2Introduction to German accounting
2.1Legal framework
2.1.1Legal regulations
Because Germany is a member of the European Union (EU), German accounting is harmonized with European accounting rules, meaning the EU sets up a framework that must be applied by the member states but leaves certain decisions up to member states. EU directives are not directly applicable law but must be transferred and enacted by the member states. Thus, German accounting will be explained, not the EU framework, keeping in mind that German accounting complies with the EU framework.
Starting with the transferral of the fourth, seventh and eighth EC directives into German law, the “Accounting Directive Act” (Bilanzrichtliniengesetz) was enacted in 1985. It included a summary of accounting rules in one law, the “Commercial Code” (Handelsgesetzbuch HGB); until then the accounting rules for companies were spread out over many laws with partially different content.
The third book of the Commercial Code comprises all accounting rules that are applicable to all kinds of commercial businesses as long as the business itself requires, because of its nature or size, a commercial organization (§ 1 sect. 2).
In addition, additional laws specify accounting requirements for the following issues:
–specific large companies: sole propietorships and partnerships considered “large” must satisfy the more detailed requirements of corporations regarding preparation and publication of financial statements (“Disclosure Act”, Publizitätsgesetz PublG; for details see Chapter 2.1.2.2);
–specific legal forms, for example limited liability companies (GmbH-Gesetz) or stock companies (Aktiengesetz);
–specific industries, for example banks and financial institutions (Kreditwesengesetz) or insurance companies (Versicherungsaufsichtsgesetz).
For consolidated financial statements, the application of the International Financial Reporting Standards (IFRS) can be mandatory (see Chapter 4.2). Whereas the IFRS are prepared by a private organization, the International Accounting Standards Board (IASB), they are adopted by the EU and transferred directly to applicable law by a specific procedure called a comitology procedure (or endorsement).38
Apart from the formally codified law, there exists so-called soft laws, which are formally accepted but usually include recommendations or interpretations of legal rules. Relevant for accounting are the “German Accounting Standards” (Deutsche Rechnungslegungsstandards DRS), which are issued by the German Accounting Standards Committee (Deutsches Rechnungslegungs Standards Committee DRSC) and interpret the requirements for consolidated financial statements. The “German Corporate Governance Code” (Deutscher Corporate Governance Kodex DCGK) focuses on the governance of listed stock companies.
In addition, the decisions of supreme courts should be taken into account because they can give guidance on specific situations.
Finally, if the application of a specific rule is unclear, the GAAP39 (Grundsätze ordnungsmäßiger Buchführung) as underlying principles and other legal commentaries and best practices can be used. Of particular importance are statements of the “Institute of Chartered Public Accountants in Germany” (Institut der deutschen Wirtschaftsprüfer IDW) because chartered accountants need to follow these statements.
Here is an overview:
In what follows, this book focuses on the parts of the Commercial Code applicable to all companies (proprietorships, partnerships and corporations) and necessary commentaries/best practices where relevant. References will be given to the relevant DRS and IDW statements as well as to the IFRS. There will be no treatment of topics related to specific industries.
2.1.2Applicability and simplifications
As mentioned earlier, the rules of the Commercial Code are applicable to any commercial business that requires, beceause of its nature or size, a commercial organization. That includes most businesses or companies. The term commercial business does not include all kinds of business activities. Management of one’s own assets (not for others) and professionals such as lawyers and architects are excluded. Apart from that, only very small businesses with no or few employees or business transactions that are run on a part-time basis are excluded.40
For all other businesses, the Commercial Code is applicable; but there are differences regarding the extent to which the rules must be applied. First, the rules to be applied depend on the legal form; second, they depend on company size.
2.1.2.1Applicability of Commercial Code depending on legal form
The Commercial Code distinguishes between proprietorships and partnerships on the one hand and corporations on the other. For proprietorships and partnerships, only §§ 238–263 must be applied, whereas for corporations §§ 264–335b must be applied as well.
According to German company law the most important legal forms are listed in Table 2.1.
There are many other legal forms, for example for professionals, public companies and insurance companies. These will not be treated here.
The general partners of a partnership are fully liable for the obligations of the partnership, i.e. they are not only liable with their contribution, but with all their possessions, meaning they have unlimited liability. Thus, the motivation to conduct business in a proper way is assumed to be high, because any failure and in particular insolvency will harm the general partners personally. In contrast to that, a corporation is at risk only for its own assets, meaning it has limited liability. Therefore, the motivation to avoid insolvency can be smaller, or higher risks may be taken by the managers, because they will not be affected personally (at least not their private assets). In consequence, the Commercial Code has basic rules to be applied by all companies and additional rules for corporations. Table 2.2 presents a simple overview; details will be discussed in subsequent chapters.
Tab. 2.1: Classification of common legal forms.
| Proprietorship/partnerships | Corporations |
| Sole proprietorship (Einzelkaufmann eK) | Limited liability company (Gesellschaft mit beschränkter Haftung GmbH) |
| General partnership (Offene Handelsgesellschaft oHG) | Entrepreneurial company (Unternehmergesellschaft UG; this is a specific subcategory of the limited liability company) |
| Limited partnership (Kommanditgesellschaft KG) | Stock company (Aktiengesellschaft AG) |
| Civil-law partnership (Gesellschaft bürgerlichen Rechts GbR) | European stock company (Socieatas Europea SE) |
| Limited partnership with shares (Kommanditgesellschaft auf Aktien KGaA) |
Tab. 2.2: Accounting rules for partnerships and corporations.
| Partnershipsa | Corporations | |
| Content of financial statements | ||
| –Balance sheet | Yes, but only aggregated structure (non-current assets, current assets, equity, liabilities, deferred items; § 247 sect 1.); details according to GAAP | Yes, detailed structure in § 266 |
| –Income statement | Yes, but only aggregated structure (income and expense; § 242 sect. 2); details according to GAAP | Yes, detailed structure in § 275 |
| –Use of profit | No | Only for stock companies § 158 AktG |
| –Notes | No | Yes, detailed rules, in particular §§ 284 and 285 |
| –Management report | No | Yes, § 289 |
| Audit | No | Yes, §§ 316–324a |
| Publication | No | Yes, §§ 325–329 |
a For more information about financial statements of partnerships, see IDW RS HFA 7 “Handelsrechtliche Rechnungslegung bei Personengesellschaften” – Accounting of partnerships according to the Commercial Code.
If a partnership has only legal persons (corporations, trusts or foundations) as general partners, i.e. there is no physical person who is general partner, then the partnership is treated like a corporation for accounting purposes (§ 264a).41 In subsequent chapters, the term corporation should be understood to include these specific partnerships that are treated like corporations.
Excursus: Combination of legal forms
Under German company law, it is possible to combine several legal forms. A very common form of combination is the GmbH & Co. KG, which is a limited partnership (KG) with a limited liability company as general partner. A common case of this is where the limited partners of a limited partnership are also the shareholders of the limited liability company that serves as the general partner (see below).
Partners 1 and 2 founded a limited partnership and act as limited partners with a certain contribution to the company. To avoid the unlimited liability of a general partner, they additionally founded a limited liability company that serves as general partner. By this two-step combination, a limited partnership can be set up and the full liability of a general partner can be avoided. If there is only one general partner, and it is a corporation (or if there are several of them, all corporations), the effect is identical to founding a corporation but using a partnership (which may have advantages in company law, accounting or taxation). In 1999, this was considered an unfair advantage, so § 264a was implemented, and such companies are treated like corporations.
2.1.2.2Applicability of Commercial Code depending on size class
As described earlier, the legal requirements for corporations are much more comprehensive than for sole proprietorships and partnerships. Fulfilling these requirements is time consuming and expensive. For smaller companies, the trade-off can be disproportionate: The advantage of better information for stakeholders is smaller than the additional expense and effort necessary to prepare the information. For this reason, the Commercial Code defines size classes; if a corporation fits in one of these classes, it can use simplifications.
Tab. 2.3: Size classes in Commercial Code.
The size classes use three criteria: total assets, sales revenue and average number of employees (Table 2.3).42
To be classified in a larger size class (e.g. large instead of medium), two of the three criteria must be fulfilled for two consecutive years. For an example, see exercise 4 in Chapter 5.2.
If a corporation is capital market oriented, it is always treated as large (independently of its size class; § 264d). Capital market oriented means that the company has issued securities that are traded in an organized market; this can be shares, but also bonds or other debt or equity instruments. Even if the company has not issued the securities yet, but is in the process of application for issuance, it is already treated as capital market oriented.43
Sole proprietorships or partnerships have much less stringent accounting requirements than corporations because there is at least one general partner who has unlimited liability. If proprietorships or partnerships become large, the need for additional information for stakeholders will increase as the importance of the company as employer, supplier or customer increases. Therefore, the Disclosure Act imposes additional requirements for large proprietorships or partnerships: they are basically treated like large corporations, must be audited and must publish their financial statements. For individual financial statements, there exist some simplifications (§ 5 PublG).
The size classes are as follows. The categorization works the same way as in the Commercial Code (Table 2.4).
Tab. 2.4: Size classes, Disclosure Act.
2.1.3Consequences of legal form and size classes
Table 2.5 shows the possible simplifications of legal form and size classes.
Note that there are no simplifications for recognition and measurement, only for the amount of detail to be provided, audited and published.
If a company is capital market oriented (§ 264d) and does not prepare consolidated financial statements (see subsequent discussion), it must prepare in addition a cash flow statement as part of its individual financial statements.
2.1.4Consolidated financial statements
If a corporation controls at least one other company, it must prepare consolidated financial statements (§ 290).
According to § 297, the consolidated financial statements consist of
–a consolidated balance sheet,
–a consolidated income statement,
–a consolidated cash flow statement,
–a consolidated changes-in-equity statement and
–consolidated notes.
In addition, a consolidated or group management report must be prepared (§ 315).
For further details on consolidated financial statements, see Chapter 4.
2.2Reporting conception
Three questions must be answered to decide upon the accounting for a specific transaction:
1.Recognition
Does this transaction have to be included in the financial statements or in the balance sheet, i.e. does it result in an asset or a liability? That is the question of whether or not.
2.Measurement
If a transaction must be recognized, i.e. if it must be included in the financial statements, the next question that arises is: What is the correct value? Or: How do we measure this transaction?
In this context, initial and subsequent measurement can be distinguished: Initial measurement refers to the value at which the transaction is recognized the first time in the financial statements. Subsequent measurement refers to the value that is attached to the transaction at a later point in time, typically at the closing date.
Tab. 2.5: Accounting rules for partnerships and corporations including size classes.
When recognition and measurement are clarified, the final question arises: How do we need to present this information? Do we have to provide details? Where are the details given, in the balance sheet or in the income statement or in the notes?
All three questions must be answered for all transactions at the beginning and at each closing date – at the beginning the focus is more on recognition, initial measurement and presentation, whereas at subsequent closing dates typically the focus is on subsequent measurement and, eventually, derecognition or presentation.
These three questions will guide the discussion in chapters 2, 3 and 4.
2.3Generally Accepted Accounting Principles
2.3.1Overview
As mentioned earlier, the notion of Generally Accepted Accounting Principles is used in two ways: The first meaning comprises all rules and guidelines that constitute German accounting (referred to as “German GAAP”), whereas the second focuses on the underlying principles that need to be applied in the accounting and that are used for transactions that lack specific rules. In this section, we focus on this second meaning, the underlying principles, and will refer to them as “GAAP”.
The term Generally Accepted Accounting Principles means that these principles represent best practices in accounting. Some of them are codified by law, some are just common practice. Originally, the GAAP were derived by induction from the behaviour of honourable businessmen. This method is limited to observable behaviour and leads to a discussion about what is honourable. Thus, using deduction, principles are derived from the goals of the accounting. Today, typically the method of hermeneutics is used, i.e. not only the goals of accounting but all relevant influences are taken into account to argue for or against a principle.44
The GAAP must be applied to the current bookkeeping (§ 238 sect. 1), to financial statements according to the Commercial Code (§ 243 sect. 2) and to the tax balance sheet (§ 5 sect. 1 EStG).
The GAAP can be distinguished in
–principles of documentation focusing on how information is recorded and
–principles of accounting focusing on the content of this information.
2.3.2Principles of documentation
One part of the principles of documentation focuses on clarity and transparency, i.e. the formal side of documentation. The other part focuses on completeness and correctness, i.e. the substantial side of documentation.45
In overview:46
Tab. 2.6: Principles of documentation.
2.3.3Principles of accounting
The principles of accounting are relevant for the preparation of the financial statements. Because this information is retrieved from current books, they influence the organization of the bookkeeping as well.
In overview:47
2.3.3.1General principles
Tab. 2.7: General principles of accounting.
| Principle | Content | Codification |
| Compliance with GAAP | The financial statements need to be in compliance with all GAAP. | § 243 sect. 1 § 264 sect. 2 |
| True and fair view | For corporations: The financial statements must provide a true and fair view of the financial situation (assets and capital) and the performance situation of the company.a | § 264 sect. 2 |
| Clarity and transparency | Clarity and transparency refer to the presentation of the financial statements. The structure used for the balance sheet and income statement must be in compliance with legal requirements, i.e. naming of items and order of items must meet legal requirements. If applicable, notes and management reports need to be clearly structured as well. | § 243 sect. 2 |
| Preparation in German and in Euros | Whereas current bookkeeping can be done in any living language and currency (§ 239 sect. 1), for the financial statements preparation in German and Euros is required. | § 244 |
| Correctness | Correctness means that the values of transactions are reflected correctly in the financial statements; whereas it might be difficult to find a real (objective) true value, the values must be verifiable by a qualified third party. This means not using arbitrary values, i.e. necessary estimates must correspond to the professional judgement of the business person and must be verifiable. | Not codifiedb |
| Closing date principle | The financial statements must include all assets and liabilities as of closing date. Any transaction that occurs after the closing date may not be recognized (corporations must report all material subsequent events in the management report). But a careful distinction must be made between subsequent events, i.e. a (new) transaction occurs after the closing date, and subsequent information (also called value clarifying), i.e. new information about a transaction that has already happened is available. This value-clarifying information must be used in the preparation of the financial statements.c | § 242 sect. 1 |
| Timely preparation | The financial statements should be prepared within the time needed for proper business conduct. Common understanding of this is not longer than 12 month. | § 243 sect. 3 § 264 sect. 1 |
| This is only applicable for proprietorships and partnerships; for corporations there are precise deadlines (see earlier, Chapter 2.1.3): 3 months; simplification for (very) small corporations: 6 months. |
a According to the structure of the Commercial Code, this principle applies only to corporations and capital-market-oriented companies, meaning it does not apply to sole proprietorships and partnerships (Beck’scher Bilanzkommentar, § 264, nos. 235–238). In consequence, sole proprietorships and partnerships must be in compliance with all the other GAAP, but not legally with “true and fair view”; nevertheless, this legal difference will usually not result in important differences in accounting.
b Wöhe/Döring, p. 683.
c Beck’scher Bilanzkommentar, § 252, no. 38.
2.3.3.2Recognition principles
Tab. 2.8: Recognition principles.
| Principle | Content | Codification |
| Balance sheet identity | The values of the closing balance of the previous year must be the values of the opening balance of the current year. Nothing may be added or left out; the attribution of individual assets and liabilities to balance sheet items must remain constant.a | § 252 sect. 1 no. 1 |
| Completeness | All assets, liabilities and deferred items must be recognized in the balance sheet and all income and expenses must be recognized in the income statement. For assets economic ownership is the relevant criterion (see Chapter 2.4.1). | § 246 sect. 1 |
| No offsetting | Assets and liabilities as well as income and expenses must be reported separately.b | § 246 sect. 2 |
| Formal comparability | This can be viewed as a subprinciple of the principle of clarity and transparency, but it is codified for corporations only: The form and structure of subsequent balance sheets and income statements must be retained; changes may be made only if necessary and unavoidable; any changes must be explained in the notes.c | § 265 sect. 1 |
| Another element of formal comparability is to keep the recognition methods constant, meaning the approach to recognizing or derecognizing assets and liabilities must be used consistently from one year to the next. In particular, recognition options (e.g. internally generated non-current intangible assets) must be exercised identically for similar items.d | § 246 sect. 3 |
a Beck’scher Bilanzkommentar, § 252, nos. 3–8.
b Offsetting of assets and liabilities is possible only if legally acceptable (§ 387 BGB); the criteria for legal offsetting are very strict, so it is seldom done (see Beck’scher Bilanzkommentar, § 246, nos. 100–115).
c Beck’scher Bilanzkommentar, § 265 nos. 2–4.
d Beck’scher Bilanzkommentar, § 246 nos. 125–132.
2.3.3.3Measurement principles
2.3.3.3.1Principle of prudence
The most important principle of GAAP is the principle of prudence – in its strictness it makes German accounting different from many other accounting standards. It stems from the idea of an honourable businessman: judging risks carefully – rather estimating a bit higher, judging chances also carefully – rather estimating a bit lower. In sum, it is a risk-averse approach to accounting that aims to protect creditors, i.e. to make sure that the net assets reported are really available and not just market-price fluctuations.48
The principle of prudence states that the measurement of assets and liabilities should be done cautiously taking into account all predictable risks and losses (§ 252 sect. 1 no. 4). It can be split into the following two subprinciples.
Realization principle
Any income and gains may be recognized only if and when they are realized. Unrealized gains, for example pure market values, cannot be realized, even if they exist at the closing date.
Income or gains are realized when the underlying transaction is completed, i.e. the company has fulfilled all its obligations by supplying products or rendering services and can now reliably expect the counterparty to fulfil its obligation, whichmeans in most cases to pay the associated invoice. German accounting follows strictly the completed contract method, even if it is not codified by law.49
A completed contract typically means, for a sales agreement,50
–a contract or similar agreement exists;
–the products have been supplied or delivered or the services rendered;
–the transfer of risk has occurred, i.e. in particular the risk of accidental loss is borne by the buyer;
–additional conditions that have to be fulfilled for remuneration have been fulfilled.
Only if all of these conditions are met can a transaction be completed and the revenue, income or gain recognized in the income statement. Because detailed arrangements can vary from contract to contract, for international trade standardized terms of trade are often used, the so-called Incoterms issued by the International Chamber of Commerce in Paris. These standardize several issues related to international deliveries, in particular when (and where) risk is transferred and who bears the costs of transport and insurance.51
Example 1
A company acquired a piece of land many years ago for €250,000. Meanwhile, prices on land have risen significantly. With good reason and backed by similar recent transactions, company management estimates the current fair value of the land at €1,000,000.
Owing to the realization principle, this gain cannot be realized, i.e. the land cannot be assessed at fair value, until the land is sold and the increase in value is confirmed by the sale.
Example 2
A producer of machines exports a machine to East Asia; in the sales contract, “free on board” is specified as the Incoterm. At the closing date, the machine is removed from the premises of the manufacturer and is stored at the harbour for shipping.
“Free on board” implies that the risk is transferred when the machine is loaded onto the ship (more precise: when it crosses the railing). Because it is stored at the harbour on the closing date, delivery is not complete. In consequence, the machine is still a piece of inventory of the manufacturer (even if not in its warehouse), and no revenue may be recognized.
Any expense or losses must be recognized if and when they become probable, i.e. before they are realized.
This results in an asymmetric approach: Income and gains are recognized only when realized, expenses and losses when probable, even if not realized; this is why this principle is called the imparity principle because gains and losses are not treated in the same way.
The Commercial Code states explicitly that any risks that occurred before the closing date but that become known after the closing date must be recognized in the financial statements (see earlier discussion: closing date principle and value clarification).52
Example
A company has sold a machine to a customer on credit. When the payment is due, the customer does not pay and a dunning process is started. On the closing date, payment is still outstanding. The management comes to the conclusion that probably not all of the receivables can be collected and estimates the risk with good reason to be 15%.
Owing to the imparity principle the receivables must be impaired: the loss is probable, even if it is not realized yet.
The combination of these two principles and their application to assets or liabilities results in two principles that can also be viewed as subprinciples of the principle of prudence.
Lower-of-cost-or-market principle (§ 253 sect. 3 and 4)
This principle is the basic approach to the subsequent measurement of assets. It means the upper limits are the acquisition or production costs of an asset (see Chapter 2.4.2). Because of the realization principle, any increases in value above the acquisition or production costs may not be recognized until they are realized (because they would result in an income/gain). On the other hand, any decreases in value must be recognized if they are probable because of the imparity principle (as they result in an expense/loss).
Thus, on the closing date two values must always be compared for an asset: the (depreciated or amortized) acquisition or production costs and the fair value. The lower one must be chosen.53
Several specific versions of this principle will be explained, together with the relevant balance sheet items.
Higher-of-cost-or-market principle
This principle is the basic approach to the subsequent measurement of liabilities. It means the lower limit of a liability is the original settlement amount. Because of the realization principle, any decreases in value below the original settlement amount may not be recognized until they are realized (because they would result in an income/gain). On the other hand, any increases in value must be recognized if they are probable because of the imparity principle (as they result in an expense/loss).
Thus, on the closing date, two values must always be compared for a liability: the original settlement amount and the fair value or current settlement amount. The higher one must be chosen.54
2.3.3.3.2Other measurement principles
Tab. 2.9: Other measurement principles.
| Principle | Content | Codification |
| With focus on comparability of profit | ||
| Accrual basis | Income and expense are recognized when they occur; occurrence refers to the economic effect a specific transaction may have: if and when a transaction has its economic effect, it is recognized as income or expense, independently of its legal occurrence (which can be earlier or later) or payments (which can be earlier or later as well).a | § 252 sect. 1 no. 5 |
| Going concern | For the measurement of assets and liabilities it is assumed that the business will continue unless there are actual or legal reasons not to.b Actual reasons can be, for example, | § 252 sect. 1 no. 2 |
| –threat of insolvency, | ||
| –substantial losses, | ||
| –inability to take on necessary loans, | ||
| –violation of financial covenants. | ||
| Legal reasons can be, for example, | ||
| –opening of insolvency proceedings, | ||
| –legal or statutory requirements to liquidate the company. | ||
| With focus on comparability of profit | ||
| Substantial comparability | The methods of measurement must be consistent, i.e. they must be applied in the same way as in earlier financial statements. This is particularly relevant for any legal or actual measurement options (e.g. definition of production costs).c | § 252 sect. 1 no. 6 |
| Corporations: If changes are unavoidable, they must be explained in notes. | ||
| With focus on verifiability of values | ||
| Individual measurement | Any asset or liability must be measured individually unless simplifications are acceptable (e.g. constant value approach, group measurement, hedge accountingd). | § 252 sect. 1 no. 3 |
| Paid cost | Any income or expense must have resulted or will result in a payment. Imputed costs or income, i.e. costs/income that will never result in a payment, may not be included in financial statements. | § 255 sect. 1 and 2 |
a Beck’scher Bilanzkommentar, § 252 nos. 51–54.
b Beck’scher Bilanzkommentar, § 252, nos. 9–16
Further reading: IDWRS 17 “Auswirkungen einer Abkehr von der Going-concern-Prämisse auf den handelsrechtlichen Jahresabschluss” – Effects of a dismissal of the going concern principle on financial statements according to the Commercial Code.
c Beck’scher Bilanzkommentar, § 252, nos. 55–63.
d Beck’scher Bilanzkommentar, § 252, nos. 22–28.
Further readings
IDW RS HFA 38 “Ansatz- und Bewertungsstetigkeit im handelsrechtlichen Jahresabschluss” – Formal and substantial comparability in financial statements according to the Commercial Code.
IDW RH HFA 1.1011 “Insolvenzspezifische Rechnungslegung im Insolvenzverfahren” – Specific accounting for insolvency purposes during insolvency proceedings.
IDW RH HFA 1.1012 “Externe (handelsrechtliche) Rechnungslegung im Insolvenzverfahren” – External (according to the Commercial Code) accounting during insolvency proceedings.
The IFRS specify their underlying principles in a conceptual framework. Most GAAP of German accounting and the principles of IFRS are aligned. The most important difference is the principle of prudence and its dominance in German accounting. The conceptual framework has no corresponding principle and follows the overarching principles of a true and fair view or decision usefulness. This results in a (more) symmetric approach to measurement, in contrast to the asymmetric approach in the Commercial Code, and is detailed in many IAS/IFRS in which, for example, fair values above acquisition/production costs are possible.55
In addition, German accounting specifies (of course) the currency and language of financial statements and the timeline for their preparation. There is no need for the IFRS to do so.56
In German GAAP, the realization principle implies the application of the completed contract method for revenue recognition. In IFRS, the revenue recognition principles are specified in IAS 18 “Revenue” and IAS 11 “Construction contracts”. IAS 11 prescribes under certain conditions the percentage of completion method, meaning revenue must be recognized while production is still ongoing.
New standard IFRS 15
The IASB adopted a new standard, IFRS 15, “Revenue from contracts with customers”, that supersedes IAS 11 and 18. IFRS 15 is substantially in line with the new US GAAP regulations.
IFRS 15 must be applied to all contracts with customers, with only a few exceptions (leasing contracts, insurance contracts, financial instruments, non-monetary exchanges of companies within the same line of business).
It defines a general five-step-approach to recognizing revenue (IFRS 15.IN7):
1.Identify the contract(s) with a customer.
A contract is a mutual agreement that defines enforceable rights and obligations. In some cases, contracts must be aggregated and accounted for as one.
2.Identify the performance obligations in the contract.
A contract includes a promise to transfer goods or services to the customer. If those goods or services are clearly distinct, performance obligations exist and are accounted for separately.
3.Determine the transaction price.
The consideration the company expects to receive in exchange for the promised goods or services is the transaction price. It may be fixed or variable, cash or non-cash. If a substantial financing component is included, discounting is necessary.
4.Allocate the transaction price to the performance obligation in the contract.
Typically, this is done on a stand-alone basis. If a stand-alone selling price is not given, the company needs to estimate it.
5.Recognize revenue when (or as) the company fulfils performance obligations.
This can happen at a specific point in time (typically for goods) or over a period of time (typically for services). If a performance obligation is fulfilled over a period of time, the company recognizes revenue over time.
The transfer of goods is completed if the goods are under the control of the customer (IFRS 15.31).
A fulfilment over time occurs (IFRS 15.35) if
–the customer simultaneously receives and consumes the benefits as the company fulfils its obligation,
–the company creates or enhances an asset that is already controlled by the customer or
–there is no alternative use for the asset and the company has an enforceable right to be paid to date.
2.4Balance sheet: general recognition rules
§ 247 specifies that the balance sheet must include all non-current and current assets, equity and liabilities, as well as deferred items.
In what follows, we will briefly look at the general recognition and measurement rules for assets and liabilities.
2.4.1Recognition of assets
There is no legal definition of the term asset in the Commercial Code.
The general (or abstract) criteria for the recognition of an asset are as follows57:
–Economic benefit
An asset must provide a concrete economic benefit in the future. If an asset is acquired, for example if raw materials are purchased, the purchaser must be able to use the raw materials for its own production or be able to resell them. But assets can also be intangible, like software, or financial, like a share or a bond. The requirement is the same: the asset must probably provide some economic benefit. Mere chances or options are not sufficient if the realization of a benefit is not concrete and probable.
–Separately measurable
It must be possible to measure the value of one asset separately from other assets. If no value can be assigned individually, it is not a separate asset.
Example
A company buys a new car. The different parts of the car, the engine, the transmission, the chassis and so forth, cannot be measured separately; one price is paid for the car, but not separate prices for the components (at least not for the standard components; for the extras separate prices may be available). Therefore, the standard components of the car (even if they could be sold separately – see subsequent discussion) are not separate assets.
–Separately marketable
It must be possible to market (sell or use otherwise) an asset separately from other assets. If the asset cannot be marketed on its own, it is not a separate asset.
Example
The roof of a building provides economic benefit (it provides protection from weather); often it can be measured separately because the invoices of the carpenter allow a precise attribution of expenses. But it cannot be used separately from the building; the roof cannot be sold or leased without the rest of the building. Therefore, the roof is not a separate asset; it is part of the asset “building”.
All three criteria must be fulfilled at the same time.
Apart from these general criteria defining an asset, additional criteria must be fulfilled whereby an asset can be recognized in a specific situation:
–Economic ownership
All assets that are economically owned must be recognized (§ 246 sect. 1 sent. 2). Economic ownership means that the asset can be used and that the economic owner is responsible for the majority of risks and opportunities related to their use; the latter includes also sales proceeds or changes in value in which the company participates (§ 39 sect. 2 AO).58
In many cases, legal and economic ownership are identical, but not necessarily. Typical examples are as follows:
Tab. 2.10: Examples for differences between legal and economic ownership.
| Transaction | Legal owner | Economic owner |
| Sale with retention of title | Seller | Buyer |
| Goods transferred as security/with transfer of title | Creditor/holder of security | Borrower/user of security |
| Use of goods as pledge | Original owner | Holder of pledge |
| Leasinga | ||
| Operating leases | Lessor | Lessor |
| Finance leases | Lessor | Lessee |
a There is no legal definition of leasing in the Commercial Code. The typical classification is based on tax rules; the classification here is a bit superficial – just to clarify the tendency; for details refer to Chapter 3.1.10.4.
–For proprietorships/partnerships:
Distinction between business assets and private assets of owner(s):
Some assets can be used for both commercial and private purposes, for example a car can be used to deliver goods to customers and for personal shopping. However, many assets are unambiguously either part of a business or held privately, though some assets are not so easily defined and may be owned both by a company and privately. Since only the assets of a company or business are to be included in financial statements, the owners must assign assets to either the business or private individuals (under the rebuttable presumption that an asset that was acquired by the owner must be included in the business).59 More detailed rules on how this assignment must be made exist for tax purposes.60 Such a distinction is necessary only for proprietorships and partnerships. A corporation has no private assets. Thus, no assignment is necessary.61
–Specific legal recognition rules
The Commercial Code requires, prohibits or allows certain transactions to be recognized as an asset. These specific rules may deviate from the general rules. They will be explained in Chapter 3 in a detailed explanation of balance sheet items.
The conceptual framework defines assets in CF 4.8–4.14. The major difference is that the Commercial Code requires separate marketability of an asset and is thus stricter than IFRS.
2.4.2Initial measurement of assets
The Commercial Code prescribes different measures for the initial measurement of assets; this depends on whether the assets were acquired or produced.
An acquisition against remuneration is assumed in the following cases:62
–Purchase of asset against cash or on credit;
–Barter trades, where assets are exchanged against other assets and no cash is used;
–Capital increases of the company, i.e. a contribution to the equity independent of whether it is in cash or in kind/goods.
An acquisition without remuneration is assumed in cases of donations of assets; typically the acquisition costs are assumed to be zero; donations of money are measured at the nominal value. For tax purposes, specific rules must be applied.63
If other parties are used to produce the asset for the purposes of the company, the line between acquisition and production may not be completely clear. Whether an event is treated as an acquisition or production depends on the detailed contractual arrangements; in particular, it is important to know who bears the risk of the production process, meaning if the production fails, who covers the costs and any damages? If these risks are borne by the contractor, the produced asset is assumed to be acquired by the customer (in the easiest case the customer pays only if a fully functional asset is received). If these risks are borne by the customer, the produced asset is assumed to be produced by the customer (with the help of the contractor; in the most straightforward case, the customer must pay the contractor even if the asset does not work properly).64
This question can become important for outsourcing arrangements or other complex service agreements.
Example
A company (the customer) needs new software that must be programmed to its specific needs. Because it does not have sufficient programming capacity in its IT department, an external IT company (the contractor) is used.
The customer provides the contractor with a detailed description about the new software. The contract states that the customer must accept and pay the software only if it complies with the description. In this case, the software will be treated as acquired because the risk of failure (i.e. programming a software that does not fulfil the requirements) is borne by the contractor.
Case B: Production
The customer has an idea about the new software, but not yet a detailed plan. The project management is carried out by the customer and the specification of the software is produced on an ongoing basis (evolutionary development). The contractor makes available several people to do the programming according to the instructions of the customer. In consequence, the contractor is paid on the basis of working hours of its employees – independently of whether or not the programming was successful. In this case, the software is considered to be produced by the customer himself.
2.4.2.1Acquisition costs
If an asset is acquired (against a remuneration, see earlier discussion), it is measured using acquisition costs. § 255 sect. 1 defines acquisition costs as follows: Any expenses that are incurred to acquire an asset and make it ready for operation, meaning the acquisition process does not stop with the initial purchase but continues until the asset can be used; this does not imply that it is used, only that it can be used.65
Any expenses incurred must be directly attributable to the acquisition, i.e. only direct expenses can be recognized, no indirect expenses.66 Imputed costs may not be included in the acquisition costs.
Table 2.11 shows this in more detail.67
Subsequent price reductions or acquisition costs change the acquisition costs when they are incurred, meaning there is no retrospective application.68
Important differences to IFRS
The conceptual framework provides a general definition of acquisitions costs that is detailed further in the specific standards. Any specific important differences are described there.
The Commercial Code does not provide legal rules for the accounting of the exchange of assets (barter trades). IAS 16 provides specific rules for that.
Tab. 2.11: Components of acquisition costs.
| Component of acquisition costs | Examples | |
| Purchase price/consideration | As typically specified in purchase agreement | |
| − | Price reductions that can be attributed to specific transaction | Trade or cash discounts, rebates and any additional bonuses, if directly attributable |
| + | Incidental acquisition costs | Any costs incurred to make the asset ready for operation, for example: |
| –purchaser transport expenses | ||
| –customs duties on imported goods | ||
| –transport insurance | ||
| –installation expenses | ||
| –prototypes or test runs | ||
| –security checks | ||
| –notary or broker fees (if necessary for acquisition) | ||
| –land acquisition tax | ||
| = | Initial acquisition costs | |
| − | Subsequent price reductions | Any subsequent price reductions that are directly attributable |
| + | Subsequent acquisition costs | Expenses that are a direct consequence of the acquisition but charged at a later point in time (e.g. public fees for the development of roads and sewer systems are often charged years after the acquisition of the land) or expenses that improve the usability or extend the useful life of the asset (e.g. when a truck is upgraded with an air-conditioning/cooling system). |
| = | Final acquisition costs |
2.4.2.2Production costs
If an asset is not acquired, it has been produced by the company itself. When an asset is produced or has been produced, it is measured initially with its production costs. Production costs are defined in § 255 sect. 2, 2a and 3: Production costs are expenses incurred by the use of goods or services to produce an asset, enlarge it or improve it over its original condition.
This can be seen in more detail in Table 2.12.69
Imputed costs may not be included in production costs (the same as for acquisition costs).
Tab. 2.12: Components of production costs.
| Mandatory component of production costs | Examples | |
| Direct material costs | Acquisition costs of raw materials, parts or services used for production | |
| + | Direct manufacturing costs | Costs directly attributable to production process, such as wages of production workers, including all legal social security expenses |
| + | Special direct costs of manufacturing | Special direct costs are costs that can be directly attributed to the production process but are typically one-time items and not linked to the quantity produced, for example models or prototypes, specific moulds or toolsa |
| + | Indirect material costs | Costs of materials that cannot be directly attributed to the specific production process, for example procurement costs, transport costs within the company, storage costs, insurance costs, costs for quality management |
| + | Indirect manufacturing costs | Costs that cannot be directly attributed to the production process, for example energy costs (if not directly attributable), costs for production administration and planning, maintenance costs, costs for quality management |
| + | Depreciation/amortization of non-current assets | Depreciation for non-current assets used in production process |
| = | Mandatory components / Minimum production costs Optional components | |
| Adequate portion of | ||
| + | General administration costs | For example costs of human resource management, finance and accounting, information and communication technology |
| + | Voluntary social benefits | For example costs of a canteen, day care centre, sports facilities, anniversary and other voluntary payments |
| + | Voluntary pension scheme / retirement benefits | Costs for additional (not mandatory) payments for retired employees |
| + | Borrowing costs | In principle, borrowing costs are not included; only if the credit capital has been used for the specific production process and the interest corresponds to the period of production can they be included |
| = | Maximum of production costs |
| Prohibited is the inclusion of | |
| Distribution costs | Any costs incurred after the production has finished, for example costs of storage of finished goods or merchandise, costs of transport to customers or sales facilities, salaries and wages and other costs of sales department, costs of marketing and advertising, costs to reach a sales agreement (see above on special direct costs of production) |
| Research costs | Research and development are defined in § 255 sect 2a: Research is the search for and creation of new knowledge; it is an open-ended process, and success is uncertain. In contrast, development is the application of existing knowledge to a new situation; this is also an open-ended process, but the degree of certainty that it will be successful is substantially higher |
a A specific topic here are special direct costs of distribution, in particular costs incurred to reach a sales agreement. These may not be included in the production costs because they are distribution costs; see Beck’scher Bilanzkommentar, § 255 nos. 454–456.
Indirect costs may be included with an adequate portion that relates to the production process. This means, in particular, that any impairments of assets, idle time costs or extraordinary expenses may not be included.70 In consequence, which costs may be included to what extent depends also on the methods of cost accounting that are used in the company.
Whether or not optional elements are included depends on the accounting policy of the company and the corresponding decisions of management. From 2017 onwards, options must be applied in the commercial balance sheet and the tax balance sheet in the same way, meaning the use of options not only is accounting policy in the commercial balance sheet but has a tax effect as well.71
The accounting effect of the definition of production costs is not completely intuitive. This definition is relevant for the measurement of assets, i.e. it defines which expenses that were incurred are recognized in the balance sheet and thus reduce the expenses in the income statement. This definition is not about cost management, i.e.
a reduction of costs. In consequence, the higher the production costs are defined, the higher the profit (because more expenses are transferred as assets to the balance sheet) and vice versa.
Subsequent production costs occur, if an asset
–was completely worn out and is reproduced.
This means that not just parts of the asset but the asset in total can no longer be used. This worn-out asset is reproduced so that a new asset exists (even if some parts that are still functional are reused);
–can be used for other functions/purposes after changes are made;
–is enlarged, for example when the usable space of a building is increased by adding an additional floor;
–is substantially improved over its initial condition, i.e. the usage potential has been enhanced.
Any expenses incurred that are not subsequent production costs are in consequence (maintenance) expenses of the period.72
Under German tax law, a more detailed simplification is relevant: Any expenses incurred within the first 3 years after acquisition or production that do not exceed 15% of the initial acquisition or production costs are assumed to be maintenance costs without any further documentation (§ 6 sect. 1 no. 1a EStG).
Further reading
IDW RS HFA 31 “Aktivierung von Herstellungskosten” – Recognition of production costs
Important differences to IFRS
There is no general definition of production costs in IFRS. IAS 2.12–18 specifies that general administration costs or voluntary social security are not to be included under production costs when measuring inventories (overhead costs are to be included only insofar as they relate directly to the production process).
Interest expenses for the production of qualifying assets must be included (IAS 23). A qualifying asset is an asset that takes a considerable period of time to be acquired or produced.73
2.4.3Recognition of liabilities
There is no legal definition of liabilities in the Commercial Code. Liability is a more general term for provisions and debt or payables (for more details see chapters 3.1.7 and 3.1.8).
The general (or abstract) criteria for the recognition of a liability are as follows:74
–Obligation
There must be an obligation to a third party that needs to be fulfilled in the future. This can be a legal, contractual or constructive obligation. A constructive obligation is an obligation that cannot be avoided (even if not legally enforceable) because of common practice in the industry, past behaviour of the company and so forth.
Example
A company sold its products. A customer is not satisfied with the product.
Case A: Legal obligation
The product is faulty and the company is legally required to fulfil its obligation to supply a proper model of the product, say, by repairing it or exchanging it. This is a legal obligation.
Case B: Constructive obligation
The customer does not like the colour of the product; he has no legal right to exchange or return it. In the past, the policy of the company was driven by customer friendliness – all wishes to return or exchange products were honoured. The customer knows that and expects the company to behave that way again. This can be a constructive obligation.
–Economic burden
Economic burden means that the settlement of an obligation requires economic resources that can no longer be used, for example cash, goods, working time of employees. The economic burden must be probable, i.e. even if not certain it must be more likely than not that the economic resources will be used.
Example
A company gives a guarantee to a business partner, for example as collateral for a loan: The company guarantees to repay a loan instead of the business partner if the business partner fails to do so. This is typically a contractual obligation and is quantifiable (see below). As long as the business partner fulfils his duties, this obligation will probably not result in an economic burden; thus, it is not a liability (in this specific case it is a so-called contingent liability) and is not recognized in the balance sheet of the company.
Only if the business partner fails to fulfil his duties (or it becomes probable that he will do so), the economic burden becomes probable and only then must a liability be recognized.
–Quantifiable
The economic burden to settle the obligation must be quantifiable. If the quantity of economic resources that will be needed cannot be estimated with sufficient reliability, it is not a liability.
All three criteria must be fulfilled to establish that a liability exists. The liability must be recognized by the company (or person) who has the obligation to fulfil it.75
2.4.4Measurement of liabilities
The basic measure of liabilities is the settlement amount, or the amount of economic resources required to meet an obligation (§ 253 sect. 1 sent. 2). The settlement amount includes any economic resources that will be used, such as cash, goods or services. For debt/payables the initial measurement is typically the nominal value of the contract. For provisions the settlement amount must be estimated based on commercial judgement (for further details see chapters 3.1.7 and 3.1.8).76
Annuity charges are measured based on the present value of the expected future payments (§ 253 sect. 2; for further details see Chapter 3.1.7).77
2.5Stock taking/inventory
The basis for any accounting is the regular verification and documentation of all assets and liabilities, which is legally required for the beginning of a business (opening balance) and then once a year (§ 240 sect. 1 and 2). Physical assets must be counted (or, if that is not possible, measured, weighed or estimated); this is the process of stock taking. Intangible assets, financial assets and liabilities must be verified by supporting documents, for example a receivable is verified by an invoice that was sent to the customer.78
The purpose of stock taking is to verify the amounts and to detect any errors, meaning missing or additional amounts. Detected errors can then be corrected in the financial accounting (missing amounts of an asset result in an expense, additional amounts in income).
Example Methods of stock taking
Tab. 2.13: Methods of stock taking.
| Asset | Method |
| Large parts or components | Counting |
| Numerous small parts (e.g. small screws) | Weighing: weigh a sample of 10–20 screws and then estimate the total number by weighing all screws |
| Liquids (e.g. fuel) | Measuring: measure and eventually calculate volume of tank and measure filling level |
| Numerous, irregular parts (e.g. a heap of coal) | Estimating: measure and calculate volume of heap (approximately), estimate weight of a cubic metre of coal and then estimate total weight |
The annual stock taking at the closing date is the applicable principle (§ 240 sect. 2): All assets and liabilities are verified at the closing date. Common practice is to allow for 10 days before and after the closing date, but this range should be kept as small as possible. The amounts must be adjusted for any changes (increases or decreases) between the date of the stock taking and the closing date.
Several simplifications are possible:
–Stock taking before or after closing date (so-called pre- or post-terminated stock taking) (§ 241 sect. 3):
The stock taking can be done 3 months before or 2 months after closing date if the value of the assets at the closing date can be determined properly.79
–Permanent stock taking (§ 241 sect. 2):
This can differ in two ways from the stock taking at the closing date:
a)It can be done on any date (not only within the limits of the pre- or post-termination stock taking).
b)Not all items must be counted on the same date; stock taking on multiple dates (theoretically every day) is possible. Nevertheless, all assets must be verified at least once a year. All amounts and values must be updated for the closing date values. Typically, this must be done by an IT system.80
–Sample stock taking (241 sect. 1):
If statistical methods can be applied, it is sufficient to verify only a sample and then calculate a projection of the total amounts and values. Nevertheless, the GAAP must be applied, meaning completeness and correctness must be ensured and the process must be documented properly.81
–Constant value approach (§ 240 sect. 3):
This is a simplification for both stock taking and measurement for tangible non-current assets and raw materials. This is explained in more detail in Chapter 3.1.3.5.
–Groupmeasurement (§ 240 sect. 4):
Similar inventories or other similar moveable assets or payables can be grouped and measured together. Similar means similar in kind/function or similar in value. This is explained in more detail in Chapter 3.1.5.1.82
Further readings
IDW RH HFA1.1010 “Bestandsaufnahme im Insolvenzverfahren” – Stock taking during insolvency proceedings.
2.6Definition of income and expense
There is no legal definition of income and expense in the Commercial Code.
The dominant opinion is that income and expense reflect changes in net assets (assets – liabilities), as long as these changes are not caused by changed relations with shareholders. Put another way, any increase in the value of an asset that is not offset by a decrease in the value of an asset or an increase in the value of a liability is income; any increase in the value of a liability that is not offset by a decrease in the value of a liability or an increase in the value of an asset is an expense (vice versa).83
There are no specific measurement rules for income or expense. Any income or expense that is incurred in one’s own account is to be recognized in the financial statements; typically this coincides with economic ownership, i.e. changes in the recognized assets or liabilities must be reflected in the income statement.
Tab. 2.14: Definition of income and expense.
| Income | Increase in net assets = |
| Increase in assets − liabilities unless caused by contributions or withdrawals of shareholders | |
| Expense | Decrease in net assets = |
| Decrease in assets − liabilities unless caused by contributions or withdrawals of shareholders |
Important differences to IFRS
The conceptual framework defines the terms income and expense. Income encompasses revenue and gains; whereas revenue results from ordinary operating activities, gains can also result from non-operating activities or from one-time items. Expenses are subdivided into expenses (ordinary operating) and losses (eventually non-operating or one-time). There is no consistent concept about how income and expense are linked to the balance sheet (IFRS CF4.29–35).84
Depending on specific standards, in some cases changes in the value of assets or liabilities are not recognized as income or expenses in the income statement, but only as other comprehensive income in equity. This possibility does not exist in the Commercial Code.