United Utilities Group PLC – Annual report – 31 March 2020
Accounting policies (extract)
Critical accounting judgements and key sources of estimation uncertainty
In the process of applying its accounting policies set out in note A7, the group is required to make certain estimates, judgements and assumptions that it believes are reasonable based on the information available. These judgements, estimates and assumptions affect the carrying amounts of assets and liabilities at the date of the financial statements and the amounts of revenues and expenses recognised during the reporting periods presented. Changes to these estimates, judgements and assumptions could have a material effect on the financial statements.
As part of the evaluation of critical accounting judgements and key sources of estimation uncertainty, the group has considered the implications of climate change on its operations and activities. The group has considered the potential financial statement impacts, including asset lives and impairments and identified that the environmental impact of certain bioresources assets were considered as part of the strategic review leading to the conclusion that the chances of any future economic benefit being derived from these assets is now considered remote and resulting in accelerated depreciation as set out in the Property, Plant and Equipment section below.
On an ongoing basis, the group evaluates its estimates using historical experience, consultation with experts and other methods considered reasonable in the particular circumstances. Actual results may differ significantly from the estimates, the effect of which is recognised in the period in which the facts that give rise to the revision become known.
The following paragraphs detail the estimates and judgements the group believes to have the most significant impact on the annual results under IFRS, including specific considerations in light of the COVID-19 pandemic.
Revenue recognition and allowance for doubtful receivables
Accounting judgement – The group recognises revenue generally at the time of delivery and when collection of the resulting receivable is reasonably assured. When the group considers that the criteria for revenue recognition are not met for a transaction, revenue recognition is delayed until such time as collectability is reasonably assured. There are two different criteria whereby management does not recognise revenue for amounts which have been billed to the customer on the basis that collectability is not reasonably assured. These are as follows:
- The customer has not paid their bills for a period of at least two years; and
- The customer has paid their bills in the preceding two years; however, has previously had bills de-recognised and has more than their current year debt outstanding.
This two-criteria approach resulted in a £19.4 million reduction in revenue compared with what would have been recognised had no adjustment been made for amounts where collectability is not reasonably assured. Had management made an alternative judgement that where customers have paid in the preceding two years, and have more than their current year debt outstanding, the recoverability of the entirety of their debt was deemed to be reasonably assured (i.e. the second criteria were disapplied), the
required adjustment to revenue would have been £8.5 million lower.
Accounting estimate – At each reporting date, the company and each of its subsidiaries evaluate the estimated recoverability of trade receivables and record allowances for expected credit losses based on experience. Estimates associated with these allowances are based on, among other things, a consideration of actual collection history. The actual level of receivables collected may differ from the estimated levels of recovery, which could impact operating results positively or negatively. At 31 March 2020, the allowance for expected credit losses relating to household customer debt of £49.4 million was supported by a six-year cash collection projection. Based on a five-year or seven-year cash collection projection the allowance for doubtful receivables would have increased by £2.3 million or reduced by £0.8 million respectively.
In the current year, the expected future impact of the COVID-19 pandemic on the ability of some customers to pay their bills has specifically been taken into consideration as part of the expected credit loss assessment for trade receivables. This has given rise to a further £16.7 million incremental increase in the allowance for expected credit losses based on judgements around the likely impact of the pandemic on the non-payment risk profile of the group’s customer base on a segmented basis. Scenarios have been modelled based on a moderate, shorter-term pandemic impact, and a more severe and longer-lasting impact. In arriving at the £16.7 million increase, the outcomes of these scenarios have been weighted on a 50:50 basis representing management’s best estimate of their relative probability. If this weighting were 70:30 towards either the more severe scenario or the more moderate scenario, the incremental allowance relating to the COVID-19 pandemic would be +/- £1.6 million respectively.
Accounting estimate – United Utilities Water Limited raises bills in accordance with its entitlement to receive revenue in line with the limits established by the periodic regulatory price review processes. For household water and wastewater customers with water meters, the receivable billed is dependent on the volume supplied, including the sales value of an estimate of the units supplied between the date of the last meter reading and the billing date. Meters are read on a cyclical basis and the group recognises
revenue for unbilled amounts based on estimated usage from the last billing through to each reporting date. The estimated usage is based on historical data, judgement and assumptions; actual results could differ from these estimates, which would result in operating revenues being adjusted in the period that the revision to the estimates is determined. Revenue recognised for unbilled amounts for these customers at 31 March 2020 was £54.6 million. Had actual consumption been 5 per cent higher or lower than the estimate of units supplied, this would have resulted in revenue recognised for unbilled amounts being £4.5 million higher or lower respectively. For customers who do not have a meter, the receivable billed and revenue recognised is dependent on the rateable value of the property, as assessed by an independent rating officer.
Revenue in relation to wholesale charges billed to non-household retailers is recognised based on a series of settlement statements produced by the Central Market Operating System (CMOS). These statements are based on a combination of meter readings and estimated consumption. Due to the iterative nature of the settlement process, the final wholesale charge for a period is not known until 16 months after that period. Accordingly, an estimate of credit notes that may need issuing in the future, for example where future statements include allowances or premises subsequently marked as vacant, is required. The estimated credit note provision is based on an analysis of historic changes to wholesale charges as settlement statements are received. At 31 March 2020, the credit note provision, and therefore the revenue not recognised in relation to billed amounts, was £21.5 million.
Due to temporary business closures required as a result of lockdown measures introduced by the UK Government during March 2020, the level of non-household consumption fell significantly in the final two weeks of March. As part of its measures to protect liquidity within the non-household market, Ofwat introduced a change to the market code to allow retailers to temporarily mark premises as vacant where they had been forced to close. Due to the timing of the code change, the impact of increased vacancy had not flowed through to CMOS billing reports at the end of March 2020, an estimate of the expected reduction in revenue compared with what was billed for March 2020 has, therefore, been required. The level of revenue not recognised since lockdown measures began, is £7.1 million based on estimates received from retailers pending a full analysis, reduction in consumption during this period. If actual consumption was 20 per cent lower in this period the revenue not recognised would have been around £5.5 million, and if actual consumption were 40 per cent lower the revenue not recognised would have been around £8.7 million.
Property, plant and equipment
Accounting judgement – The group recognises property, plant and equipment (PPE) on its water and wastewater infrastructure assets where such expenditure enhances or increases the capacity of the network, whereas any expenditure classed as maintenance is expensed in the period it is incurred. Determining enhancement from maintenance expenditure requires an accounting judgement, particularly when projects have both elements within them. Enhancement spend was 67 per cent of total spend in relation to infrastructure assets during the year. A change of +/- 1 per cent would have resulted in £4.4 million less/more expenditure being charged to the income statement during the period. In addition, management capitalises time and resources incurred by the group’s support functions on capital programmes, which requires accounting judgements to be made in relation to the appropriate capitalisation rates. Support costs allocated to PPE represent 44 per cent of total support costs. A change in allocation of +/- 10 per cent would have resulted in £5.6 million less/more expenditure being charged to the income statement during the period.
Accounting estimate – The estimated useful economic lives of PPE and intangible assets is based on management’s experience. When management identifies that actual useful economic lives differ materially from the estimates used to calculate depreciation, that charge is adjusted prospectively. Due to the significance of PPE and intangibles investment to the group, variations between actual and estimated useful economic lives could impact operating results both positively and negatively. As such, this is a key source of estimation uncertainty. Although historically few changes to estimated useful economic lives have been required, during the current year PPE with a net book value of £82.3 million was written down to £nil following a review of the group’s bioresources strategy, which concluded that because of improvements in alternative lower-cost and more environmentally friendly processes the likelihood of these assets generating future economic benefit is now considered to be remote. As such these assets are deemed to have reached the end of their useful economic lives earlier than previously anticipated. Excluding this accelerated depreciation, the depreciation and amortisation expense for the year was £397.9 million. A 10 per cent increase in average asset lives would have resulted in a £37.4 million reduction in this figure and a 10 per cent decrease in average asset lives would have resulted in a £42.7 million increase in this figure.
Accounting estimate – The group operates two defined benefit pension schemes which are independent of the group’s finances. Actuarial valuations of the schemes are carried out as determined by the trustees at intervals of not more than three years. Profit before tax and net assets are affected by the actuarial assumptions used. The key assumptions include: discount rates, pay growth, mortality, and increases to pensions in payment and deferred pensions. It should be noted that actual rates may differ from the assumptions used due to changing market and economic conditions and longer or shorter lives of participants and, as such, this represents a key source of estimation uncertainty. Sensitivities in respect of the assumptions used during the year are disclosed in note A5.
Accounting estimate – Included within the group’s defined benefit pension scheme assets are assets with a fair value estimated to be £232.1 million that are categorised as ‘level 3’ assets within the IFRS 13 ‘Fair value measurement’ hierarchy, meaning that the value of the assets is not observable at 31 March 2020. The fair value of these assets has been estimated based on the latest available observable prices, updated with reference to movements in comparable observable indices to the reporting date, and adjusted for judgements to reflect differences in the liquidity and credit components of the asset pricing. Judgement is required in estimating the fair value of these assets, with the values estimated to fall within a range of £219 million and £245 million.
Joint ventures – Water Plus
Accounting judgement – The group’s financial interests in Water Plus Group Limited, a joint venture with Severn Trent PLC, comprise an investment in the ordinary shares of Water Plus, and loans issued to the joint venture in the form of revolving credit facilities and a zero coupon shareholder loan note, further details of which are included in note A6. Judgement is required in determining whether these loans form part of the group’s long-term interest in Water Plus whose value would be reduced in accordance with the group’s share of joint venture losses in excess of the value of its equity investment when applying the equity method in accordance with IAS 28 ‘Investments in Associates and Joint Ventures’. As they bear interest, have a relatively near-term expiry date and tend to fluctuate as amounts are drawn down and repaid, the revolving credit facilities are not considered to be part of the group’s long-term interest in Water Plus. In contrast, the zero coupon shareholder loan notes are considered to be part of the group’s long-term interest given that they do not bear interest and have a longer-term maturity. Had an alternative judgement been applied such that the revolving credit facilities were considered to be part of the group’s long-term interest in Water Plus, the group’s £5.3 million unrecognised share of Water Plus’s losses for the year (see note 12) would have been recognised in the income statement resulting in a higher share of losses from joint ventures, and the carrying value of the amount owed by Water Plus in respect of the revolving credit facility (see note A6) would have been reduced by this amount. Similarly, had an alternative judgement been applied such that the zero coupon shareholder loan note were not considered to be part of the group’s long-term interest in Water Plus, the group’s share of Water Plus losses for the year would have been £9.5 million lower.
Accounting estimate – During the year, the impact of the COVID-19 pandemic crystallised an impairment of £51.1 million in Water Plus, which was recognised in relation to the joint venture’s goodwill and certain intangible assets and was a significant contributor to Water Plus’s losses for the year, of which the group has allocated its share against its equity investment and other long-term interest in the joint venture. The impairment assessment undertaken by the management of Water Plus was calculated based on the company’s value in use, determined by discounting the estimated future cash flows of the Water Plus business to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the business. The inputs into the value in use assessment were subject to judgements in respect of the future cash flows included in the Water Plus five-year business plan, discount rate, and terminal growth rate. If the future cash flows were 10 per cent higher than those included in the Water Plus impairment assessment this would have resulted in a £12.0 million reduction in the group’s share of Water Plus losses, eliminating the £5.3 million unrecognised loss and reducing by £6.7 million the share of Water Plus losses recognised by the group. This would have resulted in a corresponding £6.7 million increase in the carrying value of the zero coupon shareholder loan notes forming part of the group’s long-term interest in Water Plus. If the future cash flows had been 10 per cent lower this would have resulted in the group’s unrecognised share of losses increasing by £12.0 million.
Accounting estimate – The significant economic impact of the COVID-19 pandemic has given rise to a significant increase in credit risk in respect of loans extended to Water Plus. Accordingly, these balances have been assessed for expected credit losses, which have been estimated based on a forward-looking economic assessment derived from Water Plus’s latest board-approved business plan out to 2025, assuming a 2 per cent growth rate beyond this point and Water Plus securing external financing of a portion of its working capital in the year ending 31 March 2023. A 2.5 per cent (1 in 40 years) probability of a loss event occurring in a given year during which loan balances are assumed to be outstanding has been considered against the forward-looking economic assessment and applied against the assumed outstanding loan balances. Various scenarios have then been modelled based on higher and lower generation of free cash that could be used to repay the loans, and these have been probability-weighted to give an expected credit loss estimated at £5.0 million as at 31 March 2020. Within the expected credit loss assessment the most significant source of estimation uncertainty is considered to be the level of trade receivables that could be recovered in the event of Water Plus suffering a liquidation event, with the group having estimated that 70 per cent of Water Plus’s gross trade receivables could be recovered. If the recovery rate were 60 per cent, the group’s expected credit losses in respect of loans to Water Plus would have been £2.1 million higher, and if the recovery rate were 80 per cent the group’s expected credit losses would have been £2.2 million lower.
Derivative financial instruments
Accounting estimate – The model used to fair value the group’s derivative financial instruments requires management to estimate future cash flows based on applicable interest rate curves. Projected cash flows are then discounted back using discount factors which are derived from the applicable interest rate curves adjusted for management’s estimate of counterparty and own credit risk, where appropriate. Sensitivities relating to derivative financial instruments are included in note A4.