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Accounting and Measurement Policies

(49) Measurement policies

The main assets and liabilities disclosed in the consolidated balance sheet are measured as follows:

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Balance sheet item Measurement principle
ASSETS
Intangible assets
With finite useful life Amortized cost
With indefinite useful life or not yet available for use Amortized cost (subsequent measurement: impairment-only approach)
Property, plant and equipment Amortized cost
Financial assets (current / non-current)
Held-to-maturity investments Amortized cost
Available-for-sale financial assets Fair value
Loans and receivables Amortized cost
Derivative assets (financial transactions) Fair value
Other assets
Derivative assets (operational) Fair value
Receivables from non-income related taxes Amortized cost
Other receivables Amortized cost
Deferred tax assets Undiscounted measurement based on tax rates that are expected to apply to the period when the asset is realized or the liability is settled
Inventories Lower of cost and net realizable value
Trade accounts receivable Amortized cost
Income tax receivables Expected tax refunds based on tax rates that have been enacted
or substantively enacted by the end of the reporting period
Cash and cash equivalents Nominal value
Assets held for sale Lower of carrying amount and fair value less costs to sell
Equity and Liabilities
Provisions for pensions and other post-employment benefits Projected unit credit method
Other provisions (current / non-current) Present value of the expenditures expected to be required to settle
the obligation
Financial liabilities (current / non-current)
Bonds Amortized cost
Liabilities to related parties Amortized cost
Bank loans Amortized cost
Liabilities from derivatives (financial transactions) Fair value
Finance lease liabilities Amortized cost
Other liabilities (current / non-current)
Liabilities from derivatives (operational) Fair value
Liabilities from non-income-related taxes Settlement amount
Other liabilities Settlement amount
Deferred tax liabilities Undiscounted measurement based on tax rates that are expected to apply to the period when the asset is realized or the liability is settled
Trade accounts payable Amortized cost
Income tax liabilities Expected tax payments based on tax rates that have been enacted
or substantively enacted by the end of the reporting period
Liabilities directly related to assets held for sale Fair value

(50) Consolidation methods

The consolidated financial statements are based on the single-­entity financial statements of the consolidated companies as of the balance sheet date, which were prepared applying consistent accounting policies in accordance with IFRS.

Acquisitions are accounted for using the purchase method in accordance with IFRS 3. Subsidiaries acquired and consolidated for the first time were measured at the carrying values at the time of acquisition. Differences resulting in this context are recognized as assets and liabilities to the extent that their fair values differ from the values carried in the financial statements. Any remaining – and usually – positive difference is recognized as goodwill within intangible assets.

In cases where a company was not acquired in full, non-controlling interests are measured using the fair value of the proportionate share of net assets. The option to measure non-controlling interests at fair value on the date of their acquisition (full goodwill method) was not utilized.

When additional shares in non-controlling interests are acquired, the purchase price amount that exceeds the carrying amount of this interest is recognized immediately in equity.

IFRS 11 is applied for joint arrangements. A joint arrangement exists when, on the basis of a contractual arrangement, Merck and third parties jointly control business activities. Joint control means that decisions about the relevant activities require unanimous consent. Joint arrangements are either joint operations or joint ventures. Revenues and expenses as well as assets and liabilities from joint operations are included in the consolidated financial statements on a pro rata basis in accordance with Merck’s rights and obligations. By contrast, interests in joint ventures as well as in material associates over which Merck has significant influence are included in accordance with IAS 28 using the equity method of accounting.

Intragroup sales, expenses and income, as well as all receivables and payables between the consolidated companies, are eliminated. The effects of intragroup deliveries reported under non-­current assets and inventories are adjusted by eliminating any intragroup profits. In accordance with IAS 12, deferred taxes are applied to these consolidation measures.

(51) Currency translation

The functional currency concept applies to the translation of financial statements of consolidated companies prepared in foreign currencies. The subsidiaries of the Merck Group generally conduct their operations independently. The functional currency of these companies is normally the respective local currency. Assets and liabilities are measured at the closing rate, and income and expenses are measured at weighted average annual rates in euros, the reporting currency. Any currency translation differences arising during consolidation of Group companies are recognized in equity. If Group companies are deconsolidated, existing currency differences are reversed and reclassified to profit or loss.

When the financial statements of consolidated companies are prepared, business transactions that are conducted in currencies other than the functional currency are recorded using the current exchange rate on the date of the transaction. Foreign currency monetary items (cash and cash equivalents, receivables and payables) in the year-end financial statements of the consolidated companies prepared in the functional currency are translated at the respective closing rates. Exchange differences from the translation of monetary items are recognized in the income statement with the exception of net investments in a foreign operation. Hedged items are likewise carried at the closing rate. The resulting gains or losses are eliminated in the consolidated income statement against offsetting amounts from the fair value measurement of derivatives.

Currency translation was based on the following key exchange rates:

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Average annual rate Closing rate
€ 1 = 2016 2015 Dec. 31, 2016 Dec. 31, 2015
British pound (GBP) 0.816 0.728 0.857 0.737
Chinese renminbi (CNY) 7.343 7.003 7.343 7.183
Japanese yen (JPY) 121.127 134.431 123.070 131.576
Swiss franc (CHF) 1.090 1.075 1.075 1.081
Taiwan dollar (TWD) 35.571 35.337 34.004 35.831
U.S. dollar (USD) 1.102 1.112 1.051 1.093

(52) Recognition of net sales and other income

Net sales and other income are recognized when the amount of revenue can be measured reliably, it is probable that the economic benefits will flow to the entity and when the following preconditions have been met.

Net sales are deemed realized once the goods are delivered or the services have been rendered and the significant risks and rewards of ownership have been transferred to the purchaser. In the case of sales of equipment in the Life Science business sector, these preconditions are only met after installation has been successfully completed to the extent that the installation requires specialized knowledge, does not represent a clear ancillary service and the relevant equipment can only be used by the customer once successfully set up.

Net sales are recognized net of sales-related taxes and sales deductions. When sales are recognized, estimated amounts are taken into account for expected sales deductions, for example rebates, discounts and returns.

The vast majority of Group sales are generated by the sale of goods.

In the Healthcare business sector, products are often sold to pharmaceutical wholesalers and to a lesser extent directly to pharmacies or hospitals. In the Life Science and Performance Materials business sectors, products are largely sold to business customers, and to a lesser extent to distributors.

In addition to revenue from the sale of goods, sales also include commission income, profit-sharing and in the Life Science business sector revenue from services, but the volume involved is insignificant. In the case of long-term service agreements, Merck records the sales revenues on a pro rata basis over the term of the agreement or in accordance with the services rendered.

Revenues from multiple-element arrangements (e.g. sales of goods in combination with services) are recognized when the respective contract element is delivered or rendered.

Royalty and license income is recognized when the contractual obligation has been met.

Dividend income is recognized when the shareholders’ right to receive the dividend is established. This is normally the date of the dividend resolution.

Interest income is recognized in the period in which it is earned.

(53) Research and development costs

Research and development costs comprise the costs of research departments and process development, the expenses incurred as a result of research and development collaborations as well as the costs of clinical trials (both before and after approval is granted).

The costs of research cannot be capitalized and are expensed in full in the period in which they are incurred. As internally generated intangible assets, it is necessary to capitalize development expenses if the cost of the internally generated intangible asset can be reliably determined and the asset can be expected to lead to future economic benefits. The condition for this is that the necessary resources are available for the development of the asset, technical feasibility of the asset is given, its completion and use are intended, and marketability is given. Owing to the high risks up to the time that pharmaceutical products are approved, these criteria are not met in the Healthcare business sector. Costs incurred after regulatory approval are usually insignificant and are therefore not recognized as intangible assets. Owing to the risks existing up until market launch, development expenses in the Life Science and Performance Materials business sectors can likewise not be capitalized.

Reimbursements for R&D are offset against research and development costs.

(54) Intangible assets

Acquired intangible assets are recognized at cost and are classified as assets with finite and indefinite useful lives. Self-developed intangible assets are only capitalized if the requirements specified by IAS 38 have been met. Intangible assets acquired in the course of business combinations are recognized at fair value on the acquisition date. If the development of intangible assets takes a substantial period of time, the directly attributable borrowing costs incurred up until completion are capitalized as part of the costs.

Intangible assets with indefinite useful lives and intangible assets not yet available for use

Intangible assets with indefinite useful lives and intangible assets not yet available for use are not amortized; however they are tested for impairment when a triggering event arises or at least once a year. Here, the respective carrying amounts are compared with the recoverable amount and impairments are recognized as required. Impairment losses other than goodwill recognized on indefinite-life intangible assets and intangible assets not yet available for use are reversed if the original reasons for impairment no longer apply.

Goodwill is allocated to cash-generating units or groups of cash-generating units and tested for impairment either annually or if there are indications of impairment. The carrying amounts of the cash-generating units or groups of cash-generating units are compared with their recoverable amounts and impairment losses are recognized where the recoverable amount is lower than the carrying amount. The recoverable amount of a cash-generating unit is determined as the higher of fair value less costs of disposal and value in use estimated using the discounted cash flow method.

Intangible assets with finite useful lives

Intangible assets with a finite useful life are amortized using the straight-line method. The useful lives of customer relationships, marketing authorizations, acquired patents, licenses and similar rights, brand names, trademarks and software are between three and 24 years. Amortization of intangible assets and software is allocated to the functional costs in the consolidated income statement. An impairment test is performed if there are indications of impairment. Impairment losses are determined using the same methodology as for indefinite-life intangible assets. Impairment losses are reversed if the original reasons for impairment no longer apply.

(55) Property, plant and equipment

Property, plant and equipment is measured at cost less depreciation and impairments plus reversals of impairments. The component approach is applied here in accordance with IAS 16. Subsequent costs are only capitalized if it is probable that future economic benefits will arise for the Group and the cost of the asset can be measured reliably. The cost of self-constructed property, plant and equipment is calculated on the basis of the directly attributable unit costs and an appropriate share of overheads. If the construction of property, plant and equipment takes a substantial period of time, the directly attributable borrowing costs incurred up until completion are capitalized as part of the costs. In accordance with IAS 20, costs are reduced by the amount of government grants in those cases where government grants or subsidies have been paid for the acquisition or manufacture of assets (grants related to assets). Grants related to expenses which no longer offset future expenses are recognized in profit or loss. Property, plant and equipment is depreciated by the straight-line method over the useful life of the asset concerned. Depreciation of property, plant and equipment is based on the following useful lives:

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Useful life of property, plant and equipment

Useful life
Production buildings maximum of 33 years
Administration buildings maximum of 40 years
Plant and machinery 6 to 25 years
Operating and office equipment; other facilities 3 to 10 years

The useful lives of the assets are reviewed regularly and adjusted if necessary. If indications of a decline in value exist, an impairment test is performed. If the reasons for an impairment loss no longer exist, a reversal of the impairment loss recognized in prior periods is recorded.

(56) Leasing

Where non-current assets are leased and economic ownership lies with Merck (finance lease), the asset is recognized at the present value of the minimum lease payments or the lower fair value in accordance with IAS 17 and depreciated over its useful life. The corresponding payment obligations from future lease payments are recorded as liabilities. If an operating lease is concerned, the associated expenses are recognized in the period in which they are incurred.

(57) Financial instruments: Principles

A financial instrument is a contractual arrangement that gives rise to a financial asset of one entity and a financial liability or an equity instrument of another entity. A distinction is made between non-­derivative and derivative financial instruments.

Merck accounts for regular way purchases or sales of non-­derivative financial instruments at the settlement date and of derivatives at the trade date.

Upon initial recognition, financial assets and financial liabilities are measured at fair value, taking into account any transaction costs, if necessary.

Financial assets are derecognized in part or in full if the contractual rights to the cash flows from the financial asset have expired or have been fulfilled or if control and substantially all the risks and rewards of ownership of the financial asset have been transferred to a third party. Financial liabilities are derecognized if the contractual obligations have been discharged, cancelled, or expired. Cash and cash equivalents are carried at nominal value.

(58) Financial instruments: Categories and classes of financial instruments

Financial assets and liabilities are classified into the following IAS 39 measurement categories and IFRS 7 classes. The classes required to be disclosed in accordance with IFRS 7 consist of the measurement categories set out here. Additionally, cash and cash equivalents with an original maturity of up to 90 days, finance lease liabilities, and derivatives designated as hedging instruments are also classes in accordance with IFRS 7.

Financial assets and financial liabilities at fair value through profit or loss

“Financial assets and financial liabilities at fair value through profit or loss” can be both non-derivative and derivative financial instruments. Financial instruments in this category are subsequently measured at fair value. Gains and losses on financial instruments in this measurement category are recognized directly in the consolidated income statement. This measurement category includes an option to designate non-derivative financial instruments as “at fair value through profit or loss” on initial recognition (fair value option) or as “financial instruments held for trading”. The fair value option was applied neither during the fiscal year nor the previous year. Merck only assigns derivatives to the “held for trading” measurement category. Special accounting rules apply to derivatives that are designated as hedging instruments in a hedging relationship.

Held-to-maturity investments

“Held-to-maturity investments” are non-derivative financial assets with fixed or determinable payments and a fixed maturity that are quoted in an active market. To be able to assign a financial asset to this measurement category, the entity must have the positive intention and ability to hold it to maturity. These investments are subsequently measured at amortized cost using the effective rate method. If there is objective evidence that such an asset is impaired, an impairment loss is recognized in profit or loss. Subsequent reversals of impairment losses are also recognized in profit or loss up to the amount of the amortized cost. At Merck, this measurement category is used for current financial assets.

Loans and receivables

“Loans and receivables” are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. They are subsequently measured at amortized cost using the effective rate method. If there is objective evidence that such assets are impaired, an impairment loss is recognized in profit or loss. Subsequent reversals of impairment losses are also recognized in profit or loss up to the amount of amortized cost. Long-term non-interest-bearing and low-interest receivables are measured at their present value. Merck primarily assigns trade receivables, loans, and miscellaneous other current and non-current receivables to this measurement category. Merck always uses a separate allowance account for impairment losses on trade and other receivables. Amounts from the allowance account are recognized in the carrying amount of the corresponding receivable as soon as this is derecognized due to irrecoverability.

Available-for-sale financial assets

“Available-for-sale financial assets” are those non-derivative financial assets that are not assigned to the measurement categories “financial assets and financial liabilities at fair value through profit or loss”, “held-to-maturity investments” or “loans and receivables”. Financial assets in this category are subsequently measured at fair value. Generally, changes in fair value are recognized immediately in equity and are only transferred to the consolidated income statement when the financial asset is derecognized. Changes in the fair values of contingent consideration resulting from adjustments to cash flow estimated are recognized in profit or loss. If there is substantial evidence of an asset impairment, the accumulated loss recognized immediately in equity is to be reclassified to the consolidated income statement, even if the financial asset has not been derecognized. Reversals of impairment losses on previously impaired equity instruments are recognized immediately in equity. Reversals of impairment losses on previously impaired debt instruments are recognized in profit or loss up to the amount of the impairment loss. Any amount in excess of this is recognized directly in equity. Financial assets in this category for which no fair value is available or fair value cannot be reliably determined are measured at cost less any accumulated impairment losses. Impairment losses on financial assets carried at cost may not be reversed. At Merck, this measurement category is used in particular for interest-bearing securities, financial assets, contingent consideration, and financial investments in equity instruments as well as interests in subsidiaries that are not consolidated due to secondary importance (affiliates). Both interests in non-consolidated subsidiaries as well as to some extent financial investments in equity instruments are measured at cost.

Other liabilities

Other liabilities are non-derivative financial liabilities that are subsequently measured at amortized cost. Differences between the amount received and the amount to be repaid are amortized to profit or loss over the maturity of the instrument. Merck primarily assigns financial liabilities such as issued bonds and bank loans, trade payables, and miscellaneous other non-derivative current and non-current liabilities to this category.

(59) Financial instruments: Derivatives and hedge accounting

Merck uses derivatives solely to economically hedge recognized assets or liabilities and forecast transactions. The hedge accounting rules in accordance with IFRS are applied to some of these hedges. A distinction is made between fair value hedge accounting and cash flow hedge accounting. Designation of a hedging relationship requires a hedged item and a hedging instrument. Merck currently only uses derivatives as hedging instruments.

The hedging relationship must be effective at all times, i.e. the change in fair value of the hedging instrument almost fully offsets changes in the fair value of the hedged item. Merck uses the dollar offset method as well as regression analyses to measure hedge effectiveness. Derivatives that do not or no longer meet the documentation or effectiveness requirements for hedge accounting, whose hedged item no longer exists, or for which hedge accounting rules are not applied are classified as “financial assets and liabilities at fair value through profit or loss”. Changes in fair value are then recognized in profit or loss.

At Merck, cash flow hedges normally relate to highly probable forecast transactions in foreign currency and to future interest payments. In cash flow hedges, the effective portion of the gains and losses on the hedging instrument taking deferred taxes into consideration is recognized in equity until the hedged expected cash flows affect profit or loss. This is also the case if the hedging instrument expires, is sold, or is terminated before the hedged transaction occurs and the occurrence of the hedged item remains likely. The ineffective portion of a cash flow hedge is recognized directly in profit or loss.

(60) Other non-financial assets and liabilities

Other non-financial assets are carried at amortized cost. Allowances are recognized for any credit risks. Long-term non-interest- bearing and low-interest receivables and liabilities are carried at their present value. Other non-financial liabilities are carried at the amount to be repaid.

(61) Deferred taxes

Deferred tax assets and liabilities result from temporary differences between the carrying amount of an asset or liability in the IFRS and tax balance sheets of consolidated companies as well as from consolidation activities, insofar as the reversal of these differences will occur in the future. In addition, deferred tax assets are recorded in particular for tax loss carryforwards if and insofar as their utilization is probable in the foreseeable future. In accordance with the liability method, the tax rates enacted and published as of the balance sheet date are used.

Deferred tax assets and liabilities are only offset on the balance sheet date if they meet the requirements of IAS 12.

(62) Inventories

Inventories are carried at the lower of cost or net realizable value. When determining cost, the “first-in, first-out” (FIFO) and weighted average cost formulas are used. In addition to directly attributable unit costs, manufacturing costs also include overheads attributable to the production process, which are determined on the basis of normal capacity utilization of the production facilities.

Inventories are written down if the net realizable value is lower than the acquisition or manufacturing cost carried in the balance sheet.

Since the inventories are not manufactured within the scope of long-term production processes, the manufacturing costs do not include any borrowing costs.

Inventory prepayments are recorded under other current assets.

(63) Provisions for pensions and other post-employment benefits

Provisions for pensions and other post-employment benefits are recorded in the balance sheet in accordance with IAS19. The obligations under defined benefit plans are measured using the projected unit credit method. Under the projected unit credit method, dynamic parameters are taken into account in calculating the expected benefit payments after an insured event occurs; these payments are spread over the entire period of service of the participating employees. Annual actuarial opinions are prepared for this purpose. The actuarial assumptions, e.g. for discount rates, salary and pension trends, which were used to calculate the benefit obligation, were determined on a country-by-country basis in line with the economic conditions prevailing in each country; the latest country-specific actuarial mortality table was used in each case. The respective discount rates are generally determined on the basis of the returns on high-quality corporate bonds issued with adequate maturities and currencies. For euro-denominated obligations, bonds with ratings of at least AA” from one of the three major rating agencies (Standard & Poor’s, Moody’s or Fitch), and a euro swap rate of adequate duration served as the basis for the data. Actuarial gains and losses resulting from changes in actuarial assumptions and / or experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred) are recognized immediately in equity as soon as they are incurred, taking deferred taxes into account. Consequently, the consolidated balance sheet discloses – after deduction of the plan assets – the full scope of the obligations while avoiding the fluctuations in expenses that can result especially when the calculation parameters change. The actuarial gains and losses recorded in the respective reporting period are presented separately in the Statement of Comprehensive Income.

(64) Other provisions and contingent liabilities

Provisions are recognized in the balance sheet if it is more likely than not that a cash outflow will be required to settle the obligation and the amount of the obligation can be measured reliably. The carrying amount of other provisions takes into account the amounts required to cover future payment obligations, recognizable risks and uncertain obligations of the Merck Group to third parties.

Measurement of other provisions is based on the settlement amount with the highest probability or, if a large number of similar cases exist with respect to the provision being measured, it is based on the expected value of the settlement amounts. Long-term provisions are discounted and carried at their present value as of the balance sheet date if the discount rate effect is material. To the extent that reimbursement claims exist as defined in IAS 37, they are recognized separately as an asset if their realization is virtually certain and the asset recognition criteria have been met.

Contingent liabilities comprise not only possible obligations arising from past events and whose existence is subject to the occurrence of uncertain future events, but also present obligations arising from past events where an outflow of resources embodying economic benefits is not probable or where the amount of the obligation cannot be measured with reliability. Contingent liabilities that were not assumed within the context of a business combination are not recognized in the consolidated balance sheet. Unless the possibility of an outflow of resources embodying economic benefits is remote, information on the relevant contingent liabilities is disclosed in the notes.

In this context, the present value of the future settlement amount is used as the basis for measurement. The settlement amount is determined in accordance with the rules set out in IAS 37 and is based on the best estimate.

(65) Share-based compensation ­programs

Provisions have been set up for obligations from share-based compensation programs. These share-based compensation programs with cash settlement are aligned not only with target achievement based on key performance indicators, but above all also with the long-term performance of Merck shares. Certain executives and employees could be eligible to receive a certain number of virtual shares – Merck Share Units (MSUs) – at the end of a three-year performance cycle. The number of MSUs that could be received depends on the total value defined for the respective person and the average closing price of Merck shares in Xetra® trading during the last 60 trading days prior to January 1 of the respective fiscal year (reference price). In order for members of top management to receive payment, they must personally own an investment in Merck shares dependent on their respective fixed annual compensation. When the three-year performance cycle ends, the number of MSUs to then be granted is determined based on the development of two key performance indicators (KPIs). These are on the one hand the performance of the Merck share price compared to the performance of the DAX® with a weighting of 70%, and on the other hand the development of the EBITDA pre margin during the performance cycle as a proportion of a defined target value with a weighting of 30%. Depending on the development of the KPIs, at the end of the respective performance cycle the eligible participants are granted between 0% and 150% of the MSUs they could be eligible to receive.

Based on the MSUs granted, the eligible participants receive a cash payment at a specified point in time in the year after the three-year performance cycle has ended. The value of a granted MSU, which is relevant for payment, corresponds to the average closing price of Merck shares in Xetra® trading during the last 60 trading days prior to January 1 after the performance cycle. The payment amount is limited to three times the reference price. The fair value of the obligations is recalculated on each balance sheet date using a Monte Carlo simulation based on the previously described KPIs. The expected volatilities are based on the implicit volatility of Merck shares and the DAX® in accordance with the remaining term of the respective tranche. The dividend payments incorporated into the valuation model orient towards medium-term dividend expectations.

The Executive Board members have their own Long-Term Incentive Plan, the conditions of which largely correspond to the Long-Term Incentive Plan described here. A description of the plan for the Executive Board can be found in the compensation report, which is part of the Statement on Corporate Governance.