Capita plc – Annual report – 31 December 2019
Industry: support services
Section 1: Basis of preparation (extract)
Significant accounting judgements, estimates and assumptions
The preparation of financial statements in line with generally accepted accounting principles requires the Directors to make judgements and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingencies at the date of the financial statements and the reported income and expense during the presented periods. Although these judgements and assumptions are based on the Directors’ best knowledge of the amount, events or actions, actual results may differ.
The key sources of estimation uncertainty that have a significant risk of causing material adjustment to the carrying amounts of assets and liabilities within the next financial year are summarised below and set out in more detail in the related note:
• Contract accounting (note 2.1)
– Impairment of contract fulfilment assets
– Onerous contract provisions
• The measurement of intangible assets other than goodwill in a business combination (note 3.3)
• The assessment of costs capitalised as intangible assets to generate future economic benefits (note 3.3)
• The measurement and impairment of goodwill (note 3.4)
• The measurement of defined benefit obligations (note 5.2)
• The measurement of provisions (note 3.6) and contingent liabilities (note 6.2)
• For ease of reference, this symbol has been used to denote significant accounting judgements, where they occur within the note:
J Denotes significant accounting judgements
Section 2: Results for the year (extract)
2.1 Contract accounting
At 31 December 2019, the Group had the following results and balance sheet items related to long-term contracts:
The Group operates a number of diverse businesses. The majority of the Group’s revenue is from contracts greater than two years in duration (long-term contractual), 72% of Group adjusted revenue in 2019 (2018: 72%).
These long-term contracts can be complex in nature given the breadth of solutions the Group offers and the transformational activities involved. Typically, Capita takes a customer’s process and transforms it into a more efficient and effective solution which is then operated for the customer. The outcome is a high quality solution that addresses a customer’s needs, delivered consistently over the life of the contract. The Group recognises revenue on long-term contracts as the value is delivered to the customer, which is generally evenly over the contract term, regardless of any restructuring and transformation activity. Capita will often incur greater costs during the transformation phase with costs diminishing over time as the target operating model is implemented and efficiencies realised. This results in lower profits or losses in the early years of contracts and potentially higher profits in later years as the transformation activities are successfully completed and the target operating model fully implemented (the business as usual, or BAU, phase). The inflection point is when the contract becomes profitable.
Contract fulfilment assets are recognised for those costs qualifying for capitalisation and the utilisation of these assets is recognised over the contract term. The cash received from our customers reflects when the costs are incurred to transform, restructure and run the service. This results in income being deferred and released as the Group continues to deliver against its obligation to provide services and solutions to its customers.
An example, showing the revenue, cost, profit and cash profit of a typical long-term contract lifecycle is as follows:
J Significant accounting judgements, estimates and assumptions
Due to the size and complexity of some of the Group’s contracts, there are significant judgements to be applied, specifically in assessing 1) the recoverability of contract fulfilment assets and 2) completeness of onerous contract provisions. These judgements are dependent on assessing the contract’s future profitability.
It should be noted while management must make judgements in relation to applying the revenue recognition policy and recognition related balance sheet items (trade receivables, deferred income, accrued income) these are not considered significant judgements (refer to note 2.2 for the Group’s policies).
Assessing contract profitability
In assessing a contract’s future lifetime profitability, management must estimate forecast revenue and costs to both transform and run the service over the remaining contract term. The ability to accurately forecast the outcomes involves estimates in respect of: costs to be incurred; cost savings to be achieved; future performance against any contract-specific key performance indicators (KPIs) that could trigger variable consideration or service credits, and the outcome of any commercial negotiations.
The level of uncertainty in the estimated future profitability of a contract is directly related to the stage of the life-cycle of the contract and the complexity of the performance obligations. Contracts in the transformation stage and pre-inflection, are considered to have a higher level of uncertainty due to:
• the ability to accurately estimate the costs to deliver the transformed process;
• the dependency on the customer to agree to the specifics of the transformation, for example where they are involved in signing off that the new process or the new technical solution designed by Capita meets their specific requirements; and
• the assumptions made to forecast expected savings in the target operating model.
Those contracts which are post-inflection and in BAU stage tend to have a much lower level of uncertainty in estimating the contract future profitability.
Recoverability of contract fulfilment assets and completeness of onerous contract provisions
Management first assesses whether the contract assets are impaired and then further considers whether an onerous contract exists. The Audit and Risk Committee specifically review the material judgements and estimates and the overall approach in respect of the Group’s major contracts for each reporting period, including comparison against previous forecasts. Major contracts include those that are material in size or risk to the Group’s results. Other contracts are reported to the Audit and Risk Committee as deemed appropriate. These contracts are collectively referred to as “major contracts” in the remainder of this note.
The major contracts contributed £1.4billion (2018: £1.3billion) or 39% (2018: 35%) of Group adjusted revenue. Non-current contract fulfilment assets as at 31 December 2019 were £275.8m, of which £80.7m (2018: £55.2m) related to major contracts with on-going transformational activities. The remainder relates to contracts post transformation and includes non-major contracts.
The major contracts, both pre and post transformation, are rated according to their financial risk profile, which is linked to the level of uncertainty over future assumptions. For those that are in the high and medium rated risk categories the associated non-current contract fulfilment assets in aggregate were £52.4m at 31 December 2019 (2018: £37.5m). The recoverability of these assets is dependent on no significant adverse change in the key contract assumptions arising in the next financial year. The deferred income associated with these contracts was £243.6m at 31 December 2019 (2018: £336.3m) and is forecast to be recognised as performance obligations continue to be delivered over the life of the respective contracts.
Following these reviews, as outlined in note 3.1.3, contract fulfilment asset provisions for impairment of £9.6m (2018: £22.2m) were identified and recognised within adjusted cost of sales, of which, £2.2m (2018: £22.2) relates to contract fulfilment assets added during the period. There were no material onerous contract provisions recognised in the period.
Given the quantum of the relevant contract assets and liabilities management has considered the nature of the estimates noted above and concluded that it is reasonably possible, on the basis of existing knowledge, that outcomes within the next financial year may be different from management’s assumptions and could require a material adjustment to the carrying amounts of contract assets and onerous contract provisions. However, as noted above, £80.7m of non-current contract fulfilment assets relates to major contracts with on-going transformational activities and £52.4m of non-contract fulfilment assets relates to the highest and medium rated risk category. Due to the level of uncertainty, combination of variables and timing across numerous contracts, it is not practical to provide a quantitative analysis of the aggregated judgements that are applied, and management do not believe that disclosing a potential range of outcomes on a consolidated basis would provide meaningful information to a reader of the accounts. Due to commercial sensitivities, Capita does not specifically disclose the amounts involved on any individual contract. Additional information, which does not form part of the financial statements, on the results and performance of the underlying divisions including the outlook on certain contracts is set out in the strategic report.
2.2 Revenue including segmental revenue
AP Accounting policies
The Group generates revenue largely in the UK and Europe. The Group operates a number of diverse businesses and accordingly applies a variety of methods for revenue recognition, based on the principles set out in IFRS 15.
The revenue and profits recognised in any period are based on the delivery of performance obligations and an assessment of when control is transferred to the customer.
Revenue is recognised either when the performance obligation in the contract has been performed (so ‘point in time’ recognition) or ‘over time’ as control of the performance obligation is transferred to the customer.
For all contracts, the Group determines if the arrangement with a customer creates enforceable rights and obligations. This assessment results in certain Master Service Agreements (MSAs) or Frameworks not meeting the definition of a contract under IFRS 15 and as such the individual call-off agreements, linked to the MSA, are treated as individual contracts.
The Group enters into contracts which contain extension periods, where either the customer or both parties can choose to extend the contract or there is an automatic annual renewal, and/or termination clauses that could impact the actual duration of the contract. Judgement is applied to assess the impact that these clauses have when determining the appropriate contract term. The term of the contract impacts both the period over which revenue from performance obligations may be recognised and the period over which contract fulfilment assets and capitalised costs to obtain a contract are expensed.
For contracts with multiple components to be delivered such as transformation, transitions and the delivery of outsourced services, management applies judgement to consider whether those promised goods and services are:
(i) distinct – to be accounted for as separate performance obligations;
(ii) not distinct – to be combined with other promised goods or services until a bundle is identified that is distinct; or
(iii) part of a series of distinct goods and services that are substantially the same and have the same pattern of transfer to the customer.
At contract inception the total transaction price is estimated, being the amount to which the Group expects to be entitled and has rights to under the present contract. This includes an assessment of any variable consideration where the Group’s performance may result in additional revenues based on the achievement of agreed KPIs. Such amounts are only included based on the expected value or the most likely outcome method, and only to the extent that it is highly probable that no revenue reversal will occur.
The transaction price does not include estimates of consideration resulting from change orders for additional goods and services unless these are agreed.
Once the total transaction price is determined, the Group allocates this to the identified performance obligations in proportion to their relative stand-alone selling prices and recognises revenue when (or as) those performance obligations are satisfied.
The Group infrequently sells standard products with observable stand-alone prices due to the specialised services required by clients and therefore the Group applies judgement to determine an appropriate standalone selling price. More frequently, the Group sells a customer bespoke solution, and in these cases the Group typically uses the expected cost-plus margin or a contractually stated price approach to estimate the stand-alone selling price of each performance obligation.
The Group may offer price step downs during the life of a contract, but with no change to the underlying scope of services to be delivered. In general, any such variable consideration, price step down or discount is included in the total transaction price to be allocated across all performance obligations unless it relates to only one performance obligation in the contract.
For each performance obligation to be recognised over time, the Group applies a revenue recognition method that faithfully depicts the Group’s performance in transferring control of the goods or services to the customer. This decision requires assessment of the real nature of the goods or services that the Group has promised to transfer to the customer. The Group applies the relevant output or input method consistently to similar performance obligations in other contracts.
When using the output method, the Group recognises revenue on the basis of direct measurements of the value to the customer of the goods and services transferred to date relative to the remaining goods and services under the contract. Where the output method is used, in particular for long-term service contracts where the series guidance is applied, the Group often uses a method of time elapsed which requires minimal estimation. Certain long-term contracts use output methods based upon estimation of number of users, level of service activity or fees collected.
If performance obligations in a contract do not meet the overtime criteria, the Group recognises revenue at a point in time when the service or good is delivered.
The Group’s contracts are often amended for changes in contract specifications and requirements. Contract modifications exist when the amendment either creates new or changes the existing enforceable rights and obligations. The effect of a contract modification on the transaction price and the Group’s measure of progress for the performance obligation to which it relates, is recognised as an adjustment to revenue in one of the following ways:
a) prospectively as an additional separate contract;
b) prospectively as a termination of the existing contract and creation of a new contract;
c) as part of the original contract using a cumulative catch up; or
d) as a combination of (b) and (c).
For contracts for which the Group has decided there is a series of distinct goods and services that are substantially the same and have the same pattern of transfer where revenue is recognised over time, the modification will always be treated under either (a) or (b); (d) may arise when a contract has a part-termination and a modification of the remaining performance obligations.
The facts and circumstances of any contract modification are considered individually as the types of modifications will vary contract by contract and may result in different accounting outcomes.
Judgement is applied in relation to the accounting for such modifications where the final terms or legal contracts have not been agreed prior to the period end as management need to determine if a modification has been approved and if it either creates new or changes existing enforceable rights and obligations of the parties. Depending upon the outcome of such negotiations, the timing and amount of revenue recognised may be different in the relevant accounting periods. Modification and amendments to contracts are undertaken via an agreed formal process. For example, if a change in scope has been approved but the corresponding change in price is still being negotiated, management use their judgement to estimate the change to the total transaction price. Importantly, any variable consideration is only recognised to the extent that it is highly probable that no revenue reversal will occur.
Principal versus agent
The Group has arrangements with some of its clients whereby it needs to determine if it acts as a principal or an agent as more than one party is involved in providing the goods and services to the customer. The Group acts as a principal if it controls a promised good or service before transferring that good or service to the customer. The Group is an agent if its role is to arrange for another entity to provide the goods or services. Factors considered in making this assessment are most notably the discretion the Group has in establishing the price for the specified good or service, whether the Group has inventory risk and whether the Group is primarily responsible for fulfilling the promise to deliver the service or good.
This assessment of control requires judgement in particular in relation to certain service contracts. An example is the provision of certain recruitment and learning services where the Group may be assessed to be agent or principal dependent upon the facts and circumstances of the arrangement and the nature of the services being delivered.
Where the Group is acting as a principal, revenue is recorded on a gross basis. Where the Group is acting as an agent, revenue is recorded at a net amount reflecting the margin earned.
Software licences delivered by the Group can either be right to access (‘active’) or right to use (‘passive’) licences, which determines the timing of revenue recognition. The assessment of whether a licence is active or passive involves judgement.
The key determinant of whether a licence is active is whether the Group is required to undertake continuing activities that significantly affect the licensed intellectual property (or the customer has a reasonable expectation that it will do so) and the customer is, therefore, exposed to positive or negative impacts resulting from those changes. The Group is in a majority of cases responsible for any maintenance, continuing support, updates and upgrades and accordingly the sale of the initial software is not distinct. All other licences which have significant stand-alone functionality are treated as passive licences.
When software upgrades are sold as part of the software licence agreement (i.e. software upgrades are promised to the customer), the Group applies judgement to assess whether the software upgrade is distinct from the licence (i.e. a separate performance obligation). If the upgrade is considered fundamental to the ongoing use of the software by the customer, the upgrades are not considered distinct and not accounted for as a separate performance obligation.
The Group considers for each contract that includes a separate licence performance obligation all the facts and circumstances in determining whether the licence revenue is recognised over time (‘active’) or at a point in time (‘passive’) from the go live date of the licence.
Deferred and accrued income
The Group’s customer contracts include a diverse range of payment schedules dependent upon the nature and type of goods and services being provided. This can include performance-based payments or progress payments as well as regular monthly or quarterly payments for ongoing service delivery. Payments for transactional goods and services may be at delivery date, in arrears or part payment in advance. Our long-term service contracts tend to have higher cash flows early on in the contract to cover transformational activities.
Where payments made to date are greater than the revenue recognised to date at the period end date, the Group recognises a deferred income contract liability for this difference. Where payments made are less than the revenue recognised at the period end date, the Group recognises an accrued income contract asset for this difference.
At each reporting date, the Group assesses whether there is any indication that accrued income assets may be impaired by considering whether the revenue remains highly probable that no revenue reversal will occur. Where an indicator of impairment exists, the Group makes a formal estimate of the asset’s recoverable amount. Where the carrying amount of an asset exceeds its recoverable amount, the asset is considered impaired and is written down to its recoverable amount.
The Group disaggregates revenue from contracts with customers by contract type, as management believe this best depicts how the nature, amount, timing and uncertainty of the Group’s revenue and cash flows are affected by economic factors. Categories are: ‘long-term contractual – greater than two years’; and ‘short-term contractual – less than two years’, and ‘transactional’. Years based from service commencement date.
Long-term contractual – greater than two years
The Group provides a range of services in the majority of its reportable segments under customer contracts with a duration of more than two years. The nature of contracts or performance obligations categorised within this revenue type is diverse and includes:
(i) long-term outsourced service arrangements in the public and private sectors; and
(ii) active software licence arrangements.
Majority of the long-term contractual contracts form part of a series of distinct goods and services as they are substantially the same service; and have the same pattern of transfer (as the series constitutes services provided in distinct time increments (eg daily, monthly, quarterly or annual services)) and therefore treats the series as one performance obligation.
Short-term contractual – less than two years
The nature of contracts or performance obligations categorised within this revenue type is diverse and includes:
(i) short-term outsourced service arrangements in the public and private sectors; and
(ii) software maintenance contracts.
The Group has assessed that maintenance and support (i.e. on-call support, remote support) for software licences is a performance obligation that can be considered capable of being distinct and separately identifiable in a contract if the customer has a passive licence. These recurring services are substantially the same as the nature of the promise is for the Group to ‘stand ready’ to perform maintenance and support when required by the customer. Each day of standing ready is then distinct from each following day and is transferred in the same pattern to the customer.
Transactional (point in time) contracts
The Group delivers a range of goods or services in all reportable segments that are transactional services for which revenue is recognised at the point in time when control of the goods or services has transferred to the customer. This may be at the point of physical delivery of goods and acceptance by a customer or when the customer obtains control of an asset or service in a contract with customer-specified acceptance criteria.
The nature of contracts or performance obligations categorised within this revenue type is diverse and includes:
(i) provision of IT hardware goods;
(ii) passive software licence agreements;
(iii) commission received as agent from the sale of third-party software; and
(iv) fees received in relation to delivery of professional services.
3.1.3 Contract fulfilment assets (extract)
The Group regularly incurs costs to deliver its outsourcing services in a more efficient way (often referred to as ‘transformation’ costs). These costs may include process mapping and design, system development, project management, hardware (generally in scope of the Group’s accounting policy for property, plant and equipment), software licence costs (generally in scope of the Group’s accounting policy for intangible assets), recruitment costs and training.
Contract fulfilment costs are divided into: (i) costs that give rise to an asset; and (ii) costs that are expensed as incurred.
When determining the appropriate accounting treatment for such costs, the Group firstly considers any other applicable standards. If those other standards preclude capitalisation of a particular cost, then an asset is not recognised under IFRS 15.
If other standards are not applicable to contract fulfilment costs, the Group applies the following criteria which, if met, result in capitalisation: (i) the costs directly relate to a contract or to a specifically identifiable anticipated contract; (ii) the costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future; and (iii) the costs are expected to be recovered.
The Group has determined that, where the relevant specific criteria are met, the costs for (i) process mapping and design; (ii) system development; and (iii) project management are likely to qualify to be capitalised as contract fulfilment assets.
The incremental costs of obtaining a contract with a customer are recognised as a contract fulfilment asset if the Group expects to recover them. The Group incurs costs such as bid costs, legal fees to draft a contract and sales commissions when it enters into a new contract.
The Group has determined that the following costs may be capitalised as contract fulfilment assets: (i) legal fees to draft a contract (once the Group has been selected as a preferred supplier for a bid); and (ii) sales commissions that are directly related to winning a specific contract.
Costs incurred prior to selection as preferred supplier are not capitalised but are expensed as incurred.
Utilisation: The utilisation charge is included within cost of sales. The Group utilises contract fulfilment assets over the expected contract period using a systematic basis that mirrors the pattern in which the Group transfers control of the service to the customer. Judgement is applied to determine this period.
Derecognition: A contract fulfilment asset is derecognised either when it is disposed of or when no further economic benefits are expected to flow from its use or disposal.
Impairment: At each reporting date, the Group determines whether or not the contract fulfilment assets are impaired by comparing the carrying amount of the asset to the remaining amount of consideration that the Group expects to receive less the costs that relate to providing services under the relevant contract. In determining the estimated amount of consideration, the Group uses the same principles as it does to determine the contract transaction price, except that any constraints used to reduce the transaction price will be removed for the impairment test.
Significant accounting judgements, estimates and assumptions
Judgement is applied by the Group when determining what costs qualify to be capitalised in particular when considering whether these costs are incremental and when considering if costs generate or enhance resources to be used to satisfy future performance obligations and whether costs are expected to be recoverable. For example, the Group considers which type of sales commissions are incremental to the cost of obtaining specific contracts and the point in time when the costs will be capitalised. See note 2.1 for further information.