3.1 Adopted accounting standards

Pursuant to Regulation 1606 issued by the European Parliament and the European Council in July 2002, the consolidated financial statements of the Pirelli & C. Group have been prepared in accordance with the current International Financial Reporting Standards (“IRFSs”) issued by the International Accounting Standards Board (“IASB”) and endorsed by the European Union at December 31, 2011, as well as the measures issued in implementation of Article 9 of Legislative Decree 38/2005. The term “IFRSs” also refers to all revised International Accounting Standards (“IAS”) and all interpretations issued by the International Financial Reporting Interpretations Committee (“IFRIC”), formerly known as the Standing Interpretations Committee (“SIC”).

The consolidated financial statements have been prepared in accordance with the historic cost method, with the exception of:

  • derivative financial instruments, financial instruments held for trading, and available-for-sale financial assets, which are measured at fair value;
  • financial statements of companies operating in hyperinflationary economies, which are prepared according to the current cost method.

 

Business combinations

Business acquisitions are accounted for by using the acquisition method.

When a controlling interest in a company is acquired, goodwill is initially recognised at cost and calculated as the difference between:

  • the price paid plus any non-controlling interests in the acquired entity. These latter interests are measured at fair value (if this option is chosen for the acquisition in question) or in proportion to the share of the non-controlling interest in the net assets of the acquired entity;
  • the fair value of the acquired assets and liabilities.

If this difference is negative, that difference is immediately recognised as income in the Income Statement. In the case of acquisition of control of an entity in which a non-controlling interest is already held (step acquisition), the investment previously held must be recognised at fair value through profit or loss.

The costs for the business combination are recognised in the Income Statement.

Contingent consideration, i.e. the obligations of the acquirer to transfer additional assets or shares to the seller if certain future events occur or specific conditions are fulfilled, should be measured at fair value at the acquisition date and recognised as a portion of the consideration transferred in exchange for the acquisition itself.

Subsequent changes in the fair value of these agreements are normally recognised in the Income Statement.

 

Intangible assets

Intangible assets having finite useful lives are measured at cost less accumulated amortisation and accumulated impairment losses.

Amortisation begins when the asset is available for use or operable in the opinion of management and ceases on the date when the asset is classified as held for sale or is derecognised.

Gains and losses resulting from the sale or disposal of an intangible asset are determined as the difference between the net sale proceeds and the carrying amount of the asset.

Goodwill

Since this is an intangible asset with an indefinite useful life, goodwill is not amortised.

Goodwill is tested for impairment in order to identify any impairment losses at least annually or whenever there are indications of an impairment loss, and is allocated to cash generating units for this purpose.

Trademarks and licenses

Trademarks and licenses are measured at cost less accumulated amortisation and accumulated impairment losses. The cost is amortised over the contract period or the useful lives of the assets, whichever is shorter.

Software

Software license costs, including direct incidental costs, are capitalised and recognised net of accumulated amortisation and accumulated impairment losses. Software is amortised over its useful life on a straightline basis.

Research and development

Research costs for new products and/or processes are expensed when incurred.

There are no development costs that satisfy the conditions for capitalisation under IAS 38.

Trademarks and licences 5 years
Software from 2 to 3 years

 

Property, plant and equipment

Property, plant and equipment are recognised at the cost of acquisition or production, including directly attributable incidental expenses.

Subsequent expenditure and the cost of replacing certain parts of property, plant and equipment are capitalised only if they increase the future economic benefits inherent in the affected asset. All other costs are expensed as incurred. When the cost of replacing certain parts is capitalised, the carrying amount of the replaced part is recognised in the Income Statement. Property, plant and equipment are recognised at cost less accumulated depreciation and accumulated impairment losses, except for land, which is not depreciated and is recognised at cost less accumulated impairment losses.

Depreciation is recognised starting from the month in which the asset is available for use, or is potentially capable of providing the economic benefits associated with it.

Depreciation is charged monthly on a straight-line basis at rates that allow depreciating the assets until the end of their useful life or, in the case of disposal, until the last month of use.

The applied depreciation rates are illustrated as follows:

Buildings 3% -10%
Plant 7% -20%
Machinery 5% -20%
Equipment 10% -33%
Furniture 10% -33%
Motor veichles
10% -25%

Government grants related to assets referring to property, plant and equipment are recognised as deferred income and credited to the income statement over the period of depreciation of the relevant assets.

Borrowing costs directly attributable to the purchase, construction or production of a qualifying asset are capitalised as part of the cost of the asset. A qualifying asset is one that requires substantial time in order to be prepared for use. The capitalisation of borrowing costs ceases when substantially all the activities necessary to render the qualifying asset available for use have been completed.

Leasehold improvements are classified as property, plant and equipment, consistently with the nature of the cost incurred. The depreciation period corresponds to the remaining useful life of the asset or the residual period of the lease agreement, whichever is shorter.

Spare parts of significant value are capitalised and depreciated over the estimated useful life of the assets to which they refer.

Any dismantling costs are estimated and added to the cost of property, plant and equipment with a corresponding accrual to provisions for liabilities and charges if the prerequisites for establishing such provisions are satisfied. They are then depreciated over the remaining useful life of the assets to which they refer.

Assets acquired finance lease agreements, in which substantially all the risks and rewards of ownership are transferred to the Group, are recognised as property, plant and equipment at their fair value or, if lower, at the present value of the minimum lease payments, with a corresponding entry for the relevant financial payable. The lease instalment payments are allocated between interest expense, which is recognised in the Income Statement, and principal repayment, which is recorded as a reduction of the financial payable.

Leases in which the lessor maintains substantially all the risks and rewards associated with ownership are classified as operating leases. The costs referring to an operating lease are recognised as an expense in the Income Statement over the lease term on a straightline basis.

Property, plant and equipment are derecognised at the time of disposal or retirement from use and, consequently, when no future economic benefits are expected to derive from their sale or use. Gains and losses resulting from the sale or disposal of property, plant and equipment are determined as the difference between the net sale proceeds and the carrying amount of the asset.

 

Impairment of assets

Property, plant and equipment and intangible assets

Whenever there are specific indicators of impairment, and at least annually for intangible assets with indefinite life, including goodwill, the property, plant and equipment and intangible assets are tested for impairment.

The test consists of an estimate of the recoverable amount of the asset and a comparison with its carrying amount.

The recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use, where the latter is the present value of the expected future cash flows arising from the use of the asset and those deriving from its disposal at the end of its useful life, excluding income taxes and applying a discount rate, which should be the pre-tax rate, which reflects the current market assessments of the time value of the money and the risks specific to the asset.

If the recoverable amount is lower than the asset carrying amount, the latter is reduced to the recoverable amount. This reduction constitutes an impairment loss, which is recognised in the Income Statement.

In order to assess impairment, assets are allocated to the lowest level at which independent cash flows are separately identifiable (cash generating units). Specifically, goodwill must be allocated to the cash generating unit or group of cash generating units, complying with the maximum level of aggregation allowed, which must never be greater than the operating segment.

When there is evidence that an impairment loss recognised in previous years and relating to property, plant and equipment or intangible assets other than goodwill may no longer exist or can be reduced, the recoverable amount is estimated again. If it is higher than the net carrying amount, then the net carrying amount should be increased to the revised estimate of its recoverable amount. The reversal of an impairment loss may not exceed the carrying amount that would have been recognised (net of impairment and depreciation or amortisation) had no impairment loss been recognised in previous years.

The reversal of an impairment loss other than goodwill is recognised in the Income Statement. An impairment loss recognised for goodwill may not be reversed in subsequent years. An impairment loss recognised for goodwill on the interim financial statements may not be reversed in the subsequent annual period.

 

Investments in associates and joint ventures

When there are indicators of impairment, the value of investments in associates and joint ventures accounted for using the equity method must be compared with the recoverable amount (impairment test). The recoverable amount corresponds to the higher of the fair value, less selling costs, and the value in use. There is no need to estimate both amounts because it is sufficient to verify that one of the two amounts is higher than the carrying amount in order to establish that no impairment has occurred.

For the purposes of impairment testing, the fair value of an investment in an associate or joint venture with shares listed on an active market is always equal to its market value, irrespective of the percentage of ownership.

For the purpose of determining the value in use of an associate or joint venture, the following estimates should be made alternatively:

  • the share of the present value of estimated future cash flows that are expected to be generated by the associate or joint venture, including cash flows deriving from the operating activities of the associate or joint venture and the consideration that will be received upon final disposal of the investment (known as the Discounted Cash Flow – asset side method);
  • the present value of estimated future cash flows that are expected to arise from dividends to be received and  from final disposal of the investment (known as the dividend discount model – equity side).

If there is evidence than an impairment loss recognised in previous years may no longer exist or can be reduced, the recoverable amount of the investment is estimated again, and if it is higher than the amount of the investment, then the latter amount should be increased up to the recoverable amount.

The reversal of an impairment loss may not exceed the amount of the investment that would have been recognised (net of impairment) had no impairment loss been recognised in previous years.

The reversal of an impairment loss on investments in associates and joint ventures is recognised in the Income Statement.

Available-for-sale financial assets

The category of available-for-sale financial assets includes investments in entities other than subsidiaries, associates and joint ventures and other financial instruments not held for trading. They are recognised on the Balance Sheet at the item “Other financial assets.” They are measured at fair value, if this can be reliably determined.

Gains and losses deriving from changes in fair value are recognised in a specific equity reserve.

When a reduction in fair value has been recognised directly in equity and there is objective evidence that the asset was impaired, the losses recognised up to that time in equity are recycled to the Income Statement. A prolonged (meaning more than 12 months) or significant (meaning more than one-third) reduction in the fair value of equity instruments as compared with their cost is considered an indicator of impairment. In the event of disposal, the gains and losses recognised up to that time in equity are recycled to the Income Statement.

Any impairment losses of an available-for-sale financial asset recognised in the Income Statement may be reversed through the Income Statement, with the exception of those recognised for equity instruments classified as available for sale, which may not be reversed through the Income Statement.

Available-for-sale financial assets, whether debt or equity instruments for which fair value is not available, are accounted for at cost, reduced by any impairment losses based on the best market information available at the Balance Sheet date.

Purchases and sales of available-for-sale financial assets are accounted for at the settlement date.

 

Inventories

Inventories are measured at the lower of cost, determined according to the FIFO method, and their estimated realisable value.

The measurement of inventories includes direct costs of materials and labour and indirect costs. Provisions are calculated for obsolete and slow-moving inventories, taking into account their expected future use and estimated realisable value. The realisable value is the estimated selling price, net of all costs estimated to complete the asset and selling and distribution costs that will be incurred.

Cost includes incremental expenses and borrowing costs qualifying for capitalisation, similarly to what has been described for property, plant and equipment.

 

Construction contracts

A construction contract is a contract specifically negotiated for the construction of an asset, based on the instructions of a principal who, as a preliminary step, designs the plans and the technical characteristics.

Contract revenues include the consideration initially agreed with the customer, as well as changes in the construction work and price variations envisaged by the contract that can be determined reliably.

When the outcome of a contract can be estimated reliably, the contract revenues and costs are measured using the percentage of completion method.

The stage of completion is determined with reference to the costs incurred up to the Balance Sheet date as a percentage of the total estimated costs for each contract.

Costs incurred in connection with future activities on the contract are excluded from contract costs when determining the stage of completion and are recognised as inventories.

When total contract costs are expected to exceed total contract revenues, the expected loss is immediately recognised as an expense.

The gross amount due from customers for contract work for all the contracts in progress and for which the costs incurred plus recognised profit (or net of recognised losses) exceed progress billings is recognised as a receivable, under the item “trade receivables.”

The gross amount due to customers for contract work for all the contracts in progress and for which the progress billings exceed the costs incurred plus recognised profit (or net of recognised losses) is recognised as a payable, under the item “trade payables.”

 

Receivables

Receivables are initially recognised at their fair value, which normally corresponds to the consideration agreed or to the present value of the amount that will be collected.

They are subsequently measured at amortised cost, less provisions for impairment losses.

Amortised cost is calculated by using the effective interest rate method, which is equivalent to the discount rate that, when applied to future cash flows, renders the present value of such flows equal to the initial fair value.

Impairment losses on receivables are calculated according to counterparty default risk, which is determined by considering available information on the solvency of the counterparty and historic data. The carrying amount of receivables is reduced indirectly by accruing provisions. Individual material positions that are objectively found to be partially or entirely uncollectable are impaired individually. The amount of the impairment loss reflects the estimate of future recoverable flows and the applicable date of collection, recovery costs and expenses, and the fair value of guarantees, if any.

The positions that are not written down individually are included in groups with similar characteristics in terms of credit risk, and they are impaired as a group on an increasing percentage basis as the period during which they are overdue increases. The group impairment procedure also applies to receivables not yet due.

The impairment percentages are determined on the basis of historic experience and statistical data.

When the conditions that led to impairment of the receivables no longer exist, the impairment losses recognised in previous periods are reversed by crediting the Income Statement up to the amortised cost that would have been recognised had no impairment loss been recognised.

Receivables in currencies other than the functional currency of the individual companies are adjusted to the year-end exchange rates, with a balancing entry in the Income Statement.

Receivables are derecognised when the right to receive cash flows is extinguished, when substantially all the risks and rewards connected with holding the receivable have been transferred, or when the receivable is considered definitely irrecoverable after all necessary credit recovery procedures have been completed. When the receivable is derecognised, the related provision is also derecognised, if the receivable had previously been impaired.

Payables

Payables are initially recognised at their fair value, which normally corresponds to the consideration agreed or to the present value of the amount that will be paid. They are subsequently measured at amortised cost.

Amortised cost is calculated by using the effective interest rate method, which is equivalent to the discount rate that, when applied to future cash flows, renders the present value of such flows equal to the initial fair value.

Payables in currencies other than the functional currency of the individual companies are adjusted to the year-end exchange rates, with a balancing entry in the Income Statement.

Payables are derecognised when the specific contractual obligation is extinguished.

Financial assets carried at fair value through profit or loss

This category includes financial instruments that are purchased mainly for resale in the short term and classified under current assets as “securities held for trading,” financial assets that are initially recognised at fair value through profit or loss, classified as “other financial assets,” and derivatives (except those designated as effective hedging instruments), classified as “derivative financial instruments.”

They are measured at fair value with a balancing entry in the Income Statement. Transaction costs are expensed to the Income Statement.

Purchases and sales of these financial assets are accounted for at the settlement date.

 

Cash and cash equivalents

Cash and cash equivalents include bank deposits, postal deposits, cash and cash equivalents on hand.

 

Provisions for other liabilities and charges

Provisions for other liabilities and charges include accruals for current obligations (legal or constructive) deriving from a past event, for the fulfilment of which an outflow of resources will probably be necessary and whose amount can be reliably estimated.

Changes in estimates are recognised in the Income Statement of the period when the change occurs.

If the effect of discounting is material, provisions are presented at their present value.

Employee benefit obligations

Employee benefits paid after termination of the employment relationship under defined benefit plans and other long-term benefits are subject to actuarial measurements. The liability recognised in the financial statements is the present value of the Group’s obligation, net of the fair value of any plan assets.

With regard to defined benefit plans, the Pirelli Group has elected the option allowed by IAS 19, under which actuarial gains and losses are fully recognised in equity in the financial year when they arise.

For other long-term benefits, actuarial gains and losses are recognised immediately in the Income Statement.

The interest expense and expected return on plan assets are recognised under personnel costs.

The costs relating to defined contribution plans are recognised in the Income Statement when incurred.

Until December 31, 2006, the provision for employees’ leaving indemnities (TFR) of Italian companies was considered a defined benefit plan. The rules governing this provision were amended by Law 296 of December 27, 2006 (“2007 Italian Budget Act”) and subsequent decrees and regulations issued in the early months of 2007. In light of these changes, and specifically in reference to Group companies with more than 50 employees, the provision is now considered a defined benefit plan for the portion accrued prior to January 1, 2007 (and not yet paid out at the reporting date), whereas subsequent to that date, it is considered a defined contribution plan.

 

Derivative financial instruments designated as hedging instruments

In accordance with IAS 39, hedging instruments are subject to hedge accounting only when:

  • formal designation and documentation of the hedging relationship between the hedging derivative and the hedged item exist at the beginning of the hedge;
  • it is expected that the hedge be highly effective;
  • its effectiveness can be measured reliably;
  • the hedge is highly effective during the various accounting periods for which it is designated.

These derivative instruments are measured at fair value.

The following accounting treatment is applied according to the type of hedge:

  • Fair value hedge – if a derivative financial instrument is designated as a hedge against exposure to changes in the fair value of an asset or liability attributable to a specific risk, the gain or loss resulting from subsequent changes in fair value of the hedging instrument is recognised in the Income Statement. For the portion attributable to the hedged risk, the gain or loss on the hedged item modifies the carrying value of that item (basis adjustment), and is also recognised in the income statement;
  • Cash flow hedge – if a derivative financial instrument is designated as a hedge against exposure to the variable cash flow of an asset or liability recognised in the balance sheet or a highly probable future transaction, the effective portion of the change in fair value of the hedging instrument is recognised directly in equity, while the ineffective portion is immediately recognised in the Income Statement. The amounts recognised directly in equity are reversed to the Income Statement in the year when the hedged item produces an effect in the Income Statement.

When a hedging instrument expires or is sold, terminated, exercised or no longer meets the criteria to be designated as a hedge, or whenever the Group voluntarily revokes the designation, hedge accounting is interrupted. The fair value adjustments accumulated in equity remain in equity until the hedged item produces an effect in the Income Statement. Subsequently they are reclassified to the income statement over the periods in which the acquired financial asset or assumed financial liability impacts the Income Statement. When the hedged item is no longer expected to impact the Income Statement, the fair value adjustments accumulated in equity are immediately recycled to the Income Statement.

For the derivative instruments that do not satisfy the prerequisites established by IAS 39 for the adoption of hedge accounting, please see the section “Financial assets carried at fair value in the Income Statement.”

Purchases and sales of these derivative financial instruments are accounted for at the settlement date.

 

Determination of the fair value of financial instruments

The fair value of financial instruments traded on an active market is based on listed market prices at the reporting date. The listed market price used for financial assets is the bid price, while for financial liabilities it is the ask price. The fair value of instruments that are not traded on an active market is determined by using measurement techniques with a variety of methods and assumptions that are based on market conditions at the balance sheet date.

The fair value of interest rate swaps is calculated as the present value of expected future cash flows.

The fair value of forward exchange contracts is determined by using the forward rate at the reporting date.

 

Income taxes

Current taxes are determined on the basis of a realistic forecast of the taxes payable under the current tax law of the country.

Deferred taxes are calculated according to the temporary differences existing between the asset and the liability amounts in the balance sheet and their tax basis (full liability method), and are classified under noncurrent assets and liabilities.

Deferred tax assets on tax loss carry-forwards, as well as on temporary differences, are only recognised when there is a likelihood of future recovery.

Current and deferred tax assets and liabilities are offset when the income taxes are levied by the same tax authority and when there is a legally enforceable right to offset. Deferred tax assets and liabilities are determined according to enacted tax rates that are expected to be applicable to taxable income in the years when those temporary differences are expected to be recovered or settled, with reference to the jurisdictions where the Group operates.

The deferred tax liabilities related to equity investments in subsidiaries, associates and joint ventures are not recognised if the parent can control the reversal of the temporary differences and if it is probable that such reversal will not arise in the foreseeable future. Deferred taxes are not discounted.

Deferred tax assets and liabilities are credited or debited to equity if they refer to items that have been credited or debited directly in equity during the period or during previous periods.

 

Equity

Treasury shares

Treasury shares are recognised as a reduction in equity. If they are sold, reissued or cancelled, the resulting gains or losses are recognised in equity.

Costs of equity transactions

Costs that are directly attributable to equity transactions of the parent are recognised as a reduction in equity.

 

Recognition of revenue

Revenue is measured at the fair value of the consideration received for the sale of products or provision of services.

Sales of products

Revenue from the sale of products is recognised when all the following conditions are met:

  • the material risks and rewards of ownership of the goods are transferred to the buyer;
  • effective control over the goods and the normal continuing level of activities associated with ownership have ceased;
  • the amount of revenue is reliably determined;
  • it is likely that the economic benefits deriving from the sale will be enjoyed by the enterprise;
  • the costs incurred or to be incurred are determined reliably.

If the nature and extent of involvement of the seller are such as to cause that the risks and rewards of ownership are not in fact transferred, then the recognition date of the revenue is deferred until the date on which this transfer can be considered to have taken place.

Provision of services

Revenue from the provision of services is recognised only when the results of the transaction can be measured reliably, by reference to the stage of completion of the transaction at the balance sheet date.

The results of a transaction can be measured reliably only when all the following conditions are met:

  • the amount of revenue can be determined reliably;
  • it is likely that that company will enjoy the economic benefits of the transaction;
  • the stage of completion of the transaction at the reporting date can be reliably measured;
  • the costs incurred for the transaction and the costs to be incurred to complete it can be determined reliably.

Interest income

Interest income is recognised on a time proportion basis that considers the effective return of the asset.

Royalty income

Royalty income is recognised on an accrual basis, according to the substance of the relevant agreement.

Dividend income

Dividend income is recognised when the right to receive payment is established, which normally corresponds to the resolution passed by the Shareholders’ Meeting for the distribution of dividends.

 

Earnings (losses) per share

Earnings (losses) per share are calculated by dividing the income (loss) attributable to the equity holders of the company by the weighted average number of outstanding shares during the year. To calculate diluted earnings (losses) per share, the weighted average number of outstanding shares is adjusted by assuming the conversion of all shares having a potentially dilutive effect.

 

Operating segments

The operating segment is a part of the Group that engages in business activities from which it may earn revenues and incur expenses, whose operating results are regularly reviewed by top management in view of making decisions about resources to be allocated to the segment and assessing its performance, and for which discrete financial information is available.

 

Accounting policies for hyperinflationary countries

Group companies operating in high-inflation countries recalculate the amounts of their non-monetary assets and liabilities in their individual financial statements to eliminate the distorting effects caused by the loss of purchasing power of the currency. The inflation rate used for implementation of inflation accounting corresponds to the consumer price index.

Companies operating in countries where the cumulative inflation rate over a three-year period approximates or exceeds 100% adopt inflation accounting and discontinue it in the event that the cumulative inflation rate over a three-year period falls below 100%.

Gains or losses on the net monetary position are recognised in the Income Statement.

 

Non-current assets held for sale and disposal groups

Non-current assets and disposal groups are classified as held for sale if their carrying value is recovered mainly through sale rather than through continuous use. This occurs if the non-current assets or disposal group are available for sale under current conditions and the sale is highly probable, or if a binding programme for sale has already begun, activities to find a buyer have already commenced and it is expected that the sale will be completed within one year after the classification date.

On the consolidated Balance Sheet, the non-current assets held for sale and the current and non-current assets/ liabilities of the disposal group are presented as a separate item from other assets and liabilities, and their totals are reflected in current assets and liabilities, respectively.

Non-current assets classified as held for sale and disposal groups are measured at the lesser of their respective carrying value and fair value net of the costs of sale.

The property, plant and equipment and intangible assets classified as held for sale are not depreciated or amortised.

 

Discontinued operations

A discontinued operation is a component that has been disposed of or classified as held for sale and that represents an important business unit or geographical area of activity, and pertains to a single, coordinated disposal programme.

On the consolidated Income Statement for the period, the net result of the discontinued operations, as well as the gain or loss resulting from fair value measurement net of the costs of sale or from disposal of the assets or disposal groups constituting the discontinued operation are combined in a single item at the end of the Income Statement separately from the result for continuing operations.

The cash flows for discontinued operations are shown separately in the statement of cash flows.

The foregoing information is also presented for the comparative period.