Risks and opportunities are an integral part of our entrepreneurial activities. We have put responsibilities, processes and tools in place to identify risks at an early stage and mitigate them by taking appropriate action. Within the company, risk and opportunity management is a core component of our internal business planning.
Risk and opportunity management
We operate in a complex, global business world and is exposed to a wide range of external and internal influences. Every business decision is therefore based on the associated risks and opportunities.
In our internal risk reporting, risks are defined as potential future events or developments that could lead to a negative deviation from our (financial and non-financial) targets. In parallel, opportunities imply a positive deviation from our planned targets. Identified future events and expected developments are taken into account in internal planning, provided that it can be assumed that their occurrence is likely in the planning period. The risks and opportunities presented in the risk and opportunities section are those potential future events or developments that could respectively lead to a negative or positive deviation from existing plans.
Risk management process
The objective of our risk management activities is to identify, assess, and manage risks early and to implement appropriate measures to reduce them. The responsibilities, objectives, and processes of risk management are described in our internal risk management guidelines. The business heads, managing directors of our subsidiaries, and the heads of Group functions are specified as employees with responsibility for risks. The risk owners regularly assess their risk status and report their risk portfolio to Risk Management. We use special risk management tools to support these activities.
In this context, risk-mitigating measures are evaluated. The effectiveness of these measures and the planned implementation time frame are monitored and the residual risk is presented in the internal risk report as net risk.
Group Controlling & Risk Management forms the organizational framework for risk management and reports directly to the Group Chief Financial Officer. Within the scope of audits, Group Internal Auditing regularly reviews the performance of risk management processes within the units and, at the same time, the communication of relevant risks from the operating businesses to Group Risk Management. Furthermore, the external auditor reviews the risk early warning system in the course of its annual audit of the financial statements. Group Risk Management uses the information reported to determine the current risk portfolio for the Group, presenting this in a report to the Executive Board, the Supervisory Board, and relevant Committees with detailed explanations twice per year. This also encompasses a quantitative aggregation of risks at Group level, using a Monte Carlo simulation. Furthermore, significant changes in the assessment of the risks already known and new significant risks can be reported at any time and are communicated to the Executive Board on an ad-hoc basis.
For the internal bottom-up risk reporting process, a minimum threshold of a potential negative impact on our EBITDA pre is set at the level of € 10 million in the standard cycle and € 25 million in the ad-hoc process. The timeframe applied for internal risk reporting is five years. It can go beyond five years in special cases, e.g., for regulatory risks related to climate change. The outlined risks and their evaluation are based on respective annual values in the reporting timeframe. The assessment of the risks presented relates to December 31, 2021. There were no relevant changes after the balance sheet date that would have necessitated an amended presentation of the risk situation of the Group.
Opportunity management process
The opportunity management process is integrated into our internal controlling processes and is carried out in the operating units on the basis of the Group strategy. The businesses analyze and assess potential market opportunities as part of strategy and planning processes. In this context, investment opportunities are examined and prioritized primarily in terms of their potential value proposition, in order to ensure an effective allocation of resources. We specifically invest in growth markets to leverage the opportunities of dynamic development and customer proximity at a local level.
If the occurrence of the identified opportunities is rated as likely, they are incorporated into the business plans and the short-term forecasts. Trends going beyond this, or events that could lead to a positive development in the net assets, financial position, and results of operations, are presented in the following report as opportunities. These could have a positive effect on our medium-term prospects.
Risk and opportunity assessment
Risks
The significance of risks is calculated on the basis of their potential negative impact on the forecasted financial targets in conjunction with the probability of occurrence of the respective risk.
The underlying scales for measuring these factors are shown below:
Probability of occurrence |
|
Explanation |
|---|---|---|
< 1% |
|
Highly improbable |
1 – 5% |
|
Improbable |
5 – 20% |
|
Possible |
20 – 50% |
|
Likely |
> 50% |
|
More than likely |
Degree of impact |
|
Explanation |
|---|---|---|
> € 500 million |
|
Critical negative impact on the net asset, financial position, and results of operations |
€ 100 – 500 million |
|
Substantial negative impact on the net asset, financial position, and results of operations |
€ 25 – 100 million |
|
Moderate negative impact on the net asset, financial position, and results of operations |
€ 10 – 25 million |
|
Minor negative impact on the net asset, financial position, and results of operations |
< € 10 million |
|
Immaterial negative impact on the net asset, financial position, and results of operations |
Opportunities
Opportunities are assessed in their respective specific business environment. General measures of the business functions are quantified during operational planning, usually in relation to sales, EBITDA pre, and operating cash flow. Net present value, internal rate of return, the return on capital employed (ROCE), and the payback period of the investment are primarily used to assess and prioritize investment opportunities. We use these indicators to assess the opportunities arising from the investment projects. Similarly, scenarios are frequently set up to simulate the influence of possible fluctuations and changes in the respective parameters on results. An overarching, systematic classification of the probability of occurrence and impact of opportunities is not carried out.
Internal control system for the (Group) accounting process
The objective of the internal control system for the accounting process is to implement controls that provide assurance that the financial statements are prepared in compliance with the relevant accounting laws and standards. This system covers measures designed to ensure the complete, correct, and timely conveyance and presentation of information that is relevant for the preparation of the Consolidated Financial Statements and the Combined Management Report.
Key tools
Our internal control system for financial reporting is based on the COSO framework, a globally recognized standard divided into five components: control environment, risk assessment, control activities, information and communication, as well as monitoring activities. Each of these components is regularly documented, tested and/or assessed.
The internal control system aims to ensure the accuracy of the consolidated accounting process through functioning internal controls with reasonable assurance. The Group Accounting function centrally steers the preparation of the Consolidated Financial Statements of Merck KGaA, Darmstadt, Germany, as the parent company of the Group. This Group function defines the reporting requirements that all our subsidiaries must meet. At the same time, this function steers and monitors the scheduling and process-related requirements of the Consolidated Financial Statements. Group Accounting centrally manages all changes to the equity holding structure and correspondingly adapts the Group’s scope of consolidation. The proper elimination of intragroup transactions within the scope of the consolidation process is ensured. Group-wide accounting guidelines form the basis for the preparation of the statutory financial statements of the parent company and of the subsidiaries, which are reported to Group Accounting; the guidelines are adapted in a timely manner to reflect changes in the financial regulatory environment and are updated in accordance with internal reporting requirements. For special issues, such as the accounting treatment of intangible assets within the scope of company acquisitions or pension obligations, external experts are additionally involved where necessary.
The individual companies have a local internal control system within a global framework. Where financial processes are handled by a Shared Service Center, the internal control system of the Shared Service Center is additionally applied. Both ensure that accounting complies with IFRS (International Financial Reporting Standards) and with the Group accounting guidelines.
Group Accounting provides support to the local contacts and ensures a consistently high quality of reporting throughout the entire reporting process.
For Group financial reporting purposes, most of our subsidiaries use standard SAP software. Consolidation software from SAP is also used for the elimination of intragroup transactions. A detailed authorization concept ensures the separation of duties with respect to both single-entity reporting and the Consolidated Financial Statements. The accounting process is generally designed to ensure that all units involved adhere to the principle of dual control.
The operational effectiveness of our internal control system is regularly tested in the format of self-assessments by our legal entities, group functions, and shared services. The quality is systematically reviewed by a dedicated global financial control and governance team. Control deficiencies are properly recorded and, where necessary, adequate countermeasures are taken to remediate control deficiencies in a timely manner.
The overall effectiveness of our internal control system with regard to accounting and compliance with financial reporting on the part of the individual companies is confirmed by both the local managing director and the local chief financial officer by signing the single-entity reporting and a separate confirmation regarding the effectiveness of the financial control system (internal control system sign-off letter). For the accounting treatment of balance sheet items, Group Accounting closely cooperates with Group Risk Management to correctly present potential risks in the balance sheet.
All structures and processes described related to the Group accounting procedures are subject to regular review by Group Internal Auditing based on an annual audit plan set out by the Executive Board.
The results of the self-assessments, quality reviews, and internal audits are dealt with by the Executive Board, the Supervisory Board, and the Audit Committee. The internal control system at Merck KGaA, Darmstadt, Germany, makes it possible to lower the risk of material misstatements in accounting to a minimum. However, no internal control system can entirely rule out a residual risk, whatever its design.