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Rolls-Royce Accounts Adjustments – Were They Prudent?

Rolls-Royce provided a trading update today, and covered the impact of IFRS 15 which is probably a lot more important. IFRS 15 is a new accounting standard concerning revenue recognition which will come into use in 2018. It will have a major impact on the figures reported by Rolls-Royce because of their past recognition of revenue and profits from long term maintenance contracts.

For example, Rolls-Royce report that when looking at the 2015 accounts the “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)”. In addition they say that “approximately £3.5bn of transition adjustments (before tax) would have been applied to reduce shareholder reserves”. These are not trivial sums in comparison with the company’s revenue and profits (£13.7bn revenue and only £83m in profit in the last full year).

In effect they have been recognising future revenue and profits in advance of receiving the cash. So although they say that “cumulative profit and cash flow recognised over the life cycle of a product is not changed”, they have in reality being pulling them forward!

Doing so is one of the oldest accounting tricks to flatter your results. Just recognise profits on long term contracts in advance. Quindell were expert at this abuse for example. Of course it does not affect the reported cash flows that Rolls-Royce have been reporting, because cash is cash. But it might affect an investors view of the profitability of the company.

Investors should ask the directors whether it was prudent or not to recognise revenue in this way? Investors in Rolls-Royce know that it supposedly loses money on new aircraft engine sales, offset by profits on the long-term service contracts that it sells with them. But surely that’s no excuse for manipulating the figures in this way.

The Trading Statement

What else did the announcement say? The outlook for 2016 is unchanged. Free cash flow is expected to be in the range of minus £100m to £300m in 2016, which is the main negative point (although the CEO is quoted in the FT this morning as saying that “In 2018 we expect to be cash generative and in 2019 considerably cash generative”. Is he giving advance information to the media as that was not even in this mornings announcement?

Progress on strategic priorities is being made, but in summary this was a pretty downbeat report. The share price is down 2% on the day at the time of writing. It is clearly taking new CEO Warren East longer than expected to sort out this business.

For investors, it’s a reminder that revenue recognition is one of the key things to look at when you are reviewing the accounts of companies. And if profits don’t turn into cash, it can explain why.

Roger Lawson

  1. Cliff Weight says:

    Roger, my view is:

    1. FT article was on Nov 13. IMO, it seemed to have little impact on the share price on that day or immediately preceding and after it. Since then the news about Emirates has caused a 10% drop in the share price.
    2. So, we may conclude IMO that this IFRS accounting nicety was information that was already in the market when the FT printed its story.
    3. RR share price dropped 35% in 2015 following a 32% drop in 2014. Share price was £12.71 at 1.1.2014; £8.62 at 1.1.2015 and £5.595 at 31.12.2015. It is now £6.43.
    4. So was the LTIP for the performance period 1.1.2012 to 31.12.2014 deserved? It paid out £1.2million (45% of “maximum” vesting) and the share price had increased from £4.835 at the date of grant to £8.70 at the date of vesting. The LTIP performance measures were Cash flow per share (not impacted by the IFRS change), TSR (possibly impacted by the profit figures showing higher than they really were) with a EPS underpin (which would definitely be impacted by the previous generous accounting practices).
    5. Unusually the remuneration policy does not mention clawback. So there is no legal scope to claw back any of the 2012-2014 LTIP award.
    6. Other later LTIPs have not paid out nor was there any bonus in 2014 or 2015.
    7. A question to the rem com chair (it was Dame Helen Alexander) at the next AGM would be in order. I suggest “I am worried about the IFRS changes and their implication on remuneration and whether some historic awards were justified. Why was there no provision for clawback in the LTIP scheme? And secondly if there had been, would you have attempted to claw back some of the previous CEO’s (John Rishton) remuneration?

    Cliff Weight

  2. […] In addition to these bribery problems, the company has only recently disclosed that the reported profits should really be lower because they have been claiming profits on future maintenance contracts which were probably imprudent – see a previous blog post on that issue here: […]

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