Short overview of forms of financing
How such a large-scale project should be financed is something that has to be thought through by the decision-makers already at a very early stage. The basic forms of financing that can be considered here are:
- non-debt financing,
- debt financing,
- lease financing with the variants of
- finance leases and
- operating leases as well as
- the sale-and-lease-back model as a special form of financing.
These forms of financing can be briefly defined as follows:
(1) Non-debt financing - This can occur either in the form of internal financing via accumulated earnings (revenue reserves, retained profits), or non-cash expenses (e.g. depreciation financing), or by way of external financing via equity capital inflows from outside, thus via capital contributions from partners/shareholders or from capital increases.
(2) Debt financing - Here, the project is financed through borrowed funds, usually in the form of bank loans. To this end, besides the interest charged on loan capital during the construction phase, longer-term financing interest is also usually incurred.
(3) Operating leases - The characteristic feature here (at least in theory) is that the contractual relationship can generally be terminated (at short notice) at any time, thus no basic lease term is agreed; however, in practice, there are effectively no cases where there is no basic lease term (for the construction of a logistics centre such an operating lease model would hardly be possible and we have only briefly mentioned it here for the sake of completeness). By contrast, of the utmost importance in practical terms are the leasing decrees issued by the fiscal administration and the understanding of the terms therein (more on this subsequently under "Finance leases" and then in the next Article).
(4) Finance leases - These constitute cases of (hidden) rental arrangements that include the elements of a purchase agreement. Here, the characteristic feature is that the lease agreement is concluded for a fixed basic term during which regular cancellation is excluded. Furthermore, according to the so-called leasing decrees issued by the fiscal administration that are relevant for lease accounting, a condition that proves the existence of a finance lease is that the lease rates to be paid by the lessee during the basic term should at least cover the lessor’s acquisition and construction costs as well as all their ancillary expenses including the financing costs.
(5) The sale-and-lease-back model, in principle, constitutes a special case in lease financing where the lessor acquires the leased item not from a third party but, instead, from the lessee and then leases it back to the vendor.
In addition to these ‘pure forms’ of financing, in practice you can also frequently find mixed finance operations thus, for example, a combination of equity and debt financing.
Please note: Moreover, more specialised forms of financing also exist - often referred to as mezzanine capital - such as, for example, profit participating loans, silent partnership holdings, etc. However, for reasons of simplicity, these will not be further expounded here.
Basic recognition and measurement issues for the financial accounts
For accounting purposes, the financial accounting regulations under the Commercial Code (Handelsgesetzbuch, HGB), tax law governing German accounting treatment and the internationally focused IFRS have partly separate rules available. In the following section, for the practical case to be presented (the construction of a logistics centre), we primarily consider German regulations governing financial accounts and tax accounts; here, the German principle of Maßgeblichkeit (under which financial accounting leads tax) means that the overlap between the two sets of accounts are not insignificant.
Recognition issues - Land, buildings and operating equipment
Land has to be separately capitalised in addition to the buildings and it is not subject to any scheduled depreciation. With regards to the construction costs for a building, in the financial accounts the portion of the construction costs that relate to the building itself have to be clearly demarcated from those that relate to the operating equipment, which has to be separately capitalised. This distinction between the components of a building and the operating equipment will be important
- for depreciation (operating equipment is usually depreciated over a shorter expected useful life),
- for the amount of the assessment base for real estate transfer tax (RETT) purposes (if, in the future, the property should be the subject of a transaction that generates a RETT liability, for example, as part of a share deal that generates a RETT liability) or also
- for the extended trade tax exemption for property.
Please note: As regards the distinction between real estate and the operating equipment, it is possible to turn to the comprehensive decrees of the fiscal administration that were issued by the German federal states - these provide a good initial point of reference for practice.
Measurement – Component approach for depreciation purposes?
(1) Under German commercial law, the component approach may be used for depreciation purposes in cases where physically separable components are exchanged that are essential in relation to the entire tangible fixed asset (cf. accountancy notes from the Institute of Public Auditors in Germany [Institut der Wirtschaftsprüfer, IDW] in their (German language) opinion statement HFA RH 1.016). The component approach should be understood here to mean a method by which an asset is notionally split into its main components of differing economic useful lives in order to determine the amount of scheduled deprecation of the asset for a period as the sum of the scheduled deprecation apportioned to its individual components for a period. Here, the IDW has provided the example of a building where the roof (useful life 20 years) is depreciated separately from the rest of the building (useful life 60 years). When compared with determining scheduled deprecation for a period for an entire asset on the basis of its general overall useful life, such component-by-component depreciation leads to differing depreciation amounts and, ultimately, to a more appropriate periodisation of the expense of using the asset.
Please note: It is then however not possible to likewise treat the costs for replacing such separable components that correspond to the component-by-component depreciation as maintenance expenses but, instead, they have to be capitalised as subsequent acquisition and construction costs. For the sake of good order, it should also be noted that the asset (e.g. a building) as a unit to be reported will itself not be affected by the use of the component approach - the only thing that will change is the method for determining scheduled depreciation.
(2) In accounts prepared according to IFRS, under IAS 16.43 ff. a component approach is likewise applied within the scope of scheduled depreciation.
(3) In the tax accounts, however, component-by-component depreciation is precluded - Section 7 of the Income Tax Act (Einkommenssteuergesetz, EStG) takes into account the asset as a whole. The German principle of Maßgeblichkeit (under which financial accounting leads tax) does not apply here in view of the tax assessment reservation (Section 5(6) EStG). In the case of buildings in the business sector, tax law generally assumes a single standardised depreciation period of 33.33 years.
Please note: In view of the various priorities and alternatives with respect to financing, accounting and taxation and the interdependencies that exist between these, it is only possible to consider selected aspects here and to provide an initial overview.