Report on Risks and Opportunities Audited

Risk and opportunity management

Merck is part of a complex, global business world and is exposed to a multitude 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 possible future events or developments that could lead to a negative deviation from our (financial) targets. In parallel, opportunities are defined as possible events or developments that imply a positive deviation from our planned (financial) targets.

Risk management process

The objective of our risk management activities is to recognize, assess and manage risks early on and to implement appropriate measures to minimize them. The responsibilities, objectives and process of risk management are described in our internal risk management guideline. Group Controlling & Risk Management forms the organizational framework for risk management and reports directly to the Group Chief Financial Officer.

Within the context of the Group-wide risk management process, the division heads, managing directors of Merck subsidiaries and heads of Group functions are specified as employees with responsibility for risk. The group of consolidated companies for risk reporting purposes is the same as the group of consolidated companies for the consolidated financial statements. Every six months, the risk owners assess their risk status and report their entire risk portfolio to Risk Management. In addition to presenting risks, this also includes reporting on measures to minimize risk. Merck uses special risk management software in the context of these activities.

Risks are assessed in the internal risk management process on the basis of their possible negative effect on the forecast financial targets and their anticipated probability of occurrence. If risk-mitigating measures can be taken, their impact on risk is also assessed. The residual risk after the implementation of mitigation measures is presented in the internal risk report as net risk. The planned timeframe for implementation and the assumed mitigation effect are tracked by Group Risk Management.

Group Risk Management uses the information reported to determine the current risk portfolio for the Merck Group, presenting this in a report to the Executive Board, the Supervisory Board and the Finance Committee with detailed explanations twice per year. 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 corporate bodies on an ad hoc basis.

For the standard process, a lower limit for risk reporting is set at a value of € 5 million, and for the ad hoc process at a value of € 25 million. Risks below these limits are managed independently in the units. The relevant timeframe for internal risk reporting is five years. The effect of risks is presented as an annual value. The assessment of the risks presented relate to December 31, 2013. There were no relevant changes after the end of the reporting period that would have necessitated an amended presentation of the risk situation of the Group.

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 units to Group Risk Management.

In addition to these bottom-up processes, Group Risk Management addresses potential risks and risk areas on a top-down basis. This process is based on independent analyses of both internal and external information.

Opportunity management process

The risk management system described concentrates on business risks, and not on opportunities at the same time. The Merck Group’s opportunity management process is integrated into our internal controlling processes and carried out in the operating units on the basis of the Group strategy. The divisions analyze and assess potential market opportunities as part of strategy and planning processes. In this connection, investment opportunities are examined and prioritized in terms of their potential value proposition to Merck in order to ensure an effective allocation of resources. Thereby, Merck selectively invests 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 medium-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 result in a positive deviation from forecasts and Merck’s medium-term prospects.

Risk and opportunity assessment

Risks

The significance of risks to Merck is calculated on the basis of their possible negative impact on the forecast financial targets in conjunction with the probability of occurrence of the respective risk. In line with these two factors, risks are classified as “high”, “medium” or “low”.

The underlying scales for measuring these factors are shown below:

In our process, individual risks are quantified as specifically as possible and the probability of occurrence of the risk is estimated. The combination of the two factors results in the risk matrix below, which shows the individual risks and their significance to Merck.

Opportunities

Opportunities are assessed in their respective specific business environment. Marketing measures for operational planning are usually quantified in relation to sales and EBITDA. Net present value, the return on capital employed (ROCE) and the amortization period of the investment are used to assess and prioritize investment opportunities. Similarly, scenarios are frequently set up to simulate the influence of possible fluctuations and changes in the respective factors on results. There is no overarching, systematic classification of the probability of occurrence and impact of opportunities.

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. It covers measures designed to ensure the complete, correct and timely transfer and presentation of information that is relevant to the preparation of the consolidated financial statements and the management report of the Merck Group.

The control system is subject to continuous further development and is an integral component of the accounting and financial reporting processes in all relevant local units and Merck Group functions.

With respect to the accounting process, the measures of the internal control system are intended to minimize the risk of a material misstatement in the consolidated accounting process of the Merck Group.

Key tools

The internal control system is geared to ensuring the accuracy of the consolidated accounting process and the implementation of internal controls for the preparation of compliant financial statements with reasonable assurance. The Group Accounting function centrally steers the preparation of the consolidated financial statements of Merck KGaA as the parent company of the Merck Group. This Group function defines the reporting requirements that all Merck subsidiaries must meet as a minimum requirement. At the same time, this function steers and monitors the scheduling and process-related requirements of the consolidated financial statements. The Group-wide accounting guidelines form the basis for the preparation of the statutory financial statements of the parent company as well as of the German and foreign subsidiaries; the guidelines are adapted to reflect changes in the financial regulatory environment and are updated in accordance with internal reporting requirements. One of the requirements of the Group-wide guidelines is to present internal business processes as the basis for proper settlement of intercompany balances. Additional controls have been implemented in the consolidation process.

Group Accounting also ensures the timely central management of changes to the equity holding structure and correspondingly adapts the Merck Group’s scope of consolidation. The individual companies have a local internal control system. Where financial processes are handled by a Shared Service Center, the internal control system of the Shared Service Center is additionally applied. They ensure that accounting complies with IFRS (International Financial Reporting Standards) and with the Merck Group accounting guidelines.

Group Accounting provides support to the local contacts and ensures a consistently high quality of reporting throughout the entire reporting process.

The accounting process is designed at all levels to ensure a clearly defined segregation of duties and assignment of responsibilities to the units involved in the accounting process at all times within the scope of continuous dual control.

For the assessment of balance sheet items, Group Accounting closely cooperates with Group Risk Management in order to correctly present potential balance sheet risks. For special issues, such as the measurement of intangible assets and pension obligations, external experts are additionally involved where necessary. For the Group accounting process, Merck uses in most countries a standard SAP software tool. Via a detailed authorization concept to limit user rights on a need-to-have basis, and in line with the principles of the separation of duties, the system contains both single-entity reporting and the consolidated financial statements.

The effectiveness of Merck’s internal control system with regard to accounting and the compliance of financial reporting by the individual companies is confirmed by both the local managing director and the local chief financial officer when they sign the single-entity reporting. All the structures and processes described are subject to regular review by Group Internal Auditing based on an annual audit plan set out by the Executive Board. The results of these audits are dealt with by the Executive Board, the Supervisory Board and the Finance Committee.

The internal control system at Merck makes it possible to lower the risk of material misstatements in accounting to a minimum. However, no internal control system – regardless of its design – can entirely rule out a residual risk.

Overall view of the risk and opportunity situation and management assessment

Although the number of risks reported is higher than the specific opportunities, Merck considers the distribution of risks and opportunities to be balanced. A balanced overall view within the Group is also supported by the fact that total revenues and business success are built on a diversity of pharmaceutical and chemical products for a variety of industries. As the markets differ in their structure and economic cycles, this diversification helps to lower risk. The overall view of the opportunity and risk profile of the four divisions would also be further balanced by the proposed acquisition of AZ Electronic Materials moving forward. This diversification also reflects Merck’s strategy to continue its development as an integrated pharmaceutical and chemical company.

The most significant individual risks in the divisions have been named in the report above, with business-related risks being the most significant to us alongside legal risks.

Although the assessment of the individual risks has altered over the fiscal year as a result of changing external conditions, the risk situation of the Group as a whole is not significantly different compared to 2012. There have been no new additions in the area of high risks in particular. Merck has observed only minor changes in the area of medium risks. Thanks to the mitigating measures taken – such as the consistent implementation of management action (organizational responsibility and process improvements), the increased insurance coverage and accounting precautions – Merck’s significant risks in particular have been further minimized in net terms.

The overall view of the risk situation of the Group, which is derived from the summary of the risks described on the basis of their impact and probability of occurrence, leads Merck to the assessment that the risks are not of a nature to threaten the existence of the Group as a going concern, either individually or collectively. Merck is confident that it will continue to successfully master the challenges arising from the above risks in the future as well.

In terms of opportunities, we feel that the greatest potential lies in the business-related topics of the operational areas. Thanks in particular to the expansion of our business in emerging markets, the optimization of the Merck Serono R&D organization, the newly founded biosimilars initiative and other activities as part of the “Fit for 2018” transformation and growth program, Merck has launched changes that hold significant opportunities in the medium to long term beyond the underlying forecast period.

Merck pursues the opportunities that arise and shows their expected effects in the forecast development of its key performance indicators – sales, EBITDA pre one-time items and business free cash flow. Merck will actively seek out opportunities beyond this and move ahead their implementation. In the event that opportunities arise in addition to the forecast developments, or that these occur more quickly than anticipated, this could have correspondingly positive effects on Merck’s net assets, financial position and results of operations.