Rolls-Royce Holdings plc – Annual report – 31 December 2019
Significant accounting policies (extract)
Key judgement – Whether Civil Aerospace OE and aftermarket contracts should be combined
In the Civil Aerospace business, OE contracts are with the airframers (except for spare engines), while the aftermarket contracts 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, as the operators are ultimately purchasing an aircraft from the airframer, of which the engines are part, 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 which is also of a nature that the Group would not expect to incur and hence is not reflected in the contract price. For example: where there are 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 cost in the period. Any costs identified as wastage are expensed when the obligation to incur them arises – see note 2.
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 its assessment, 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, 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 rates, based on historical trends and economic forecasts.
As previously explained, under IFRS 15 the Group, most significantly in Civil Aerospace, experiences volatility in revenue recognition and contract accounting adjustments of £33m have been recognised in 2019 (2018: £(276)m). Based upon the stage of completion of all widebody programmes as at 31 December 2019 within Civil Aerospace, the following changes in key estimates would result in the following catch-up adjustments recognised in 2020 (at underlying rates):
– 5% increase/decrease in shop visit costs over the life of the programmes – £142m impact
– 2% increase/decrease in revenue over the life of the programmes – £200m impact
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 above. 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 services and OE 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 and profit 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 and therefore 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.
- 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 costs incurred to meet performance obligations.
- Where material, wastage costs (see key judgements on page 125) 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 engine is 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).
Risk and revenue sharing arrangements (RRSAs)
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.
The payments to suppliers of their shares of the programme cash flows for their production components are charged to cost of sales as programme revenue arises. Cash entry fees received are initially deferred on the balance sheet and recognised as a reduction in cost of sales incurred, on a 15-year straight-line basis pro rata over the estimated number of units produced.
The Group 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.
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 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 in the balance sheet 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 revenue for Power Systems for 31 December 2018 has been re-presented to reclassify the North America Civil Nuclear business as non-core.
2 ITP Aero prior year disaggregation of revenue has been restated to be consistent with current year presentation.
3 Includes £(93)m (2018: £(196)m) of revenue recognised in the year relating to performance obligations satisfied in previous years.
1 Includes the North America Civil Nuclear business and the Knowledge Management System business which have been treated as a disposal group held for sale at 31 December 2019, the Commercial Marine business disposed of on the 1 April 2019, RRPD disposed of on 15 April 2019, L’Orange until the date of disposal on 1 June 2018 and other smaller non-core businesses including former Energy businesses not included in the disposal to Siemens in 2014 (Retained Energy). See note 27 for more details.
2 Non-core businesses for 31 December 2018 has been restated to include North America Civil Nuclear business.
3 Includes £(187)m (2018: £nil) of revenue recognised 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 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. We exclude Civil Aerospace OE orders (for deliveries beyond the next 7–12 months) that our customers have placed where they retain a right to cancel. Our expectation 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.
14 Trade receivables and other assets
- Balances at 31 December 2018 have been re-presented to move £217m from prepayments to other receivables to better reflect the nature of these balances.
1 Includes £267m (2018: £146m) of trade receivables held to collect or sell and £76m (2018: nil) 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 £8m (2018: £13m) in the year. There were no impairment losses recognised in either year.
3 Other receivables includes the RRSA component of the LTSA which is held separately on the basis of differing counterparties, together with receivables arising from overhaul activity outside of LTSA coverage.
The expected credit losses for trade receivables and other assets has increased by £12m to £138m (2018: £126m). Amounts included are considered as current so no ageing of expected credit losses is disclosed.
For many years the Group has undertaken the sale of trade receivables, without recourse, to banks. This is commonly known as invoice discounting or factoring, and is common place in the aerospace industry. The absolute amount carried out in any given year depends on specific engine delivery volumes and phasing. This activity has been used to normalise customer receipts as certain aerospace customers have extended their payment terms. This in turn has helped to normalise our Group cash flows in line with physical delivery volumes. Over the last three years the sale of trade receivables has averaged £1,037m at the year end. Trade receivables factored are generally due within the following quarter.
At 31 December 2019 £1,117m was drawn under factoring facilities, an increase of £95m compared to December 2018, representing cash collected before it was contractually due from the customer.
In exceptional circumstances, the sale of trade receivables has taken place where amounts contractually due from aerospace customers before the period end have been deferred into the following period. There was £504m relating to this activity at the 2018 year end. There were no equivalent amounts in 2019.
The assumption 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:
15 Contract assets and liabilities
Contract assets include £1,086m (2018: £1,097m) of Civil Aerospace LTSA assets, with most of the remainder relating to Defence. The main driver of the increase is driven by Defence which increased by £90m due to the timing differences between revenue being recognised on a stage of completion basis and when customers are billed, as well as the timing of the flow down of amounts received in prior years from programme partners. Revenue from performance obligations satisfied in previous years has been adjusted by £(166)m.
Participation fee contract assets have reduced by £(55)m due to amortisation exceeding additions by £(35)m and FX on consolidation of overseas entities of £(20)m. No impairment losses (2018: none) of contract assets have arisen during the year. The expected credit losses for contract assets has decreased by £9m in relation to normal business cycle to £13m (2018: £22m).
During the year, £3,491m (2018: £2,823m) of the opening contract liability was recognised as revenue and contract liabilities have increased by £1,710m. The main reasons for the increase being a £1,199m growth in Civil Aerospace LTSA liabilities to £6,783m (2018: £5,584m) driven by an overall growth in engine flying hour receipts. Our installed base increased by 6% in 2019 compared with 2018. In addition, engine flying hours increased by 7% year-on-year. Revenue from performance obligations satisfied in previous years has been adjusted by £(114)m.