Rolls-Royce Holdings plc – Annual report – 31 December 2020
Significant accounting policies (extract)
Revenue recognition and contract assets and liabilities
Revenue recognised comprises sales to the Group’s customers after discounts and amounts payable to customers. Revenue excludes value added taxes. The transaction price of a contract is typically clearly stated within the contract, although the absolute amount may be dependent on escalation indices and long-term contracts require the key estimates highlighted below. Refund liabilities where sales are made with a right of return are not typical in the Group’s contracts. Where they do exist, and consideration has been received, a portion based on an assessment of the expected refund liability is recognised within other payables. 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 standard OE, spare parts and time and material overhaul services are generally recognised on transfer of control to the customer. This is generally on delivery to the customer, unless the specific contractual terms indicate a different point. The Directors consider whether there is a need to constrain the amount of revenue to be recognised on delivery based on the contractual position and any relevant facts, however, this is not typically required.
Sales of OE and services that are specifically designed for the contract (most significantly in the Defence business) are recognised by reference to the progress towards completion of the performance obligation, using the cost method described in the key judgements, provided the outcome of contracts can be assessed with reasonable certainty.
The Group generates a significant portion of its revenue on aftermarket arrangements arising from the installed OE fleet. As a consequence, in particular in the Civil Aerospace large engine business, the Group will often agree contractual prices for OE deliveries that take into account the anticipated aftermarket arrangements. Sometimes this may result in losses being incurred on OE. As described in the key judgements, these contracts are not combined. The consideration in the OE contract is therefore allocated to OE performance obligations and the consideration in the aftermarket contract to aftermarket performance obligations.
Key areas of the accounting policy are:
- Future variable revenue from long-term contracts is constrained to take account of the risk of non-recovery of resulting contract balances from reduced utilisation e.g. engine flying hours, based on historical forecasting experience and the risk of aircraft being parked by the customer.
- A significant amount of revenue and cost related to long-term contract accounting is denominated in currencies other than that of the relevant Group undertaking, most significantly US dollar transactions in sterling and euro denominated undertakings. These are translated at estimated long-term exchange rates.
- 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 accounts for a portfolio of contracts together as the effect on the Consolidated Financial Statements would not differ materially from applying the standard to the individual contracts in the portfolio. When accounting for a portfolio of long-term service arrangements the Group uses estimates and assumptions that reflect the size and composition of the portfolio.
- A contract asset/liability is recognised where payment is received in arrears/advance of the revenue recognised in meeting performance obligations.
- Where material, wastage costs (see key judgements below) are recorded as an exceptional non-underlying expense.
If the expected costs to fulfil a contract exceed the expected revenue, a contract loss provision is recognised for the excess costs.
The Group pays 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 the engines are transferred to the customer.
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. Where costs to obtain a contract are recognised in the balance sheet, they are amortised over the performance of the related contract (average of three years).
Key judgement – Whether Civil Aerospace OE and aftermarket contracts should be combined
In the Civil Aerospace business, OE contracts for the sale of engines to be installed on new aircraft are with the airframers, while the contracts to provide spare engines and aftermarket goods and services are with the aircraft operators, although there may be interdependencies between them. IFRS 15 Revenue from Contracts with Customers includes guidance on the combination of contracts, in particular that contracts with unrelated parties should not be combined. Notwithstanding the interdependencies, the Directors consider that the engine contract should be considered separately from the aftermarket contract. In making this judgement, they also took account of industry practice.
Key judgement – How performance on long-term aftermarket contracts should be measured
The Group generates a significant proportion of its revenue from aftermarket arrangements. These aftermarket contracts, such as TotalCare and CorporateCare agreements in the Civil Aerospace business, 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’ engines in an operational condition and this is achieved by undertaking various activities, such as maintenance, repair and overhaul, and engine monitoring over the period of the contract. Revenue on these contracts is recognised over the period of the contract and the basis for measuring progress is a matter of judgement. The Directors consider that the stage of completion of the contract is best measured by using the actual costs incurred to date compared to the estimated costs to complete the performance obligations, as this reflects the extent of completion of the activities performed.
Key judgement – Whether any costs should be treated as wastage
In rare circumstances, the Group may incur costs of wasted material, labour or other resources to fulfil a contract where the level of cost was not reflected in the contract price. The identification of such costs is a matter of judgement and would only be expected to arise where there has been a series of abnormal events which give rise to a significant level of cost of a nature that the Group would not expect to incur and hence is not reflected in the contract price. Examples include technical issues that: require resolution to meet regulatory requirements; have a wide-ranging impact across a product type; and cause significant operational disruption to customers. Similarly, in these rare circumstances, significant disruption costs to support customers resulting from the actual performance of a delivered good or service may be treated as a wastage cost. Provision is made for any costs identified as wastage when the obligation to incur them arises – see note 22.
Key judgement – Whether sales of spare engines to joint ventures are at fair value
The Civil Aerospace business maintains a pool of spare engines to support its customers. Some of these engines are sold to, and held by, joint venture companies. The assessment of whether the sales price reflects fair value is a key judgement. The Group considers that based upon the terms and conditions of the sales, and by comparison to the sales price of spare engines to other third parties, the sales made to joint ventures reflect the fair value of the goods sold.
Key estimate – Estimates of future revenue and costs on long-term contractual arrangements
The Group has long-term contracts that fall into different accounting periods and which can extend over significant periods (generally up to 25 years), the most significant of these are long-term service arrangements (LTSAs) in the Civil Aerospace business. The estimated revenue and costs are inherently imprecise and significant estimates are required to assess: engine flying hours (EFHs), time-on-wing and other operating parameters; the pattern of future maintenance activity and the costs to be incurred; lifecycle cost improvements over the term of the contracts; and escalation of revenue and costs. The estimates take account of the inherent uncertainties, constraining the expected level of revenue as appropriate. In addition, many of the revenues and costs are denominated in currencies other than that of the relevant Group undertaking. These are translated at an estimated long-term exchange rate, based on historical trends and economic forecasts. During the year, changes to the estimate resulted in catch-up adjustments to revenue of £1.0bn.
Key estimate – Determination of the time period and profile over which the aerospace industry will recover
The COVID-19 pandemic has resulted in significant uncertainty across the aerospace industry. Airline customers have grounded a significant number of their aircraft in response to COVID-19 which has resulted in a reduction to EFHs in Civil Aerospace during 2020. Further details have been included in the going concern disclosure on page 52. Estimates of future LTSA revenue within Civil Aerospace are based upon future EFH forecasts, influenced by assumptions over the recovery of the aerospace industry. Based upon the stage of completion of all widebody LTSA contracts within Civil Aerospace as at 31 December 2020, the following changes in estimates would result in catch-up adjustments being recognised in the period in which the estimates change (at underlying rates):
- A further reduction in forecast EFHs of 15% over the remaining term of the contracts would decrease LTSA income and to a lesser extent costs, resulting in a catch-up adjustment of £100m – £130m. An estimated 90% of this would be expected to be a reduction in revenue with the remainder relating to onerous contracts which would be an increase in cost of sales.
- A 2% increase or decrease in revenue over the life of the contracts would lead to a catch-up adjustment of £200m.
- A 5% increase or decrease in shop visit costs over the life of the contracts would lead to a catch-up adjustment of £150m.
Risk and revenue sharing arrangements (RRSAs)
Cash entry fees received are initially deferred on the balance sheet within trade payables and other liabilities. They are then recognised as a reduction in cost of sales incurred. Individual programme amounts are allocated pro rata to the estimated number of units to be produced. Amortisation commences as each unit is delivered and then charged on a 15-year straight-line basis.
The payments to suppliers of their shares of the programme cash flows for their production components are charged to cost of sales when OE sales are recognised or as LTSA costs are incurred.
The Group also has arrangements with third parties who invest in a programme and receive a return based on its performance, but do not undertake development work or supply parts. Such arrangements (financial RRSAs) are financial instruments as defined by IAS 32 Financial Instruments: Presentation and are accounted for using the amortised cost method.
Key judgement – Determination of the nature of entry fees received
RRSAs with key suppliers (workshare partners) are a feature of the Civil Aerospace business. Under these contractual arrangements, the key commercial objectives are that: (i) during the development phase the workshare partner shares in the risks of developing an engine by performing its own development work, providing development parts and paying a non-refundable cash entry fee; and (ii) during the production phase it supplies components in return for a share of the programme cash flows as a ‘life of type’ supplier (i.e. as long as the engine remains in service).
The non-refundable cash entry fee is judged by the Group to be a contribution towards the development expenditure incurred. These receipts are deferred on the balance sheet and recognised against the cost of sales over the estimated number of units to be delivered on a similar basis to the amortisation of development costs – see 121.
Where a government or similar body has previously acquired an interest in the intellectual property of a programme, royalty payments are matched to the related sales.
Government grants received are varied in nature and are recognised in the income statement so as to match them with the related expenses that they are intended to compensate. Where grants are received in advance of the related expenses, they are initially recognised as liabilities within trade payables and other liabilities and released to match the related expenditure. Non-monetary grants are recognised at fair value.
Interest receivable/payable is credited/charged to the income statement using the effective interest method. Where borrowing costs are attributable to the acquisition, construction or production of a qualifying asset, such costs are capitalised as part of the specific asset.
2 Segmental analysis (extract)
Disaggregation of revenue from contracts with customers
Analysis by type and basis of recognition
1 The underlying results for Power Systems for 31 December 2019 have been restated to reflect the 2020 non-core businesses as described above.
2 Includes £(1,012)m (2019: £(93)m) of revenue recognised in the year relating to performance obligations satisfied in previous years.
1 Non-core businesses are set out above. The underlying results for 31 December 2019 have been restated to reflect the 2020 non-core businesses.
2 Includes £nil (2019: £(187)m) of revenue recognised in the year relating to performance obligations satisfied in previous years over and above that in underlying revenue.
Analysis by geographical destination
The Group’s revenue by destination of the ultimate operator is as follows:
Contracted consideration, translated at estimated long-term exchange rates, that is expected to be recognised as revenue when performance obligations are satisfied in the future (referred to as order backlog) is as follows:
The parties to these contracts have approved the contract and our customers do not have a unilateral enforceable right to terminate the contract without compensation. The Group excludes Civil Aerospace OE orders (for deliveries beyond the next 7–12 months) that customers have placed where they retain a right to cancel. The Group’s expectation is based on historical experience is that these orders will be fulfilled. Within the 0–5 years category, contracted revenue in: Defence will largely be recognised in the next three years; Power Systems will be recognised over the next two years as it is a short cycle business; and ITP Aero (where internal Group revenues have been eliminated) evenly spread over the next five years.
15 Trade receivables and other assets
1 Includes £577m (2019: £267m) of trade receivables held to collect or sell and £361m (2019: £76m) of receivables from joint ventures and associates held to collect or sell.
2 These are amortised over the term of the related contract, resulting in amortisation of £10m (2019: £8m) in the year. There were no impairment losses.
3 Includes £2m of amounts owed by the UK Government at 31 December 2020 for amounts claimed by the Group under furlough arrangements. In addition, other receivables includes unbilled recoveries relating to overhaul activity.
4 During the year the presentation of trade receivables and other assets has been analysed in greater detail, without changing the total amount previously reported. As a consequence some comparative balances and currency movements have been represented in additional and more appropriate line items. Trade receivables has decreased by £184m, costs to obtain contracts with customers has increased by £2m and other receivables has decreased by £903m. Receivables due on RRSAs and other taxation & social security receivable totalling £1,085m are now presented as separate lines. This has also resulted in an associated re-presentation between financial and non-financial assets, with an increase of non-financial instruments of £2m and a decrease in financial instruments of £2m (trade receivables and similar items £(91)m and other non-derivative financial assets £89m). The total amount of trade receivables and other assets from 2019 remains unchanged.
The Group has historically undertaken the sale of trade receivables, without recourse, to banks (commonly known as invoice discounting or factoring). This activity has previously been used to normalise customer receipts as certain aerospace customers have extended their payment terms. This in turn has helped normalise Group cash flows in line with physical delivery volumes. During the year to 31 December 2020, invoice discounting has substantially reduced. At 31 December 2020, £54m was drawn under factoring facilities, a decrease of £1,063m compared to 2019, representing cash collected before it was contractually due from the customer. Trade receivables factored are generally due within the following quarter.
The expected credit losses for trade receivables and other assets has increased by £114m to £252m (2019: £138m). This increase is mainly driven by the impact of COVID-19 on the Civil Aerospace business of £97m, of which £46m relates to the deterioration of the market credit ratings of customers and £51m relates to updates to the recoverability of other receivables.
The assumptions and inputs used for the estimation of the expected credit losses are disclosed in the table below:
The movements of the Group expected credit losses provision are as follows:
16 Contract assets and liabilities
1 Contract assets and contract liabilities have been presented on the face of the balance sheet in line with the operating cycle of the business. Contract liabilities is further split according to when the related performance obligation is expected to be satisfied and therefore when revenue is estimated to be recognised in the income statement. Further disclosure of contract assets is provided in the table above, which shows within current the element of consideration that will become unconditional in the next year.
2 Contract assets are classified as non-financial instruments.
Contract assets with customers includes £726m (2019: £1,086m) of Civil Aerospace LTSA assets, with most of the remainder relating to Defence. The main driver of the decrease in the Group balance is a result of revenue relating to performance obligations satisfied in previous years being adjusted by £599m in Civil Aerospace, primarily as a result of COVID-19 reducing engine flying hours (resulting in a reduction in total contract price) below the levels previously estimated over the term of the contracts with a corresponding reduction in the contract asset.
Participation fee contract assets have reduced by £(165)m (2019: reduced by £(55)m) due to the impairment of engine programme participation fees of £(149)m, amortisation exceeding additions by £(36)m and foreign exchange on consolidation of overseas entities of £20m.
The absolute value of expected credit losses for contract assets has increased by £1m to £14m (2019: £13m).
No impairment losses of contract assets (2019: none) have arisen during the year to 31 December 2020.
During the year £2,792m (2019: £3,491m) of the opening contract liability was recognised as revenue. Contract liabilities have decreased by £408m. The main driver of the change in the Group balance is as a result of a reduction in deposits held, reflecting utilisation of amounts received in previous years as engines and aftermarket services were delivered in 2020. As a result of COVID-19 the level of new deposits received were at lower than normal levels.
The Civil Aerospace LTSA liabilities increased by £58m to £6,841m (2019: £6,783m). LTSA revenue recognised as the performance obligations have been completed has exceeded cash receipts in the year due to the lower level of flying hours that drive cash receipts, decreasing the contract liability. This has been offset due to the 54% decrease in current year Civil Aerospace EFHs, together with a phased recovery, resulting in revenue relating to performance obligations satisfied in previous years being adjusted downwards by £462m which increases the contract liability.