IFRS 15, quantified description of expected effects of future implementation on 2017 figures, contracting

Rolls-Royce Holdings plc – Annual report – 31 December 2017

Industry: manufacturing

Financial Review (extract)

IFRS 15

As highlighted in 2016, the introduction of the new revenue reporting standard, IFRS 15 Revenue from Contracts with Customers, will change fundamentally how Rolls-Royce measures its revenue and profit, Civil Aerospace having by far the largest impact. There are three broad implications:

  • linked accounting will cease to exist so all OE sales will be treated on the same basis;
  • OE engine cash deficits will no longer be capitalised and recorded as contractual aftermarket rights, they will instead be recognised on delivery; and
  • revenue and profit for aftermarket services will be recognised on an activity basis as costs are incurred.

Further information on the 2017 results under IFRS 15 can be found on page 55.

IFRS 15 (page 55)

Group – impact of adopting IFRS 15

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IFRS 15 overview

IFRS 15 Revenue from Contracts with Customers (effective from 1 January 2018) replaces the separate models for goods, services and construction contracts currently included in IAS 11 Construction Contracts and IAS 18 Revenue. The Group will present its 2018 results, including 2017 comparatives, on an IFRS 15 basis.

IFRS 15 impact

The impact of IFRS 15 on the 2017 underlying results is shown in the tables on this page with further information provided in notes 1 and 27 to the Consolidated Financial Statements. The cumulative impact on net assets as at 31 December 2017 is £(5.2)bn.

As processes and procedures are further embedded during 2018, it is possible that some changes to the impact may result. The adoption of IFRS 15 has had a significant impact on the measurement and the timing of recognition of revenue, most particularly in the Civil Aerospace business. It has no impact on the timing or measurement of the reported cash flows.

The key impacts of adopting IFRS 15 on our Civil Aerospace business are:

  • generally, our contracts with airframers for OE and with operators for aftermarket services will not be linked;
  • revenue for OE will be recorded at the net amount of consideration receivable with any profit or loss on sale, after recognition of the costs of producing the OE, recorded on delivery; and
  • revenue on LTSAs will be recognised as services are performed rather than as the equipment is used as is frequently the case under the current accounting policy. The stage of completion will be measured using the actual costs incurred to date compared to the estimated costs to complete the performance obligation. As we are generally paid on a monthly basis as engine flying hours occur, whilst overhaul and repair activities happen periodically over the term of the LTSA, the recognition of revenue and profit will generally be deferred compared to the current accounting policy and to cash receipts.

In addition, the overall net impact on operating profit of the adoption of IFRS 15 within the Defence Aerospace business was £4m. This comprised a £34m LTSA margin impact which is broadly expected to recur in the short term, but was offset by a £30m favourable timing benefit from a spares distribution contract, which is not expected to repeat in 2018.

Civil Aerospace – impact of adopting IFRS 15

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The following tables provide more detail on the impact of adopting IFRS 15 in Civil Aerospace. We have provided additional information about this business here as it is most significantly impacted by IFRS 15. A more detailed analysis of the impact of adopting IFRS 15 on the other segments are set out in note 27 to the Consolidated Financial Statements.

The adoption of IFRS 15 reduces Civil Aerospace underlying revenue and underlying operating profit by £1,410m and £850m respectively.

Underlying OE revenue reduces by £913m, primarily from de-linking the OE and service contracts and no longer capitalising cash deficits. In addition, participation fees paid to airframers are treated as a reduction to revenue where previously presented as a cost.

Underlying service revenue reduces by £497m. This reduction is driven by: a timing change to revenue recognition on TotalCare and CorporateCare long-term contracts where stage of completion has been amended from a flying hours basis to a cost incurred or ‘input’ basis; the de-linking of OE and services contracts; and classification of operator guarantee payments as a reduction to revenue under IFRS 15 where classified as costs under current accounting.

Underlying revenue by market segmentation under IFRS 15

The most significant changes to Civil Aerospace revenue from the adoption of IFRS 15 relate to large engine OE and long-term service contract revenue for both large and business aviation engines.

Large engine service revenue is £299m lower under IFRS 15. Under current accounting service revenue is recognised on an engine flying hour basis, i.e. as the engines are being used by the airline operators. The move to recognising revenue on an activity basis (i.e. when Civil Aerospace performs the repairs, maintenance and overhauls) changes the point at which revenue is recognised. This change will typically delay the point at which revenue is recognised under IFRS 15 when compared with the treatment under current accounting and as a result lowers service revenues due to the relatively young age of the fleet with many engines yet to reach their first overhaul.

The nature of the change is the same for CorporateCare service packages in business aviation. For business jet engines the timing impact may be more pronounced than for large engines as business jet engines are often on wing for many years before requiring an initial overhaul.

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Contract accounting adjustments under IFRS 15

Under current accounting, the stage of completion of long-term service contracts is assessed based on flying hours. As set out on page 55, this means that the percentage of completion will usually be lower under IFRS 15 than under current accounting. For linked OE and service contracts, the stage of completion takes into account both OE and flying hour revenue. The consequence of this linkage with the services contract means that the difference between the completion percentage under IFRS 15 and current accounting will be greater. This is because the linked OE revenue is no longer included in assessing the stage of completion. This change in the way the percentage of completion is calculated will impact the level of contract accounting benefit recognised under current accounting in respect of beneficial lifecycle cost margin adjustments by £(96)m from £113m under current accounting to £17m under IFRS 15.

On the other hand, the contract margin adjustment associated with technical costs will be £50m lower under IFRS 15.

The benefit from other operational changes totalled £17m in 2017 under current accounting. This included a £77m benefit arising from a change to a customer credit rating risk assessment on a linked contract where under IFRS 15, with no linkage, there is no benefit in the year.

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Balance sheet adjustments under IFRS 15

The impact of adopting IFRS 15 on the Civil Aerospace balance sheet is summarised below.

£(5.1)bn of the £(5.2)bn impact to the Group’s opening reserves from the adoption of IFRS 15 is driven by Civil Aerospace.

The transition to IFRS 15 requires de-recognition of the contractual aftermarket rights recorded as intangible assets under current accounting. As this cost will now be recorded at the point of sale of OE the amortisation previously recorded will cease benefiting the gross profit reported on underlying services revenue.

Under IFRS 15 we regard participation fees as payments to customers that are offset against future revenue from those customers. Therefore, they are recognised as contract assets rather than as intangible assets under current accounting.

In assessing the accounting for the participation fee payments we make to our OE customers, we have also assessed the accounting for up-front payments we sometimes receive from the Group’s suppliers under RRSAs to allow them to participate in an engine programme. We have concluded that, consistent with changes to how we will account for participation fees noted above, these receipts should be deferred and recognised against cost of sales over the period of supply. This will also require judgement as to the number of units over which the receipts will be allocated.

The most significant change is to the net contract balance. Other than the reclassification of participation fees and the transition from revenue recognition on an engine flying hours to a cost input basis, the adjustment also represents £(3.2)bn of reversal of profit from contract linkage. The majority of service contracts are on monthly payment terms based on engine flying hours. As a result, in many cases we will receive cash in advance of incurring costs to support the contract including for overhauls. Under IFRS 15 we will recognise the revenue as costs are incurred, changing the net contract debtor under current GAAP to a net deferred revenue creditor under IFRS 15.

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Notes to the Consolidated Financial Statements (extract)

1 Accounting policies (extract)

Revisions to IFRS not applicable in 2017 (extract)

IFRS 15 Revenue from Contracts with Customers

IFRS 15 provides a single, principles based five-step model to be applied to all sales contracts. It is based on the transfer of control of goods and services to customers and replaces the separate models for goods, services and construction contracts currently included in IAS 11 Construction Contracts and IAS 18 Revenue. There are three broad implications:

  • linked accounting will cease to exist so all OE sales will be treated on the same basis;
  • OE engine cash deficits will no longer be capitalised and recorded as contractual aftermarket rights, they will instead be recognised on delivery; and
  • revenue and profits for aftermarket services will be recognised on an activity basis as costs are incurred.

The Group will adopt IFRS 15 on 1 January 2018 using the ‘full’ retrospective approach. The Group has undertaken significant analysis on the impact of IFRS 15 and the most significant accounting judgements, estimates and policies are set out below. Work will continue during 2018 to review and refine policies and procedures required to implement IFRS 15. As a result it is possible that there may be some changes to the impact reported. 

Key areas of judgement:

Determining the timing of satisfaction of performance obligations:

  • Where the performance obligation is the supply of goods (principally OE and spare parts) which is satisfied at the point in time that those goods are transferred to the customer, the Group will recognise revenue at that point in time.
  • The Group generates a significant proportion of its revenue and profit from aftermarket arrangements arising from the use of the installed OE. These aftermarket contracts, such as TotalCare and CorporateCare agreements in Civil Aerospace, cover a range of services and generally have contractual terms covering more than one year. Under these contracts, the Group’s primary obligation is to maintain customers’ equipment in an operational condition and this is achieved by undertaking various activities, such as repair, overhaul and engine monitoring over the period of the contract. Revenue on these contracts is recognised over the period of the contract and the measure of performance is a matter of judgement. In general, the Directors consider that the stage of performance of the contract is best measured by using the actual costs incurred to date compared to the estimated costs to complete the performance obligations.
  • The assessment of stage of completion is generally measured for each contract. However, in certain cases, such as for CorporateCare agreements where there are many contracts covering aftermarket services, each for a small number of engines, the Group will apply the practical expedient offered by IFRS 15 to account for a portfolio of contracts together as it expects that the effects on the Financial Statements would not differ materially from applying the standard to the individual contracts in the portfolio.

The Group has paid participation fees to airframe manufacturers, its customers for OE on certain programmes. Amounts paid are initially treated as contract assets and subsequently charged as a reduction to the OE revenue when it is transferred to the customer. The number of units over which the asset will be charged is a matter of judgement as the orders will grow over the course of the programme.

In assessing the accounting for the participation fee payments we make to our OE customers, we have also assessed the accounting for up-front payments we sometimes receive from the Group’s suppliers under RRSAs to allow them to participate in an engine programme. We have concluded that, consistent with changes to how we will account for participation fees noted above, these receipts should be deferred and recognised against cost of sales over the period of supply. This will also require judgement as to the number of units over which the receipts will be allocated.

The Group has elected to use the practical expedient to expense as incurred any incremental costs of obtaining or fulfilling a contract if the amortisation period of an asset created would have been one year or less. 

Key sources of estimation uncertainty:

Assessment of long-term contractual arrangements.

  • The estimated revenue and costs under such agreements are inherently imprecise and significant estimates are required to take into account uncertainties relating to: (i) the forecast utilisation of the engines by the operator and related pricing; (ii) the frequency of engine overhauls where the principal variables are the operating parameters of the engine and operational lives of components; and (iii) the forecast costs to maintain the engines in accordance with the contractual requirements where the cost of each overhaul is dependent on the required work-scope and the cost of parts and labour at the time.
  • An allowance is made against the risk of non-recovery of resulting contract balances from reduced utilisation e.g. engine flying hours, based on historical forecasting experience, the risk of aircraft being parked by the customer and the customer’s creditworthiness.
  • A significant amount of revenue and cost is denominated in currencies other than that of the relevant Group undertaking. These are translated at estimated long-term exchange rates.

Significant accounting policies:

Revenue recognition comprises sales to outside customers after discounts and amounts payable to customers and excludes value added taxes. The Group has elected to use the practical expedient not to adjust revenue for the effect of financing components where the expectation is that the period between the transfer of goods and services to customers and the receipt of payment is less than a year.

Sales of services are recognised by reference to the progress towards complete satisfaction of the performance obligation provided the outcome of contracts can be assessed with reasonable certainty. Full provision is made for any estimated losses to completion of contracts, having regard to the overall substance of the arrangements.

TotalCare and similar long-term aftermarket service arrangements are accounted for on a stage of completion basis. A contract liability will be created where payment is received ahead of the costs incurred to meet performance obligations. In making the assessment of future revenue, costs and the level of profit recognised, the Group takes account of the inherent uncertainties and the risk of non-recovery of any resulting contract balances. To the extent that actual revenue and costs differ from forecast or that forecasts change, the cumulative impact is recognised in the period. When accounting for a portfolio of long-term service arrangements, such as CorporateCare agreements, the Group uses estimates and assumptions that reflect the size and composition of the portfolio. The new standard has no impact on the timing of the reported cash flows.

The comparative 2017 results to be included in the 2018 Financial Statements will be restated. Certain tables from note 2, have been prepared on the IFRS 15 basis set out above and are shown in note 27. Overall, the adoption of IFRS 15 is expected to result in a reduction in 2017 underlying revenue and operating profit of £1,408m and £854m respectively and a reduction of net assets of £5.2bn at 31 December 2017.

27 Impact of IFRS 15

The segmental analysis shown in note 2 would have been as follows if prepared under the IFRS 15 policies set out in note 1:

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Reconciliation to reported results

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Underlying adjustments

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As processes and procedures are further embedded during 2018, it is possible that some changes to the information above may result.

 

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