Notes to the Consolidated Financial Statements of the Covestro Group – Principles and Methods

3. Accounting Policies and Valuation Principles

Accounting policies and valuation principles classified as material for the Covestro Group under IAS 1 and the Practice Statement are described in the following. Accounting policies and valuation principles may be material by their nature, even if the associated amounts are immaterial. Examples include disclosures on accounting policies and valuation principles that are discretionary, that are based on options, or that are not already obvious from the wording of an IFRS pronouncement itself, and that appear relevant overall for an understanding of the Covestro Group’s financial statements. The main focus of the accounting policies and valuation principles presented in the following is on particular aspects that are at the specific discretion of Covestro’s management and on options exercised.

Judgements and Estimation Uncertainties

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.

Judgements are made when applying accounting policies that may materially affect the financial statements. These include:

• Identifying indications of impairment (triggering events), determining an appropriate peer group to derive the weighted cost of capital, and defining cash-generating units or groups of cash-generating units, in each case for the purposes of centralized impairment tests for noncurrent assets
• The identification of impairment losses or reversals of impairment losses on noncurrent assets, taking individual lower value thresholds into account
• The identification and valuation of intangible assets and liabilities in the context of purchase price allocation in connection with the acquisition of companies

Such assumptions and estimates mainly relate to the following areas:

• Defining the useful life of noncurrent assets
• Goodwill impairment testing, including long-term planning assumptions with respect to growth and profitability using discounted cash flows in the context of centralized impairment tests of noncurrent assets
• Accounting for income taxes and assessing the recoverability of deferred tax assets in respect to future taxable income and the recognition of tax effects in the future and as well the recognition of uncertain tax positions due to any different findings made during tax audits
• Recognition and measurement of provisions, e.g., for litigation, for pensions and other employee benefits, termination benefits (e.g., in the context of restructurings), for other taxes, for environmental protection and for product liability
• The determination of assumptions underlying the recognition, measurement, and disclosure of financial instruments

The risks relating to the impacts of the current crisis caused by Russia’s war against Ukraine and other geopolitical conflicts are taken into account here.

In addition, Covestro’s management must decide which information is relevant to 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, is disclosed in the following notes. The following estimates are based on historical experience and assumptions that are believed to be reasonable. They are reviewed on an ongoing basis, but may differ from the actual values subsequently recognized.

Climate-related Impacts

Covestro is striving to become climate-neutral and has set itself the target of achieving net zero greenhouse gas (GHG)^* emissions in its own production (Scope 1) and from the provision and use of energy produced outside the company (Scope 2) at all environmentally relevant sites. For the first time, Covestro also set itself a new absolute reduction target for its Scope 3 GHG Emissions in the 2023 reporting year. In light of this, it is also working on solutions to reduce GHG emissions along the value chain. The concept of the circular economy is also a key element of Covestro’s strategy. By moving away from the use of fossil resources, through regenerative approaches and circularity, the aim is to sustainably transform value creation into a holistic orientation toward regenerative production.

All the assumptions and estimates in these financial statements are based on the circumstances and assessments on the reporting date. On this basis, there are no identifiable specific indications of any material need to recognize impairment losses on noncurrent assets or for any material adjustment to the remaining useful lives of assets at the reporting date. The Group will continuously review the basic assumptions made and will adjust them if necessary. Covestro continuously monitors legislation regarding climate change.

Consolidation

The Consolidated Financial Statements of Covestro AG as of December 31, 2023, include all material subsidiaries and associates as well as one joint operation. Subsidiaries that, in the aggregate, are immaterial for the Group’s net assets, financial position, and results of operations are not consolidated. Such subsidiaries are recognized at cost.

• See note 5.1 “Scope of consolidation and investment.”

Joint Operations and Associates

Joint operations 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 or a separate legal entity 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.

The Covestro Group recognizes the share of assets, liabilities, revenues, and expenses in its consolidated financial statements in accordance with its rights and obligations in joint operations. 

The only entity included in the Covestro Consolidated Financial Statements that is classified as a joint operation is LyondellBasell Covestro Manufacturing Maasvlakte V.O.F, Rotterdam (Netherlands). This company was formed together with Lyondell PO-11 C.V., Rotterdam (Netherlands). The two venturers each own a 50% interest in the capital and voting rights. The company operates production facilities for the sole account of the venturers, who therefore receive substantially all the economic benefits of the assets. The venturers are the sole source of cash flows. Liabilities incurred are primarily settled through cash flows resulting from sales to the venturers. Variable costs are reimbursed by the shareholders depending on the specific purchase quantities. 

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

Currency Translation

The financial statements of the individual companies included in the consolidated financial statements are prepared in their respective functional currencies. As a rule, the functional currency of the consolidated company is the applicable local currency, as these companies operate their business autonomously from a financial, economic, and organizational point of view.

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 whose functional currency is not the euro 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.

Sales

All revenues in connection with customer contracts, primarily from product sales, are recognized as sales. Sales also include income from services rendered and licensing agreements.

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. 

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 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, the point in time at which control is transferred depends on the contractual agreement concluded with the customer in each case and the stipulated transportation clauses.

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.

Exceptionally, 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.

Invoices are usually payable in 0 to 90 days. Contracts may contain early payment discounts or rebates. Rebates are generally retroactively granted 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 contractual 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 (Revenue from Contracts with Customers). 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. Refund liabilities are reported in other financial liabilities.

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.

Government Grants

Government grants are recognized if there is sufficient certainty that the benefits will be granted and the related conditions will be met. Asset-related grants from third parties, such as investment grants, are reported under other receivables and other nonfinancial liabilities and are recognized in profit or loss in accordance with the asset’s useful life. Depending on the circumstances, income-related grants are either offset against expenses or are recognized under other operating income. If realized in the income statement before the payment is received or if it is dependent on specific conditions, these are recognized as other receivables or other nonfinancial liabilities. The Covestro Group mainly receives income-related grants.

Covestro regularly verifies that conditions attaching to government grants received are fulfilled.

Emission rights granted free of payment by government authorities are recognized in the statement of financial position at zero euros or at a reminder value. Emission rights acquired on the market in return for payment are capitalized at cost of acquisition and are impaired, if the fair value is lower than the acquisition cost. Emissions caused generally result in return obligations which have to be recognized.

Functional Cost

Functional cost is calculated using the cost of sales method for the functions that incur them on the basis of cost center accounting. A distinction is made here between cost of goods sold, selling expenses, research and development expenses, and general administration expenses. Operating expenses that cannot be allocated to the functions that caused them are presented as other operating expenses.

Cost of goods sold includes all production costs for products and services sold in the fiscal year as well as the cost of products acquired and resold in the fiscal year. This also includes impairment losses on inventories and overheads attributable to the production process.

In addition to transportation and logistics costs, selling expenses primarily include the costs of selling, advertising, and marketing activities, as well as the costs of sales representatives and distribution warehouses.

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. Capitalized development costs also include the cost of material IT projects if the recognition criteria are met. 

Expenses that are not related to the functions described are reported under general administration expenses. These include administrative personnel costs, depreciation of and impairment losses on other equipment, and external audit costs.

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. Detailed explanations of impairment testing of deferred tax assets can be found in “Judgements and Estimation Uncertainties” in this note.

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 (outside basis differences).

The expected effects of uncertain deferred and actual income tax positions are estimated 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.

Business Combinations

Businesses acquired are accounted for pursuant to IFRS 3 (Business Combinations) using the acquisition method, which requires that all identifiable assets acquired and all (contingent) liabilities assumed be recognized and measured at their respective fair values on the date control is obtained.

The Covestro Group recognizes the components of noncontrolling interests in the acquiree either at fair value or at the noncontrolling interest’s proportionate share of the acquiree’s identified net assets. The Covestro Group exercises this option separately for each business combination in accordance with the standard.

Noncurrent Assets

Noncurrent assets include property, plant and equipment and intangible assets, with definite or indefinite useful lives in each case.

If the construction phase or manufacturing process of noncurrent assets 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).

Depreciation and amortization charges, which are recognized on a straight-line basis in the Covestro Group, impairment losses, and reversals of impairment losses on finite-lived noncurrent assets are allocated to the relevant functions.

The following useful lives are applied to other intangible assets, except where the actual depletion demands a different amortization pattern:

Determination of the expected useful lives of other intangible assets is based in particular on estimates of the period for which they will generate cash flows.

In the Covestro Group, intangible assets with an indefinite useful life relate mainly to goodwill. Impairment losses on goodwill are reported in other operating expenses.

• See Note 13.3 “Impairment Testing.”

Intangible assets that may result from internal development projects, including IT and software projects, are often associated with uncertainties, which means that the criteria for capitalization are generally not met. Capitalization requirements are reviewed on a project- and contract-specific basis, taking materiality into account.

Depreciation of property, plant and equipment is largely based on the following useful lives, which are standard throughout the Group:

Significant asset components with different useful lives are accounted for and depreciated separately. In cases where the special recognition criteria are met, the associated costs may be capitalized as a separate component, for example if extensive maintenance work is carried out regularly (such as the general overhaul of a machine). 

When assets are sold, closed down, or scrapped, the difference between the recoverable amount, which normally amounts to the fair value less costs of disposal, and the net carrying amount of the assets is recognized as a gain or loss in other operating income or expenses, respectively.

Leases

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. Lease liabilities are reported under financial debt and classified as current or noncurrent according to their maturity.

For low-value leased assets and short-term leases (lease term of less than twelve months), use is made of the practical expedients and corresponding contractual payments are reported in cash flows from operating activities and recognized as an expense in the operating result. Covestro also exercises the option not to recognize any leased intangible assets as leases.

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. 

Lease liabilities are measured at the present value of the lease payments to be made over the term of the lease, which are generally discounted using the incremental borrowing rate, as the interest rate implicit in the lease cannot generally be determined. Lease liabilities are measured at amortized cost using the effective interest method. They are adjusted in the event of modifications to or reassessment of the lease.

At Covestro, lease agreements usually include fixed contractual terms. If there are additional options to extend or terminate the lease, 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.

For leases in which Covestro is the lessor, a differentiation is made between finance leases and operating leases 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, Covestro 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 property, plant and equipment. In an operating lease, the underlying asset continues to be shown under Covestro’s property, plant and equipment and depreciated over its useful life. Lease payments received are recognized through profit or loss.

Investment Property

Investment property is measured at amortized costs unless a lower carrying amount is required. The carrying amount of investment property is depreciated using the straight-line method. The useful lives are the same as those for property, plant and equipment described above. The fair value to be determined to meet disclosure requirements is mainly calculated on the basis of internally prepared valuations. In the case of buildings and developed land, this is carried out using a method known as the German income approach, and in the case of undeveloped land, using the sales comparison approach.

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. Impairment losses on inventories are recognized if their net realizable value on the reporting date is lower than the value calculated using the weighted-average method. Impairment losses are reversed if the net recoverable amount subsequently exceeds the carrying amount.

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.

Financial Assets

Financial assets comprise loans, acquired equity and debt instruments, cash and cash equivalents, trade accounts receivable, other financial assets, as well as derivatives with positive fair values. Regular-way purchases and sales of financial assets are generally recognized on the settlement date.

The “at amortized cost” measurement category comprises trade accounts receivable, the loans included in other financial assets, and cash and cash equivalents. Interest income from financial assets assigned to this category is determined using the effective interest method.

Debt instruments like purchased bonds can be classified as financial assets at fair value through other comprehensive income if the purpose of the investment is to hold the financial asset to collect the contractual cash flows or to sell it. 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 changes in fair value 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. At the time of disposal, the Covestro Group reclassifies all gains and losses recognized in other comprehensive income, including any recognized impairment losses and reversals of impairment losses, to retained earnings. Examples of this category of other strategically held instruments classified as equity are certain investments made under the Covestro Venture Capital (COVeC) initiative.

Depending on the contractual design, COVeC investments are also recognized as debt instruments at fair value through profit or loss. This category also includes all financial assets not allocated to any of the abovementioned categories. These are in particular derivatives with a positive fair value.

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.

Financial Liabilities

Financial liabilities generally comprise financial debt, lease liabilities and negative fair values of derivatives and other financial liabilities.

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. Further, assets and liabilities from certain energy contracts that are intended to be settled net are also recognized as derivatives. 

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 in accordance with IAS 37 (Provisions, Contingent Liabilities and Contingent Assets). Where embedded derivatives are identified that are required to be separated from the pending transactions, they are accounted for separately. To cover possible peak demand, a nonmaterial volume of transactions may be entered into for which the possibility of immediate resale cannot be excluded. 

Reportable derivatives are carried at fair value. This applies to what are known as stand-alone derivatives as well as derivatives embedded in certain types of contracts and 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 other operating income or expenses. 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 income or expenses.

Covestro has entered into master netting or similar agreements for derivative financial instruments. These take effect in particular in the event of the insolvency of one of the contractual partners involved.

Fair Value

The valuation techniques and input factors of fair value hierarchy Level 1 and Level 2 that are used to determine the fair value of financial instruments are shown in the following table: 

The valuation techniques and input factors of fair value hierarchy Level 3 are shown in the following table:

The gains and losses from Level 3 financial assets and liabilities are reported as follows:

• Gains and losses from embedded derivatives recognized in profit or loss are reported in other operating income or expenses;
• Gains and losses from contingent purchase price receivables, from divestments, and debt instruments recognized in profit or loss are reported in other financial result; and
• Gains and losses from other financial investments are reported in other comprehensive income from equity instruments.

Expected Credit Losses (ECL) Model

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

The credit risk the Covestro Group is exposed to through its trade accounts receivable and contract assets depends largely on the creditworthiness of the customer. In order to manage this risk, the corporate Supply Chain & Logistics function implemented a process in the framework of the Covestro Group’s Credit Management that uses internal and external data to assess each customer in terms of its creditworthiness. Quantitative and qualitative data that can be obtained with reasonable effort are evaluated during the assessment process. The assessment reflects financial data, ratings, payment history, and data on the customer’s environment. The customer is allocated to one of five risk categories on the basis of the final assessment. The categories range from A to E, with risk category A representing the most creditworthy companies and risk category E the least. 

Meaningful data is used to determine an expected loss rate for each risk category. Data such as default probabilities from rating agencies and credit insurance firms, historical impairment losses recognized by the Covestro Group, and the empirical data from Credit Management are used to determine the expected loss rates. In addition, forward-looking information such as the country rating is also used in determining the expected loss rates. The expected and actual losses are compared regularly (backtesting) to validate the method.

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.

Covestro uses a general, three-stage approach for measuring the risk provision for expected credit losses as follows:

• Stage 1: The risk provision is calculated as the 12-month expected credit loss, whereby the default probability is derived from historical data published by recognized rating agencies. The Covestro Group assumes that investment-grade ratings imply a low level of credit risk.
• Stage 2: The amount of the risk provision is measured as the expected credit loss over the lifetime of the debt instrument if the credit risk has increased significantly since its initial recognition. Changes in credit risk are assessed using the actual payment history and external information. Whenever available, Covestro uses credit default swap prices and other forward-looking information such as ratings outlooks in addition to external ratings. If no specific information relating to the case in question is available, it is assumed that a significant increase in credit risk has occurred when the financial asset is more than 30 days past due.
• Stage 3: Covestro reclassifies a debt instrument to Level 3 if it determines that its creditworthiness is impaired. This is the case, for instance, when a counterparty has obtained insolvency status, when there is sufficient information available to show that the counterparty has applied for insolvency proceedings, or when debt instruments are more than 90 days overdue.

Indicators of possible 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
• Impending bankruptcy or other impending reorganization proceedings on the part of the borrower
• The loss of an active market for this financial asset

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.

Cash Flows

The statement of cash flows shows how the Covestro Group’s cash and cash equivalents changed in the reporting year.

The effect due to exchange rate movements is recognized in the separate line “Change in cash and cash equivalents due to exchange rate movements.”

When determining the cash flows from financing activities, Covestro exercises the option of recognizing dividend payments and profit withdrawals in cash flows from financing activities.

Cash flows from interest and dividends received are presented under cash flows from investing activities in the separate line “Interest and dividends received.”

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. As such, they are included in the functional cost items. 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.

Future obligations under defined benefit pension plans are calculated using the actuarial projected unit credit method and are allocated over the employees’ entire period of employment. This requires specific assumptions to be made regarding the 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 disbursements from the pension plans. The uniform discount rate derived from this interest rate structure is thus based on the yields, on 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 the functional cost items. The net interest is reflected in the financial result.

Other Provisions

As a company with international operations, the Covestro Group is exposed to numerous legal risks for which provisions for litigation must be recognized under certain conditions – 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. It is possible that legal judgments, regulatory decisions, or settlements could give rise to expenses that are not covered, or not fully covered, by insurers’ compensation payments and could significantly affect the earnings of the Covestro Group.

The Covestro Group considers whether, and if so, in which amount, provisions for litigation need to be recognized for pending or future legal proceedings on the basis of the information available to its Law, Intellectual Property & Compliance corporate function and in close consultation with legal counsel acting for the Covestro Group. 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 pending or future litigation. Due to the special nature of these litigation, provisions are generally 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 can be determined. Provisions for legal defense costs are recognized if it is probable that material costs will have to be incurred for external legal counsel to defend the company’s legal position and an outflow of resources can generally be expected.

Internal and external legal counsels evaluate the current status of the material legal risks to the Covestro Group at the end of each reporting period. The need to recognized 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.

• See note 26 “Legal Risks.”

Provisions for restructuring are based either on a legal or a constructive external obligation. They 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. Prior to recognition of this type of provision, the associated assets are tested for impairment. Provisions are recognized when a detailed restructuring plan has been drawn up, resolved by the responsible decision-making level of management, and communicated to the affected employees and/or their representatives.

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. Calculation of provisions for short-term variable compensation (“Covestro Profit Sharing Plan,” Covestro PSP) is based on the following financial performance indicators: profitable growth measured in terms of earnings before interest, taxes, depreciation, and amortization (EBITDA), liquidity measured in terms of free operating cash flow (FOCF), and profitability measured in terms of return on capital employed (ROCE) above weighted average cost of capital (WACC). This contains a sustainability component (environment). Other criteria relating to social and corporate governance are also to be incorporated in the future.  

Personnel-related provisions also include obligations under cash-settled share-based payment transactions (“Prisma”). The compensation of the Board of Management of Covestro AG and of managerial employees includes cash compensation based on the share price 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. It is measured on the basis of a mathematical option pricing model at the grant date and at each reporting date. When determining long-term variable compensation, a sustainability component is defined for annual reductions in greenhouse gas emissions (CO₂ equivalents).

Provisions for environmental protection are recognized if future cash outflows are likely to be necessary to ensure compliance with environmental regulations or to carry out remediation work based on an obligation, 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 for existing environmental programs, current costs, and new developments affecting these 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 business environment in which the Covestro Group operates and the inherent difficulties in accurately estimating environmental liabilities, material additional costs beyond the amounts accrued may be incurred under certain circumstances. 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 trade-related commitments are disclosed separately within other provisions. Miscellaneous provisions include those for other liabilities, for product liability, for warranty, and insurance payments. 

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 generally recognized in the functional cost item(s) in which the original charge was recognized. 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 for certain provisions in each case.

Claims for reimbursements from third parties are separately recognized in other receivables if their realization is virtually certain.

Trade Accounts Payable

Trade accounts payable comprise current liabilities arising from the supply of goods and services, i.e., from the receipt of goods or services. These are based on agreements with the supplier, are invoiced and, in total, are part of working capital within Covestro’s normal business cycle. At Covestro, these also include payment terms agreed with certain suppliers (supplier finance arrangements). For information on assessing the contract terms and conditions, see note 24.1 “Financial Instruments by Category.”

Pending Transactions

Pending transactions relating to contributions in kind (“executory contracts”), i.e., agreements in relation to which (to a degree) neither the service nor the consideration has been rendered, are not recognized in the statement of financial position on the reporting date if there is no risk of a loss on the reporting date. If there is the risk of a loss, this is generally anticipated in the form of provisions if all the other requirements are met. In contrast, gains anticipated from such agreements on the reporting date may not be recognized in the statement of financial position. Examples of executory procurement contracts include contracts regarding the procurement of energy for the operation of production facilities (“own requirements”), which also includes power purchase agreements.