Scania annual report 2006 68 The key judgements and estimates for accounting purposes that are discussed in this section are those that Group Management and the Board of Directors deem the most important for an understanding of Scania’s financial reports, taking into account the degree of significant influence and uncertainty. These judgements are based on historical experience and the various assumptions that Group Management and the Board deem reasonable under the prevailing circumstances. The conclusions drawn in this way provide the basis for decisions regarding recognised values of assets and liabilities, in those cases where these cannot easily be established through information from other sources. Actual outcomes may diverge from these judgements if other assumptions are made or other conditions emerge. Note 1 presents the accounting principles the company has chosen to apply. Important estimates and judgements for accounting purposes are attributable to the following areas. Revenue recognition Scania delivers about 10 percent of its vehicles with residual value obligations or repurchase obligations. These are recognised as operating lease contracts, with the consequence that recognition of revenue and earnings is allocated over the life of the obligation. In case of major changes in the market for used vehicles, this affects Scania’s successive income recognition. In case the profit is insufficient to cover a possible downturn in market value, there is a provision in the required amount. At the end of 2006, obligations related to residual value or repurchase amounted to about SEK 6,100 m. Credit risks In its Customer Finance operations, Scania has an exposure in the form of contractual payments. At the end of 2006, these amounted to SEK 31,841 m. In all essential respects, Scania has collateral in the form of the right to repossess the underlying vehicle. In case the market value of the collateral does not cover the exposure to the customer, Scania has a risk of loss. On 31 December, 2006, the reserve for doubtful receivables in Customer Finance operations amounted to SEK 521 m. See also “Credit risk exposure” under Note 30. Intangible assets Intangible assets at Scania are essentially attributable to capitalised product development expenditures and “acquisition goodwill”. All goodwill items at Scania stem from acquisitions of previously independent importers/dealerships. All goodwill items are subject to an annual impairment test, which is mainly based on recoverable amounts, including important assumptions on the sale trend, margin and discount rate before tax. See also below. NOTE 2 Key judgements and est imates In the long term, the increase in sales of Scania’s products is deemed to be closely correlated with economic growth (GDP) in a market. The revenue/cost ratio, or margin, for both vehicles and service is kept constant over time compared to the latest known level. When discounting to present value, Scania uses its average cost of equity (currently 11 percent before taxes). These assumptions do not diverge from information from external information sources or from earlier experience. To the extent the above parameters change negatively, an impairment loss may arise. On 31 December 2006, Scania’s goodwill amounted to SEK 1,041 m. The impairment tests that were carried out showed that there are ample margins before an impairment loss will arise. Scania’s development costs are capitalised in the phase of product development where decisions are made on future production and market introduction. In this case there is future predicted revenue and a corresponding production cost. In case future volume or the price and cost trend diverges negatively from the preliminary calculation, an impairment loss may arise. Scania’s capitalised development costs amounted to SEK 1,275 m. on 31 December. Pension obligations In the actuarial methods that are used to establish Scania’s pension liabilities, a number of assumptions are highly important. The most critical ones are related to the discount rate on the obligations and expected return on managed assets. Other vital assumptions are the estimated pace of wage and salary increases and estimated life expectancy. A lower discount rate increases the recognised pension liability. In calculating the Swedish pension liability, the discount rate was left unchanged during 2006, while in 2005 it was lowered by 1.5 percentage points to 4.0 percent. Such a change in the above-mentioned actuarial parameters is recognised directly in equity, net after taxes. Product obligations Scania’s product obligations are mainly related to vehicle warranties in the form of a one-year “factory warranty” plus extended warranties and, in some cases, special quality campaigns. For each vehicle sold, Scania makes a warranty provision. For extended warranties and campaigns, a provision is made at the time of the decision. Provisions are dependent on the estimated quality situation and the degree of utilisation in the case of campaigns. An essential change in the quality situation may require an adjustment in earlier provisions. Scania’s product obligations can be seen in Note 18 and amounted to SEK 1,057 m. on 31 December. Legal and tax risks On 31 December 2006, provisions for legal and tax risks amounted to SEK 457 m. See Note 18. Legal risks Demands and claims aimed at the Group, including demands and claims that lead to legal proceedings, may be related to infringements of intellectual property rights, faults and deficiencies in products that have been delivered, including product liability, or other legal liability for the companies in the Group. The Group is party to legal proceedings and related claims that are normal in its operations. In addition, there are demands and claims normal to the Group’s operations that do not lead to legal proceedings. In the best judgement of Scania’s management, such demands and claims will not have any material impact on the financial position of the Group, beyond the reserves that have been set aside. Tax risks The Group is party to tax proceedings. However, Scania’s management has made the assessment, based on individual examination, that the final outcome of these proceedings will not have any material impact on the financial position of the Group, beyond the recognised reserves. In addition, during 2003 the Swedish local tax authority denied a request for deduction of a loss of SEK 2.9 billion. This decision has been appealed by Scania. The aggregate effect on earnings may total a maximum of SEK 575 m. if the deduction is disallowed in its entirety. Significant judgements are made in order to determine both current and deferred tax liabilities/assets. As for deferred tax assets, Scania must assess the likelihood that deferred tax assets will be utilised to offset future taxable profits. The actual result may diverge from these judgements, among other things due to future changes in business climate, altered tax rules or the outcome of still uncompleted examinations of filed tax returns by authorities or tax courts. Scania recognised deferred net tax liabilities totalling SEK 1,629 m. at the end of 2006. In addition, at the end of 2006 the Group had deferred tax receivables related to unutilised tax loss carry-forwards of about SEK 225 m. that were not carried in the financial statements after assessment of the potential for utilising the tax loss carry-forwards. This judgement may affect income both negatively and positively.