Notes to the Consolidated Financial Statements

General

(1) Company information

The accompanying consolidated financial statements as of December 31, 2017 have been prepared with MERCK Kommanditgesellschaft auf Aktien (Merck KGaA), Frankfurter Strasse 250, 64293 Darmstadt as parent company. Merck KGaA, which manages the operations of the Merck Group, is registered under HRB 6164 with the Commercial Register of Darmstadt. In accordance with the provisions of the German financial reporting disclosure law (Publizitätsgesetz), consolidated financial statements are also prepared for E. Merck Kommanditgesellschaft (E. Merck KG), the ultimate parent company and general partner of Merck KGaA with an equity interest of 70.274% as of December 31, 2017 (December 31, 2016: 70.274%). These consolidated financial statements include Merck KGaA and its subsidiaries. The authoritative German versions of these financial statements are filed with the German Federal Gazette (Bundesanzeiger) and can be accessed at www.bundesanzeiger.de.

(2) Reporting principles

These consolidated financial statements have been prepared in accordance with the International Financial Reporting Standards in force on the reporting date as issued by the International Accounting Standards Board and the IFRS Interpretations Committee (IFRS and IAS, as well as IFRIC and SIC) and as adopted by the European Union as well as the additionally applicable provisions of section 315e of the German Commercial Code (HGB). The fiscal year corresponds to the calendar year. These financial statements have been prepared in euros, the reporting currency. The figures reported in the consolidated financial statements have been rounded, which may lead to individual values not adding up to the totals presented.

In comparison with the previous year, there were no material changes to accounting and measurement principles. The accounting and measurement policies used in the consolidated financial statements are presented in Notes (51) ‟Measurement policies” to (69) ‟Share-based compensation programs”.

The following rules take effect as of fiscal 2017:

  • Amendment to IAS 7 ‟Statement of Cash Flows”
  • Amendments to IAS 12 ‟Income Taxes”
  • Annual Improvements to IFRSs 2014 – 2016 Cycle: Amendment to IFRS 12 ‟Disclosure of Interests in Other Entities”

The amendments had no material effects on the consolidated financial statements.

The following rules take effect as of fiscal 2018:

  • IFRS 9 ‟Financial Instruments”
  • IFRS 15 ‟Revenue from Contracts with Customers”
  • Amendment to IFRS 4 ‟Insurance Contracts”
  • Amendments to IFRS 15 ‟Revenue from Contracts with Customers”
  • Annual Improvements to IFRSs 2014 - 2016 Cycle: Amendments to IFRS 1 ‟First-time Adoption of International Financial Reporting Standards” and to IAS 28 ‟Investments in Associates and Joint Ventures”

We did not opt for early application of any of these rules.

Over the past two years, an in-depth analysis of the impact of the new IFRS 9 rules was performed with respect to the accounting practices and processes in place at Merck. The following table highlights the major subject areas for Merck and their estimated impact on Group equity as of January 1, 2018, before taking into account deferred taxes.

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Subject area Accounting change Expected effect on Group equity as of January 1, 2018, in € million1 (increase (+)/decrease (–))
Classification of financial assets In individual cases, the classification of financial assets will change, with subsequent measurement being recorded either in other comprehensive income or in the consolidated income statement. The expected material effect on Merck is represented by the change from previous classification as available for sale debt instruments to future classification as ‟measured at fair value through profit or loss”.
Measurement of equity instruments For all material equity instruments existing as of January 1, 2018, and not held for trading, Merck will make the election to recognize future changes in fair value in other comprehensive income and to continue to present these changes in equity after the disposal of the financial instrument.
Measurement of trade accounts receivable and other financial assets In future, loss allowances for trade accounts receivable are determined on the basis of their lifetime expected credit losses. The first-time application of IFRS 9 will lead to an increase in allowances for losses from expected credit risks of financial assets, particularly trade accounts receivable. – 5 to – 10
Designation of hedging instruments The existing hedge accounting relationships can remain in place also after the first-time application of the requirements of IFRS 9. For hedgrelationships where Merck uses options, only the intrinsic value of options will be designated as the hedged item. For hedging relationships where Merck uses forward contracts, only the spot element will be designated as the hedged item. Changes in the fair value of the forward element in forward contracts or in the time value component of option contracts will initially be recorded in a new hedging cost reserve within Group equity. The further accounting treatment of these amounts depends on the type of hedged transaction. 1
1
Before taking deferred taxes into consideration.

In addition, the implementation of IFRS 9 will change the presentation of financial instruments in the consolidated income statement and the consolidated balance sheet.

Merck will make use of the following practical expedients provided by IFRS 9:

  • Possibility of modified initial application to record the cumulative adjustment from initial application as of January 1, 2018. Comparative information for prior periods as regards classification and measurement as well as impairment is not disclosed under IFRS 9.
  • Application of the simplified impairment model in accordance with IFRS 9 for the recognition of lifetime expected credit losses of contract assets as well as trade receivables, lease receivables, receivables from licenses and commission receivables.

The implementation of the new IFRS 9 rules in the systems and processes of Group companies was correspondingly prepared in 2016 and 2017. The necessary adjustments to the system relate in particular to the new impairment rules, the new classification of financial assets and expanded disclosure requirements in the notes to the consolidated financial statements.

Since the beginning of 2015, a cross-functional project team has been analyzing the effects of the new rules on revenue recognition of IFRS 15, using quantitative and qualitative analyses, surveys and contract analyses to do so.

Merck generates more than 95% of its revenues from contracts on the sale of goods that usually have a simple structure and normally do not constitute long-term contracts. Based on the knowledge as of the date of preparing these consolidated financial statements, the initial application of IFRS 15 is not expected to have any material impact on the consolidated income statement for 2018.

The expected adjustment effects on Group equity as of January 1, 2018, before taking into account deferred taxes, can be summarized as follows.

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Subject area Accounting change Expected effect on Group equity as of January 1, 2018, in € million1 (increase (+)/decrease (–))
Date of the transfer of control within the context of product sales In the case of specific supplies of goods, the transfer of control and thus the date of revenue recognition in accordance with IFRS 15 will occur later than the transfer of risks and rewards within the meaning of IAS 18. This affects in particular overseas shipping transports in the Healthcare business sector. – 20
Out-licensing of intellectual property Out-licensing intellectual property may, in some cases, lead to an earlier revenue recognition as compared with IAS 18 if the outlicensed intellectual property meets the criteria of right-of-use asset (recognition of revenue apoint in time), rather than an access right (recognition over a period of time) and the consideration is not paid in the form of sales- or usage-based royalties. 17
Long-term supply contracts with minimum purchase quantities (take-or-pay contracts) In individual cases, contracts with customers provide for minimum purchase quantities. In such cases, in accordance with IFRS 15, the expected transaction price attributable to the minimum purchase quantity has to be allocated to individual supplies. However, under IAS 18, revenue is recognized in the amount of the invoiced selling price for the individual supplies. 4
Multiple-element arrangements In the Life Science business sector, there are multiple-element arrangements with service elements to minor extent. In future, the transaction price will have to be allocated in some cases in a different manner than previously. 1
Presentation of payments to customers as sales deduction rather than operating expenses In individual cases, payments to customers will be presented in the consolidated income statement as sales deductions rather than operating expenses.
1
Before taking deferred taxes into consideration.

Moreover, the new rules of IFRS 15 in the following areas are of no or only of very minor relevance for Merck:

  • variable consideration
  • revenue recognition over time for long-term service contracts and customer-specific construction contracts
  • consignment arrangements
  • costs of obtaining or fulfilling a contract
  • principal-agent relationships
  • bill-and-hold arrangements
  • financing components
  • barter transactions
  • repurchase agreements
  • separate performance obligations from transportation or other logistics services
  • gross presentation of rights of return granted by recognition of an asset for expected physical returns by customers

Collaboration agreements are within the scope of IFRS 15 only if there is a customer-supplier relationship. This is normally not the case for the existing collaborations, most of which relate to the Healthcare business sector.

The implementation of the new rules in the systems and processes of the Group companies commenced in 2016 and was completed in the course of 2017. The necessary system adaptations related in particular to the expanded disclosure requirements in the Notes to the Consolidated Financial Statements.

Merck will make use of the following practical expedients of IFRS 15:

  • Possibility of applying the modified retrospective method where the cumulative effect of initially applying IFRS 15 as of January 1, 2018 is recognized as an adjustment of Group equity
  • The promised amount of consideration is not adjusted for the effects of a significant financing component if the period between the fulfillment of a performance obligation and the payment by the customer amounts to up to one year
  • Costs of obtaining a contract are expensed as incurred if the amortization period is one year or less.

The following standard is required to be applied as of fiscal 2019:

  • IFRS 16 ‟Leases”

The impact of IFRS 16 on the consolidated financial statements is currently being examined. The standard will not be applied early.

The implementation of IFRS 16 will mean that as a lessee, for all leases Merck will generally be required to recognize a liability and a corresponding right of use in its balance sheet. The possibility to classify a lease as an operating lease and to recognize the associated expenses in the period in which they are incurred will no longer exist. Merck will make use of the option under IFRS 16 to continue to refrain from recognizing rights of use and the corresponding liabilities from leases of low-value assets in its balance sheet. At the time of initial application, Merck will also make use of the transition relief provided by IFRS 16 to recognize the cumulative transition effect instead of adjusting the prior-year periods retroactively. In order to determine the impact of IFRS 16, around 7,000 leases have been identified and analyzed to date. According to the current status of the analysis, with the transition to IFRS 16, the increase in the balance sheet total will be less than 2%.

As of the balance sheet date, the following standards were published by the International Accounting Standards Board and the IFRS Interpretations Committee, but not yet endorsed by the European Union:

  • IFRS 14 ‟Regulatory Deferral Accounts”
  • IFRS 17 ‟Insurance Contracts”
  • IFRIC 22 ‟Foreign Currency Transactions and Advance Consideration”
  • IFRIC 23 ‟Uncertainty over Income Tax Treatments”
  • Amendments to IAS 28 ‟Investments in Associates and Joint Ventures”
  • Amendment to IAS 40 ‟Investment Property”
  • Amendment to IFRS 2 ‟Share-based Payment”
  • Amendment to IFRS 9 ‟Financial Instruments”
  • Amendment to IFRS 10 ‟Consolidated Financial Statements”
  • Annual Improvements to IFRSs 2015 – 2017 Cycle

From today’s perspective, the new rules are not expected to have any material effects on the consolidated financial statements.

(3) Changes in the scope of consolidation

The scope of consolidation changed as follows in the reporting period:

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Fully consolidated companies as of December 31, 2016 313
Additions Establishments 2
Acquisitions 2
Materiality 8
Retirements Liquidations/Mergers – 10
Divestments
Immateriality – 1
Loss of control
Fully consolidated companies as of December 31, 2017 314
Non-consolidated subsidiaries as of December 31, 2016 48
Non-consolidated subsidiaries as of December 31, 2017 57

Overall, the impact of subsidiaries not consolidated due to immateriality on sales, profit after tax, assets and equity was less than 1% relative to the entire Merck Group. The interests in subsidiaries not consolidated due to immateriality were classified as available-for-sale financial assets and presented under non-current financial assets (see Note (19) ‟Financial Assets”).

The list of shareholdings presents all of the companies included in the consolidated financial statements as well as all of the shareholdings of Merck KGaA (see Note (70) ‟List of shareholdings”).

(4) Acquisitions and divestments

Acquisitions in the fiscal year

On May 8, 2017, Merck acquired all of the shares in Grzybowski Scientific Inventions Ltd. (GSI) headquartered in Evanston, USA. GSI developed Chematica, a computer-aided retro-synthesis tool. The software uses advanced reaction rules and proprietary algorithms to identify synthesis pathways that meet user-defined constraints. GSI is being integrated into the Life Science business sector. The purchase price comprises fixed compensation of US$ 7 million (€ 7 million) as well as milestone payments of up to US$ 1 million (€ 1 million).

On September 15, 2017 Merck acquired a 100% interest in Natrix Separations, Inc. (Natrix). The company, which is headquartered in Burlington, Canada, supplies hydrogel membrane products for single-use chromatography. Natrix is being integrated into the Life Science business sector. The purchase price comprises fixed compensation of around US$ 14 million (€ 12 million) as well as milestone payments of up to US$ 8 million (€ 7 million).

As of December 31, 2017, the purchase price allocations for GSI and Natrix had not been completed in respect of intangible assets and deferred taxes. The most significant impact from the preliminary purchase price allocations resulted, in both cases, from the remeasurement of technology-related intangible assets. Both acquisitions only contributed immaterially to the sales and earnings of the Merck Group.

Acquisition in the previous year

BioControl Systems, Inc., USA

Effective December 21, 2016, Merck acquired a 100% interest in BioControl Systems, Inc., Bellevue, USA (BioControl), a company that develops, manufactures and commercializes materials and systems to check food safety. BioControl was integrated into the Life Science business sector. The purchase price amounted to US$ 169 million (€ 161 million). The purchase price allocation had not been completed by December 31, 2016; therefore, the acquired assets and liabilities were measured at preliminary carrying values in 2016. The corresponding adjustments to the year-earlier figures in the consolidated balance sheet due to the completed purchase price allocations are presented under ‟Adjustment of the consolidated balance sheet for 2016 due to the completion of the purchase price allocation in 2017”. The acquired assets and liabilities were measured at fair values in the balance sheet as follows:

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€ million Fair values on the acquisition date
Non-current assets  
Other intangible assets (excluding goodwill) 56
Property, plant and equipment 2
Other non-current assets 1
  59
Current assets  
Cash and cash equivalents 4
Inventories 6
Receivables 5
Other current assets 1
  15
Assets 75
   
Non-current liabilities  
Deferred tax liabilities 4
4
Current liabilities  
Other current liabilities and provisions 3
3
Liabilities 8
 
Acquired net assets 67
 
Purchase price for the acquisition of shares 161
Positive difference (goodwill) 94

The most significant impact of the purchase price allocation resulted from the remeasurement of customer-related and technology-related intangible assets which are amortized over a period of 13 years.

The positive difference of € 94 million was recognized as goodwill. This comprised anticipated synergies from the integration of BioControl into the Life Science business sector as well as intangible assets that are not recognizable, such as the expertise of the workforce. Goodwill is allocated to the Life Science business sector and is deductible for tax purposes.

Costs of € 4 million directly related to the acquisition of the company were incurred almost in full in 2016 and were recorded under other operating expenses.

Within the scope of the acquisition, no contingent consideration was agreed upon which Merck would possibly have to pay in the future. The selling shareholders did not contractually indemnify Merck for the outcome of a contingency or uncertainty related to the acquired assets or liabilities.

The development of goodwill, which is carried in U.S. dollars, during the period from December 31, 2016 to December 31, 2017 was as follows:

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€ million Development of goodwill
Goodwill on December 31, 20161 94
Exchange rate effects – 9
Goodwill on December 31, 2017 85
1
Previous year’s figure has been adjusted.

No material contingent liabilities were identified in the course of the preliminary purchase price allocation.

Adjustment of the consolidated balance sheet for 2016 due to the completion of the purchase price allocation in 2017

The purchase price allocation for BioControl was completed in 2017.

The values in the consolidated balance sheet as of December 31, 2016 were retroactively adjusted as follows:

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Previous-Year Adjustment

  Dec. 31, 2016
€ million
Pre adjustment BioControl Systems, Inc. Post adjustment
Non-current assets 30,582 7 30,589
of which:      
Goodwill 15,064 – 49 15,015
Other intangible assets 9,925 55 9,980
Property, plant and equipment 4,230 1 4,231
Unadjusted non-current assets 1,362 1,362
     
Current assets 7,670 7,670
of which:      
Inventories 2,607 2 2,609
Other current assets 674 – 2 672
Unadjusted current assets 4,389 4,389
     
Total assets 38,251 7 38,258
     
Total equity 14,050 14,050
     
Non-current liabilities 15,115 4 15,119
of which:      
Deferred tax liabilities 2,720 4 2,724
Unadjusted non-current liabilities 12,395 12,395
     
Current liabilities 9,086 3 9,089
of which:      
Other current liabilities 1,947 3 1,950
Unadjusted current liabilities 7,139 7,139
     
Total equity and liabilities 38,251 7 38,258

Divestment of the Biosimilars business

On August 31, 2017, Merck completed the divestment of the Biosimilars business to subsidiaries of Fresenius SE & Co. KGaA. Since fiscal 2016, the Biosimilars business, which is part of the Healthcare business sector, had been reported as a disposal group and consists of allocable goodwill, inventories, property, plant and equipment, pension obligations, and intangible assets. In addition to the divestment of the business activities, the contract parties entered into supply and services agreements, which include drug development support and manufacturing services.

As compensation for the sale of the business activities, Merck received an upfront payment of € 156 million. According to the agreed terms of the transaction, Merck is entitled to future milestone payments of up to € 497 million, which will partly be covered by services to be performed, as well as tiered royalties on product sales. Additionally, Merck received an advance payment of € 45 million for services to be performed at short notice. As of 2018, Merck will receive further payments for services performed, partly from future milestone payments. The fair values determined by an independent external expert for the contingent consideration components of the business activities being divested were classified as available-for-sale financial assets. A sensitivity analysis of the measurement of the contingent consideration can be found in Note (6) ‟Management judgments and sources of estimation uncertainty”. The calculated disposal gain amounted to € 319 million and was recorded under other operating income. Revenue from the provision of services is mainly recorded as part of net sales.

(5) Collaborations of material significance

Strategic alliance with Pfizer Inc., USA, to co-develop and co-commercialize active ingredients in immuno-oncology

On November 17, 2014 Merck formed a global strategic alliance with Pfizer Inc., USA, (Pfizer) to co-develop and co-commercialize the anti-PD-L1 antibody avelumab. In 2017, this antibody was approved for the first time under the trade name Bavencio® for the treatment of patients with metastatic Merkel cell carcinoma (in the United States, the European Union, Iceland, Japan, Canada, Liechtenstein, Norway, and Switzerland) as well as patients with locally advanced or metastatic urothelial cancer (in the United States). This antibody is also being studied in multiple clinical trials as a potential treatment for further tumor types. The active ingredient is to be developed as a single agent as well as in various combinations with a broad portfolio of approved and investigational active ingredients. As part of the strategic alliance, the two companies have combined resources and expertise to also co-develop and co-commercialize Pfizer’s anti-PD-1 antibody. The overriding objective of the strategic alliance is sharing the development risks and to accelerate the two companies’ presence in immuno-oncology.

According to the collaboration agreement, during the development period each company will bear one-half of the development expenses. In the commercialization phase, Merck realizes the vast majority of sales from the commercialization of Bavencio® while Pfizer realizes the vast majority of sales from the commercialization of its anti-PD-1 antibody. At the same time, Merck and Pfizer evenly split defined income and expense components. The execution of the collaboration agreement is not being structured through a separate vehicle. Under the terms of the agreement, in 2014 Pfizer made an upfront cash payment of US$ 850 million (€ 678 million) to Merck after the closing. Pfizer also committed to make further payments of up to US$ 2 billion to Merck subject to the achievement of defined regulatory and commercial milestones. Based on the collaboration agreement, Merck additionally received the right to co-promote for multiple years Xalkori® (crizotinib), a kinase inhibitor indicated for the treatment of patients with metastatic non-small cell lung cancer (NSCLC) whose tumors are anaplastic lymphoma kinase (ALK)-positive. In the United States and Europe, Xalkori® is also indicated for the treatment of metastatic NSCLC in patients whose tumors are ROS1-positive. During co-promotion of Xalkori®, Merck receives from Pfizer a profit share, which is reported in net sales. In 2017, this profit share income amounted to € 72 million (2016: € 64 million). At initial recognition, the right was measured at fair value by an independent external expert using the multi-period excess earnings method. The right was capitalized when it was granted and is being amortized over the term of the agreement. The residual book value of this intangible asset of December 31, 2017 was € 93 million (December 31, 2016: € 153 million). The need to recognize an impairment loss arose for Xalkori® in both 2017 and 2016. More information on the impairments recognized can be found in Note (6) ‟Management judgments and sources of estimation uncertainty.”

On the date of the closing of the collaboration agreement, both the upfront payment received and the value of the right to co-promote Xalkori® were recognized in the balance sheet as deferred income under other liabilities. Both amounts are being recognized as income over the expected period during which Merck is to meet certain obligations and will be presented under other operating income (2017: € 191 million/2016: € 191 million). More information on the exercise of management judgments and estimation uncertainties in this regard can be found in Note (6) ‟Management judgments and sources of estimation uncertainty.” In fiscal 2017, Merck generated sales of € 21 million with Bavencio® (2016: € 0 million), recorded research and development expenses of € 264 million (2016: € 245 million) and received milestone payments amounting to € 124 million (2016: € 0 million), which were recorded under other operating income.

Agreement with Bristol-Myers Squibb Company, USA for the co-commercialization of Glucophage® in China

In March 2013, Merck established an agreement with Bristol-Myers Squibb Company, USA, (BMS) for the co-commercialization of the antidiabetic agent Glucophage® (active ingredient: metformin hydrochloride) for the treatment of type 2 diabetes in China. Based on this agreement, as of fiscal 2017 Merck took over the exclusive distribution of Glucophage® in China. Instead of commission income, Merck has recorded sales of Glucophage in China and has made license payments to BMS since then. In fiscal 2017, Merck generated sales of € 279 million with Glucophage® in China (2016: commission income amounting to € 104 million).

Agreement with Intrexon Corporation, USA, on the joint development and COMMERCIALIZATION of CAR-T cancer therapies

In March 2015, Merck and Intrexon Corporation, USA, entered into an exclusive strategic collaboration and license agreement to develop and commercialize Chimeric Antigen Receptor T-cell (CAR-T) cancer therapies. The agreement provided Merck exclusive access to Intrexon’s proprietary and complementary suite of technologies to engineer T-cells with optimized and inducible gene expression. Intrexon will be responsible for all platform and product developments until the investigational new drug application is submitted for regulatory approval. Merck will select targets of interest for which CAR-T products will be developed. Merck will also lead the regulatory submission process and pre-submission interactions with the regulatory authorities, as well as clinical development and commercialization. Intrexon received an upfront payment of US$ 115 million. This amount was recognized as part of intangible assets not yet available for use (carrying amount as of December 31, 2017: € 104 million/December 31, 2016: € 104 million). For the first two targets of interest selected by Merck, Intrexon will receive research funding and is eligible to receive up to US$ 826 million development, regulatory and commercial milestones, as well as tiered royalties on product sales. In addition, Intrexon is also eligible to receive further payments upon achievement of certain technology development milestones.

Development agreement with Avillion LLP, United Kingdom, to develop Merck’s anti-IL-17 A/F Nanobody®

On March 30, 2017, Merck announced an agreement with a subsidiary of Avillion LLP, London, United Kingdom (Avillion), to develop the anti-IL-17-A/F-Nanobody® M1095. Merck acquired full, exclusive rights to anti-IL-17 A/F Nanobody® through a global development and commercialization license from Ablynx nv, Ghent, Belgium, in 2013. This Nanobody® is an investigational therapy which has completed Phase I development. As part of the cooperation, Avillion will be responsible for developing anti-IL-17 A/F Nanobody® from Phase II through Phase III in plaque psoriasis. Avillion will also finance the clinical program through to regulatory submission. During the development stages, Merck recognizes a financial liability for potential repayment obligations to Avillion and records a corresponding expense as research and development costs.

Immuno-oncology collaboration withF-star Delta Ltd., United Kingdom

On June 4, 2017, Merck announced a strategic collaboration with F-star Delta Ltd, Cambridge, United Kingdom (F-star), for the development and commercialization of bispecific immuno-oncology antibodies. Merck has the option, upon delivery of pre-defined data packages by F-star, to fully acquire the company that owns five bispecific programs, including the preclinical lead asset FS118. In return, Merck made upfront payments to F-star and its shareholders totaling € 60 million, which were capitalized in 2017. Moreover, payments to finance R&D and for the achievement of certain milestones in an amount totaling up to € 55 million will be made during the first two years. The milestone payments will be capitalized when they are incurred. R&D financing will be recorded under research and development expenses. If the option is exercised and defined milestones are reached, Merck will incur further payment obligations of up to € 715 million.

(6) Management judgments and sources of estimation uncertainty

The preparation of the consolidated financial statements requires Merck to make discretionary decisions and assumptions as well as estimates to a certain extent. The discretionary decisions, assumptions relating to the future and sources of estimation uncertainty described below are associated with the greatest potential effects on these consolidated financial statements.

Recognition and measurement of assets, liabilities and contingent liabilities acquired in the context of business combinations

The recognition and measurement of assets, liabilities and contingent liabilities at fair value during purchase price allocations involve the use of estimates. The expertise of external valuation experts is normally obtained here. The fair values of the assets and liabilities recognized as part of the purchase price allocations for BioControl Systems, Inc., USA, Grzybowski Scientific Inventions, USA, as well as Natrix Separations, Inc., Canada, can be found in Note (4) ‟Acquisitions and divestments”.

Contingent consideration

To the extent that, in the context of the divestment or the acquisition of businesses, contingent consideration is contractually agreed with the acquirer or seller, the fair value of the transaction is recognized in the balance sheet as a financial asset classified as available for sale or financial liability. As of December 31, 2017, Merck reported financial assets from contingent consideration in the amount of € 277 million (December 31, 2016: € 51 million) and financial liabilities from contingent consideration amounting to € 3 million (December 31, 2016: € 1 million). The assets mainly were based on contractual entitlements from potential future milestone payments and royalties in connection with the disposal of the Biosimilars business in 2017 as well as the disposal of the Kuvan® business in 2016. The determination of the fair value of contingent consideration is, to large extent, subject to judgment. The most significant parameters for the measurement of contingent consideration are the estimated probabilities of success of the individual milestone events, the sales planning assumed to derive the royalties as well as the discount factor used. Any change in these material input factors may lead to significant changes in the value of the recognized financial assets or financial liabilities.

The most significant contingent consideration is the future purchase price claim from the disposal of the Biosimilars business (see Note (4) ‟Acquisitions and divestments”). It was determined by an external expert and amounted to € 228 million. If, in the context of determining the fair value of this contingent consideration at the date of transaction, the probability of approval as well as the discount factor of the three major development programs had been estimated to be lower or higher to the extent presented below, this would have led to the following changes in the measurement and the corresponding effects on the profit before tax:

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Change in probability of regulatory approval
€ million – 10% unchanged 10%
Change of discount rate 6.0% – 42 6 54
unchanged (6.5%) – 47 47
7.0% – 52 – 6 39

Sales deductions

Merck grants its customers various kinds of rebates and discounts. In addition, expected returns, state compulsory charges and rebates from health plans and programs are also deducted from sales.

The most significant portion of these deductions from sales was attributable to the Healthcare business sector. The most substantial sales deductions in this business sector relate to government rebate programs in North America.

Insofar as sales deductions were not already made on payments received, Merck determined the level of sales deductions on the basis of current experience and recognizes them as a liability (carrying amount on December 31, 2017: € 435 million/December 31, 2016: € 443 million). The sales deductions reduce gross sales. Adjustments of liabilities can lead to subsequent increases or reductions in net sales in later periods.

Impairment tests of goodwill and intangible assets not yet available for use

The goodwill (carrying amount as of December 31, 2017: € 13,582 million/December 31, 2016: € 15,015 million1) and other intangible assets not yet available for use (carrying amount as of December 31, 2017: € 421 million/December 31, 2016: € 181 million) reported in the consolidated financial statements are tested for impairment at least once a year or when a triggering event arises.

Owing to the termination of development projects in the Healthcare business sector, in 2017 impairment losses of other intangible assets not yet available for use were recorded in the amount of € 17 million (2016: € 12 million).

1 Previous year’s figure has been adjusted, see Note (4) ‟Acquisitions and divestments”.

The carrying amounts of goodwill were allocated to the following cash-generating units or groups of cash-generating units on which level the impairment tests were performed:

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€ million Dec. 31, 2017 Dec. 31, 2016
Biopharma 1,534 1,560
Consumer Health 251 251
Life Science1 10,519 11,752
Performance Materials 1,278 1,452
Goodwill1 13,582 15,015
1
Previous year’s figures have been adjusted, see Note (4) ‟Acquisitions and divestments”.

The changes in the carrying amounts over the previous year were mainly attributable to currency effects.

The identified cash-generating units or groups of cash-generating units represented the lowest level at which goodwill was monitored by management.

As in 2016, no impairment losses for goodwill were recorded in the year under review.

When conducting the impairment tests the following parameters were used:

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Measurement basis Value in use
Impairment test level Biopharma (including Allergopharma; in 2016 also including Biosimilars1)
Consumer Health
Life Science
Performance Materials
Planning basis Most recent financial medium-term planning approved by the Executive Board and used for internal purposes
Detailed planning period 4 years
Key assumptions Net cash flows
Long-term growth rate after the detailed planning period
Discount rate after tax (weighted average cost of capital after tax – WACC)
Determination of the value of the key assumptions Net cash flows
  • Sales growth
    Based on internal planning, taking into consideration internal and external market information and market estimations, e.g. regarding market shares, excluding approvals of new compounds from the development pipeline and other expansion investments
  • Profit margins
    Based on past experiences, adjusted for expected changes
    Long-term growth rate after the detailed planning period
    Based on long-term inflation expectations and expected long-term sector growth
    Discount rate after taxes (weighted average cost of capital after tax – WACC)
  • Cost of equity
    Risk-free interest rate: Derived from the returns of long-term government bonds
    Beta factor: Derived from the respective peer group
    Market risk premium: Range as recommended by the Technical Committee for Business Valuation and Commerce of the Institute of Public Auditors in Germany (Institut der Wirtschaftsprüfer e.V. – IDW)
  • Cost of debt and capital structure
    Derived from market data and the respective peer group
1
Biosimilars was not yet reported as a disposal group when the impairment test was performed.

The long-term growth rates and weighted average costs of capital (WACC) used to conduct the goodwill impairment tests were as follows:

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Long-term growth rate Cost of capital after tax Cost of capital before tax
  2017 2016 2017 2016 2017 2016
Biopharma 0.00% 0.00% 6.7% 6.1% 8.9% 8.1%
Consumer Health 2.00% 2.00% 6.6% 5.9% 8.2% 7.2%
Life Science 1.75% 1.75% 6.8% 6.1% 8.4% 7.5%
Performance Materials 0.50% 0.50% 5.9% 6.1% 7.5% 7.9%

Net cash flows were discounted using cost of capital after tax. The aforementioned cost of capital before tax was subsequently derived iteratively. All of the aforementioned assumptions are considered a source of estimation uncertainty due to their inherent uncertainty.

In all the impairment tests performed, the recoverable amount was more than 10% higher than the carrying amount of the respective cash-generating unit or group of cash-generating units. Irrespective of this, the planning data used were checked for plausibility against externally available forecasts and the recoverable amounts determined were validated using valuation multiples based on peer group information. In addition, sensitivity analyses of the key assumptions were performed as part of the impairment tests. Overall, no change of a significant assumption deemed possible by management would have resulted in an impairment. The following table presents the amount by which key assumptions would have to change before an impairment would need to be recognized as a result of the impairment tests:

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Decrease in long-term growth rate Increase in cost of capital after tax Decrease in net cash flows
2017 2016 2017 2016 2017 2016
in percentage points in percentage points in %
Biopharma > 2.0 > 2.0 > 2.0 > 2.0 > 5% > 5%
Consumer Health > 2.0 > 2.0 > 2.0 > 2.0 > 5% > 5%
Life Science > 2.0 > 2.0 > 1.5 > 1.5 > 5% > 5%
Performance Materials > 2.0 > 2.0 > 2.0 > 2.0 > 5% > 5%

Determination of the amortization of intangible assets with finite useful lives

In addition to goodwill and intangible assets not yet available for use, Merck has a significant amount of intangible assets with finite useful lives. This relates in particular to intangible assets from customer relationships, brands, trademarks, marketing authorizations, patents, licenses and similar rights (carrying amount as of December 31, 2017: € 7,549 million/December 31, 2016: € 9,516 million1). Substantial assumptions and estimates are required to determine the appropriate level of amortization of these intangible assets. This related in particular to the determination of the underlying remaining useful life, which Merck reviews regularly and adjusts if necessary. Merck considers factors including the typical product life cycles for each asset and publicly available information about the estimated useful lives of similar assets.

If the amortization of intangible assets from customer relationships, brands, trademarks, marketing authorizations, patents, licenses and similar rights had been 10% higher, for example due to shortened remaining useful lives, profit before tax would have been € 120 million lower in fiscal 2017 (2016: € 122 million).

In fiscal 2017, a reduction of the useful life of the intangible asset reported in connection with the drug Rebif® by one year would have lowered profit before tax by € 184 million (2016: € 123 million). An extension of the useful life by one year would have increased profit before tax by € 92 million (2016: € 74 million).

Research and development collaborations as well as in- and out-licensing of intangible assets

Merck is regularly a partner of research and development collaborations with research institutions, biotechnology companies or other contract parties. These collaborations are aimed at developing marketable products. Merck also enters into in-licensing agreements regarding intellectual property of contract partners. Such agreements typically involve making upfront payments and payments for the achievement of certain milestones related to development and commercialization. In this context, Merck has to judge to what extent upfront or milestone payments represent remuneration for services received (research and development expense) or whether such payments result in an in-licensing of an intangible asset that has to be capitalized. This assessment is regularly subject to judgment.

Merck regularly receives upfront and milestone payments as part of research and development collaborations or out-licensing agreements. In this context, income may only be recognized if Merck has transferred all material risks and rewards of an intangible asset to the acquirer, has no interest in the remaining business activities and has no material continuing commitment. If these criteria are not deemed to be met, the received payments are deferred and recognized over the period in which Merck is expected to fulfill its performance obligations. Both the assessment of the criteria for income recognition and the determination of the appropriate period during which income is recognized are subject to judgment.

If the consideration that was received as part of the strategic alliance with Pfizer Inc., USA, in November 2014 and deferred as a liability had been recognized in the income statement over a shorter period reduced by one year, in 2017 this would have increased other operating income and thus profit before tax would have increased by € 96 million (2016: € 64 million). Recognition over a period extended by one year would have lowered other operating income and profit before tax by € 48 million (2016: € 38 million).

Identification of impairment or reversals of impairment of non-financial assets

Discretionary decisions are required in the identification of objective evidence of impairment as well as in the identification of a reversal of impairment of other intangible assets and property, plant and equipment. As of December 31, 2017, the carrying amounts of these assets totaled € 12,829 million (December 31, 2016: € 14,211 million1). External and internal information is used to identify indications of impairment and reversals of impairment. For example, the approval of a competing product in the Healthcare business sector or the closure of a site can be an indicator of impairment.

In 2017 impairment losses for the biopharmaceutical production facility in Corsier-sur-Vevey, Switzerland, were reversed in the amount of € 69 million to depreciated historical cost. The impairment loss reversal was recorded under other operating income and allocated to the Healthcare business sector. The impairment loss reversal was recorded under other operating income and allocated to the Healthcare business sector. The decision to reverse the impairment loss was due to improved expectations for the capacity utilization of the production facility, particularly owing to the recent approvals of the immuno-oncology medicine Bavencio®, which is to be produced in this facility. An impairment loss of € 165 million was originally recognized for the facility in 2011.

In addition, the intangible asset in connection with the co-promotion right for Xalkori® (crizotinib), a medicine to treat patients with ALK-positive metastatic non-small cell lung cancer, was subjected to an impairment test, as in the prior year owing to negative developments in the market environment. This test led to an impairment loss of € 33 million (2016: € 71 million) on the intangible asset, which was reported under other operating expenses. Within the scope of the impairment test, the recoverable amount was determined using a discount rate before tax of 7.5%. This included an asset-specific risk premium.

Impairment of financial assets

On every balance sheet date, Merck reviews whether there is any objective evidence that a financial asset is impaired and, if this is the case, recognizes allowances to the extent estimated as necessary. Particularly important in this context are allowances on trade accounts receivable, whose carrying amount was € 2,923 million as of December 31, 2017 (December 31, 2016: € 2,889 million).

Key indicators for the identification of impaired receivables and the subsequent recoverability tests are, in particular, payment default or delay in the payment of interest or principal, negative changes in economic framework conditions as well as considerable financial difficulties of a debtor. These estimates are discretionary.

Other provisions and contingent liabilities

As a global company for high-tech products, Merck is exposed to a multitude of litigation risks. In particular, these include risks from product liability, competition and antitrust law, pharmaceutical law, patent law, tax law and environmental protection. Merck is engaged in legal proceedings and official investigations, the outcomes of which are uncertain. A description of the most important legal matters as of the balance sheet date can be found in Notes (27) ‟Other provisions” and (40) ‟Contingent liabilities”. The provisions recognized for legal disputes mainly relate to the Healthcare and Performance Materials business sectors and amounted to € 526 million as of the balance sheet date (December 31, 2016: € 483 million).

To assess a reporting obligation in relation to provisions and to quantify pending outflows of resources, Merck draws on the knowledge of the legal department as well as other outside counsel. In spite of this, both the assessment of the existence of a present obligation and the estimate of the probability of a future outflow of resources are highly subject to uncertainty. Equally, the measurement of provisions is to be considered a major source of estimation uncertainty.

To a certain extent, Merck is obliged to take measures to protect the environment and reported provisions for environmental protection of € 137 million as of December 31, 2017 (December 31, 2016: € 142 million). The underlying obligations were located mainly in Germany and Latin America. Provisions were recognized primarily for obligations from soil remediation and groundwater protection in connection with the discontinued crop protection business.

The calculation of the present value of the future settlement amount requires, among other things, estimates of the future settlement date, the actual severity of the identified contamination, the applicable remediation methods, the associated future costs, and the discount rate. The measurement is carried out regularly in consultation with independent experts. The determination of the future settlement amount of the provisions for environmental protection measures is subject to a considerable degree of uncertainty.

In the event of the discontinuation of clinical development projects, Merck is regularly required to bear unavoidable subsequent costs for a certain future period of time. The measurement of these provisions requires estimates regarding the length of time and the amount of the follow-on costs.

Apart from provisions, contingent liabilities are also subject to estimation uncertainties and discretionary judgments. Accordingly, contingent liabilities from legal and tax disputes are subject to the same estimation uncertainties and discretionary judgment as provisions for litigation. Therefore, the existence and the amount of the outflow of resources, which is not remote, are subject to estimation uncertainties similarly to the date on which a potential obligation arises.

Share-based compensation programs

Provisions for employee benefits included amongst others obligations from long-term variable compensation programs in the form of cash-settled share-based compensation programs. The amounts disbursed to the beneficiaries largely depend on long-term indicators of company performance and the share price development. The strongest influence comes from price fluctuations of Merck share in relation to the DAX®. More information can be found in Notes (27) ‟Other provisions” and (69) ‟Share-based compensation programs”. The amount recognized in the consolidated balance sheet as of December 31, 2017, as non-current provisions, which comprises the 2016 and 2017 tranches from long-term variable compensation programs, amounted to € 22 million. The following overview shows the amounts by which the non-current provisions would have been impacted by changes in the DAX® (increase or decrease by 10%, respectively) and the closing price of Merck shares, as of December 31, 2017 (increase or decrease by 10%, respectively). The amounts stated would have led to a corresponding reduction or increase in profit before tax.

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€ million Increase (+) /decrease (–)in the provision
Change in Merck share price 10% 15
– 10% – 2
Change in DAX® 10%
– 10% 16

Sensitivities were determined in general on the basis of the respective observed parameters, with all other measurement assumptions remaining unchanged. The 2015 tranche reported under current provisions will not be subject to any value fluctuations between December 31, 2017 and the payout date and was therefore not included in the sensitivity analysis.

Provisions for pensions and other post-employment benefits

Merck maintains several defined benefit pension plans, particularly in Germany, Switzerland and the United Kingdom. The amount recorded in the consolidated balance sheet for provisions for pensions and other post-employment benefits amounted to € 2,257 million as of the balance sheet date (December 31, 2016: € 2,313 million). The present value of the defined benefit obligations was € 4,707 million as of December 31, 2017 (December 31, 2016: € 4,698 million). The determination of the present value of the obligation from these defined benefit pension plans primarily requires discretionary judgment as regards the selection of methods to determine discount rates as well as estimates of future salary increases and future pension increases. The actuarial assumptions which are used as the basis for the calculation of the defined benefit obligation, e.g. discount rates, salary and pension trends, which were used to calculate the benefit obligation, were determined on a country-by-country basis in line with the economic conditions prevailing in each country; the latest country-specific actuarial mortality table was used in each case. The respective discount rates are generally determined on the basis of the returns on high-quality corporate bonds issued with adequate maturities and currencies. For euro-denominated obligations, bonds with ratings of at least ‟AA” from one of the three rating agencies Standard & Poor’s, Moody’s or Fitch, and a euro swap rate of adequate duration served as the basis for the data.

The following overview shows how the present value of all defined benefit obligations would have been impacted by changes to relevant actuarial assumptions.

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€ million Dec. 31, 2017 Dec. 31, 2016
Increase (+)/decrease (–) in the present value of all defined benefit ohligations if
the discount rate is 50 basis points higher – 438 – 441
the discount rate is 50 basis points lower 508 518
the expected rate of future salary increases is 50 basis points higher 155 160
the expected rate of future salary increases is 50 basis points lower – 133 – 138
the expected rate of future pension increases is 50 basis points higher 256 280
the expected rate of future pension increases is 50 basis points lower – 198 – 209

To determine the sensitivities, in principle each of the observed parameters was varied while keeping the measurement assumptions otherwise constant. The amounts for social security vary in line with the salary trend. Further information on the existing pension obligations is provided in Note (26) ‟Provisions for pensions and other post-employment benefits” and under ‟Accounting and measurement policies” in Note (67) ‟Provisions for pensions and other post-employment benefits”.

Income taxes

The calculation of the reported assets and liabilities from current and deferred income taxes requires extensive discretionary judgments, assumptions and estimates. Income tax liabilities were € 1,059 million as of December 31, 2017 (December 31, 2016: € 883 million). The carrying amounts of deferred tax assets amounted to € 1,106 million (December 31, 2016: € 1,013 million), the carrying amounts of deferred tax liabilities were € 1,489 million as of December 31, 2017 (December 31, 2016: € 2,724 million1).

The recognized income tax liabilities and provisions are partially based on estimates and interpretations of tax laws and ordinances in different jurisdictions.

With regard to deferred tax items, there are degrees of uncertainty concerning the date on which an asset is realized or a liability settled and concerning the tax rate applicable on this date. This particularly relates to deferred tax liabilities recognized in the context of the acquisitions of the Sigma-Aldrich Corporation, the Millipore Corporation, Serono SA, and AZ Electronic Materials S.A. The recognition of deferred tax assets from loss carryforwards requires an estimate of the probability of the future realizability of loss carryforwards. Factors considered in this estimate are results history, results planning and the existing tax planning of the respective Group company.

More information on management judgments made in connection with the accounting treatment of the U.S. tax reform can be found in Note (14) ‟Income Taxes”.

Assets held for sale, disposal groups and discontinued operations

The assessment as to when a non-current asset, disposal group or discontinued operation meets the prerequisites of IFRS 5 for a classification as ‟held for sale” is subject to significant discretionary judgment. Even in the case of an existing management decision to review a disposal, an assessment subject to uncertainties has to be made as to the probability that a corresponding disposal will occur during the year or not.

On September 5, 2017, Merck announced that it is preparing strategic options for its Consumer Health business. Potential candidates were approached and, in November 2017, they were sent information about the Consumer Health business. They were requested to submit non-binding offers in the course of December 2017. The analysis of these offers had not been completed by December 31, 2017. Based on these offers, the Executive Board is currently analyzing which strategic options are to be pursued. In addition, if a disposal is intended, the structure of the business to be potentially divested has to be defined. The analysis of the strategic options had not been completed as of the date of preparation.

Only on the basis of this information will candidates be able to submit binding offers that can be analyzed by Merck based on its price expectations. Only in the case of subsequent negotiations with potential candidates will it be possible to define the transaction in more specific terms, i.e. material changes are not unlikely until negotiations are completed.

Against this background, the Executive Board’s view as of December 31, 2017 is that a disposal of the Consumer Health business within the next 12 months cannot be regarded as highly likely.

The carrying amount of the assets of the Consumer Health business as of December 31, 2017 was € 647 million. The corresponding liabilities amounted to € 192 million as of December 31, 2017. In fiscal 2017, the Consumer Health business generated net sales of € 911 million and profit after tax of € 99 million (calculated on the basis of the operating result (EBIT) and the income tax rates applicable in the individual jurisdictions).

Other judgments, assumptions andsources of estimation uncertainty

Merck makes other judgments, assumptions and estimates in the following areas:

  • Cash flow hedging for highly probable forecast transactions
  • Determination of the fair value of financial instruments classified as available-for-sale and of derivative financial instruments
  • Determination of the fair value of plan assets.