Accounting policies

3. Accounting policies

INTANGIBLE ASSETS

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

Amortization starts when the asset is available for use or is able to function as management intends, and ceases on the date on which the asset is classified as held for sale or is derecognized. The gains or losses from the sale or disposal of an intangible asset are determined as the difference between the net proceeds from the sale and the carrying amount of the asset.

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.

Any negative difference (negative goodwill) is recognized in the income statement at the date of acquisition. In the absence of a standard or a specific interpretation on the subject, in the event of the acquisition of minority interests in companies already controlled, the difference between the acquisition cost and the carrying amount of assets and liabilities acquired is recognized as goodwill, according to the “Parent entity extension method”. Any negative difference is recognized in the income statement.

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.

Upon the disposal of a part or the whole of a previously acquired company to which goodwill has been allocated, the corresponding residual amount of goodwill is taken into account in the determination of the gain or loss on sale.

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 developments costs which meet the conditions for capitalization under IAS 38.

The useful lives of intangible assets are the following:

Trademarks and licenses

5 years

Software

from 1 to 3 years

PROPERTY, PLANT AND EQUIPMENT

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

Subsequent expenditures and the cost of replacing some parts of property, plant and equipment are capitalized only if they increase the future economic benefits embodied in the related item of property, plant and equipment. All other expenditures are expensed as incurred. When the cost of replacing some parts is capitalized, the carrying amount of the part replaced is recognized in the income statement.

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% - 20%

Machinery

5% - 20%

Equipment

10% - 33%

Furniture

10% - 33%

Motor vehicles

10% - 25%

Government investment 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. A qualifying asset is one that takes a substantial period of time to get ready for use. The capitalization of borrowing costs ceases when substantially all the work necessary to render the qualifying asset available for use has 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 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.

Assets acquired under finance lease contracts, in which substantially all the risks and rewards of ownership are transferred to the Group, are recorded in property, plant and equipment at their fair value or, if lower, at the present value of the minimum lease payments, with a corresponding entry to the relative financial payable. The lease payment is allocated between interest expense, recorded in the income statement, and the principal repayment, recorded as a reduction of the financial payable.

Leases in which the lessor maintains substantially all the risks and rewards of ownership are classified as operating leases. The costs referring to an operating lease are recognized as an expense in the income statement over the lease term on a straight-line basis.

Property, plant and equipment are eliminated from the balance sheet at the time of disposal or upon retirement of the asset from use and, consequently, future benefits are not expected from their sale or use.

Gains or losses from the sale or disposal of property, plant and equipment are determined as the difference between the recoverable amount and the carrying amount of the asset.

INVESTMENT PROPERTY (HELD BY COMPANIES IN THE REAL ESTATE SECTOR ACCOUNTED FOR BY THE EQUITY METHOD)

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 re-measured at fair value. The changes in the fair value 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, 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 to owner-occupied property, the fair value at the date of the change in 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, and at least annually for intangible assets with an indefinite life, including goodwill, the property, plant and equipment and intangible assets should be 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 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 excluding income taxes, and applying a discount rate which should be the pre-tax rate which reflects the current market assessment of the time value of money and the risks specific to the asset.

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.

An impairment loss recognized in the half-year financial statements on goodwill cannot be reversed in the following annual period.

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, irrespective 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 alternatively:

a) 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, taking into account also the higher implicit values relating to the real estate portfolios held (known as the Discounted Cash Flow – asset side criterion);

b) 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 “Other financial assets”.

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

In case of impairment, the losses recognized up to that time in equity are reversed to the income statement. A prolonged (more than 12 months) or significant (more than one-third) reduction in the fair value of equity securities compared to cost is considered as an indicator that the securities are impaired. In any case, before recognizing an impairment loss in the income statement, the investment should be measured specifically.

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.

Impairment losses recognized in the half-year financial statements on equity securities classified as available-for-sale cannot be reversed to the income statement in the following annual period.

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

Other financial assets, whether debt or equity securities, 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.

INVENTORIES

Tyre Sector

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

Inventories include direct costs of materials and labor and indirect overheads. Provisions are calculated for obsolete and slow moving inventories and take into account their expected future use and estimated realizable value. Net realizable 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 capitalization, similarly to what is described for property, plant and equipment.

Real Estate Sector

Inventories consist of land to be developed, properties for renovation, properties under construction/renovation, completed properties for sale, trading properties and consumables.

Land to be developed is recognized at the lower of cost and estimated realizable value, net of direct selling costs. Cost includes incremental expenses and borrowing costs qualifying for capitalization, similarly to what is described for property, plant and equipment.

Properties under construction and/or renovation are valued at the lower of cost, including incremental expenses and borrowing costs qualifying for capitalization, and estimated realizable value, net of direct selling costs.

Trading properties are recognized at the lower of cost and estimated realizable value, which is normally taken as market value, inferred from sales of comparable properties in terms of location and type.

Cost is increased by any incremental expenses incurred up to the time of sale.

Classification of real estate portfolio: Inventories (IAS 2) – Investment Property (IAS 40)

In accordance with the business model prevalent within the Real Estate sector, 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.

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, 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 contract can be estimated reliably, the contract is 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 the total estimated costs for each contract.

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

When it is probable that total contract costs will exceed total contract revenues, the expected loss is immediately recognized 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 recognized profit (or less recognized loss) exceed progress billings is recognized as a receivable in the line item “trade receivables”.

The gross amount due to customers for contract work for all the contracts in progress for which the progress billings exceed the costs incurred plus recognized profit (or less recognized loss) is recognized as a payable in the line item “trade payables”.

RECEIVABLES

Receivables are initially recorded at their fair value, generally represented by the agreed consideration or 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 of 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 substantially all the risks and rewards connected with holding the receivable have been transferred 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 (found in the Real Estate sector) as well as non-performing receivables (deep discount receivables purchased at prices significantly below the carrying amounts) are classified as 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.

Shareholders’ loans to associates and joint ventures

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 similar characteristics.

Any difference between the nominal amount of the loan and the fair value re-measured 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 by the equity method, recognizes the same difference as a reduction of its financial payables and as an increase, net of the tax effect, of equity.

After initial recognition, shareholders’ loans are measured at amortized cost.

PAYABLES

Payables are initially recorded at their fair value, generally represented by the agreed consideration or 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 OR LOSS

This category of financial assets includes securities purchased principally for resale in the short term and classified in current assets in “securities held for trading”. They also comprise 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 settlement date.

CASH AND CASH EQUIVALENTS

Cash and cash equivalents include bank and postal deposits and cash and valuables 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 fulfillment of which an outflow of resources will probably be necessary, the amount of which can be estimated in a reliable manner.

Changes in estimates are recognized in the income statement in the period in which the change occurs.

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

EMPLOYEE BENEFIT OBLIGATIONS

Employee benefit obligations 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, actuarial gains and losses are recognized immediately in the income statement.

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

The costs relating to defined contribution plans are recognized in the income statement when incurred.

Up to December 31, 2006, the provision for the employees’ leaving indemnity of the Italian companies (TFR) was considered a defined benefit plan. The rules regarding this provision were changed by Law 297 dated December 27, 2006 (Italian Budget Law 2007) and subsequent Decrees and Regulations issued in the early months of 2007. In light of these changes, particularly with 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 at the balance sheet date), whereas subsequent to that date, it is considered a defined contribution plan.

Stock option

The Group offers additional benefits to some of its senior executives and employees in the form of equity compensation plans (stock option plans).

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 increasing 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 option, re-measured at the end of every reporting period, is recognized in the income statement over the vesting period of the plan, with a corresponding entry to a liability in the balance sheet. The changes in the fair value of the liability subsequent to the vesting period are recognized in the income statement.

The Group has applied the transitional provisions of IFRS 2 and has therefore applied the standard to all stock option plans granted after November 7, 2002 and not yet vested at the date IFRS 2 came into force (January 1, 2005).

Detailed disclosure is also provided on the plans granted prior to that date.

DERIVATIVE 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.

Beginning in 2008, for purposes of the application of cash flow hedges, in the companies accounted for by the equity method, the Real Estate sector has implemented dynamic type hedging relationships between the derivatives portfolio and existing loans. This approach makes it possible to review and redefine, on a quarterly basis, the hedging strategy in relation to loan reimbursement forecasts in strict correlation with the business plan of the various initiatives.

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.

Purchases and sales of derivatives are recorded at settlement date.

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 on tax loss carryforwards, as well as on temporary differences, are only recognized when there is a probability of future recovery.

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

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 to equity in the period or in previous periods.

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 equity transactions

Costs directly attributable to equity 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 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 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 the following conditions are met:

  • the amount of the revenues can be determined reliably;
  • it is probable that the company will enjoy economic benefits from the transaction;
  • the stage of completion of the transaction at the balance sheet date can be measured reliably;
  • the costs incurred for the transaction and the costs to be incurred to complete the transaction can be determined in a reliable manner.

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.

Earnings per share

Basic earnings per share is calculated by dividing the income attributable to the equity holders of the company by the weighted average number of outstanding ordinary shares during the year. To calculate diluted earnings per share, the weighted average number of outstanding shares is adjusted by assuming the conversion of all shares with a potentially dilutive effect.

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.