Capita plc – Annual report – 31 December 2017
Industry: support services
CHIEF FINANCIAL OFFICER’S REVIEW (extract)
We have adopted IFRS 15 from 1 January 2017 using the full retrospective method, thereby restating the 2016 comparatives, to provide investors with clarity on the impact of the new accounting standard in a transitional period for Capita, in line with our strategy of simplifying the business and improving transparency. This was a significant project and I would like to thank all concerned for delivering it.
IFRS 15 gives rise to changes in the timing of revenue and cost recognition but will not impact upon the lifetime profitability of contracts, the cash flow of contracts or the majority of our transactional businesses. The main changes for Capita from the adoption of IFRS 15 are on its long-term contracts and software businesses, in particular:
- Revenue is more evenly phased over the life of contracts and active software licences in line with the delivery of outcomes to clients and, consequently, the timing of profits is re-profiled.
- We will potentially recognise lower profits or make losses in the early years of contracts where there are significant upfront restructuring costs or higher operating costs prior to transformation, with a compensating increase in profits in later years. The total net impact at Group level is a function of the balance of contracts in the early or late stage of their life cycle at transition to IFRS 15 and in subsequent years. As a result, contract profits, and in certain cases contract losses, are now reported in the prior periods.
- The Group’s balance sheet includes new contract fulfilment assets created in the process of transforming services; and a significant increase in the level of deferred income in relation to contracts where payments have been received from clients to undertake work prior to the recognition of revenue and planned outcomes being delivered. For some contracts, in particular the Life and Pensions business, there are instances where this creates future profits in excess of future cash inflows. The majority of deferred income will unwind within the following 12 months and Capita aims to replace this with similar advanced payments subject to additions or changes to the Group’s contract portfolio.
- The net impact of the recognition of the deferred income balances, contract fulfilment assets and other movements has resulted in the Group recording consolidated net liabilities, which were ￡929.8m as at 31 December 2017 (2016: net liability ￡552.9m).
- Contract terminations arising in the normal course of business may give rise to the disposal of a contract fulfilment asset and/or a true up of revenue recognised, which if material, may give rise to one-off gains or losses. Such amounts are included in underlying operating profit and separately disclosed if considered material.
- Due to the changes in the pattern and timing of revenue and cost recognition under IFRS 15, and the recognition of a deferred income liability and contract fulfilment assets on the balance sheet from 1 January 2016, the principles of IAS 12 give rise to a movement in deferred tax, primarily an increase in the deferred tax asset recognised.
The adoption of IFRS 15 will increase our focus upon efficiency and performance within the business, better aligning our financial results with the value delivered to its clients.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (extract)
(d) Changes in accounting policies (extract)
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: Revenue from Contracts with Customers. In addition, the Group has adopted the following new amendments to IFRS: IAS 7 Amendments: Disclosure Initiative and IAS 12 Amendments: Recognition of Deferred Tax Assets for Unrealised Losses.
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 1 January 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 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
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 expedients:
- in respect of completed contracts, the Group will not restate contracts that: (i) begin and end within the same annual reporting period; or (ii) are completed contracts at the beginning of the earliest period presented (para. C5(a));
- 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)); and
- for all reporting periods presented before the date of initial application, the Group will not disclose the amount of the transaction price allocated to the remaining performance obligations or an explanation of when the Group expects to recognise that amount as revenue (para. C5(c)).
Details of the change in the Group’s accounting policy in respect of revenue recognition, related matters consequent upon the early adoption of IFRS 15 and an explanation of the impact on the Group’s prior period financial statements are set out in note 38.
38 FINANCIAL STATEMENTS RESTATEMENT UNDER IFRS 15
The Group early adopted IFRS 15 Revenue from Contracts with Customers (IFRS 15) on 1 January 2017 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.
The cumulative effect of the adoption of IFRS 15 has resulted in a decrease in net assets of ￡942.3m as at 1 January 2016 (31 December 2016: ￡1,036.3m). This reflects an important change in accounting policy as the Group moves from one based predominantly on percentage of completion revenue recognition to a methodology that is focused on aligning revenue recognition to the delivery of solutions and value to its clients.
Consolidated income statement restatement under IFRS 15
Total adjustment to Total profit for the period due to the adoption of IFRS 15 is £(114.7)m to underlying and £20.7m to specific items, being £94.0m.
Consolidated balance sheet restatement under IFRS 15
Consolidated cash flow statement restatement under IFRS 15
As a result of the adoption of IFRS 15, certain reclassifications are required in relation to the following cash flow movements between relevant balance sheet accounts. There has been no change in the net cash generated from operations as a result of these reclassifications or restatement of these balance sheet accounts:
- As identified in adjustment H (below), in 2016, the Group recognised a write down of accrued income in underlying profit and specific items in relation to certain long-term service contracts. Under IFRS 15, this accrued income would not have been originally recognised and hence has been reversed out of the income statement on adoption of IFRS 15. Movements in the operating cash flow note reflect the reversal of this non-cash movement;
- As identified in adjustment D (below), the Group has recognised new contract fulfilment assets on adoption of IFRS 15 from 1 January 2016 with amortisation and impairment expenses recorded through the income statement in the year ended 31 December 2016. Movements in the operating cash flow note reflect these non-cash movements recorded in the income statement; and
- As identified in adjustments D, B and C, on transition to IFRS 15 as at 1 January 2016, the Group has recognised contract fulfilment assets and restated the accrued income and deferred revenue accounts recorded in the balance sheet. Movements in the operating cash flow note reflect the relevant cash and non-cash movements in reclassified line items.
Consolidated statement of changes in equity restatement under IFRS 15
No reconciliation of the restated consolidated statement of changes in equity is presented as the only changes to this primary statement for the relevant period presented are as follows:
- Consolidated statement of changes in equity as at 1 January 2016: recognition of the restated retained earnings figure as presented in the restated consolidated balance sheet as at this date.
- Consolidated statement of changes in equity as at 31 December 2016: recognition of the restated profit for the year ended 31 December 2016 as presented in the restated consolidated income statement for this year.
Notes to the financial statements restatement under IFRS 15
Management has undertaken an extensive exercise to consider the Group’s major contractual arrangements as part of the implementation of IFRS 15. A number of significant areas have been identified for adjustment which include:
- Recognition of revenue by the Group as agent or principal (Adjustment A);
- Accounting for software licences (Adjustment B);
- Recognition of profit from service contracts over time in line with the output method (Adjustment C);
- Recognition, utilisation and derecognition of contract fulfilment assets (Adjustment D);
- Impact on tax balances as a result of adoption of IFRS 15 (Adjustment E);
- Decrease in trade and other receivables (Adjustment F);
- Reclassification of trade and other payables (Adjustment G);
- Reversal of prior period accrued income impairment within specific items (Adjustment H); and
- Reclassification of significant restructuring costs to underlying (Adjustment I).
These adjustments are discussed in the relevant sections below.
Under IFRS 15, the pattern and timing of revenue recognition has changed resulting in an overall decrease of £224.3m in revenue for the year ended 31 December 2016, increase in deferred income of £1,099.3m at the 1 January 2016 opening balance sheet date (31 December 2016:£1,256.9m) and decrease in accrued income of £325.8m at the 1 January 2016 opening balance sheet date (31 December 2016: £254.5m).
Table 1 on the following page reconciles the movements in relation to IFRS 15 for the income statement for the year ended 31 December 2016 and the balance sheet as at 1 January 2016 and as at 31 December 2016.
Table 2 provides further detail on the reconciling movements for the income statement for the year ended 31 December 2016.
Following the tables are explanatory notes for each of the adjustments referred to above.
The table below reconciles movements in relation to IFRS 15 for the income statement for the year ended 31 December 2016 and the balance sheet as at 1 January 2016 and as at 31 December 2016. Refer to below the tables for explanatory notes on each of the adjustments.
The table below provides further detail on the reconciling movements for the income statement for the year ended 31 December 2016. Refer to below the table for explanatory notes in respect of each adjustment.
Adjustment A – Accounting for agent vs. principal
The previous agent vs. principal guidance contained in IAS 18 has been revisited by the Group in light of the revised guidance under IFRS 15 in assessing whether it acts as an agent or as a principal in its major contractual arrangements.
As a result of this assessment, the Group concluded that for certain contracts it is appropriate to move from principal to agency accounting or vice versa. In respect to moving from principal to agency, this related to certain software sales arrangements as the Group has concluded that the Group does not control the goods or service being provided to the customer. As a result, there is a net adjustment of £90.9m to reduce revenue and cost of sales for the year ended 31 December 2016.
Adjustment B – Accounting for software licences
Under previous accounting, revenue in relation to certain software licences was recognised at a point in time. Under IFRS 15, the Group has determined that a number of these arrangements result in the customer having the right to access the licence (an ‘active’ licence) rather than having the right to use the licence (a ‘passive’ licence). Under an active licence the ongoing support and upgrades are fundamental to the ongoing use of the licences by the customer.
Hence total revenue for the licence and upgrades are combined with these revenues now recognised over the term of the customer contract rather than at a point in time resulting in a net decrease in accrued/deferred income at 1 January 2016 of £163.2m, 31 December 2016: £178.5m; and a net decrease in revenue in the year ended 31 December 2016 of £15.3m.
For the year ended 31 December 2016, the net decrease in revenue comprises the recognition of £100.0m of revenue from pre 1 January 2016 and the deferral of £115.3m of revenue previously recognised in 2016.
Adjustment C – Revenue recognition in line with output
Under the previous accounting, 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, all elements of the contract, including transformation activity, are combined. Due to the application of the series guidance and output methodology within IFRS 15, these contracts now have revenue recognised in line with their output measured on a contract specific basis.
As such, revenue is now spread over the expected life of the contract rather than in line with the costs profile, which has resulted in a reduction in revenue recognised in periods prior to 1 January 2016 and a net increase in deferred/accrued income as at 1 January 2016 of £1,214.8m, as at 31 December 2016: £1,332.9m; and a decrease in opening retained earnings as at 1 January 2016 of £1,214.8m, and a decrease in revenue in the year ended 31 December 2016 of £118.1m.
For the year ended 31 December 2016, the net decrease in revenue comprises the recognition of £1,096.6m of revenue from pre 1 January 2016 and the deferral of £1,214.7m of revenue previously recognised in 2016.
Adjustment D – Recognition, utilisation and derecognition of contract fulfilment assets
IFRS 15 specifies that certain costs to fulfil a contract are to be capitalised as non-current contract fulfilment assets (if utilisation is expected to occur beyond 12 months from balance sheet date) and current contract fulfilment assets (if utilisation is expected to occur within 12 months from balance sheet date) if relevant criteria are met.
The Group incurred costs that were previously expensed and which related to resources to allow it to deliver services under its contracts and active software licence arrangements. In certain situations, costs associated with the installation of certain IT equipment in contracts have also been capitalised as non-current and current contract fulfilment assets, where relevant.
The adjustments to recognise non-current and current contract fulfilment assets on the balance sheet as at 1 January 2016 of £277.6m and £40.4m respectively recognise the net book value of the identified contract fulfilment assets at the opening balance sheet date.
These adjustments also include the recognition of certain costs of obtaining a contract. IFRS 15 specifies that the incremental costs of obtaining a contract with a customer are capitalised if the entity expects to recover them.
The cost of utilising these assets is recognised within cost of sales on a consistent basis over the life of the relevant customer contract.
The adjustment of £6.5m for the year ended 31 December 2016 is to recognise a net decrease in cost of sales due to the derecognition of contract costs now capitalised as contract fulfilment assets net of the utilisation charge recorded for the year in relation to these assets and the derecognition of certain contract fulfilment assets.
For the year ended 31 December 2016, the above net adjustment of £6.5m comprises: non-current contract fulfilment additions of £63.5m, utilisation of £47.1m, and derecognition of £17.0m; software contract fulfilment additions of £13.0m, and utilisation of £7.1m; and current contract fulfilment asset additons of £41.6m, and utilisation of £40.4m.
As disclosed in the 31 December 2016 financial statements, Capita ceased to work on the IT system transformation in respect of its contract with The Co‑operative Bank plc. Under IFRS 15, this modification has led to an impairment of a contract fulfilment asset in respect of this contract as these costs were no longer considered recoverable.
The adjustment of £42.3m in the year ended 31 December 2016 recognises the charge incurred on derecognising this contract fulfilment asset. This item has been included within the other non-underlying column because it is one-off in nature and is due to a contractual dispute rather than arising as a result of service credit penalties
Adjustment E – Tax
Due to the changes in assets, liabilities, income and expenses recognised as a result of the application of IFRS 15, there are consequent IAS 12 Income taxes differences that arise as discussed below.
Due to the changes in the pattern and timing of revenue recognition under IFRS 15, a deferred income liability is recognised on the balance sheet from 1 January 2016, which will be recognised through the income statement in later periods. The impact of these revenue recognition changes is only recognised for tax purposes via a one-off transitional tax adjustment on 1 January 2017, so no tax deduction is available in 2016 for the reduction in historic revenue recognised.
Contract fulfilment assets have also been recognised on the balance sheet from 1 January 2016, which will be charged to the income statement in later periods. Under IAS 12, the tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset. The tax base of the contract fulfilment asset recognised on the balance sheet prior to 1 January 2017 is therefore reduced by the amounts for which tax deductions have already been taken, creating a temporary difference.
Under the principles of IAS 12, a movement of £164.8m in deferred tax therefore arises, recognised as an increase in the deferred tax asset of £162.8m and a reduction in the deferred tax liability of £2.0m as at 1 January 2016 (31 December 2016: £192.9m movement, increase in deferred tax asset of £190.4m, and reduction in deferred tax liability of £2.5m) as a result of the transition to IFRS 15.
Income statement deferred tax credit
The deferred tax asset balance increase of £190.4m and the deferred tax liability decrease of £2.5m as at 31 December 2016, give rise to an income statement deferred tax credit of £28.1m for the year ended 31 December 2016.
Income statement current tax expense
There is no income statement current tax expense impact for the year ended 31 December 2016.
Adjustment F – decrease in trade and other receivables
The decrease in trade and other receivables relates to the restatement of accrued revenues as detailed in Adjustments B and C above. The decrease in non-current accrued income is £41.7m as at 1 January 2016, and £79.6m at 31 December 2016, and the decrease in current accrued income is £284.1m and £174.9m at 31 December 2016.
Adjustment G – Reclassification of trade and other payables
In order to provide users with relevant financial information in the primary financial statements, the Group has decided to reclassify deferred income into its own primary statement line item reflecting the materiality and nature of this balance in the context of the Group’s business.
The decrease in trade and other payables relates to the reclassification and restatement of deferred income as discussed above. Prior to adoption of IFRS 15, deferred income was classified within ‘Trade and other payables’ although this was not accounted for as a financial liability.
Adjustment H – Reversal of accrued income impairments
In 2016, the Group recognised an impairment of £47.1m historic accrued income, of which £39.6m was recognised in underlying profit, and £7.5m within the specific items column in relation to the dispute with The Co-operative Bank plc. Under IFRS 15, this accrued income would not have been originally recognised as the timing of revenue recognition has changed in comparison to the previous accounting policy as discussed in Adjustment C above, hence the adjustment of £47.1m for the year ended 31 December 2016 recognises the reversal of these previous impairments.
Adjustment I – Reclassification of significant restructuring
Following the adoption of IFRS 15, the Board has adopted a policy to separately disclose the in-year operating profit/loss from significant new contract wins and related, or significant, restructuring (‘Significant new contract wins and restructuring’) within underlying results, in order for users of the financial statements to obtain a proper understanding of the financial information and the performance of the business.
The Group continually assesses the resourcing levels, both at a divisional level and also in relation to the management and delivery of individual contracts. This results in restructuring in the normal course of business and any such charges are recorded in ‘underlying before significant new contract wins and restructuring’ results. A significant restructuring is assessed as that above this normal level of restructuring.
In the year ended 31 December 2016, the Board announced a major programme, with the restructuring of the Group into 6 new reporting divisions under a Group-wide programme. The cost of this Group-wide programme, £59.4m (£57.2m: continuing operations), was charged to specific items, being the element above the normal level of restructuring undertaken by the Group. Following the adoption of the above policy, the 2016 income statement has been restated to reclassify the cost of this programme to ‘Significant new contract wins and restructuring’ within underlying.