Root Theory in the context of accounting for adjusting events

In accounting practice, the distinction between non-adjusting events or events that affect value and adjusting events frequently gives rise to definitional issues. An especially difficult question is: which events from the year that has just ended will still be factored into the financial statements for the current year if the effects of these events will only be unambiguously discernible in the new year? To make it possible to clearly distinguish between adjusting events and non-adjusting events, in this report, we draw on Root Theory - already long established in business valuation. In practice, this theory will allow you to relatively easily categorise most of the accounting events.
Application of Root Theory
Root Theory is an important concept in the business and accounting fields; it is concerned with the measurement of single assets and groups of assets. This theory states that any changes in values that arise after a specific valuation cut-off date may be taken into account insofar as their causes (‘roots’) were already present prior to this cut-off date. This makes it possible to provide a more realistic and precise presentation of a company’s financial situation because all the foreseeable risks and losses that have arisen as per the balance sheet date are included in the evaluation. The application of Root Theory is particularly relevant for the preparation of annual financial statements and for the evaluation of long-term investments because this theory promotes transparent financial reporting.
Specifying the accounting for adjusting events
In the context of accounting for adjusting events, this means that all foreseeable risks and losses that have arisen as per the balance sheet date are to be included in the evaluation even if they have become known only after this cut-off date. This is codified in the Commercial Code (Handelsgesetzbuch, HGB) under Section 252(1) no. 4.
The following approach is an adaptation of Root Theory - which was developed in 1973 by the Federal Court of Justice for business valuation - for accounting purposes. A cut-off date is a key criterion both for business valuation and for the preparation of annual financial statements. In accounting legislation, the cut-off date principle was established through Section 242(1) HGB and specified in the ‘Generally Accepted Accounting Principles’ (Grundsätzen ordnungsmäßiger Buchführung, GoB) through the accrual basis principle of accounting. It can generally be assumed here that the cut-off date principle is appropriate both for business valuation as well as for annual financial statements. The application of ‘Root Theory’ - which in a tax law context is reflected in the taking into account of so-called adjusting events - is therefore permitted by law.
While the relevant commentaries on German commercial law do not use the term ‘root’ directly to precisely define adjusting events in connection with the delimitation of foreseeable risks, nevertheless the idea that underlies Root Theory can be found in various places in the specialist literature. It is generally acknowledged that foreseeable risks have to be included in the financial statements when their source is already present prior to the balance sheet date. It does not matter here whether these risks were already discernible as per the reporting date if you take an objective understanding of adjusting events as a basis.
The application of Root Theory in accounting practice - an example
Global value adjustments on receivables constitute a typical example of the application of Root Theory. This entails the presentation of a risk in the financial statements, namely, the possibility that the receivables as at the balance sheet date - especially trade receivables - will in some cases remain unpaid in the subsequent financial year. This risk describes “a future circumstance that, on the balance sheet date, cannot be foreseen with certainty and is thus solely a potential one”. Here, “previous experience from past business operations can provide valuable pointers for estimates so long as there are no radical changes to conditions.” The default risk prediction is therefore based on the average percentage of uncollectable receivables recorded in the past, whereby a sufficient - although not absolute - degree of predictability gleaned from experience in prior periods can be derived and even calculated using statistical methods.
Accordingly, for a global value adjustment, specific risks would not need to be present on the reporting date for individual receivables. The statistical probability of a calculable payment default would be sufficient to guarantee the necessary predictability. Given that a global value adjustment also takes into account payment defaults caused by individual debtors that will actually become insolvent in the new financial year, it is only possible to convincingly explain why all receivables have to be included via Root Theory. This is because the origination of receivables in the old financial year already entails the creation of the seeds for specific and predictable default risks.