Basis of presentation

2. Basis of presentation

Accounting standards adopted

In accordance with Regulation 1606 issued by the European Parliament and by the Council of the European Union in July 2002, the consolidated financial statements of the Pirelli & C. Group have been prepared in accordance with the IFRS international accounting standards issued by the International Accounting Standards Boards (IASB) and endorsed by the European Union as at December 31, 2007.

The consolidated financial statements have been prepared under the historical cost convention except for investment property, financial instruments, financial assets designated at fair value and available-for-sale financial assets, which are measured at fair value.

Accounting standards and interpretations in force as from January 1, 2007

IFRIC 7 - Applying the Restatement Approach under IAS 29, Financial Reporting in Hyperinflationary Economies

This interpretation, endorsed by the European Union in May 2006 (EC Regulation 708/2006), provides guidance on how to apply the requirements of IAS 29 in a reporting period in which an entity for the first time identifies the existence of hyperinflation in the economy of its functional currency. Under IFRIC 7, the entity must re-measure the amounts in its financial statements in accordance with IAS 29, as if the economy had always been hyperinflationary.

This interpretation is not applicable to the Group.

IFRIC 8 - Scope of IFRS 2

IFRIC 8, endorsed by the European Union in September 2006 (EC Regulation 1329/2006), clarifies that IFRS 2 also applies to contracts where an entity makes share-based payments for services for apparently nil consideration.

In particular, IFRIC 8 states that where the identifiable consideration given appears less than the fair value of the equity instrument granted (or liability incurred), this typically indicates that additional consideration has been or will be received.

This interpretation is not applicable to the Group.

IFRIC 9 – Reassessment of Embedded Derivatives

This interpretation, endorsed by the European Union in September 2006 (EC Regulation 1329/2006), requires an entity to assess whether an embedded derivative is required to be separated from the host contract and accounted for as a derivative when the entity first becomes a party to the contract, that is, at the time of initial recognition. Subsequent reassessment is prohibited unless there is a change in the terms of the contract that significantly modifies the original cash flows.

This interpretation is not applicable to the Group.

IFRS 7 – Financial Instruments: Disclosures

This standard, endorsed by the European Union in January 2006 (EC Regulation 108/2006), supersedes IAS 30 (Disclosures in Financial Statements of Banks and Similar Financial Institutions) and includes the section on disclosures contained in IAS 32 (Financial Instruments: Disclosure and Presentation) with amendments and additions; the title of IAS 32 has been changed to “Financial Instruments: Presentation”.

The additional information required by the new standard, if applicable, is presented in the following Note 4 “Financial risk management policies” and in the notes to the financial statements (specifically, receivables, borrowings from bank and other financial institutions and financial instruments).

Amendments to IAS 1 – Presentation of Financial Statements – Capital Disclosures

These amendments, endorsed by the European Union in January 2006 (Regulation EC 108/2006), require that an entity must make disclosures that allow the user of financial statements to evaluate its objectives, its policies and its procedures for capital management. This disclosure is presented in the following Note 5 “Capital management policies”.

IFRIC 10 – Interim Financial Reporting and Impairment

This interpretation, endorsed by the EU in June 2007 (EC Regulation 610/2007) deals with the interaction between the requisites of IAS 34 (Interim Financial Reporting) and the impairment of goodwill (IAS 36 – Impairment of Assets) and certain financial assets (IAS 39 – Financial instruments: Recognition and Measurement). IFRIC 10 clarifies that if impairment losses on goodwill or a financial asset represented by an equity instrument are recognized in an interim period, such impairment losses, if the conditions which gave rise to the writedowns no longer exist, cannot be reversed in subsequent interim or annual financial statements.

New accounting standards or interpretations issued but not yet in force

As required by IAS 8 “Accounting Policies, Changes in Accounting Estimates and Errors”, new Standards or Interpretations issued but not yet in force are summarized and briefly described below.

The Group did not elect the early adoption of any of these standards or interpretations.

IFRIC 11 – IFRS 2 – Group and treasury share transactions

This interpretation, endorsed by the EU in June 2007 (EC Regulation 611/2007), provides guidance on the application of IFRS 2 “Share-based Payment” for certain types of plans that involve various units of the Group.

IFRIC 11 comes into force from January 1, 2008. The future application of this interpretation is not expected to have a material impact on the financial statements.

IFRIC 12 – Service Concession Arrangements

IFRIC 12 addresses private sector operators contracted for the supply of typical public sector services (e.g. roads, airports and energy and water distribution under concession arrangements). Under these arrangements, the assets are not necessarily controlled by the private operators which, however, are responsible for constructing, operating or maintaining the public sector infrastructure. Assets under these arrangements could possibly not be recorded as property, plant and equipment in the financial statements of the private operators but rather as financial assets and/or intangible assets depending on the type of service concession arrangement.

IFRIC 12, not yet endorsed by the EU, comes into effect from January 1, 2008 and is applicable to the Group but is not expected to have a material impact on the consolidated financial statements.

IFRIC 13 – Customer loyalty programmes

IFRIC 13 addresses the accounting treatment that must be adopted by entities that grant loyalty award credits to customers who buy goods or services. It also establishes that the fair value of the obligations connected with the loyalty awards must be separated from the revenues from sales and deferred until the entity has fulfilled its obligation to the customers.

IFRIC 13, not yet endorsed by the EU, comes into effect from July 1, 2008 and is applicable to the Group but is not expected to have a material impact on the consolidated financial statements.

IFRIC 14 – IAS 19 - The Limit on a Defined Benefit Asset, Minimum Funding Requirements and their Interaction

IAS 19 “Employee Benefits” establishes a limit on the assets of a defined benefit plan which can be recognized in the balance sheet. This interpretation provides guidance on how to assess this limit and clarifies the impact on the assets and liabilities relating to a defined benefit plan when minimum contractual or statutory funding requirements exist.

IFRIC 14, not yet endorsed by the EU, comes into effect from January 1, 2008. The future application of this interpretation is not expected to have a material impact on the financial statements.

IFRS 8 – Operating Segments

This principle, endorsed by the EU in November 2007 (EC Regulation 1358/2007), supersedes IAS 14 (Segment Reporting) and aligns segment disclosure with the requisites of US GAAP (SFAS 131 Disclosures about Segments of an Enterprise and Related Information), introducing the approach whereby the segments are identified in the same way they are identified in internal reports for management.

IFRS 8 comes into effect from January 1, 2009. The future application of this standard is not expected to have a material impact on the disclosures provided by group in the financial statements.

Amendments to IAS 23 “Borrowing Costs”

These amendments, which are part of the project for convergence with US GAAP (SFAS 34 Capitalization of Interest Cost), remove the option of immediately expensing borrowing costs directly attributable to the acquisition, construction or production of a qualifying asset. Therefore, borrowing costs are required to be capitalized as part of the cost of that asset.

These amendments, not yet endorsed by the European Union, come into effect from January 1, 2009. The future application of the amendments to this standard is not expected to have a material impact on the consolidated financial statements since the Group does not avail itself of the option that was eliminated.

Revision to IAS 1 “Presentation of Financial Statements”

IAS 1 has undergone a revision which is not one of substance but requires a change in the name of some of the statements forming the full set of financial statements and the introduction of a new statement (“statement of changes in equity”). The information in this statement had previously been disclosed in the notes. The amendments of the new IAS 1 also apply to comparative figures presented together with the period financial statements.

These revisions, not yet endorsed by the European Union, come into effect from January 1, 2009. The future application of the amendments to this standard is not expected to have a material impact on the financial statements.

Amendments to IFRS 2 “Share-based Payment: vesting conditions and cancellations”

The amendments to IFRS 2 aim to clarify the following aspects that are not explicitly dealt with in the current standard:

  • vesting conditions: vesting conditions refer only to service conditions (whereby a party should complete a specific period of service) and performance conditions (whereby it is necessary to reach specific targets). Other conditions, on which the current standard makes no explicit statements, should not be considered vesting conditions;
  • cancellations: all cancellations, whether by the entity or by other parties, should receive the same accounting treatment. The current IFRS 2 describes the accounting treatment in the case of cancellation by the entity but does not provide any indication in the case of cancellation by parties other than the entity.

These amendments, not yet endorsed by the European Union, come into effect from January 1, 2009. The future application of the amendments to this standard is not expected to have an impact on the consolidated financial statements.

Amendments to IAS 32 “Financial instruments: presentation” and IAS 1 “Presentation of financial statements”: puttable instruments and obligations arising on liquidation.

These amendments refer to the accounting treatment of certain particular types of financial instruments which have characteristics similar to ordinary shares, but are currently classified as financial liabilities, in that they give the holder of the instrument the right to request redemption by the issuer.

In accordance with these amendments, the following types of financial instruments must be classified as equity instruments on condition that they have particular characteristics and satisfy specific conditions:

  • puttable financial instruments (financial instruments redeemable upon the request of the holder), for example certain types of shares issued by cooperative companies;
  • instruments which give rise to an obligation for the entity to deliver to another party a pro-rata share of the net assets of the entity only on liquidation – for example certain partnerships and certain types of shares issued by limited duration companies.

These amendments, not yet endorsed by the European Union, come into effect from January 1, 2009. The future application of the amendments to this standard is not expected to have an impact on the financial statements.

Revision of IFRS 3 “Business Combinations”

This revision is also part of the project for convergence with US GAAP and has the purpose of aligning the accounting treatment of business combinations. The main changes over the previous version refer to:

  • recognition in the income statement – when incurred – of the expenses relating to business combination transactions (legal, advisory, valuation and audit fees and professional fees in general);
  • the option of recognizing minority interests at fair value (full goodwill); this option can be elected for each single business combination transaction;
  • specific rules for the recognition of step acquisitions: in the case of the acquisition of control of a company in which a minority interest is already held, the previously held investment must be measured at fair value, recognizing the effects of this adjustment in the income statement;
  • contingent consideration, that is, the obligations of the acquirer to transfer additional assets or shares to the seller in the case certain future events or specific conditions arise, must be recognized and measured at fair value at the date of acquisition. Subsequent changes in the fair value of such agreements are normally recognized in the income statement.

These revisions, not yet endorsed by the EU, come into effect starting from the fiscal years beginning after June 30, 2009. The effects on the financial statements in the year of first-time application of the new standard cannot be determined at this time.

Amendments to IAS 27 “Consolidated and separate financial statement”

The revision of IFRS 3 “Business Combinations” also required amendments to IAS 27 “Consolidated and separate financial statements”, which can be summarized as follows:

  • changes in the equity interests of a subsidiary, which do not entail the loss of control, qualify as equity transactions. In other words, the difference between the price paid/received and the share of equity acquired/sold must be recognized in equity;
  • in the event of the loss of control, but where an interest is retained, such interest must be measured at fair value at the date in which the loss of control is established.

These amendments, not yet endorsed by the EU, come into effect starting from the fiscal years beginning after June 30, 2009. The effects on the financial statements in the year of first-time application of the new standard cannot be determined at this time.

In conformity with the provisions of art. 5, paragraph 2, of Legislative Decree 38 of February 28, 2005, these financial statements have been prepared in euro, the functional currency.

Financial statement formats

The Company has applied the provisions of Consob Resolution 15519 of July 27, 2006 for the formats of the financial statements and Consob Communication 6064293 of July 28, 2006 for corporate disclosure.

The consolidated financial statements consist of the balance sheet, the income statement, the statement of recognized income and expense, the statement of cash flows and the notes, together with the report on operations by the directors on the operating performance.

The format adopted for the balance sheet classifies assets and liabilities between current and non-current.

The income statement applies the classification of costs by nature.

The format for the changes in equity is entitled “Statement of recognized income and expense” and includes the result for the year and, by homogeneous categories, the income and expenses which, under IFRS, are recognized directly in equity. The amounts of transactions with equity holders and movements during the year in the earnings reserves are presented in the notes.

In the statement of cash flows, cash flows from operating activities are presented using the indirect method where the income or loss for the year is adjusted by the effect of non-monetary transactions, by any deferral or accrual of previous or future operating collections or payments and by revenues or costs connected with cash flows from investing or financing activities.

Compared to the published consolidated financial statements at December 31, 2006, the following captions have been redenominated in the income statement:

  • “Valuation of financial assets” has been changed to “Gains (losses) from changes in fair value of financial assets”; this caption now solely includes the change in fair value of financial assets at fair value through profit or loss; therefore, impairment losses on available-for-sale financial assets have been reclassified for the comparative period from “Valuation of financial assets” (now “Gains (losses) from changes in fair value of financial assets”) to “Financial expenses” for an amount of Euros 13,378 thousand; the gains on disposal of securities held for trading and financial income on derivatives have been reclassified for the comparative period from “Financial income” to “Valuation of financial assets” (now “Gains (losses) from changes in fair value of financial assets”) for amounts equal, respectively, to Euros 7,989 thousand and Euros 13,000 thousand; losses on disposal of securities held for trading and financial expenses on derivatives have been reclassified for the comparative period from “Financial expenses” to “Valuation of financial assets” (now “Gains (losses) from changes in fair value of financial assets”) for amounts equal, respectively, to Euros 1,018 thousand and Euros 34,911 thousand.

In the balance sheet the following caption has been redenominated:

  • “Available-for-sale financial assets” has been redenominated to “Other financial assets”: the caption now includes both available-for-sale financial assets (whose changes in fair value are recognized in equity) and financial assets which at the date of initial recognition are designated at fair value through profit or loss. Securities held for trading, whose changes in fair value are also recognized through profit or loss, continue to be presented in a separate caption of the balance sheet.

Scope of consolidation

The scope of consolidation includes the subsidiaries, the associates and the investments in joint ventures.

Subsidiaries are considered all those companies and entities in which the Group has the power to determine the financial and operating policies. This circumstance is generally considered to occur when more than half of the voting rights are held.

Joint ventures are considered those companies in which, under a contractual agreement or in accordance with the bylaws, two or more parties undertake an economic activity subject to joint control.

Associates are considered all those companies in which the Group exercises a significant influence. This influence is presumed to exist when the Group holds a percentage of voting rights of between 20 and 50 percent.

The main changes in the scope of consolidation during 2007 refer the acquisitions of the DGAG group and Ingest Facility S.p.A., as described in Note 9 – Intangible assets.

Consolidation

For consolidation purposes, the financial statements used are those of the companies included in the scope of consolidation, prepared at the reporting date and adjusted, where necessary, to conform to IAS/IFRS as applied by the Group.

The financial statements expressed in foreign currencies have been translated into Euros at rates prevailing at the year-end for the balance sheet and at the average exchange rates for the income statement.

The differences arising from the translation of opening equity at year-end exchange rates have been recorded in the reserve for translation differences, together with the difference between the result for the year translated at year-end rate compared to the average rate. The reserve for translation differences is recognized in the income statement when the company that generated the reserve is either sold or put into a wind-up.

The consolidation principles can be summarized as follows:

  • Subsidiaries are consolidated on a line-by-line basis according to which:
  • the assets, liabilities, revenues and costs of the financial statements of the subsidiaries are assumed in full, regardless of the percentage of ownership;
  • the accounting amount of the investments is eliminated against the underlying share of equity;
  • the balance sheet and income statement transactions between companies consolidated line-by-line, including dividends distributed within the Group, are eliminated;
  • the equity and income (loss) attributable to the minority interest is presented separately in equity and in the income statement;
  • investments in associates and joint ventures are accounted for by the equity method and the carrying amount of the investments is adjusted by:
  • the share of the post-acquisition results of the associate or joint venture;
  • the adjustments from movements in equity that were not recognized in the income statement, in accordance with benchmark principles;
  • dividends paid by the associate;
  • unrealized gains on transactions for sales made by subsidiaries to joint ventures or associates are eliminated to the extent of the Group’s interest in the joint ventures and associates;
  • gains arising on transactions for sales of properties made by one joint venture to other joint ventures or associates are recognized to the extent of the lower of the Group’s interest in the buyer company compared to that of the seller company, that is, only to the extent of the gain realized with third parties;
  • gains arising on sales transactions of properties from associates to other associates are recognized to the extent of the gain realized with third parties;
  • at the time of acquisition of the subsidiaries, associates or joint ventures, the price paid is allocated according to the purchase method by:
  • determining the cost of acquisition in accordance with IFRS 3;
  • determining the fair value of the assets and liabilities acquired (both actual and contingent);
  • by allocating the price paid to the fair value of the assets acquired and liabilities assumed;
  • by recognizing any residual amount in goodwill, consisting of the excess of the cost of acquisition over the net fair value of the Group’s share of the identifiable/assumed net assets and liabilities;
  • by immediately recognizing the negative goodwill, if any, directly in the income statement if the fair value of the net assets acquired exceeds the cost of acquisition.

3. Summary of significant accounting policies

Intangible assets

Intangible assets with a definite useful life are measured at cost less accumulated amortization and accumulated impairment losses.

Amortization starts when the asset is available for use.

Goodwill

Goodwill represents the excess of the cost of acquisition over the fair value of the Group’s interest in the identifiable assets and liabilities acquired as of the date of acquisition.

Goodwill is tested annually in order to identify any impairments.

Goodwill is allocated to cash-generating units test purposes for impairment.

Trademarks and licenses

Trademarks and licenses are stated at cost less accumulated amortization and accumulated impairment losses. Cost is amortized over the contract period or the useful lives of the assets, whichever is sooner.

Software

Software license costs, including direct incidental costs, are capitalized and recorded in the balance sheet less accumulated amortization and accumulated impairment losses. Software is amortized over its useful life on a straight-line basis.

Research and development

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

There are no development costs which meet the conditions for capitalization under IAS 38.

Useful lives

The useful lives of intangible assets are the following:

Trademarks and licenses

5 years

Software

not more than 3 years.

Property, plant and equipment

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

Property, plant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses, except for land, which is not depreciated and is stated at cost less accumulated impairment losses.

Depreciation is accounted for starting from the month in which the asset is available for use, or is potentially able to provide the economic benefits associated with it.

Depreciation is charged monthly using the straight-line method at rates designed to write-off the assets to the end of their residual useful lives or, for disposals, until the last month of use.

Depreciation rates are as follows:

Buildings

3% - 10%

Plant

7% - 10%

Machinery

5% - 10%

Equipment

10% - 33%

Furniture

10% - 33%

Motor vehicles

10% - 25%

Government grants relating to property, plant and equipment are recorded as deferred income and credited to the income statement over the period of depreciation of the relative assets.

Borrowing costs incurred for the purchase of an asset are expensed unless they are directly attributable to the purchase, construction or production of a qualifying asset, in which case they are capitalized.

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 contract, whichever is sooner.

Spare parts of a significant amount are capitalized and depreciated over the estimated useful life of the assets to which they refer.

Dismantling costs, if any, are estimated and added to the cost of property, plant and equipment with a corresponding entry to a provision account for other liabilities and charges. They are then depreciated over the remaining useful life of the assets to which they refer.

Leased assets

Asset held under finance leases, in which substantially all the risks and rewards of ownership are transefered to the Group, are recognized as assets at their fair value or, if lower, at the present value of the minimum lease payments, including any sum payable to exercise the purchase option. The corresponding liability due to the lessor is recognized in a financial
liabilities.

The lease cost is divided into its two components: the interest expense, recognized in the income statement, and the principal payment, recognized as a deduction of the financial payable.

Leased assets are depreciated at the shorter of them of the lease contract and the estimated useful life of the asset.

Arrangements which do not take the legal form of a lease but which fulfillment of the arrangement depends upon a specific asset and which convey rights to use the asset in return for a payment or a series of payments is accounted for the same way as a finance lease, as provided in IFRIC 4.

Investment propertY

Investment property is defined as property held to earn rent or for capital appreciation or both.

Investment property is initially recognized at cost, including transaction costs, and subsequently remeasured at fair value. The changes in the fair values of investment property are recorded in the income statement.

The fair value of an investment property reflects the market value at the balance sheet date and represents the amount at which the investment property could be exchanged between knowledgeable and willing parties in an arm’s length transaction and after the outcome of adequate sales negotiations based on the principle of reciprocal independence.

Each single property is measured and takes into consideration the future rental income and, where significant, the relative costs, discounted by applying a discount rate that reflects the risks specific to the cash flows generated by the asset.

The income or expense representing changes in the fair value of the investment property is recorded in the income statement in the year in which the change occurs.

The gain or loss on the disposal of investment property is calculated as the difference between the net proceeds from disposal and the carrying amount of the asset, and is recorded in the income statement in the year of sale.

When there is a change in use of an investment property from inventories to investment property to be recognized at fair value, the difference between the fair value at the balance sheet date and the previous carrying amount is recorded in the income statement.

When there is a change in use from investment property recognized at fair value to owner-occupied property, the fair value at the date of the change of use is considered the cost of the property under its new classification.

Impairment of assets

Property, plant and equipment and intangible assets

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

The test consists of an estimate of the recoverable amount of the asset and a comparison with its net 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 value in use is the present value of expected future cash flows originating from the use of the asset and those deriving from its disposal at the end of its useful life.

If the recoverable amount is lower than the asset’s carrying amount, the carrying amount is reduced to the recoverable amount. This reduction constitutes an impairment loss which is recognized in the income statement.

To test for impairment, assets are allocated to the lowest level at which independent cash flows are separately identifiable (cash-generating unit). Specifically, goodwill must be allocated to the cash-generating unit or group of cash-generating units which must never be at a higher level than the business segment.

When there are indications that an impairment loss recognized in prior 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 and 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 recorded (net of writedowns and depreciation and amortization) had no impairment loss been recognized in prior years.

The reversal of an impairment loss, other than on goodwill, is recognized in the income statement.

An impairment loss recognized on goodwill cannot be reversed in subsequent years.

Investments in associates and joint ventures

In order to test for impairment, the value of investments in associates and joint ventures accounted for by the equity method must be compared with the recoverable amount. The recoverable amount corresponds to the higher of the fair value, less costs to sell, and the value in use. It is not necessary to estimate both amounts since it is sufficient to verify that one of the two amounts is higher than the carrying amount in order to establish the absence of an impairment.

In keeping with recent interpretations, for 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 regardless of the percentage of ownership.

In order to determine the value in use of an associate or joint venture accounted for by the equity method, the following estimates should be made:

  1. the share of the present value of estimated future cash flows that will be generated by the associate or joint venture, including cash flows generated by the operating activities of the associate or joint venture and the consideration that will be received on the final disposal of the investment (known as the Discounted Cash Flow – asset side criterion);
  2. the present value of estimated future cash flows that will be generated by dividends to be received and the final disposal of the investment (known as the Dividend Discount model – equity side criterion).

When there are indications that an impairment loss recognized in prior years and relating to investments in associates and joint ventures no longer exists 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 to the revised estimate of the recoverable amount.

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

The reversal of an impairment loss on investments in associates and joint ventures is recognized in the income statement.

Available-for-sale financial assets

Available-for-sale financial assets include investments in other companies and other securities not held for trading. They are included in non-current assets in “Other financial assets”, since there is no intention to dispose of them within 12 months of the balance sheet date.

They are measured at fair value. The gains and losses from changes in fair value are recognized in a specific equity reserve.

In the case of impairment, the gains and losses recognized up to that time in equity are reversed to the income statement. A prolonged or significant reduction in the fair value of the securities compared to cost is considered an impairment indicator.

In the event of disposal, the gains and losses recognized up to that time in equity are reversed to the income statement.

Any impairment losses recognized on available-for-sale financial assets in the income statement cannot be reversed through the income statement.

Purchases and sales of available-for sale financial assets are recognized on the settlement date.

Inventories

Inventories are stated at the lower of cost, using the FIFO method, and estimated realizable value.

Cost is increased by incremental expenses and borrowing costs that can be capitalized, similarly to what was 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 that, as a preliminary step, designs the plans and the technical characteristics.

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

When the outcome of a construction contract can be estimated reliably, the contracts are measured using the percentage of completion method. The stage of completion is measured by reference to the costs incurred up to the balance sheet date as a percentage of total estimated costs for each contract.

Costs incurred during the year in connection with future activity on a contract are excluded from contract costs in determining the stage of completion and recorded as inventories.

When it is probable that total contract costs will exceed total contract revenues, the expected loss is recognized as an expense immediately.

The gross amount due from customers for contract work for all the contracts in progress and for which the costs incurred plus recognized profit (or less recognized losses) exceed progress billings is included in trade receivables.

The gross amount due to customers for contract work for all contracts in progress for which progress billings exceed costs incurred plus recognized profit (or less recognized losses) is included in trade payables.

Receivables

Receivables are initially recorded at their fair value, generally represented by the agreed consideration or rather the present value of the amount that will be collected.

They are subsequently measured at amortized cost, less provision for impairment.

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

In the event of an impairment loss, the carrying amount of the receivables is reduced indirectly by recognition in a provision account. When the conditions that gave rise to the impairment of the receivables no longer exist, the impairment losses recorded in previous periods are reversed by a credit to the income statement up to the amortized cost that would have been recorded had no impairment loss been recognized.

Receivables in currencies other than the functional currency of the individual companies are adjusted to the year-end exchange rates with a corresponding entry to the income statement.

Receivables are derecognized when the right to receive cash flows is extinguished, when the Group has transferred substantially all the risks and rewards connected with holding the receivable or in the case the receivable is considered definitively irrecoverable after all the necessary recovery procedures have been completed. When the receivable is derecognized, the relative provision is also derecognized if the receivable had previously been written down.

Junior notes and non-performing loans

Junior notes generated by transactions for the securitization of non-performing loans (NPL found in the Real Estate Sector) as well as non-performing deep discount receivables (non-performing receivables purchased at prices significantly below the carrying amounts) are classified in loans and receivables and initially recorded at fair value, generally represented by the price paid.

They are subsequently measured at amortized cost. Amortized cost is calculated using the effective interest rate method, which is equivalent to the discount rate which, applied to future cash flows, resulting from the first business plan prepared subsequent to purchase, renders the present value of such flows equal to the cost of purchase including any transaction costs.

The carrying amount is adjusted, whenever there is a change in the estimate of expected cash flows, to the amount resulting from discounting future cash flows at the original effective interest rate.

Any differences, whether positive or negative, are recognized in the income statement.

Shareholder loans

Financial receivables representative of loans to associates and joint ventures are initially recorded at their fair value, corresponding to the present value of future cash flows.

Loans by shareholders made at non-market conditions are discounted over the term of the loan at a rate representative of a loan having the same characteristics.

Any difference between the nominal amount of the loan and the fair value remeasured as previously described is recognized, by the lender, as an increase in the carrying amount of the investment, net of any tax effects. The beneficiary of the loan, in its financial statements prepared in accordance with Group principles and used for valuation of the investment with the equity method, recognizes the same difference as a reduction of its borrowings and as a increase, net of the tax effect, of equity.

After initial recognition, the shareholder loans are measured at amortized cost.

Payables

Payables are initially recorded at their fair value, generally represented by the agreed consideration or rather the present value of the amount that will be paid.

They are subsequently measured at amortized cost.

Amortized cost is calculated using the effective interest rate method, which is equivalent to the discount rate which, 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 corresponding entry to the income statement.

Payables are derecognized when the specific contractual obligation is extinguished.

Financial assets at fair value through profit and loss

This category of financial assets includes securities principally purchased for resale in the short term and classified in current assets in “securities held for trading” and financial assets which at the time of initial recognition are designated at fair value through profit or loss and classified in “other financial assets”.

They are measured at fair value with a corresponding entry to the income statement. Transaction costs are expensed to the income statement.

Purchases and sales of such financial assets are recognized on the settlement date.

Cash and cash equivalents

Cash and cash equivalents include bank and postal deposits and cash and valuables on hand. They are recorded at amortized cost which generally corresponds to nominal value.

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 fulfillment of which an outflow of resources will probably be necessary, the amount of which can be estimated in a reliable manner.

Employee benefits

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

With regard to defined benefit plans, the Pirelli & C. Group elected the option allowed by IAS 19 under which actuarial gains and losses are recognized in equity in full in the year in which they arise.

For other long-term benefits, the actuarial gains and losses are recognized immediately in the income statement.

The cost for interest and the expected return on plan assets are classified in personnel costs.

Stock options

Stock options are divided into two types which require different accounting treatments according to the features of the plan:

  • equity-settled: are plans in which the grantee has the right to purchase shares of the company at a fixed price whenever specific conditions are met. In such cases, the fair value of the option, determined at the grant date, is recognized as an expense over the period of the plan with a corresponding entry to increase the reserves in equity;
  • cash-settled: are plans which provide for put options on behalf of the recipient, combined with call options on behalf of the issuer, or plans in which the recipient directly receives the monetary equivalent amount of the benefit originating from the exercise of the stock option. The fair value of the liability, re-measured at the end of every reporting period, is recognized in the income statement over the vesting period. The changes in the fair value of the liability subsequent to the vesting period are recognized in the income statement.

Financial instruments

Derivatives are recognized initially at fair value with a corresponding entry in the income statement and subsequent re-measurement is always at fair value. Fair value gains or losses are recognized in the income statement except for derivatives designated as cash flow hedges.

In all cases in which derivatives are designated as hedging instruments under IAS 39, at the inception of the transaction, the Group formally documents the relationship between the hedging instrument and the hedged item, its risk management objectives and the strategy followed in effecting the hedge transaction.

The Group also assesses the effectiveness of the hedging instrument in offsetting the variations in the cash flows attributable to the hedged risk. Such assessment is performed at hedge inception and on an ongoing basis for the duration of the hedge.

The effective portion of the change in the fair value of the derivative that was designated and qualifies as a hedging instrument is recognized directly in equity; the gain or loss relating to the ineffective portion is recognized in the income statement.

The amounts recognized directly in equity are reversed to the income statement at the same time the hedged item produces an effect in the income statement.

When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the hedged item ultimately produces an effect in the income statement. When the hedged item is no longer expected to produce an effect in the income statement, the cumulative gain or loss that was reported in equity is immediately recognized in the income statement.

Fair value estimation

The fair value of financial instruments traded in active markets is based on listed market prices at the balance sheet date. The listed market price used for financial assets is the current bid price; the appropriate listed market price for financial liabilities is the current ask price. The fair value of financial instruments that are not traded on an active market is determined by using valuation techniques with a variety of methods and assumptions that are based on market conditions existing at each balance sheet date.

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

The fair value of forward exchange contracts is determined using the forward rate at the balance sheet date.

Income taxes

Current income taxes are determined on the basis of a realistic estimate of the tax expense payable under the current tax laws of the country.

Deferred taxes are calculated on temporary differences arising between the asset and liability amounts in the balance sheet and their tax bases (full liability method) and are classified in non-current assets and liabilities.

Deferred tax assets are only recognized when there is a probability of future recovery.

Equity

Treasury shares

Treasury shares are classified as a deduction from equity.

In the event of sale, re-issue or cancellation, the gains and losses as a result thereof are classified in equity.

Costs of capital transactions

Costs directly attributable to capital transactions of the parent are recognized as a deduction from equity.

Recognition of revenues

Revenues are measured at the fair value of the consideration received for the sale of the products or the rendering of services.

Sales of products

Revenues from sales of products are recognized when all the following conditions are met:

  • the significant risks and the rewards of ownership of the goods are transferred to the buyer;
  • the effective control over the goods has ceased;
  • the amount of revenues is determined in a reliable manner;
  • it is probable that the economic benefits deriving from the sale will be enjoyed by the enterprise;
  • the costs incurred or to be incurred are determined in a reliable manner.

With specific reference to sales of properties, revenues are generally recognized at the time of transfer of ownership to the buyer which corresponds to the date of the deed of sale. If the nature and degree 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 revenues is deferred until such time as the transfer can be considered to have taken place.

Rendering of services

Revenues from rendering of services are recognized by reference to their completion at the balance sheet date.

Interest income

Interest income is recognized on a time-proportion basis which considers the effective return of the asset or liability.

Royalty income

Royalty income is recognized on an accrual basis in accordance with the substance of the relevant agreement.

Dividend income

Dividend income is recognized when the right to receive payment is established, which normally corresponds to the resolution passed by the shareholders’ meeting for the distribution of dividends.

Segment information

The business segment (primary reporting segment) is a distinctly identifiable part of the Group which supplies a single product or service or an aggregate of related products and services and is subject to risks and rewards different from those of the other business segments of the Group.

The geographical segment (secondary reporting segment) is a distinctly identifiable part of the Group which supplies a single product or service or an aggregate of related products and services and is subject to risks and rewards different from those relating to components which operate in other economic environments.

Accounting principles for hyperinflationary countries

The companies of the Group operating in high-inflation countries redetermine the amounts in their original respective financial statements to eliminate distorting effects due to the loss of the purchasing power of the currency. The inflation rate used for purposes of the adoption of inflation accounting corresponds to the consumer price index.

The companies operating in countries in which the cumulative inflation rate over a three-year period approximates or exceeds 100 percent adopt inflation accounting and discontinue it in the event the cumulative inflation rate over a three-year period falls below 100 percent.

Gains and losses on monetary positions are recognized in the income statement.

Classification of property portfolio: inventories (IAS 2) – Investment property (IAS 40)

In accordance with the business model prevalent within the Group, the majority of property assets are classified in inventories insofar as they are held for the purpose of trading and are in any case intended for sale during the course of the normal operating cycle of the companies included in the scope of consolidation.