Notes to the Combined Financial Statements

1. Overview and Summary of Significant Accounting Policies

1.1 Background

The Animal Health segment (“Animal Health” or “the Company”) of Bayer AG, Leverkusen (“Bayer” or “Bayer Group”) develops, produces and markets prescription and non-prescription veterinary products to promote the health and wellbeing of companion and farm animals. The Company’s companion animal products, which focus on the prevention and treatment of parasites and infections, include the Advantage™, Seresto™, and Drontal™, and Baytril™ products. Farm animal products include medicines and solutions to treat parasitic diseases, in addition to anti-invectives, immunostimulants, pharmacological treatments and farm hygiene products.

On November 29, 2018, Bayer announced its intention to divest the Animal Health segment. The Combined Financial Statements were prepared on August 6, 2019 by management of Bayer Animal Health GmbH, Alfred-Nobel-Str. 50, 40789 Monheim am Rhein, Germany.

1.2 Basis of Presentation

These financial statements were prepared in accordance with the International Financial Reporting Standards (“IFRS”) – as issued by the International Accounting Standards Board (“IASB”) and are derived from Bayer’s consolidated financial statements. They are prepared on a combined basis.

During the reporting periods presented, Animal Health was not a group of entities under the control of an immediate parent as defined by IFRS 10 (“Consolidated Financial Statements”) and did not historically prepare consolidated financial statements. The Combined Financial Statements reflect the companies and the operations assigned to Animal Health as historically included in the IFRS consolidated financial statements of the Bayer Group and managed by Animal Health management. The Combined Financial Statements reflect the legal entities historically fully dedicated to Animal Health (dedicated entities), in addition to balances held by legal entities shared between the Animal Health segment and other Bayer Group businesses (shared entities) for each of the periods presented. Transactions and account balances associated with Bayer Group businesses outside the scope of combination (“Remaining Bayer”) are excluded from the Combined Financial Statements (Refer to Note 3.1 for the scope of combination.)

The Combined Statements of Income include revenues and expenses directly attributable to Animal Health. In addition, Bayer Group historically provided general corporate services to Animal Health, including communications and public affairs, controlling and planning, human resources, procurement, risk management, engineering and technology, accounting, and finance. The costs for general corporate services are directly attributed at historical cost or, where this was not possible, allocated using appropriate and consistent allocation methods, including revenue, expenses, headcount, or other relevant measures. Management of the Company and Bayer Group consider these allocations to be a reasonable reflection of the utilization of services by, or the benefits provided to, Animal Health. These allocations may not reflect the expenses Animal Health would have incurred as a standalone company for the periods presented. Consistent with Bayer Group, the new accounting standards IFRS 9 (“Financial Instruments”) and IFRS 15 (“Revenue from Contracts with Customers”) were applied for the first time as of January 1, 2018 using the modified retrospective approach. Therefore, the new standards have not been applied consistently for all periods in the Combined Financial Statements.

The Combined Statements of Financial Position of Animal Health include assets and liabilities specifically identifiable or attributable to Animal Health. The assets and liabilities of Animal Health were measured at carrying amounts that were included in Bayer Group’s consolidated financial statements.

Assets and liabilities are classified by maturity. They are regarded as current if they mature within one year or within the normal business cycle of the Company. The normal business cycle is defined for this purpose as beginning with the procurement of the resources necessary for the production process and ending with the receipt of cash or cash equivalents as consideration for the sale of the goods or services produced in that process. Inventories and trade accounts receivables and payables are always presented as current items. Deferred tax assets and liabilities and pension provisions are always presented as noncurrent items.

Historically, Animal Health financed its operations using cash pooling or financing arrangements through entities of Bayer Group. The treatment of the associated financing balances varies for dedicated and shared entities. The Combined Financial Statements include interest expense, interest income, Other financial assets (Note 12), and Financial liabilities (Note 19) balances resulting from cash pooling agreements between dedicated Animal Health entities and Bayer Group. Conversely, balances resulting from such cash pooling arrangements for shared entities, including cash, debt, interest expenses, and interest income, are excluded from the Combined Financial Statements, unless they can be fully attributed to Animal Health. The Combined Statements of Income only include interest income and expense amounts pertaining to financing arrangements attributable to Animal Health. Furthermore, debt and related interest expenses incurred outside the Animal Health scope of combination are excluded from the Combined Financial Statements. Consequently, Animal Health’s Combined Financial Statements may not reflect the same financing costs, had the Company obtained financing on a stand-alone basis.

The combined financial information presented does not necessarily reflect the financial position and results of operations that would have occurred if Animal Health had existed as a separate company during each of the reporting periods presented. The fact that Animal Health did not historically exist therefore limits the applicability of the combined financial information. It also means that the combined financial information cannot be used to forecast the future development of the operations that have been combined to form the Animal Health business.

All figures are presented in euro (EUR). Amounts are stated in millions of euros (€ million) except when otherwise indicated. As the indicators in this report are stated in accordance with commercial rounding principles, totals and percentages may not always be exact.

1.3 Significant Accounting Policies and Critical Accounting Estimates and Judgements

In general, Animal Health applied the same accounting policies and measurement principles in preparing the Combined Financial Statements as those used by Bayer Group in the preparation of financial information included in Bayer’s consolidated financial statements.

Critical Accounting Estimates

Certain accounting policies are considered to be critical to the Company. An accounting policy is considered to be critical if, the Management’s judgement, its selection or application materially affects the Company’s financial position or results. The application of the Company’s accounting policies also requires the use of estimates and assumptions that affect the Company’s financial position or results. Below is a summary of areas in which estimation is applied primarily in the context of applying critical accounting policies and judgements.

Under IFRS, management is required to make estimates, judgments and assumptions that affect the amounts reported in Combined Financial Statements and accompanying notes. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances. These estimates form the basis for making judgments that affect the carrying amounts of assets and liabilities as of the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Making estimates and judgments about future events is inherently unpredictable and is subject to significant uncertainties, some of which are beyond the Company’s control. Should any of these estimates and assumptions change or prove to have been incorrect, it could have a material impact on the Company’s income, financial position and cash flows.

Management believes the critical accounting policies for revenue recognition (Net sales), pension provisions and goodwill reflect the significant estimates and assumptions used in the preparation of the Company’s Combined Financial Statements. Furthermore, in preparing the Combined Financial Statements, additional assumptions and estimates were made in connection with the allocation of expenses from Bayer Group, which were necessary to present Animal Health on a stand-alone basis. These expense allocations represent a significant estimate in the Combined Financial Statements.

Net sales

The Company’s material revenues are derived from the sale of prescription and non-prescription veterinary products. This is done on the basis of customer contracts and the performance obligations contained therein. Revenues are recognized through profit or loss when the Company transfers control of goods to a customer. Control lies with the customer if the customer can independently determine the use of and consume the benefit derived from a product. Revenues from product deliveries are recognized at a point in time based on an overall assessment of the existence of a right to payment, the allocation of ownership rights, the transfer of physical possession, the transfer of risks and rewards, and acceptance by the customer. The Company does not engage in material bill and hold arrangements.

Net sales are limited to the amount Animal Health expects to receive for the fulfillment of performance obligations. Payments withheld, including expected sales taxes, rebates, and sales discounts are deducted from Net sales. Sales deductions and rebates are estimated primarily on the basis of historical experience, specific contractual terms and future expectations. Net sales are also reduced by provisions for expected customer returns. The net sales are reduced on the date of sale or on the date when the amount of future product returns can be reasonably estimated. For customer contracts where more than one year passes between performance and payment, significant financing components are accounted for separately based on their present values and the subsequent unwinding of the discount. The underlying discount rate takes into account the individual credit risk of the contracting party that receives the financing.

The Company adopted IFRS 15 effective January 1, 2018 using the modified retrospective approach (Refer to Note 2).

Research and development expenses

For accounting purposes, research expenses are defined as costs incurred for current or planned investigations undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development expenses are defined as costs incurred for the application of research findings or specialist knowledge to plans or designs for the production, provision or development of new or substantially improved products, services or processes, respectively, prior to the commencement of commercial production or use. Research and development (R&D) expenses are incurred for in-house R&D activities as well as numerous research and development collaborations and alliances with third parties. R&D expenses mainly comprise the costs for active ingredient discovery, research and development activities in the areas of application technology and engineering, field trials, regulatory approvals and approval extensions.

The Company does not capitalize research costs. Capitalization of development costs requires sufficient certainty that the development activity will generate future cash flows that will cover the associated development costs. Since the Company’s development projects are often subject to regulatory approval procedures and other uncertainties, the conditions for the capitalization of costs incurred before receipt of approvals are not normally satisfied. The company did not capitalize any internal development costs during the periods presented.

Income Taxes

Current and deferred income taxes are recognized in accordance with IAS 12 (“Income Taxes”). For purposes of the Combined Financial Statements, income taxes were determined using the separate tax return approach based on the assumption that Animal Health entities constitute separate taxpayers. This assumption implies that current and deferred taxes assigned to Animal Health are calculated separately and that the recoverability of deferred tax assets is assessed on this basis. For shared entities, which did not historically constitute separate income tax payers, current tax expenses and tax income were recognized in the Combined Financial Statements in the year in which they arose as non-cash contributions or withdrawals by Bayer Group. Current tax receivables or payables are derecognized for shared entities.

Deferred tax assets resulting from tax loss carry forwards for dedicated entities are recognized to the extent it is probable that they can be offset against future taxable income. For dedicated and shared entities tax income resulting from tax loss carry forwards was recognized in the Combined Financial Statements. Deferred tax assets resulting from tax loss carry forwards for shared entities are derecognized as non-cash contributions or withdrawals by Bayer Group, because these tax deductions will remain with Bayer Group.

The Combined Statements of Cash Flows only include the taxes actually paid by dedicated entities of Animal Health. Income taxes paid on behalf of shared entities within Animal Health are treated as equity contributions from Bayer Group.

Goodwill

In a business combination, goodwill is capitalized at the acquisition date. It is measured as the excess of the acquisition price over the proportionate share of net assets acquired. The goodwill attributed to Animal Health resulted from prior acquisitions specifically related to the Animal Health business. Goodwill is not amortized, but tested at least annually for impairment. Once an impairment loss has been recognized on goodwill, it is not reversed in subsequent periods. The Company’s acquired goodwill balance is consistent with the historical Animal Health segment financial information presented within the consolidated financial statements of Bayer Group.

Other Intangible Assets

Other intangible assets include patents, trademarks, and marketing rights. They are capitalized if the future economic benefits attributable to the asset will probably flow to the Company and the cost of acquisition or generation of the asset can be reliably measured. Other intangible assets are recognized at the cost of acquisition or development. Intangible assets with a finite life are amortized on a straight-line basis over a period of up to 20 years. The expected useful life is based on estimates of the period for which the asset will generate future cash flows.

Intangible assets with a finite useful life are evaluated for impairment when events have occurred that may give rise to an impairment. Other intangible assets with an indefinite life and intangible assets not yet available for use are not amortized, but tested annually for impairment.

Property, plant and equipment

Property, plant and equipment is depreciated on a straight-line basis over an asset’s expected useful life, except where use-related depreciation is more appropriate. The Company applies the following useful lives when estimating depreciation of Property, plant and equipment:

When disposing of an asset, the difference between the net proceeds and the net carrying amount is recognized as a gain or loss in Other operating income or Other operating expenses, respectively.

Impairment Testing Procedures

Impairment tests are performed not only on individual items of intangible assets and property, plant and equipment, but also at the cash generating unit level. A cash-generating unit is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Management determined that Animal Health constituted a single cash generating unit (CGU) for each of the reporting periods presented, which it subjected to global impairment testing. Goodwill is tested at the CGU level.

The Animal Health CGU is tested for impairment at least annually, or when an event becomes known that may trigger impairment.

Impairment testing involves comparing the carrying amount of a cash-generating unit, unit group or item of intangible assets, or property, plant and equipment to the recoverable amount, which is the higher of its fair value less costs of disposal or value in use. If the carrying amount exceeds the recoverable amount, an impairment loss must be recognized for the difference. In this case an impairment loss is first recognized on any goodwill assigned to the cash generating unit or unit group. Any remaining impairment loss is allocated among the other noncurrent nonfinancial assets in proportion to their carrying amounts. The resulting expense is reflected in the functional item of the income statement in which the depreciation or amortization of the respective assets is recognized. The same applies to income from impairment loss reversals.

The recoverable amount is generally determined on the basis of the fair value less costs of disposal, taking into account the present value of the future net cash flows as market prices for the individual units are not normally available. These are forecasted on the basis of the Company’s current planning, the planning horizon normally being three to five years. Forecasting involves making assumptions, especially regarding future selling prices, sales volumes, costs, market growth rates, economic cycles and exchange rates. These assumptions are based on internal estimates along with external market studies. Where the recoverable amount is the fair value less costs of disposal, measurement is undertaken from the viewpoint of an independent market participant. Where the recoverable amount is the value in use, the object of valuation is measured as currently used. In either case, net cash flows beyond the planning period are determined on the basis of long-term business expectations using the respective individual growth rates derived from market information. The fair value less costs of disposal is determined on the basis of unobservable inputs (Level 3).

The net cash inflows are discounted at a rate equivalent to the weighted average cost of equity and debt capital. The after-tax cost of capital considers information and risks specific to Animal Health, such as regional focus areas and a capital structure benchmarked against comparable companies in the same industry sector. The cost of equity corresponds to the return expected by stockholders, while the cost of debt is based on the conditions on which comparable companies can obtain long-term financing. Both components are derived from capital market information.

The growth rates applied for impairment testing in 2016, 2017 and 2018 and the capital cost factors are shown in the following table:

Although the estimates of the useful lives of certain assets, assumptions concerning the macroeconomic environment and industry developments, and estimates of the discounted future cash flows are believed to be appropriate, changes in assumptions or circumstances could require changes in the carrying amounts. This could lead to the recognition of additional impairment losses in the future or – except in the case of goodwill – to reversals of previously recognized impairment losses if developments are contrary to expectations.

A sensitivity analysis undertaken for the impairment testing of goodwill was based on a 10% reduction in future cash flows, a 10% increase in the weighted average cost of capital or a one-percentage-point reduction in the long-term growth rate. For all reporting periods the sensitivity analysis showed no impairment loss.

Financial Assets (2018)

The Company adopted IFRS 9 effective January 1, 2018 using the modified retrospective method, resulting in a change to the Company’s accounting policy.

Financial assets include receivables, acquired equity and debt instruments, cash and cash equivalents, and derivatives with positive fair values. Regular-way purchases and sales of financial assets are generally posted on the settlement date. The amount at which a financial asset is initially recognized comprises its fair value and in most cases the transaction costs.

The classification and measurement of financial assets is based in each case on the business model and the characteristics of the cash flows. The business models “hold” and “sell” are applied to divested trade accounts receivable depending on the structure of the respective sale agreements, resulting in measurement at amortized costs or fair value. The option of recognizing debt instruments at fair value through profit or loss under certain conditions is not exercised. In the case of equity instruments that are not held for trading, the option of recognizing future changes in their fair value through Other comprehensive income is generally exercised.

Loss allowances for expected credit losses are recognized for financial assets measured at amortized cost.

Expected defaults on receivables expected over the respective term (stage 2 of the impairment model) is determined for trade accounts receivable based on portfolio-specific default rates. These expected default rates are mainly based on the average defaults on receivables in recent years. In individual cases, these default rates are adjusted during the year for the respective customer portfolio if a significant increase or decrease in defaults is expected in the future. The business model, specific customer circumstances, and the economic environment of the customer’s geographic region are considered when determining the expected default rates. Further differentiation is achieved by taking into account the Company’s various customer groups. Customers are assigned to risk classes with different expected default rates depending on their individual credit risk assessments.

Where action such as insolvency or comparable proceedings has been initiated against a defaulter or other substantial indications exist that receivables are impaired (such as a considerable worsening of creditworthiness or a financial restructuring), the receivables are individually tested for impairment (stage 3 of the impairment model). In addition, all receivables more than 90 days past due are individually tested for impairment during the year.

For other financial assets, the expected credit loss for the next 12 months is determined on first-time recognition and on subsequent measurement using the Monte Carlo simulation method (stage 1 of the impairment model). In the event of a significant increase in the default risk, which is defined as a more than 0.25% increase in the probability of default, the expected credit losses over the respective term of the asset are taken into account (stage 2 of the impairment model). An impairment loss is recognized if there are objective indications of an impairment.

Expected credit losses are not calculated for contract assets or lease receivables due to insignificant carrying amounts.

Financial assets are derecognized when contractual rights to receive cash flows from the financial assets expire or the financial assets were transferred together with all material risks and benefits.

Financial Assets (2017 and 2016)

Financial assets comprise loans and receivables, acquired equity and debt instruments, cash and cash equivalents, and derivatives with positive fair values.

Regular-way purchases and sales of financial assets are generally posted on the settlement date. Financial assets are initially recognized at fair value plus transaction costs. The transaction costs incurred for the purchase of financial assets held at fair value through profit or loss are expensed immediately.

If there are substantial and objective indications of a decline in the value of loans and receivables, held-to maturity financial assets or available-for-sale financial assets, an impairment test is performed. Indications of possible impairment include a high probability of insolvency, a significant deterioration in credit standing, a material breach of contract, operating losses reported by a company over several years, a reduction in market value, the financial restructuring of the debtor, or the disappearance of an active market for the asset.

Impairment losses are generally recorded on receivables in the event of insolvency or similar proceedings being launched, financial restructuring at business partners, or the initiation of enforcement measures. Payment history and past-due receivables are also analyzed, with customer-specific facts assessed in each case.

Financial assets are derecognized when contractual rights to receive cash flows from the financial assets expire or the financial assets are transferred together with all material risks and benefits.

Inventories

Inventories include assets consumed in production or in the rendering of services (raw materials and supplies), assets in the production process for sale (work in process), goods held for sale in the ordinary course of business (finished goods and goods purchased for resale), and advance payments on inventories. Inventories are recognized at the lower of cost or net realizable value. Net realizable value is the estimated selling price in the ordinary course of business less associated selling expenses.

Cash and cash equivalents

Cash and cash equivalents comprise cash funds and all short-term investments with original maturities of up to three months. Short-term investments are highly liquid and readily convertible into known amounts of cash. The risk of changes in value is insignificant.

Provisions for pensions and other post-employment benefits

Animal Health employees receive post-employment benefits under defined contribution and defined benefit plans. In regards to these plans, employees primarily dedicated to the Company (greater than 50% of an employee’s time) are attributed to Animal Health. For dedicated entities, active and non-active employees were attributed to Animal Health. For shared entities, only active employees were attributed to Animal Health since it is unfeasible to assign inactive employees to Animal Health or Remaining Bayer precisely. The impact of employee transfers between Animal Health and Remaining Bayer is separately presented for each of the reporting periods, with corresponding changes to plan assets and obligations.

In the case of defined contribution plans, the business historically paid contributions to publicly or privately administered pension plans on a mandatory, contractual or voluntary basis. After making the contributions, the business had no further payment obligations. The regular contributions constitute expenses for the year in which they are due. Defined contribution plan expenses are allocated to Animal Health and classified within operating expenses based on employee mappings.

All other post-employment benefit plans are salary defined benefit plans, which may be either unfunded (financed by provisions) or funded (financed through pension funds). Obligations under these plans are measured using actuarial valuations prepared by an external expert.

The present value of provisions attributable to Animal Health employees for defined benefit plans and the resulting expense are calculated in accordance with IAS 19 (“Employee Benefits”) by the projected unit credit method. The future benefit obligations are valued by actuarial methods and spread over the entire employment period using specific assumptions regarding beneficiary structure and the economic environment. These assumptions relate mainly to the discount rate, expected future salary and pension increases, variations in health care costs, and mortality rates. The discount rates used are calculated from the yields of high-quality corporate bond portfolios in specific currencies with cash flows approximately equivalent to the expected disbursements from the pension plans. The uniform discount rate derived from this interest-rate structure is thus based on the yields, at the closing date, of a portfolio of AA-rated corporate bonds whose weighted residual maturities approximately correspond to the duration necessary to cover the entire benefit obligation.

Plan assets are assigned to Animal Health using a pro rata method consistent with the attribution of benefit obligations. Plan assets for inactive employees for shared entities are excluded from Animal Health. The fair value of plan assets is deducted from the present value of the defined benefit obligation for pensions and other post-employment benefits to determine the net defined benefit liability. The fair values of assets without quoted prices in active markets are determined by applying measurement methods on the basis of freely accessible data such as interest rate curves and credit spreads. Plan assets in excess of the benefit obligation are reflected in Other receivables, subject to the asset ceiling specified in IAS 19. The balance of all income and expenses, except the net interest on the net liability, is recognized in Operating income. The net interest on the net liability is reflected in the financial result under financial income and expenses. The effects of remeasurements of the net defined benefit liability are reflected in Other comprehensive income. They consist of actuarial gains and losses, the return on plan assets and changes in the effects of the asset ceiling, less the amounts included in net interest. Deferred taxes relating to the effects of remeasurements are also recognized in Other comprehensive income.

Bayer-Pensionskasse

Employees of Animal Health participate in the Bayer-Pensionskasse VVaG (Bayer-Pensionskasse), Leverkusen, Germany. This plan has been closed to new members since 2005. This legally independent fund is considered a life insurance company and is subject to the German Insurance Supervision Act. The benefit obligations covered by Bayer-Pensionskasse comprise retirement, surviving dependents’ and disability pensions. The Bayer-Pensionskasse pension obligations are classified as a multi-employer plan as defined under IAS 19. A defining characteristic of multi-employer plans is that assets from various employers not under common control are pooled at plan level and used to collectively grant pension benefits to employees. Allocation mechanisms that would permit an exact distribution of the plan assets managed by the pension plan to individual employers often do not exist. The Company applied an estimation method to allocate the proportional share of the assets of the pension plans to Animal Health.

Other Provisions

Other provisions are recognized for present legal and constructive obligations arising from past events that will probably give rise to a future outflow of resources, provided that a reliable estimate can be made of the amount of the obligations. If the projected obligation declines as a result of a change in the estimate, the provision is reversed by the corresponding amount and the resulting income recognized as an operating expense.

Financial Liabilities

Financial Liabilities include Trade accounts payable and other liabilities that are settled in cash and cash equivalents or other financial instruments, as well as negative fair values of derivatives. Financial liabilities are measured at amortized cost with the exception of those carried at fair value, such as derivatives with negative fair values or liabilities designated at fair value through profit or loss.

Other Receivables and Liabilities

Accrued items and other nonfinancial assets and liabilities are carried at amortized cost. They are amortized to income on either a straight-line basis or according to performance of the underlying transaction.

Derivatives

Animal Health uses derivatives to mitigate the risk of changes in currency exchange rates. Derivatives are recognized at the trade date and carried at fair value. Positive fair values at the end of the reporting period are reflected in financial assets and negative fair values are reflected in financial liabilities. Changes in the fair values of these derivatives are recognized directly in profit or loss except where hedge accounting is used.

Changes in the fair values of the effective portion of derivatives designated as cash flow hedges are initially recognized in Other comprehensive income. They are reclassified to profit or loss when the underlying transaction is recognized through profit or loss. The ineffective portion of derivatives designated as cash flow hedges is recognized either in Other operating income, Other operating expenses, or Financial result, depending on the type of underlying transaction. Changes in the fair values of derivatives designated as fair-value hedges and the adjustments in the carrying amounts of the underlying transactions are recognized in profit or loss.

Changes in the fair values of forward exchange contracts and currency options serving as hedges of items in the Statements of Financial Position are reflected in financial income and expenses as exchange gains or losses. Effects from cash flow hedges of forward exchange contracts used to hedge forecasted sales transactions in foreign currencies are initially recognized in other comprehensive income and then reclassified to other operating income or expenses at the time the sales are recognized. Changes in the fair values of stock options or forward stock transactions used to hedge stock-based employee compensation are initially recognized in other comprehensive income and subsequently reclassified to profit or loss in the functional costs over the periods of the Aspire programs.

Related Party and Intercompany Transactions

Transactions between Bayer Group businesses outside the scope of combination and Animal Health are recognized as third party transactions and are disclosed as related party transactions. The treatment of these transactions, which were historically treated as intercompany transactions for purposes of the Bayer consolidated financial statements, depends on the nature of the entities involved. No impairment losses were recognized on receivables from related entities in any of the reporting periods.

As discussed in Note 3.1, Animal Health consists of both dedicated and shared entities. Transactions historically occurred between Animal Health and Remaining Bayer within individual shared entities (“intracompany transactions”). These transactions primarily consisted of local overhead cost allocations, which are treated as contributions from Bayer Group and do not result in related party payables or receivables.

The treatment of related party transactions with Remaining Bayer occurring between separate legal entities depends on the nature of the transaction. These types of transactions primarily include sales and purchasing activity and corporate allocations, such as overhead, employee benefits, and financing. Generally, cost allocations from Remaining Bayer are treated as equity contributions from Bayer Group, while sales and purchases result in amounts payable from or due to Bayer Group. Refer to Note 25 for further details regarding the treatment of these transactions.

Intercompany balances, which represent transactions entirely within Animal Health, are eliminated in preparation of the Combined Financial Statements.

Equity

The equity of Animal Health consists of the Invested equity attributable to the Bayer Group and Other components of equity. Invested equity attributable to the Bayer Group represents Bayer’s historical investment in Animal Health, the net effect of transactions with and allocations from Bayer Group and Animal Health’s accumulated earnings. Other components of equity primarily consist of accumulated currency exchange differences and cash flow hedging activity.

The Company assumed an accumulated amount of Other comprehensive income of zero as of January 1, 2016, due to the infeasibility of estimating historical allocations to the entire Animal Health business. Subsequent amounts of Other comprehensive income are allocated to Animal Health using reasonable methods consistent with the underlying account balances.

Leases

A lease is an agreement whereby the lessor assigns to the lessee the right to use an asset for an agreed period of time in return for a payment or series of payments. Leases are classified as either finance or operating leases. Leasing transactions that transfer substantially all the risks and rewards incidental to ownership of the leased asset to the lessee are treated as finance leases. All other leasing agreements are classified as operating leases. Whether an agreement constitutes a lease or contains a lease is determined upon inception of the agreement.

In regards to finance leases, the leased asset is capitalized at the lower of the fair value of the asset or the present value of the minimum lease payments at the beginning of the lease term and simultaneously recognized under financial liabilities. The minimum lease payments are divided into the principal portion of the remaining obligation and the financing costs, which are determined using the effective interest method. The leased asset is depreciated by the straight-line method over the shorter of its estimated useful life or the lease term.

When the Company is a lessee in an operating lease, the lease payments are expensed using the straight-line method. When the Company is the lessor, the lease payments received are recognized in combined profit or loss. The leased asset continues to be recognized under Property, plant and equipment in the Combined Statements of Financial Position.

In addition to leasing arrangements with third parties, Animal Health leases land and equipment from Bayer Group. For purpose of the Combined Financial Statements these leasing arrangements are presented as third party transactions in the Combined Statements of Financial Position and Combined Income Statements.

Foreign Currency

The financial information comprising Animal Health is based on each entity’s functional currency. Refer to Note 3.1 for the specific entities included within the scope of combination for Animal Health. An entity’s functional currency is that of the economic environment in which it primarily operates. The majority of Animal Health entities carry out their activities autonomously from a financial, economic and organizational point of view, and their functional currencies are therefore the respective local currencies.

When preparing the Combined Statements of Financial Position, non-euro denominated assets and liabilities are translated into euros using the closing rates of each period presented. Income and expense items and cash flows are translated into euros at average annual rates. The components of equity are translated at the historical exchange rates prevailing at the respective dates of their first-time recognition in Animal Health.

The exchange differences arising between the resulting amounts and those obtained by translating at closing rates are recognized as Other comprehensive income.

The exchange rates for major currencies against the euro varied as follows:

Currency translation for Animal Health is calculated based on the value of assets and liabilities attributed to the Company.

Hedging transactions for Animal Health are mainly initiated by Bayer Animal Health or KVP Kiel with Bayer. For the purpose of the Combined Financial Statements all hedging transaction were treated as third party transactions. All hedged items and hedged instruments that are related to Animal Health dedicated entities, were reflected in the Combined Financial Statements.

2. Effects of new financial reporting standards

Financial reporting standards applied for the first time in 2016

The first-time application of the following amended financial reporting standards had no impact, or no material impact, on the presentation of Animal Health’s financial position or results of operations.

In May 2014, the IASB published amendments to IAS 16 (“Property, Plant and Equipment”) and IAS 38 (“Intangible Assets”) entitled “Clarification of Acceptable Methods of Depreciation and Amortisation.” These amendments clarify that revenue-based depreciation of property, plant and equipment or amortization of intangible assets is inappropriate.

In May 2014, the IASB published amendments to IFRS 11 (“Joint Arrangements”) entitled “Accounting for Acquisitions of Interests in Joint Operations.” The amendments clarify the accounting for the acquisition of an interest in a joint operation in which the activity constitutes a business.

In December 2014, the IASB published its Disclosure Initiative containing amendments to IAS 1 (“Presentation of Financial Statements”), which are intended to clarify the disclosure requirements. They relate to materiality, line-item aggregation, subtotals, the structure of the Notes to the financial statements, the identification of significant accounting policies and the separate disclosure of the other comprehensive income of associates and joint ventures.

In December 2014, the IASB published amendments to IFRS 10 (“Consolidated Financial Statements”), IFRS 12 (“Disclosure of Interests in Other Entities”) and IAS 28 (“Investments in Associates and Joint Ventures”) entitled “Investment Entities: Applying the Consolidation Exception.” The amendments largely clarify which subsidiaries an investment entity must consolidate and which must be recognized at fair value through profit or loss.

Financial reporting standards applied for the first time in 2017

The first-time application of the following amended financial reporting standards had no impact, or no material impact, on the presentation of Animal Health’s financial position or results of operations.

In January 2016, the IASB published amendments to IAS 7 (“Statement of Cash Flows”) under the title “Amendments to IAS 7: Disclosure Initiative.” The following changes in liabilities arising from financing activities must be disclosed: (a) changes from financing cash flows; (b) changes arising from obtaining or losing control of subsidiaries or other businesses; (c) the effect of changes in foreign exchange rates; (d) changes in fair values; (e) other changes.

In January 2016, the IASB also published amendments to IAS 12 (“Income Taxes”) under the title “Recognition of Deferred Assets for Unrealized Losses.” These amendments clarify that in the case of assets recognized at fair value (e.g. fixed-rate debt instruments) where the taxable value is the cost of acquisition, unrealized losses result in deductible temporary differences, irrespective of the future use of the asset. Further, when estimating future taxable profits for the purpose of recognizing deferred tax assets, the tax deductions resulting from the reversal of other deductible temporary differences must be eliminated.

In December 2016, the IASB published “Annual Improvements to IFRS Standards 2014 - 2016 Cycle” as part of its annual improvements project. The changes relating to IFRS 12 (“Disclosure of Interest in Other Entities”) primarily pertain to clarifications.

Financial reporting standards applied for the first time in 2018

IFRS 9 (“Financial Instruments”) and IFRS 15 (“Revenue from Contracts with Customers”) were applied for the first time as of January 1, 2018. The Company elected the modified retrospective approach for both standards, accounting for the aggregate amount of any transition effects by way of an adjustment to equity and presenting the comparative periods in line with previous rules.

The effects that the first time application of IFRS 9 and IFRS 15 had on equity are detailed in the table below.

Invested equity attributable to Bayer Group Reconcilation IFRS 9 and IFRS 15  

IFRS 9 is the new standard for accounting for financial instruments. It replaces the previous rules under IAS 39 (“Financial Instruments: Recognition and Measurement”). Animal Health applied IFRS 9 using the modified retrospective approach for the first time effective January 1, 2018, accounting for the aggregate amount of any transition effects by way of an adjustment to equity and presenting the comparative periods in line with previous rules.

Based on the Company’s investment holdings, the overall impact of IFRS 9 on the value of equity instruments was immaterial.

IFRS 9 introduces new provisions for the classification and measurement of financial assets and replaces the current rules on the impairment of financial assets. The new standard requires a change in accounting methods for the effects resulting from a change in the Company’s own credit risk for financial liabilities classified at fair value and modifies the requirements for hedge accounting. The classification and measurement of financial liabilities are otherwise largely unchanged from the existing regulations.

Under IFRS 9, the classification and measurement of financial assets is determined by the Company’s business model and the characteristics of the cash flows of each financial asset. In the case of equity instruments held as of January 1, 2018, that are not held for trading, Animal Health has uniformly opted to recognize future changes in their fair value through Other comprehensive income and to continue to classify these changes as equity upon the derecognition of the financial instrument. As for new instruments, Animal Health can opt to make use of this option on an instrument-by-instrument basis upon recognition, but it must continue to do so thereafter.

Changes in the classification and measurement of financial assets led to the following effects as at the date of first-time application:

The standard had no effects on financial liabilities.

The following table shows the effects of the first-time application of IFRS 9 on Invested equity attributable to Bayer Group and Other comprehensive income in the Combined Statements of Comprehensive Income, broken down by measurement category:

¹  See table 2/2 for definition of measurement categories.

As of the transition date, the Company did not have any financial assets or liabilities measured at fair value using unobservable inputs (Level 3).

The overall impact of IFRS 9 on the Company’s loss allowances was immaterial as of the transition date.

For hedge accounting, Animal Health has opted to prospectively apply IFRS 9 from January 1, 2018. If only the intrinsic value of an option is designated as a hedging instrument in a hedging relationship, IFRS 9 requires that changes in the fair value of the time value of options during the hedging period initially be recognized as other comprehensive income in the Combined Statements of Comprehensive Income. The release of the accumulated amounts, either in the form of a basis adjustment or directly through profit or loss, depends on the type of hedged transaction. In contrast to the other rules on hedge accounting, the revised accounting method is to be applied retrospectively. Animal Health opted to not change the accounting treatment for foreign currency derivatives upon adoption of IFRS 9. As at the transition date, these changes did not have any material impact on the presentation of the Company’s financial position and results of operations.

In October 2017, the IASB published an amendment to IFRS 9 under the title “Prepayment Features with Negative Compensation.” It also published a clarification regarding the accounting for a modification of a financial liability that does not result in its derecognition. For these nonsubstantial modifications, modification gains or losses – including the costs of the modification – must be immediately recognized in profit or loss. This amendment to IFRS 9 is to be applied for annual periods beginning on or after January 1, 2018. This amendment did not have any impact on the presentation of the Company’s financial position and results of operations.

IFRS 15 – Revenue from Contracts with Customers

IFRS 15 introduced the five-step model for revenue recognition from contracts with customers. Under the standard, revenue is recognized at amounts that reflect the consideration that an entity expects to be entitled to receive in exchange for transferring goods or services to a customer. Under the new standard, the Company primarily recognizes revenue from performance obligations satisfied at a point in time when control of goods or services has been transferred to a customer. In addition, IFRS 15 clarifies the allocation of individual topics to (new) line items in the Combined Statements of Financial Position and to functional cost items in the Combined Statements of Income, and whether gross or net amounts are to be presented.

The Company adopted IFRS 15 effective January 1, 2018, using the modified retrospective method. Under the modified retrospective method, the aggregate transition effect is recorded by an adjustment to equity as of January 1, 2018. Comparative period balances for 2016 and 2017 are presented in accordance with the prior standards and remain unchanged. The Company elected to retrospectively apply the new standard to uncompleted contracts as of January 1, 2018, reflecting the aggregate effect of all contract modifications that occurred prior to the date of first-time application in accordance with IFRS 15.C7A(b).

The adoption of IFRS 15 has led to the following effects:

Adoption of IFRS 15 under the modified retrospective approach had the following impact on the opening statement of financial position as of January 1, 2018:

The transition to IFRS 15 had the following impact on the Statement of Financial Position as of December 31, 2018:

Reconcilliation IFRS 15 to IAS 18 for Presentational Changes: Combined Statement of Financial Position as of December 31, 2018

In addition to IFRS 9 and IFRS 15, the following changes were applied as of January 1, 2018, but did not have any material impact on the Animal Health’s financial position and results of operations.

Amendments to standards with no material impact

Published financial reporting standards that have not yet been applied

The IASB and the IFRS Interpretations Committee have issued the following standards, amendments to standards, and interpretations whose application was not yet mandatory for the 2018 fiscal year. The following IFRS and interpretations have not yet been applied by the Company:

The information below pertains only to future amendments to accounting standards whose foreseeable effects – if any – could be material to Animal Health’s financial position or results of operations.

IFRS 16 - Leases

In January 2016, the IASB published the new standard for lease accounting, IFRS 16 (“Leases”), which replaces the rules contained in IAS 17 (“Leases”) along with the associated interpretations. The new standard is to be applied for annual periods beginning on or after January 1, 2019. The standard introduces a single lessee accounting model, requiring lessees to recognize assets for granted rights of use and corresponding lease liabilities. It eliminates the previous requirement for lessees to differentiate between operating leases – without recognizing the respective assets or liabilities – and finance leases. However, IFRS 16 contains the option of exercising exemptions for the recognition of short-term leases and those pertaining to low-value assets. As under the previous standard, IAS 17, lessors are required to differentiate between operating and finance leases. According to IFRS 16, subleases are classified with reference to the right-of-use asset arising from the sublease in relation to the head lease.

The Company will apply IFRS 16 for the first time as of January 1, 2019, retrospectively without restating the prior-year figures. Upon transition, various options and practical expedients can be applied as of the transition date for lease agreements in which Animal Health is the lessee. On the date of first-time application, no additional assessment will be undertaken with regard to whether a contract represents or contains a leasing relationship. For contracts previously classified as operating leases, Animal Health will measure the lease liabilities as of the date of first-time application of IFRS 16 at the present value of the outstanding lease payments, using as the discount rate the respective incremental borrowing rate as of that date. On the date of first-time application, the right-of-use asset will generally be measured at the amount of the lease liability, adjusted by the amounts of any prepaid or accrued lease payments and / or provisions for onerous leases recognized in the statement of financial position as of December 31, 2018. Initial direct costs will not be taken into account in the measurement of the right-of-use asset as of the date of first-time application. The Company will perform the analysis of lease liabilities based on the facts and circumstances that exist as of the date of first-time application.

Animal Health plans to elect to exempt intangible assets from the scope of application of IFRS 16 and will apply the exemptions for short-term leases commencing after Dec. 31, 2018.

The first-time application of IFRS 16 as of January 1, 2019, is anticipated to result in the recognition of additional lease liabilities and right-of-use assets of approximately €10 million.

In the Combined Statements of Income, Animal Health will cease recognizing expenses for operating leases in Operating income and will instead recognize the amortization of the right-of-use assets and the interest expense for the lease liabilities under IFRS 16. An analogous effect will occur in the Combined Statement of Cash Flows, where IFRS 16 leads to an improvement in the operating cash flow by reducing cash outflows for operating activities, while the repayment component of lease payments and the interest expense will be recognized in the financing cash flow.

3. Scope of combination and acquisition

3.1 Scope of combination

The Combined Financial Statements of Animal Health consist of both dedicated entities and shared entities. Dedicated entities are comprised entirely of Animal Health operations, with all assets and liabilities attributed to the Company. The shared entities consist of both Animal Health and Remaining Bayer operations, with assets and liabilities attributed to both Animal Health and Remaining Bayer. Shared entity costs are allocated when direct attribution is not possible.

Animal Health consists of the following entities for all periods presented.

3.2 Acquisition

On January 3, 2017, Animal Health acquired the Cydectin™ portfolio in the United States from Boehringer Ingelheim Vetmedica, Inc., St. Joseph, Missouri, United States for a purchase price of €158 million, which the Company accounted for as an asset deal. The acquired portfolio includes the CYDECTIN Pour-On, CYDECTIN Injectable and CYDECTIN Oral Drench endectocides for cattle and sheep. The acquisition is intended to strengthen the Company’s antiparasitics portfolio in the United States. The purchase price pertained mainly to trademarks and goodwill, which is fully tax-deductible. The goodwill included expected synergies and cost savings in the selling and general administration functions, in addition to the sales synergies resulting from combined product offerings.

The effects of this transaction – as of the acquisition date – on the Animal Health’s assets and liabilities are shown in the following table.

In fiscal 2017, the Cydectin™ business contributed €31 million to the sales of Animal Health. After-tax income of €5 million was recorded for the Cydectin™ business in the same period since the acquisition date.

4. Net sales

The Company’s net sales are derived primarily from product deliveries. During each of the reporting periods, the Company recognized sales to customers in each of the following markets:

Sales of €4 million were recognized in 2018 from performance obligations already satisfied in previous years. These sales primarily resulted from adjustments to refund liabilities for expected product returns and from rebates to be granted and pertain to customer contracts which have original terms in excess of one year.

The Company has certain sales contracts with minimum sales commitments. The unfulfilled performance obligations for these contracts are expected to be reclassified into profit and loss as follows, based on the underlying contract terms and estimated dates of delivery:

Contract liabilities mainly result from advance payments by customers for product deliveries and are generally recognized as sales within one year. Contract liabilities were approximately €2 million as of December 31, 2018 and €2 million as of January 1, 2018, the Company’s transition date for IFRS 15.

5. Other operating income

Other operating income is comprised of the following:

In 2017, Miscellaneous operating income includes gains from the Company’s long-term incentive compensation hedging activities (€1 million).

In 2018, Miscellaneous operating income was primarily comprised of a litigation settlement in Germany related to royalty licensing arrangements (€3 million) and a working capital adjustment settlement associated with the Company’s 2013 Teva acquisition (€2 million).

6. Other operating expenses

Other operating expenses are comprised of the following:

In 2016 and 2018, Miscellaneous operating expenses includes €1 million in legal expenses in the United States.

In 2017, Miscellaneous operating expenses includes €2.5 million in legal expenses in the United States and €2 million related to penalties claimed by fiscal authorities in Costa Rica.

7. Personnel expenses

Personnel expenses consisted of the following:

The interest portion of personnel-related expenses – mainly for pensions and other post-employment benefits – is included within Financial result on the Combined Statements of Income.

8. Financial result

8.1 Net interest expense

The net interest expense is comprised of the following:

The interest expense and interest income included above resulted entirely from financial liabilities and financial assets, respectively.

8.2 Other financial income and expenses

Other financial income and expenses were comprised as follows:

9. Taxes

The tax expense comprises the following major components:

Current income taxes comprise current income tax expenses from prior years of €7 million in 2018 (2017: €-1 million, 2016: €3 million).

Deferred tax assets and liabilities result from the following temporary differences and tax loss carryforwards:

Based on the separate tax return approach described in Note 1.3, for shared entities that did not constitute separate income tax payers in the reporting periods, current tax expenses and tax income were recognized in the Combined Financial Statements in the year in which they arose as non-cash contributions or withdrawals by the respective stockholders. As a result, current tax liabilities were reduced by €70 million in 2018 (2017: €63 million; 2016: €64 million).

For shared entities which are not separate income tax payers, deferred tax assets for tax losses carryforwards of 2018 by €28 million (2017: €13 million; 2016: €5 million) were derecognized as non-cash withdrawals, because the tax losses pertain to the respective shareholders.

Deferred tax assets on tax loss carryforwards at an amount of €0 million in 2018 (2017: €1 million; 2016: €0 million) were recognized for fully dedicated entities which suffered a taxable loss in the current or previous period.

In addition to the tax loss carryforwards for which deferred tax assets were recognized, the Group owns tax loss carryforwards from fully dedicated entities for which utilization is not probable as of reporting date:

¹ The tax loss carryforwards for which no deferred assets were capitalized are related to state tax losses suffered in the United States.

No deferred tax liabilities were recognized for taxable temporary differences associated with investments in subsidiaries amounting €73 million in 2018 (2017: €56 million; 2016: €37 million) as the Group is able to control the timing of the reversals and the temporary differences will not reverse in the foreseeable future.

The following table shows the reconciliation of expected to reported income tax expense and of applicable to effective tax rate for the Group:

¹ Expected income tax expense is calculated by applying an expected weighted average tax rate to the pre-tax income of the Group. This average rate was determined on the basis of expected tax rates for the individual Group companies.

10. Goodwill and other intangible assets

Changes in intangible assets in the years presented were as follows: