Rolls-Royce Holdings plc – Annual report – 31 December 2022
Industry: manufacturing
1 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 that require the key estimates highlighted below to be made. 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. Consideration is received in the form of deposits and payments for completion of milestones or performance obligations. LTSA cash receipts are typically received based on EFHs.
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. EFHs, 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 USD 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 LTSAs, 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 on page 115) 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 (two to 13 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. 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 to be 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 21.
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. See note 26 for the value of sales to joint ventures during the year.
Key judgement – When revenue should be recognised in relation to spare engine sales
Revenue is recognised at the point in time when a customer obtains control of a spare engine. The customer could be a related party, an external operator or a spare engine service provider. Depending on the contractual arrangements, judgement is required on when the Group relinquishes control of spare engines and, therefore, when the revenue is recognised. The point of control passing has been concluded to correspond to the point of legal sale, even for instances where the customer is contracted to provide some future spare engine capacity to the Group to support its installed engine base. In such cases, the customer has responsibility for generating revenue from the engines and exposure to periods of non-utilisation; exposure to risk of damage or loss, risk from residual value movements, and will determine if and when profits will be made from disposal. The spare engine capacity that will be made available to the Group in the future does not consist of identified assets and the provider retains a substantive right to substitute the asset through the Group’s period of use. It is, therefore, appropriate to recognise revenue from the sale of the spare engines at the point that title transfers. During 2022, of the total 44 (2021: 36) large spare engine sales delivered, 20 (2021: six) engines were sold to customers where contractual arrangement allows for some future spare engine capacity to be used by the Group. These sales contributed £454m (2021: £111m) to revenue for the year.
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 LTSAs in the Civil Aerospace business, with an average remaining term of around ten years. The estimated revenue and costs are inherently imprecise and significant estimates are required to assess: 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 (that includes the impact of inflation). The impact of climate change on EFHs and costs is also considered when making these estimates. Industry and customer data on expected levels of utilisation is included in the forecasts used. Across the length of the current Civil Aerospace LTSA contracts, allowance has been made for around a 1% (2021: 1%) projected cost increase resulting from carbon pricing and commodity price changes.
The sensitivities below demonstrate how changes in assumptions (including as a result of climate change) could impact the level of revenue recognised were assumptions to change. The Directors believe that the estimates used to prepare the Consolidated Financial Statements take account of the inherent uncertainties, constraining the expected level of revenue as appropriate.
Estimates of future LTSA revenue within Civil Aerospace are based upon future EFH forecasts, influenced by assumptions over the recovery of the civil aviation industry. Finally, 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 in relation to the Civil Aerospace LTSA contracts resulted in favourable catch-up adjustments to revenue of £360m (2021: £214m).
Based upon the stage of completion of all LTSA contracts within Civil Aerospace as at 31 December 2022, the following reasonably possible changes in estimates would result in catch-up adjustments being recognised in the period in which the estimates change (at underlying rates):
- A change in forecast EFHs of 1% over the remaining term of the contracts would impact LTSA income and to a lesser extent costs, resulting in an in-year impact of around £20m. This would be expected to be seen as a catch-up change in revenue or, to the extent it impacts onerous contracts, within cost of sales.
- A 2% increase or decrease in our pricing to customers over the life of the contracts would lead to a revenue catch-up adjustment in the next 12 months of around £260m.
- A 2% increase or decrease in shop visit costs over the life of the contracts would lead to a revenue catch-up adjustment in the next 12 months of around £100m.
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 recognised 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 aviation industry 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 the workshare partner 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 page 120.
Royalty payments
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
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
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
Analysis by geographical destination
The Group’s revenue by destination of the ultimate operator is as follows:
Order backlog
Contracted consideration, translated at the 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 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 our customers have placed where they retain a right to cancel. The Group’s 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 and Power Systems will be recognised over the next two years as it is a short cycle business.
14 Trade receivables and other assets
1 Non-current trade receivables relate to amounts not expected to be received in the next 12 months from customers on payment plans
2 Includes receivables due from ITP Aero that were previously eliminated on consolidation
3 These are amortised over the term of the related contract in line with engine deliveries, resulting in amortisation of £11m (2021: £9m) in the year. There were no impairment losses
4 Other receivables includes unbilled recoveries relating to completed overhaul activity where the right to consideration is unconditional
The Group has adopted the simplified approach to provide for ECLs, measuring the loss allowance at a probability weighted amount incorporated by using credit ratings which are publicly available, or through internal risk assessments derived using the customer’s latest available financial information.
The ECLs for trade receivables and other assets has increased by £87m to £346m (2021: £7m to £259m). This movement is mainly driven by the Civil Aerospace business of £90m, of which £83m relates to specific customers and £7m relates to updates to the recoverability of other receivables.
The assumptions and inputs used for the estimation of the ECLs are disclosed in the table below:
1 During the year, the presentation of ECLs has been analysed in greater detail. This has resulted in comparative balances being represented in more appropriate line items. Trade receivables and other financial assets that are classified as investment grade has increased by £204m, with a decrease of £99m and £105m to those classified as non-investment grade and without credit rating respectively. The loss allowance against assets classified as investment grade has increased by £41m with the respective decrease in the loss allowance for those without a credit rating. The total amount of trade receivables and other financial assets and loss allowance as at 31 December 2021 has remained unchanged
2 Counterparties with a credit rating of ‘C’ or above are classified as investment grade
The movements of the Group ECLs provision are as follows:
15 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 are 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
The balance includes £885m (2021: £915m) of Civil Aerospace LTSA assets, with most of the remaining balance relating to Defence. The decrease in the Civil Aerospace balance is due to collection of higher cash receipts than revenue recognised in relation to completion of performance obligations on those contracts with a contract asset balance. Revenue recognised relating to performance obligations satisfied in previous years was £26m in Civil Aerospace. No impairment losses in relation to these contract assets (2021: none) have arisen during the year.
Participation fee contract assets have reduced by £3m (2021: £188m) due to amortisation exceeding additions by £7m, offset by foreign exchange on consolidation of £4m.
The absolute value of ECLs for contract assets has increased by £6m to £21m (2021: £15m).
During the year £3,321m (2021: £2,713m) of the opening contract liability was recognised as revenue.
Contract liabilities have increased by £1,853m. The movement in the Group balance is as a result of increases in Civil Aerospace of £1,395m and Defence of £324m. The main reason for the Civil Aerospace increase is a growth in LTSA liabilities of £1,128m to £8,257m (2021: £7,129m) driven by growth in customer payments as engine flying hours continue to recover from the COVID-19 pandemic and price escalation. There have also been additional buy-in fees received in relation to new contracts. This has been partly offset by revenue being recognised in relation to performance obligations satisfied in previous years of £334m as contract performance improves, which decreases the contract liability. An increase in Defence is from the receipt of deposits in advance of performance obligations being completed.
Accounts examples 