2   Accounting and valuation principles

The preparation of the consolidated financial statements requires estimates and assumptions to be made. These relate to the reported amounts of assets, liabilities and contingent liabilities on the balance sheet date and to income and expenditure during the reporting period. The balance sheet is prepared strictly on the basis of acquisition costs, with the exception of investment real estate and derivative financial instruments, which are entered at market values. For significant estimates and assumptions, see following accounting and valuation principles, in particular 2.30. If these estimates and assumptions, made to the best of our knowledge at that date, subsequently transpire to diverge from the facts, the original estimates and assumptions are adjusted for the year in which the situation changed. Significant changes are disclosed in the consolidated financial statements.

Derivative financial instruments are classified as hedging instruments if the hedging transaction covering the related future cash flow is considered highly effective and the effectiveness of the hedge can be reliably measured. In addition, the expected future cash flow is highly probable and there is documentation of the hedging relationship at the inception of the hedge.

The Allreal Group uses interest rate swaps as hedging instruments as the underlying transaction and the interest rate swaps largely cover each other: The swaps are considered to be highly effective and are subject to hedge accounting (cash flow hedges). The interest rate swaps are recognised at acquisition values and are subsequently carried at market value. Thus, until they are realised, changes in replacement values are recognised under equity, taking account of deferred taxes. Positive replacement values are recognised under other receivables or under financial assets, depending on whether the derivative financial instruments have remaining terms of more than twelve months. Negative replacement values are recognised under other short-term liabilities or under long-term liabilities, depending on whether the derivative financial instruments have remaining terms of more than twelve months. Deferred taxes on the replacement values of the interest rate swaps are booked as deferred tax assets or deferred tax liabilities. The net amount of replacement values and deferred taxes is reported as a hedging reserve in the consolidated statement of changes in shareholders' equity. In the income statement, the changes in replacement values arising during the period under review are presented with the effect of deferred tax assets as other earnings.

Income from renting investment real estate includes net rental income after deduction of ground rent, vacancy losses, and losses due to bad debts. Income and expenses in connection with the settlement of ancillary costs are not included because they are prepared by real estate management companies. Costs for management, operation, maintenance and repairs are reported separately in the income statement as direct expenses for rented investment real estate.

Gains and losses on the sale of investment real estate correspond to the difference between the realised net proceeds after deduction of transaction costs and the latest recorded market value of the properties sold. The earnings are taken to the income statement at the time of the transfer of benefits and risks.

In accordance with IAS 40, the revaluation of yield-producing properties and investment real estate under construction shows changes in the market value of the real estate portfolio. The basis is the report of the independent real estate valuer. In accordance with IAS 40, paragraph 30, the real estate valuation underlying the revaluation excludes the deduction of transaction costs at the time of sale.

For more details of the recognition of investment real estate, see 2.9.

Income from the Projects & Development division includes the project volume completed during the period under review for third parties ("third-party projects") and corresponds to the total of all project costs, fees and earnings from construction activity recognised by the percentage of completion method (POC) in accordance with IAS 11. In the case of loss-making projects, provisions are immediately made for the estimated final loss in the project accounts (trade receivables or payables).

In accordance with IAS 18, earnings realised and received from the sale of development real estate (“own projects”) are recognised as income from sales Development in the consolidated statement of comprehensive income. These earnings are posted at the time of transfer of benefits and risks, i.e. on transfer of ownership and entry in the land register. Gains and losses from the sale of own projects are posted at the time of transfer of the final unit.

Direct expenses from realisation Projects & Development and sales Development contain the accrued project costs of all third-party projects bought in by contractors as well as cumulative investment costs including capitalised company-produced assets for own projects sold.

Capitalised company-produced assets accrue from investment real estate under construction as well as development real estate and are carried at cost in the consolidated statement of comprehensive income if own project work is incurred.

The presentation of net profit in the internal reports is similar to that in the segment reports. As regards the Projects & Development division, the segment reports differ from the consolidated statement of comprehensive income in respect of the quantification of sales.

In the segment reports, the volume of projects completed for all third-part and own projects is taken as the relevant sales figure.

In the consolidated statement of comprehensive income, sales from realisation Projects & Development and sales of development real estate are recognised in accordance with 2.6. In the segment reports, in respect of the volume of projects completed for the Real Estate division (intra-Group sales) and for own projects, the difference between projects completed and sales Development is stated.

Interest expenses are accrued/deferred between reporting periods on the basis of the effective interest rate method and charged directly to the income statement.

For development real estate and investment real estate under construction, interest costs from third-party financing which can be directly attributed to a project are capitalised in full. In addition, by analogy to internal financial reporting and in interpretation of IAS 23, paragraph 14, it is assumed that the other unfinished buildings are 55–60% debt-financed. Based on this assumption, for buildings under construction interest expenses on 55–60% of the debt incurred are capitalised from the start of construction. The underlying debt interest rate is the average borrowing rate during the reporting period.

The investment real estate reported under fixed assets is divided into yield-producing properties (residential and commercial properties) and investment real estate under construction. All investment real estate is carried at market value in accordance with IAS 40. The valuation at the time of initial recognition is based on acquisition cost, including directly attributable transaction costs. After the initial recognition, the external independent real estate valuer regularly determines the market value on the balance sheet cut-off date using the discounted cash flow method (DCF) (fair value). For details of the valuation method and the key assumptions see 2.30. Changes in market value are taken to the income statement, factoring in deferred taxes. In the consolidated statement of changes in shareholders' equity, the cumulative difference between the acquisition cost and market value of all investment real estate, factoring in deferred taxes encumbering said real estate, is recognised as part of retained earnings (revaluation reserves). In accordance with IFRS 5, where a decision has been taken to sell yield-producing properties to third parties, those properties are reported separately at market value in current assets as investment real estate due to be sold. For projects to be assigned to investment real estate under construction, the following requirements must be cumulatively met: The realisation is intended for the portfolio of investment real estate, a legally binding building permit has been secured and the internal decision to proceed has been taken by Group Management. In addition, expenditure and income can be reliably estimated so that an estimate of market value can be made using the DCF method.

The development real estate carried in current assets includes land reserves, buildings under construction and completed properties which were not sold to third parties. If the criteria for investment real estate under construction mentioned in 2.9 are not met, such projects are also carried on the balance sheet as development real estate.

Development real estate is reported in accordance with IAS 2, which requires these properties to be recognised in the consolidated financial statements at acquisition or production costs or at a lower net realisable value. The latter corresponds to the estimated sale price less expected project, construction and sales costs up until the disposal. Any impairment is taken to earnings from Projects & Development division.

Land already owned by Allreal or payments on account for planned land purchases and third-party cost (but not company-produced assets) are capitalised under land reserves if the project is expected to be realised, but work has not yet started.

Projects in progress, on which structural work has yet to be completed, for which the property-specific full statement of accounts is not yet available and for which the transfer of ownership to a third party has not yet been completed are recognised as buildings under construction. Realised development real estate which has reached structural completion and development real estate destined for immediate sale to third parties are reported as completed buildings.

Other property, plant and equipment is stated at acquisition or production costs less operationally necessary depreciation and where appropriate less additional depreciation as a result of impairment losses. The estimated useful life of plant and equipment is four to five years and three years for IT infrastructure and operating facilities in investment real estate. The works of art capitalised under other property, plant and equipment are not depreciated. Repair and maintenance costs are charged to income. Depreciation is calculated on a straight-line basis.

Intangible assets relate to goodwill. Goodwill corresponds to the surplus of the purchase price, the contribution of minority interests in the companies taken over and the market value of the share of equity held previously over the balance of the assets, liabilities and contingent liabilities valued at market values.

Financial assets include long-term loans in the context of usual business operations and the pre-financing of tenant fit-outs, as well as positive replacement values of interest rate swaps with terms to maturity of more than twelve months. Loans are stated using the "amortised cost method" and are freely available.

Receivables arising from construction activities undertaken on behalf of third parties are recognised according to the net principle, i.e. payments on account received from clients and partial settlements of accounts arising from the construction activities are offset against each other (order balances). Positive net positions are shown under trade receivables, while negative net positions are reported under trade payables; see also 2.6.

Trade receivables and other receivables are reported at their nominal value less necessary value adjustments for irrecoverable claims. Value adjustments are based on an individual assessment of the claim in the light of deposited collateral and also take account of appropriate historical empirical values.

All short-term receivables are freely disposable and are not pledged.

Cash includes cash on hand, postal and bank balances and short-term time deposits with maximum maturities of 90 days. They are reported at nominal value.

<p class="x4-lauftext-blocksatz">The share capital of Allreal Holding AG is reported as equity as it is not subject to any repayment obligation or dividend guarantee. Issuing costs which are incurred in connection with a capital increase and are directly attributable to the issuance of new shares are offset against the capital reserves under equity. The premium paid with capital increases or through conversion of a convertible bond is reported under capital reserves.</p>
<p class="x4-lauftext-blocksatz">Treasury shares may be held by Allreal Holding AG or by one of its Group companies on the balance sheet cut-off date. These are stated at acquisition cost offset directly against equity and are listed as a separate item in the consolidated statement of changes in shareholders' equity. Gains and losses from transactions with treasury shares are taken to retained earnings in equity.</p>

Outstanding convertible bonds are recognised in accordance with IAS 32 by breaking them down into liabilities (financial liabilities) and equity. The allocation to equity corresponds to the difference between the proceeds from proceeds of the issue before issuing costs and the fair value of the financial liabilities. The issuing costs are offset against the convertible bond and split proportionately between liabilities and equity. The share of equity remains unchanged until the bonds are converted or redeemed. The difference between reported financial liabilities and the repayment amount is amortised to the income statement over the convertible bond's term to maturity using the effective interest method.

Outstanding bonds are recognised on issue on the basis of the proceeds received, net of transaction costs. The difference between reported financial liabilities and the repayment amount is amortised to the income statement over the bond's term to maturity using the effective interest method.

In addition to bond issues and convertible bonds, finance debts include bank loans secured by mortgages and are recognised as long-term financial liabilities in compliance with IAS 1 if the contractually agreed remaining term to maturity in the credit agreements is longer than twelve months. All other financial liabilities are recognized as a short-term bank debt, including amortisation payments due within twelve months of the balance sheet cut-off date. Financial liabilities are recognised at amortised costs using the effective interest method.

Provisions are made to the extent that corresponding obligations exist as at the balance sheet cut-off date and the respective event is in the past. In addition, the amount can be estimated reliably and the probability of occurrence is rated higher than that of the non-occurrence. Provisions are classified as short-term or long-term depending on whether they are expected to be utilised within one year or later.

Liabilities arising from construction activities undertaken on behalf of third parties are recognised according to the net principle, i.e. payments on account received from clients and partial settlements of accounts arising from the construction activities, are offset against each other (order balances). Negative net positions are shown under trade payables, while positive net positions are reported under trade receivables.

Trade payables and other liabilities (accrued liabilities) due within one year are recorded at their nominal value.

Leasing agreements are reported as financial leases if essentially all risks and opportunities associated with ownership of the leased property are transferred to the Allreal Group. They are classified at the beginning of the lease. At the same time, the leasing liabilities are broken down into interest and repayment amounts and the leased property is depreciated over its estimated useful life or over the term of the lease, whichever is the shorter. The leased property is capitalised at the lower of the present value of the lease payments or fair value.

Operating leasing agreements such as rental income or ground rent are not reported on the balance sheet as they usually involve long-term rental agreements of fixed duration under which ownership is not transferred to the lessee when the agreement expires. The cash flows are taken to income directly at the time of payment.

If there is reason to believe that the value of assets has been impaired, an impairment test will be carried out at least once a year and the realisable value will be estimated. The realisable value is determined on the basis of the lower of value in use or market value less selling costs. Any difference between the asset and the realisable value is depreciated to the income statement and reported separately in the consolidated financial statements. All assets other than investment real estate and deferred tax assets may be subjected to an impairment test.

The item tax expenses in the consolidated statement of comprehensive income covers current taxes on business activities, deferred taxes on revaluation and other deferred taxes.

Taxes on business activities include income taxes due for the business year as well as property gains tax on the completion and sale of development real estate (Projects & Development division) and the sale of investment real estate (Real Estate division).

Current income taxes are calculated net of tax loss carry-forwards and are based on the applicable tax regulations established on the basis of the results reported by the individual group companies and are recognised under current tax liabilities.

Deferred taxes are determined using the comprehensive balance sheet liability method and are calculated at the tax rates in force or announced on the balance sheet cut-off date. With the exception of taxes on the replacement values of cash flow hedges, changes in deferred taxes are taken to income through the consolidated statement of comprehensive income.

Deferred tax liabilities take account of discrepancies in income and property gains taxes between the valuation for purposes of the consolidated financial statements and the applicable tax valuation of individual assets and liabilities for tax purposes. At the same time, a deferred tax is calculated on strictly all discrepancies leading to delays in the timing of taxation. For the higher valuation of investment real estate (positive difference between acquisition cost and market value), an individual tax rate is applied, with a realistic holding period defined for each individual investment real estate property.

Deferred tax assets from tax loss carry-forwards and the downward revaluation of investment real estate (negative difference between tax value and market value) are capitalised, if they appear certain to be recoverable with future taxable income.

Employees of the Allreal Group are covered by the Allreal pension fund for mandatory and extra-mandatory staff pension provision as required by the Swiss Federal Law on Occupational Retirement, Survivors' and Disability Pension Plans (BVG). The Allreal pension fund is a legally independent pension institution based on the principle of defined contributions in accordance with Swiss law.

Due to its characteristics, the pension plan is classified under IAS 19 as a defined benefit plan. In the case of defined benefit plans, the present value of expected claims is calculated using the projected unit credit method and set aside. All commitments and the pension assets intended to cover those commitments are recalculated annually at market value by an independent actuary. Pension costs associated with work carried out during the period under review and interest paid on the pension entitlements accrued are recognised in income. Pension costs relating to work carried out in prior periods, which costs are attributable to new or improved pension benefits (past service costs), are recognised on a straight-line basis under expenses for staff pension plans until such time as scheme members become entitled to benefits.

Actuarial gains and losses resulting from the recalculation are taken to income on a straight-line basis over the average remaining working lives of the active scheme members, if they exceed 10 percent of the higher value of benefit obligations and plan assets (corridor method).

Surpluses are only capitalised up to an amount not exceeding the sum of the unrecognised past service cost, unrecognised actuarial losses and benefits from future contribution refunds or reductions.

Some Allreal staff are covered by a management insurance scheme arranged with an insurance company which is classed as a defined contribution plan under IAS 19. The expenditure reported during the period under review corresponds to the employer's contributions to the plan.

Part of the variable remuneration may be paid to the members of Group Management and selected senior executives in the form of shares of Allreal Holding AG. Beneficiaries have immediate right of disposal over the first half of the shares allocated to them. The second half of the shares allocated will be placed at the beneficiary's disposal in two years, provided that the employment relationship has not been terminated by such time. Entitlements will be satisfied by the company by means of treasury shares. The amount in connection with the share allocation is charged to personnel expenses over the vesting period in accordance with IFRS 2. Immediately disposable shares are recognised at market value at the time of allocation and the remaining shares at market value on the balance sheet cut-off date.

Net profit per share are calculated by dividing net profit by the weighted average number of shares outstanding during the reporting period. As well as allowing for expenditure and income in connection with convertible bonds (interest expenses, amortisation effects, taxes), diluted earnings per share also take account of additional shares that may be created as a result of the exercising of option or conversion rights and will have a dilutive effect on the result.

Liquid assets (cash on hand, postal and bank account balances) and short-term deposits with maximum terms of 90 days are used as funds. Cash flow from operating activities consists of operating cash flow before changes in net working capital (NWC), changes in NWC (excluding cash and current tax liabilities), as well as cost of finance paid, financial income received, income and property gains taxes paid. Cash flows from investing and financing activities are presented separately.

The geographical range of the Allreal Group´s activities is confined to Switzerland. The Group therefore has no significant assets or liabilities in foreign currencies. As all Group companies prepare their annual accounts in Swiss francs, consolidation does not result in any currency translation differences.

Investment real estate

As at 31 December 2011, Allreal holds investment real estate with a book value of CHF 2 951.0 million. The investment real estate is valued at market value calculated using the discounted cash flow method (DCF). The DCF method is based on various estimates and assumptions, with the yield potential of a property being determined on the basis of future revenue and expenditure. Market values do not take account of transaction costs upon sale.

Future rental income is forecast on the basis of current contractual rents and target annual rental income. In the case of expiring commercial leases, a market rent which appears sustainable from a current perspective is used. Where tenants have extension options, as a rule the lower of market rent and contractual rent is stated. Sustainable market rents will also be used in the case of open-ended leases where there is a significant difference between the contractual rents and the market level in the exit year.

Management and building costs are in principle based on the relevant property accounts and include non-apportionable operating and maintenance costs, as well as future repair costs based on Allreal's multi-year budgets. These costs include only costs for asset maintenance to secure the long-term level of contractual and market interest rates on which the valuation is based. Future value-enhancing investments and associated additional income are therefore not included in the calculation.

A property-specific discount is made on each investment property on the basis of macro- and micro-locational considerations and depending on real estate segment. Inflation is taken into account in the forecast cash flows. The discount and capitalisation rates are based on the interest paid on long-term, risk-free investments plus a specific risk premium.

On the basis of a sensitivity analysis of investment real estate with a market value of CHF 2 529.2 million on 31 December 2011, an isolated change in discount and capitalisation rates by 50 basis points would lead to an increase or decrease in value of CHF 253.3 million or CHF 207.9 million respectively.

Development real estate

As at 31 December 2011, Allreal holds development real estate with a book value of CHF 504.1 million. They were valued at acquisition or production costs – including company-produced assets for buildings under construction – less value adjustments for impairment losses. On the balance sheet cut-off date at the latest, an impairment test is carried out for all development projects by comparing incurred and future costs with the realisable value. On the cost side, expenses are determined on the basis of investment calculations, the chronological progress of projects and project managers´ cost forecasts, among other factors. The proceeds are based on market assessments, empirical values and completed sales to date. If actual construction costs and sales proceeds in subsequent periods differ from the estimates and planned figures, the book values may need to be adjusted.

Taxes

The Allreal Group has significant deferred tax assets (31.12.2011: CHF 43.0 million) and liabilities (31.12.2011 : CHF 137.6 million) which stem mainly from valuation differences relating to investment real estate; see 2.24. In calculating the deferred taxes on investment real estate, a remaining holding period was estimated for each property. If the actual holding period of the investment real estate does not correspond to the assumed holding period, this may result in a considerable difference between the tax due and the capitalised deferred taxes when the property is sold.

Allreal has a comprehensive management system (QMS) in place. This system describes all parent processes and associated controls and integrates the tasks of management, operational processes and support processes. The QMS also covers non-financial processes. There is also a documented internal control system in place for accounting and financial reporting to prevent, minimise or identify the risk of material representation in the annual accounts. The financial reporting controls are based on the COSO framework. Once a year, Group Management provides the Board of Directors with written confirmation that a system of internal controls is in place and is functioning effectively.

The Board of Directors and the Risk and Audit Committee evaluate at corporate level the risk assessment prepared by Group Management (identification, quantification, monitoring and control). In particular, the risk assessment must explicitly give consideration to the reliability and completeness of financial information (fair presentation), asset protection, compliance with laws, regulations, contracts and the risk of balance sheet fraud.

Effective internal control and management systems are in place to ensure that the consolidated financial statements of Allreal Group comply with the applicable accounting rules and to ensure the fair presentation of reporting. Accounting and valuation involve making forward-looking estimates and assumptions. Estimates and assumptions which pose a significant risk in the form of an adjustment to the book values of assets and liabilities within the next financial year are shown under the individual positions in the notes to the financial statements. For financial risk management see 5.4.2.