2. Effects of New Financial Reporting Standards

2.1 Financial Reporting Standards Applied for the First Time in the Reporting Period

In the “Annual Improvements to IFRS Standards 2014–2016 Cycle” published by the International Accounting Standards Board (IASB) on December 8, 2016, only the amendments to IFRS 12 (Disclosure of Interests in Other Entities) had to be applied for the first time as of January 1, 2017. By contrast, the amendments to IFRS 1 (First-time Adoption of International Financial Reporting Standards) and IAS 28 (Investments in Associates and Joint Ventures) were required to be applied for the first time as of January 1, 2018.

With the exception of IFRS 9 and IFRS 15, initial application of the standards listed in the table had little or no material impact on the presentation of the net assets, financial position, and results of operations. The impact of the initial application of IFRS 9 (Financial Instruments) and IFRS 15 (Revenue from Contracts with Customers) as well as Amendments to IFRS 15 (Effective Date of IFRS 15 and Clarifications to IFRS 15) is outlined below.

The following table shows the effect of initial application of IFRS 9 and IFRS 15 on the items in the consolidated statement of financial position as of January 1, 2018:

Initial application of IFRS 9

The new financial reporting standard IFRS 9 (Financial Instruments) has been applied since January 1, 2018. It replaces the previous regulations on financial instruments. The new standard contains rules on classifying and measuring financial assets and financial liabilities. In contrast to IAS 39, IFRS 9 defines three instead of four measurement categories for financial assets, with classification based partly on the entity’s business model and partly on the characteristics of the contractual cash flows from the respective financial asset. In the case of equity investments that are not held for trading, an entity may irrevocably opt at initial recognition to recognize future changes in their fair value outside profit or loss in the statement of comprehensive income. Furthermore, the hedge accounting rules were revised with the aim of achieving a closer link between risk management activities and the reporting of hedging instruments in the financial statements. This involves additional disclosures in the notes. IFRS 9 also includes new rules for the recognition of impairments on financial instruments. This new impairment model is based on the principle of accounting for expected losses.

In accordance with the transition requirements, IFRS 9 was applied retrospectively without restatement for reference periods. The cumulative effect of initially applying the standard as of January 1, 2018, has been recognized outside of profit or loss in retained earnings. The data for the reference periods are presented on the basis of the previous rules.

The new impairment rules result in an increase in provisions for default on financial assets due to the inclusion of expected credit losses. The following table provides a reconciliation from impairment losses based on the IAS 39 rules to the new impairment losses based on IFRS 9:

Additional impairment losses were recognized almost exclusively for trade accounts receivable. The additional impairments calculated for cash and cash equivalents, financial assets, receivables under lease agreements, contract assets as defined in IFRS 15, and other financial assets are not material.

As a result of the introduction of the new classification and measurement rules, financial assets were allocated to the new IFRS 9 measurement categories on the basis of their business model and the underlying cash flow characteristics of the respective financial asset. The following table shows a reconciliation from the original measurement categories and carrying amounts of financial assets based on IAS 39 to the new measurement categories and carrying amounts based on IFRS 9:

The €10 million difference in the carrying amounts of trade accounts receivable results from remeasurement due to the introduction of the new impairment model.

For equity investments that were not held for trading as of January 1, 2018, Covestro applies the option of recognizing changes in fair value in other comprehensive income without transfer from equity on retirement. The €1 million increase in the carrying amount of the relevant other investments results from reclassification from the IAS 39 valuation category “available-for-sale financial assets” to the new IFRS 9 category “at fair value through other comprehensive income”. While the other investments were carried at amortized cost under IAS 39, they are now recognized in the statement of financial position at fair value as stipulated by IFRS 9.

Trade accounts receivable, other financial assets, other receivables, and cash and cash equivalents that were classified as loans and receivables under IAS 39 are now classified at amortized cost under IFRS 9, because the cash flow condition is fulfilled, and Covestro holds these financial assets with the objective of collecting the contractual cash flows.

Subsidiaries that are not consolidated due to their immateriality for the consolidated financial statements and which were previously classified as available-for-sale financial instruments and carried at amortized cost in accordance with IAS 39 are recognized in other receivables from fiscal 2018 onward. The corresponding carrying amount of €2 million was reclassified as of January 1, 2018.

The initial application of IFRS 9 did not have any impact on the classification and measurement of financial liabilities.

The fundamental changes in hedge accounting did not lead to any reclassification effects because Covestro did not have any designated hedges pursuant to IFRS 9 either at the date of initial recognition or on the reporting date.

Initial application of IFRS 15

On May 28, 2014, the IASB issued IFRS 15 (Revenue from Contracts with Customers). An amendment (Effective Date of IFRS 15) was published on September 11, 2015, and clarifications (Clarifications to IFRS 15 – Revenue from Contracts with Customers) were published on April 12, 2016. IFRS 15 replaces IAS 11 (Construction Contracts), IAS 18 (Revenue), IFRIC 13 (Customer Loyalty Programmes), IFRIC 15 (Agreements for the Construction of Real Estate), IFRIC 18 (Transfers of Assets from Customers), and SIC-31 (Revenue – Barter Transactions Involving Advertising Services). In principle, IFRS 15 specifies that an entity must recognize the expected consideration for the transfer of goods or services as sales as soon as control over the goods passes to the customer or the services are rendered. To comply with this, recognizing sales involves the following five steps: In step one, the contract with the customer is identified. In step two, the distinct performance obligations in the contract are identified. In step three, the transaction price is determined. In step four, this transaction price is allocated to the distinct performance obligations. In step five, sales are recognized either over time or at a point in time, depending when control is transferred. As a result of these principles, IFRS 15 may affect the timing of revenue recognition, among other things. IFRS 15 also results in new items in the statement of financial position, such as contract assets, contract liabilities, and refund liabilities, and requires additional disclosures in the notes to the financial statements.

IFRS 15 was applied as of January 1, 2018, using the modified retrospective approach. The positive cumulative effect of €14 million resulting from initial application of the standard was recognized in equity as of January 1, 2018. The reference periods were not restated. At the date of initial application, IFRS 15 was applied retrospectively to contracts that had not yet been completed. Where contracts were modified before initial application of the standard, the aggregate effect of such modifications was recognized. The use of this practical expedient is not expected to have any material effect.

The application of IFRS 15 resulted in changes to the following issues at Covestro:

• Consignment warehousing agreements: In line with the control concept in IFRS 15, under certain agreements the customer obtains control of the goods when they are delivered to the consignment warehouse. As a consequence, the corresponding sales are realized at this point in time and not, as in the past, upon documented withdrawal.
• Transportation clauses: Under certain transportation clauses agreed with customers, Covestro is responsible for transportation of the goods sold. For some of these clauses, the control concept in IFRS 15 means that control over the goods sold is only transferred to the customer at the end of the transportation or freight service. Therefore, the transportation or freight service does not constitute a separate performance obligation. The transfer of control at the end of the transportation or freight services means that under some transportation clauses all sales for the transaction are recognized at a later point in time than in the past. In addition, under some transportation clauses, Covestro provides transportation or freight services in connection with the delivery of the goods sold after the customer has obtained control over these goods. In general, the sales allocated to these transportation or freight services are recognized at the time of performance of the service.
• Provisional prices: Under some contracts with customers, the final prices are only determined after control over the respective products has passed to the customer. Provisional prices are billed at the time of delivery. In view of the uncertainty about the resulting variable consideration at this point in time, the amount of the corresponding sales is initially estimated observing the relevant rules constraining estimates of variable consideration.
• Licenses: A contractual right to use intellectual property is transferred to some customers. The consideration takes the form, among other things, of usage-based royalties, for which a minimum annual amount is agreed for the term of the contract. When IFRS 15 was initially applied, the minimum outstanding royalties that Covestro will receive were taken into account.
• Customer-specific products: Certain products are only sold to one customer. Covestro has no alternative use for some of these products. Insofar as Covestro has an enforceable right to receive payment for completed performance, sales are recognized on the basis of progress towards satisfaction of the performance obligation and thus earlier than in the past.

In addition, the application of IFRS 15 results in changes to the presentation of the financial statements.

The adjustments to all items in the income statement and statement of financial position resulting from IFRS 15 compared with the application of the standards and interpretations replaced by IFRS 15 are presented below, together with an explanation of the reasons. There are no material effects on the statement of comprehensive income or the statement of cash flows.

The reduction in sales is mainly attributable to licenses and consignment warehousing agreements. Further decreases in sales are due to transportation clauses. Countereffects result from provisional prices. The cost of goods sold was lower owing to transportation clauses and consignment warehousing agreements. The aforementioned effects result in lower EBIT and earnings per share overall.

The principal reasons for the above adjustments to the amounts reported in the statement of financial position are as follows:

• Inventories: The decline is mainly attributable to consignment warehousing agreements. This effect is compensated in part by an increase from transportation clauses.
• Trade accounts receivable: The decline is mainly attributable to transportation clauses.
• Other receivables: The increase in contract assets, which are included in other receivables, is mainly attributable to consignment warehousing agreements.
• Other reserves: The increase is mainly attributable to consignment warehousing agreements and also licenses. This is offset in part by a decline attributable to transportation clauses and provisional prices.
• Other provisions: The decline reflects the reclassification of amounts that Covestro has received or will receive from customers for which refunds are anticipated. These mainly comprise amounts for rebates. As a result of the application of IFRS 15, these are included in refund liabilities within other liabilities.
• Trade accounts payable: The decline is attributable to the reclassification of advance payments received from customers for future product deliveries to contract liabilities, which are included in other liabilities.
• Other liabilities: The increase is mainly attributable to reclassifications from other provisions to refund liabilities and trade accounts payable to contract liabilities, as described above.

2.2 Published Financial Reporting Standards That Have Not Yet Been Applied

The IASB and the IFRS IC have issued the following standards, amendments to standards, and interpretations whose application has not yet been mandatory to date. The application of these IFRS standards is conditional upon their endorsement by the European Union.

The date of initial application of the standards not yet endorsed by the EU is deemed to be the effective date stipulated by the IASB. Because the annual improvements to IFRSs and the amendments to IAS 19 outlined in the table above have not yet been endorsed by the EU, Covestro did not yet apply these changes as of January 1, 2019.

The financial reporting standards whose application will or could influence the presentation of the Covestro Group’s net assets, financial position, and results of operations are outlined in greater detail below. As far as the following sections do not contain any statement to the potential effects, the Covestro Group is currently evaluating the actual impact of these standards.

On January 13, 2016, the IASB published IFRS 16 (Leases), a new standard for recognizing leases which replaces IAS 17 (Leases), IFRIC 4 (Determining whether an Arrangement Contains a Lease), SIC-15 (Operating Leases – Incentives), and SIC-27 (Evaluating the Substance of Transactions Involving the Legal Form of a Lease). While IFRS 16, which was endorsed by the European Union on October 31, 2017, basically retains the previous accounting rules for lessors, only one accounting model is now intended for use by lessees. This requires a lessee to recognize a right-of-use asset and a corresponding lease liability for each lease. The right-of-use asset reflects a lessee’s right to use the asset being leased. The lease liability represents the lessee’s obligation to make contractual lease payments. Exemptions are available for leases with a term of less than 12 months or those with a low-value underlying asset.

The new lease accounting rules must be applied for the first time for annual periods beginning on or after January 1, 2019. Covestro will transition its reporting in accordance with IFRS 16 using the modified retrospective approach during the first quarter of 2019. Comparative information for the 2018 fiscal year will not be restated. The IFRS 16 transition rules stipulate that no new assessment must be made at the date of initial application as to whether an existing agreement meets the definition of a lease according to IFRS 16. Instead, existing assessments based on IAS 17 in conjunction with IFRIC 4 may continue to be applied. Covestro will make use of this exemption when applying IFRS 16 for the first time.

Upon initial application of IFRS 16, the right-of-use assets will generally be recognized by Covestro in the amount of the corresponding lease liabilities. In specific cases, the right-of-use asset will be adjusted by the amount of the deferred advance payments or liabilities recognized in the financial statements as of the end of fiscal 2018. The corresponding lease liability will be measured using the incremental borrowing rate at the date of initial application. In addition, Covestro will take advantage of the optional exemptions regarding short-term leases and leases of low-value assets.

The introduction of IFRS 16 from the perspective of a lessee will materially affect Covestro’s net assets, financial position and results of operations. Recognizing future payment obligations as right-of-use assets and lease liabilities in the statement of financial position is expected to increase noncurrent assets and noncurrent liabilities by an amount in the mid-three-digit millions of euros. This is mainly due to the leasing of land and real estate, production-related infrastructure, as well as street vehicles and rail wagons. The expected increase in total assets and liabilities will reduce the equity ratio and increase net financial debt. No material effect on retained earnings is anticipated from initial application of this standard.

In the future, the amortization of the right-of-use assets and the interest expense from the interest cost of lease liabilities will be recognized in the income statement instead of reporting expenses from operating leases, as in the past. This substitution is expected to improve EBITDA by an amount in the mid- to high-double-digit millions of euros and will also likely increase EBIT by an amount in the low-double-digit millions of euros. No material effects on net income are anticipated.

Under IFRS 16, the actual payments from leases will generally be reported in the statement of cash flows going forward, in cash flows from financing activities as repayment of the lease liability or cash interest expense. As a result, the application of the standard will improve operating cash flows and free operating cash flows and, conversely, will result in decrease in cash flows from financing activities.

On October 12, 2017, the IASB also issued amendments to IFRS 9 (Financial Instruments) under the title “Prepayment Features with Negative Compensation”. The amendments extend the rules of IFRS 9 to the extent that prepayable financial assets can be measured at amortized cost or fair value through other comprehensive income, also in the case of reasonable negative compensation payments. Furthermore, the amendments contain clarification with regard to reporting on modifications to financial liabilities. On October 12, 2017, the IASB also issued amendments to IAS 28 (Investments in Associates and Joint Ventures) under the title “Long-term Interests in Associates and Joint Ventures”. The amendments clarify that IFRS 9 (Financial Instruments) shall be applied to long-term interests, which are part of the net investment in an associate or a joint venture to which the equity method is not applied. The application of the amendments to IFRS 9 (Financial Instruments) and to IAS 28 (Investments in Associates and Joint Ventures) does not materially affect Covestro’s net assets, financial position and results of operations at this time. Nevertheless, the presentation of its net assets, financial position and results of operations could be affected depending on future arrangements and transactions.

On December 12, 2017, the IASB published “Annual Improvements to IFRS Standards 2015–2017 Cycle”. The Annual Improvements include clarifications of IFRS 3 (Business Combinations), IFRS 11 (Joint Arrangements), IAS 12 (Income Taxes), and IAS 23 (Borrowing Costs). The amendments to IFRS 3 clarify that interests in a business previously held in a joint operation must be remeasured when an entity obtains control of this business. In contrast, the amendments to IFRS 11 state that when an entity obtains joint control of a business held to date in a joint operation, the entity does not remeasure previously held interests in that business. Among other things, the amendments to IAS 12 stipulate that the tax consequences of accounting for dividend payments must be recognized in the same way as the related transaction. The clarifications with regard to IAS 23 mainly explain that the capitalization of borrowing costs for a qualified asset ceases when the asset is ready for its intended use or sale. Accordingly, any specific borrowing for this asset outstanding after that time becomes part of the funds that an entity borrows generally which are the basis for calculating a capitalization rate according to IAS 23.

On February 7, 2018, the IASB published changes to IAS 19 (Employee Benefits) under the title “Plan Amendment, Curtailment or Settlement”. With these changes, the IASB clarified in particular that in the event of an amendment, curtailment or settlement of a plan, not only must the net defined benefit liability or asset of the defined benefit plan be remeasured, the current service cost and the net interest for the period remaining after the amendment, curtailment or settlement must also be calculated using the new assumptions.

The IASB published amendments to the IFRSs entitled “References to the Conceptual Framework in IFRS Standards” on March 29, 2018. The amendments update quotes and references to the new Conceptual Framework 2018 in the standards and specify the version of the Conceptual Framework to which they refer.

On October 22, 2018, the IASB issued amendments to IFRS 3 (Business Combinations) under the title “Definition of a Business”. The amendments specify the definition of a business to draw a clearer line between the acquisition of a business and the purchase of a group of assets. Revised criteria, additional guidelines, and examples as well as an optional concentration test are intended to simplify the process of distinguishing between a business and a group of assets.

On October 31, 2018, the IASB published amendments to IAS 1 (Presentation of Financial Statements) and IAS 8 (Accounting policies, changes in accounting estimates and errors) under the title “Definition of Material”. The amendments clarify the definition of materiality and harmonize it across standards.

On May 18, 2017, the IASB issued IFRS 17 (Insurance Contracts). IFRS 17 regulates the recognition, measurement and presentation of issued insurance contracts as well as the necessary disclosures in the notes. In addition, IFRS 17 requires the application of similar principles in the case of existing reinsurance contracts held and, insofar as insurance contracts are issued, also issued investment contracts with a discretionary participation feature. IFRS 17 will replace IFRS 4 (Insurance Contracts).