3.Accounting Policies and Valuation Principles

Covestro’s consolidated financial statements are based on the principle of the historical cost of acquisition, construction or production. Exceptions are items measured at fair value, such as certain financial assets and derivatives.

In preparing the consolidated financial statements, Covestro management has to make assumptions and estimates to a certain extent that may substantially impact the presentation of the Covestro Group’s net assets, financial position, and results of operations and could deviate from the actual results. Such estimates, assumptions, and the exercise of discretion mainly relate to the following areas: defining the useful life of noncurrent assets, calculating the discounted cash flows used for impairment testing to be conducted at least annually, purchase price allocations, accounting for income taxes, the assessment of the amount of deferred tax assets recoverable in future periods as well as the recognition of provisions, (e.g. for litigation-related expenses, pensions and other employee benefits, other taxes, environmental compliance and remediation costs, and product liability). In addition, Covestro’s management must decide which information is relevant for readers of the IFRS consolidated financial statements and should be included in the notes. Information about exercising discretion in the application of accounting policies that most significantly affect the amounts reported in the consolidated financial statements, and about estimates and assumptions, are disclosed in the following notes.

Consolidation

As of December 31, 2019, the direct and indirect subsidiaries of Covestro AG were fully consolidated in accordance with the principles of IFRS 10 (Consolidated Financial Statements). In addition, joint arrangements as defined by IFRS 11 (Joint Arrangements) were classified as joint operations and consolidated proportionately in the consolidated financial statements, or classified as joint ventures and accounted for in the same way as associated companies using the equity method in accordance with IAS 28 (Investments in Associates and Joint Ventures). For additional information, please see note 5.1 “Scope of consolidation and investments.”

Joint operations and joint ventures

Joint operations and joint ventures are based on joint arrangements. A joint arrangement is deemed to exist if Covestro AG, through a contractual agreement, indirectly or directly jointly controls an activity together with one or more third parties. Joint control is only deemed to exist if decisions regarding the relevant activities require the unanimous consent of the parties sharing control.

A joint operation is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets attributable to the arrangement and obligations with regard to the liabilities attributable to the arrangement. The Covestro Group recognizes the share of assets, liabilities, revenues and expenses relating to its interest in a joint operation in accordance with its rights and obligations.

A joint venture is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. Joint ventures are accounted for using the equity method.

Associates over which Covestro AG has significant influence, directly or indirectly, generally through an ownership interest between 20% and 50%, are also accounted for using the equity method.

Currency translation

The financial statements of the individual companies for inclusion in the consolidated financial statements are prepared in their respective functional currencies. The majority of consolidated companies carry out their activities autonomously from a financial, economic and organizational point of view, and their functional currencies are therefore the respective local currencies.

In the separate financial statements of the foreign companies, receivables and liabilities in currencies other than the respective functional currency are translated at closing rates. Related exchange differences are recognized in profit or loss and recorded as exchange gains or losses under other financial result.

In the consolidated financial statements, the assets and liabilities of Covestro companies outside the eurozone are translated into euros at closing rates at the start and end of the reporting period, while income and expense items and cash flows are translated into euros at average rates. Equity items are translated at historical rates.

Sales and other operating income

All revenues derived from the selling of products or rendering of services or from licensing agreements are recognized as sales. Other operational revenues are recognized as other operating income.

In principle, the amount of consideration from a contract with a customer to which Covestro expects to be entitled in exchange for the transfer of goods or services is recognized as sales when the customer obtains control of the corresponding goods or services.

Sales are generated primarily from the sale of chemical products. In most cases, control over these products is transferred to the customer at a point in time.

Depending on the contractual agreements made and transportation clauses agreed upon with the customer in the majority of cases control is transferred to the customer upon delivery at the place of destination, furthermore at the point in time of collection by the customer or upon handover to the freight carrier. In some cases, sales are made through consignment warehouses in which customers primarily obtain control over the delivered goods upon delivery to the consignment warehouse.

In principle, control is considered to be transferred when the customer can direct the use of the product to be delivered and obtain substantially all of the remaining benefits from the product, while this is no longer possible for Covestro.

Determining the point in time of the transfer of control involves considering additional indicators. In particular, it is considered at which point in time Covestro has a present right to payment for the product and when physical possession of the product or, in a broader sense, the possibility of sole access to the product, is transferred to the customer. Depending on the transportation clauses, the possibility of sole access to the product may be transferred even prior to arrival or physical handover of the product to the customer. Furthermore, the point in time when the legal title passes to the customer is also considered to the extent that it constitutes more than a protective right. The point in time when the significant rewards and risks of ownership of a product are transferred to the customer is usually linked closely with the aforementioned indicators and is therefore considered with these. Based on experience, it is assumed that products sold fulfill the agreed-upon specifications, thus acceptance by the customer is an indicator that does not generally affect the point in time at which control is transferred.

As a result, depending on the contractual agreements made and transportation clauses agreed upon with the customer, the point in time of the transfer of control is determined.

In the case of products sold through a consignment warehouse, the customer generally obtains physical possession of this product upon delivery to the consignment warehouse. In addition, the right to payment for the delivered goods generally arises upon delivery. To the extent that the other three indicators do not lead to a contrary conclusion, control of the products in the case of a sale through a consignment warehouse transfers to the customer upon delivery to the consignment warehouse. The corresponding sales are therefore realized at the time of delivery.

Certain products are only sold to one customer. Some of these customer-specific products have no alternative use for Covestro. Insofar as Covestro has an enforceable right to payment for performance completed to date, sales are recognized on the basis of progress towards complete satisfaction of the performance obligation. As a rule, control over an individual customer-specific product is considered to be transferred when the generally short production process is completed successfully and the product has been tested to confirm that the agreed-upon specifications have been met.

To the extent that, for certain types of performance obligations that are satisfied over time, there is a right to consideration in an amount that corresponds directly with the value of the performance provided by Covestro to date, revenue will normally be realized in the amount to which Covestro has a right to invoice.

Invoices are usually payable in 0 to 90 days. Contracts may contain early payment discounts or rebates. Rebates are generally retroactively granted sales- or volume-dependent rebates based on the sales or volume of a period customarily spanning up to 12 months. Some contracts include pricing formulas used to determine the billable price at the time of delivery. Moreover, the final prices for certain contracts with customers are not yet fixed at the time of transfer of control. Instead, provisional prices are billed initially.

Sales are recognized in the amount of the transaction price that Covestro is expected to receive. Sales do not include amounts collected on behalf of third parties (e.g. sales tax). Where consideration includes a variable component, for example due to the contract clauses described, this component of the consideration is estimated either based on the expected value method or the most likely amount. The method producing the best estimate is used in this case. However, variable consideration is only taken into account to the extent it is not constrained as defined by IFRS 15. Variable consideration is not constrained if it is highly probable that a significant reversal in the amount of sales will not occur when the corresponding uncertainty is subsequently resolved. The transaction price of a contract is allocated to the performance obligations therein using the relative stand-alone selling prices, which generally correspond to the agreed upon prices. If the conditions are met, variable amounts are completely allocated to individual performance obligations.

Refund liabilities result particularly from rebates granted and total the amount of the rebate expected to be refunded, which is calculated based on the methods described.

As a rule, no warranties are issued beyond normal warranties that products will fulfill the agreed-upon specifications.

In the case of contracts with customers, Covestro generally does not expect more than one year to pass between the transfer of a product to a customer and the payment thereof. As a result, the agreed consideration is not adjusted for significant financing components. When incremental costs of obtaining a contract arise, these are immediately recognized as expenses, if the potential amortization period is one year or less.

Research and development expenses

Research and development expenses are incurred in the Covestro Group for in-house research and development activities as well as research and development collaborations and alliances with third parties.

According to IFRSs, research costs cannot be capitalized. Development costs, on the other hand, must be capitalized according to closely defined conditions. An intangible asset must be recognized if there is reasonable certainty of receiving future cash flows that will cover an asset’s carrying amount. Covestro’s development projects are often subject to uncertainties, so the conditions for the capitalization of development costs are normally not satisfied. Each project or contract is reviewed to determine potential capitalization requirements.

Income taxes

Income taxes comprise the taxes levied on taxable income in the individual countries along with changes in deferred tax assets and liabilities that are recognized in profit or loss. The income taxes recognized are reflected at the amounts likely to be payable or reimbursable under the statutory regulations in force, or already enacted in relation to future periods, at the end of the reporting period.

As a rule, deferred taxes are recognized in profit or loss. However, if deferred taxes relate to items recognized outside profit or loss in equity, they, too, are recognized outside profit or loss.

The probability that deferred tax assets resulting from temporary differences, tax credits or loss carryforwards can be utilized in the future is the subject of forecasts by the individual companies regarding the future earnings situation in the respective Covestro companies and other parameters.

Deferred tax liabilities are recognized on planned dividend payments by subsidiaries. Where no dividend payment or disposal of corresponding equity investments is planned for the foreseeable future, no deferred tax liability is recognized on the difference between the proportionate equity according to IFRSs and the tax base of the carrying amount of the investment in the subsidiary.

The expected effects of uncertain deferred and actual income tax positions are estimated in accordance with IFRIC 23 (Uncertainty over Income Tax Treatments) either based on the expected value method or the most likely amount. The method producing the best estimate is used in this case. Tax audits in which the relevant tax authority could take a view differing from Covestro’s legal position are by far the most important sources of estimation uncertainties for uncertain tax positions. Uncertain tax positions are accounted for under the assumption that the tax authorities will investigate all relevant matters and have all relevant information at their disposal.

Goodwill

Goodwill is not amortized. Its carrying amount is subjected to impairment testing annually or more often if there is any indication of possible impairment. Detailed explanations of impairment testing can be found under “Procedure used in global impairment testing and its impact.” Once an impairment loss has been recognized on goodwill, it cannot be reversed in subsequent periods.

Other intangible assets

An “other intangible asset” is an identifiable nonmonetary asset without physical substance, other than goodwill (such as software or rights). Other intangible assets are recognized at the cost of acquisition or generation. Those with a determinable useful life are amortized accordingly on a straight-line basis over a period of up to 20 years, except where their actual depletion demands a different amortization pattern. Determination of the expected useful lives of other intangible assets is based on estimates of the period for which they will generate cash flows.

Property, plant and equipment

Property, plant and equipment are carried at the cost of acquisition or construction and depreciated by the straight-line method over the expected useful life. An impairment loss is recognized in addition if an asset’s recoverable amount falls below its carrying amount.

If the construction phase or manufacturing process of property, plant or equipment extends over a period of 12 months or more, the interest incurred on borrowed capital up to the date of completion is capitalized as part of the cost of acquisition or construction in accordance with IAS 23 (Borrowing Costs).

Costs for regular, comprehensive maintenance work (such as the major overhaul of a technical facility) are capitalized as a separate component if they satisfy special recognition criteria.

The following depreciation periods are generally applied throughout the Covestro Group:

Significant asset components with different useful lives are accounted for and depreciated separately. Right-of-use-assets for leases are recognized in property, plant and equipment.

When assets are sold, closed down or scrapped, the difference between the net proceeds and the net carrying amount of the assets is recognized as a gain or loss in other operating income or expenses, respectively.

Impairment of other intangible assets and property, plant and equipment

If there are indications that an individual item of intangible assets or property, plant and equipment may be impaired, the recoverable amount is compared to the carrying amount to determine whether it is higher or lower. If the recoverable amount is less than the carrying amount, an impairment loss is recognized for the difference. If the reasons for a previously recognized impairment loss no longer apply, the impairment loss is reversed provided that the reversal does not cause the carrying amount to exceed the original (amortized) cost of acquisition or generation.

Both depreciation or amortization and impairment losses are recognized in the functional cost in line with the use of the relevant asset.

Inventories

Inventories are recognized at their cost of acquisition or production (production-related full cost) – calculated by the weighted-average method – or at their net realizable value, whichever is lower. The net realizable value is the estimated selling price in the ordinary course of business less estimated cost to complete and selling expenses.

Financial instruments

Contracts are recognized as financial instruments in the financial statements which simultaneously give rise to a financial asset at one entity while resulting in a financial liability or equity instrument at another entity. Accordingly, financial assets are recognized in the consolidated financial statements if the Covestro Group has a contractual right to receive cash or other financial assets from another entity. Regular-way purchases and sales of financial assets are generally posted on the settlement date. Financial liabilities are initially recognized in the consolidated financial statements if Covestro has a contractual obligation to transfer cash or other financial assets to another entity. With the exception of trade accounts receivable, financial instruments are measured at fair value plus directly attributable transaction costs upon initial recognition. For financial instruments measured at fair value through profit or loss, transaction costs are recognized directly in the income statement. Trade accounts receivable are recognized at their transaction price. Subsequent measurement of financial instruments is based on their classification in the categories stipulated in IFRS 9 (Financial Instruments).

Financial assets

Financial assets comprise loans, acquired equity and debt instruments, cash and cash equivalents, other financial assets, and derivatives with positive fair values. The classification and measurement of financial assets is based on the business model pursued by the Covestro Group with regard to the management of its financial assets for the purpose of collecting cash flows, and on the characteristics of the contractual cash flows from the relevant financial assets (cash flow condition). Subsequent measurement takes place according to the measurement rules for the respective category, as described below.

Financial assets carried at amortized cost comprise nonderivative financial assets that are held as part of a business model that aims to collect contractual cash flows and that additionally fulfill the cash flow condition, i.e., the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. This category comprises trade accounts receivable, the loans included in other financial assets, the additional financial receivables reflected in other receivables, and cash and cash equivalents. Interest income from financial assets assigned to this category is determined using the effective interest method.

Financial assets carried at fair value through other comprehensive income encompass debt instruments held as part of a business model that aims to obtain cash flows from the instrument both by collecting contractual payments as well as through the sale thereof, and that additionally fulfill the cash flow condition. Acquired bonds may be classified in this category to the extent that they are intended to be sold before they mature. Interest income, foreign currency gains and losses, and impairment losses or impairment loss reversals are recognized in the income statement for financial assets in this category. The remaining fair value changes are recognized in other comprehensive income. Upon derecognition, the cumulative net gains or losses included in other comprehensive income are reclassified to the income statement.

The Covestro Group exercises the option of recognizing changes in the fair value of equity instruments that are not held for trading in other comprehensive income. In contrast to the treatment of debt instruments, the gains and losses recognized in other comprehensive income are not reclassified to the income statement upon derecognition, and no impairment losses are recognized in profit or loss.

Financial assets carried at fair value through profit or loss are all financial assets not assigned to any of the above categories and particularly include derivatives with positive fair values. The Covestro Group does not opt to measure financial assets at fair value for the purpose of avoiding or minimizing accounting mismatches.

Financial assets are derecognized when contractual rights to receive cash flows from the financial assets expire or the financial assets are transferred together with all significant risks and rewards.

Cash and cash equivalents

Cash and cash equivalents comprise cash, checks received and balances with banks. Cash equivalents are highly liquid short-term financial investments that are subject to an insignificant risk of changes in value, are easily convertible into a known amount of cash, and have a maturity of three months or less from the date of acquisition or investment.

Derivatives

Derivatives – such as forward exchange contracts – are used to mitigate the risk of fluctuations in exchange rates. Derivatives are recognized at the trade date.

Contracts concluded in order to receive or deliver nonfinancial goods for the company’s own purposes are not accounted for as derivatives but treated as pending transactions. Where embedded derivatives are identified that are required to be separated from the pending transactions, they are accounted for separately. To take advantage of market opportunities or cover possible peak demand, a nonmaterial volume of transactions may be entered into for which the possibility of immediate resale cannot be excluded. Such transactions are allocated to separate portfolios upon acquisition and accounted for as derivatives according to IFRS 9.

Derivatives are carried at fair value. This relates to what are known as standalone derivatives as well as derivatives embedded in certain types of contracts and therefore required to be accounted for separately from their host contracts. Positive fair values at the end of the reporting period are reflected in financial assets, negative fair values in financial liabilities. Changes in the fair values of these derivatives are recognized directly in profit or loss in the other operating result. Changes in the fair values of forward exchange contracts and currency options serving as hedging instruments for items in the statement of financial position are divided into an interest and a currency component. The interest component is recognized in interest expense or income and the currency component is recognized as exchange gains or losses in the other financial result. Changes in the fair value of forward exchange contracts used to hedge forecasted transactions in foreign currencies are recognized in other operating result.

Covestro does not apply hedge accounting.

Financial liabilities

Financial liabilities comprise primary financial liabilities and negative fair values of derivatives.

In subsequent periods, such nonderivative liabilities are measured at amortized cost using the effective interest method. The Covestro Group does not opt to measure financial liabilities at fair value to avoid or minimize accounting mismatches.

Financial liabilities are derecognized when the contractual obligation is discharged or canceled, or has expired.

Provisions for pensions and other post-employment benefits

Within the Covestro Group, post-employment benefits are provided under defined contribution and defined benefit plans. In the case of defined contribution plans, the company pays contributions to publicly or privately administered pension plans on a mandatory, contractual or voluntary basis. Once the contributions have been paid, the company has no further payment obligations. The regular contributions constitute expenses for the year in which they are due and as such are included in the functional cost items, and thus in income after income taxes plus financial result and income tax expense (EBIT). All other post-employment benefit systems are defined benefit plans, which may be either unfunded, i.e. financed by provisions, or funded, i.e. financed through pension funds.

The present value of the defined benefit obligations and the resulting expense are calculated in accordance with IAS 19 (Employee Benefits) by the projected unit credit method. The future benefit obligations are valued by actuarial methods and spread over the entire employment period on the basis of specific assumptions regarding beneficiary structure and the economic environment. These relate mainly to the discount rate, future salary and pension increases, variations in health care costs, and mortality rates.

The discount rates used are calculated from the yields of high-quality corporate bond portfolios in specific currencies with cash flows approximately equivalent to the expected cash outflows from the pension plans. The uniform discount rate derived from this interest rate structure is thus based on the yields, at the closing date, of a portfolio of corporate bonds with at least an AA or AAA rating whose weighted residual maturities approximately correspond to the duration necessary to cover the entire benefit obligation.

The fair value of plan assets is deducted from the present value of the defined benefit obligation for pensions and other post-employment benefits to determine the net defined benefit liability. Plan assets in excess of the benefit obligation are reflected in other receivables, subject to the asset ceiling specified in IAS 19. Comprehensive actuarial valuations for all major plans are performed annually as of December 31.

The balance of all income and expenses relating to defined benefit plans, except the net interest on the net liability, is recognized in EBIT. The net interest is reflected in the financial result.

The effects of remeasurements of the net defined benefit liability are reflected in other comprehensive income. They consist of actuarial gains and losses, the return on plan assets and changes in the effects of the asset ceiling, less the respective amounts included in net interest for the last two components. Deferred taxes relating to the effects of remeasurements are also recognized in other comprehensive income.

Other provisions

Other provisions are measured in accordance with IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) or, where applicable, IAS 19 (Employee Benefits). Where the cash outflow to settle an obligation is expected to occur after one year, the provision is recognized at the present value of the expected cash outflow. Claims for reimbursements from third parties are separately reflected in other receivables if their realization is virtually certain.

If the projected obligation declines as a result of a change in the estimate, the provision is reversed by the corresponding amount and the resulting income recognized in the operating expense item(s) in which the original charge was recognized.

To enhance the information content of the estimates, certain provisions that could have a material effect on the net assets, financial position and results of operations are selected and tested for their sensitivity to changes in the underlying parameters using sensitivity analysis. To reflect uncertainty about the likelihood of the assumed events actually occurring, the impact of a five-percentage-point change in the probability of occurrence is examined in each case.

Provisions for environmental protection are recorded if future cash outflows are likely to be necessary to ensure compliance with environmental regulations or to carry out remediation work, such costs can be reliably estimated, and no future benefits are expected from such measures.

Estimating the future costs of environmental protection and remediation involves many uncertainties, particularly with regard to the status of laws, regulations and the information available about conditions in the various countries and at the individual sites. Significant factors in estimating the costs include previous experiences in similar cases, the conclusions in expert opinions obtained regarding existing environmental programs, current costs, and new developments affecting costs. Also taken into consideration are management’s interpretation of current environmental laws and regulations, the number and financial position of third parties that may become obligated to participate in any remediation costs on the basis of joint liability, and the remediation methods likely to be deployed. Changes in these assumptions could impact future reported results.

Taking into consideration experience gained to date regarding environmental matters of a similar nature, Covestro’s management believes the existing provisions to be adequate based upon currently available information. Given the businesses in which the Covestro Group operates and the difficulties inherent in accurately estimating liabilities for environmental protection, it remains possible that material additional costs will be incurred beyond the amounts accrued. It may transpire during remediation work that additional expenditures are necessary over an extended period and that these exceed existing provisions and cannot be reasonably estimated.

Provisions for restructuring only cover expenses that arise directly from restructuring measures, are necessary for restructuring and are not related to future business operations. Such expenses include severance payments to employees and compensation payments in respect of rented property that can no longer be used.

Restructuring measures may include the sale or termination of business units, site closures, relocations of business activities or fundamental reorganizations of business units. The respective provisions are established when a detailed restructuring plan has been drawn up, resolved upon by the responsible decision-making level of management and communicated to the employees and/or their representatives. Provisions for restructuring are generally established at the present value of future cash outflows.

As a global enterprise, the Covestro Group is exposed to numerous legal risks for which provisions for litigations must be established under certain conditions – including especially in the areas of product liability, competition and antitrust law, patent disputes, tax law, environmental law, and compliance issues such as corruption and export control.

Litigation and other judicial proceedings often raise complex issues and are subject to many uncertainties and complexities including, but not limited to, the facts and circumstances of each particular case, the jurisdiction in which each suit is brought and differences in applicable law. The outcomes of currently pending and future proceedings generally cannot be predicted. Judgment in court proceedings, regulatory decisions or the conclusion of a settlement may result in the Covestro Group incurring charges for which no accounting measures have been taken for lack of reasonable estimate or which exceed established provisions and insurance coverage.

The Covestro Group considers the need for accounting measures in respect of pending or future litigations, and the extent of any such measures, on the basis of the information available to its legal department and in close consultation with legal counsel acting for the Covestro Group.

Where it is more likely than not that such a litigation will result in an outflow of resources that is already reasonably estimable, a provision for litigation is normally recorded in the amount of the present value of the expected cash outflows. Such provisions cover the estimated unavoidable payments to the plaintiffs, court and procedural costs, attorney costs, and the cost of potential settlements.

It is often impossible to reliably determine the existence of a present obligation or reasonably estimate the probability that a potential outflow of resources will result from a pending or future litigation. Due to the special nature of these litigations, provisions generally are not established until initial settlements allow an estimate of potential amounts or judgments have been issued and not before at least a range of possible legal outcomes of such litigations is possible. Provisions for legal defense costs are established if it is probable that material costs will have to be incurred for external legal counsel to defend the company’s legal position.

Internal and external legal counsels evaluate the current status of the material legal risks of the Covestro Group at the end of each reporting period. The need to establish or adjust a provision and the amount of the provision or adjustment are determined on this basis. Adjusting events are reflected up to the date of preparation of the consolidated financial statements.

The status of the material legal risks is described in note 26 “Legal Risks.”

Personnel-related provisions are mainly those recorded for variable one-time payments, individual performance awards, long-service awards, severance payments in connection with early retirement arrangements, surpluses on long-term accounts and other personnel costs.

Obligations under stock-based compensation programs that provide for awards payable in cash are also included here. The compensation of the Board of Management of Covestro AG and of managerial employees includes stock-based compensation components that are earned with lock-up periods and are reflected in profit or loss as personnel expenses in line with the consideration paid in the performance period. They are measured using a subscription price model at the time of granting and at each reporting date in accordance with IFRS 2 (Share-based Payment).

Miscellaneous provisions include those for other liabilities, product liability and warranties.

Other receivables and liabilities

Grants and subsidies from third parties that serve to promote investment are reflected in the statement of financial position under other liabilities, and amortized to income over the useful lives of the respective investments.

Leasing

A lease exists when the lessor grants the lessee the contractual right to control an identified asset for a specified period of time and in return the lessor receives consideration from the lessee.

When Covestro is the lessee in a lease, as a rule a right-of-use asset and a corresponding liability (lease liability) are recognized in the statement of financial position on the date the underlying asset is made available for use to Covestro.

The right-of-use asset represents a lessee’s right to use the asset being leased in return for payment. Upon initial recognition, the right-of-use asset is generally capitalized at the amount of the corresponding lease liability plus any initial direct costs, any dismantling obligations and lease payments made prior to the commencement date less any lease incentives received. For subsequent measurement, the right-of-use asset is depreciated over the lease term. Contract modifications, as long as these are not measured as separate leases, and reassessment of the lease liability are also reflected in the right-of-use asset. The right-of-use asset is included in the line item property, plant and equipment in the statement of financial position. Impairment testing and reporting of any impairment losses are carried out for the right-of-use assets in the statement of financial position in accordance with the regulations applicable to property, plant and equipment.

The lease liability represents the company’s obligation to make contractual lease payments and is measured as the present value of precisely these outstanding lease payments. While IFRS 16 requires use of the interest rate implicit in the lease in order to calculate the present value, it is frequently not possible to ascertain this interest rate. Accordingly, the incremental borrowing rate is generally applied in discounting the lease payments. If the outstanding lease payments include fixed payments or variable lease payments that depend on an index or an interest rate, these are taken into consideration in the lease liabilities. Variable lease payments that depend on an index or an interest rate are measured at the underlying index or interest rate as soon as this is to be applied. If, as an exception, there are residual value guarantees, purchase options or penalty fees, these are to be recognized accordingly in the lease liability to the extent that they are anticipated. At Covestro, lease agreements usually include fixed contract terms. Additionally, options to extend and terminate the lease exist particularly for the rental of production and logistics infrastructure and of real estate. In order to assess whether options to extend or terminate the lease are reflected in the lease term, all relevant facts are examined to determine the existence of economic incentives to exercise or not to exercise these options. The lease term is only adjusted to reflect changes in the expectations regarding whether or not such options will be exercised if there is reasonable certainty. The effective interest method is used for the subsequent measurement of lease liabilities. Using this method, periodic lease payments with an effect on cash flows are divided into an interest portion which affects profit or loss and a repayment portion not affecting profit or loss. Lease liabilities are reported in financial liabilities classified as current or noncurrent according to their maturity.

Overall, effects on income from leases to be recognized in accordance with IFRS 16 comprise depreciation of the right-of-use asset and any impairment losses on the right-of-use asset (operating result), discounting and subsequent measurement of the lease liability (financial result) and in cases in which a lease agreement is modified. Such lease modifications can result, for instance, from options to terminate or extend a lease which were previously not explicitly stipulated in the contract. Contractual lease payments for leases accounted for in accordance with IFRS 16 are shown solely under cash flows from financing activities.

IFRS 16 provides exemptions for applying the recognition and measurement rules for leases with a term of less than 12 months, those with a low-value underlying asset or if the underlying asset is an intangible asset. Covestro considers an asset to be of low value if the new value is less than €5,000. Leases are not recognized as a depreciable right-of-use asset on the balance sheet or as a lease liability at Covestro for the exceptions referenced above. Corresponding contractual payments are shown in the cash flows from operating activities and the same amount is recognized as an expense in the operating result.

For leases in which Covestro is the lessor, a differentiation is made between finance lease and operating lease in accordance with IFRS 16. Leases that transfer substantially all the risks and rewards incidental to ownership of the leased asset to the lessee are treated as finance leases. At the commencement date, the lessor recognizes a lease receivable in the statement of financial position in the amount of the net investment in the lease and derecognizes the underlying asset from the noncurrent assets. The net investment routinely comprises the present value of future contractual lease payments. Any lease incentives or variable lease payments that depend on an index or an interest rate to be paid by the lessee, as well as any residual value guarantees or other contractual payment claims against the lessee can be included in the net investment. The lessor applies the interest rate implicit in the lease for initial measurement of the net investment or the lease receivable. Using this method, periodic lease payments with an effect on cash flows are divided into an interest portion which affects profit or loss and a repayment portion not affecting profit or loss; the interest portion is shown in the financial result. The effective interest method is applied for the subsequent measurement of the net investment or lease receivable. In an operating lease, the underlying asset continues to be shown under the lessor’s noncurrent assets and depreciated over the useful life. Lease payments received are recorded as sales.

Acquisition accounting

Acquired businesses are accounted for using the acquisition method, which requires that the assets acquired and liabilities assumed be recorded at their respective fair values on the date control is obtained. Ancillary acquisition costs are recognized as expenses in the periods in which they occur.

Procedure used in global impairment testing and its impact

Global impairment testing is performed at the level of cash-generating units. A cash-generating unit (CGU) is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. The Covestro Group regards its strategic business entities as cash-generating units and subjects them to global impairment testing. The cash-generating units usually constitute the first financial reporting level below the reportable segments.

Cash-generating units are globally tested if there is an indication of possible impairment. Those to which goodwill is allocated are tested at least annually.

In the case of impairment, the resulting expense is reflected for goodwill in other operating expenses and for other assets in the functional item of the income statement in which the depreciation or amortization of the respective assets is recognized. The same applies to income from impairment loss reversals, although impairment losses on goodwill may not be reversed.

The recoverable amount is generally determined on the basis of the fair value less costs of disposal, taking into account the present value of the future cash flows as market prices for the individual units are normally not available. The forecasts of future cash flows generally have a planning horizon of three to five years and are based on the Covestro Group’s current planning. Forecasting involves making assumptions, based on internal Group estimates and external sources, especially regarding future selling prices, sales volumes, costs, market growth rates, economic cycles and exchange rates. Where the recoverable amount is the fair value less costs of disposal, the cash-generating unit is measured from the viewpoint of an independent market participant. Cash flows beyond the planning period are determined on the basis of long-term business expectations using the respective individual growth rates derived from market information. The measurement of fair value less costs of disposal is based on unobservable inputs (Level 3 of the fair value hierarchy).

The net cash inflows are discounted at the weighted average cost of capital (WACC), which is calculated as the weighted average cost of equity and cost of debt. To take into account the risk and return profile of the Covestro Group, an after-tax cost of capital is calculated and a specific capital structure is defined by benchmarking against comparable companies in the same industry sector (“peer group”). The cost of equity corresponds to the return expected by stockholders, while the cost of debt is based on the terms at which the peer group can obtain long-term financing. In principle, both components are derived from capital market information.

The growth rates for the terminal value applied for impairment testing in fiscal 2019 amounted to 1% (previous year: 1%) for the Polyether Polyols CGU in the Polyurethanes reporting segment and 2% (previous year: 2%) in each case for the following CGUs: Diphenylmethane Diisocyanate (MDI) and Toluene Diisocyanate (TDI) in the Polyurethanes reporting segment; Polycarbonates (PCS) in the Polycarbonates reporting segment; and Base & Modified Isocyanates (BMI), Resins (RES), and Specialty Films (SF) in the Coatings, Adhesives, Specialties reporting segment. These growth assumptions reflect in particular economic cycles over several years as well as expectations for capacity and the market for each cash-generating unit. The after-tax capital cost factor used to discount the expected cash flows was 6.4% (previous year: 6.5%).

As was the case in the previous year, no impairment losses were recognized on goodwill in the reporting period on the basis of the global annual impairment testing of the cash-generating units. In the fiscal year, impairment losses on property, plant and equipment and intangible assets amounted to €28 million (previous year: €7 million) and impairment loss reversals on property, plant and equipment and intangible assets amounted to €1 million (previous year: €0 million). Details are provided in notes 13 “Goodwill and Other Intangible Assets” and 14 “Property, Plant and Equipment.”

Although the estimates of the useful lives of certain assets, assumptions concerning the macroeconomic environment and developments in the industries in which the Covestro Group operates, and estimates of the discounted future cash flows are believed to be appropriate, changes in assumptions or circumstances could require changes in the analysis. This could lead to additional impairment losses in the future or – except in the case of goodwill – to reversals of previously recognized impairment losses if developments are contrary to expectations.

The sensitivity analysis for cash-generating units to which goodwill is allocated was based on a 10% reduction in the future free operating cash flow, a 10% increase in the WACC, or a one-percentage-point reduction in the long-term growth rate. On this basis, there would be no need to recognize an impairment loss for any of the cash-generating units.

The same applies at the measurement date to other deviations from the assumptions used in the impairment testing that were deemed possible.

Fair value

According to IFRS 13 (Fair Value Measurement), fair value is the price that would be received to sell an asset or paid to transfer a liability at the measurement date in an orderly transaction in a primary market or, if such is not available, in the most favorable market to which the Covestro Group has access at that time. In essence, the fair value of a liability reflects the risk of nonfulfillment.

If available, the Covestro Group calculates the fair value of a financial instrument based on quoted prices in an active market for this instrument. A market is regarded as active when transactions for the respective asset or liability take place with sufficient frequency and volume to provide regular pricing information at the reporting date.

If no quoted prices on an active market exist, measurement methods are used which maximize the use of relevant observable inputs and minimize the use of non-observable inputs. All factors taken into account by market participants in pricing such a transaction are incorporated into the relevant method of measurement.

Depending on the asset or liability category, specific information is provided about the principles for using or determining fair value. In the Covestro Group, this generally applies to items in the financial statements as well as disclosures in the notes.

Impairment losses

The Covestro Group calculates a risk provision for expected credit losses for the following items:

• financial assets measured at amortized cost,
• debt instruments measured at fair value through other comprehensive income,
• financial guarantees and loan commitments,
• contract assets.

For financial instruments without a significant increase in credit risk since initial recognition, the amount of the risk provision for expected credit losses equals the credit losses expected to occur within the next twelve months. For financial instruments with a significant increase in credit risk, a risk provision is calculated in the amount of the credit losses expected over their residual maturity.

Relevant data from within and outside the company that can be obtained with reasonable effort is considered when determining whether the credit risk has increased substantially since initial recognition. For instance, the financial data of counterparties or customers, ratings, the payment histories of counterparties or customers, and forward-looking information are all assessed. It is assumed that a significant increase in credit risk has occurred when the financial asset is more than 30 days past due.

A default event has occurred when the Covestro Group comes to the conclusion that the counterparty is highly unlikely to be able to meet its payment obligations in full.

In the case of trade accounts receivable and contract assets, the amount of the risk provision is equal to the credit losses expected over their remaining term.

At each reporting date, the Covestro Group determines whether financial assets measured at amortized cost or at fair value through other comprehensive income are credit impaired. Indicators of credit impairment of a financial asset include observable data regarding the following events:

• significant financial difficulties of the issuer or borrower,
• a breach of contract, such as default or delinquency,
• concessions that Covestro makes to the borrower for financial or legal reasons relating to the financial difficulties of the borrower that it would not otherwise make,
• it is becoming probable that the borrower will enter bankruptcy or other financial reorganization,
• the loss of an active market for this financial asset.

The gross carrying amount of a financial asset is derecognized when the Covestro Group comes to the conclusion that the counterparty is no longer able to meet its payment obligations. Following derecognition, the Covestro Group assumes that it will no longer be able to recover any significant amounts.

Accounting policies and valuation principles applied as of December 31, 2018

Leases

Leases are classified as either finance or operating leases. Leasing transactions that transfer substantially all the risks and rewards incidental to ownership of the leased asset to the lessee are treated as finance leases.

Where the Covestro Group is the lessee in a finance lease, the leased asset is capitalized at the lower of the fair value of the asset and the present value of the minimum lease payments at the beginning of the lease term and simultaneously recognized under financial liabilities. The minimum lease payments are divided into the interest portion and the principal portion of the remaining obligation, which is determined using the effective interest method. The leased asset is depreciated using the straight-line method over the shorter of its estimated useful life or the lease term.