Financial Accounting

What is financial accounting?

Financial accounting (German Bilanzierung) refers to the decisions by which a company's assets, liabilities and deferral items are carried into the balance sheet. Three questions have to be answered for each item: whether it is included (recognition), at what value (measurement) and at what place (presentation). Recognition and measurement are also called accounting as to principle and as to amount. In German single-entity financial statements, the benchmark is the German Commercial Code (Handelsgesetzbuch, HGB) and the principles of proper accounting (Grundsätze ordnungsmäßiger Buchführung, GoB), that is, the generally accepted rules for bookkeeping and financial statements.

Responsibility lies with the management, which prepares the annual financial statements under the HGB; for medium-sized and large corporations, an auditor audits the result. In transactions, financial accounting becomes a subject of negotiation: buyers examine it in due diligence, and purchase agreements determine the rules under which the financial statements as of closing are to be prepared.

Financial accounting under the HGB: principles of proper accounting

The GoB are partly regulated in the HGB and partly developed through case law and professional practice. For financial accounting, the following principles from Section 246 and Section 252(1) HGB shape the result above all:

• Completeness: All assets, liabilities and deferral items must be recognised unless the law provides otherwise; asset and liability items may not be offset against each other.
• Reporting date principle and clarification of conditions (Wertaufhellung): Each item is measured individually according to the conditions at the reporting date. What becomes known about these conditions up to the time of preparation must be taken into account, for example the insolvency of a customer whose payment problems already existed before the reporting date.
• Prudence: Profits are reported only when they are realised; foreseeable risks and losses must already be recorded when they threaten (realisation principle and imparity principle).
• Accrual accounting and going concern: Expenses and income belong in the year of their economic origin. Measurement is carried out on the assumption that the company continues as a going concern, which must be specifically examined where financing is not secured.
• Consistency: The recognition and measurement methods chosen must be retained (Section 246(3), Section 252(1) no. 6 HGB). Deviations are permitted only in justified exceptional cases and must be explained in the notes.

Recognition, measurement and presentation

Items eligible for recognition are above all assets that can be realised individually and liabilities that economically burden the company at the reporting date. An asset is recognised by whoever has economic control over it, even if legal ownership lies with someone else (Section 246(1) sentence 2 HGB). Examples are goods under retention of title and hire purchase. Whether such an item is recognised is governed by requirements, options and prohibitions. Recognition is prohibited, among other things, for expenses of incorporation and of raising equity (Section 248(1) HGB); provisions are permissible only for the purposes of Section 249 HGB.

On initial recognition, measurement is at acquisition or production cost (Section 255 HGB), which at the same time forms the upper limit of all later valuations; thereafter, depreciation reduces the value. Liabilities are carried in the balance sheet at their settlement amount (Section 253(1) HGB).

Presentation assigns each item to the layout of the balance sheet (Section 266 HGB) and the income statement (Gewinn- und Verlustrechnung, GuV, Section 275 HGB). It does not change the result, but it does change key figures. One example is the cost of sales method, which classifies the expenses in the income statement by function such as production, sales and administration. Whether customer service costs appear there in the cost of sales or in sales shifts the reported gross margin. Investors pay particular attention to it for software companies.

Accounting options and the distribution block

For technology companies, the option in Section 248(2) sentence 1 HGB is the most important: self-created intangible fixed assets, such as in-house software, may be capitalised. Capitalising means including the costs in the balance sheet as an asset and amortising them over the useful life instead of booking them immediately as an expense. This applies only to expenses of the development phase. Research costs remain an expense, and if the two phases cannot be reliably separated, capitalisation is ruled out (Section 255(2a) HGB). Self-created brands and customer lists can never be capitalised.

Because capitalised development costs are not a realised surplus, Section 268(8) HGB blocks distributions in this amount. After a distribution, the freely available reserves, plus profit carried forward and minus loss carried forward, must cover at least the capitalised amounts. Deducted here are the deferred tax liabilities, that is, the future tax burden that arises because the tax balance sheet does not capitalise the same costs. The same applies to a surplus of deferred tax assets. Further options concern, for example, the Disagio (a discount on the disbursement of a loan) and the scope of production costs. Often, however, questions of judgement weigh more heavily: useful lives, valuation allowances and the amount of provisions.

Financial accounting under the HGB, tax law and IFRS

For tax purposes, financial accounting means determining profit by comparison of business assets (Betriebsvermögensvergleich). For commercial traders who keep books, and thus for every GmbH (German limited liability company), Section 5 of the German Income Tax Act (Einkommensteuergesetz, EStG) applies: the tax balance sheet in principle follows the commercial balance sheet (authoritativeness principle, Maßgeblichkeitsprinzip). Freelancers who keep books, as well as farmers and foresters, determine their profit under Section 4(1) EStG, without this link. Deviations arise where tax law lays down its own rules. For example, self-created intangible assets of fixed assets may not be capitalised for tax purposes (Section 5(2) EStG), and provisions for anticipated losses are not permitted (Section 5(4a) EStG). Medium-sized and large corporations recognise deferred taxes for such differences; small ones are exempt (Section 274a HGB).

The International Financial Reporting Standards (IFRS), an international set of accounting rules, are mandatory for the consolidated financial statements of capital-market-oriented parent companies (Section 315e HGB). Single-entity financial statements, distributions and taxation of a GmbH continue to follow the HGB. Under IFRS, development costs must be capitalised once the criteria are met, project revenue is often recognised by stage of completion instead of only on acceptance, and lessees recognise a right-of-use asset and a lease liability. Key figures from the two sets of rules are therefore not directly comparable.

Financial accounting in due diligence and purchase agreements

In financial due diligence, financial accounting is an area of examination in its own right. The buyer side compares the methods over several years and checks whether options and judgement shift the result one-sidedly. The focus is on revenue recognition for prepayments and open projects, capitalised own work, valuation allowances, the completeness of provisions and changes of method before the transaction. The findings feed into adjusted EBITDA, the operating result before interest, taxes, depreciation and amortisation excluding one-off and special effects. If the purchase agreement provides for a closing-date statement as of closing (completion accounts), it usually governs financial accounting in a hierarchy. First, agreed individual rules apply, then the methods applied consistently so far, and last the HGB.

Worked example: financial accounting of development costs under the HGB

A medium-sized software company develops a new platform module. The attributable personnel costs amount to EUR 600,000, of which EUR 100,000 fall in the research phase and EUR 500,000 in the development phase. The module is finished at year-end and will be used for five years from the following year. EBITDA before development costs is EUR 800,000; for simplicity, no further depreciation, interest or tax adjustments arise. A uniform income tax rate of 30% applies, the order of magnitude from corporate income tax, solidarity surcharge and trade tax (as of 2026); the gradual reduction of corporate income tax decided for 2028 onwards is disregarded.

• Variant A, no capitalisation: EBITDA = 800,000 minus 600,000 = EUR 200,000
• Variant B, capitalisation of the EUR 500,000 as other capitalised own work: EBITDA = 800,000 minus 600,000 plus 500,000 = EUR 700,000. Under the nature of expense method, the item is income that offsets the booked personnel costs by this amount.
• Amortisation in B: none yet in the financial year, from the following year 500,000 / 5 = EUR 100,000 per year
• Current tax in both variants, since nothing is capitalised for tax purposes: 200,000 × 30% = EUR 60,000
• Deferred tax liabilities in B: 500,000 × 30% = EUR 150,000
• Net income for the year A: 200,000 minus 60,000 = EUR 140,000
• Net income for the year B: 700,000 minus 60,000 minus 150,000 = EUR 490,000
• Distribution block in B: 500,000 minus 150,000 = EUR 350,000
• Distributable in B without further freely available reserves: 490,000 minus 350,000 = EUR 140,000, exactly as much as in A

For the shareholders, the block offsets the capitalisation, and over the useful life the sum of the results is the same in both variants. For business valuation, however, the difference is considerable: with an assumed multiple of 8 on EBITDA, the EUR 500,000 would arithmetically correspond to EUR 4 million of company value. Buyers therefore regularly strip capitalised own work out of EBITDA or treat it as capital expenditure in free cash flow.

Distinction: financial accounting, bookkeeping and accounting policy

• Bookkeeping: records business transactions continuously throughout the year. Financial accounting starts at the reporting date and decides on the recognition and value of the balances.
• Accounting policy (Bilanzpolitik): the deliberate use of options and judgement to shape the picture presented by the financial statements. It remains within the rules, but it is calculated back in due diligence.

Common mistakes

• Capitalisation without evidence. If there is no time recording and no documented separation of the research and development phases, the capitalisation does not withstand examination.
• Change of method before the transaction. A change that improves the result in the year before the sale must be justified in the notes and is calculated back by buyers.
• Revenue at invoicing instead of at performance. Annual licences billed in advance belong, to the extent they relate to later periods, in deferred income.
• Overlooking the distribution block. A distribution that includes blocked amounts is impermissible and can trigger questions of repayment and liability.
• Set of rules not stated. If a pitch deck mixes HGB figures, tax values and adjusted figures, investors cannot follow the information.

Frequently asked questions

Who is obliged to keep a balance sheet?

The obligation applies to every merchant within the meaning of the HGB, including every GmbH and every UG (German entrepreneurial company with limited liability), regardless of size (Section 242 HGB). Exempt are only sole traders with low revenue and profit (Section 241a HGB). They and freelancers may determine their profit using the simpler income and expenditure account (Einnahmen-Überschuss-Rechnung; Section 4(3) EStG), as long as tax law does not require bookkeeping.

Should a software company capitalise its development costs?

There is no general recommendation. Capitalisation improves equity and the annual result, which can matter towards lenders or where half of the share capital is at risk of being lost. Against this stand documentation effort, deferred taxes and the distribution block; for valuation, investors strip out the effect anyway.

May the costs of a funding round be capitalised?

No. Expenses for raising equity, such as advisory and notary costs of a capital increase, are subject to a capitalisation prohibition (Section 248(1) HGB) and reduce the result of the year in which they arise.

Who decides on the exercise of accounting options?

First the management, when preparing the financial statements. The shareholders' meeting can deviate when adopting them; for companies subject to mandatory audit, a supplementary audit is then required. Investment agreements often tie changes to accounting principles to the investors' consent.

Does a growth company need IFRS financial statements?

As a rule, no. They are mandatory only in the consolidated financial statements of capital-market-oriented companies. Before an IPO or at the request of international investors, a changeover can make sense. For funding rounds, HGB financial statements with a traceable reconciliation to adjusted key figures are usually sufficient.

The Roemer Capital view

Financial accounting decisions are made by the management together with its tax adviser; we do not take on this role. Our contribution begins afterwards: for a funding round and a sale, we prepare a reconciliation from the HGB result to the adjusted result. In it, every effect from options, changes of method and one-off items, such as capitalised own work or released provisions, is visible individually.

In the financial model, which we build over at least three years with a base case, a cautious case and an optimistic case, we adopt the accounting methods of the annual financial statements. This way, every plan figure can later be measured against actual figures, and investors do not have to follow a second calculation logic.