I. Accounting Policies and Principles

1. GENERAL INFORMATION

MTU Aero Engines Holding AG, Munich, and its subsidiary companies (hereinafter referred to as MTU Aero Engines Holding AG, MTU, or the MTU group) is among the world’s leading manufacturers of engine modules and components, and is the world’s largest independent provider of MRO services for commercial aero engines.

The business activities of the MTU group range through the entire lifecycle of an engine program, i.e. from development, construction, testing and production of new commercial and military engines and spare parts, through to maintenance, repair and overhaul of commercial and military engines. MTU divides its activities into two operating segments: commercial and military engine business (OEM business) and commercial maintenance business (MRO business).

MTU’s commercial and military engine business covers the development and production of modules, components and spare parts for engine programs, including final assembly. MTU’s military engine business additionally includes maintenance services for these engines. The commercial maintenance business covers activities in the areas of maintenance and logistical support for commercial engines.

MTU Aero Engines Holding AG (parent company), registered office Dachauer Str. 665, 80995 Munich, Germany, is registered under HRB 157 206 in the commercial registry at the district court of Munich.

The consolidated financial statements were approved for publication by the Board of Management of MTU Aero Engines Holding AG, Munich, on February 7, 2011.

1.1. ACCOUNTING PRINCIPLES
MTU’s consolidated financial statements have been drawn up in accordance with International Financial Reporting Standards (IFRSs), such as these apply in the European Union (EU), and the supplementary requirements of Section 315a (1) of the German Commercial Code (HGB). All IFRSs issued by the International Accounting Standards Board (IASB) which were effective at the time these consolidated financial statements were drawn up and were applied by MTU have been endorsed by the European Commission for use in the EU. MTU’s consolidated financial statements thus also comply with the IFRSs issued by the IASB. The term IFRS used in this document refers to both sets of standards.

The consolidated financial statements and group management report as at December 31, 2010 have been compiled in accordance with Section 315a (1) of the German Commercial Code (HGB) and published in the electronic version of the Federal Gazette (Bundesanzeiger).

The financial year is identical with the calendar year. Comparative data for the previous year are disclosed in the consolidated financial statements.

In the presentation of the balance sheet, a distinction is made between non-current and current assets and liabilities. A more detailed presentation of certain of these items in terms of their timing is provided in the notes to the consolidated financial statements. The income statement is laid out according to the cost-of-sales accounting format, in which revenues are balanced against the expenses incurred in order to generate these revenues, and the expenses are recorded in the appropriate line items by function: manufacturing, development, selling and general administration. The consolidated financial statements have been drawn up in euros. All amounts are stated in millions of euros (€ million), unless otherwise specified.

The financial statements prepared by MTU Aero Engines Holding AG, Munich, and its subsidiaries are included in the group financial statements. Uniform methods of recognition and measurement are applied throughout the group.

ACCOUNTING STANDARDS AND INTERPRETATIONS, AND AMENDED ACCOUNTING STANDARDS AND INTERPRETATIONS, APPLIED FOR THE FIRST TIME
The following standards and interpretations issued by the IASB were effective and applied for the first time in the financial year 2010:

In the interests of efficient reporting practice, the following descriptions of standards and interpretations are limited to those that had an impact on the methods of reporting used by MTU as at December 31, 2010, or which will possibly or very probably have an impact in future reporting periods, based on the information on hand at the present time.

These standards and interpretations have been applied in the financial year 2010 in compliance with the respective effective dates and recommendations for early adoption. Unless another form of presentation is explicitly required by individual standards or interpretations, their application is retrospective, i.e. the statements are presented as if the new financial reporting methods had always been applied in this way. Amounts stated in respect of previous periods are adjusted accordingly.

IMPROVEMENTS TO IFRS – A COLLECTION OF AMENDMENTS TO VARIOUS DIFFERENT INTERNATIONAL FINANCIAL REPORTING STANDARDS RESULTING FROM THE ANNUAL IMPROVEMENTS PROJECTS 2007 – 2009
The collection of amendments ‘Improvements to IFRSs’ contains 15 separate amendments to twelve existing IFRSs.

The amendments to individual standards had repercussions on the classification of the convertible bond. Under the new requirements of IAS 1.69 (d), the convertible bond was recognized under non-current liabilities as of the first quarter of 2010 and also at December 31, 2010.

None of the amendments to other standards had an impact on MTU’s financial reporting methods.

REVISIONS TO IFRS 3 ‘BUSINESS COMBINATIONS’ AND IAS 27 ‘CONSOLIDATED AND SEPARATE FINANCIAL STATEMENTS’
The revised standards contain substantial amendments concerning the accounting treatment of business combinations, transactions with non-controlling interests, and loss of control of a subsidiary. Since there were no relevant transactions in the financial year 2010, this had no impact on reporting methods. The possible impacts of the revised IFRS 3 and IAS 27 on future reporting periods can only be assessed on a case-by-case basis and depend on the form and details of any relevant transactions that might take place with other companies.

STANDARDS, INTERPRETATIONS AND AMENDMENTS ISSUED BUT NOT YET EFFECTIVE
The following IASB accounting standards, which have been issued but were not yet effective for the financial year 2010, have not been applied in advance of their effective date:

MTU does not intend to apply any of these standards and interpretations in advance of their effective date.

In the interests of efficient reporting practice, the following descriptions of standards and interpre-tations are limited to those that, in view of MTU’s business model and on the basis of the currently available knowledge of business transactions within the MTU group, will very probably have an impact on the methods of reporting used in future reporting periods.

IFRS 9 ‘FINANCIAL INSTRUMENTS’
In November 2009, the IASB issued the new standard IFRS 9 which addresses the classification and measurement of financial assets. This standard represents the first part of a three-phase project to replace IAS 39. IFRS 9 requires that financial assets are measured either at amortized cost or at fair value. Financial assets are assigned to one of the two measurement categories by looking at how an entity manages its financial instruments (its business model) and identifying the contractual cash flow characteristics of the individual financial assets.

In October 2010 the IASB issued additions to IFRS 9 in relation to accounting for financial liabilities. As a result, in cases where an entity elects to measure financial liabilities at fair value, the amount of the change in fair value due to changes in the entity’s own credit risk must be recognized directly in the statement of comprehensive income or in other comprehensive income rather than in the income statement.

Given the complexity of the subject matter, it is not yet possible to make any reliable detailed statements regarding the impact of IFRS 9. From today’s standpoint, it is unlikely that the standard will be applied any earlier than the financial year 2013.

IFRS 7 ‘FINANCIAL INSTRUMENTS: DISCLOSURES’
The amendments made to IFRS 7 in October 2010 will allow users of financial statements to improve their understanding of transfer transactions of financial assets. It is not anticipated that the additional reporting requirements arising from these amendments will have any significant impact on MTU.

1.2. INVOCATION OF SECTION 264 (3) OF THE GERMAN COMMERCIAL CODE (HGB)
MTU Aero Engines GmbH, Munich, which is a consolidated affiliated company of MTU Aero Engines Holding AG, Munich, and for which the consolidated financial statements of MTU Aero Engines Holding AG, Munich, constitute the exempting consolidated financial statements, has invoked the provision of Section 264 (3) of the German Commercial Code (HGB). The official notice of the company’s invocation of the exemption was published in the electronic version of the Federal Gazette (Bundesanzeiger) in the name of MTU Aero Engines GmbH, Munich, on December 13, 2010.

1.3. NOTES RELATING TO CHANGES IN THE REPORTING OF THE CONSOLIDATED FINANCIAL STATEMENTS
In the interests of greater clarity, MTU has discontinued its earlier voluntary practice of presenting comparative data for two prior periods in its Annual Report.

Following the endorsement of amendments from the annual improvements projects 2007 – 2009 on March 24, 2010, a second sentence was added to IAS 1.69 (d). As a result, the conversion rights attached to the MTU convertible bond no longer automatically result in the presentation of the debt capital component as a current liability. Since the bond does not fall due for repayment until February 1, 2012, the debt capital component is now reported as a non-current liability. According to IAS 1.139D, the amendment is applicable for periods beginning on or after January 1, 2010. Due to the lack of any specific transitional rules in IAS 1, this change in accounting policy has been amended in accordance with IAS 8.19 (b) with retrospective effect, including adjustments to the previous year’s comparative figures. According to IAS 1.10 (f) in combination with IAS 1.39, this retrospective application of a change in accounting policy requires the presentation of a statement of financial position as at the beginning of the earliest comparative period (January 1, 2009).

In 2010, the group acquired financial assets amounting to € 189.0 million (2009: € 0.0 million), of which € 122.3 million were resold in the financial year 2010. These financial assets are not included in the calculation of free cash flow since they can be sold at any time and are held as a liquidity reserve.

 

2. GROUP REPORTING ENTITY

At December 31, 2010, the MTU group including MTU Aero Engines Holding AG, Munich, comprised 23 companies (2009: 23). These are presented in detail in the list of major shareholdings in Note 43.1.2. (Major shareholdings). MTU Versicherungsvermittlungs- und Wirtschaftsdienst GmbH, Munich, is not fully consolidated, on grounds of immateriality. Its equity capital at December 31, 2010 amounted to € 26,000 and its profit/loss was € 0. The assets of MTU München Unterstützungskasse GmbH, Munich, are classified as plan assets as defined in IAS 19. The fair value of these plan assets was included in the calculation of the group’s defined benefit obligation for pensions. For this reason, MTU München Unterstützungskasse GmbH, Munich, is not consolidated.

CHANGE IN COMPOSITION OF GROUP REPORTING ENTITY

PRESENTATION OF CHANGES IN THE GROUP COMPANIES AND EQUITY INVESTMENTS IN ASSOCIATED COMPANIES AND JOINT VENTURES INCLUDED IN THE CONSOLIDATED FINANCIAL STATEMENTS
The number of group companies and equity investments in associated companies and joint ventures included in the consolidated financial statements has developed as follows:

With effect of September 29, 2009, MTU acquired a 19.3% interest in the Middle East Propulsion Company, Riyadh (MEPC), based in the Kingdom of Saudi Arabia, at a cost of € 3.0 million. This equity investment is presented in the consolidated balance sheet under non-current assets.

The acquisition of a stake in MEPC, Riyadh, Saudi Arabia, did not materially affect the composition of the group reporting entity.

Under an asset purchase agreement dated May 18, 2009, MTU disposed of a group of assets and associated liabilities deriving from its interest in MTU Aero Engines North America Inc., Newington, USA. The disposal group mainly comprised property, plant and equipment, trade receivables, inventories, trade payables, and other liabilities and formed an operation of a cash-generating unit (the OEM segment).

In December 2009, MTU disposed of its indirect investment in Pratt & Whitney Canada’s Customer Service Centre in South Africa at a selling price of U.S. $ 1.0 million. This sale had a negligible effect on MTU’s consolidated financial statements.

The following additional assets, liabilities, expenses and income are recognized in the consolidated accounts as a result of the 50% proportionate consolidation of the joint venture MTU Maintenance Zhuhai Co. Ltd., Zhuhai, China:

At December 31, 2010, MTU Maintenance Zhuhai Co. Ltd., Zhuhai, China, had a total of 584 employees (2009: 551 employees).

 

3. CONSOLIDATION PRINCIPLES

All business combinations are accounted for using the acquisition method as defined in IFRS 3. Under the acquisition method, the acquirer accounts for the business combination by measuring and recognizing the identifiable assets acquired and the liabilities and contingent liabilities assumed. The identifiable assets, liabilities, and contingent liabilities are measured at their fair values. In accordance with IAS 36, goodwill is tested for impairment at least annually, or at shorter intervals if there is an indication that the asset might be impaired. If the group’s interest in the net fair value of the acquired identifiable net assets exceeds the cost of the business combination, that excess (negative good-will) is immediately recognized in the income statement – after remeasurement as required by IFRS 3.36.

The effects of intragroup transactions are eliminated. Accounts receivable and accounts payable as well as expenses and income between the consolidated companies are netted. Internal sales are transacted on the basis of market prices and intragroup profits and losses are eliminated.

In accordance with IAS 12, deferred taxes are recognized on temporary differences arising from the elimination of intragroup profits and losses.

Equity investments in joint ventures – with the exception of MTU Maintenance Zhuhai Co. Ltd., Zhuhai, China – are accounted for in the consolidated financial statements using the equity method from the date of acquisition and are recognized initially at cost. The share of an investee’s profit or loss to which MTU Aero Engines Holding AG, Munich, is entitled is recognized in the income statement.

4. CURRENCY TRANSLATION
Transactions in foreign currencies are translated to the functional currency using the exchange rate prevailing on the date of the transaction. At the balance sheet date, monetary items are translated using the exchange rate prevailing at that date, whereas non-monetary items are translated using the exchange rate prevailing on the transaction date. Translation differences are recognized in the income statement. The assets and liabilities of group companies whose functional currency is not the euro are translated from the corresponding local currency to the euro using the closing exchange rate at the balance sheet date. In the income statements of foreign group companies whose functional currency is not the euro, income and expense items are translated each month using the exchange rate applicable at the end of the month; from these can be derived the average exchange rate for the year. The translation differences arising in this way are recognized in other comprehensive income and do not have any impact on the net profit/loss for the year.

 

5. ACCOUNTING POLICY AND MEASUREMENT METHODS

The financial statements of MTU Aero Engines Holding AG, Munich, and of its subsidiaries are drawn up using uniform accounting policies in accordance with IAS 27.

5.1. REVENUES
Revenues from the sale of goods are recognized when goods are delivered to the customer and accepted by the latter, in other words when the significant risks and rewards of ownership of the goods have been transferred by the seller. Further recognition criteria are the probability that economic benefits associated with the transaction will flow to the seller and that the revenues and costs can be measured reliably. The company’s customers are trading partners from risk- and revenue-sharing programs, original equipment manufacturers (OEMs), cooperation entities, public-sector contractors, airlines and other third parties.

Revenues from maintenance contracts in the commercial MRO business are recognized when the maintenance service has been performed and the criteria for recognizing revenues have been met. In the case of long-term commercial maintenance agreements and military development and construction contracts, revenues are recognized by reference to the percentage of completion in accordance with IAS 18 and IAS 11. If the outcome of a contract cannot be estimated reliably, the zero-profit method is applied, whereby revenues are only recognized to the extent that contract costs have been incurred and it is probable that those costs will be recovered. Contracts are recognized in the balance sheet under ‘construction contract receivables’ (Note 24. Construction contract receivables) or under ‘construction contract payables’ (Note 35. Construction contract payables). Further explanation of the measurement of percentage of completion is given in connection with work in progress (Note 5.10. Inventories).

Revenues are reported net of trade discounts and concessions and customer loyalty awards.

The group’s forward foreign currency contracts satisfy the conditions for applying hedge accounting according to IAS 39. The instruments used to hedge cash flows are measured at their fair value, with gains and losses recognized initially under other comprehensive income. They are subsequently recorded as revenues when the hedged item is recognized.

5.2. COST OF SALES
Cost of sales comprises the production-related manufacturing cost of products sold, development services paid, and the cost of products purchased for resale. In addition to the direct material cost and production costs, it also comprises systematically allocated overheads, including depreciation of the production installations and production-related other intangible assets, write-downs on inventories and an appropriate portion of production-related administrative overheads. Cost of sales also includes expenses charged by OEMs for marketing new engines in conjunction with risk- and revenue-sharing programs.

5.3. RESEARCH AND DEVELOPMENT EXPENDITURE
Expenditure in connection with research activities (research costs) is charged to expense in the period in which it is incurred.

In the case of development costs, a distinction is drawn between purchased (‘externally acquired’) development assets and self-created (‘internally generated’) development assets. Project costs attributable to externally acquired development assets are generally allocated to construction contract receivables on the basis of percentage of completion. Any surplus expense or income remaining after the end of a development project is amortized proportionately over the subsequent production phase.

Development costs generated in the context of company-funded R&D projects are capitalized at the construction cost to the extent that they can be attributed directly to the product and on condition that the product’s technical and commercial feasibility have been proved. There must also be reasonable probability that the development activity will generate future economic benefits. The capitalized development costs comprise all costs directly attributable to the development process. Capitalized development costs are amortized on a scheduled basis over the expected product life cycle from the start of production onwards.

Capitalized development costs, as well as previously capitalized development projects that have not been completed by the end of the financial year, are subjected to an impairment test at least once a year. An impairment charge is only recognized if the carrying amount of the capitalized asset exceeds the recoverable amount.

5.4. INTANGIBLE ASSETS
Externally acquired and internally generated intangible assets are recognized in accordance with IAS 38 if it is probable that a future economic benefit associated with the asset will flow to the entity and the cost of the asset can be measured reliably.

Intangible assets with a finite useful life are carried at cost and amortized on a straight-line basis over their useful lives. In the financial years 2010 and 2009, no borrowing costs were recognized in respect of intangible assets in accordance with IAS 23 because these assets did not include any qualifying assets for which the commencement date for capitalization was on or after January 1, 2009.

With the exception of goodwill, technology assets, customer relations and capitalized program assets, intangible assets are generally amortized over a period of 3-5 years. Program assets including development costs are amortized over their useful lives of up to 30 years, technology assets over 10 years, and customer relations over periods of between 4 and 26 years.

Goodwill is apportioned between the cash-generating units (CGUs) for the purpose of impairment testing. Consistent with the distinction made for segment reporting purposes, the commercial and military engine business (OEM) and the commercial maintenance business (MRO) are viewed as cash-generating units. Goodwill was attributed to each of the two segments as of January 1, 2004.

5.5. PUBLIC SECTOR GRANTS AND ASSISTANCE
Public sector grants and assistance are recognized in accordance with IAS 20 only if there is reasonable assurance that the conditions attached to them will be complied with and that the grants will be received. Grants are recognized as income over the periods necessary to match them with the related costs that they are intended to compensate. In the case of capital expenditure on property, plant and equipment and on intangible assets, the amount of the public sector grant awarded for this purpose is deducted from the carrying amount of the asset. The grants are then recognized in the income statement using reduced depreciation/amortization amounts over the lifetime of the depreciable asset.

5.6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are subject to wear and tear and are carried at their acquisition or construction cost less accumulated depreciation charges and cumulative impairment losses. The revaluation model is not applied. Depreciation on property, plant and equipment is calculated using the straight-line method according to the useful life of the asset.

Scheduled depreciation is based on the following useful lives:

The depreciation of machines used in multi-shift operation is accelerated by using a higher shift coefficient to take account of additional usage.

The residual values, useful lives and depreciation methods pertaining to property, plant and equipment are regularly assessed for relevance, at least at every balance sheet date, and adjustments are made where necessary to the estimates used when compiling the financial statements.

The cost of items of self-constructed plant and equipment comprises all directly attributable costs and an appropriate proportion of production-related overheads, including depreciation and pro rata administrative and social security costs. Through the end of the financial year 2008, borrowing costs were not capitalized as part of acquisition or construction costs. Nor were any borrowing costs capitalized in the financial years 2009 and 2010 in accordance with IAS 23, given that the group’s property, plant and equipment did not include any qualifying assets for which the commencement date for capitalization was on or after January 1, 2009.

INVESTMENT PROPERTY
The MTU group does not hold any investment property. An insignificant part of the buildings recognized under property, plant and equipment is rented out to external third parties. The rental income from this property amounted to € 1.2 million in the financial year 2010 (2009: € 0.9 million).

5.7. LEASING
The beneficial ownership of leased assets is attributed to the contracting party in the lease arrangement that bears the substantial risks and rewards associated with ownership of the leased asset. If the lessor retains the substantial risks and rewards (operating lease), the leased asset is recognized in the lessor’s balance sheet. The lessee in an operating lease arrangement recognizes lease payments as an expense throughout the duration of the lease arrangement.

If the substantial risks and rewards associated with ownership of the leased asset are transferred to the lessee (finance lease), the leased asset is recognized in the lessee’s balance sheet. The leased object is recognized at its fair value as measured at the date of acquisition, or at the present value of future minimum lease payments if lower, and depreciated over its estimated useful life, or the contract duration if shorter. The lessee immediately recognizes a finance lease liability corresponding to the carrying amount of the leased asset. The effective interest rate method is employed to amortize and update the lease liability in subsequent periods.

5.8. IMPAIRMENT LOSSES ON INTANGIBLE ASSETS AND PROPERTY, PLANT AND EQUIPMENT
At each balance sheet date, an assessment is carried out to reveal any indication that the value of intangible assets or assets of property, plant and equipment might be impaired. If impairment is indicated, the recoverable amount of the asset in question is estimated. Assets with an indefinite useful life, intangible assets that are not yet ready for use, and goodwill acquired in connection with a business combination are not subject to scheduled amortization, but are instead reviewed for impairment at least once each year.

The impairment loss on intangible assets and property, plant and equipment is determined by comparing the carrying amount with the recoverable amount. If it is not possible to attribute separate future cash flows to discrete assets that have been generated independently of other assets, then an impairment test must be carried out on the basis of the cash-generating unit to which the asset ultimately belongs. If the reasons for impairment losses recognized in a prior period no longer exist, the impairment loss on these assets is reversed, except in the case of goodwill.

The recoverable amount is the higher amount of the fair value of the asset (or of the cash-generating unit) less costs to sell and value in use.

The recoverable amount of the assets or cash-generating units is usually determined using a discounted cash flow (DCF) method. This involves making forecasts of the cash flow that can be generated over the estimated useful life of the asset or cash-generating unit, applying a discount rate that takes into account the risks associated with the asset or cash-generating unit. The forecast cash flows reflect certain assumptions on the part of management which are validated by reference to external sources of information.

5.9. NON-CURRENT FINANCIAL ASSETS
Investments in subsidiaries and equity investments in joint ventures that are neither fully nor proportionately consolidated, investments in associated companies, and other equity investments do not have a major qualitative and quantitative impact on the MTU group’s net assets, financial situation and operating results. Since in most cases it is not possible to reliably measure their fair value because an active market does not exist, these investments are carried at cost – with appropriate adjustments for impairment loss where necessary. Dividend income and shares in the profit/loss of these investments are included in the financial result on other items.

The group’s share in the profit or loss of companies accounted for using the equity method is allocated on a pro rata basis to profit/loss and the corresponding carrying amount of the investment. This profit/loss is reported in the financial result as a separate line item for ‘profit/loss of companies accounted for using the equity method’.

5.10. INVENTORIES
Raw materials and supplies are measured at the lower of average acquisition cost and net realizable value. Trade discounts and concessions and customer loyalty awards are taken into account when determining acquisition costs. Advance payments for inventories are capitalized. Acquisition cost comprises all direct costs of purchasing and other costs incurred in bringing the inventories to their present location and condition. Net realizable value is the estimated selling price generated in the ordinary course of business for the finished product in question, less estimated costs necessary to make the sale (costs to complete and selling costs).

Work in progress is recognized at the lower of manufacturing cost and net realizable value. Manufacturing cost comprises all production-related expenses based on normal capacity utilization. In addition to direct costs, these include an appropriate and necessary portion of the cost of material and production overheads, including production-related depreciation. Administrative expenses are also included to the extent that they can be attributed to production operations. Borrowing costs are not capitalized because work in progress does not meet the definition of a qualifying asset according to IAS 23.

The group uses the percentage-of-completion (PoC) method to recognize all construction contracts. If the outcome of a specific construction contract can be estimated reliably, revenues and income are recognized in proportion to the percentage of completion. The percentage of completion is determined as the ratio of contract costs incurred to total contract costs (cost-to-cost method). If the outcome of a contract cannot be estimated reliably, the zero-profit method is applied, whereby revenues are only recognized to the extent that contract costs have been incurred, resulting in a balance of zero. If settlement has not yet been received for a construction contract, the construction costs – taking profit sharing into account where relevant – are recognized as future contract receivables in the balance sheet and as revenues arising from construction contracts in the income statement. These items are defined as the difference between the sum of contract costs incurred and measured up to the balance sheet date and recorded profits less losses incurred and partial settlements.

Receivables from construction contracts are recognized separately from trade receivables in the balance sheet under the item ‘construction contract receivables’. If advance payments received from customers are lower than the amount of receivables, the difference is deducted from the amount of construction contract receivables and accounted for as an asset. If the advance payments received are higher than the construction contract receivables, the negative balance of the construction contracts is recognized under construction contract payables. Construction contract receivables and construction contract payables are not offset against one another.

5.11. FINANCIAL INSTRUMENTS
A financial instrument is a contract that simultaneously gives rise to a financial asset in one company and to a financial liability or equity instrument in another company.

5.12. FINANCIAL ASSETS
Financial assets include, in particular, cash and cash equivalents, trade receivables, loans and other receivables, financial investments held to maturity, and non-derivative and derivative financial assets held for trading.

Financial assets are measured in accordance with their classification according to IAS 39. The measurement of a financial asset subsequent to initial recognition depends on whether the financial instrument is held for trading, held to maturity, available for sale, or whether it falls in the loans and receivables category. The assignment of an asset to a measurement category is performed at the time of acquisition and is primarily determined by the purpose for which the financial asset is held. No financial assets were re-classified in the financial year 2010 or in prior reporting periods.

At initial recognition, financial assets are measured at their fair value. In the case of financial assets that are not subsequently measured at fair value through profit or loss, the transaction costs directly attributable to the acquisition of the financial asset are included in the initial measurement.

Financial instruments held for trading are measured at fair value through profit or loss. The subcategory ‘held for trading’ primarily includes derivative financial instruments that do not form part of an effective hedging relationship as defined in IAS 39 and which hence are required to be classified as ‘held for trading’. Any profit or loss resulting from remeasurement is recognized in the income statement.

Financial investments that are intended and expected, with reasonable certainty, to be held to maturity are measured at amortized cost using the effective interest method.

Financial assets classified as ‘loans and receivables’ are measured at amortized cost less impairment, using the effective interest rate where appropriate.

Impairment loss on trade receivables is sometimes accounted for by means of valuation allowances. The decision whether to account for credit risk by means of an allowance account or by directly recording an impairment loss on receivables depends on the degree of certainty with which the risk situation can be assessed.

Other non-derivative financial assets are classified as ‘available for sale’. These are always measured at fair value. Gains or losses resulting from the measurement of fair value are recognized directly in equity. If it is not possible to reliably measure the fair value of an equity instrument that is not quoted in an active market, the investment is measured at acquisition cost (less impairment where appropriate).

IMPAIRMENT LOSS ON FINANCIAL ASSETS
At each balance sheet date, the carrying amounts of financial assets that are not measured at fair value through profit or loss are assessed to determine whether there is any substantial objective indication of impairment.

Examples of such indications include significant financial difficulties of the debtor or a high probability that the debtor will enter bankruptcy or financial reorganization, the closure of an active market for the financial asset, significant changes in technological, economic, legal or market conditions affecting the issuer, or a significant or persistent decline in the fair value of the financial asset below its (amortized) cost. The amount of the impairment loss is recognized in the income statement. If impairment is indicated for available-for-sale financial assets, the amounts previously recognized in equity are eliminated from other comprehensive income up to the amount of the assessed impair-ment loss and recycled to the income statement.

If, in a subsequent period, there is objective evidence that the fair value has increased due to an event occurring after the impairment was originally recognized, the impairment loss is reversed through profit or loss. Impairment losses affecting available-for-sale equity instruments and equity instruments not quoted in an active market are not allowed to be reversed through profit or loss, or any other means. When testing for impairment, the estimated fair value of held-to-maturity investments, and the fair value of loans and receivables measured at amortized cost, is approximated to the present value of future estimated cash flows discounted at the financial asset’s original effective interest rate. The fair value of equity instruments measured at cost and not quoted in an active market is calculated on the basis of the future estimated cash flows discounted at the current rate consistent with the specific risks to which the investment is exposed.

5.13. FINANCIAL LIABILITIES
Financial liabilities often entitle the holder to return the instrument to the issuer in return for cash or another financial asset. These include, in particular, bonds and other debts evidenced by certificates, trade payables, liabilities to banks, finance lease liabilities, borrowers’ note loans and derivative financial liabilities.

Financial liabilities are measured at their fair value at the time of acquisition, which is normally equivalent to the net loan proceeds. Transaction costs directly attributable to the acquisition are deducted from the amount of all financial liabilities that are not measured at fair value through profit or loss subsequent to initial recognition. If a financial liability is interest-free or bears interest at below the market rate, it is recognized at an amount below the settlement price or nominal value. The financial liability initially recognized at fair value is amortized subsequent to initial recognition using the effective interest method.

5.14. CASH AND CASH EQUIVALENTS
Cash and cash equivalents include current accounts and short-term bank deposits, have a maturity of three months or less from the date of acquisition, and are measured at cost.

5.15. DERIVATIVE FINANCIAL INSTRUMENTS
MTU uses derivative financial instruments as a hedge against currency, interest rate and price risks arising out of its operating activities and financing transactions.

At initial recognition, derivative financial instruments are measured at their fair value. The fair value is also of importance to subsequent measurement. The fair value of traded derivative financial instruments is derived, wherever possible, from quoted market prices in an active market. If no quoted market prices in an active market are available, the fair value is calculated using recognized actuarial models. The fair value of derivative financial instruments is represented by the amount that MTU would receive or would have to pay at the balance sheet date when the financial instrument is terminated. This value is calculated on the basis of the relevant exchange rates, interest rates and credit standing of the contractual partners at the balance sheet date.

The accounting treatment for derivative financial instruments depends on whether or not a hedging relationship exists between the underlying transaction and the hedged item. Derivative financial instruments that do not form part of an effective hedging relationship as defined in IAS 39 must be classified as ‘held for trading’ and are therefore recognized in the balance sheet at their fair value.

HEDGE ACCOUNTING (HEDGING RELATIONSHIPS)
MTU satisfies the requirements relating to hedging instruments in accordance with IAS 39 (cash flow hedge accounting) to hedge future payment cash flows. This reduces volatility in cash flows that could affect profit or loss. When a hedge is undertaken, the relationship between the financial instrument designated as the hedging instrument and the underlying transaction is documented, as are the risk management objective and strategy for undertaking the hedge. This includes assigning specific hedging instruments to the corresponding future transactions and assessing the effectiveness of the designated hedging instrument. Existing cash flow hedges are monitored for effectiveness on a regular basis.

Cash flow hedges are used to hedge the exposure of future cash flows arising from underlying transactions to fluctuations in foreign currency exchange rates. When a cash flow hedge is in place, the effective portion of the change in value of the hedging instrument is recognized in other comprehensive income, together with related deferred taxes, until such time as the outcome of the hedged transaction is recognized.

The effective hedge is recycled to the income statement as soon as the hedged transaction is recognized in profit or loss. The ineffective portion of the change in value of the hedging instrument is recognized on each balance sheet date in the financial result.

5.16. CURRENT AND DEFERRED TAX ASSETS AND LIABILITIES
Current and deferred tax assets and liabilities are recognized in the consolidated financial statements on the basis of the tax laws in force in the relevant tax jurisdictions. Current and deferred tax assets and liabilities are recognized in equity if they relate to business transactions that directly lead to a decrease or increase in equity.

Deferred tax assets and liabilities are established for temporary differences between the tax bases of assets and liabilities used when calculating taxable income and the carrying amount of these assets and liabilities in the consolidated balance sheet (‘balance sheet liability method’). Similarly, where appropriate, deferred tax assets are established on tax losses, interest expense and tax credits available for carry-forward. Deferred tax assets are recognized for deductible temporary differences, unused tax losses and unused tax credits to the extent that it is probable that taxable income will be available against which the deductible temporary differences can be utilized. Deferred tax assets and liabilities are measured on the basis of the tax rates expected to be applicable on the date when the temporary differences are reversed. Deferred tax assets and liabilities are offset, insofar as this meets the requirements of IAS 12.74.

5.17. PENSION OBLIGATIONS
Pension provisions are accounted for using the projected unit credit method in accordance with IAS 19. This method takes account not only of pension and other vested benefits known at the balance sheet date, but also of estimated future increases in pensions and salaries, applying a conservative assessment of the relevant parameters. IAS 19 permits the use of different methods for recognizing actuarial gains and losses. To avoid volatility in the amount of equity as of the balance sheet date, MTU employs the so-called ‘corridor’ method.

When using the corridor method, cumulative actuarial gains and losses are only recognized if they exceed 10% of the present value of the defined benefit obligation or 10% of the fair value of the relevant plan assets, whichever is higher. When actuarial gains or losses exceed the 10% corridor, the excess is divided by the expected average remaining working lives of the employees covered by the relevant pension plan, and recognized from the beginning of the following financial year as income or expense, as an additional component of the pension costs. The expense attributable to unwinding the interest on pension obligations and the expected return on plan assets are reported separately in the financial result. All other expenses attributable to pension obligations are allocated to the appropriate income statement line items by function.

Provisions for pre-retirement part-time working arrangements and long-service awards are measured on the basis of actuarial reports prepared in accordance with IAS 19.

5.18. OTHER PROVISIONS
Provisions are accrued to cover the cost of legal disputes and claims for damages if the group incurs a current obligation arising from a lawsuit, government investigation or other claims which derive from past events and are pending, or if it is possible that such proceedings could be initiated against the group or be enforced at a future date, and if it is probable that an outflow of economic resources will be necessary to fulfil the obligation, and it is possible to reliably estimate the amount of the obligation. Non-current provisions due in more than one year are measured on the basis of their settlement amount, discounted to the balance sheet date. The company measures provisions for pending losses on onerous contracts at the lower of the expected costs on settlement of the contract and the expected costs on termination of the contract.

5.19. CONTINGENT LIABILITIES
Contingent liabilities are potential obligations arising from past events whose existence depends on the occurrence or non-occurrence of one or more uncertain future events that are not wholly within the control of MTU.

Contingent liabilities are also present obligations for which there is unlikely to be an outflow of economic resources, or where the amount of the obligation cannot be reliably estimated.

Obligations arising from contingent liabilities assumed and identified in connection with an acquisition are recognized if it is possible to reliably determine their fair value. Subsequent to initial recognition, contingent liabilities are recognized at the higher of the two values: (a) the amount that would have been recognized as a provision according to IAS 37, (b) the originally recognized amount amortized by the actual cash flows. Negative values of engine programs resulting from purchase price allocation are accounted for as contingent liabilities.

5.20. SHARE-BASED PAYMENT TRANSACTIONS
Share options, i.e. share-based payment transactions settled by the issuance of equity instruments, are measured at fair value at the grant date. The fair value of the obligation is recognized during the vesting period as a personnel expense and in equity. Exercise conditions that are not tied to market conditions are included in the assumptions concerning the number of options that are expected to be exercised. The fair value is obtained using the internationally recognized Black-Scholes pricing model.

5.21. DIVIDEND PAYMENT AND PROFIT DISTRIBUTION
The claims of shareholders to dividend payments and profit distribution relating to a specific reporting period (financial year) are recognized as a liability in the period in which the corresponding resolution is passed. Disclosures relating to the Board of Management’s proposal to the Annual General Meeting concerning the dividend payment are provided in Part VII of these notes under the subheading ‘Recommendation for the distribution of net profit’.

5.22. DISCRETIONARY SCOPE, MEASUREMENT UNCERTAINTIES AND SENSITIVITY
The presentation of the group’s net assets, financial situation and operating results in the consoli-dated financial statements depends on the use of recognition and measurement methods and of assumptions and estimations. The estimations and corresponding assumptions detailed below are crucial to an understanding of the underlying risks of financial reporting and the effects that these estimations, assumptions and uncertainties might have on the consolidated financial statements. Actual values may occasionally deviate from the assumed and estimated values. Adjustments may be made to carrying amounts at the time that better knowledge comes to light. This is especially the case in the following circumstances:

• Both at initial measurement and subsequent measurement after initial recognition, the determination of the carrying amount of intangible assets and contingent liabilities identified in connection with business combinations as defined in IFRS 3 involve substantial use of forward-looking estimates, due to the long product life cycles. These estimates rely on assumptions concerning factors such as risk adaptation of cash flows or discount rates and future price changes with an impact on other costs including price escalation and possible contract penalties. In the financial year 2010, the contingent liabilities for individual engine programs identified and measured in connection with the purchase price allocation were affected by the consequences of the prior year’s delays in the delivery of engines and by changes in the discount rate. The carrying amount of the contingent liabilities totaled € 124.9 million at December 31, 2010. If the discount rate had been 100 basis points higher at December 31, 2010, the carrying amount of the liability would have totaled approximately € 147 million. In contrast, if the discount rate had been 100 basis points lower at December 31, 2010, the carrying amount of the liability would have totaled approximately € 79 million. Further explanations are given in Note 32. (Other provisions).

• The basic premises underlying the measurement of construction contract receivables for the TP400-D6 military engine program had to be entirely reviewed in the financial year 2009 due to the uncertainties arising from delayed deliveries at the end of the 2009 financial year and the uncertain technical status on the one hand, and the general uncertainty surrounding the future of the program on the other. As a result of the reassessment of the time schedule undertaken by MTU at the end of 2009, taking into account all recalculated premises, the carrying amount of construction contract receivables for the TP400-D6 engine program was written down in 2009 and a valuation allowance for receivables recognized in the income statement. In addition, a provision of € 45.3 million was recognized in the income statement. The measurement of the valuation allowance and allocated provision at December 31, 2009 also included a proportional share of contract penalties that – according to MTU’s estimates at the time – the company would be required to pay.
  
  Following the signing of an agreement in principle – the ‘A400M Understanding’ – in March 2010, the customer nations (represented by the procurement agency OCCAR) and Airbus Military subsequently agreed the details of the changes to the A400M contract. Although the agreements envisage that the overall economics will remain unchanged, there is nevertheless one major change that must be taken into consideration, namely Germany’s decision to reduce its order from 60 to 53 aircraft and the United Kingdom’s decision to trim its order from 25 to 22 aircraft. The ‘A400M Understanding’ was followed by appropriate agreements between Airbus Military and the military engine consortium Europrop International GmbH, Munich (EPI). This saw the total number of firm orders for the A400M project decrease to 170 and the number of Europrop TP400-D6 engines fall to approximately 680. The first aircraft are now expected to be delivered in early 2013.
  
  Based on this generally satisfactory solution for the overall project, the review of the TP400-D6 engine program at December 31, 2010 took into consideration the absence of the contractual penalties for possible program discontinuation or non-performance penalties taken into account in 2009 and also took into consideration postponements of deliveries, cancellations of previous orders by customer nations, reworking of the software for engine control and price escalations. Due to the prolonged product life cycle, changes in the applied interest rates have a significant impact on the measurement of the engine program.
  
  It is not possible to perform a sensitivity analysis of the extent of possible consequences of price changes or possible contract penalties due to the multitude of sensitivity scenarios combined with highly uncertain estimates. Further explanatory comments can be found in Note 24. (Construction contract receivables).

• The measurement of property, plant and equipment, intangible assets and financial assets (insofar as they are accounted for using the equity method or at cost) comprising a carrying amount at the end of the financial year of € 1,794.8 million (2009: € 1,814.8 million) involves the use of estimates to determine the fair value. Estimations are also employed to determine the expected useful life of assets. Judgments by management form the basis for determining the fair value of assets and liabilities and the useful life of assets. In the process of determining the impairment loss on property, plant and equipment, intangible assets and financial assets, estimations are made concerning such parameters as the source, timing and amount of the impairment loss. Many different factors can give rise to an impairment loss. Factors always considered are changes in the competitive situation, expectations concerning the growth of aviation and the aircraft industry, changes in the cost of capital, changes in the future availability of financing funds, aging and obsolescence of technologies, the suspension of services, replacement costs, purchase prices paid in comparable transactions, and other general changes providing evidence of impairment.
  
  Management is required to make estimations concerning the identification and verification of indicated impairments, expected cash flows, relevant discount rates, corresponding useful lives and residual values in order to determine the recoverable amounts for the operating segments ‘commercial and military engine business’ and ‘commercial maintenance business’, and the fair value of assets (or groups of assets). In particular, the estimation of cash flows on which the recoverable amounts are based in the case of new engine programs in both the commercial and military engine business depends on the assumption that it will be possible to raise funds on a continuous basis, but also that it will be necessary to make continuous investments in order to generate sustainable growth. If the demand for engines is slower than expected, this could reduce earnings and cash flows and possibly lead to the recognition of impairment losses on these investments. This could in turn have negative repercussions on operating results.
  
  These estimations and the method used to obtain them may have a significant impact on the determined recoverable amount and on the amount of the impairment loss recognized on goodwill. Reference is made to Note 40. (Sensitivity analysis of goodwill) for a sensitivity analysis of the goodwill of the commercial and military engine business and of the commercial maintenance business.
  
  
• Management creates allowances for doubtful accounts. Judgment of the appropriateness of allowances for doubtful accounts is based on the repayment structure of the balance of settlements and past experience with the writing-off of debts, the customer’s credit standing, and changes in the conditions of payment. At December 31, 2010, valuation allowances on trade receivables amounted to € 9.4 million (2009: € 7.9 million). If the customer’s financial situation should deteriorate, the volume of the allowances that have to be created may exceed the expected volume.
  
  
• Revenues in the military engine business and in the commercial maintenance business are recognized in progressive stages as the work advances, using the percentage-of-completion method, if it is sufficiently probable that future economic benefits associated with the business will flow to MTU. The percentage of completion is determined by comparing the actual costs up to the balance sheet date with estimated total contract costs. If the outcome of a construction contract cannot be estimated reliably, revenues are only recognized to the extent that contract costs have been incurred and it is probable that those costs can be recovered (so-called zero-profit method). Management regularly reviews all estimates made in connection with these construction contracts, making adjustments where necessary. Revenues from the sale of engine components in the month of December are partially estimated for bookkeeping purposes. These estimates are derived principally from preliminary data supplied by the consortium leader and from material flow data that provides a sufficiently reliable basis for estimating revenues.
  
  
• Income taxes must be determined for each tax jurisdiction in which the group operates. The current income taxes have to be calculated for each taxable subject, and temporary differences arising from the different treatment of certain balance sheet items in the IFRS consolidated financial statements and the tax statements need to be determined. All identified temporary differences lead to the recognition of deferred tax assets and liabilities in the consolidated financial statements. Additionally, deferred tax effects may arise, particularly from tax losses, interest expense and tax credits available for carry-forward. Management judgments come into play in the calculation of current taxes and deferred taxes.
  
  Deferred tax assets totaling € 16.7 million (2009: € 16.9 million) were recognized at December 31, 2010. The utilization of deferred tax assets depends on the possibility of generating sufficient taxable income in a particular tax category and tax jurisdiction, taking into account where appropriate any statutory restrictions relating to the maximum periods over which losses may be carried forward. A variety of factors are used to assess the probability that it will be possible to utilize deferred tax assets, including past operating results, operating business plans, the periods over which losses can be carried forward, and tax planning strategies. If the actual results deviate from these estimations, or if these estimations have to be adjusted in a future period, this may have detrimental effects on the group’s net asset position, financial situation and operating results. If there is a change in the value assessment of deferred tax assets, the recognized deferred tax assets are to be written down.
  
  
• The discount rate is an important factor when determining the provisions to be allocated for pensions and similar obligations. An increase or decrease of 25 basis points in the discount rate can lower or raise the amount of pension obligations by approximately € 12 - 14 million. Given that actuarial gains and losses are only recognized if they exceed 10% of the amount of total obligations or 10% of the fair value of plan assets, whichever is higher, changes in the discount rate usually have no impact, or only an insignificant impact, on the recognized expense or carrying amount of the provisions for the following year in respect of the retirement benefit plans in place within the group.
  
  Pension obligations for employee benefits that are classified and accounted for as defined benefit plans are not covered by any other plan assets except for the plan assets of MTU Maintenance Canada Ltd., Richmond, Canada and MTU München Unterstützungskasse GmbH, Munich. The existing plan assets are offset against the pension obligations. If the plan assets exceed the corresponding pension obligations, the surplus amount of the plan assets is capitalized according to IAS 19.58A.
  
  The total value of pension obligations and therefore the expenses in connection with employees’ retirement benefits are determined using actuarial methods based on assumptions concerning interest rates and life expectancy. If it should become necessary to modify these assumptions, this could have a significant effect on the future amount of pension provisions or the expenses for pensions.
  
  
• The recognition and measurement of other provisions amounting to € 340.1 million (2009: € 421.1 million) and contingent liabilities amounting to € 126.6 million (2009: € 144.5 million) in connection with pending legal disputes or other pending claims arising from conciliation or arbitration proceedings, joint committee procedures, government lawsuits or other types of contingent liability (particularly those arising from risk- and revenue-sharing partnerships) involve substantial estimations on the part of MTU. For instance, the assessment of the probability that a pending case will be won or that an obligation will arise, or the quantification of the probable payment, all depend on an accurate evaluation of the prevailing situation. Provisions are accrued when a present legal or de facto obligation arises from a past event, it is probable that an outflow of economic resources will be required to fulfill this obligation and it is possible to reliably estimate the amount of the obligation. Due to the uncertainties attached to this assessment, the actual losses may deviate from those originally estimated, and hence from the amount of the provision. Furthermore, the calculation of certain specific provisions (for example to cover tax obligations, environmental obligations and legal risks) also involves considerable use of estimations. These estimations may change in the light of new information.
  
  
• Financial liabilities: There was no requirement to measure or recognize non-current assets or disposal groups classified as ‘held for sale’ or discontinued operations, since there was no intention to sell. For explanatory comments concerning the disposal group comprising assets and associated liabilities of MTU Aero Engines North America Inc., Newington, USA, which was sold in the financial year 2009, reference is made to Note 2. (Group reporting entity).
  
  Further to the above, there were no other changes to estimates or forecasts with a significant effect on the results of the reporting period.
  
  All assumptions and estimates are based on the prevailing conditions and judgments made at the balance sheet date. Estimations of future business developments also take into account the economic environment of the industry and the regions in which MTU is active, such as are deemed realistic at that time. In order to obtain new information, MTU relies on the services of internal experts and external consultants such as actuaries and legal counsels. Changes to the estimations of these obligations can have a significant impact on future operating results.