Accounting in medium-sized companies in Germany – special aspects for international investors

published on 22 February 2022 | reading time approx. 2 minutes

Transaction ventures pose many challenges to investors. In the case of medium-sized targets in Germany, one of these challenges include understanding annual financial statements when they are – and most of them are – prepared in accordance with the German Commercial Code (HGB). German accounting principles are significantly different from the International Financial Reporting Standards (IFRS) and, thus, so is the evaluation and interpretation of annual financial statements during due diligence; to avoid misleading information, especially when it comes to time and intercompany comparisons and – on this basis – possibly inappropriately derived purchase prices, prospective buyers resort to external experts for help in analysing historical and possibly forward-looking financial information.

The main difference between HGB and IFRS strikes already when talking about the objective and the function of annual financial statements. While annual financial statements prepared according to HGB focus on the protection of creditors (i.a. due to the principle of conservative accounting tending towards creating provisions) and documentation, serve to calculate distributions and, in some cases, are an important means for assessing taxes, IFRS are significantly oriented towards providing investors and creditors with information that is relevant to decision-making. Even though HGB has been reformed many times, most recently by the German Accounting Directive Implementation Act (BilRUG), in force since 1 January 2016, these fundamental objectives have remained unchanged.

Special aspects of accounting practices among medium-sized companies

Because of the relevance of annual financial statement items for the calculation of taxes, especially small and medium-sized enterprises (SMEs) often use accounting to optimise taxes. The room for discretion allowed under the commercial law principles are often used for this purpose taking into account tax aspects. This leads to a situation where financial statements prepared according to HGB – depending on the economic situation of the company – often present a less favourable view of the company than is actually the case.

Special aspects of presenting information in annual financial statement according to HGB

The breakdown of income statement items under the nature of expense method, predominantly used in Germany, often makes it more difficult for foreign investors to prepare their usual analyses if these are based on the popular, cost centre-oriented cost of sales method; here, assistance from a German consultant in interpreting and reconciling financials can prove particularly valuable.

In addition, HGB and IFRS define revenue differently. According to IFRS, it only includes revenue from the sale and rental or leasing of products and goods typical of the ordinary activities of the company and from services typical of the ordinary activities of the company. According to HGB, it includes all revenue from products and services, irrespective of whether they refer to ordinary activities of the company or not; this includes, for example, revenue from recharged administrative fees, canteen services or sales of scrap. The difference in the definitions leads to a difference in the recognition of corresponding expenses, under costs of materials, as long as there is a relation to the sales revenue, or otherwise, for example, under other operating expenses. For the analysis of the cost structure, especially the distinction from non-operating expenses, this can be of immense importance.

It has also been long since leasing as a form of financing made its way into the medium-sized enterprises sector. While, according to IFRS, lessees are always required to account for a right to use the leased asset, HGB makes it possible to present leasing on an off-balance-sheet basis if the lease agreement is drafted appropriately (the lessor remains the beneficial owner of the leased asset); the lease substitute must then first be detected in the annual financial statements prepared according to HGB as part of the analysis and the financial indicators presented in the income statements, especially EBITDA and EBIT, must usually be adjusted.

 
The widespread use of company pension commitments, which, in contrast to the usual international practice, are often not reinsured in Germany or outsourced to another company, also poses special challenges to foreign investors in the area of civil, insolvency and tax law issues. Furthermore, there is a substantial difference in how to value company pension obligations under German commercial and tax laws, for example, due to the application of different interest rates, but also in comparison to IFRS.