IFRS 15 – the Rolls-Royce of standards, especially if you actually happen to be Rolls-Royce!

As we’ve discussed in many previous articles, IFRS 15 Revenue from Contracts with Customers becomes effective on January 1, 2018.

By now, companies for whom the new standard will have a material effect should surely have clearly disclosed that fact, and in many cases should have provided some quantified information about the anticipated effect as well (we mentioned expectations set out by Canadian regulators here). One of the more prominent examples of such disclosure to date comes from a British company, Rolls-Royce. Here are extracts of what it said in a news release last November:

  • Using 2015 as an example, the team evaluated how the standard would have changed revenue and profit for Civil Aerospace if it had been applied to that year:
    • Cumulative profit and cash flow recognized over the life cycle of a product is not changed by the new standard
    • Changes to the timing of revenue and profit recognition:
      • Original Equipment: to more closely reflect the cash received on original equipment sales
      • Aftermarket: to reflect the timing of actual work done to provide aftermarket services, irrespective of the commercial value of implicit performance commitments (this new aftermarket approach is known as the ‘input’ method)
    • Changes result in adverse notional adjustments to Civil Aerospace revenues and operating profit in 2015 of £0.7bn for original equipment (OE) sales and £0.2bn for aftermarket (AM).
    • From a balance sheet perspective, if IFRS 15 had been applied to the 2015 closing TotalCare®net asset and Capitalised Aftermarket Rights balances then approximately £3.5bn of transition adjustments (before tax) would have been applied to reduce shareholder reserves

These adjustments amount to cutting 2015 operating profit by more than 50%. The first bullet point above is clearly central to the company’s messaging on this, as illustrated also by a Telegraph article on the news:

  • Addressing investors on Wednesday, Rolls finance chief David Smith conceded that adopting the new accounting rules – due to be implemented in 2018 – would mean profits falling in the short term.
  • However, he denied that Rolls’s share price or the company’s long-term profitability would be hit.
  • “It doesn’t change the fundamental value, but we clearly will have to see what the market reaction is,” Mr Smith said.
  • …Asked when Rolls-Royce  would crossover from red to black – with analysts predicting a return to growth by 2020 – Mr Smith said the company was not yet in a position to comment, a reply which saw the shares fall 2.1pc.
  • “It’s very difficult actually to be precise about that,” the finance chief said. “The important thing is [the new standard] doesn’t affect profitability of contracts, it’s just when we are recognizing or reporting earnings when those profits occur.”

The same article concisely summarizes why this may be a change for the better in Rolls-Royce’s case:

  • Broker Hargreaves Lansdown said when aftermarket revenues were booked upfront, much of the cash never materialized because some customers retired aircraft rather than having them serviced. “The new system should mean greater clarity,” it said.

The coverage in the Financial Times reflected similar positivity:

  • While profit may have to be rebased, the new rule offers the advantage that it will more accurately reflect the cash coming into the business, another person familiar with the accounting changes said.
  • Nick Cunningham, aerospace analyst at Agency Partners, said reporting under IFRS15, as the standard is called, will result in complex changes but could leave the civil aero-engine business reporting losses through to 2022. He said (the hit) could affect the shares while investors digested the implications.
  • “But why is that a bad thing?” he said. “Having a share price higher than it should be is not a good thing. Management ends up having to move heaven and earth to defend it and that can’t last. From here on in, the whole thing starts to look a lot more sensible.”
  • Investors said the accounting changes would make the profitability of each engine programme more transparent….

An unwary reader might take it from this that IFRS 15 is largely a cash-based standard, placing its primary emphasis on ensuring that reported revenues bear a clear relationship to the receipt of funds. But as we know, while that may be true in some cases, it won’t be in others. For example, an entity that receives a portion of its revenue in the form of non-refundable upfront fees may find itself recognizing them later under IFRS 15 (perhaps much later) than it currently does under IAS 18 (to my considerable surprise, the post I did on this a couple of years ago has been more consistently accessed than any other on this blog, suggesting it’s a common implementation issue). It remains to be seen whether cash-oriented investors might consider those kinds of changes less transparent, at least from certain perspectives, regardless of their greater economic rationality.

Still, the conversation surrounding Rolls-Royce appears encouraging. In initially announcing the impact, the CFO commented that: “The new standard provides a number of benefits to the business. As it brings profit performance for OE more in line with cash generation, it will put a sharper focus on improving productivity across our manufacturing activities…” One hears things like this once in a while, about how the particular demands of a new standard push the company toward greater internal focus and rationality, but it’s hard to know how widespread such effects are. Perhaps IFRS 15 will generate a meaningful body of evidence in this regard…

The opinions expressed are solely those of the author

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