IFRS 15 adopted, full retrospective method, policies, judgements, contract assets and liabilities

Ocado Group plc – Annual report – 2 December 2018
Industry: retail; distribution
1.2 Basis of Preparation (extract)
New standards, amendments and interpretations issued that are effective for the current year (extract)
In the current year, the Group has early adopted IFRS 15 “Revenue from Contracts with Customers” as several Ocado Solutions contracts were signed during the year which are impacted by the adoption of IFRS 15. The adoption has had a material impact on the disclosures and amounts reported in these financial statements. See note 1.5 for further information.

1.5 Changes in Significant Accounting Policies
The accounting policies adopted are consistent with those of the previous financial year except for the early adoption of IFRS 15 “Revenue from Contracts with Customers” and “Clarifications to IFRS 15 Revenue from Contracts with Customers”.

Initial adoption of IFRS 15 “Revenue from Contracts with Customers”
The standard has an effective date of 1 January 2018 but the Group has decided to early adopt this standard with a date of initial application to the Group of 4 December 2017 using the full retrospective method.

IFRS 15 replaces all existing revenue requirements in IFRS and applies to all revenue arising from contracts with customers unless the contracts are within the scope of other standards such as IAS 17 “Leases”.

The standard outlines the principles that entities must apply to measure and recognise revenue with the core principle being that entities should recognise revenue at an amount that reflects the consideration to which the entity expects to be entitled in exchange for fulfilling its performance obligations to a customer.

The principles in IFRS 15 must be applied using the following 5 step model:
1. Identify the contract(s) with a customer;
2. Identify the performance obligations in the contract;
3. Determine the transaction price;
4. Allocate the transaction price to the performance obligations in the contract; and
5. Recognise revenue when or as the entity satisfies its performance obligations.

The standard requires entities to exercise considerable judgement taking into account all the relevant facts and circumstances when applying each step of this model to its contracts with customers. The standard also specifies how to account for the incremental costs of obtaining a contract and the costs directly related to fulfilling a contract, as well as requirements covering matters such as licences of intellectual property, warranties, principal versus agent assessment and options to acquire additional goods or services.

The Group has applied IFRS 15 fully retrospectively in accordance with paragraph C3 (a) of the standard, restating the prior period’s comparatives and electing to use the following practical expedient:
• in respect of completed contracts that have variable consideration, the Group will use the transaction price at the date the contract was completed rather than estimating variable consideration amounts in the comparative periods (para. C5(b));

Details of the change in the Group’s accounting policy in respect of revenue recognition are set out in note 2.1.

The Group early adopted IFRS 15 “Revenue from Contracts with Customers” (IFRS 15) using the full retrospective method. This note details the Group’s new accounting policy for revenue and shows the impact of the adoption of IFRS 15 on the Group’s primary financial statements.

Below is a description of the IFRS 15 impact on material areas requiring reclassification or restatement:

Consolidated Income Statement Restatement under IFRS 15

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Recognition of Revenue:
Under the Group’s previous accounting policy, revenue for certain contracts was recognised under the percentage of completion method based upon costs incurred to date as a proportion of the estimated full cost of completing the contract and applying the percentage to the total revenue expected to be earned. Such percentage of completion accounting would typically result in higher levels of revenue recognised in the earlier stages of a contract in line with the profile of costs incurred.

Under IFRS 15 revenue is recognised once, or as, a performance obligation is fulfilled. Typically, in an Ocado Solutions contract, revenue recognition would not commence until the date of “go-live”. Previously revenue was typically recognised in the earlier development stages of a contract. This change has resulted in a reduction of £9.3 million in revenue recognised in the period to 3 December 2017. Under IFRS 15, revenue is now spread over the period the services are provided.

Consolidated Balance Sheet Restatement under IFRS 15

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The cumulative effect of the adoption of IFRS 15 has resulted in a decrease in net assets of £23.1 million as at 3 December 2017 (28 November 2016 : £13.8 million) and a corresponding decrease in retained earnings. This reflects an important change in accounting policy as the Group moves from percentage of completion to a methodology that is focused on aligning revenue recognition to the delivery of their performance obligation as described in note 2.1. The new policy results in lower levels of revenue being recognised in the early stages of a contract but higher levels towards the end of a contract.

The decrease in trade and other payables relates to the reclassification and restatement of deferred income as non-current and current contract liabilities. Prior to adoption of IFRS 15 deferred income was classified within ‘Trade and other payables’.

The increase in property, plant and equipment relates to contributions received from a customer towards the cost of an asset. These are within the scope of IFRS 15 and are therefore recognised as contract liabilities and released over the life of the contract but were previously offset against the cost of the asset.

Consolidated Statement of Cash Flows Restatement under IFRS 15

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As a result of the adoption of IFRS 15, certain reclassifications are required in relation to the cash flow movements between relevant balance sheet accounts. There has been no change in the net increase in cash and cash equivalents as a result of these reclassifications or the restatement of these balance sheet accounts.

Consolidated Balance Sheet
as at 2 December 2018

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Consolidated Statement of Changes in Equity
for the 52 weeks ended 2 December 2018

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1.4 Significant Accounting Policies and Critical Estimates, Judgements and Assumptions
The preparation of the Group financial statements requires the use of certain judgements, estimates and assumptions that affect the reported amounts of assets, liabilities, income and expenses. Estimates and judgements are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances.

Key estimation uncertainties are the key assumptions concerning the future, and other key sources of estimation uncertainty at the reporting period that may have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year. Significant judgements are those that the Group have made in the process of applying the Group’s accounting policies and that have the most significant effect on the amounts recognised in the financial statements.

Changes in accounting estimates may be necessary if there are changes in the circumstances on which the estimate was based or as a result of new information or more experience. Significant accounting policies, key estimation uncertainties, and judgements are provided below.

Accounting policies that are significant due to the nature of business:

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Significant Judgements:

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Other estimates, assumptions and judgements are applied by the Group. These include, but are not limited to, depreciation and amortisation on tangible and intangible assets respectively, and provisions. These estimates, assumptions and judgements are also evaluated on a continual basis but are not significant.

Section 2 — Results for the Year (extract)
2.1 Loss Before Tax (extract)
Accounting Policies (extract)
Revenue
Revenue represents the transaction price that Ocado expects to be entitled to in return for delivering the goods or services to its customers. The value recognised in any period is based on a judgement of when the customer is able to benefit from the goods or services and an assessment of the progress made towards completely satisfying each obligation. The following provides information about the nature and timing of the satisfaction of performance obligations in our contracts and the related revenue recognition policies, categorised by reportable segments. For information about reportable segments, see note 2.2.

Retail Segment
Identification of the Performance Obligations
In a typical retail contract there is one performance obligation which is to deliver goods ordered online to the retail customer at the scheduled time and to the agreed address. “Ocado Smart Pass”, the Group’s discounted pre-pay membership scheme, is a separate contract with a customer and has a separate single performance obligation which is to provide delivery services for an agreed period of time. Ocado is able to apply the practical expedient allowed in the standard to apply the standard requirements to a portfolio of contracts, rather than individual contracts, as it believes the characteristics of each sale are similar and the effects on the financial statements of doing so would not differ materially from applying the standard to individual contracts.

Determining the Transaction Price
Customers pay in full at point of sale. The retail transaction price is based on the aggregation of all order values shown net of any material adjustment for expected returns or expected future redemption of marketing vouchers in accordance with IFRS 15 guidance on variable consideration. Standard delivery charges and carrier bag receipts are included in the transaction price. Smart Pass transaction price is as per the contracted value of the membership for the agreed period of delivery services.

Allocation of Transaction Price to the Performance Obligations
Each contract has a single performance obligation and so all the transaction price is assigned to that single obligation. At the end of each reporting period management will review and adjust for elements of variable consideration such as expected refunds or expected voucher redemptions.

Revenue Recognition
Revenue from online grocery orders is recognised at a point in time when the customer obtains control of the goods, which for deliveries performed by Ocado occurs when the goods are delivered to and have been accepted at the customer’s home. For goods which are delivered by third party couriers, revenue is recognised when the items have been transferred to the third party for onward delivery to the customer. These are shown net of returns, relevant marketing vouchers/offers and value added taxes. Relevant vouchers/offers include money-off coupons, conditional spend vouchers and offers such as buy three for the price of two. Revenue from Ocado Smart Pass is recognised over the duration of the membership on a time elapsed, straight-line basis.

Solutions Segment
Identification of the Performance Obligations
Each Solutions contract is considered on a case by case basis. A typical Ocado Solutions contract has a single performance obligation – “to enable the client to access the OSP end-to-end online grocery platform from the go-live date, with an agreed physical capacity, from a CFC for example, for the use of its retail brands”. The ability to derive independent benefit is a key determinant. For example, there are several critical contractual milestones which occur before the service is operational such as the design of the CFC for the client or preparation of the OSP. However, management has concluded that the customer is not able to derive any benefit from these individual elements until the service is operational and they are able to fulfil an order. Consequently, designing the CFC or building the customer OSP is not a performance obligation and no revenue can be assigned to satisfying these aspects of the contract. Some contracts however will have multiple components for example, the addition of Store Pick services or additional CFCs, which could lead to additional distinct performance obligations. In these situations, management will use their judgement to determine whether there are separable performance obligations that the customer is able to benefit from independently.

Determining the Transaction Price
At contract inception, the total transaction price is estimated, being the amount to which the Group expects to be entitled over the expected duration of the contract, based on the rights it has under the present contract. Such expected amounts are only included to the extent that it is highly probable that no revenue reversal will occur.

In order to arrive at the transaction price, management are initially required to make a judgement on contract duration. The majority of our Solutions contracts do not have a fixed contract term, but instead run for an indefinite period until cancelled. For the purposes of applying IFRS 15, and in particular the disclosures in respect of unsatisfied performance obligations, management determines contract duration having considered the type of contract, performance against contract SLAs and termination provisions. The point from which any termination penalties payable by the customer would no longer be considered “substantive” is particularly relevant. This key judgement on contract duration defines the period for which unsatisfied and partially unsatisfied performance obligations are measured and disclosed when calculating the transaction price.

Typically, our Solutions contracts include both upfront fees, paid by the customer in the period prior to the solution going live, and subsequent annual amounts that are either recurring or variable. The upfront fees are one-off payments and are included in the transaction price and recognised over the expected customer life. Expected customer life is a key judgement as it affects the amount of deferred upfront fees that are released as revenue each year and the factors considered in reaching the judgement on expected customer life include the nature of the performance obligation, the scale of current and
future planned investment, performance against contract SLAs, the evolving technology and competitive landscape. The judgements made for contract duration may be different than those judgements for expected customer life.

A Solutions contract often includes recurring fees which are repeated on an annual basis throughout the contract, which are recognised over the contract duration and are included in the estimate of total transaction price.

Variable amounts are annual fees whereby typically the variability relates to the volume of sales transactions processed or variable costs associated with providing the service to the customer. We determine that these variable amounts should be recognised in the period in which they arise, because they relate to the services provided in that period. In determining the total transaction price for disclosure we have estimated the amount of future variable consideration for the contract duration described above.

IFRS 15 requires estimates of future variable consideration to adopt a conservative amount that is ‘highly probable’ to become due. In respect of agreements that are already operating, we have based our constrained estimate by assuming 90% of FY18 performance. This estimate also excludes potential benefits from both indexation and future revenue growth from capacity improvements and the continued channel shift to online in the industry. It also considers potential risks from new entrants to the online fulfilment market as it continues to grow and the competitive nature of the grocery market itself which could have an adverse impact on volumes.

Although for most Solutions contracts there is the possibility that the customer will add capacity in the form of additional modules in existing CFCs or additional CFCs in new locations, which would lead to increased revenue, this has been excluded from the calculation of the estimated transaction price.

Taken together we therefore consider that this approach represents a suitably conservative view of future estimated revenue in the disclosures of unsatisfied obligations as required by IFRS 15.

For each Solutions contract an assessment has been made by the Group as to whether there is a significant finance benefit arising from the timing of payments required from the customer. Judgement is required to choose an appropriate interest rate used in the assessment and to set a reasonable threshold for determining that any finance benefit is significant.

Allocation of Transaction Price to the Performance Obligations
Single component contracts have a single performance obligation and all the transaction price is assigned to that single deliverable. Multiple component contracts will have more than one obligation, each with its own contract duration as judged by management. Each contract clearly states the fees relating to each component. This provides management with a basis for allocation of the calculated transaction price to the performance obligations as required by the standard in proportion to their relative revenue value in the contract.

Revenue Recognition
For each performance obligation and its allocated transaction price, recognition of the revenue is made from the point at which the customer starts to benefit from the services and over the period the services are provided. The nature of the services provided, that is the ability to fulfil online grocery orders, represents equal value to the customer every day that the service is provided. This uniformity of value to the customer over time has led the Group to the decision that the most appropriate method of measuring the satisfaction of obligations should be on a straight-line time-elapsed basis. IFRS 15 defines this as an “output method” which recognises revenue by reference to the value to the customer.

Judgement is applied in relation to contract and customer lives as typically, contracts have no end date. Depending on the expected contract life, the amount and timing of revenue recognised may be different in the relevant accounting periods. As the Group has not yet launched a CFC internationally, the Directors have limited relevant historical information on which to base their assumptions. Therefore, in making their judgements, the Directors have considered qualitative and quantitative reasonable and supportable information such as market evidence and certain clauses contained within Solutions’ contracts.

Contract Modifications
The Group’s contracts may be amended for changes in contract specifications and requirements. Contract modifications exist when the amendment either creates new or changes the existing enforceable rights and obligations. The effect of a contract modification on the transaction price and the Group’s measure of progress for the performance obligation to which it relates, is recognised as an adjustment to revenue in one of the following ways:
a. prospectively as an additional separate contract;
b. prospectively as a termination of the existing contract and creation of a new contract
c. as part of the original contract using a cumulative catch up; or
d. as a combination of b) and c)

For contracts for which the Group has decided there is a series of distinct goods and services that are substantially the same and have the same pattern of transfer where revenue is recognised over time, the modification will always be treated under a) or b).

The facts and circumstances of any contract modification are considered individually as the types of modifications will vary contract by contract and may result in different accounting outcomes.

Judgement is applied in relation to the accounting for such modifications where the final terms or legal contracts have not been agreed prior to the period end as management need to determine if a modification has been approved and if it either creates new or changes existing enforceable rights and obligations of the parties. Depending upon the outcome of such negotiations, the timing and amount of revenue recognised may be different in the relevant accounting periods. Modification and amendments to contracts are undertaken via an agreed formal process. For example, if a change in scope has been approved but the corresponding change in price is still being negotiated, management use their judgement to estimate the change to the total transaction price. Importantly any variable consideration is only recognised to the extent that it is highly probable that no revenue reversal will occur.

Contract Costs and Liabilities
As a result of the contracts which the Group enters into with its clients, a number of different assets and liabilities are recognised on the Group’s balance sheet. These include but are not limited to:
−− Property, plant and equipment
−− Intangible assets
−− Costs to obtain contracts
−− Contract liabilities

Incremental Costs of Obtaining a Contract
These are costs that are incurred to obtain a contract with a customer that would not have been incurred if the contract had not been obtained. Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained shall be recognised as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained.

The incremental costs of obtaining a contract with a customer are recognised as an asset if they are expected to be recoverable.

Utilisation, Derecognition and Impairment of Costs to Obtain a Contract
Incremental costs to obtain a contract shall be amortised on a basis that is consistent with the transfer to the customer of the goods or services to which the asset relates.

Incremental costs to obtain a contract are derecognised either when they are disposed of or when no further economic benefits are expected to flow from their use or disposal.

Management is required to determine the recoverability of contract related assets within property, plant and equipment, intangible assets as well as capitalised costs to obtain a contract, accrued income and trade receivables. At each reporting date, the Group determines whether or not the capitalised costs to obtain a contract are impaired by comparing the carrying amount of the asset to the remaining amount of consideration that the Group expects to receive less the costs that relate to providing services under the relevant contract. In determining the estimated amount of consideration, the Group uses the same principles as it does to determine the contract transaction price, except that any constraints used to reduce the transaction price will be removed for the impairment test.

Contract Liabilities
The Group’s customer contracts include a diverse range of payment schedules dependent upon the nature and type of goods and services being provided. The Group often agrees payment schedules at the inception of long-term contracts under which it receives payments throughout the term of the contracts. These payment schedules may include performance-based payments or progress payments as well as regular monthly or quarterly payments for ongoing service delivery. Payments for transactional goods and services may be at delivery date, in arrears or part payment in advance. Where payments made, or when the Group has an unconditional right to payment, are greater than the revenue recognised at the period end date, the Group recognises a contract liability. Where payments made are less than the revenue recognised at the period end date, and the Group have an unconditional right to payment, the Group recognises accrued income for this difference.

Cost of Sales
Cost of sales represents the cost of groceries and other products the Group sells, any associated licence fees which are driven by the volume of sales of specific products or product groups, including the branding and sourcing fees payable to Waitrose, adjustments to inventory and charges for transportation of goods from a supplier to a CFC.

Commercial Income
The Group continues to have agreements with suppliers whereby promotional allowances and volume-related rebates are received in connection with the promotion or purchase of goods for resale from those suppliers. The allowances and rebates are included in cost of sales. For the 52 weeks ended 2 December 2018, promotional allowances represent 80% (2017: 81%) of commercial income, with volume-related rebates representing 20% (2017: 19%).

Promotional Allowances
Cost of sales includes monies received from suppliers in relation to the agreed funding of selected items that are sold by the Group on promotion and is recognised once the promotional activity has taken place in the period to which it relates on an accruals basis. The estimates required for this source of income are limited because the time periods of promotional activity, in most cases, are less than one month and the invoicing for the activity occurs on a regular basis shortly after the promotions have ended.

Volume-Related Rebates
At the period end the Group is required to estimate supplier income due from annual agreements for volume rebates, which span across the year end date. Estimates are required due to the fact that confirmation of some amounts due is often only received three to six months after the period end. Where estimates are required, these are based on current performance, historical data for prior years and a review of significant supplier contracts. A material amount of this income is received from third parties via the Group’s supply agreement with Waitrose. The estimates for this income are prepared following discussions with Waitrose throughout the year and regularly reviewed by senior management.

Uncollected Commercial Income
Uncollected commercial income as at the balance sheet date is classified within trade and other receivables. Where commercial income has been earned, but not yet invoiced at the balance sheet date, the amount is recorded in accrued income.

Other Income
Other income comprises the fair value of consideration received or receivable for advertising services provided by Ocado to suppliers and other third parties on the Webshop, commission income, rental income, sublease payments receivable and amounts receivable not in the ordinary course of business. Income for advertising services is recognised over the particular time period for which the service is provided on an accruals basis. An adjustment is made at the period end to accrue the amount of income in relation to campaigns that may span the period end; however, such adjustments are not typically material.

2.4 Revenue from Contracts with Customers
Disaggregation of revenue from contracts with customers
Set out below is the disaggregation of the Group’s revenue from contracts with customers:

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Contract Balances

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Analysis of total contract liabilities:

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The contract liabilities primarily relate to the advance consideration received from customers for Solutions contracts, for which revenue is recognised as the performance obligation is satisfied.

Significant changes in the contract liabilities balance during the period is as follows:

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2016 and 2017 restatement was due to the adoption of IFRS 15 during the year. Refer to note 1.5 for further details.

Set out below is the amount of revenue recognised from:

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The transaction price allocated to the remaining performance obligations (unsatisfied or partially unsatisfied) are, as follows:

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Total transaction price includes £1,736.3 million (2017: £1,827.2 million) in respect of potential revenues in relation to the recovery of costs that are expected to be incurred in existing Solutions contracts.

The amounts disclosed above in respect of unsatisfied and partially unsatisfied performance obligations do not include estimates of any amounts that will arise if the customer continues to receive services beyond our estimate of the contract term. In addition, they are reduced, during the contract term, so as to limit our estimate of future variable amounts to a conservative amount that is ‘highly probable’. For additional information in respect of key judgements, please refer to note 2.1. The figures disclosed do not include any incremental amounts in relation to CFCs and other solutions to which a customer is not yet committed. However, they do include any amounts that are payable by the customer irrespective of whether an option for future CFCs and other solutions is exercised (e.g. amounts that are equivalent to a non-refundable deposit).

Costs to Obtain Contracts

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Management expects that the incremental costs of obtaining the contract i.e. sales bonus are recoverable. The Group has therefore capitalised them as costs to obtain contracts of £0.8 million as at 2 December 2018 (2017: £nil).

These capitalised costs will be amortised over the period of transferring goods or services to the customer.

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