only makes sense to a certain extent, since with increasing leverage both equity and debt capital costs increase in
order to compensate for the increased risk.
A company's industry affiliation has a major influence on the debt-equity ratio. The rule of thumb is that, in
industries with higher business risk, the debt-equity ratio is lower than in industries with lower business risk. This
can be illustrated by the average debt ratios in various industries in the USA. Biotech and software companies
operate in a very uncertain environment, while oil & gas or real estate development are established markets and
therefore involve significantly less uncertainty.
The optimal capital structure depends on market imperfections such as taxes, costs of financial distress, agency costs
and asymmetric information. Companies must respond to these market frictions, which is why they should observe
the following seven principles (Berk et al., 2019, p. 554):
§ Companies should use the tax shield if they have a constant taxable income. The tax shield allows
companies to pay out investors and reduce corporate taxes.
§ Tax benefits of higher debt should be weighed against the cost of financial difficulties: Financial
difficulties reduce the value of a company.
§ High level of debts may create incentives to take high risks, and at the same time discourage investors. Too
little debt, on the other hand, can lead to wasteful use of financial resources when free cash flows are high.
§ A higher level of debt can signal that management is convinced that it can meet its debt obligations, as
bankruptcy is very costly for managers.
§ Investors believe that securities issued by the company are overpriced, which is why investors value these
securities lower. This effect is particularly pronounced for equities, as the share price reacts very sensitively
to information asymmetries between investors and management.
§ Companies should first rely on retained earnings, then on bonds and only then on equity. The more insider
information managers have about the company, the more important this preference order becomes (pecking
order theory).
§ A company should only adjust its capital structure if it deviates significantly from the optimum. Active
change (sale or repurchase of shares or bonds) is associated with transaction costs, which is why the debt-
equity ratio of many companies changes passively. This passive change is caused by fluctuations in the
market value of equity but also by fluctuations in the market value of outstanding bonds.

Chapter 12:
Financing 283
Figure 133: Debt ratios in the USA
EXAMPLE
From: Berk et al. (2019), p. 529.
The optimal capital structure depends on market imperfections such as taxes, costs of financial distress, agency costs
and asymmetric information. Companies must respond to these market frictions, which is why they should observe
the following seven principles (Berk et al., 2019, p. 554):
§ Companies should use the tax shield if they have a constant taxable income. The tax shield allows
companies to pay out investors and reduce corporate taxes.
§ Tax benefits of higher debt should be weighed against the cost of financial difficulties: Financial
difficulties reduce the value of a company.
§ Over-indebtedness can create incentives to take high risks while discouraging investors from investing in a
company. Too little debt, on the other hand, can lead to wasteful use of financial resources when free cash
flows are high.
§ A higher level of debt can signal that management is convinced that it can meet its debt obligations, as
bankruptcy is very costly for managers.

Chapter 12:
Financing 284
§ Companies should first rely on retained earnings, then on bonds and only then on equity. The more insider
information managers have, the more important this preference order becomes (pecking order theory).
§ Investors believe that securities issued by the company are overpriced, which is why investors value these
securities lower. This effect is particularly pronounced for equities, as the share price reacts very sensitively
to information asymmetries between investors and management.
§ A company should only adjust its capital structure if it deviates significantly from the optimum. Active
change (sale or repurchase of shares or bonds) is associated with transaction costs, which is why the debt-
equity ratio of many companies changes passively. This passive change is caused by fluctuations in the
market value of equity but also by fluctuations in the market value of outstanding bonds.
12.6 Summary
The basic prerequisite for business activities is the existence of financial resources. A company can finance itself
with equity or debt, both internally and externally. Inside financing instruments include retained earnings and
provisions. Provisions can be regarded as debt capital that is not yet due. It can therefore be used for financing
purposes. However, the most important source of inside financing is undistributed profits. The plowback ratio is the
share of the retained profit in the total profit.
Business growth in particular leads to new financing requirements. The internal growth rate (𝑃𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 ∗
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 ∗ 𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔) refers to the growth that a company can sustain with self-
financing. The sustainable growth rate (𝑃𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 ∗ 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦), on the other hand, is how strongly
the company can grow through self- and debt capital financing without having to change the capital structure.
In addition to inside financing, there is also outside financing. The classic example of outside financing is financing
by means of loans, whereby there are various possibilities for companies:
§ Bonds
§ Commercial papers
§ Bank loans
§ Open credit
§ Supplier credit
Credit financing is allocated to debt capital, the counterpart of which is the raising of equity capital by means of
capital increases. In addition to the two generic options of equity and debt capital, there are also various hybrid
forms which are summarized under the term mezzanine capital. These include, among others:
§ Options bonds
§ Convertible bonds
§ Subordinated loans
§ Participation certificates
For the company, the question arises as to the right ratio of inside and outside financing or equity and debt capital,
i.e. the optimal capital structure. Companies prefer self-financing, followed by credit financing. The cost of capital
•ž £ž
(WACC = k •ž × «ž + k £ž × «ž) influences the decision-making regarding the optimal capital structure. The
deductibility of interest on borrowed capital (tax shield) means that borrowing has a positive effect on the value of

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the company to a certain extent. In addition, raising debt capital can benefit from the leverage effect: If a project
achieves a higher return than the cost of debt capital, the return on equity and thus the enterprise value can be
increased. However, this also increases the risk borne by the company.

Apple (2018). Condensed Consolidated Balance Sheets (Unaudited). Abgerufen am 19. November 2018 von
https://www.apple.com/newsroom/pdfs/Q4-FY18-Consolidated-Financial-Statements.pdf
Becker, H. P. & Peppmeier, A. (2018). Investition und Finanzierung: Grundlagen der betrieblichen Finanzwirtschaft
(8. Aufl.). Wiesbaden: Springer Fachmedien.
Berk, J. B, DeMarzo, H., & Harford, J. (2019). Fundamentals of Corporate Finance (4th Ed.). Harlow, UK: Parson.
Boemle, M. & Stolz, C. (2010). Unternehmungsfinanzierung: Grundlagen und Kapitalbeschaffung. Zürich: SKV.
Brealey, R. A., Myers, S. C. & Allen, F. (2017). Principles of Corporate Finance. New York: McGraw-Hill.
Cash (2018, 7. Juni). Firmenbonds: Nestle belebt Obligationenbörse mit Milliarden-Emission. Abgerufen am 19.
November 2018 von https://www.cash.ch/news/top-news/firmenbonds-nestle-belebt-obligationenboerse-
mit-milliarden-emission-1180316
Dutordoir, M., Lewis, C., Seward, J., Veld, C. (2014). What we do and do not know about convertible bond
financing. Journal of Corporate Finance, 24, 3-20.
Euler Hermes / ZIS Universität Mannheim (2006). Ursachen von Insolvenzen: Gründe für
Unternehmensinsolvenzen aus der Sicht von Insolvenzverwaltern. Wirtschaft Konkret Nr. 414.
Finanzen.net (2018). Nestle-Anleihe: 0.250% bis 28.06.2024. Abgerufen am 19. November 2018, von
https://www.finanzen.net/anleihen/a1916a-nestle-anleihe
Jensen, M. C. und Meckling W. H. (1976). Theory of the Firm: Managerial Behavior, Agency Costs and Ownership
Structure. Journal of Financial Economics, 3(4), 305-360.
Miller, M. H. (1988). The Modigliani-Miller Propositions after Thirty Years. Journal of Economic Perspectives,
2(4), 99-120.
Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment.
The American Economic Review, 48(3), 261-297.
Myers, S. C. (1984). The Capital Structure Puzzle. The Journal of Finance, 39(3), 574-592.
Ross, S. A., Westerfield, R. W., Jaffe, J. F. und Jordan, B. D. (2008). Modern Financial Management (8th ed.). New
York: McGraw-Hill.
Volkart, R. & Wagner, A. F. (2014). Corporate Finance: Grundlagen von Finanzierung und Investition (6. Aufl.).
Zürich: Versus.
Zademach H. M. & Baumeister C. (2014) Wagniskapital und Entrepreneurship: Grundlagen, empirische Befunde,
Entwicklungstrends. In: Pechlaner H., Doepfer B. (Hrsg.) Wertschöpfungskompetenz und
Unternehmertum. Entrepreneurial Management und Standortentwicklung (S. 121-144). Wiesbaden:
Springer Gabler.

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Credit Rating
No other indicator provides as comprehensive financial

information and other information about a company in
condensed form as its rating. As a seemingly easily
understandable indicator, the rating – which shows a
company's probability of default and provides an
assessment of creditworthiness – is of use to many
stakeholder groups. The calculation of a rating is no
trivial matter, however, since it offers a great deal of
information in compact form and also involves
subjective components. Although they came under
pressure in the financial crisis of 2008, ratings awarded
by international rating agencies are still widely applied
as an external assessment of creditworthiness and are
used by many stakeholder groups “Rating” is a generic
term for many different kinds of rating, which typically
have significant influence on the financing options of
companies as described in the previous chapter.
13.1 Introductory example Schmolz + Bickenbach AG
INTRODUCTION: CREDIT RATING
S&P upgrades S+B's credit rating

New rating S&P has upgraded the credit rating of steel
producer Schmolz+Bickenbach subsequent to a capital
increase. Analysts expect that all new funds will be used to
reduce debt.
The rating agency Standard & Poor's (S&P) has raised its long-term
rating for Swiss steel producer Schmolz+Bickenbach (S+B) to “B”,
up from its previous rating of «B-». The outlook is said to be “stable”. In an announcement on Thursday evening, the agency
explained this step with reference to S+B's recent capital increase, which at CHF 439 million was higher than originally
expected.

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The agency went on to say that S+B were expected to use almost the entire amount to reduce debt. It thus expects a substantial
reduction in debt, which should be around EUR 1 billion by the end of the year as compared with 1.3 billion at the end of
2012. However, according to the agency, the upgrade also reflects the recovery of profits in the first half of 2013 in contrast to
the very poor figures in the second half of 2012. The agency went on to say that there was now less risk of S+B breaching its
credit terms (covenants).
As became known this Thursday from an obligatory announcement of the SIX Swiss Exchange, Martin Haefner, head of the
biggest Swiss automobile importer, Amag, will become the third most important shareholder in Schmolz+Bickenbach. Within
the framework of the capital increase approved at the end of September the steel group increased its share to 11 percent.
Article adapted. From: Handelszeitung (2013, October 10).
1. What reasons are given for S+B's upgraded rating?
2. Why are financial debts and their amount important for a company?
3. To what extent is the increase in Mr. Haefner's shareholding positive with regard to the rating?
3. What connection do you see between covenants and rating? (Note: see chapter 11.5.1)
13.2 The basis of ratings
LEARNING OBJECTIVES
• The ability to understand and explain the term “rating”

• An understanding of the historical background and purpose of ratings
• An understanding of rating agencies and their function
“Rating” means an “assessment” or an “evaluation”. Rating is a method of classifying and evaluating facts, objects
or persons. Rating is usually understood as the result of the evaluation procedure. (Schwab & Keidel. 2008.) In the
world of business, and especially in the world of finance, a rating is usually understood as an assessment of a
debtor's creditworthiness, i.e. of the probability that the interest on a loan can be paid and that the loan can be
redeemed at the end of the term. There are different kinds of ratings, which is why it is always necessary to make a
critical assessment of the underlying rating procedure when comparing ratings. The term “rating” is neither
protected nor reserved for an exclusive area of application and so it is not only used to assess the creditworthiness of
a debtor. In an economic context the term rating is also used for share recommendations, to assess the market power
of corporations, to classify products or services, to assess industries etc. The term rating is sometimes used in
connection with the term ranking. There follow three examples of other ways in which the term is used, besides
being used to assess a debtor's creditworthiness.

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Table 55: Case Study: Diverse use of the term “rating”
VARIOUS USES OF THE TERM “RATING”

O
Excerpt from a share recommendation:

CASE STUDY
(Source: SGKB. January 28, 2014)
Excerpt from a sustainability study:
(Source: Hower. 2013, October 22.)
Excerpt from a market study:
(Source: Interbrand. 2012.)

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13.2.1 Definition of credit rating and loan default
This book uses the term “rating” in the sense of a credit rating, i.e. a statement regarding a debtor's creditworthiness.
In contrast to the term rating, which can generally be used for any evaluation of persons, objects or companies,
statements regarding a credit rating solely relate to a credit relationship between the company to be evaluated and
another person. Since the term rating always means a credit rating in the financial services industry, this book also
uses the term rating as a synonym for credit rating.
A company's rating is the product of a large amount of quantitative and qualitative information condensed into a
number or a letter on a scale, thus allowing simple statements to be made. The lowest and the highest number or
letter are defined in such a way that a relative comparison is possible. The rating is an assessment of
creditworthiness and should make a general statement about strengths, weaknesses, risks and potential as well as to
provide information about a debtor's ability to fulfill interest and repayment commitments. (Füser & Heidusch, 2003
& Schneck, 2008). While the rating makes a statement about a possible default on interest and repayments, the
probability of default, as a quantitative variable of the credit risk as used by banks, makes it possible to put a
percentage to the statistical probability of whether or not a company will default on payments of interest and
principal. The probability of default is therefore contained in the rating, but the two terms should not be equated.
From a credit point of view, creditworthiness can be broken down into credit status and borrowing capacity.
Qualitative information (to assess credit status) as well as quantitative information (to assess borrowing capacity) is
therefore included in the rating.
Definition The term rating generally means a procedure for assessing or evaluating persons, objects or companies.
of rating (Schwab & Keidel. 2008.)
Definition of In the world of banking, a rating is an estimation of a debtor's solvency. The rating agency Moody’s thus
credit rating defines the term rating as follows: “A rating is an independent opinion of the future ability and legal
commitment of a borrower or issuer to comply with interest and repayment obligations by the due date. It can
either be issued for an economic unit or for a debt instrument.” A fundamental distinction is made between
issuer ratings and issue ratings and between short-term and long-term ratings. (Schwab & Keidel) 2008.)
A third important term in connection with the assessment of creditworthiness is credit default or event of default.
Definition of A credit default with regard to a specific debtor is considered certain if one or both of the following events
credit default occurs:
(according to Basel § The bank assumes that it is highly probable that the debtor will not meet all of its credit obligations
II & III)9 towards the banking group without the bank taking such measures as the realization of collateral (if
provided).
§ A material liability of the debtor towards the banking group is more than 90 days overdue. Overdrafts
are regarded as overdue if the borrower has exceeded an approved limit or has been given a lower limit
than the one actually drawn upon.
(Basel Committee on Banking Supervision, 2004)
9
Basel II and III are sets of rules issued by the Bank for International Settlement (BIS) in Basel. The BIS is also known as the bank of central
banks and pursues the objective of upholding international financial stability. Basel II and III address the question of how much equity capital a
bank has to hold. The credit risk plays an important role here as this risk traditionally ties up most of a bank's equity.

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As a rule, a credit default does not occur suddenly. The Basel Committee on Banking Supervision10 has defined
various signs that point to a possible credit default. From the bank's standpoint, the following situations serve as
indicators of impending insolvency:
§ The bank has stopped debiting interest

§ The bank makes an individual allowance for bad debt or recognizes an impairment due to what it perceives
as a significant deterioration in the quality of the credit since the credit was granted
§ The bank sells the credit obligation at a significant financial loss due to the debtor's creditworthiness
§ The bank agrees to an unavoidable restructuring of the loan, which will probably reduce the debt by means
of the bank waiving a substantial part of it or by deferring the repayment of the principal, the payment of
interest or fees, if applicable.
§ The bank has filed for the debtor's insolvency or taken a comparable measure in relation to the debtor's
obligations as a borrower towards the banking group.
§ The borrower has filed for insolvency or has been placed under protection against its creditors or similar
protection so that repayments of the loan owed to the bank are suspended or delayed.
(Basel Committee for Banking Supervision, 2004)
Figure 134: Influence on a company's creditworthiness
From the standpoint of external stakeholder groups (such as investors) the following indicators point towards
impending insolvency:
§ Consumption of equity / increased use of equity over a number of years

§ Negative free cash flow over a number of years
§ Several increases in the credit limit or a massive increase in the use of borrowed capital
§ No new purchases (no investments) over a number of years (outdated production facilities)
10
The Basel Committee on Banking Supervision is a committee of the BIS that monitors banks for compliance with Basel II and Basel III.

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§ Massive fall in revenue

§ Operational losses that can no longer be financed
§ The cancellation of credit limits
The causes of insolvency or a corporate bankruptcy are manifold and often go unnoticed until it is very late or after
the fact. The following diagram summarizes possible external and internal causes for deterioration in a company's
solvency or its bankruptcy.
13.2.2 History
The assessment of the credit risk has its origins in the USA. In the 19th century economic development led to a
heavy demand for investment. The mechanical engineering and railway industry had a heavy demand for capital due
to the development of the country's infrastructure. Capital was raised primarily by issuing bonds. However, it was
difficult for contemporary investors to evaluate the bonds that had been issued, since information from the
companies was hard to come by. This situation or the information problem between railway companies and
investors in the USA in the 19th century can still be used today as a classical example of information asymmetry.
Because of this information asymmetry there was an increasing growth in fraud and insolvency. This situation saw
the birth of the first rating specialists who were supposed to reduce the risks and losses suffered by investors. The
first ratings were prepared by Bradstreet’s Improved Commercial Agency in 1849. The rating agencies that are
important today, Standard and Poor’s (S&P) and Moody’s, have their origins in the first comments made by Henry
Varnum Poor in 1867 on rating railway bonds and the founding of John Moody & Company by John Moody in
1900. Moody’s began as the first rating agency in 1909. Rating therefore developed from a way of tackling the
problem of the asymmetrical distribution of information. The main purpose of these ratings was and still is to give
investors and other external stakeholder groups a way of assessing a company's creditworthiness. (Everling, no date;
Tec7, no date; Sylla, 2001).
13.2.3 Types of credit rating
Figure 135: Types of rating

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Ratings, or assessments and evaluations of creditworthiness, are prepared not only by rating agencies like Moody’s
or Standard & Poor’s and are not only used by investors. Banks in particular regularly prepare internal ratings
concerning their commercial borrowers in order to assess their creditworthiness and to take the corresponding
measures where appropriate. But industrial companies, trading companies and other companies also assess their
counterparties. An assessment of the other party's creditworthiness makes it possible to say how high the probability
it is that a debt will be repaid or that goods or services received will be paid for. The well-known rating agencies
such as Moody's or Standard & Poor's have particularly focused on preparing ratings for potential investors
(Moody's, no date a).
In principle, ratings can be distinguished according to the rater, the object or subject to be rated (rating subject), the
contractual relationship between the rater and the rating subject, as well the observation period. The following
overview summarizes these categories.
Ratings prepared by rating agencies:

These will be explained in detail in chapter 13.3 below.
Ratings prepared by banks:

Each bank assesses the creditworthiness of its borrowers by means of an internal rating. An internal rating is
individually calculated for each customer on the basis of the quantitative and qualitative information received from
the borrower. The borrower does not commission this rating. It puts the bank in a better position to judge the credit
risk. The bank has to back each loan with equity (see Credit Risk in chapter 13.2.1). The rating is usually disclosed
to the commercial borrower and discussed with the customer from time to time. The monitoring of ratings for
commercial borrowers is usually linked to financial reporting (half-yearly or annual financial statements). The
existing rating is reviewed in the light of the new financial statements and adjusted or confirmed as required.
Ratings by banks are usually given for the long term, since banks are interested in long-term customer relations.
However, banks also prepare ratings for companies with outstanding bond issues on the capital market. It is
irrelevant in this regard whether or not the company itself is listed with shares, because it involves assessing the
quality of the debtor. In Switzerland, Zürcher Kantonalbank (ZKB), Credit Suisse and UBS in particular regularly
prepare ratings for Swiss companies with outstanding bonds. Due to the high costs of having a rating prepared by
rating agencies such as Moody's or S&P, a rating carried out by a bank represents a low-cost alternative for
companies. For this reason companies can also actively approach banks and commission a rating. A disadvantage in
comparison with a rating from a rating agency, however, is the lack of international pertinence. Ratings prepared by
Swiss banks are not so well-known or even fully unknown beyond national borders. International investors usually
request a rating from a well-known rating agency.
Ratings prepared by companies:

There is usually a credit risk in the relationship between a company and its counterparties, such as suppliers or
customers. As a rule, there is only a credit risk with regard to counterparties on the asset side, since these
counterparties have a liability towards the company. The insolvency of an important customer with a big order
volume, for instance, or a bank where the company has a substantial positive account balance can rapidly lead to a
threatening situation for the company. However, the credit risk or the default of a counterparty may also be
problematic for a company on the liabilities side. If an important supplier becomes bankrupt or if a bank threatened
by bankruptcy calls in a loan granted to the company, the company may also find itself in a distressing situation. The

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financial crisis in particular, but also other economic crises, has drawn attention to the importance of assessing the
credit risk.
Thus industrial, trading or service companies can design their own rating systems and assess their counterparties
using their own ratings. Very often it is neither necessary nor efficient to monitor the creditworthiness of all
counterparties. Important customers and suppliers, banks as debtors or lenders as well as other lenders are
particularly suitable for monitoring. As a first step, therefore, it is necessary to identify the counterparties and
evaluate their relevance for the company's business activities. As has already been mentioned, both assets and
liabilities need to be taken into account. Banks, for instance, may be found as a counterparty on the assets side of a
company's statement of financial position if the company has deposited money, securities or financial investments
with a bank. On the liabilities side, banks usually appear as lenders. Below, Nestlé explains in its annual report
which credit risks exist and how these are dealt with.
Figure 136: Nestlé example: Management of credit risks
Nestlé EXAMPLE
In order to assess the creditworthiness of its counterparties, Nestlé creates a limit system based on existing credit
ratings of rating agencies, the calculated company value and the traded credit default swaps of each counterparty.
For reasons of efficiency, companies often base their assessments solely on the public credit rating of their
counterparty and do without their own method of preparing a rating or monitoring a counterparty. Geberit, for
example, deals only with banks that have an A (S&P rating) or an A2 (Moody’s rating) (see example below) when
conducting financial transactions.
Figure 137: Example: Management of counterparty risks
Counterparty risks
From: Consolidated financial statements Geberit Group 2018. p. 11

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13.3 External credit ratings
LEARNING OBJECTIVES
This chapter should convey the following knowledge and skills:
• Understanding what a rating means
• Knowledge of the various rating agencies

• Understanding the use of ratings in practice
• Being able to understand and explain the relevance of timeliness in connection with ratings
• Understanding criticism of rating agencies as well as their advantages and disadvantages
• Being able to show how a rating is prepared
Probably the most well-known ratings are those prepared by external rating agencies. The precondition for a rating
prepared by a rating agency is the existence of a debt instrument or a similar loan note against future payments of a
predefined amount to be made by an issuer. Rating agencies prepare ratings, for instance, for short and long-term
loan notes, bonds, debenture stock, commercial papers, certificates of deposit, bank deposits, claims under insurance
policies, money market and fixed-income funds and also issuer ratings and country ratings. Often ratings are
commissioned by companies. It must be noted that rating agencies also call themselves independent even if the
rating is being paid for by the company under scrutiny. However, external rating agencies may also prepare a rating
themselves, without being commissioned to do so. External ratings are often called public ratings, since the results
are made available to many users and interested parties. The rating is not usually a one-off assessment. Rather,
rating agencies continue their assessment of creditworthiness through regular monitoring. (See chapter 13.4.4)
External ratings can be differentiated into issue ratings and issuer ratings. The starting point for an issuer rating is to
assess the creditworthiness of the debtor itself. The pertinent questions are to what extent a company has the ability
and the will to repay the financial liability. The issuer rating is also referred to as the “probability of default” or the
“risk of default”, i.e. the risk that a company might become bankrupt. An issue rating in the assessment of
creditworthiness is only indirectly related to the creditworthiness of the debtor. The main focus of attention with an
issue rating is the assessment of the financial instrument itself. The interesting point is what amount of this
instrument is likely to be recoverable if the company becomes bankrupt. We speak here of the “risk of loss” or the
“loss given default”, that is the loss in the event that the company should become bankrupt. In the case of classical
corporate bonds, in particular, it is obvious that the issue rating is identical with the issuer rating. But there are
different kinds of bonds, although the risk may be greater for the creditor due to the structure of the financial
instrument. This can result in a higher or a lower rating for a financial instrument.
Rating agencies also prepare country ratings. These ratings are based on an assessment of a country's
creditworthiness and on an assessment of the repayment of outstanding debts owed by this country in this
framework. We will not discuss country ratings any further in this book.
While ratings of banks and companies are usually used for internal purposes and are not published, the results of the
external ratings of rating agencies are primarily intended for the public. With their estimation of a debtor's relative
default risk, external credit ratings are an important instrument for reducing information asymmetry (see chapter 2).
So in this sense the following statements also apply to bank ratings or internal corporate ratings (see chapter 13.3).

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13.3.1 Relevance of ratings
According to Standard & Poor’s (S&P) and Moody’s, a credit rating expresses an opinion about a debtor's ability
and will to comply with its financial obligations under the terms of a contract. In addition, the rating makes a
statement about a debtor's credit quality and the probability of this debtor defaulting. Rating agencies are opinion-
makers, based on a careful, analytic and multi-level process. This is why ratings should not be used to predict the
probability of default with exactitude, but should always be understood as relative measures of the credit risk.
Although an important and major part of the analysis of the company is made on the basis of historical data, ratings
always look towards the future. Possible future events that could influence the credit risk are priced into the rating.
Well-known and repeated economic cycles are also taken into account, for instance. Ratings are not therefore static,
since a change in the company or in its environment can improve or diminish a debtor's credit quality at any time.
Such changes may be the purchase or sale of a division, for instance, or a change in the legal conditions due to a
change in legislation. Changes to ratings always result from circumstances that were unknown at the time when the
rating was prepared. Otherwise, this information would already have been considered in the rating. Rating agencies
deliberately refrain from claiming that all possible circumstances can be foreseen and insist that a rating is no
guarantee for the credit quality of a debtor or a financial instrument. (S&P, no date a.) A list of the rating categories
used by S&P, Moody’s and Fitch is given below.
Figure 138: Rating categories used by Moody’s, S&P and Fitch
Note. Own depiction. Based on: Moody’s, Fitch, S&P and PIMCO (no date).

Chapter 13:
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Calculation method and comparability:
Although S&P, Moody's and Fitch use the same rating categories (AAA to D and Aaa to C) and most stakeholder
groups see these ratings as being comparable, there are nevertheless differences in the calculation logic underlying
the ratings. In principle S&P’s ratings are based on an estimation of the probability of default (PD), while Moody’s
uses the Expected Loss (EL) approach, which uses the probability of default (PD) as well as the expected financial
loss in the event of default (Loss Given Default = LGD). (Ghosh, 2013) For a detailed discussion of the calculation
methods please refer to the reference literature. When comparing the ratings used by different rating agencies it must
be remembered that rating agencies apply different methodologies. These methodologies are admittedly available to
the public as a rough concept, but the details are not disclosed. Although it is always advisable to be cautious when
comparing ratings, and it is important to understand the underlying model or logic, rating agencies do try to make
their rating categories comparable on as broad a basis as possible. (S&P, no date a)
Influence of companies and connection between ratings and the cost of finance:
A rating usually has a direct influence on an entity's financing costs. Since the rating describes a debtor's probability
of default, the interest rate for borrowing heavily depends on a rating agency's estimation of this likelihood. The
higher the rating, the less probable is a default and the less willing an entity is to pay a high rate of interest on
borrowed capital. A poor rating leads to a higher risk premium on the interest rate for borrowed capital, since the
lender takes a bigger risk and wants to be compensated in return. There is therefore a statistically proven connection
between a rating and the interest paid on debt instruments. Despite this connection, a company does not necessarily
strive to achieve the highest “AAA” rating in order to get the lowest possible borrowing rate. As the rating rises,
constraints are placed on entrepreneurial freedom, since certain financial ratios have to be maintained in order to
achieve or keep a certain rating. In the case of very good creditworthiness, there is a conflict in the “yield, liquidity
and risk” triangle, especially as far as liquidity is concerned. The highest “AAA” rating means that the company has
to keep a high level of liquidity and seek the safest solution in most cases. This limits the options for generating
yield and business opportunities, i.e. strategic business decisions, decisions regarding the capital structure and
investment decisions. A company with an external rating will thus usually aim for a target rating that supports its
strategic decisions.
Statistical probability of default:
Figure 139: Distribution of defaults by S&P-rating before default

Note. S&P (2016, pp. 22f).

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Ratings given by rating agencies are not exact measures of the probability of default as used in the credit-risk
models of banks. Banks model their credit risks on the basis of mathematical-statistical processes in order to make a
statistical estimation of the probability of default for their credit portfolio. Rating agencies, however, measure the
relative credit risk of an issuer or a financial instrument. This is done by S&P, Moody’s and Fitch using predefined
risk categories (AAA, AA, A, etc.), with the credit risk being placed on a scale ranging from first-rate to poorest
quality. All companies or financial instruments that are researched are classified into these categories. Rating
agencies have deliberately conceived of the rating process as an estimation of various factors, including quantitative
and qualitative or subjective influences. The process of preparing a rating is not a scientifically exact discipline. The
defaults of companies can naturally be observed and classified in a rating category. However, the information thus
obtained regarding credit defaults varies in each rating category. A rating and the credit defaults observed within this
category can therefore not be compared with the mathematically and statistically calculated probabilities of default
used by banks. The debenture stock issued by a company with an “AA” rating has a higher credit quality than a
corporate bond with a “BBB” rating, but the “AA” rating is no guarantee that this company will not become
insolvent. The probability of default, however, is lower for an “AA” rating than it is for a “BBB” rating, as is the
case with the bank models. (S&P, no date a) The following table shows the probabilities of changes in S&P ratings
(1981-2010). The percentages indicate the probability of a company with a certain rating being in a different rating
category within one year (e.g. being downgraded from AAA to AA). The final column also shows the probabilities
of default for the individual rating categories. In the year 2015, 105 of the 113 companies with default (92.9%) were
ranked “speculative grade” by S&P. The long-term average is 86.4% (S&P, 2016, p. 18). The following diagram
shows the change in the probabilities of default within a rating category since 1981. The number of bankruptcies has
risen significantly, as it did in times of crisis such as in 1991 (Japan crisis), 2000 (Dotcom bubble) and 2008
(financial crisis). The three lines show the default rates of companies across all rating categories and in the two
rating categories Investment Grade and Speculative Grade.
Figure 140: Change in the probabilities of default

Note. S&P (2016, p. 5).

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13.3.2 Rating agencies
All three rating agencies – S&P, Moody’s and Fitch – that dominate the market for external ratings have their roots
in the USA (chapter 13.2.2). There have been European attempts for rating agencies, but no alternative to S&P,
Moody’s or Fitch has yet been able to establish itself. The three rating agencies are active throughout the whole
world and have now become familiar names among the general public. The core competence of all three agencies is
the assessment of creditworthiness. Due to the consistent goal of providing better information to investors in relation
to corporate creditworthiness, the work of all three agencies is geared towards the needs of investors. With decades
of experience in assessing creditworthiness, the rating agencies have extensive databases and profound known-how.
The rating agencies also maintain constant contact with the senior management of the companies they research in
order to take account of qualitative factors as well as future developments in their ratings and therefore of
information that is not available to the public (see chapter 13.5). Ratings and further financial information and
analyses are sometimes published on the Internet or sold to interested stakeholders. The ratings are usually made
accessible to the public by the companies themselves in the context of investor or creditor relations. In addition to
ratings, all three agencies also offer products and services in the field of credit ratings, investment research and
software tools. All these activities are intended to help increase the transparency of global capital markets.
Standard & Poor’s was established in 1941 through the merger of the US companies Poor
Publishing and Standard Statistics. In 1966 S&P was taken over by McGraw-Hill Companies
and thus expanded into the field of financial information services. S&P is now a company
belonging to the McGraw-Hill Companies Group with the divisions S&P Rating Services,
S&P Dow Jones Indices and S&P Capital IQ. As this subdivision shows, S&P not only prepares ratings, but
maintains well-known indices such as the S&P 500 and offers investment research, risk management and the
development of models of finance. In 2011 S&P had around 1 190 500 credit ratings outstanding. S&P has 8 500
employees, some 1 400 of whom are analysts and economists. S&P is represented at 23 locations worldwide. (S&P,
no date b)
Moody’s was founded in 1900 by John Moody (see chapter 13.2.2). Moody’s Corporation is
listed on the New York stock exchange, NYSE, under the ticker MCO. The company is
divided into Moody’s Investors Service and Moody’s Analytics. Moody’s Investor Service is
responsible for preparing the ratings. Moody’s Analytics is a supplier of risk management
software and offers financial data, analyses and consulting services. According to information provided by the
company, the volume of liabilities covered by Moody’s amounts to more than USD 35 trillion and outstanding credit
ratings as of 2011 amounted to around 1 039 187. Moody’s is represented at 29 locations worldwide and has around
7 000 employees. (Moody’s, no date b)
Fitch Ratings was founded in 1913 by John Knowles Fitch of the Fitch Publishing Company. Today Fitch Group
includes Fitch Ratings, Fitch Solutions and Fitch Learnings. Fitch Solutions offers products and services in the field
of credit risk and Fitch Learnings is active in the field of training and continuing professional development Fimalac
S.A., Paris and Hearst Corporation, New York each hold 50% of the shares in Fitch Group. In 2011 Fitch had
around 505 024 credit ratings outstanding. Fitch is represented at more than 50 locations worldwide and has 2 000
employees. (Fitch, no date a)

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13.3.3 Use of ratings
Through the reduction of information asymmetry as the primary goal of credit ratings, all stakeholder groups benefit
from credit ratings. Since all stakeholder groups have an interest in a company's survival, ratings have diverse
applications.
Investors are helped to make decisions:

Ratings are often used to make investment decisions. This applies to both investments in equity instruments such as
shares and investments in borrowing instruments such as bonds. All rating agencies, however, point out that an
investment decision should not be based entirely on a rating. In practice, changes in the market prices of financial
instruments thus depend not only on the credit quality of the debtor (issuer rating) or of the instrument (issue rating),
but these prices change even when ratings remain constant, e.g. due to economic data. In order to make a sound
investment decision, other factors besides credit quality have to be considered. This may be a share analysis, for
instance, which calculates the share ratios and also takes account of share developments and stock market prices in
the assessment. But the economic climate, the current level of interest rates, one's own investment strategy or the
desired time horizon are further factors that also have to be considered when taking a decision. Despite this, the
rating often has a great significance. Many companies and private individuals use ratings as the chief criterion for
investment decisions. The investment regulations of pension funds in Switzerland, for instance, usually allow them
to invest only in financial instruments with a minimum rating of BBB. Instruments with a minimum rating of BBB
are also known as investment grade instruments. (S&P, no date a) For an investor the rating is also very interesting,
since data that is not available to the public is sometimes taken into account when preparing the rating. In this
connection the publication of the rating leads to greater information efficiency in money markets and capital
markets, which investors take advantage of.
Companies are helped to find access to capital:

While investors use ratings for support in the investment process, issuers of a financial instrument can gain access to
a wider group of investors by means of a rating. The rating improves access to the capital market, since many
investors trust independent credit ratings. An external rating is particularly helpful if the company is not so well-
known or if a large issue volume is being planned. It is usually an external rating that makes it at all possible to go to
international capital markets.
Companies are helped to control capital costs:

A rating can be used when negotiating loans and interest rates with banks or on the issue of a bond with regard to
the sum of the coupon. In this way the company uses the rating to control the costs of capital by achieving or
maintaining a target rating with targeted corporate or financial control. A better rating and therefore lower costs of
capital due to growing restraints on entrepreneurial freedom is not always something to aspire to (see chapter
13.3.1). However, a target rating and knowledge of the effects that rating changes have on the costs of capital give
the company more financial flexibility.
Banks are helped to control credit:

A bank's granting of credit depends on a company's creditworthiness. In the case of large loans, covenants are
agreed, setting out the terms of the loan (see chapter 11.5) and specifying what is to happen in the event of
deteriorating creditworthiness. As a rule, a deterioration in creditworthiness causes interest rates to rise and this
leads to the automatic termination of the loan agreement when they reach a certain level. The rating is a ratio that

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can also be linked with covenants. A deteriorating rating, for instance, can lead to higher interest rates or a sharp fall
in the rating to below investment grade could result in the loan being called in.
Companies are assisted with financial marketing:

For the issuer a rating represents an important element of financial marketing, since the rating often indicates its
degree of financial stability, or the company can be compared with the competition by means of benchmarking. The
rating can convince suppliers and customers as well as other stakeholder groups of a company's financial
independence and strength. The rating therefore forms a good basis for negotiating private contracts, since the other
contracting party is in a better position to assess the credit risk. The rating can generally be used to improve the
company's image. But there are also situations where a rating is simply mandatory. When public or private
invitations to bid for a major contract are issued a rating may be specified as a possible precondition for taking part.
Figure 141: Nestlé example: Credit rating for financial assets
EXAMPLE Nestlé
Companies use ratings for self-analysis and accreditation:

Since a rating is prepared independently and externally, it can support a self-assessment by management and help
define a company's position in relation to competitors by means of benchmarking. A rating is therefore a good
starting point for an analysis of one's own company or of another company.
Companies are helped to assess the counterparty risk:

A rating is considered not only when new investments are made. Ratings are also helpful when assessing existing
receivables owed by counterparties. Receivables and financial assets are thus generally classified according to the
underlying external rating.
Regulatory bodies and stock exchanges:

Numerous regulatory bodies, both national and international, in banking, at stock exchanges and in insurance, use
ratings as a supporting instrument when performing their tasks. The use of ratings, for instance, is dealt with in the
provisions for capital allocation in the case of credit risks according to Basel II. There, the supervisory authority
allows ratings of external rating agencies to be used in the risk weighting of receivables. Some stock exchanges
stipulate external ratings or make the equivalent rating level a precondition for a listing or for admission to a certain
stock exchange segment.

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Figure 142: Use of ratings
13.3.4 Process of preparing an issuer rating
There is no statutory or regulatory basis for stipulating how a rating is to be prepared. However, the preparation
process of the three rating agencies is still quite similar. The main differences lie in the subjective assessment and
the rating model. The rating is generally commissioned and paid for by the company itself. Agencies gain a deeper
insight into corporate activities than the general public and therefore undertake to keep all confidential information
secret and not to make it public.
Ideal typical procedure:

The rating process can be roughly broken down into the following six phases:
1. Preliminary and informatory discussions

2. Analytical preparation
3. Main rating discussions and analysis of creditworthiness
4. Rating recommendation and judgment
5. Notification and, if necessary, publication
6. Monitoring
The diagram below shows the ideal typical procedure for preparing a rating. At the start of the rating process one or
several preliminary discussions take place between the rating agency and management in which they agree on the
rules for their collaboration. The corporate documents required and the time framework are defined. The rating
contract is then signed and the analytical preparations begin. The team of analysts examines the information that is
in the public domain and the information made available by the company. After this initial data analysis the main
discussions begin. These usually start with a presentation and an explanation of the corporate strategy and the
company's plans by its management. The discussions afterwards concentrate on the aspects regarded as central for
an assessment of creditworthiness. A lot of confidential information is also disclosed. It is only after the main rating
discussions that the analysts start the actual analysis of creditworthiness. First of all, they define the criteria that

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have the biggest influence on the company's creditworthiness. Both qualitative and quantitative information is
considered here. The criteria can generally be subdivided into the business risk and the financial risk.
Figure 143: Ideal typical procedure for preparing a rating
Note. Own depiction. Based on Füser & Heidusch. 2003. p. 135.
The analysis of creditworthiness as the core part of the rating process is explained in more detail in the next section.
On the basis of the analysis of creditworthiness by considering all qualitative and quantitative criteria of the business
risk and the financial risk, the team of analysts prepares a rating recommendation. A rating committee, made up of
the heads of the analyst team and other experienced industry experts from the rating agency, then takes a decision
regarding this recommendation and makes an assessment. The rating assessment is then communicated to the
company, with reasons and explanations being given. If the company is not in agreement with the rating it can file
an objection. In this case the company can submit new information that could influence the assessment. The rating
agency has to decide whether the information is so fundamentally new that the rating assessment has to be revised.
If the company rejects the rating assessment entirely, the process has come to an end. In this case, however, the
agreed fee for preparing the rating must still be paid in full. If the rating assessment is accepted, the company has to
decide whether the rating should be made public or used only for internal purposes. According to information from
Moody’s, the entire rating process usually lasts no longer than 90 days. However, with regard to the planned capital
market transaction, this process may be significantly shorter if the necessary documents are already available. Since
the rating is made in relation to a certain point in time, monitoring will be necessary in order to guarantee that the
rating is up to date. Published ratings are usually monitored by the rating agencies. More about this can be found in
the next chapter on “timeliness”. (Füser & Heidusch, 2003, p. 135ff.; Moody’s, no date c)
Qualitative and quantitative factors in the analysis of creditworthiness:

The core element in preparing a rating is the analysis of creditworthiness. This analysis is also known as the rating
model, rating methodology or the rating framework. Every agency has developed its own methods and uses this
rating model to prepare every rating. The model contains the definitions of the criteria, the approaches, the

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calculation of the ratios and their interpretation, scoring models for purposes of comparisons as well as further
analyses to assess creditworthiness. This rating model also includes the calculation bases and methods mentioned in
chapter 13.4.1 (estimating the probability of default or the expected loss). The rating model is not static, but is
developed further by the rating agencies and adapted to the general conditions. Although the rating agencies disclose
a large part of their methodology, there are details that are not made public.
The main factors in the rating model can be said to be the assessment of the business risk and the financial risk. The
business risk includes the analysis of management, the general economic conditions and of business opportunities.
According to the methodology adopted by S&P, an analysis is made on the basis of the business risk and the
financial risk. Moody’s, on the other hand, distinguishes between three partial analyses: the business risk, the
financial risk and also an evaluation of management. The different subdivision is not decisive, since all aspects of
the business risk have to be considered. The following overview shows the various criteria that are assessed. The
criteria are virtually identical for both external ratings and internal bank ratings (p. 138). However, banks do not
usually make such a profound analysis as rating agencies when assessing their borrowers.
Figure 144: Categories and criteria in preparing a rating
Note. Own depiction. Based on Füser & Heidusch (2003). p. 138 & S&P (no date a).
There is no predefined weighting for the individual ratios, criteria and categories that are assessed. The significance
of the specific criteria is determined from situation to situation. With regard to prioritization of the business risk and
the financial risk, S&P at least makes a distinction in that the business risk is given the same or a slightly heavier
weighting in the case of investment grades (rating of BBB or higher), whereas the financial risk receives a higher
weighting in the case of non-investment grades (S&P, no date a). When assessing the criteria comparisons are also
made with peer groups in the analysis of the business risk and the financial risk of the company in question, which
allows the results to be judged in relation to comparable companies. The analysis therefore comprises many
influential factors, both quantitative and qualitative, weighted according to the company's individual situation. Cash
flow and liquidity play a central role in the quantitative analysis of the financial risk and can heavily influence the

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rating. Rating agencies place a strong focus on available liquidity (liquidity ratios), the degree of indebtedness and
interest coverage, the cash generated (operative cash flow) and the free cash flow. This heavy emphasis on cash flow
can be particularly explained by the financial crisis of 2008. To assess the financial risk, rating agencies calculate
ratios, which we have already learned about in performance measurement and financial statement analysis (chapter
11). Rating agencies, however, make adjustments to the “financial statement figures”. These adjustments are also
defined in a rating agency's methodology. The business risk consists of many qualitative criteria. In order to make
an objective assessment of a company, there are ratios and scoring models, which are part of the overall rating
methodology. (Moody’s, no date c) The diagram below takes a closer look at the assessment of the business risk and
the financial risk on the basis of S&P's rating methodology.
Figure 145: S&P's process for preparing a rating
Note. From: S&P (2013, November 19).
1.) Determining the industry risk and the country risk

S&P assesses the business risk (business risk profile) on the basis of its own scoring model known as “CICRA”
(Corporate Industry and Country Risk Assessment). An assessment is made of the industries and countries in which
the company operates. For the industry risk, the development, market position and stability are considered. For
country assessment an evaluation is made of the economic and sovereign risks, the financial system, the payment
culture and the general legal conditions in a country. A company's industry risk and country risk are measured on a
scale of 1 to 6. The average is not taken, since according to S&P the industry risk has a higher weighting. If a
company operates in Switzerland, for instance, (country risk = 1, for example) and in mechanical engineering
(industry risk = 4, for example), the company is given a CICRA of 4 in accordance with the following S&P matrix.
Table 56: S&P CICRA
Country risk assessment

Industry risk 1 (very low risk) 2 (low risk) 3 (intermediate 4 (moderately 5 (high risk) 6 (very high
assessment risk) high risk) risk)
1 (very low risk) 1 1 1 2 4 5
2 (low risk) 2 2 2 3 4 5
3 (intermediate risk) 3 3 3 3 4 6
4 (moderately high risk) 4 4 4 4 5 6
5 (high risk) 5 5 5 5 5 6
6 (very high risk) 6 6 6 6 6 6
Note. From: S&P (2013, 19. November).

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2.) Determining the competitive position

After assessing the industry risk and the country risk, the company's relative competitive position is assessed. The
criteria are considered regarding the competitive position and management. The company's competitive strength is
classified on a scale of 1 to 6. The business risk profile results from the competitive position rating and the CICRA
rating shown in the matrix below. If the company serving as an example with CICRA rating 4 has a satisfactory
competitive position and thus a rating of 3, it is classified into business risk profile 4.
Table 57: S&P Business Risk Profile
Corporate Industry and Country Risk Assessment (CICRA)

Competitive position 1 (very low risk) 2 (low risk) 3 (intermediate 4 (moderately 5 (high risk) 6 (very high
assessment risk) high risk) risk)
1 (excellent) 1 1 1 2 3 5
2 (strong) 1 2 2 3 4 5
3 (satisfactory) 2 3 3 3 4 6
4 (fair) 3 4 4 4 5 6
5 (weak) 4 5 5 5 5 6
6 (vulnerable) 5 6 6 6 6 6
3.) Determining the financial risk

S&P usually calculates the financial risk from ratios. S&P uses its own ratios for this purpose (S&P ratios) and
carries out adjustments (S&P adjustment criteria). The Funds from Operations (FFO) ratio is being introduced, for
example. FFO is calculated on the basis of EBITDA less net interest and tax, as well as further S&P-specific
adjustments. The ratios are compared with reference values for rating the quality of the financial risk. The following
table shows such reference values for companies with a CICRA rating of 2 or below. S&P (2013, November 19).
Table 58: S&P Financial Risk Profile
Core ratios Supplementary coverage ratios Supplementary payback ratios

FFO / Debt / FFO / EBITDA / CFop / FCFpo / DCF / debt
debt (%) EBITDA (x) cash interest (x) interest (x) debt (%) debt (%) (%)
1 Minimal 60+ Less than 1.5 More than 13 More than 15 More than 50 40+ 25+
2 Modest 45-60 1.5-2 9-13 10-15 35-50 25-40 15-25
3 Intermediate 30-45 2-3 6-9 6-10 25-35 15-25 10-15
4 Significant 20-30 3-4 4-6 3-6 15-25 10-15 5-10
5 Aggressive 12-20 4-5 2-4 2-3 10-15 5-10 2-5
6 Highly leveraged Less than 12 Greater than 5 Less than 2 Less than 2 Less than 10 Less than 5 Less than 2
4.) Provisional rating

The provisional rating is determined on the basis of the business risk and the financial risk. Subjective assessments
are also included in this step.

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Table 59: S&P Anchor Rating
Financial risk profile

6 (highly
Business risk profile 1 (minimal) 2 (modest) 3 (intermediate) 4 (significant) 5 (aggressive)
leveraged)
1 (excellent) AAA/AA+ AA A+/A A- BBB BBB-/BB+
2 (strong) AA/AA- A+/A A-/BBB+ BBB BB+ BB
3 (satisfactory) A/A- BBB+ BBB/BBB- BBB-/BB+ BB B+
4 (fair) BBB/BBB- BBB- BB+ BB BB- B
5 (weak) BB+ BB+ BB BB- B+ B/B-
6 (vulnerable) BB- BB- BB-/B+ B+ B B-
S&P calls this provisional rating an anchor. This provisional rating can be modified due to various circumstances
specific to the company or due to external influences, which will not be discussed in any detail here.
13.3.5 The process of preparing issue ratings
In the case of an issue rating the credit quality and the probability of default are assessed on the basis of current
information about the financial instrument. This information either comes straight from the issuer or from another
reliable source. The following information and facts are assessed in detail:
§ issue prospectus and conditions of issue for the instrument

§ relative ranking and repayment process for the financial instrument in the event of bankruptcy (for instance
ranking higher than or subordinate to other existing debts)
§ guarantees from other parties (such as the parent company, the government etc.), collateral (such as liens)
or insurance for the financial instrument (such as capital protection by another company)
If the financial instrument is issued by companies (not banks) or the government, the process of rating the issue
usually starts by assessing the company's credit quality in a similar way to an issuer rating (see previous section).
(S&P, no date a)
13.3.6 Timeliness of external ratings
A rating is prepared at a certain point in time and is therefore a static view of a situation. However, an assessment of
creditworthiness is only any use if this assessment is relatively up to date. A company will not usually go bankrupt
overnight, but all of a company's stakeholder groups want to be given an indication as soon as possible if there is
any deterioration in its creditworthiness. Such indications concerning deterioration in creditworthiness are typically
expected of external ratings.
Existing ratings are usually subject to review at certain intervals or at the request of the company being assessed. If
the rating agencies receive fresh information from the company that could lead to an adjustment in the rating, a new
rating process is initiated. (Reichling, Bietke & Henne, 2007, p. 62) Rating agencies therefore depend on the
company being assessed and the time when a company provides them with further information. Rating agencies can
only have a limited influence on the timeliness of a rating. In order to nevertheless inform investors in good time of
possible rating changes, additional instruments such as the rating outlook and the watch-list (rating reviews) have
been introduced in addition to the rating categories. Since they were introduced at the beginning of the 1990s, these
instruments have become extremely important within the framework of the overall rating process.

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Rating outlook:
A rating outlook is supposed to indicate the direction in which a company's current rating might develop in the
future. The future time horizon is generally 6 to 24 months. A rating agency classifies a company's rating into one of
four categories: positive outlook, negative outlook, stable, or developing (positive or negative). The categories are
explained in the next table. A rating outlook does not necessarily signal a rating change. However, it is often used as
an indicator for the reliability and accuracy of a rating (S&P, no date a; Moody’s, 2009, June; Langohr & Langohr,
2009, p. 176.) Before such a rating change actually takes place, rating agencies check whether there is been a
fundamental and permanent change in an issuer's credit risk profile. In order to avoid a heavy fluctuation of ratings
(rating volatility) and to increase their reliability, only permanent changes in creditworthiness usually lead to a
rating change. Temporary changes should not entail any rating change.
A company, for instance, shows an above-average or below-average growth in revenue. In this case the rating
agency may declare that the company has a “positive” or a “negative outlook”. This rating outlook is maintained
until it becomes clear whether the change in the company's creditworthiness is permanent or merely temporary.
During this time of uncertainty regarding the reliability of the company's new situation the rating agency maintains
the rating, but signals the uncertainty in the rating outlook. (Langohr & Langohr, 2009, p. 176.)
Watch-list (rating review, credit watch or rating watch):

If it is highly probable that events internal or external to a company could lead to a change in its creditworthiness,
the “rating review” process is initiated. With this process the company is placed on the “watch-list” and monitored.
This process is known as a rating review (Moody’s), credit watch (S&P) or rating watch (Fitch).
Table 60: Instruments used for monitoring ratings
Purpose Reasons Time Category Description

Positive or negative trends or Positive Rating may be upgraded
developments that have not yet
To point to a materialized and will not Possible downgrading of the
Negative
possible change materialize in the near future. Outlook rating
Rating
of direction in a 6-24
outlook: No trends or developments that
company's months Stable Rating stays the same
could lead to a rating change.
current rating
Trends or developments that Rating may develop
Developing
could lead to a rating change. positively or negatively.
§ Changes in demand for the Watch for

Strong Rating likely
upgrade*
probability that issuer's products to be upgraded
/ positive**
events internal § Technological changes
Watch list or external to Watch for Rating likely
§ Corporate takeovers 90-120
(Rating the company downgrade* to be
§ Government intervention days
review) will cause a / negative** downgraded
permanent § Changes in the regulatory
change in Direction Trend of the
environment uncertain* rating change is not yet
creditworthiness
§ Macro-economic changes / Developing** clear
Note. Own depiction. Based on: S&P. (2013, November 25); Moody’s. (no date c). & Fitch. (no date b)
*=Moody’s / **=S&P
A company is usually informed in advance before it is placed on the watch-list. The triggering events may be
structural changes in demand for the issuer's products, technological changes, corporate takeovers, government
intervention, changes in the regulatory environment or changes in macro-economic variables. The watch-list process
is intended to analyze the way in which these events influence the company's operational activities and its long-term
business prospects. (Berblinger, 1996, p. 60.) A rating agency classifies the company into one of three categories in
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accordance with the anticipated rating change: watch for upgrade (positive), watch for downgrade (negative) and
direction uncertain (developing). The watch-list process indicates to the capital market that the rating agency expects
an improvement or a deterioration in the company's creditworthiness. The process takes around 90 to 120 days. The
rating committee determines the rating in a similar way to the process of preparing ratings. (Dimitrakopoulos &
Spahr, 2004, p. 215 f.) This is based on a comprehensive analysis of the possible rating change, which causes the
rating to be either changed or confirmed at the end of the watch-list phase. (Reichling, Bietke & Henne, 2007, p. 62)
However, a rating change is only possible after the end of the watch-list process. So it is not absolutely necessary for
a company to have been on a watch-list prior to a rating change. (S&P, 2013, 25. November; Fitch, no date b)
13.3.7 Criticism of external ratings
All stakeholder groups of companies hope that external ratings will help them predict possible defaults by these
companies. The diagram below shows how ratings develop prior to default. It indicates the average ratings of
companies prior to default.
Figure 146: Average development of ratings prior to default
Note. From: Cheng &Neamtiu (2009), p. 116.
The diagram above shows that since 2002 ratings have become more reliable in predicting a default. But rating
agencies have nevertheless come under criticism by both issuers and investors, and not only since the financial crisis
of 2008. They are accused of being too late or too unreliable in providing advance warnings of possible defaults by
issuers. The rating system was already exposed to criticism during the scandals involving Enron (2001) and
Parmalat (2004), which triggered a discussion about the role and function of rating agencies.
A notorious example prior to the financial crisis of 2008 was the energy group Enron. The rating agencies S&P and
Moody’s were still giving the energy group top ratings until shortly before it became insolvent. During the fraud
scandal surrounding Enron not only the audit system was criticized, but also the independent award of ratings.
However, despite all criticism a distinction must be made between the various ratings. The Enron case (2001) was
about issuer and issue ratings. However, the financial crisis of 2008 involved country ratings as well as ratings of
special financial instruments, the asset backed securities. As we saw in previous chapters, there are various
assessments, processes and definitions to be considered when preparing ratings, which are not entirely comparable.
To understand the criticism leveled at rating agencies and the problems surrounding them, the following list shows
the major advantages and points of criticism.

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Table 61: Criticism of rating agencies
CRITICISM OF RATING AGENCIES
MEDIA RELEASE
CASE STUDY
Criticism of rating agencies

Rating agencies assess the creditworthiness of companies. They are
now accused of having given poor debtors good ratings for far too
long. The European Commission wants to take a closer look at the
work of the credit raters.
Political pressure on rating agencies is growing. As a reaction to the
crisis on international financial markets, the European Commission wishes to review the work of credit raters. A
spokesperson said on Thursday that the Commission was worried because agencies were so slow to react to the
difficulties with mortgage loans for subprime debtors in the USA. “In the coming weeks we'll see what consequences can
be drawn from this,” said the spokesperson, but emphasized that no decision about new rules for agencies will be taken
before next spring. Voices from the Commission were saying that both new legislation and changes to the existing code
of conduct for rating agencies were conceivable. [….]
Downgrades just a few weeks ago.

The three biggest rating agencies, Standard & Poor’s (S&P), Fitch and Moody’s, are faced with reproaches from
investors and politicians because for a long time they gave good ratings to bonds secured by shaky mortgage debt, which
furthered the resale of these structured financial instruments. It was only a few weeks ago that they reacted with
downgrades, although the growing default rates in the U.S. mortgage market have been known for months.
The EU now intends to look into the regulation of rating agencies, the reliability of their ratings, their funding and their
handling of possible conflicts of interest. The fact that agencies are paid by the issuers of securities and not by investors
or other people who use their data is seen as being problematical in Brussels. The EU Commission is first waiting for a
report currently being prepared for it by the Committee of European Securities Regulators. [….]
Enron was also rated as a sound debtor for a long time.
After the Enron scandal in 2001 – the company had been rated as a sound debtor just a few weeks before its collapse –
there was already a discussion about regulation, said Richard Hunter of Fitch on Thursday. All those involved - including
the political establishment – were in agreement, he said, that it would make sense to regulate rating processes, but that
there would be no point in the government influencing methods and contents. On Thursday Moody’s reacted to the latest
attacks by merely offering discussions and cooperation. S&P made no comment at all.
Note. From: Busse & Ruhkamp (2007, August 16). Article adapted.
Advantages of ratings and rating agencies:

§ They help reduce information asymmetry between investors or other stakeholder groups and companies.
§ Condensing the assessment and information about creditworthiness into the form of a letter makes it
possible to classify the credit risk in a clear form.
§ A company's creditworthiness is monitored by rating agencies (rating outlook and watch list process), thus
providing a basis of information for taking preventative measures.
§ A serious assessment of creditworthiness takes a lot of time and this is done by rating agencies.
§ Ratings are often available free of charge and accessible to a broad public.
§ Rating agencies also use corporate information that is not available to the public, since companies disclose
confidential information to rating agencies while they are preparing a rating.

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Credit Rating 310
Disadvantages or points of criticism of ratings and rating agencies:

§ Certain details regarding the assessment models are not entirely transparent and available (business secret
of rating agencies)
§ Companies pay for a commissioned rating (conflict of interest).
§ S&P, Moody’s and Fitch have a dominant market position (oligopoly).
§ The timing of a premature rating adjustment can have a devastating effect on a company (falling share
prices, avoidance of the company as a business partner, etc.)
§ The timing of a belated rating adjustment can be harmful to the company's stakeholder groups.
§ Senior management at the rating agencies can be induced to accept an overvalued rating through wrong
incentives.
§ The ownership structures of Moody’s and S&P may affect their independence.
13.4 Summary
The basis of ratings:
In the business world, a rating is generally regarded as an estimation of a debtor's creditworthiness. A company's
rating contains a great deal of information, both quantitative (borrowing capacity) and qualitative (credit status).
This information is condensed into a ratio, which allows a simple statement to be made by means of a figure or a
letter on a predefined scale. The probability of default indicates the statistical probability, expressed as a percentage,
of whether or not the company will default on its payments of interest and principal. A credit default or event of
default is an event where the debtor is no longer able to comply with its obligations arising from a liability. The
causes of insolvency or a corporate bankruptcy may be of external or internal origin and are frequently not noticed
until very late or only after the fact. Credit ratings had their origin in the need to reduce information asymmetry
between investors and the management of US railway companies.
Ratings can be differentiated according to the rater, the object or subject to be rated (rating subject), the contractual
relationship between the rater and the rating subject (commissioned or not) and the observation period (short term or
long term). Banks regularly prepare internal ratings of their commercial borrowers in order to assess their
creditworthiness. Banks also prepare ratings for companies that have bonds outstanding on the capital market.
Industrial, trading or service companies sometimes use their own rating systems in order to assess their
counterparties by means of internal ratings.
External credit ratings:

The three rating agencies that dominate the market, S&P, Moody’s und Fitch, prepare issue ratings (financial
instruments) and issuer ratings (companies). Very often ratings are commissioned by companies. But rating agencies
can also prepare ratings without being commissioned to do so. Rating agencies also prepare country ratings.
External credit ratings are mainly intended for a broad circle of interested parties, or for the public, and serve to
reduce information asymmetry on the part of lenders. A credit rating expresses an opinion about a debtor's ability
and will to comply with its financial obligations under the terms of a contract. In addition, the rating makes a
statement about the credit quality and the probability of default. Rating agencies express opinions based on a
careful, analytical, complex and multi-level process. The calculation logic and the process for preparing external

Chapter 13:
Credit Rating 311
ratings are known as the rating methodology. This is not a scientifically exact process, but the creation of an
opinion. External ratings can be used for various purposes:
§ Investors are helped to make decisions (e.g. when investing in a company's shares and/or bonds)
§ Companies are helped to find access to capital (e.g. a large circle of investors)
§ Companies are helped to control the costs of capital (e.g. negotiating loans with banks)
§ Banks are helped to control credit (e.g. a bank's decision to grant a loan to a company)
§ Companies are assisted with financial marketing (e.g. negotiating private contracts)
§ Companies use ratings for purposes of self-analysis and accreditation (e.g. being approved for a contract)
§ Companies are helped to assess the counterparty risk
§ Regulatory institutions and stock exchanges are helped to assess risks, for instance
Ideally, the rating process can be roughly broken down into the following six phases:
1. Preliminary and informatory discussions
2. Analytical preparation
3. Main rating discussions and analysis of creditworthiness
4. Rating recommendation and judgment
5. Notification and publication, if applicable
6. Monitoring
In order ensure greater timeliness for static ratings and to warn investors in good time about possible rating changes,
additional instruments such as rating outlook and the watch list (rating reviews) have been introduced in addition to
rating categories.
§ Rating outlook: information about a possible direction for the development of a company's current rating
(time horizon: 6-24 months)
§ Watch list (rating reviews): companies on the watch list have a high probability of internal or external
events causing a permanent change in creditworthiness or in the rating (time horizon: 90-120 days)
Although rating agencies and external ratings are used a great deal and make a contribution towards reducing
information asymmetry, there is also criticism of the rating system.

Basler Ausschuss für Bankenaufsicht (2004, Juni). Internationale Konvergenz der Eigenkapitalmessung und der
Eigenkapitalanforderungen. Gefunden am 10.10.2013 unter http://www.bis.org/publ/bcbs107ger.pdf
Berblinger, J. (2007). Marktakzeptanz des Rating durch Qualität, In: Büschgen, H. & Everling, O. (Hrsg), Handbuch
Rating (2. Aktualisierte und überarbeitete Auflage). Wiesbaden: Gabler Verlag.
Cheng, M. & Aeamtiu, M. (2009). An empirical analysis of changes in credit rating properties: Timeliness, accuracy
and volatility, In: Journal of Accounting and Economics 47, 2009, S. 108-130.
Dimitrakopoulos, D. & Spahr, R. (2004). Ablauf des Ratingverfahrens bei internationalen Ratingagenturen, In:
Achleitner, A. & Everling, O. (Hrsg), Handbuch Ratingpraxis, Wiesbaden: Gabler Verlag
Everling. O. (Hrsg). (2008). Certified Rating Analyst. München: Oldenbourg.
Everling, O. (ohne Datum). Credit Rating. Aus: Gabler Wirtschaftslexikon. Gefunden am 09.10.2013 unter
http://wirtschaftslexikon.gabler.de/Definition/credit-rating.html

Chapter 13:
Credit Rating 312
Fitch. (ohne Datum a). About Us. Gefunden am 08.10.2013 unter

http://www.fitchratings.com/web/en/dynamic/about-us/about-us.jsp
Füser, K. & Heidusch M. (2003). Rating – einfach und schnell zur erstklassigen Positionierung Ihres
Unternehmens. Freiburg i.Br.: Haufe Mediengruppe.
Ghosh, S. (2013, 4. März). A Study of Differences in Standard & Poor’s and Moody’s Corporate Credit Ratings.
Gefunden am 08.10.2013 unter
http://www.stern.nyu.edu/cons/groups/content/documents/webasset/con_041250.pdf
Kisgen, D.J. (2007). The influence of credit ratings on corporate capital decisions, In: Journal of Applied Corporate
Finance, 19(3), summer 2007.
Langohr, H. & Langohr, P. (2009). The rating agencies and their credit ratings: what they are, how they work and
why they are relevant. Chichester: John Wiley & Sons.
Moody’s. (ohne Datum a). Ratings Definitions. Gefunden am 09.10.2013 unter https://www.moodys.com/ratings-
process/Ratings-Definitions/002002
Moody’s. (ohne Datum c). Ratingmethodik. Gefunden am 09.10.2013 unter
https://www.moodys.com/pages/default_de.aspx
Moody’s. (2009, Juni). Moody’s Rating Symbols and Definitions. Gefunden am 06.10.2013 unter
https://www.moodys.com/sites/products/AboutMoodysRatingsAttachments/MoodysRatingsSymbolsand%2
0Definitions.pdf
Reichling, P., Bietke, D. & Henne, A. (2007). Praxishandbuch Risikomanagement und Rating - Ein Leitfaden, 2.
Auflage. Wiesbaden: Gabler Verlag.
Schneck, O. (2008). Rating - Wie Sie Ihre Bank überzeugen. München: Vahlen.
Schwab & Keidel. (ohne Datum). Ratingarten. Gefunden am 11.10.2013 unter http://www.certified-rating-
analyst.de/glossar/Ratingarten.htm
Standard & Poor’s [S&P]. (without date). About Credit Ratings. Retrieved 08.10.2013
http://www.standardandpoors.com/aboutcreditratings/
S&P. (2013, 19. Nov.). Criteria. Corporates. General: Corporate Methodology. Retrieved 07.10.2013
http://www.standardandpoors.com/prot/ratings/articles/en/eu/?articleType=HTML&assetID=12453604077
21
S&P. (2013, 25. November). Standard & Poor's Ratings Definitions. Retrieved 07.10.2013
https://www.globalcreditportal.com/ratingsdirect/renderArticle.do?articleId=1221284&SctArtId=198387&f
rom=CM&nsl_code=LIME
Sylla, R. (2001). A Historical Primer on the Business of Credit Ratings. Retrieved 09.10.2013
http://www1.worldbank.org/finance/assets/images/historical_primer.pdf
Tec. (without date). Geschichte des Ratings. Retrieved 09.10.2013 http://www.tec7-
factoring.de/studien/bilanzrating/das-unternehmensrating/geschichte-des-ratings.html

Chapter 14:
Mergers & Acquisitions 313
Mergers & Acquisitions
In addition to organic growth, companies can also

grow inorganically by taking over other companies.
Various reasons can lead to the owner of a company
wanting to sell it or parts of it. There are also
different motives for buying a company. This
chapter is dedicated to these transactions, which are
summarized under the term Mergers &
Acquisitions. Central topics in M&A are the
analysis (Due Diligence) and valuation of
companies (how much should be paid for the
acquisition) as well as the planning and execution of
the integration that must be completed after the
purchase.
14.1 Introductory example Liechtensteinische Landesbank
INTRODUCTION: MERGERS & ACQUISITIONS
LLB expands business in Austria

With the acquisition of Semper Constantia Privatbank, the Liechtensteinische Landesbank increases its client assets by
CHF 17 billion.
The Liechtensteiner Landesbank (LLB) is following up its announcement on Monday with action and expanding its business
in Austria. To this end, it has acquired the Semper Constantia Privatbank, a private bank based in Vienna. The purchase price
amounts to approximately €185 million, consisting of equity and goodwill, and will be partially paid in cash and shares. The
LLB will use 1.85 millions of its shares for this purpose.
This transaction will increase client assets by around CHF 17 billion, as reported in a statement on Friday. The LLB would
then report a new business volume of CHF 75 billion and would continue to enjoy a very high level of financial stability and
security after the transaction.
At the beginning of the week, the LLB had already announced that talks would be held in Austria for acquisition-related
growth. In addition, the fund business is also to be expanded in Switzerland, it was announced on Monday. As part of its
"StepUp2020" strategy, the bank had set itself the goal of achieving a business volume of over CHF 70 billion by 2020. Georg
Wohlwend, Chairman of the LLB's Board of Managing Directors, said in the press release that this had now been

Chapter 14:
"significantly exceeded at an early stage".
The takeover will take place in two stages. It is expected that the LLB will take over Semper Constantia in July. In September
2018, Semper Constantia is planned to merge with LLB Austria to form Liechtensteinische Landesbank (Österreich) AG.
Bernhard Ramsauer will be CEO of the new subsidiary, with Gabriel Brenne to become Chairman of the Supervisory Board.
In 2019, Ramsauer will then move to the Supervisory Board of LLB Austria.
Alongside Liechtenstein and Switzerland, Austria is one of the three home markets of the LLB Group, and the takeover is
strategically justified. This means that the asset management business in the neighboring country will now be significantly
expanded and, following the merger, the company will be "optimally positioned" to continue growing.
The current major shareholders of Semper Constantia are also planning to acquire a stake of around 6% in the LLB. The
current Chairman of Semper Constantia's Supervisory Board, Karl Sevelda, will also be proposed for election as a member of
the LLB's Supervisory Board at the Annual General Meeting in May 2018.
Article in the illustration edited. From: Finance and Economy (2017, 22 December).
1. What were the motives for buying Semper Constantia?
2. How does one value a company?
3. How did LLB finance the acquisition?
4. Are there other ways to finance a company acquisition?
14.2 Introduction Mergers & Acquisitions
LEARNING OBJECTIVES

• Knowing and being able to describe the term M&A
• Understanding the reasons for buying and selling companies
• Knowing possible reasons for the failure of M&A
14.2.1 Fundamentals and terminology of M&A
The term M&A stands for mergers and acquisitions and serves as a collective term for a wide variety of company
transactions. From the point of view of buyers and sellers, there are a multitude of motives for carrying out M&A
activities. For example, on the buyer’s side, the purchase of know-how can be a motive, while on the seller’s side,
an unclear succession arrangement can lead to a transaction. The reasons for M&A from the buyer's and seller's
point of view will be discussed on the following pages.
Figure 147: Phases of the M&A process
Pre-M&A Phase M&A Phase Post-M&A Phase
Integration and
Preparation Phase Transaction Phase
Disintegration Phase
Own illustration

Chapter 14:
M&A activities have been increasing for many years. The main objective here is to generate additional value for
shareholders. However, studies show that this is not the case for more than 50% of acquisitions. Causes can be
located in all three phases of the M&A process:
Looking at global M&A activities since the mid-1980s, it can be seen that the number of transactions increased
sharply in the 1980s and 1990s, and stabilized somewhat in the current decade. On the other hand, stronger
fluctuations can be seen in the value of transactions. During the boom years, the value of transactions also rose
sharply. This can partly be explained by the fact that many deals contain a share component. This means that part of
the purchase price is paid with own shares of the buying company. These own shares of the buying company are
also valued more strongly in economically strong times, which makes it possible at all to finance the higher
transaction prices.
Figure 148: Global M&A activity
Note. IMMA (2018a).
In Switzerland, a strong increase can be observed, in particular during the years before 2000 and before 2008. With
the bursting of the dotcom bubble in the 2000s and the escalation of the financial crisis in 2008, both the valuation
and the number of transactions fell sharply.
Figure 149: M&A activity in Switzerland
Note. IMMA (2018b).
In addition, differences can also be observed in the various sectors. Certain industries are much more active in M&A
than others:

Chapter 14:
Figure 150: M&A by industry (number of transactions, globally, since 1985)
Note. IMMA (2018c).
It is also interesting to take a look at the largest transactions in history. Contrary to intuition, the largest takeover did
not take place in the USA but in Germany:
Figure 151: The largest business transactions of all time
Transaction value
Rank Year Buying Company Target
(in billion USD)
1 1999 Vodafone AirTouch PLC Mannesmann AG 202.79
2 2000 America Online Inc Time Warner 164.75
3 2015 Altice Sa Altice Sa 145.71
4 2013 Verizon Communications Inc Verizon Wireless Inc 130.30
5 2007 Shareholders Philip Morris Intl Inc 107.65
6 2015 Anheuser-Busch Inbev SA/NV SABMiller PLC 101.48
7 2007 RFS Holdings BV ABN-AMRO Holding NV 98.19
8 1999 Pfizer Inc Warner-Lambert Co 89.17
9 1998 Exxon Corp Mobil Corp 78.95
10 2000 Glaxo Wellcome PLC SmithKline Beecham PLC 75.96

Note. IMMA (2018a).
This record transaction dates back several years and went down in German economic history as a spectacular
takeover battle:
Example: VODAFONE TAKES OVER MANNESMANN
The takeover battle

Mannesmann defended itself against Vodafone for months on end — and already took care of the financial security of
its management during the negotiations.
28 May 1999: Klaus Esser replaces Joachim Funk as CEO of Mannesmann, Funk is Chairman of the Supervisory Board.
1 November 1999: Mannesmann acquires Orange, the third-largest British mobile communications operator, for the
equivalent of more than 30 billion euros. Esser not only wants to improve the market chances of the Düsseldorf-based
company but also to deter potential buyers — already at this point there are rumors about the interest of British competitor

Chapter 14:
Vodafone in a takeover.
The Germans are paying Orange's top managers recognition bonuses in the millions. After the share swap, the Chinese
businessman Li Ka Shing, owner of the Hutchison Whampoa conglomerate and to date Orange's major shareholder, is
Mannesmann's largest single shareholder.
14 November 1999: Vodafone CEO Chris Gent proposes a merger with Mannesmann. Esser rejects it.
16 November 1999: Gent announces a hostile takeover if no friendly merger comes off.
19 November 1999: The Vodafone CEO announces the terms of his takeover bid, which was to be valid from 24 December to
7 February 2000: Gent offers 53.7 Vodafone shares per Mannesmann share, which totals some 124 billion euros — the largest
takeover bid in economic history to date.
December 1999: Parallel to the defense against the Vodafone offer, Mannesmann is discussing how to financially secure the
management team in the event of a takeover. This also involves the compensation of pensioners.
3 December 1999: Shareholder representatives apply to the Düsseldorf Regional Court for a temporary injunction: The
Mannesmann Management Board should not take any measures that run counter to the interests of the shareholders. The
Regional Court rejects the application.
Early January 2000: The Mannesmann management plans to grant at least the employees of the Friedland project a
"shareholder value bonus". The Friedland project was initiated at the end of the 1980s when Thyssen AG tried in vain to gain
a majority stake in Mannesmann. Since 1998, the project staff have been working with external consultants to develop defense
strategies in the event of a hostile attack.
10 January 2000: Mannesmann shares rise on rumors that the French conglomerate Vivendi, with which Esser has apparently
been negotiating for some time, will come to the aid of the Düsseldorfers. On the same day, Esser proposes to the chairman of
the supervisory board, Funk, to set up a fund of five to 10 million euros in order to honor the performance of the employees of
the Friedland project if the takeover is successfully fended off. In the event that Vodafone is successful, however, only
proportional bonuses should be paid out.
30 January 2000: In the morning, Gent and Esser meet at the airport in Paris to again discuss the possibility of a friendly
takeover — without result. In the afternoon, Vivendi and Vodafone instead announce that they will cooperate in the future.
31 January 2000: Esser confirms to the Supervisory Board that the agreement between Vodafone and Vivendi has weakened
Mannesmann's position. Only the media group AOL/Bertelsmann, with whom Esser has also been negotiating for some time,
can now be considered as an ally.
1 February 2000: Gent and Esser meet at the Industrieclub in Düsseldorf. Esser demands for the Mannesmann shareholders a
52 percent share of a united company, but Gent remains with the 49 percent already offered at the end of January.
2 February 2000: Events are now developing rapidly. Canning Fok, who arrived from Hong Kong to represent the interests of
major shareholder Hutchison Whampoa and sits on the Mannesmann Supervisory Board, is striving for a peaceful solution
with Vodafone. Until now, he had supported Esser in his defensive struggle.
The reason for the change of heart: Since the beginning of the takeover battle, Mannesmann shares have risen significantly.
The 10 percent share that Hutchison received in exchange for the Orange shares has since risen in value by eight billion euros.
In order to realize these profits, however, Hutchison needs Esser's approval of the takeover. When Orange was acquired, it
was agreed that Hutchison would have to hold Mannesmann securities for at least one year. Only if Mannesmann agrees to a
takeover may Hutchison sell part of the shares prematurely. The Chinese are now afraid that they could suffer substantial
losses in the event of long negotiations and a hostile takeover.
In this situation, Hutchison's representative Fok uses a tried and tested method: After consulting with his boss Li Ka Shing, he

Chapter 14:
proposes that Esser receive a premium of 10 million British pounds (equivalent to around 15 million euros) as recognition.
Another 10 million pounds are to go to Esser's team. That same evening, Esser and Gent reach an oral agreement on the
conditions for a friendly takeover. Esser breaks off talks with AOL/Bertelsmann.
3 February 2000: The Vodafone and Mannesmann consulting teams negotiate the details of the agreement throughout the
day. The special payments to Mannesmann's management team are not the problem because Gent made it clear that Vodafone
would not pay anything; if premiums or bonuses were to flow, it would be Mannesmann's business. They must therefore be
decided before the takeover; the parties involved understand the point in time when the takeover becomes official to be the
approval of the Mannesmann Supervisory Board for the agreement with Vodafone.
4 February 2000: Haste is the order of the day. The Supervisory Board meets at 12.30 pm. In an adjoining room, the
Committee for Management Board Matters decides on bonuses. In addition to Funk, the members of this committee include
Josef Ackermann, the current head of Deutsche Bank, Klaus Zwickel, the former head of the IG Metall union, and Jürgen
Ladberg, Mannesmann's group works council chairman. Ladberg is absent due to illness, Zwickel is connected by telephone.
Within a few minutes, Ackermann and Funk distribute "recognition bonuses" amounting to around 30 million euros. Zwickel
raises no objection. Approximately 4.6 million euros have been earmarked for Funk, almost 10 million euros for members of
the defense team. Esser himself will receive a good 16 million euros — together with his severance payment, it will amount to
more than 30 million euros to sweeten his defeat.
The million-euro bonuses are not an issue at the meeting of the Supervisory Board. The Supervisory Board approves the
agreement with Vodafone: The British group acquires Mannesmann for around 180 billion euros. Mannesmann shareholders
hold a 49.5 percent stake in the new company. The two-month defensive battle cost the traditional company at least 200
million euros.
11 February 2000: The public learns about the windfall for Esser. "60 million DM and goodbye", reads the headline in Bild.
24 February 2000: A Stuttgart law firm files a criminal complaint, claiming suspicion of breach of trust.
27 March 2000: The Supervisory Board Committee for Management Board Matters decides: The retired members of the
Board of Management and their relatives receive payments amounting to approximately 32 million euros.
Article in the illustration edited. From: Süddeutsche Zeitung (2010, 11. Mai).
14.2.2 Reasons for M&A
To answer the question of why companies are bought and sold, a distinction must be made between two
perspectives: that of the buyer and that of the seller.
14.2.2.1 Reasons for buying companies
With the purchase of a company, an attempt is made to achieve added value. This added value of the acquired
property should be greater than the price paid and can result from various factors:
§ Fixed cost reduction and economies of scale: The size gained after a transaction allows a company to
benefit from various economies of scale. In this way, synergy effects can be exploited and efficiency
increased, as savings can be made in group-wide functions, for example. Many functions are independent
of the size of a company, which is why they are duplicated after a merger/acquisition and can be rationed
away, saving costs. In addition, a larger company can benefit from economies of scale and greater
bargaining power. The learning effects described above are faster than those of the competition, for
example thanks to the larger production volume. With the takeover of Bank Cler, the Basel Cantonal Bank

Chapter 14:
aims to achieve economies of scale, as stated in a media release of 20 June 2018: "Furthermore, the
complete takeover will enable economies of scale in operations, investment and innovation to be
consistently realized, thus strengthening the competitiveness of the Basel Cantonal Bank".
§ Qualified employees: The aim of a takeover can also be to take over employees with specific know-how.
It is often easier to purchase them in bundles than to build them up within the company itself.
§ Access to competencies and resources: Potential added value through an acquisition is not limited to the
know-how of employees but can also lie in company-specific competencies and resources. This can be, for
example, a specific process for the production or refinement of a material or unique sources of supply and
suppliers. A classic example is the pharmaceutical industry, in which external developments are regularly
purchased from startups (this also has the advantage that purchased R&D expenses can be capitalized,
whereas this is difficult for in-house developments due to accounting standards).
§ Diversification: As part of a group's portfolio strategy, previously untapped business areas can be acquired
through acquisitions in order to diversify risks. These can be independent business units, or a company can
expand its depth of value creation in this way, as a larger part of the value chain is now covered within the
group. For example, in 2014 Geberit has expanded its product range with the acquisition of Sanitec and at
the same time opened up new geographical markets (see chapter 11.7).
§ Tax advantages: The acquisition of a company may possibly result in tax advantages for the group. For
example, loss carryforwards of the purchased object can be utilized: Depending on the country, tax
legislation allows past losses to be offset against profits. If, for example, a company has a loss carryforward
of CHF 1 million, the acquiring company can take it over depending on the structure of the transaction and
thus has to pay CHF 1 million less tax on its profits. In addition, transfer prices (sale of goods within a
group of companies) allow for profit shifts within the group. This makes it possible to tax profits where low
tax rates prevail. However, new OECD guidelines (BEPS) attempt to minimize these profit shifts.
§ Improving market position: A takeover can also have the aim of improving market position. For
example, a competitor can be eliminated by the purchase. It may even be possible for a company to become
the market leader. If, for example, the number 2 in a market takes over the number 3 and thus becomes
larger than the number 1, the company has both one less competitor and, at the same time, has taken over
the market leadership. In principle, the improvement of the market position can also be achieved by
entering new markets. For example, with the AB InBev brewery and the takeover of SABMiller (see largest
transactions in history), the number 1 in the global beer market took over the number 2, making it the
undisputed market leader to this day.
§ Get a bargain: A takeover can also have the aim of acquiring a company at a favorable price. For
example, if the market value of a company is lower than the value of its net assets, an active investor could
acquire that company and make a profit by liquidating it.
§ Increase in shareholder value: The aim of a takeover is always to increase shareholder value. For
example, a higher margin in the course of a takeover can result in a higher profit.

Chapter 14:
14.2.2.2 Reasons for selling companies
Just like the buyer, sellers have a variety of motives as to why they would look to sell a company:
§ Concentration on core competencies: Can be seen as a counter motive to diversification. In different

waves of trends, companies try to diversify or focus on their core competencies. Various studies show that
companies that diversify too much destroy value. By focusing on core competencies, a higher return can
often be achieved than in a highly diversified business model. ABB is currently focusing its business model
in a strategic realignment and selling its power grids division to focus on digital industries (ABB, 2018).
§ Survival strategy: If a company is in crisis, it can strengthen its capital base by selling individual units and
possibly even gain strategic partners.
§ Lack of succession arrangements: Owner-managed companies are often faced with the challenge of what
happens after the founder leaves the company. A sale can thus ensure the continued existence of the
company and at the same time the retirement provision of the founder.
§ Location concentration: Due to lower logistics costs, it can make sense to consolidate production
locations. The simplification of cross-border activities further reinforces this motive.
§ Privatization of the public sector: Many state-owned enterprises have been privatized in recent decades.
In this way, the public sector can reduce debt and at the same time surrender tasks that can also be
performed by market-oriented companies in order to concentrate on main fields of activity. Examples of
this in Switzerland are Swisscom, the Swiss Federal Railways and the Swiss Post, which have been
(partially) privatized. Many other countries have also privatized telecom and railway companies in the past.
§ Direct approach: Investment banks in particular try to identify potential in the market and may initiate a
deal by approaching one of the two parties. Other consultants can also encourage companies to take on an
acquisition activity by approaching them directly. This can represent a further cause of company sales apart
from economic reasons.
14.2.3 Reasons for the failure of M&A
Various studies show that the desired added value cannot be achieved with a large number of transactions. Some
studies even assert that fewer than half of all company acquisitions are successful. According to Jansen (2016, p.
377), the reasons for failures can be located in three fields:
(1) Overoptimistic assessment of the situation: Excessive optimism leads to an overestimation of synergy
potentials and, as a result, to paying too high of a purchase price.
(2) Inadequate planning process: Errors and inadequacies in the planning phase are another cause of failed
transactions. This can be due, for example, to inadequate market and company analyses or the lack of
preparation and planning for the individual M&A phases. Furthermore, a lack of coordination of the
subplans with the corporate strategy can also lead to failed transactions.
(3) Personnel, cultural and organizational integration problems: In many cases, cultural differences
between two companies are also underestimated. This is reflected in a lack of integration planning and in
personnel problems in the course of integration.

Chapter 14:
14.3 Due Diligence
LEARNING OBJECTIVES

• Knowing and being able to describe the term due diligence
• Understanding the need for due diligence in company acquisitions
A company transaction is characterized by uncertainty and information asymmetries. The seller knows the object to
be sold (often also: target) very well, while a potential buyer needs information before a purchase decision, for
example to be able to estimate risks and determine the purchase price. This is why due diligence plays an important
role in M&A transactions. The takeover target11 must be analyzed in detail before the contract is concluded in order
to identify all pitfalls and inherent risks. The topics identified in the due diligence form the basis for the contract
negotiations:
Figure 152: Ideal-typical M&A process
Buyer Formulate Locate Investigate Negotiate Integrate
Approach
Preparation Selection Negotiate
Seller Investors
Effective date of the transaction

Contract negotiations
Analysis in data room
Price and conditions

Letter of Intent
Due Diligence
Preliminaries
Form legal base
Press Releases
Mutual interest
Signing
Closing
Note. Own illustration (2018).
But what does due diligence actually mean? Due diligence is defined as the "careful examination and analysis of a
company, in particular with regard to its economic, legal, tax and financial circumstances, carried out by a potential
buyer of a company" (Gabler Business Dictionary, 2018). Obtaining the relevant information makes it possible to
identify and assess risks and to form an opinion on the expediency and profitability of the planned transaction.
Following careful due diligence, any guarantees and warranties to be asked of the seller can be estimated.
On this basis, a decision can be made on the purchase of the company. The due diligence is therefore the basis for
contract negotiations and integration plans. A purchase price can only be determined once the relevant information
has been identified.
In practice, finding the relevant information is a major challenge. Huge amounts of data must be analyzed within a
short period of time and possible risks identified. Due diligence is usually carried out by a team of employees,
supplemented by consultants and experts such as lawyers or experts. The findings are recorded in a due diligence
report.
The due diligence can be divided into different sections. Depending on the target and industry, some areas are more
important than others.
11
The takeover target can also be a part of a company or a division.

Chapter 14:
Figure 153: Main areas of due diligence
Basic Strategic External

Due Diligence Due Diligence Due Diligence
Basic company data Business objectives and overall strategy Economics analysis
History of the company Acquisition strategy Socio-demographic analysis
Other general information Assessment of acquisition synergy Legal and political
potential framework conditions
Financial Marketing HR Legal & Tax Environmental Organizational &

Due Diligence Due Diligence Due Diligence Due Diligence Due Diligence IT Due Diligence
Accounting Sales organization Management Internal legal Environmental Outsourcing

systems and structures regulations
organization Prices and Employees Organization
External legal
Annual reports conditions structures Products and
and planning production Information
Industry Effects on
Legal disputes process Technology
Analysis of competition employees
internal and growth Tax-optimized
contract design Contamination
performance Valuation
management Tax risks Fact of depletion
Note. Own illustration (2018).
Financial due diligence plays a central role. Findings from other areas, such as taxes, production or environment,
influence financial due diligence. Internal and external accounting are analyzed with regard to historical earnings
and financial position as well as planned values. The company valuation is based on the accounting values.
Identified facts from other areas play a particularly important role in financial due diligence. For example, have
appropriate provisions been made for tax or environmental risks? If this is not the case, there is a risk that the
provision will be recognized in profit or loss in the future and the purchase price must be adjusted accordingly or the
risk transferred to the seller by way of guarantees.
Problems in financial due diligence can have various causes. However, the core problem always lies in identifying
the actual net assets, financial position and results of operations. Particular attention must be paid to the following
problem areas:
§ Inventory evaluation: Is the inventory correctly evaluated or, for example, have necessary depreciations
not yet been made? Is the inventory valuable?
§ Valuation of receivables: Are the receivables recoverable? Are the receivables based on actual events and
are they not invented?
§ Bad investments / investment backlog: Have necessary investments been made or will they have to be
made up for to a large extent in the near future?
§ Supplier / customer dependencies: Are there (too) large dependencies on certain suppliers or customers?
§ Management quality: What is the quality of management? Does it have to be replaced after a takeover?
§ Environmental liabilities: Are there obligations arising from environmental protection measures or risks
of a penalty payment from past events?
§ “One-time" results: Are "one-off expenses" really one-off or are they in reality regularly recurring
expenses?
§ “Window dressing”: Have any measures been taken to put the company in a better light? For example,
have hidden reserves recently been released or have write-downs and provisions not been made?
§ Pension obligations: Are the pension obligations shown correctly? Is the amount correct?
Chapter 14:
§ Tax liabilities: Are there any tax liabilities? Are deferred taxes reported correctly? Are there any tax risks?
§ Special agreement: Are there special agreements (typical in family businesses) with employees, suppliers,
customers or other business partners (unusually long-term contracts, unusually high wages, etc.)?
§ Lack of financing / security of planned figures: Are there indications of poor quality in finance and
accounting? Are the budgets plausible?
§ Tax-oriented presentation: Is the presentation based on a true and fair view or a commercial or tax-
oriented presentation (with hidden reserves, typical for SMEs)?
The result of the due diligence is a due diligence report, which makes a statement about chances and conditions for
the realization of a market value increase. The results from the various sub-areas are divided into three categories
after completion of the due diligence:
Deal-breaker
Findings on the basis of which a transaction does not seem feasible or no longer feasible in the
form originally planned (e.g., liability cases threatening the existence of the company)
Need-to-know
Results that relate to the actual value drivers of the target and represent the focus of the due
diligence (e.g., quality and quantity of human resources, areas in which synergy effects can be
achieved, etc.)
Nice-to-have
Information that does not relate to the focus of the due diligence but is generally advantageous
for the assessment of the transaction (e.g., current market information, number of serious
bidders, etc.)
14.4 Company valuation
LEARNING OBJECTIVES

• Understanding the difference between price and company value
• Knowing and being able to apply different business valuation methods
In the following, various methods will be presented to calculate the value of a company. It is important to
understand that the calculated company value rarely corresponds to the price paid afterward. The price is rather to be
understood as the result of the negotiations, while the calculated enterprise value represents the basis for the price
negotiations. The negotiations are influenced by general conditions, such as the economic situation, the motives of
the parties and negotiating skills. Nor is company valuation an exact science. Different methods can lead to different
results. Subjective input factors such as a discount rate can also have a very large impact on the result. For a
valuation, therefore, a mix of methods, supplemented by sensitivity analyses, must be used and the result presented
as a valuation range (Hauser & Turnes, 2014, p. 24).

Chapter 14:
Figure 154: Pricing in the M&A process
Demand and supply
Negotiations skills
Negotiation environment Price
of partners
Interests and motivation of Company valuation Current state of the

negotiation partners Basis for price negotiations financial markets
Subjective expectations and

projections regarding company,
industry and economic situation
Note. Hauser & Turnes (2014, S. 24)
Since the 1920s, various methods have been used for company valuations. In the case of transactions by SMEs, a
mix of the net asset value and German income approach is generally used; in the case of larger transactions by larger
companies, a mix of the DCF and multiplier methods is used.
Valuation approach The calculated company value corresponds to …
Net asset value (1920) the actual book value.
Earning power (1940) the capitalized, future (constant) income.
the current market or stock capitalization

Market efficiency (1950)
ð Number of shares multiplied by current share price
a reference figure from the annual financial statements (e.g., EBITDA) multiplied by a
Multiplier method (1960)
market multiple (e.g., EV/EBITDA).
DCF method (1970) the sum of the discounted free cash flows (FCF).
EVA method (1990) the sum of discounted excess profits (Economic Value Added) and invested capital (IC).
14.4.1 Net asset value method
The calculation using the net asset value method has already been explained in this book as part of the calculation of
goodwill. The net asset value corresponds to the book value of equity:
Figure 155: Net asset value method
Liabilities &
Assets Equity
Revalued Current
Current Liabilities
Assets
Gross Asset Non-current

Value Liabilities
Revalued
Non-current
Assets Net Asset
Equity
Value
Note. Own illustration.
The net asset value method is an inventory-based method, which excludes any increase in equity due to future
profits. The net asset value method is therefore used in practice as the sole method for company valuation only in

Chapter 14:
exceptional cases (e.g., purchase of production capacities). Rather, the net asset value is to be understood as the
lower limit for the selling price under the going-concern assumption. In the case of a planned liquidation of
companies or parts of companies, various assets may be valued at large discounts, which is why the liquidation
value may be lower than the net asset value under the going-concern assumption.
14.4.2 Practitioner method
In the so-called practitioner method, which is used for the valuation of SMEs, the intrinsic value also plays a role in
practice. The enterprise value according to the practitioner method is calculated as follows, according to Hauser and
Turnes (2014, p. 78):
2 ∗ 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 + 1 ∗ 𝑆𝑢𝑏𝑠𝑡𝑎𝑛𝑐𝑒 𝑣𝑎𝑙𝑢𝑒

𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑣𝑎𝑙𝑢𝑒 =
3
For the capitalized earnings value, the expected net profits of the company are discounted (the procedure
corresponds to that of the DCF method, see below). The capitalized earnings value thus corresponds to the value of
a perpetual annuity. By linking the capitalized earnings value and the net asset value, weaknesses of the net asset
value method (no consideration of the future) can be avoided in a pragmatic compromise. Due to the simplicity and
comprehensibility of the method, it is widespread in the German-speaking SME environment (Hauser & Turnes,
2014, p. 79).
14.4.3 DCF method
To calculate company value using the DCF (discounted cash flow) method, the company's expected free cash flows
are discounted on the basis of long-term planning. The free cash flow before interest and dividends is used to
calculate the company value (Attention: the formula differs from the internal view, where a minimum dividend is
deducted, see chapter 11.4.7):
Figure 156: Free cash flow DCF method
In the DCF method, the cash flows that are generally available to all investors (debt and equity investors) are
discounted (Hauser & Turnes, 2014, p. 82). The tax-adjusted weighted cost of capital (tax-adjusted WACC) is used
as the discount factor for the DCF method, as the borrowing costs are tax-deductible. The weighted cost of capital is
used because the gross company value (value of total capital, i.e. the sum of equity and debt) is calculated (Hauser
& Turnes, 2014, p. 91).

Chapter 14:
Figure 157: Tax-adjusted WACC as discount factor for DCF method
For valuation purposes, free cash flows are forecast for a certain period. This is based on the financial reporting of
the company being valued and its planned values. As this method is very costly for certain periods due to the
adjustments to be made and is characterized by a high degree of uncertainty for the distant future, free cash flows
are only forecast for a certain period (usually up to 5 years).
After this period, the so-called terminal value is used. This assumes that the free cash flow of the simulated period
will be accrued for all future periods and is calculated as a perpetual annuity (discounted value of all future free cash
flows). A growth rate g can also be assumed for the calculation of the terminal value. This expresses that the free
cash flows increase annually by a certain growth factor.
Figure 158: DCF method with Terminal Value
The terminal value must also be discounted with the WACC, since it is a value in the future. The discount factor for
the TV corresponds to that of the last calculated period: If five periods are calculated, the FCF5 and the TV must be
discounted with the factor (1+WACC) 5. The following example illustrates the calculation:
Figure 159: Calculation of net company value using the DCF method

Chapter 14:
In summary, the DCF method forecasts and discounts free cash flows (before interest and dividends) for a certain
period of time. For all periods after the estimated period, the terminal value is calculated, which must also be
discounted. The company value calculated in this way with the tax-adjusted WACC is to be understood as the gross
company value, i.e. the valuation of the total capital of the company. If the value of the equity capital is to be
calculated, the value of the borrowed capital must be deducted, as this is usually shown in the balance sheet at
market value. The following diagram summarizes the discussed followed by a step-by-step instruction which shows
the DCF Valuation graphically.
Figure 160: DCF calculation of gross and net company value
Step-by-step instruction for DCF valuation
In order to approach and explain the previous discussion of DCF valuation from a different perspective, the
following paragraphs offer a step-by-step instruction for DCF calculation method. The DCF calculation starts with
planning of Free Cash Flows (i.e. planned of future financial statements). The Free Cash Flows are planned in detail
for a certain number of years, e.g. 3 to 5 years, for the later years typically a stable development of Free Cash Flow
is planned, e.g. stable (growth of 0%) or constant growth rates (such as 2% or 5% annual growth of Free Cash
Flows). The following step-by-step instruction uses a detailed planning period of 5 years, with a growth of 0% for
all following periods until eternity (i.e. all Free Cash Flows after the year 5 are the Same as the Free Cash Flow of
year 5, so FCF5), see figure below. The formula for calculation of the net company value using the DCF calculation
method, which shall be explained step-by-step in the following paragraphs, is:
e
FCF® TV²
CV(net) = - + − debt
(1 + WACC®¯° )® (1 + WACC®¯° )²
g³o

Chapter 14:
Figure 161: initial situation DCF calculation (zero growth after detailed planning period)
()(* 343 ()(5 × +,?

CV net = ∑678+ + − debt TV3 = (ℎCDC: F = 0)
+,-.))*/0 1 +,-.))*/0 5 -.))*/0@?
Detailed planning period
FCF1 FCF2 FCF3 FCF4 FCF5 FCF6 FCF7 FCF8 ∞

Step 1: the Free Cash Flow of each of the five periods of detailed planning is discounted individually. With this step,
the present value (i.e. discounted value) of each Free Cash Flow is calculated, and then added to the total present
value of all 5 discounted Free Cash Flows. The figure below explains this calculation graphically. This discounting
formula explains the first part of the DCF calculation formula.
e
FCF®
-
(1 + WACC®¯° )®
g³o
Figure 162: Discounting of detailed planning periods

FCF.
1 + WACCtax .
FCF-
1 + WACCtax -
FCF,
1 + WACCtax ,
FCF+
1 + WACCtax +
FCF#
1 + WACCtax #

4546 >?> 454@ × 78J
CV net = ∑ABC7 = + @ − debt TV> = (ℎNON: Q = 0)
789:556;< 789:556;< 9:556;<KJ
Step 2: for the totality of all years after the detailed planning period (i.e. year 6 to eternity), the so called Terminal
Value is calculated. Mathematically, this is a calculation of perpetuity (i.e. discounted annual Free Cash Flow until
eternity as annual amount/interest):
FCF² × (1 + g)
TV² = here: g = 0
WACC®¯° − g

Chapter 14:
Figure 163: Calculation of Terminal Value
FCF'
TV# =
WACCtax
0102 ;<; 010= × 34F

CV net = ∑>?@3 + − debt TV; = (ℎJKJ: M = 0)
345611278 9 345611278 = 5611278GF
Step 3: the formula of the previous step discounts the Free Cash Flows of the periods 6 to ∞ onto period 5.
Therefore, the Terminal Value calculates the present value at t=5, but not yet t=0. Hence, this steps calculates the
present value of the Terminal Value by discounted the Terminal Value with t=5. This then finalizes the second part
of the DCF calculation formula.
TV²
(1 + WACC®¯° )²
Figure 164: Discounting Terminal Value
TV'
1 + WACCtax '
Reminder (previous step):

FCF'
TV# =
WACCtax

2324 <=< 232> × 56G
CV net = ∑?@A5 + − debt TV< = (ℎKLK: N = 0)
56783349: ; 56783349: > 783349:HG
Step 4: the gross company value is now calculated by adding the sum of the five individual discounted cash flows to
the present value of the Terminal Value. The net company value is calculated by further deducting the debt value
according to the statement of financial position (modern financial reporting requires debt to be disclosed at market
value, which is a prerequisite to use debt in combination of the present value calculations of Free Cash Flows).

Chapter 14:
14.4.4 EVA method
The EVA method can also be used for company valuation (see above for the calculation of the EVA). The EVA is to
be understood as residual profit, since the total capital costs (equity and borrowing costs) are deducted from the
operating profit (NOPAT). For illustration purposes, the EVA calculation methods already discussed are shown
again below:
Figure 165: EVA approach
EVA NOPAT Cost of capital
WACC is used to
Economic value Net operating profit
calculate cost of
added after taxes capital
EVA ROCE WACC NOA
Economic value Return on capital Weighted average

Net operating assets
added employed cost of capital
For the company valuation, the procedure is very similar to the DCF procedure. EVA values are forecast
individually for a certain number of periods. For all subsequent periods, a terminal value is again calculated and
discounted. Since only the excess profits are calculated, the operating assets (NOA) at time 0 must be added to the
excess profits. As with the DCF method, borrowing costs must be deducted from the net company value:
Figure 166: Calculation of company value using the EVA method
Formula for Company Value calculation with EVA method and TV

3
EVAt TVT
CV net = NOA* + , + − debt
1 + WACCtax 2 1 + WACCtax 8
456
Terminal Value as eternal EVA without growth

EVA8
TV8 =
WACCtax
Wolfgang Lücke has shown that the EVA method theoretically leads to the same result as the DCF method (cash
flows correspond to profit flows when viewed as a whole). This reconciliation is therefore also known as the Lücke
theorem. Nevertheless, it should be noted that there are relevant differences between the two approaches:
§ The DCF method considers cash flows, while the EVA method considers profit flows.
§ The DCF approach incurs investments immediately as cash out-flows. The EVA approach takes
investments only into account later in the form of depreciation and precisely calculated capital costs.
§ With the EVA method, the share of terminal value is significantly lower than with the DCF method, which
also reduces the forecasting error.

Chapter 14:
Figure 167: Example of company valuation using the EVA method
t=1 t=2 t=3 t=4 t=5 TV
NOA 1 000 1 200 1 150 1 300 1 500
WACCtax 10%
NOPAT 150 210 170 200 170
Cost of capital 100 120 115 130 150
EVA 50 90 55 70 20 200
Discounted EVA 45.5 74.4 41.3 47.8 12.4 124.2

Gross Company
NOA0 + discounted EVA + TV = 1 000 + 221.4 + 124.2 = 1 345.6
Value
Debt 200
Net Company
1 145.6
Value
Year 1 Year 2 Year 3 Year 4 Year 5 Year 5 ff.

EXAMPLE
Invested Capital (IC) 100.0 120.0 115.0 130.0 150.0 150.0
Turnover 150.0 175.0 188.9 181.8 170.0 170.0

EBIT 25.0 35.0 28.3 33.3 28.3 28.3
Taxes 40% 10.0 14.0 11.3 13.3 11.3 11.3
NOPAT 15.0 21.0 17.0 20.0 17.0 17.0
An EVA valuation can be carried out from this information:

NOPAT 15.0 21.0 17.0 20.0 17.0 17.0
Capital costs (WACC 10%) 10.0 12.0 11.5 13.0 15.0 15.0
EVA 5.0 9.0 5.5 7.0 2.0 2.0
Present value EVA 22.1 (17%)

Terminal Value 12.4 (9%) (20.0)
Invested Capital 100.0 (74%)
Entity Value 134.6 (100%)
With a few additional details, the initial situation can also be assessed using the DCF method:
NOPAT 15.0 21.0 17.0 20.0 17.0 17.0
Plus depreciation 5.0 5.0 5.5 5.5 5.5 5.5
Minus investments 25.0 0 20.5 25.5 5.5 5.5
Free Cash Flow -5.0 26.0 2.0 0.0 17.0 17.0
Present value Free Cash Flow 29.0 (22%)

Terminal Value 105.6 (78%) (170.0)
Entity Value 134.6 (100%)
From: Hoke, 2002, S. 767.
This example illustrates the differences between the two methods. As already mentioned, the DCF method considers
cash flows. Due to the initial investment, this leads to a negative free cash flow at the beginning of the analysis. The
EVA method, on the other hand, takes profit flows into account. Depreciation is spread over the term of an
investment, which is why the annual profit flows are distributed more evenly than the cash flows.
It should also be noted that the terminal value using the EVA method is significantly lower than using the DCF
method. This is partly due to the fact that the EVA method takes NOA into account and only calculates the excess
profit. So the EVA method uses a better forecast quality, while the DCF method result is largely influenced by the
terminal value, which is calculated on the basis of estimates far in the future.

Chapter 14:
Figure 168: Comparison of EVA and DCF methods
The example also shows that the two methods should lead to the same result. In practice, on the other hand, both
methods require various assumptions to be made, which ultimately means that this is usually not the case in practice.
It is therefore worth using a mix of methods to calculate a range of company values.
14.4.5 Multiplier method
The multiplier method is very widespread in practice, due to its simple applicability. In addition, it is argued that the
multiplier method can be used to make an objective assessment based on market valuations of comparable
companies. To use the multiplier method, a portfolio of comparable companies is compiled in a first step. Various
criteria can be used to select comparable companies (Hauser & Turnes, 2014, p. 151):
§ Industry affiliation
§ Sales and cost structure (cf. operating leverage)
§ Capital structure (cf. financial leverage)
§ Size and diversification of the company
§ Competitive strategy
§ Phase in the company life cycle
§ Liquidity and diversification of shares, if listed
§ Tax and legal framework conditions
In a second step, various multiples are calculated for this portfolio. To calculate a multiple, the company value
(market valuation of the company, i.e. the number of shares multiplied by share price) is compared with various
reference values. Frequently used benchmarks are, for example, sales, EBITDA or EBIT. These multiples are then
used as a final step in the valuation process.
´^\_]g b^€…] ´^\_]g b^€…]
A multiple is calculated as µ]j]\]c‚] b^€…], for example a[¶e
. If a company is to be valued, the EBIT multiple
calculated in this way (e.g., 9.5) is multiplied by the EBIT of the company to be valued in order to obtain the market
value of the equity.
Since a premium often has to be paid for transactions in order to win the bid as a buyer, the consideration of market
multiples is likely too little. If data on comparable transactions is available, it may be more sensible to calculate
multiples not on market values but on the purchase prices of comparable transactions. It should always be
questioned whether a particular multiple is used to calculate the net or gross enterprise value. If the market value is
taken as the basis, only the value of equity, i.e. the net enterprise value, is calculated (equity multiples). If the total
capital is taken into account, a gross enterprise value is calculated (entity multiples).

Chapter 14:
In addition to the advantages of the multiplier method (simplicity, objectivity of the market), there are also
disadvantages. For example, when selecting peers, there is room for discretion, which somewhat invalidates the
argument of objectivity. In addition, the value drivers behind the valuation are not visible, which is the case with the
EVA and DCF methods. Sensitivity analyses can be used to simulate various scenarios.
14.4.5.1 Entity multiples
Entity multiples are used to calculate the gross enterprise value (EV). To do this, the total capital is set in relation to
a reference figure, such as sales, EBIT or EBITDA. Equity is valued at market value (𝐸𝑞𝑢𝑖𝑡𝑦 ∗
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠). In the case of debt capital, the book value corresponds to the market value. The following
table provides an overview of the areas of application of entity multiples:
Table 62 Entity Multiples
§ Fast and rough valuation

§ Can also be used if only the turnover is known (e.g., private companies)
§ Can also be applied to unprofitable companies that generate losses but have future earnings potential
EV / Sales (startups or turnaround companies)
§ Dependent on the definition of turnover but largely independent of accounting latitude and accounting
regulations
§ Limited informational value, as cost structure and therefore profitability are not taken into account
§ Consideration of operating earning power (value added)

§ Not applicable to negative EBITDA
EV / EBITDA § Low dependence on accounting latitude, accounting rules and one-off effects
§ Limited meaningfulness if the peer companies show differences in the investment volume and thus
depreciation volume, in the debt-equity ratio or in the tax rate
§ Consideration of operating earning power (value added)

§ Not applicable for negative EBIT
EV / EBIT
§ Limited meaningfulness if the peer companies show differences in the debt-equity ratio or tax ratio
§ Distortion possible due to different depreciation policies
14.4.5.2 Equity multiples
Equity multiples are used to calculate the net enterprise value (value of equity). For this purpose, equity is set in
relation to a reference value, such as the profit or book value of equity. Frequently used are P/E (price-earnings
ratio: market capitalization / net profit) and P/B (price book ratio: market capitalization / book value of equity). The
following table provides an overview of the areas of application of entity multiples (Hauser & Turnes, 2014, pp.
160-161):
Table 63: Equity Multiples
§ Is widespread due to its simplicity

§ Not applicable to companies with losses (e.g., startups or turnaround companies)
P/E
§ Profit depends on accounting latitude, accounting rules and one-off effects (i.e. they are volatile)
§ Distortion possible due to differences in depreciation policy
§ Suitability for companies in which the operational substance is directly related to the earnings
situation or which primarily hold liquid assets as important value drivers (e.g., banks or insurance
P/B
companies) but not for companies in the technology sector (e.g., biotech).
§ Can also be applied to companies with losses or before bankruptcies
The following table provides an overview of the explained multiples in different industries. It can be seen that there
can be considerable differences between the multiples in some industries:

Chapter 14:
Figure 169: European industry multiples in November 2018
Note. Wollny WP (2018).
14.4.6 Example of company valuation from a fairness opinion
In 2012, ABB acquired Newave, a developer of power supply systems. As part of this transaction, Newave's Board
of Directors commissioned Bank Sarasin to prepare a fairness opinion. The question was whether the price offered
by ABB for Newave shares could be considered fair.
In this fairness opinion Bank Sarasin used multiples of market valuations and comparable transactions, the DCF
method and a premium analysis (according to Bank Sarasin, an average premium of 35% on the share price 60 days
before the takeover is paid on the Swiss capital market for transactions that are comparable to the ABB-Newave
deal). Based on these different valuation methods, Bank Sarasin concluded that a valuation of between 51.50 and
59.90 per share was appropriate and that ABB's offer was therefore fair.

Chapter 14:
14.5 Execution and post-merger integration
LEARNING OBJECTIVES

• Knowing the difference between an asset deal and a share deal
• Knowing the terms signing and closing in the M&A process
• Understanding the relevance of post-merger integration for the success of M&A
14.5.1 Asset deal vs. share deal
There are two basic ways to design a transaction.
§ The buyer acquires all or selected assets of a company ("purchase in kind")

Asset deal § The purchase price for the individual economic goods flows to the selling company
§ The accounting is done at cost, and the acquired assets are depreciated accordingly
§ The buyer acquires the equity of a company and takes on all rights and obligations ("legal purchase of
the legal entity")
Share deal § The purchase price flows to the shareholders
§ The accounting is done at amortized book values
§ The goodwill paid is disclosed
The two methods have various advantages and disadvantages which must be taken into account when selecting the
appropriate purchase method. The asset deal offers greater flexibility if the whole target is not to be purchased but
only individual assets. However, this approach is legally more complex than a share deal, as each asset must be
transferred separately and the consent of all parties is required (for example, a supplier relationship with specific
conditions cannot be transferred to the new party without the consent of the supplier).
In the case of a share deal, the legal entity remains, only the owner of this legal entity changes. For this reason, the
consent of third parties is not required, and the procedure is legally less complex. The disadvantage is that this
procedure is less flexible and all inherited burdens and risks of the acquired company are assumed. This makes
comprehensive and careful due diligence unavoidable.
14.5.2 Signing & closing
After the contract negotiations have been concluded, signing and closing is still to take place. Signing is the signing
of the negotiated contracts. The signing is followed by the closing (date from which the contract is executed). With
the closing, benefits and risks are often legally transferred to the buyer.
Another important component of closing is the payment of the purchase price at a certain point in time and in the
agreed manner (cash or share exchange). In addition, so-called closing conditions are contractually determined.
These include, for example, resignations of executive bodies (board of directors, management), a contractually
agreed level of liquidity, the existence of confirmations of the validity of patents or contracts or the approval of the
competition authorities and the existence of tax rulings. A net equity, net debt or working capital guarantee at the
closing date is also often part of the contract. In many cases, part of the purchase price is paid into a blocked account
or to a trusted third party and paid out to the seller once the guarantees have been established (on the basis of interim
financial statements including auditor's certification).

Chapter 14:
14.5.3 Post-merger integration
Post-merger integration (also known as PMI) is the process of merging two companies as part of a single company
transaction. This complex process is one of the main reasons for the failure of M&A activities. The PMI process can
be divided schematically into three subprocesses:
Figure 170: Processes of Post-Merger Integration
Integration design Integration execution Integration assessment
The aim of PMI is to exploit the synergy potentials and efficiency increases identified during the analysis so that
these improvements can be achieved. Therefore, before the PMI, an integration plan, a new distribution of
competencies, training measures and the harmonization of internal processes must be planned. As part of the
integration process, assets, employees, processes, IT systems, accounting standards and the like must be merged and
harmonized. The implementation of measures as planned and the review of the need for further measures are
components of integration controlling.
PMI is also so complex and often unsuccessful because many different factors have to be taken into account. The
following table highlights some factors that must be taken into account in PMI (cf. Bachmann, 2008, p. 47):
§ Coordination of competitive strategies

Strategy § Integration of brands
§ Consolidation of performance programs
§ Consolidation of service provision processes

Organization § Adaptation of operational performance measurement systems
§ Ensuring a uniform level of quality
§ Determination of capacity requirements

Assets § Pooling of production resources
§ Consolidation of IT resources
§ Replacement of staff
Personnel § Avoidance of personal resistance
& Culture § Ensuring an integration-accompanying knowledge transfer
§ Integration of cultures
§ Integration of interfaces to customers

Customer &
§ Stabilization of customer loyalty
supplier
§ Consolidation of customer and supplier bases

Chapter 14:
14.6 Summary
If companies want to grow inorganically, they can buy other companies or parts of them. The M&A process itself
can be divided into three phases (preparation phase, transaction phase, integration and divergence phase). There are
various reasons for acquiring (or selling) a company:
Reasons to buy Reasons to sell

§ Concentration on core competencies
§ Fixed cost reduction and economies of scale
§ Survival strategy
§ Qualified employees
§ Lack of succession arrangements
§ Access to competencies and resources
§ Site concentration
§ Diversification
§ Privatization of the public sector
§ Tax benefits
§ Direct approach
§ Improvement of the market position
§ Get a bargain
§ Increase in shareholder assets
M&A activities are often not crowned with success, which can be attributed to various reasons (overoptimistic
assessment of the situation, inadequate planning process and personnel, cultural and organizational integration
problems). A key success factor of M&A is the due diligence carried out by potential buyers of a company, which
includes the careful examination and analysis of the takeover target with regard to its economic, legal, tax and
financial circumstances.
The valuation of the object to be purchased is also of central importance. The net asset value method, for example,
determines the book value of a company, while the DCF method discounts the free cash flows (cash flow from
operating activities before interest + cash flow from investing activities; note, different than the definition of FCF
from an internal perspective) that are available to the investors:
•¸• ²¾
The net enterprise value is calculated as: CV(net) = ∑eg³o (o‡º»¸¸¹ ¹
¿
+ (o‡º»¸¸ À − debt
¹¼½ ) ¹¼½ )
ÄÂÃ® £ÉÊÆ®Ë
where the WACC is calculated as WACC®¯° = cÁÂÃ® × ¸¯ÅÆ®¯Ç × (1 − tax) + cÂÉÊÆ®Ë × ¸¯ÅÆ®¯Ç
•¸• ×(o‡Ì)
¿
and the Terminal Value as TV² = º»¸¸
¹¼½ ` Ì
The procedure for the EVA method is similar, except that excess profits are discounted instead of free cash flows
and added to operating assets (NOA) at time 0. In theory, the EVA method results in the same value as a calculation
using the DCF method (Lücke theorem).
£¾» ²¾
The enterprise value is therefore calculated as: CV(net) = NOAq + ∑eg³o (o‡º»¸¸¹ ¹
¿
+ (o‡º»¸¸ À − debt
¹¼½ ) ¹¼½ )
The multiplier method is very widespread in practice because of its simplicity. The enterprise value is calculated as
a multiple of one variable (e.g., EBIT) and is calculated on the basis of comparable companies and their market
valuation. A distinction must be made between entity multiples (e.g., EV/Sales, EV/EBITDA or EV/EBIT) and
equity multiples (e.g., P/E or P/B).
Further aspects of a transaction are the design of the deal (asset vs. share deal) and the post-merger integration in
order to exploit the identified potentials. The PMI must take into account several factors, making it very complex
and a major cause of failed transactions.

Chapter 14:

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University of St.

Prof. Dr. Dirk Schäfer

Summary of Contents............................................................................................................................... III

Table of Contents ........................................................................................................................................ V

List of Figures .......................................................................................................................................... XII

List of Charts ........................................................................................................................................ XVII

List of Abbreviations ..............................................................................................................................XIX

Part A Introduction to Financial Management ........................................................................................ 1

Part B: Looking outside – External Financial Management ................................................................. 26

Objectives and Principles of Financial Reporting ............................................................. 27

Statement of Financial Position ........................................................................................... 69

Statement of Profit or Loss ................................................................................................ 124

Statement of Cash Flows .................................................................................................... 145

Notes and Audit Report ...................................................................................................... 161

Corporate Governance and Other Reports ...................................................................... 175

Group Reporting ................................................................................................................. 187

Part C: Looking inside – Internal Financial Management ................................................................. 203

Introduction to Management Accounting ........................................................................ 204

Performance Measurement ................................................................................................ 226

Part D: Looking forward – Strategic Planning .................................................................................... 265

Financing ............................................................................................................................. 266

Principles of Financial Management – a practice-oriented introduction

Credit Rating ....................................................................................................................... 286

Mergers & Acquisitions ...................................................................................................... 313

Bibliography ............................................................................................................................................. 339

List of Internet sources ........................................................................................................................... 341

Principles of Financial Management – a practice-oriented introduction

Summary of Contents............................................................................................................................... III

Table of Contents ........................................................................................................................................ V

List of Figures .......................................................................................................................................... XII

List of Charts ........................................................................................................................................ XVII

List of Abbreviations ..............................................................................................................................XIX

Part A Introduction to Financial Management ........................................................................................ 1

Part B: Looking outside – External Financial Management ................................................................. 26

Objectives and Principles of Financial Reporting ............................................................. 27

Principles of Financial Management – a practice-oriented introduction

3.3.1 Swiss Code of Obligations ............................................................................... 32

Statement of Financial Position ........................................................................................... 69

4.1 Introductory Example from Alpiq ................................................................................ 69

Statement of Profit or Loss ................................................................................................ 124

Principles of Financial Management – a practice-oriented introduction

Statement of Cash Flows .................................................................................................... 145

Notes and Audit Report ...................................................................................................... 161

Principles of Financial Management – a practice-oriented introduction

7.4.2 Scope of the Audit .......................................................................................... 170

Corporate Governance and Other Reports ...................................................................... 175

Group Reporting ................................................................................................................. 187

Part C: Looking inside – Internal Financial Management ................................................................. 203

Introduction to Management Accounting ........................................................................ 204

Principles of Financial Management – a practice-oriented introduction

10.4 Break-Even Analysis .................................................................................................. 216

Performance Measurement ................................................................................................ 226

11.1 Introductory Example from Schindler ........................................................................ 226

Part D: Looking forward – Strategic Planning .................................................................................... 265

Financing ............................................................................................................................. 266

Credit Rating ....................................................................................................................... 286

Mergers & Acquisitions ...................................................................................................... 313

Bibliography ............................................................................................................................................. 339

List of Internet sources ........................................................................................................................... 341

Principles of Financial Management – a practice-oriented introduction