The Group’s significant accounting policies are outlined in note 1 to the Group accounts. Not all of these significant accounting policies require management to make difficult, subjective or complex judgements or estimates.
The following is intended to provide an understanding of those policies that management considers critical because of the level of complexity, judgement or estimation involved in their application and their impact on the consolidated financial statements. These judgements involve assumptions or estimates in respect of future events, which can vary from what is anticipated. However, the directors believe that the consolidated financial statements reflect appropriate judgements and estimations and provide a true and fair view of our financial performance and position over the relevant period.
Contract revenue and profit recognition
The majority of the Group's defence activities are conducted under long-term contract arrangements and are accounted for in accordance with International Accounting Standard 11 Construction Contracts (IAS 11). Revenue is recognised on such contracts based on the achievement of performance milestones. No profit is recognised on contracts until the outcome of the contract can be reliably estimated.
Profit is calculated by reference to reliable estimates of contract revenue and forecast costs after making suitable allowance for technical and other risks related to performance milestones yet to be achieved.
Owing to the complexity of many of the contracts undertaken by the Group the cost estimation process requires significant judgement and is based upon the knowledge and experience of the Group’s project managers, engineers, finance and commercial professionals and using the Group’s contract management processes. Factors that are considered in estimating the cost of work to be completed and ultimate profitability of the contract include the nature and complexity of the work to be performed, availability and productivity of labour, the effect of change orders, the availability of materials, performance of subcontractors and availability and access to government-furnished equipment.
Cost and revenue estimates and judgements are reviewed and updated at least quarterly and more frequently as determined by events or circumstances. When it is probable that total contract costs will exceed total contract revenue, the expected loss is recognised immediately as an expense. Contract costs comprise directly attributable costs including an allocation of direct overheads. Indirect overheads are only regarded as contract costs when their recovery is explicitly allowed for under the terms of the contract. Indirect costs are otherwise treated as a period cost and are expensed as incurred. Material changes in one or more of these estimates, whilst not anticipated, would affect the profitability of individual contracts.
Where goods are supplied under arrangements not considered to represent Construction Contracts, as defined by IAS 11, sales are recognised when the significant risks and rewards of ownership have been transferred and the related revenue and costs can be measured reliably.
Where services are rendered, sales are recognised when the stage of completion of the services and the related revenue and costs can be measured reliably.
Additional details concerning the Group’s revenue recognition policy are in note 1 to the Group accounts.
Retirement benefit plans
The Group accounts for post-retirement pension and healthcare plans in accordance with IAS 19 Employee Benefits (IAS 19).
For defined benefit retirement plans, the cost of providing benefits is determined periodically by independent actuaries and charged to the income statement in the period in which those benefits are earned by the employees. Actuarial gains and losses are recognised in full in the period in which they occur and are recognised in the statement of recognised income and expense. Past service cost is recognised immediately to the extent the benefits are already vested, or otherwise is amortised on a straight-line basis over the average period until the benefits become vested.
The retirement benefit obligations recognised in the balance sheet represent the present value of the defined benefit obligation as adjusted for unrecognised past service cost and as reduced by the fair value of plan assets.
The main assumptions made in accounting for the Group’s post-retirement plans relate to the expected return on investments within the Group’s plans, the rate of increase in pensionable salaries, the rate of increase in the retail price index, the mortality rate of plan members and the discount rate applied in discounting liabilities. For each of these assumptions there is a range of possible values and, in consultation with our actuaries, management decides the point within that range that most appropriately reflects the Group’s circumstances. Small changes in these assumptions can have a significant impact on the size of the deficit calculated under IAS 19.
The Group has allocated an appropriate share of the pension deficit to its equity accounted investments and to other participating employers using a consistent and reasonable method of allocation which represents, based on current circumstances, the directors’ best estimate of the proportion of the deficit anticipated to be funded by these entities. The Group’s share of the pension deficit allocated to the equity accounted investments is included on the balance sheet within equity accounted investments.
The valuing of assets and liabilities at a point in time rather than matching expectations of assets and liabilities over time has no impact on short-term cash contributions to the pension plans. These funding requirements are derived from separate independent actuarial valuations.
Additional details concerning the Group’s retirement benefit plans are given in note 1 and note 22 to the Group accounts.
Intangible assets
In accordance with International Financial Reporting Standard 3 Business Combinations (IFRS 3), goodwill arising on acquisition of subsidiaries is capitalised and included in intangible assets. Goodwill on acquisitions of joint ventures and associates is included in equity accounted investments. IFRS 3 also requires the identification of other acquired intangible assets. The techniques used to value these intangible assets are in line with internationally used models but do require the use of estimates which may differ from actual outcomes. Future results are impacted by the amortisation period adopted for these items and, potentially, any differences between estimated and actual circumstances related to individual intangible assets.
Goodwill is not amortised but is tested annually for impairment and carried at cost less accumulated impairment losses. The impairment review calculations require the use of estimates related to the future profitability and cash-generating ability of the acquired business. Additional details concerning the Group’s treatment of intangible assets and impairment reviews are given in note 1 to the Group accounts.
Regional Aircraft valuations
The Group holds a number of regional aircraft on its balance sheet. These aircraft are leased to airline operators. In addition, the Group has provided residual value guarantees (RVGs) in respect of certain regional aircraft sold. The aircraft held on balance sheet are subject to regular impairment testing. During the year the anticipated aircraft values were reassessed to a value based on their contracted rental inflows plus a residual value determined by the aircraft type and age. Provisions related to the RVGs are measured as the difference between amounts payable to customers and the estimated fair value of the aircraft. The estimated fair value of those aircraft is made on the same basis as for the aircraft held on balance sheet.
Much of the leasing business was underpinned by the Group’s Financial Risk Insurance Programme, which makes good shortfalls in actual lease income against originally estimated future income for a 15-year period from 1998 to 2013. Since 2006, BAE Systems and certain of the reinsurers have been in dispute over several areas of the policy. During 2007, agreement was reached with almost all the reinsurers and settlements have been paid by them based on the net present value of estimated future claims. Arbitration proceedings now continue with only one reinsurer. Additional details concerning these arrangements are contained in the Risk management and principal risks section.
The Group has granted RVGs in respect of certain aircraft sold of which £134m remains outstanding (2006 £191m). It is considered that the Group’s net exposure to these guarantees is covered by the provisions held, on a net present value basis, and the estimated residual values of those aircraft. Additional details concerning this are given in note 24 to the Group accounts.
