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Changes in disclosures for (derivative) financial instruments for financial reporting in Germany

Changes in disclosures for financial instruments

Financial statements prepared in accordance with the German Commercial Code (HGB) naturally have to include an account of financial instruments.

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Financial statements prepared in accordance with the German Commercial Code (HGB) naturally have to include an account of financial instruments. Additional disclosures are also needed in the relevant notes, however. While these disclosures are generally produced by the corporate treasury department, it is not normally their job to interpret the finer points of financial reporting standards. In practice, therefore, the accounting department or an external consultant usually prepares a draft version of the notes, leaving the treasury to fill in the blanks with figures for "special" business transactions and strategic content.

This procedure works well enough until such time as amendments are made to the said financial reporting standards. To make matters worse, amendments to the laws enshrined in the German Commercial Code are customarily accompanied by a legal amendment act whose focus lies elsewhere, but which simply seeks to get the updated commercial law pushed through quickly and without further comment.

A case in point: In 2017, changes brought about by the CSR Directive Implementation Act1 necessitated amendments to Section 285 Item 20 and Section 314 (1) Item 12 of the German Commercial Code. These amendments – regarding mandatory disclosures for derivative financial instruments – were picked up and interpreted by IDW, Germany's Institute of Public Auditors, in the form of an accounting note (IDW RH 1.005) in June 2018. The two legal provisions in question already clarify that the amendments must be taken into account in both the individual and consolidated financial statements of corporate entities.2 The accounting note in question merely clarifies the legal position that has been valid since last year. Now, at the latest, corporate entities should at least be able to interpret the content.

The amended provisions distinguish between cases in which a financial instrument is to be recognised at fair value and those in which fair value does not apply. This distinction results in a requirement for the disclosures described below:

Pursuant to Section 285 HGB (along similar lines to Section 314 HGB)

19. For each category of derivate financial instruments not recognised at fair value:

a) its nature and scope;
b) its fair value insofar as this can be reliably determined pursuant to Section 255 (4), citing the measurement method used;
c) its carrying amount and the balance sheet item under which the carrying amount (where one exists) is subsumed; and
d) the reasons why fair value cannot be determined.

20. For financial instruments recognised at fair value:
a) the fundamental assumptions underlying the determination of fair value with the aid of genuinely recognised measurement methods; and
b) the scope and nature of each category of derivative financial instruments, including the key conditions that can influence the amount, timing and certainty of future cash flows.

In principle, the distinction should be easy to make, as the procedure appears intuitive. Yet this is precisely the point at which the amendment act makes a relevant point, revealing how deceptive intuition can be in the context of commercial law.

A standalone derivative with a negative market value, understood as a pending transaction, must be recognised as a provision equivalent to the discounted settlement amount (Section 253 (1) Sentence 2 in conjunction with (2) HGB) based on sound business judgment. Strictly by the letter of the law as stated in Section 285 Item 20 HGB, the settlement amount is not the fair value. The purely formal nature of this statement can be seen in particular in the fact that IDW's interpretation regarding the measurement of derivatives (with negative market values) also demands that fair value should be the standard of measurement used in this case (IDW RS HFA 4 Section 44). For this reason, derivative financial instruments are recognised at fair value in order to determine the discounted settlement amount. The discounted settlement amount – but not the fair value – is thus recognised as the provision, even though fair value is used to measure the discounted settlement amount (IDW RH 1.005 Section 44). This, then, is the basis on which the mandatory disclosures discussed above are determined.

Importantly, staff of the accounting or treasury department must know this distinction in the first place – and not just assume it is an editorial mistake!

To summarise the above: Derivatives with a negative market value are recognised at their settlement amount, which is actually measured as fair value. The corresponding mandatory disclosures prescribed by Section 285 Item 20 HGB therefore do not apply. Since the requirements specified in Section 285 Item 20 HGB are interpreted narrowly,3 the conditions laid out in Section 285 Item 19 HGB must therefore be interpreted more broadly, with the result that the disclosures prescribed by this provision do have to be presented in the notes. In the past, corporate entities often argued to the contrary, claiming that the disclosures prescribed by Section 285 Item 19 were not needed, because Section 285 Item 20 HGB applied in principle – albeit not to corporate entities. The new legal position thus triggers a very concrete change in mandatory disclosures.

Given that the conditions governing individual financial reporting disclosures are spread far and wide in the German Commercial Code and tend to be updated and fine-tuned in the manner described above, it makes sense to continually review all financial statements prepared in accordance with German commercial law. 

Source: KPMG Corporate Treasury News, Edition 83, August 2018
Author: Felix Wacker-Kijewksi, Senior Manager, Finance Advisory, fwackerkijewski@kpmg.com

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1CSR Directive Implementation Act dated 11 April 2017 (Federal Law Gazette [BGBl.] I p. 802)
2For the financial statements of financial institutions, the requirement already applied by virtue of a reference to Section 340e (3) Sentence 1.
3The scope of interpretation explicitly includes fund assets (Section 253 (1) Sentence 5 HGB) and provisions for securities-based commitments (Section 253 (1) Sentence 4 HGB).

 

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