Interpretative communication concerning certain Articles of the fourth and seventh Council Directives on accounting
OJ C 16, 20.1.1998, p. 5–12 (ES, DA, DE, EL, EN, FR, IT, NL, PT, FI, SV)
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INTERPRETATIVE COMMUNICATION CONCERNING CERTAIN ARTICLES OF THE FOURTH AND SEVENTH COUNCIL DIRECTIVES ON ACCOUNTING (98/C 16/04)
(Text with EEA relevance)
1. The fourth and seventh Council Directives are the main harmonization instruments in the accounting field within the European Union (1).
2. In the present interpretative communication, the Commission comments on topics where authoritative clarification appears to be required. The topics have been chosen taking into account discussions in the Contact Committee on the Accounting Directives as well as discussions at the Accounting Advisory Forum.
The views expressed in this Communication do not necessarily represent the views of the Member States and should not, in themselves, impose any obligation on them. They do not prejudge the interpretation that the Court of Justice, as the final instance responsible for interpreting the Treaty and secondary legislation, might place on the matters at issue.
3. The Contact Committee was set up pursuant to Article 52 of the fourth Directive and it consists of representatives of the Member States and the Commission. An important function of the Contact Committee is to facilitate a harmonized application of the Accounting Directives through regular meetings, dealing in particular with practical problems arising in connection with their application. The adoption in 1995 of a new approach to accounting (2) gave a fresh impetus to this aspect of the Contact Committee's work. In particular, the comparison between international accounting standards (IAS) and the Accounting Directives made for the Contact Committee by its special Task Force (3), and the continuing work on avoiding divergence between IAS and the Directives carried out in the Committee's Technical Sub-committee, has allowed the Contact Committee to resolve a number of long-standing differences on questions relating to the application of the Directives. The Accounting Advisory Forum is a consultative body which the Commission set up in 1990. It is composed of representatives of the accounting standard setting bodies in Member States and of European organizations which represent the main users and preparers of accounts.
On environmental accounting, the Commission intends to issue further guidance through a recommendation.
2. THE FOURTH COUNCIL DIRECTIVE ON THE ANNUAL ACCOUNTS OF CERTAIN TYPES OF COMPANIES (4)
2.1. General provisions
2.1.1. True and fair view (Article 2 (3) to (5))
4. According to Article 2 (3) of the Directive, the annual accounts shall give a true and fair view of the company's assets, liabilities, financial position and profit or loss. In addition, Article 2 (4) requires that additional information must be given where the application of the provisions in the Directive is not sufficient to give a true and fair view. Article 2 (5) requires that a specific provision of the Directive must be departed from where, in exceptional cases, application of that provision would be incompatible with the obligation to give a true and fair view. Any such departure must be disclosed in the notes to the accounts together with an explanation of the reasons for it and a statement of its effect on the assets, liabilities, financial position and profit or loss.
5. The true and fair view principle must be applied by the companies themselves. Only where additional information is not sufficient to give a true and fair view can any provision of the Directive be departed from. Such a situation will only occur in exceptional cases.
6. As stated in the last sentence of Article 2 (5), Member States may define the exceptional cases in question and lay down the relevant special rules. In the interest of harmonization, Member States may however not use the last sentence of Article 2 (5) in order to introduce an accounting rule of a general nature which is contrary to provisions of the Directive, nor can they use this sentence to create additional options allowing for accounting treatments which are not in conformity with the Directive.
2.2. General provisions concerning the layouts
2.2.1. Prohibition of setting-off (Article 7)
7. Article 7 of the Directive prohibits any set-off between asset and liability items, or between income and expenditure items.
8. The setting-off cases referred to in Article 7 should not be confused with the cases where a legal right exists to set off claims and debts by virtue of the law or of a contractual arrangement. An immediate consequence of the legal right to set off is that only the remaining amount can and must be shown in the accounts.
9. There exist, however, complex transactions where the income and expenditure involved is, from an economic viewpoint, without importance as regards the final outcome of the transaction. In some cases the true and fair principle would require that only the final result of a complex operation be shown, although every case must be judged on its own merits.
2.3. Balance sheet
2.3.1. Capitalization of certain intangible fixed assets (Articles 9 and 10)
10. In accordance with the layout of the balance sheet, the heading 'Intangible assets` includes concessions, patents, licences, trade marks and similar rights and assets if they were acquired for valuable consideration or if they were created by the company itself and capitalization is permitted under national law.
11. It follows from the wording of the Directive that these assets, when acquired for valuable consideration, must be capitalized. Only in the case of rights and assets created by the company itself does the Directive permit Member States to decide whether or not they should be capitalized.
2.3.2. Balance sheet items concerning undertakings with which a company is linked by virtue of participating interests (Articles 9, 10 and 11)
12. The balance sheet layouts require that claims on and amounts owed to undertakings with which a company is linked by virtue of participating interests are shown separately. A participating interest is defined in Article 17 as meaning rights in the capital of other undertakings, whether or not represented by certificates, which, by creating a durable link with those undertakings, are intended to contribute to the company's activities.
13. The question arises whether claims on and amounts owed to such undertakings should be shown separately only by the company which held the participating interest or also by the company in which the participating interest is held. The expression 'linked by virtue of participating interests` in Articles 9 and 10 of the Directive suggests that the broader interpretation was intended. The phrase 'creating a durable link` used in the definition of participating interest applies equally to the company holding the participating interest and to that in which the interest is held.
14. Where the company holding the participating interest and the company in which the interest is held are governed by the law of different Member States and where the presumption of a participatory link is based on different percentages, the question whether a participating interest exists is decided by reference to the law of the Member State in which the reporting company is established.
2.3.3. Subordinated loans in the balance sheet (Articles 9 and 10)
15. Subordinated loans are loans which, in the event of liquidation of the debtor company, are repaid after all other creditors have been satisfied but before shareholders receive any distribution.
16. The balance sheet layouts in the Directive do not include a separate heading for subordinated loans. Subordinated loans may not be shown under 'Capital and reserves`. They are liabilities which must be shown under 'Creditors`. In order to emphasize the specific nature of these loans, it may be appropriate to create a specific balance sheet item for such loans and to give further details in the notes about the terms and interest rates of these loans.
2.3.4. Provisions for liabilities and charges (Article 20)
17. Article 20 distinguishes between two categories of provisions. The provisions referred to in Article 20 (1) cover losses or debts, the nature of which is clearly defined and which, at the balance-sheet date, are either likely to be incurred or certain to be incurred but uncertain as to amount or as to the date on which they will arise. In addition to these provisions, Article 20 (2) permits Member States to authorize the creation of a further category of provisions. These are intended to cover charges which have their origin in the financial year under review or in a previous financial year.
18. Provisions according to Article 20 (1) cover probable losses (arising from transactions in the course of settlement) and probable debts. The basic approach behind these provisions is that a relation to a third party exists (e.g. supply or service contract, legal proceedings, etc.). Provisions which meet these conditions must be formed irrespective of the profit or loss for the financial year in accordance with the general principle laid down in Article 31 (1) (c) (bb). This Article requires that account must be taken of all foreseeable liabilities and potential losses arising in the course of the financial year concerned or of a previous one, even if such liabilities or losses become apparent only between the date of the balance sheet and the date on which it is drawn up.
19. Provisions according to Article 20 (2), however, do not cover provisions for losses and debts but only provisions for charges. These are expenses which have their origin in the financial year under review or in a previous financial year, the nature of which is clearly defined and which at the balance sheet date are either likely to be incurred or certain to be incurred but uncertain as to amount or as to the date on which they will arise. Although there is no obligation to a third party, the possibility to create a provision in this case gives companies the opportunity to calculate the profit or loss for the period more precisely. This is meant to cover, for example, major and recurring maintenance costs over a number of years and expenditure on major repairs.
2.3.5. Provisions for environmental liabilities and risks (Article 20)
20. The general conditions in Article 20 (1) of the Directive apply also to provisions for environmental risks and liabilities. Where Member States have implemented the option contained in Article 20 (2), it is also applicable to environmental charges.
21. Environmental liabilities or risks, which result from past transactions or events, qualify for recognition as a provision in the balance sheet, if:
(a) the company has a legal or contractual obligation to prevent, reduce or repair environmental damage, or
(b) the company's management is committed to prevent, reduce or repair environmental damage. Such commitment would exist, for instance, where management has little discretion to avoid action on the basis of statements of policy or intention, industry practice or public expectations or where the company's management has decided to prevent, reduce or repair environmental damage and has communicated this decision either internally to another company organ or externally.
2.4. Profit and loss account
2.4.1. Definition of net turnover (Article 28)
22. In accordance with Article 28 of the Directive, the net turnover comprises the amounts derived from the sale of products and the provision of services falling within the company's ordinary activities, after deduction of sales rebates and of value-added tax and other taxes directly linked to the turnover.
23. The expression 'other taxes directly linked to the turnover` excludes excise duty. Unlike VAT, which is levied and reimbursed at each stage in the production chain, excise duty is normally paid only once by the producer when the product first leaves the factory. The most logical approach is therefore to regard excise duty as an inseparable part of the price of the product, which should therefore always be included in the net turnover.
2.4.2. Extraordinary items (Article 29 (1))
24. Article 29 (1) states that income and charges that arise otherwise than in the course of the company's ordinary activities must be shown as extraordinary income or extraordinary charges.
25. In modern accounting practice there is a trend whereby the number of items which are considered as extraordinary is decreasing.
26. The definition of extraordinary items in the Directive does not preclude that income and charges are only classified as extraordinary in rare cases. Different factors, such as the size and the activities of the company, need to be taken into account when classifying items. The classification of an item as extraordinary or not may often depend on the size of the enterprise: the larger the business, the more often certain events may occur, with the consequence that they may be more correctly classified as ordinary items.
2.4.3. Environmental expenditure
27. Environmental expenditure is not explained in the Directive. Environmental expenditure may include the costs of steps taken by an undertaking or on its behalf by others to prevent, reduce or repair damage to the environment which results from its operating activities, or to deal with the conservation of renewable and non-renewable resources. These costs include, inter alia, the disposal and avoidance of waste, the protection of surface and groundwater, preserving or improving air quality, noise reduction, the removal of contamination in buildings, researching for more environmentally friendly products, raw materials or production processes, etc. (5).
28. Environmental expenditure should in most cases be treated as ordinary expenditure. Consequently it is normally to be expensed in the current period, i.e. the period in which it is recognized.
2.5. Valuation rules
2.5.1. Depreciation of fixed assets (Articles 31 (1) (b), 33 (3) and 35 (1) (b))
29. The purchase price of any fixed asset with a limited useful economic life must be depreciated systematically over its useful economic life (Article 35 (1) (b)).
30. The requirement to depreciate applies even where the fair value of a building is equal to or higher than the book value or where the estimated remaining useful life is unlimited or at any rate so prolonged that annual depreciation would be insignificant. The Directive requires that fixed assets, such as buildings with limited useful economic lives are depreciated over their useful economic lives. Depreciation serves to stagger the purchase price systematically over the useful life of the building.
31. The application of a valuation method which is not based on the purchase price is however not precluded. The application of such a method may be authorized within the meaning of Article 33. Where such a method is applied, the value adjustments must be calculated each year on the basis of the value adopted for the financial year in question (current value) (Article 33 (3)).
2.5.2. Split depreciation in the case of revalued buildings (Articles 32 and 33 (3))
32. The depreciation charge in the case of revalued buildings may not be split into a part which is based on the historical cost and which is charged to the profit and loss account and another part which is based on the revalued amount and which is charged directly to the revaluation reserve.
33. Article 33 (3) allows Member States to permit or to require that only the amount of the depreciation arising as a result of the application of the general rule laid down in Article 32 (purchase price) be seen under the relevant items in the profit and loss account and that the difference arising as a result of the valuation method adopted under Article 33 be shown separately in the layouts. This provision still requires the depreciation to be calculated on the basis of the value adopted for the financial year in question. It merely allows Member States to require or to permit the purchase price element of the depreciation to be shown under the relevant items. That part of the depreciation charge which relates to the revalued amount may appear separately in the profit and loss account layout.
2.5.3. Determination of the depreciable amount (Article 35 (1) (b))
34. The basis for depreciation, or the depreciable amount, is indicated in Article 35 (1) (b) of the Directive to be the 'purchase price or production cost`. In accounting practice, however, the depreciable amount of an asset is sometimes determined after deducting the residual value of the asset. Although the Directive does not contain a specific reference to residual value, the use of a residual value in the calculation of the depreciable amount of an asset is not contrary to the Directive.
2.5.4. Accounting for long-term contracts (Article 31 (1) (c))
35. Long-term contracts are generally understood to mean contracts which relate to work or services extending over a period of more than one year. There are different methods to account for this situation. One method is to take the profit from the contract into account only after final completion of the contract (completed contract method). Another method is to relate the profit to be taken into account to the proportion of the contract that has been completed at the end of the financial year (percentage of completion method). Both methods are allowed under the Directive.
36. The second method is however only allowed on condition that the prudence principle laid down in Article 31 (1) (c) is clearly observed. In other words,
(a) the total contract income must be known;
(b) it must be possible for the proportion of work completed to be calculated accurately, and
(c) the work on the contract must be sufficiently advanced.
Furthermore, where a loss is anticipated on contract, a provision must be set up for the entire loss as soon as it is discovered.
37. Irrespective of the method chosen, appropriate information must be given in the notes of the accounts as to the method applied in accordance with Article 43 of the Directive.
2.5.5. Accounting for positive differences in exchange rates (Article 31)
38. The Directive does not specifically address the problem of accounting for the effects of changes in foreign exchange rates. Article 43 (1) requires that for items included in the annual accounts which are or were originally expressed in a foreign currency, the bases of conversion used to express them in local currency should be disclosed.
39. The question of how to account for translation differences in exchange rates has been the subject of a long-running debate in Europe (6). While there has always been agreement on the fact that negative exchange differences should be charged to the profit and loss account as soon as they arise, doubts have existed as to the possibility of including positive differences in the profit and loss account.
40. Article 31 of the Directive does not exclude an interpretation whereby positive exchange differences may be included in the profit and loss account. Furthermore, this possibility exists for both short-term and long-term monetary items. Because of the existence of very sophisticated financial instruments, it would indeed be arbitrary to operate a distinction between short-term and long-term monetary items.
2.5.6. Capitalization of borrowing costs (Article 35 (4))
41. Interest on capital borrowed to finance the production of fixed assets may, according to Article 35 (4), be included in the production costs to the extent that it relates to the period of production. The term 'production` in Article 35 (4) should not be interpreted too narrowly.
42. Borrowing costs relating to the construction of a fixed asset may equally qualify for capitalization. In the same way, borrowing costs relating to the acquisition of a fixed asset may also be capitalized provided the acquisition does not result in an asset being immediately ready for use or sale. Indeed, capitalization of borrowing costs presupposes that a substantial period of time is needed before the asset is ready for its intended use or sale. As far as acquisitions are concerned, this could be the case where components are being acquired which are then assembled.
2.5.7. Capitalization of environmental expenditures (Article 15 (2))
43. Where environmental expenditures are incurred to prevent or reduce future environmental damage damage or conserve resources, they may qualify for recognition as an asset if, in accordance with Article 15 (2) of the Directive, they are intended for use on a continuing basis for the purpose of the undertaking's activities and if in addition one of the following criteria is met:
(a) the costs relate to anticipated environmental benefits and extend the life, increase the capacity, or improve the safety or efficiency of assets owned by the company, or
(b) the costs reduce or prevent environmental contamination that is likely to occur as a result of future operations.
2.5.8. Valuation of inventories (Article 39 (1) (b))
44. Article 39 (1) (b) states that current assets should be shown at the lower market value or, in particular circumstances, another lower value to be attributed to them at the balance sheet date.
45. Although the Directive does not make any specific reference to the concept of net realizable value, it appears difficult to imagine any practical case where the lower value to be attributed to inventories at the balance sheet date is materially different from the net realizable value. The concept of net realizable value is therefore compatible with the Directive.
2.6. Notes on the accounts
2.6.1. Possible omission of certain items concerning undertakings in which participating interests are held (Article 43 (1) (2) and 45 (1) (b))
46. According to Article 45 (1) (b), Member States may allow the disclosures prescribed in Article 43 (1) (2) concerning undertakings in which the company holds, either directly or indirectly, a participating interest to be omitted when their nature is such that they would be seriously prejudicial to 'any of the undertakings to which Article 43 (1) (2) relates`.
47. The reference to 'any of the undertakings to which Article 43 (1) (2) relates` covers not only those undertakings in which the company has a participating interest but also the holding company itself, since disclosure can be prejudicial in both cases.
2.6.2. Environmental information (Articles 29, 42 and 43)
48. In general the following provisions in the Directive also apply to financial information regarding environmental matters that ought to be included in the notes on the accounts:
(a) Article 43 (1) (1) on disclosure of valuation methods applied;
(b) Article 29 on disclosure of extraordinary items;
(c) Article 42 on disclosure and details of provisions included under 'Other provisions`;
(d) Article 43 (1) (7) on disclosure of contingent liabilities, including narrative information in sufficient detail, so that the nature of the contingency can be understood.
2.7. Annual report
2.7.1. Environmental information (Article 46)
49. Based on Article 46, the following information regarding environmental matters could usefully be given in the annual report:
(a) where environmental issues are relevant to the financial position of the undertaking, a description of the respective issues and the undertaking's response thereto;
(b) the policy that has been adopted by the enterprise in respect of environmental protection measures;
(c) the improvements that have been made in key areas of environmental protection;
(d) an indication of government incentives related to environmental protection measures, such as grants and tax concessions;
(e) the extent to which environmental protection measures, resulting from changes in future legal requirements that have already been enacted, or substantially enacted, into law, are in the process of implementation;
(f) if other quantitative or qualitative environmental information is provided in a separate environmental report, a reference to this report.
3. THE SEVENTH COUNCIL DIRECTIVE ON CONSOLIDATED ACCOUNTS (7)
3.1. Group definition and scope of consolidation
3.1.1. Majority of voting rights in another undertaking (Article 1 (1) (a))
50. Article 1 (1) (a) of the Directive requires consolidated accounts to be drawn up where an undertaking holds a majority of the voting rights in another undertaking. The majority of the voting rights does not necessarily correspond with the majority of the share capital.
51. Where the undertaking in question has issued shares with plural voting rights, full account has to be given to these shares when determining whether a company should be included in the consolidation or not, even where those shares do not represent a majority of the capital. The same principle applies to non-voting shares, i.e. the shares held by the undertaking concerned should be taken into account purely on the basis of the voting rights attached to them and irrespective of the proportion of the capital they represent.
52. For the definition of the parent-subsidiary relationship, the majority of voting rights should always be taken to mean a simple majority of all voting rights in a company. This applies even if the law, the memorandum or the articles of association require that all or certain decisions in a company can be taken only on the basis of a qualified majority. The parent-subsidiary relationship is not affected by provisions in the law, or the memorandum or the articles of association which limit the voting power of a shareholder or member to a given percentage of the total voting rights which is less than a majority of all the voting rights, irrespective of the size of his shareholding and the associated voting rights.
53. The restrictions referred to in paragraph 52 must however be seen in the light of Article 13 (3) (a) (aa) which allows an undertaking not to be included in consolidated accounts where severe long-term restrictions substantially hinder the parent undertaking in the exercise of its rights over the assets or management of that undertaking.
54. Where the proportion of capital and the proportion of voting rights held differ and consolidation has taken place on the basis of the majority of the voting rights, the notes on the consolidated accounts must include information concerning the basis on which the consolidation has been carried out, i.e. information as to the proportion of voting rights held (Article 34 (2) (a)).
3.1.2. Right to appoint or remove a majority of the members of the administrative, management or supervisory body of another undertaking (Article 1 (1) (b))
55. Article 1 (1) (b) requires consolidated accounts to be drawn up where an undertaking has the right to appoint a majority of members of the administrative, management or supervisory body of another undertaking (a subsidiary undertaking) and is at the same time a shareholder in or member of that undertaking.
56. In principle this provision does not cover the situation in which a company is entitled, in respect of another company and on the basis of the memorandum or the articles of association, to appoint a minority of the members of one of the bodies mentioned and that minority holds a majority of the voting rights within the body in question. Consolidation is only required where the right exists to appoint or remove a majority of the board members.
3.1.3. Exclusion of subsidiaries with incompatible activities (Article 14 (1))
57. Article 14 (1) of the Directive states that an undertaking must be excluded from the consolidated accounts when its inclusion would be incompatible with the requirement to show a true and fair view. Even though the second paragraph restricts the scope of this Article, modern accounting practice gives this kind of exclusion an even more restricted role.
58. Since the adoption of the Directive a development has taken place whereby more and more subsidiaries have been included in the consolidated accounts, regardless of the nature of their business compared with that of the parent undertaking. Preference is given to the inclusion of the subsidiary in the consolidated accounts with appropriate information (on a segmented basis) in the notes. Article 14 (1) should be read in the light of this development and exclusion from the scope of the consolidation should therefore only take place in very rare circumstances when the application of the true and fair view principle as described in Article 16 (3) so requires.
3.2. Preparation of the consolidated accounts
3.2.1. Consolidated balance sheet and profit and loss account (Article 17)
59. According to Article 17 of the Directive, the layouts of the consolidated balance sheet and profit and loss account are governed by the provisions in the fourth Directive (Article 9 and 10 and 23 to 26). However, adjustments resulting from the particular characteristics of consolidated accounts can be made. Those adjustments involve, firstly, those items which the seventh Directive specifically provides for to supplement those of the fourth Directive and which follow naturally from the consolidation process. Those items are the following:
- the positive or negative consolidation difference (Article 19 (1) (c)),
- the amount of capital (Article 21) and profit or loss (Article 23) attributable to minority shareholders,
- the difference between the book value of a participating interest and the amount corresponding to the proportion of capital and reserves represented by that participating interest in the case of application of the equity method (Article 33 (2) (a) (b)) and the proportion of the profit or loss of associated undertakings to which the equity method has been applied (Article 33 (6)).
60. Article 17 (2) gives Member States the option to omit the classification of stocks between raw materials and consumables, work in progress, finished goods and payments on account, where there are special circumstances which would entail undue expense in providing such detailed information. Stocks may therefore be classified in accordance with the purpose most frequently used during the financial year.
3.2.2. Requirements when applying 'international` accounting rules (Articles 17 and 29)
61. If an undertaking which is required to prepare its consolidated accounts in conformity with the seventh Directive wishes to satisfy at the same time the requirements following from other rules such as International Accounting standards (IAS) or US generally accepted accounting principles (GAAP), this is only possible to the extent that the consolidated accounts remain in conformity with the seventh Directive. This is particularly relevant for the layouts of the accounts and for the valuation methods.
The consolidated balance sheet and profit and loss account must be drawn up in accordance with the requirements of the Directive. This means that no other adjustments to the layouts in the fourth Directive than those allowed by Article 4 of this Directive can be made.
As far as the valuation rules are concerned, Article 29 (2) allows Member States to require or to permit the use in consolidated accounts of valuation methods other than those used by the parent undertaking in its annual accounts. However, these other valuation methods must also be in conformity with the fourth Directive. No valuation methods may be used which are in conflict with those allowed under the fourth Directive.
(1) Fourth Council Directive 78/660/EEC of 25 July 1978 on the annual accounts of certain types of companies (OJ L 222, 14.8.1978, pp. 11 to 31).
Seventh Council Directive 83/349/EEC of 13 June 1983 on consolidated accounts (OJ L 193, 18.7.1983, pp. 1 to 17).
In the banking and insurance sectors respectively also the following Directives apply:
Council Directive 86/635/EEC of 8 December 1986 on the annual accounts and consolidated accounts of banks and other financial institutions (OJ L 372, 31.12.1986, pp. 1 to 17).
Council Directive 91/674/EEC of 19 December 1991 on the annual accounts and consolidated accounts of insurance undertakings (OJ L 374, 31.12.1991, pp. 7 to 31).
(2) 'Accounting harmonization: A new strategy vis-à-vis international harmonization`, communication from the Commission, COM(95) 508, November 1995.
(3) 'An examination of the conformity between the international accounting standards and the European Accounting Directives`, European Commission, 1996.
(4) When the term 'the Directive` is used in this part it refers to the fourth Directive, unless other references are clearly made.
(5) See also 'Paper of the Accounting Advisory Forum: Environmental issues in financial reporting`, (Document XV/6004/94), European Commission 1995, page 5.
(6) See for example 'Paper of the Accounting Advisory Forum: Foreign currency translation`, European Commission, Office for Official Publications of the European Communities, Luxembourg, 1995.
(7) When the term 'the Directive` is used in this part it refers to the seventh Directive, unless other references are clearly made.