ThE GERMAN ACT To MoDERNIzE ACCoUNTING LAW (BILMoG)

(for example, pursuant to IAS/IFRS all parts of an airplane – fuselage, nozzles, interior – must be individually written-off). The determining factor here is that key parts, with varying useful life, of a single asset are written-off differently (cf.

IAS 16.43). In contrast, pursuant to the German Commercial Code (hGB) the plane would be written-off as one (§ 253 (3) hGB, in connection with § 255 (1) hGB). A (small) German company that does not have to create their accounts pursuant to IAS/IFRS but chooses to do so, will in all likelihood portray their annual financial statement in a better light than it actually is. The reason for this is the improved leeway of scope for portraying the accounts if accounting pursuant to IAS/IFRS.

As such, one can conclude that for recognizing the actual commercial viabil- ity of a company, the ability of the person analyzing the annual financial statement is the deciding factor. Specific positions of the annual financial statement pursuant to IAS/IFRS must be, as a minimum requirement, present in the statement of the financial position within the accounts (cf. IAS 1.54). The extension of these mini- mum requirements – i.e. the segmentation of these items – can occur either in the balance sheet or the notes (cf. IAS 1.54). A qualified reader of balance sheets will take a close look at the structure of these items – especially of their segmentation – within the annual financial statement.

In relation to the possibility of discovering balance sheet manipulations one should note that with increasing complexity of the annual financial statement also the difficulty increases to discover manipulated items. Especially small and me- dium-sized companies have the possibility to hide inaccuracies when accounting pursuant to IAS/IFRS, as its addressees are mainly small credit institutions and taxation authorities. Their employees normally do not have the competencies re- quired to uncover cunningly hidden balance sheet violations.

2008. on 26 March 2009 the German Act to Modernize Accounting Law was ap- proved by the German Federal Parliament (Bundestag) and came into effect on 29 May 2009. The primary goal of the German Act to Modernize Accounting Law – according to the Federal Ministry of Justice – was to advance the German accounting principles so as to become a lasting and fully-fledged alternative to the international accounting standards (IFRS). It should be a simpler and more cost-effective alternative that would provide especially small and medium-sized companies with the option of using modern accounting principles without hav- ing to apply the IFRS. During this process, the German Commercial Code (hGB) was “cleansed” from outdated decision rights and the reverse authoritativeness principle of the tax law upon the commercial code was abolished. In addition, the German Act to Modernize Accounting Law wanted to implement a deregulation in order to free companies from unnecessary costs. Also in future the trade bal- ance will play an important role for the assessment of distributions and for the determination of taxable income (cf. BDI, 2009, p. 6). The remainder of this chapter, based on the focus on accounting fraud, will initially refer to the changes which have no potential impact on stopping account manipulations or which even nur- ture accounting manipulations. Following this, there will be a short description of further statutory updates through the German Act to Modernize Accounting Law.

The modernization of the German Commercial Law led to measures of cost relief. The German Act to Modernize Accounting Law supports the reduction of bureaucratic costs by freeing sole traders from the duty of bookkeeping and ac- counting obligations according to the commercial law. In § 241a of the German Commercial Code (hGB) it states in relation to the release from the duty of book- keeping and for preparing the inventory that: “Sole traders who at the time of the financial reporting dates of two consecutive business years, have not more than 500,000 euros turnover and 50,000 euros annual surplus do not need to apply § 238 to 241 of the German Commercial Code (hGB) ⁶⁶. In the case of start-ups the legal requirements already apply when the values do not exceed the values of the block 1 at the time of the start-ups first financial reports”⁶⁷ (translated in context 66 This relates to the release from the duty to do bookkeeping and for preparing the inventory.

67 „Einzelkaufleute, die an den Abschlussstichtagen von zwei aufeinander folgen- den Geschäftsjahren nicht mehr als 500.000 Euro Umsatzerlöse und 50.000 Euro

by the author). Pursuant to § 242 (4) of the German Commercial Code (hGB) the parties affected do not require a financial statement – consisting of a balance sheet and the profit and loss account – to be prepared in accordance with the German Commercial Code (cf. BDI, 2009, p. 7).

Bittmann’s view on the de-coupling of the bookkeeping and accounting re- quirements from the (full) merchant status (§ 241a hGB) is of “deep systematic concern”⁶⁸ (literally translated by the author). The explosiveness of the fact that retail traders are freed from the need to bookkeep or prepare inventory if their turnover is below 500,000 euros and their profit below 50,000 euros is self-explan- atory. he raises serious questions in relation to the possibility of manipulating the accounts. This is, on the one side, the question how are threshold values de- termined especially relating to when they are exceeded. Bittmann fears that such regulations will entice entrepreneurs to manipulate their profit assessment to be below the threshold, especially since there is no documentation requirement for the rationale provided. Another question raised by Bittmann is then how le- gitimate the Accounting and Balance Sheet Criminal Law remains. § 331 of the German Commercial Code (hGB) as well as § 283 b (3) and 283 (1), number 5 and 7 of the German Criminal Code base their penal code mainly on the identity of the qualification of a merchant on the one hand and the bookkeeping and accounting obligation on the other hand (cf. Bittmann, 2008, p. 444 f). one must agree with Bittmann when he states that a merchant who does not have the appropriate level of information can hardly manage a business effectively. If a merchant does not do exact bookkeeping, then he cannot know what the current financial status of the company is. he cannot, for example, based on missing calculations assess if he can accept a specific contract at the offered price. he is not in the position to define his assets and his liabilities and as such cannot assess his capital resources.

In addition, he can neither calculate his customer nor creditor repayment periods and does not know how often the goods in his warehouse are handled. Without an appropriate level of bookkeeping, it is not possible to lead a solid operation.

Jahresüberschuss aufweisen, brauchen die §§ 238 bis 241 hGB nicht anzuwenden.

Im Fall der Neugründung treten die Rechtsfolgen schon ein, wenn die Werte des Satzes 1 am ersten Abschlussstichtag nach der Neugründung nicht überschritten werden.“

68 „stärksten systematischen Bedenken“

Annual financial statement: A fundamental part of the German Act to Modernize Accounting Law is the modernization of the recognition and measure- ment provision for all merchants. In addition, there are supplementary require- ments for corporate enterprises which encompass not only a convergence towards international financial reporting standards but also the adoption of European re- quirements (cf. BDI, 2009, p. 8).

For self-created intangible assets § 248 (2) the German Commercial Code (hGB) foresees a restricted option to capitalize these. Should one make use of the option to capitalize then one must, pursuant to § 285 number 22 of the German Commercial Code (hGB), declare in the notes the full year amount of research and development costs as well as the value of the self-created intangible assets. For trademarks, print titles, publishing rights, customer lists or comparable intangible assets which have not been purchased, there is a capitalization prohibition pursu- ant to § 248 (2), sentence 2 of the German Commercial Code (hGB). The reason for this capitalization prohibition is that the production costs for the previously men- tioned intangible assets cannot be clearly isolated from the expenditures for the development of the company as a whole – this refers to the self-created business and company value (cf. BDI, 2009, p. 12).

Bittmann views this restrictive capitalization prohibition of trademarks, print titles, publishing rights, customer lists or comparable intangible assets as a big issue for the person applying the law. The legislator does not provide more de- tail what such or comparable items are. What, for example, is the view on patents, know-how or ideas? Should these items be categorized as exceptions then what could still be classified as a capitalized internally generated intangible asset? At least the rationale for the law provides some interpretation support. According to this, those self-created intangible assets can be capitalized where a cost of produc- tion can reliably be determined (cf. Bittmann, 2008, p. 443).

Pursuant to § 255 (2a) of the German Commercial Code (hGB) “production costs of intangible assets are costs created during its development”⁶⁹ (translated in context by the author). Development costs are not allowed to be included in the production costs pursuant to § 255 (2), sentence 4 of the German Commercial Code 69 „herstellungskosten eines selbst geschaffenen immateriellen vermögensgegenstandes des Anlagevermögens die bei dessen Entwicklung an- fallenden Aufwendungen“

(hGB). only such expenditures are allowed to be capitalized that occur during the development phase. For this purpose, one can find a legal definition in § 255 (2a), sentence 2 and 3 of the German Commercial Code (hGB) of what research and development is. It is stated that; “a development is the application of research results or of new knowledge used for further development of goods or processes or the advancement of goods or processes by making significant changes. Research is the independent and planned search for new scientific or technical insights or experiences of a general nature and to which no statement can be made as to their technical applicability or economic chances for success.”⁷⁰ (translated in context by the author). It is not possible to reliably separate research and development and as a result one is not allowed to capitalize development costs pursuant to § 255 (2a), sentence 4 of the German Commercial Code (hGB) (cf. BDI, 2009, p. 12 f). Also in re- lation to this Bittmann critically states that for all practical purposes one can often not effectively distinguish between research and development costs. The point in time when the research phase of a project is finished and it goes into the phase of development cannot always be reliably determined. This in turn offers the possi- bility of manipulation by capturing the costs as not to be capitalized research costs or as deductible development costs. According to Bittmann, the changes made to

§ 255 (2a), sentence 4 of the German Commercial Code (hGB), whereby it is not allowed by law to capitalize development costs if they cannot be clearly differenti- ated from the research costs, does not change anything relating to the actual op- portunities to manipulate (cf. Bittmann, 2008, p. 442 f).

For reasons of creditor protection there is a payout block for corporate enter- prises. Pursuant to § 268 (8), sentence 1 of the German Commercial Code (hGB) profits up to the amount capitalized are only allowed to be paid out if the amount of available reserves remaining after the pay-out plus any profits carried forward and minus losses carried forward and minus accruals formed for deferred taxes 70 „Entwicklung ist die Anwendung von Forschungsergebnissen oder von an- derem Wissen für die Neuentwicklung von Gütern oder verfahren oder die Weiterentwicklung von Gütern oder verfahren mittels wesentlicher Änderungen.

Forschung ist die eigenständige und planmäßige Suche nach neuen wissenschaftli- chen oder technischen Erkenntnissen oder Erfahrungen allgemeiner Art, über deren technische verwertbarkeit und wirtschaftliche Erfolgsaussichten grundsät- zlich keine Aussagen gemacht werden können“.

is at least equal to this amount (cf. BDI, 2009, p. 13). As such the amount of payout blocked relating to self-created intangible assets is not based on the full amount of capitalized assets but is formed based upon the difference between the book value of self-created intangible assets and the related deferred tax assets (cf. küting et al., 2011, p. 3). Also according to Bittmann this payout block leads to the situation where the available distributable profits only consist of the surplus minus the capi- talized self-created intangible assets and further blocked assets. The impact on the Criminal Law is not uniform but has to be assessed on a case-by-case basis. This can be seen in the following example: For making an assessment whether being over-indebted pursuant to § 263 of the German Criminal Code or a delay in filing for an insolvency pursuant to § 15a of the Insolvency Statute exists, the self-created intangible assets only recently have to be considered as assets. Depending on the situation, this can definitely lead to a major move in the timing of becoming insol- vent. The time of insolvency will clearly occur at a later point in time. Consequently, there is a contrast between this regulation and the goals of the Insolvency Statute.

This is aimed at initiating insolvency proceeding as early as possible in the interest of improving the chances for recovery (cf. Bittmann, 2008, p. 442).

A completely different effect has been made through the abolition of § 269 of the German Commercial Code. In order to help with the balance sheets this paragraph also allowed the capitalization of expenses relating to start-ups and ex- pansions, whereby these were also with a payout block. But since the German Act to Modernize Accounting Law came into force it is forbidden to capitalize start- up and expansion investments. The delay in the timing of the over-indebtedness is therefore lessened by the fact that this form of capitalization is forbidden (cf.

Bittmann, 2008, p. 442).

The purchased (derivative) goodwill is a short-term useable asset which has to be capitalized pursuant to § 246 (1), sentence 4 of the German Commercial Code (hGB). It has to be amortized over the planned useful life. The erstwhile permitted fixed-rate amortization over four years under § 255 (4) of the German Commercial Code is now obsolete. If a company wants to capitalize a purchased goodwill over a planned period of more than five years, they must provide the rationale in the notes as to why the goodwill should be used for a period of more than five years (cf. BDI, 2009, p. 9). In addition § 253 (5), sentence 2 of the German Commercial Code prescribes that the lower amount stated for a purchased goodwill has to be

upheld. This restrictive directive is based upon the rationale that an occurring re- versal after an asset is written down is related to the business and operating activi- ties of a company and is therefore self-created. And that the self-created goodwill is not to be capitalized today or in the future (cf. Ernst/Seidler, 2007, p. 2558). From a taxation point of view, the purchased goodwill can be activated as an asset, as is current praxis. As a result, it is possible to have a discrepancy between commercial and tax balance sheets resulting from the different rules of write-downs. From a tax perspective, purchased goodwill must be amortized over a standard useful life of fifteen years. If, based on this directive, the situation should occur where the goodwill from a commercial law perspective has a shorter useful life than the term used in the balance sheet for taxation purposes, then one must possibly form deferred tax assets which must be commercially carried forward. In addition, the future commercial capitalization of goodwill can have an effect on the commercial equity ratio (cf. BDI, 2009, p. 9).

The duty to capitalize purchased derivative goodwill is viewed critically by Bittmann. In his opinion there is a scope of assessment when taking over compa- nies that affects the value of the derivative goodwill, which in turn provides the opportunity to manipulate. Similar concern was already raised by Bittmann in regard to the capitalization of intangible assets. It is also questionable that self- created goodwill should not be capitalized. If, for example, three years after takeo- ver one finds an item of goodwill, then it must be clarified to which percentage it is derived and to which percentage it is self-created. This appears to be a difficult issue to solve for the person developing the accounts. At this point, Bittmann raises the question how one should proceed when the overall value of the goodwill does not decrease, but the derivative goodwill must be value-corrected due to continu- ous reduction of its value whereby at the same time the self-created value of the goodwill increases by the same amount. Bittmann gives rise to concern that, given such complex scenarios, it is hardly possible to generally quantify the planned use- ful life (cf. Bittmann, 2008, p. 443).

Another aspect is that the capitalization of the derivative goodwill poten- tially leads to the over-indebtedness occurring at a later point in time and this therefore makes a mockery of the Insolvency Statute (cf. Bittmann, 2008, p. 443).

A company which is in a state of crisis must, when creating the annual finan- cial statements documentations, check if there is a case for over-indebtedness.

According to the definition of insolvency which prevailed until 2008, the assets had to outweigh the debts. If this was not the case, then you were over-indebted pursuant to the Insolvency Statute. From 2008 to the end of 2013 there was an in- terim arrangement whereby, if you had a positive prognosis for the company, you were not over-indebted pursuant to the Insolvency Statute (§ 19 Inso). This regula- tion was then indefinitely extended with the introduction of the Financial Market Stabilization Act and is thereby valid for an unlimited period of time. Should a company, however, become over-indebted without a positive prognosis, the goal of the Insolvency Statute is to bring forward an application of insolvency (cf. Steffen, 2001, p. 7; Nickert, 2012, p. 1; German Federal Ministry of Justice (press report), 2012, Neue Rechtsbehelfsbelehrung und Entfristung des Überschuldungsbegriffs beschlossen).

Pursuant to § 253 (1), sentence 2 of the German Commercial Code (hGB) provisions should be valued according to prudent commercial assessment of the required amount payable. Thus the valuation of provisions must take into account future price and cost relations at the time the obligation is to be settled. By contrast, the § 6 (1), number 3a, letter f of the Income Tax Act explicitly points out that for the purpose of determining taxable net income when assessing provisions, the condi- tions prevailing on the reporting date are essential. For this reason future price and cost increases are not allowed to be considered. In the commercial balance sheet this can lead to a situation where, for the purpose of differentiation, deferred tax assets are established and have to be carried forward in the balance sheet (cf.

BDI, 2009, p. 16).

Provisions must generally be discounted taking into account the individual evaluation principle. This applies for financial liabilities as well as for the obliga- tion to supply goods. § 253 (2), sentence 1 of the German Commercial Code (hGB) states that provisions maturing in more than one year must be discounted using the average market interest rate of the past seven years, according to their remain- ing maturities. By applying a market interest rate, the individual credit risk of the debtor is not considered within the interest rate. An average market interest rate of the past seven years is used in order to absorb elements of randomness in the inter- est rate development. The required discount rates pursuant to § 253 (2), sentences 4 and 5 of the German Commercial Code (hGB) are established by the German federal bank in line with legal regulations and are published on a monthly basis