ORLEN Group 2016 Integrated Report

7.1. EXPLANATORY NOTES TO THE STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

7.1.1. Sales revenues by assortments

SELECTED ACCOUNTING PRINCIPLES

Sales revenues
Sales revenues of goods and services are recognized, when the significant risks and rewards of ownership are transferred to the buyer and when the Group is no longer permanently involved in managing sold goods to the extent, that such function is usually carried out in relation to goods, to which there is right of ownership, and it does not exercise effective control over them. Revenues include received and due payments for delivered finished goods, merchandise, raw materials and services, decreased by the amount of any trade discounts and value added tax (VAT), excise tax and fuel charges. Revenues are measured at the fair value of the payment received or due.
Revenues from the sale of finished goods, merchandise, raw materials and services are adjusted for profits or losses from settlement of cash flows hedging instruments related to the above mentioned revenues.
Revenues and costs from services, which beginning and end fall within different reporting periods, are recognized by reference to  the stage of completion of the service, when the outcome of a contract can be valuated reliably, in other cases, revenues are recognized only to the extent of costs incurred to the date, but not higher than the costs that the Group expects to recover.

In 2016 and 2015 no leading customers were identified in the Group, for which turnover individually would exceeded 10% of total revenues from sale of the ORLEN Group.

7.1.2. Sales revenues geographical division - disclosed by customer’s premises countries

The line “Other countries” comprises mainly sales to customers from Switzerland, Ukraine, Hungary, Slovakia, Great Britain, the Netherlands, Canada and Austria.

7.1.3. Cost by nature

SELECTED ACCOUNTING PRINCIPLES

Costs

Cost of sales include costs of finished goods, merchandise, services and raw materials sold and adjustments related to inventories written down to net realizable value.
Costs are adjusted for profits or losses from settlement of cash flow hedging instruments related to the above mentioned costs.
Distribution expenses include selling brokerage expenses, trading expenses, advertising and promotion expenses as well as distribution expenses.
Administrative expenses include expenses relating to management and administration of the Group as a whole.

7.1.4. Other operating income

The line penalties and compensation in 2016 includes mainly the amount of partial compensation received from insurers related to the steam cracker unit accident in Unipetrol Group in August 2015 in the amount of PLN 1,280 million. Detailed information is presented in note 7.4.4.

7.1.5. Other Operating expenses

7.1.6. Finance income and costs

7.1.6.1. Finance income

7.1.6.2. Finance costs

7.1.6.3. Interest, net

7.1.6.4. Foreign exchange loss

7.1.7. Tax expense

SELECTED ACCOUNTING PRINCIPLES

Income tax expenses (tax expense)

Income tax expenses (tax expense) include of current tax and deferred tax. Current tax expense is determined in accordance with the relevant tax law based on the taxable profit for a given period and is recognized as a liability, in the amount which has not been paid or receivable, if the amount of the current and prior periods income tax paid exceeds the amount due the excess is recognized.
Deferred tax assets and liabilities are accounted as non-current and are not discounted and are offset on the level of particular financial statements of the Group companies when there is a legally enforceable right to set off the recognized amounts.

7.1.7.1. The differences between tax expense recognized in profit or loss and the amount calculated based on the rate from profit before tax

As at 31 December 2016 and as at 31 December 2015, the Group had unsettled tax losses mainly relating to the ORLEN Lietuva Group, the Unipetrol Group and the Anwil Group of PLN 410 million and PLN 1,155 million respectively, for which no deferred tax asset was recognized due to the lack of certainty regarding the possibility of their realization in the future.

7.1.7.2 Deferred tax

As at 31 December 2016 deferred tax assets and liabilities amounted to PLN 167 million and PLN 809 million, respectively.

7.1.7.3. Tax expense (paid)

 
7.2. EXPLANATORY NOTES TO THE STATEMENT OF FINANCIAL POSITION

7.2.1. 7.2.1. Property, plant and equipment

SELECTED ACCOUNTING PRINCIPLES

7.2.1. Property, plant and equipment
Property, plant and equipment are initially measured at cost, including grants related to assets. Property, plant and equipment are stated in the statement of financial position prepared at the end of the reporting period at the net book value which is the amount at which an asset is initially recognized (cost) less accumulated depreciation and any accumulated impairment losses, as well as received grants for assets.
The costs of significant repairs and regular maintenance programs are recognized as property, plant and equipment.
Fixed assets are depreciated with straight-line method and in justified cases units of production method of depreciation (catalysts, assets arising from development and extraction of mineral resources).
Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item is depreciated separately over the period reflecting its useful lives.
The following standard useful lives are used for property, plant and equipment:

• Buildings and constructions 10-40 years
• Machinery and equipment 4-35 years
• Vehicles and other 2-20 years

The method of depreciation, residual value and useful life of an asset are reviewed at least at the end of each year. When it is necessary adjustments of depreciation are carried out in subsequent periods (prospectively).

Grants
Grants are recognized if there is reasonable assurance that the grants will be received and the entity will comply with the conditions attaching to them.
Grants related to assets are recognized as a decrease of a carrying amount of an asset and as a result a decrease of depreciation and amortisation charges over the useful life of the asset.

Exploration and extraction of mineral resources
Within the framework of exploration and extraction of mineral resources, the following classification of stage was made:

Stage of exploration and assessment of mineral resources include:

• acquisition of rights to explore and extract, exploration and recognition of resources are recognized according to the successful efforts method,
• expenditures for exploratory,
• other expenditures which are directly attributable to the phase of exploration and recognition and are subject for capitalization.

The Group shall review annually expenditures incurred in the stage of exploration and recognition of mineral resources in order to confirm the intention of further work. If the work is unsuccessful, the cost previously recognized as an asset are recognized as cost of a current period.
Expenditure incurred in the exploration and recognition of resources are recognized as assets related to development and extraction of mineral resources within property, plant and equipment at the moment of the conclusion of their technical feasibility and economic viability of mining.

Stage of site planning and of extraction of mineral resources
Expenditures incurred for mineral resource sites planning and extraction of resources are capitalized and amortised by unit of production method calculated proportionally to the amount of extraction of hydrocarbons based on unit of installation. The Group calculates the depreciation of all assets related to sites planning and extraction of mineral resources (including their significant components) based on proved plus probable reserves.
In case of significant change in estimated mineral resources, at the reporting date potential impairment allowances are recognized or reversed.
In case of performance of exploratory drillings on already extracted resource, the Group analyses, if costs incurred enable rising new boreholes. If not, the expenditures are recognized in costs of the current period.

PROFESSIONAL JUDGEMENTS

Expenditures for exploration and evaluation of mineral resources
Application of the Group’s accounting policy for expenditures for exploration and evaluation of mineral resources requires an assessment, whether future economic benefits resulting from extraction or sale are possible or if indications allowing to estimate the resources does not yet exist. When estimating the resources, the Group assesses future events and circumstances, including the assessment whether the extraction will be economically feasible.

ESTIMATES

Estimated useful lives of property, plant and equipment
The Group verifies useful lives of property, plant and equipment once at year end with effect from the beginning of next year. Should the economic useful lives of properties, plant and equipment from 2015 be applied in 2016, the depreciation expense would be higher by PLN 40 million.

Exploration and evaluation of mineral resources
The Group estimates resources based on interpretation of available geological data and verifies then on a the current basis, based on effects of further drills, trial exploitation, actual extraction and economic factors such as: hydrocarbons’ prices, contractual terms or investment plans.
At the end of each reporting period the Group analyses cost of removal of wells and supporting infrastructure.

Remediation of land – water environment
The Group estimates the level of capitalized provisions related to non-current assets, which to a significant probability are needed for land – water environment remediation of the territory of petrol stations, fuel depots and areas of production plants.

^* Increases/(Decreases) net of impairment allowances include recognition, reversal, usage, reclassifications.
In 2016 and 2015,  net increases/(decreases) of impairment allowances covers respectively: recognition and reversal, net in the amount of PLN 148 million and PLN (993) million, usage due to sale/liquidation in the amount of PLN 157 million and PLN 57 million and reclassifications to assets classified as held for sale and due to changes the Group structure in the amount of PLN 12 million and PLN 139 million.

In 2016 and 2015 the capitalization rate used to calculate borrowing costs amounted to 1.14% and 1.44%, respectively.
The gross carrying amount of all fully depreciated property, plant and equipment still in use as at 31 December 2016 and as at 31 December 2015 amounted to PLN 5,086 million and PLN 4,711 million, respectively.
Information regarding property, plant and equipment that were pledged for loans of the Group is presented in note ‎7.2.6.1.1.

7.2.2. Intangible assets

SELECTED ACCOUNTING PRINCIPLES

Intangible assets

An intangible asset shall be measured initially at acquisition or production cost and shall be presented in the financial statements in its net carrying amount, including grants.
Intangible assets with the finite useful life are amortised using straight-line method. Amortization shall begin when the asset is available for use.
Standard useful lives of intangible assets are from 2 to 10 for software and from 2 to 15 years for concessions, licenses, patents and similar.
The amortization method and useful life of intangible asset item are verified at least at the end of each year.

Goodwill

Goodwill acquired in a business combination shall, from the acquisition date, be allocated to each of the acquirer's cash-generating units (CGU), that is expected to benefit from the synergies of the combination.
After combination the acquirer shall measure goodwill in the amount recognized at the acquisition date less any accumulated impairment allowances.
A cash-generating unit to which goodwill has been allocated shall be tested for impairment annually, and whenever there is an indication that the unit may be impaired. An impairment loss recognized for goodwill shall not be reversed in a subsequent period.

Rights

The main item of rights is CO₂ emission rights, not amortised, tested for impairment.
Granted emission allowances are presented as intangible assets in correspondence with deferred income at fair value as at the date of registration. Purchased allowances are presented at purchase price.
For the estimated CO₂ emission during the reporting period, a provision is created (taxes and charges).
Grants are recognized on a systematic basis to ensure proportionality with the related costs which the grants are intended to compensate.
Outgoing of allowances is recognized using FIFO method (First In, First Out) within the individual types of rights (EUA, CER).
Rights also include energy certificates.

ESTIMATES

Estimated useful lives of intangible assets

The Group verifies useful lives of intangible assets once at year end with effect from the beginning of next year. Should the economic useful lives of intangible assets from 2015 be applied in 2016, the depreciation expense would not change significantly.

As at 31 December 2016 and as at 31 December 2015 internally generated intangible assets amounted to PLN 108 million and PLN 67 million, respectively.

The changes in other intangible assets

^* Increases/(Decreases) net of impairment allowances include recognition, reversal, usage, reclassifications.
In 2016 and 2015, increases/(decreases), net of impairment allowances covers: recognition and reversal in the amount of PLN (3) million and usage and reclassifications.
^** Other increases/(decreases) of property rights in the net book value consist mainly of forward transactions settlement, granted free of charge and settlement of rights for 2015 and 2014.

The gross carrying amount of all fully amortised intangible assets still in use as at 31 December 2016 and as at 31 December 2015 amounted to PLN 586 million and PLN 506 million, respectively.

7.2.2.1. Rights

Change in owned CO₂ emission rights in 2016.

As at 31 December 2016 the market value of one EUA amounted to PLN 28.93 (representing EUR 6.54 at exchange rate as at 31 December 2016) (source: www.theice.com).
As at 31 December 2016 and as at 31 December 2015 the Group recognized the rights to colourful energy in the amount PLN 11 million and PLN 10 million, respectively. In 2016 the Group granted free of charge rights to colourful energy in the amount of PLN 95 million.

Additionally, as at 31 December 2016 and as at 31 December 2015 the Group recognized CO₂ emission rights in the amount PLN 11 million and PLN 18 million, respectively and rights to colourful energy in the amount PLN 3 million and PLN 32 million, respectively (note 7.2.5.2) in trade and other receivables.

7.2.3. Assets by operating segments and non-current assets by geographical allocation

Operating segments include all assets except for financial assets, tax assets and cash. Assets used jointly by the operating segments are allocated based on revenues generated by individual operating segments.

Non-current assets by geographical allocation include property, plant and equipment (note 7.2.1), intangible assets (note 7.2.2), investment property and perpetual usufruct of land (note 7.2.8).

7.2.4. Impairment of property, plant and equipment and intangible assets

SELECTED ACCOUNTING PRINCIPLES

Impairment of property, plant and equipment and intangible assets
At the end of the reporting period, the Group assesses whether there are indicators that an asset or cash-generating unit (CGU) may be impaired or any indicators that the previously recognized impairment should be reversed.
Assets that do not generate the independent cash flows are grouped on the lowest level on which cash flows, independent from cash flows from other assets, are generated (CGU). If such case occurs, the recoverable amount is determined on the CGU level, to which the asset belongs.
Recognition and reversal of impairment allowances of property, plant and equipment and intangible assets is recognized in other operating activity.

ESTIMATES

Impairment of property, plant and equipment and intangible assets
The Management Board assesses whether there is any indicator for impairment of an asset or cash generating unit. If there is any indicator for impairment, the estimation of recoverable amount of an asset is made.

Net impairment allowances of property, plant and equipment and intangible assets

As at 31 December 2016, an impairment indicators were identified in the ORLEN Group in accordance with IAS 36 “Impairment allowances of assets” related to the approval on 15 December 2016 Strategy of the ORLEN Group for the years 2017-2021 ("Strategy") by the Management Board and the Supervisory Board of PKN ORLEN.
Assumptions of the ORLEN Group Strategy include among others, economic growth in key markets activity of the ORLEN Group, the increase of crude oil prices resulting from the need to replace natural decreases in extractions by productions from more expensive sources and restrictions on investment in recent years, the stabilization of downstream margin at a lower level than that observed in the last 2 years and a further increase in regulatory pressure, especially in the field of low carbon economy and environmental protection. Macroeconomic assumptions were developed on the basis of commercially available sources of knowledge of industry analitical agencies, forecasts of bank analysts, expert knowledge of the ORLEN Group.

Due to the lack of a basis for a reliable estimate of the price, at which would have taken place potential transaction to sale the assets of the Group as the recoverable value of its individual assets is its value in use, according to IAS 36.20.
The tests were performed on the basis of assets of the ORLEN Group as at 31 December 2016 and net cash flows projected in the approved within the Strategy the Mid-term Plan, discounted to their present value using the discount rates which reflect the current market value of money and the specific risks to the valued assets.
Discount rates were calculated as the weighted average cost of engaged equity and debt. Sources of macroeconomic indicators necessary to determine the discount rate were published by prof. Aswath Damodaran (source: pages.stern.nyu.edu), government bonds quotation and government agencies available as at 31 December 2016.

The discount rate structure used in the impairment tests of assets by cash-generating unit of ORLEN Group as at 31 December 2016

At the same time, ORLEN Upstream Sp. z o.o. evaluated the validity of continuing exploration work on the concession areas located in the Mazowieckie, Lubelskie, Łódzkie and Małopolskie province and decided to continue further exploration work on these concessions only in selected, the most promising areas of conventional research.

As a result in the 4^th quarter of 2016 recognized effects of reversal of impairment allowance of refinery assets of Unipetrol Group in the amount of PLN 315 million and recognition of impairment allowance of exploration assets of ORLEN Upstream Group in Poland in the amount of PLN (72) million and assets of ORLEN Oil in the amount of PLN (55) million.
As a part of above tests discount rates of 8% were applied for the Unipetrol Group refining assets and 9.57% for the ORLEN Oil assets.

Sensitivity analysis of the Unipetrol Group refining assets value in use within an impairment test performed as at 31 December 2016

 Sensitivity analysis of the ORLEN Oil assets value in use within an impairment test performed as at 31 December 2016

Impairment allowances of property, plant and equipment and intangible assets in 2015

In the 4^th quarter of 2015 an impairment allowance of evaluation and extraction of mineral resources assets in ORLEN Upstream Canada within ORLEN Upstream Group of PLN (423) million was recognized.
As at 31 December 2015 the fair value of evaluation and extraction of mineral resources assets in Canada was based on the estimated crude oil prices and reserves evaluation prepared by an independent company engaged in the evaluation of the reserves in accordance with professional standards for the Canadian market. Estimated net cash flow used to forecast the fair value of assets were discounted to their present value using a base discount rate which reflects the current market value of money and the specific risks to the assets on the Canadian market, which amounted to 9%.

Sensitivity analysis of the ORLEN Upstream Canada assets value in use within an impairment test performed as at 31 December 2015

In the 2^nd quarter of 2015 ORLEN Upstream Group has determined, based on the gathered data of previous work, the most promising areas for further exploration of hydrocarbon in Poland. Narrowing the search area influenced the partial impairment of assets related to exploration and recognition of mineral resources in the amount of PLN (429) million.
The fair value of assets due to exploration and evaluation of mineral resources has been established basing on the analysis of future cash flows, which take into account the current and forecasted hydrocarbon prices, expected changes in the regulatory environment, probability of success/failure and long-term production forecasts. Net cash flow projections used for the purposes of estimating the fair value of the assets were discounted to their present value using a discount rate at 8.99%, which reflects current market assessment of the time value of money and the risks specific to the respective assets on the Polish market.

Sensitivity analysis of the ORLEN Upstream assets value in use within an impairment test performed as at 30 June 2015

While lowering prices by 5% the entire value of the tested assets is impaired, with each of the analysed discount rates.

As a consequence of the steam cracker unit accident in Litvinov (Unipetrol Group) in August 2015, impairment of property, plant and equipment of PLN (93) million translated using the exchange rate as at 30 September 2015 (representing approximately CZK (597) million) was recognized in the 3^rd quarter of 2015.

7.2.5. Working capital

^*Working capital = Inventories +Trade and other receivables – Trade and other liabilities

7.2.5.1. Inventories

SELECTED ACCOUNTING PRINCIPLES

Inventories
Inventories, including mandatory reserves comprise products, semi-finished products and work in progress, merchandise and materials.
Finished goods, semi-finished products and work in progress are measured initially at production cost. Production costs include costs of materials and costs of conversion for the production period. Costs of production also include a systematic allocation of fixed and variable production overheads estimated for normal production level.
Finished goods, semi-finished products and work in progress shall be measured at the end of the reporting period at the lower of cost or net realizable value.
Outgoings of finished goods, semi-finished products and work in progress are determined based on the weighted average cost of production.
Merchandise and materials are measured initially at acquisition cost, while as at the end of the reporting period merchandise and raw materials are measured at the lower of cost or net realizable value. Outgoings of merchandise and raw materials are determined based on the weighted average acquisition cost.
The initial value of inventories is adjusted for profits or losses from settlement of cash flow hedging instruments related to the above mentioned.
Impairment tests for specific items of inventories are carried out on a current basis during a reporting period. Write-down to net realizable value concerns inventories that are damaged or obsolete and the selling price have fallen. Raw materials held for use in the production are not written down below acquisition or production cost if the products in which they will be incorporated are expected to be sold at or above cost.
However, when a decline in the price of materials indicates that the cost of the products exceeds net realizable value, the materials are written down to net realizable value.
Recognition and reversal of impairment allowances of inventories is recognized in cost of sales.

ESTIMATES

Net realizable values from sale of inventories
The inventory allowances required estimation of the net realizable value based on the most recent sales prices at the moment of estimations.

As at 31 December 2016 and as at 31 December 2015 the value of mandatory reserves presented in consolidated financial statement amounted to PLN 4,109 million and PLN 4,534 million, respectively.

Change in impairment allowances of inventories to net realizable value

In 2016 and in 2015 the recognition and reversal of impairment allowances of inventories to net realizable value related mainly to the downstream segment and amounted to PLN (42) million and PLN (170) million, respectively.

7.2.5.2. Trade and other receivables

SELECTED ACCOUNTING PRINCIPLES

Receivables
Receivables, including trade receivables, are recognized initially at a fair value and subsequently, at amortised cost using the effective interest method less impairment allowances.
Impairment allowances of receivables are based on the individual analysis of the value of held collaterals, and based on the possible compensation of debts.
Recognition and reversal of impairment allowances of receivables are recognized in other operating activity in relation to principal amount and in financial activities in relation to interest for delayed payments.

ESTIMATES

Impairment of trade and other receivables
The Management Board assesses whether there is any indicator for impairment of trade and other receivables taking into account the adopted internal procedures as individual assessment of each customer with regard to credit risk.

^*Position other includes compensation from insurers due to Unipetrol Group as at 31 December 2016 in the amount PLN 222 million.

Division of financial assets denominated in foreign currencies is presented in note 7.3.5.2. Division of receivables from related parties is presented in note 7.4.6.

7.2.5.2.1. The ageing analysis of receivables

Based on the analysis of balances of receivables the customers were divided into two groups:

• Group I – customers with very good or good history of cooperation in the current year;
• Group II – other customers.

The division of not past due receivables

The division of past due receivables, but not impaired as at the end of the reporting period

7.2.5.2.2. Change in impairment allowances of trade and other receivables

7.2.5.3. Trade and other liabilities  

SELECTED ACCOUNTING PRINCIPLES

Liabilities
Liabilities, including trade liabilities, are initially measured at fair value and subsequently, at amortised cost using the effective interest rate method.

Division of financial liabilities denominated in foreign currencies is presented in note 7.3.5.2. Division of liabilities from related parties is presented in note 7.4.6.

As at 31 December 2016 and as at 31 December 2015 in the Group were no material overdue liabilities.

7.2.6. Net debt and equity management

SELECTED ACCOUNTING PRINCIPLES

Net debt
The Group defined net debt as: non-current and current loans, borrowings and bonds lower by cash and cash equivalents.
Cash comprises cash on hand and in a bank accounts. Cash equivalents are short-term, highly liquid investments (of initial maturity up to three months), that are readily convertible to known amounts of cash and which are subject to an insignificant risk of change in value. Valuation and outflows of cash and cash equivalents in foreign currencies are based on FIFO (First In First Out) method.
The Group to assess the level of debt used ratios: net financial gearing (net debt / equity (calculated as at the end of the period) x 100%) and net debt / EBITDA before net impairment allowances.

Changes in net debt

7.2.6.1. Loans, borrowings and bonds

The ORLEN Group bases its financing on fixed and floating interest rates. Depending on the currency of financing these are relevant interbank rates increased by margin. The margin reflects risk connected with financing of the Group and in case of some long-term contracts depends on net debt/EBITDA ratio.

On 10 March 2017 PKN ORLEN early repaid the long-term credit in the amount of PLN 763 million with interest due, under the agreement the maturity falling in 2025. The credit agreement allowed the early repayment at the request of the borrower .

7.2.6.1.1. Loans
- by currency (translated into PLN)/ by interest rate

As at 31 December 2016 unused credit lines (note 7.3.5.4) increased by trade and other receivables (note ‎7.2.5.2) and cash and cash equivalents exceeded trade and other liabilities (note ‎7.2.5.3) by PLN 11,144 million.
The Group hedges partially cash flows related to interest payments regarding external financing in EUR and USD, by using interest rate swaps (IRS).
In the period covered by the foregoing consolidated financial statements as well as after the reporting date there were no cases of violations of loans or interests repayment.

As at 31 December 2016 there were no property, plant and equipment pledged as collateral for loans of the Group. As at 31 December 2015 pledge on property, plant and equipment as security for loans amounted to PLN 997 million and loans secured by these assets amounted to PLN 361 million.

7.2.6.1.2. Bonds
- by currency (translated into PLN)

- by interest rate

^* translated into PLN using the exchange rate as at 31 December 2014
^** translated into PLN using the exchange rate as at 31 December 2016

The difference between the nominal value and carrying amount of bonds results from measurement of bonds according to amortized cost using the effective interest method.

7.2.6.2. Equity management policy

Equity management is performed on the Group level in order to protect the Group’s ability to continue its operations as a going concern while maximizing returns for shareholders.

The Management Board monitors the following ratios:

• net financial gearing of the Group - as at 31 December 2016 and as at 31 December 2015 amounted to 11,5% and 28,1%, respectively;
• dividend per ordinary shares – depends on financial position of the Group. In 2016 and in 2015 the dividend of PLN 2 per share and PLN 1.65 per share was paid, respectively.

7.2.7. Equity

SELECTED ACCOUNTING PRINCIPLES

Share capital
Equity paid by shareholders and stated at nominal value in accordance with the Parent Company’s of association and the entry in the Commercial Register.
Share capital as at 31 December 1996, in accordance with IAS 29, § 24 and 25, was revalued based on monthly price indices of consumer goods and services.

Share premium
Created by the surplus of the issuance value in excess of the nominal value of shares decreased by issuance costs. Capital from issue of shares above their nominal value as at 31 December 1996, in accordance with IAS 29, § 24 and 25, was revalued based on monthly price indices of consumer goods and services.

Hedging reserve
Relates to valuation and settlement of hedging instruments that meet the criteria of cash flow hedge accounting.

Exchange differences on translating foreign operations
Result mainly from translation of the financial statements of the foreign companies into PLN under consolidation procedures.

Retained earnings
include:

• reserve capital created and used in accordance with the Commercial Companies Code,
• actuarial gains and losses from post-employment benefits,
• the current reporting period profit/loss,
• other capitals created and used according to the rules prescribed by law.

7.2.7.1. Share capital

In accordance with the Polish Commercial Register, the share capital of Polski Koncern Naftowy ORLEN S.A. as at 31 December 2016 and as at 31 December 2015 amounted to PLN 535 million and is divided into 427,709,061 ordinary shares with nominal value of PLN 1.25 each.

In Poland, each new issue of shares is labelled as a new series of shares. All of the above series have the exact same rights.

Shareholders’ structure

^*Shareholders holding directly or indirectly via related parties, at least 5% of total votes at the Extraordinary Shareholders Meeting of PKN ORLEN S.A. held on 24 January 2017

7.2.7.2. Share premium

7.2.7.3. Hedging reserve

On 30 June 2016 repayment of the loan tranche took place, for which interest flows hedge accounting was applied. Therefore, further evaluation of instruments is recognized in profit or loss, and a part of the effective valuation at date of repayment was recognized in equity in the amount PLN (106) million. At the time of the expected cash flows, this amount will be settled for as an adjustment to interest expenses.

7.2.7.4. Retained earnings

7.2.7.5. Equity attributable to non-controlling interest

 Condensed financial information of UNIPETROL GROUP

In 2016 and in 2015, there were no significant restrictions in entities with significant non-controlling interest resulting from credit agreements, regulatory requirements and other contractual arrangements that restrict access to assets and settlement of liabilities of the Group.

7.2.7.6. Proposal to distribution of the Parent Company’s profit for 2016

Dividend policy of the Group assumes a gradual increase in the level of dividend per share by taking into account the implementation of strategic financial objectives and forecasts of the macroeconomic situation. This method does not relate the rate of dividend to net profit, which in the ORLEN Group’s area of operations is subject to high fluctuations and can include non-cash items, such as revaluation of assets, inventories or loans, distorting the view of the current financial situation of the Group.

The Management Board of PKN ORLEN, after considering the liquidity situation and achievement of strategic financial objectives, proposes to distribute the net profit of PKN ORLEN for the year 2016 in the amount of PLN 5,364,455,552.64 as follows: PLN 1,283,127,183 will be allocated as a dividend payment (PLN 3 per 1 share) and the remaining amount of PLN 4,081,328,369.64 as reserve capital. The Management Board of PKN ORLEN recommends 14 July 2017 as the dividend date and 4 August 2017 as the dividend payment date. This recommendation of the Management Board will be presented to the General Shareholders’ Meeting of PKN ORLEN, which will make a conclusive decision in this matter.

7.2.7.7. Distribution of the Parent Company’s profit for 2015

Pursuant to article 395 § 2 point 2 of the Commercial Code and § 7 sec. 7 point 3 of the Parent Company’s Articles of Association, the Ordinary General Shareholders’ Meeting of PKN ORLEN S.A. on 3 June 2016, having analysed the motion of the Management Board, decided to distribute the net profit of PKN ORLEN for the year 2015 of PLN 1,047,519,491.84 as follows: the amount of PLN 855,418,122 for dividend payment (PLN 2 per 1 share) and the remaining amount of net profit of PLN 192,101,369.84 as reserve capital.

7.2.8. Embedded derivatives and hedging instruments and other assets and liabilities

Embedded derivatives and hedging instruments and other assets

Embedded derivatives and hedging instruments and other liabilities

7.2.9. Provisions 

SELECTED ACCOUNTING PRINCIPLES

Provisions
The amount recognized as a provision is the best estimate of the expenditure required to settle the present obligation at the end of the reporting period.

Environmental provision
The Group creates provisions for future liabilities due to reclamation of contaminated land or water or elimination of harmful substances if there is such a legal or constructive obligation. Environmental provision for reclamation is periodically reviewed on the basis of contaminated assessment. Changes in the value of provision increase or decrease in the current period the value of assets to reclamation. In case of  increase of provision is higher than carrying amount of the asset, the amount of that excess is recognized in profit or loss.

Jubilee bonuses and post-employment benefits
Under the remuneration plans employees of the Group are entitled to jubilee bonuses, paid to employees after an elapse of a defined number of years in service as well as retirement and pension benefits, paid once at retirement or pension. The amount of above benefits and jubilee bonuses depends on the number of years in service and an employee’s average remuneration.
The jubilee bonuses are other long-term employee benefits, whereas retirement and pension benefits are classified as post-employment defined benefit plans.
Provisions are determined by an independent actuary and revalued if there are any indications impacting their value, taking into account the staff turnover and planned growth of wages.
Actuarial gains and losses from post-employment benefits are recognized in components of other comprehensive income and from other employment benefits are recognized in profit or loss.

CO₂ emissions, energy certificates
The Group recognizes the estimated CO₂ emissions costs during the reporting period in operating activity costs (taxes and charges). Provision is recognized based on the value of allowances taking into account the principle of FIFO. In case of a shortage of allowances, the provision is created based on the purchase price of allowance concluded in forward contracts or market quotations at the reporting date.
During the reporting period the Group recognizes provision for the estimated volume of energy  rights and energy efficiency certificates for depreciation, which is recognized as a reduction of revenues from sales of energy.

Other provisions
Other provisions include mainly provisions for legal proceedings and are recognized after consideration of all available information, including the opinions of independent experts.
The Group recognizes provisions if at the end of the reporting period the Group is an obligation arising from past events that can be reliably estimated and it is probable that fulfilment of this obligation will cause an outflow of resources embodying economic benefits.

ESTIMATES

Recognition of provisions requires estimates of the probable outflow of resources embodying economic benefits and defining the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. Provisions are recognized when the probability of outflow of resources embodying economic benefits is higher than 50%.

Changes in provisions

7.2.9.1. Environmental provision 

The Group has legal obligation to clean contaminated land – water environment in the area of production plants, fuel stations, fuel terminals and warehouses.
The Management Board estimated the provision for environmental risks based on analyses provided by independent experts or based on current and expected costs of removal of contaminants.

In the Czech Republic, the Government is responsible for liabilities arising from contamination of land-water environment before date of entity’s privatization. In case of new contamination that arose after this date the Group is responsible for those liabilities.
In 2016, due to the planned in 2017 cease of production of chlorine using mercury electrolysis in Spolana a.s, Unipetrol Group recognized provision for the estimated costs of plant for the production of chlorine using the mercury electrolysis liquidation in the amount of approximately PLN 21 million.
As at 31 December 2016 the balance of provision for liquidation and contaminations clean up costs in the plant amounted to PLN 27 million translated using the exchange rate as at 31 December 2016 (representing CZK 163 million).

Moreover, at the stage of development and extraction of mineral resources the Group recognizes provisions for the cost of removal of drillings and supporting infrastructure.
Increase in the provision results from the updating of present value estimates of investment expenditures required to settle the present obligation at the reporting date.

7.2.9.2. Provision for jubilee bonuses and post-employment benefits

Change in employee benefits obligations

The carrying amount of employee benefits liabilities is identical to their present value as at 31 December 2016 and 31 December 2015.

Employee benefits liabilities divided into active and retired employees

The weighted average duration of liabilities for post-employment benefits in 2016 and in 2015 amounted to: Poland 9 and 11 years, Czech Republic 10 in both years and Lithuania, Latvia, Estonia 10 and 14 years, respectively.

In 2016 the amount of provision for employee benefits changed as the result of update of assumptions, mainly in relation to discount rate, projected inflation and expected remuneration increase ratio. Should the 2015 assumptions be used, the provision for the employee benefits would be lower by PLN (22) million.

Sensitivity analysis to changes in actuarial assumptions
As at 31 December 2016, the Group used the following actuarial assumptions that had an impact on the level of actuarial provisions for the Polish entities: discount rate 3.5%, expected inflation 1.3% in 2017, 1.5% in 2018 and 2.5% in subsequent years the remuneration increase rate: 0% in years 2017-2018 and 2.5% in subsequent years. In the Group's foreign entities the main impact had: value of discount rate: from 0.56% to 0.85%.
The Group analysed the impact of the financial and demographic assumptions and calculated that the changes of ratios: remuneration ratio by +/- 1 p.p., the discount rate by +/- 0.5 p.p. and the rate of turnover by +/- 0.5 p.p. in Poland, Czech, Lithuania, Latvia and Estonia are no higher than PLN 8 million. Therefore, the Group does not present any detailed information.
The Group carries out the employee benefit payments from current resources. As at 31 December 2015 there were no funded plans and the Group paid no contributions to fund liabilities.

7.2.9.3. Provision for CO₂ emissions, energy certificates

Provision for CO₂ emissions, energy certificates comprises mainly recognition of the provisions for estimated in the reporting period, the cost of CO₂ emissions. As at 31 December 2016 and as at 31 December 2015 the value of the provision amounted to PLN 353 million and PLN 440 million, respectively.

7.2.9.4. Other provisions

As at 31 December 2016 and as at 31 December 2015 other provisions comprise mainly provisions for the risk of unfavourable decisions of pending administrative or court proceedings of PLN 192 million and PLN 170 million, respectively.

7.3. EXPLANATORY NOTES TO THE FINANCIAL INSTRUMENTS AND FINANCIAL RISK

SELECTED ACCOUNTING PRINCIPLES

Financial instruments

Measurement of financial assets and liabilities
At initial recognition, the Group measures financial assets and liabilities at their fair value plus, in the case of a financial asset or a financial liability not at fair value through profit or loss (i.e. held for trading), transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability. The Group does not classify instruments as measured at fair value through profit or loss upon initial recognition, i.e. does not apply the fair value options.
At the end of the reporting period, the Group measures item of financial assets and liabilities at amortised cost using effective interest rate method, except for derivatives, which are measured at fair value.
Gains and losses resulting from changes in fair value of derivatives, for which hedge accounting is not applicable, are recognized in the current year profit or loss.

Hedge accounting
Derivatives designated as hedging instruments whose cash flows are expected to offset changes in the cash flows of a hedged item are accounted for in accordance with the cash flow hedge accounting.
The Group assess effectiveness of cash flow hedge at the inception of the hedge and later, at minimum, at reporting date. In case of cash flow hedge accounting, the Group recognizes in other comprehensive income part of profits and losses connected with the effective part of the hedge, whereas profits or losses connected with the ineffective part - under profit or loss.
The Group uses statistical methods, in particular regression analysis, to assess effectiveness of the hedge.
If a hedge of a forecast transaction subsequently results in the recognition of a financial asset or a financial liability, the associated gains or losses that were recognized in other comprehensive income are reclassified to profit or loss of the reporting period in the same period or periods during which the asset acquired, or liability assumed, affects profit or loss.
However, if the Group expects that all or a portion of a loss recognized in other comprehensive income will not be recovered in one or more future periods, it reclassifies the amount that is not expected to be recovered to profit or loss.
If a hedge of a forecast transaction subsequently results in the recognition of a non-financial asset or a non-financial liability, or a forecast transaction for a non-financial asset or non-financial liability becomes a firm commitment for which fair value hedge accounting is applied, the Group removes the associated gains and losses that were recognized in the other comprehensive income and includes them in the initial cost or other carrying amount of the asset or liability.
If a hedge of a forecast transaction results in the recognition of revenue from sales of products, merchandise, materials or services, the Group removes the associated gains or losses that were recognized in the other comprehensive income and adjusts these revenues.

Fair value measurement
The Group maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs to meet the objective of fair value measurement, which is to estimate the price at which an orderly transaction to transfer the liability or equity instrument would take place between market participants as at the measurement date under current market conditions.
The Group measures derivatives at fair value using valuation models for financial instruments based on generally available exchange rates, interest rates, forward and volatility curves, for currencies and commodities quoted on active markets.The fair value of derivatives is based on discounted future flows related to contracted transactions as the difference between term price and transaction price.
Forward exchange rates are not modelled as a separate risk factor, but derives from the spot rate and the respective forward interest rate for foreign currency in relation to PLN.
Derivative instruments are presented as assets, when their valuation is positive and as liabilities, when their valuation is negative.

PROFESSIONAL JUDGEMENTS

Financial instruments
The Management Board assesses the classification of financial instruments, nature and extent of risk related to financial instruments and application of the cash flow hedge accounting. The financial instruments are classified into different categories depending on the purpose of the purchase and nature of acquired assets.

7.3.1. Financial instruments by category and class

7.3.2. Income, expense, profit and loss in the consolidated statement of profit or loss and other comprehensive income

7.3.3. Fair value measurement

31/12/2016

31/12/2015 

For other classes of financial assets and liabilities fair value represents their carrying amount.

7.3.3.1. Methods applied in determining fair value (fair value hierarchy)

Financial liabilities due to loans, bonds, finance lease and liabilities and receivables for borrowings are measured at fair value using discounted cash flows method. Discount rates are calculated based on market interest rates according to quotations of 1- month, 3-months and 6-months interest rates increased by proper margins for particular financial instruments.
As at 31 December 2016 and as at 31 December 2015 the Group held unquoted shares in entities, for which fair value cannot be reliably measured, due to the fact that there are no active markets for these entities and no comparable transactions in the same type of instruments were noted. The value of shares of these entities was recognized in the consolidated statement of financial position as at 31 December 2016 and as at 31 December 2015 of PLN 40 million at acquisition cost less impairment allowances. As at 31 December 2016 and as at 31 December 2015 the Group did not intend to sell financial instruments classified as available for sale, for which it is not possible to determine fair value.
During the reporting period and comparative period there were no reclassifications of financial instruments in Group between Level 1 and 2 of fair value hierarchy.

7.3.4. Hedge accounting

Net carrying amount of cash flows hedging instruments

Planned realization date of hedged cash flows which will be recognized in the profit or loss

7.3.5. Risk identification

Risk management is mainly focused on the unpredictability of markets and aims to minimize any potential negative impacts on the Group's financial results.

The ORLEN Group applies a consistent financial risk hedging policy based on market risk management policy supported and supervised by the Financial Risk Committee, the Management Board and the Supervisory Board.

7.3.5.1. Commodity risk

The impact of commodity hedging instruments on the Group's financial statements

The net carrying amount of hedging instruments for commodity risk as at 31 December 2016 and as at 31 December 2015 amounted to PLN (142) million and PLN 8 million, respectively.

Sensitivity analysis for changes in prices of products and raw materials

Analysis of the influence of changes in the carrying amount of financial instruments on hedging reserve to a hypothetical change in prices of products and raw materials:

At decrease in prices in 2016 and 2015, respectively by the same percentage, sensitivity analysis assumes  values with the opposite sign in comparison to the table above.
Applied for the sensitivity analysis of commodity risk hedging instruments variations of crude oil and products prices were calculated based on volatility and available analysts’ forecasts.
The influence of changes of prices was presented on annual basis.
In case of derivatives, the influence of crude oil, and products prices variations on fair value were examined at constant level of currency rates.

7.3.5.2. The risk of exchange rates changes

Currency structure of financial instruments as at 31 December 2016