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As stated in note 1, in accordance with European Union Regulations, the Group adopted IFRS from January 1, 2004, and restated its financial statements for the year ended December 31, 2004, which were previously reported under UK Generally Accepted Accounting Practices (GAAP). An analysis of the impact of implementing IFRS was published in a news release on April 14, 2005, available on the Investors section of the Group's website www.rolls-royce.com

The major changes required by the introduction of IFRS were:

• recognition of intangible assets, whereby certain qualifying costs, in particular related to research and development and recoverable engine costs, which were written off under UK GAAP, are required to be recognised and amortised over a future period of time;
• treatment of financial instruments, whereby the majority of financial assets and derivatives, employed by the Group to provide stability for long-term business planning, for example in respect of foreign exchange rates, will be fair-valued on the balance sheet with subsequent changes in fair values recorded in the income statement, unless cash flow hedge accounting is applied;
• financial risk and revenue sharing partnerships, whereby a balance sheet liability is required to be established to reflect the expected future value of payments to partners;
• pensions and other post-retirement costs, whereby pension scheme deficits are required to be recorded on the balance sheet;
• the cessation of amortisation of goodwill; and
• the recording of share-based payments at fair value.

The Group achieved hedge accounting under UK GAAP. However the strict methodology to achieve hedge accounting under IAS 39 limits its application for use by the Group unless there are significant changes to the way in which the Group operates its economic hedging policies. The Group has determined that its existing hedging strategy is in the best interests of the business and its shareholders. It has not, therefore, altered its hedging activities in order to achieve a particular accounting presentation under the new rules.

The Group has applied hedge accounting to its interest rate derivative hedge book, but has not applied cash flow hedge accounting to its foreign exchange and commodity derivative hedge books.

Details of the adjustments made in adopting IFRS are provided below. Reconciliations for the 2004 restated opening and closing balance sheets, income statement and cash flow are also provided.

Presentation of financial statements

The Group's primary financial statements have been presented in accordance with IAS 1 Presentation of Financial Statements.

The principal impact on the income statement is the presentation of the Group's share of the results of joint ventures (which are accounted for using the equity method) as a single line. Under UK GAAP, the Group's shares of operating profit, interest and taxation were reported separately. As a consequence, the Group's share of joint venture taxation is included in profit before tax. There is no impact on reported profit after tax.

The format of the balance sheet has been amended to include the items required by IAS 1 to be presented on the face of the balance sheet.

Transitional arrangements

The rules for the first-time adoption of IFRS are set out in IFRS 1. In general, a company is required to determine its IFRS policies and apply those retrospectively to determine its opening balance sheet under IFRS. IFRS 1 allows a number of exemptions to this general requirement. Where Rolls-Royce has applied these exemptions, they are noted in the relevant section below. In particular the Group has adopted the exemption that IAS 32 and IAS 39 Financial Instruments need not be applied to the comparative period. Consequently the restated results for the year ended December 31, 2004 have been prepared using the accounting policies for financial instruments previously adopted under UK GAAP. This has led to a second transition at January 1, 2005, details of which are provided below, together with a balance sheet reconciliation.

Research and development

IAS 38 requires that all development costs meeting specified criteria be capitalised as intangible assets.

As part of its IFRS transition project, Rolls-Royce reviewed all development projects, whether the costs were previously recognised under UK GAAP or not, to determine whether the criteria in IAS 38 were met. The key eligibility criteria for capitalisation relate to:

• Identification of development costs. In general, research and development activities are closely interrelated and it is not until the technical feasibility of the project can be determined with reasonable certainty that development costs can be separately identified; and
• The generation of future economic benefit. Intangible assets are not recognised unless the project is expected to generate future economic benefit exceeding the amount capitalised.

Certain expenditures on internal product development meet all the criteria of IAS 38 and have therefore been capitalised.

Development costs capitalised are amortised on a straight-line basis over a period not exceeding 15 years. The impact arising from this change is summarised as follows:

	At January 1, 2004 £m	Year ended December 31, 2004 £m
Income statement
Capitalisation of internal expenditure		11
Amortisation of intangible asset		(17)
Adjustment to profit before taxation		(6)
Net assets
Intangible asset – cost	246	257
Intangible asset – accumulated amortisation	(86)	(103)
	160	154
Related tax effect	(48)	(46)
Adjustment to net assets	112	108

 

Recoverable engine costs

On occasions, the Group may sell original equipment to customers at an amount below its cost of manufacture, with the expectation that this deficit will be recovered from future aftermarket sales to the original customer. Where the Group has a contractual right to supply aftermarket parts to the customer and its intellectual rights, warranty arrangements and statutory airworthiness requirements provide reasonable control over this supply, these arrangements are considered to meet the definition of an intangible asset. Under UK GAAP, these intangible assets were required to be written-off as they arose; under IAS 38 such intangible assets are required to be recognised. The resulting intangible asset will be amortised over the expected utilisation period of the equipment by the initial customer - generally to a maximum of ten years, subject to any specific contractual circumstances.

The impact arising from this change is summarised as follows:

	At January 1, 2004 £m	Year ended December 31, 2004 £m
Income statement
Capitalisation of intangible assets previously written off in 2004		21
Amortisation of intangible assets		(26)
Elimination of related inventory provision recognised under UK GAAP		(5)
Adjustment to profit before taxation		(10)
Net assets
Intangible assets – cost	208	229
Intangible assets – accumulated amortisation	(88)	(114)
	120	115
Elimination of related inventory provision recognised under UK GAAP	14	9
	134	124
Related tax effect	(40)	(37)
Adjustment to net assets	94	87

 

Goodwill and business combinations

IFRS 3 Business Combinations prohibits the amortisation of goodwill. Instead, it requires goodwill to be carried at cost. Annual impairment tests are required to be performed.

The Group has applied the exemption granted by IFRS 1 to apply IFRS 3 prospectively from the date of transition to IFRS. This has the following impact:

• All prior business combination accounting is frozen at the transition date; and
• The value of goodwill is frozen at the transition date and amortisation previously reported under UK GAAP for the year ended December 31, 2004 is reversed for the IFRS restatement.

The impact arising from this change is summarised as follows:

	At January 1, 2004 £m	Year ended December 31, 2004 £m
Income statement
Reversal of goodwill amortisation relating to subsidiaries		47
Reversal of goodwill amortisation relating to joint ventures		1
Adjustment to profit before taxation		48
Net assets
Reversal of goodwill amortisation	—	48
	—	48
Related taxation effect	—	(1)
Adjustment to net asset	—	47

 

Pensions and other post-retirement benefits

IAS 19 Employee Benefits requires separate recognition of the operating and financing costs of defined benefit pension schemes (and similarly funded employee benefits) in the income statement. The standard permits a number of options for the recognition of actuarial gains and losses. The Group's policy is to recognise immediately any variations in full in a statement of recognised income and expense, as permitted in the IASB's amendment to IAS 19 entitled Actuarial Gains and Losses, Group Plans and Disclosures.

The cash funding of the plans is designed, in consultation with independent qualified actuaries, to ensure that present and future contributions should be sufficient to meet future liabilities.

The impact arising from this change is summarised as follows:

	At January 1, 2004 £m	Year ended December 31, 2004 £m
Income statement
Adjustments to operating profit		42
Adjustments to financing costs		(1)
Adjustment to profit before taxation		41
Net assets
Eliminate amounts recognised under SSAP 24
Prepaid pension contributions	(239)	(263)
Provision for pension costs	160	159
Include IAS 19 pension liability	(1,466)	(1,409)
	(1,545)	(1,513)
Related taxation effect	447	437
Adjustment to net assets	(1,098)	(1,076)

 

Share-based payments

IFRS 2 Share-based Payments requires the fair value of share options granted to employees since November 7, 2002 (the publication date of the exposure draft of IFRS 2) to be charged to the income statement. The fair value is calculated using an option-pricing model and is charged to income over the relevant vesting periods, adjusted to reflect actual and expected levels of vesting.

The basis of calculation for deferred taxation is in respect of all schemes (including pre November 7, 2002 grants) and is the difference between the market price at the date of the financial statements and the option exercise price. This will not necessarily correlate to the fair value charge.

The impact arising from this change is summarised as follows:

	At January 1, 2004 £m	Year ended December 31, 2004 £m
Income statement
Fair value of share options charged to operating profit		(6)
Adjustment to profit before taxation		(6)
Net assets
Related taxation effect	2	9
Adjustment to net assets	2	9

 

Scope of consolidation

On transition to IFRS, IAS 27 Consolidated and Separate Financial Statements required the consolidation of all subsidiaries and special purpose entities that the Group controlled at January 1, 2004. Based on the IAS 27 Definitions of Control, and after taking into account the facts and circumstances relevant at the transition date, the Group determined that it controlled one arrangement (Pembroke 717 Holdings Limited) that was not required to be consolidated under UK GAAP. The consolidation of this company did not have any net impact on the reported results for 2004.

The impact arising from this change is summarised as follows:

	At January 1, 2004 £m	Year ended December 31, 2004 £m
Income statement
Operating profit		4
Finance costs		(4)
Adjustment to profit before taxation		—
Net assets
Property, plant and equipment	69	46
Current liabilities	(1)	(1)
Borrowings	(77)	(69)
Elimination of provision recognised under UK GAAP	9	24
Adjustment to net assets	—	—

 

Income taxes

The net deferred tax impact of the changes above is shown as part of the relevant adjustment.

In addition, under IAS 12 Income Taxes, certain temporary differences, for example in respect of capital losses and unremitted earnings from joint ventures, which previously were not recognised under UK GAAP, will be recognised.

The impact arising from this change is summarised as follows:

	At January 1, 2004 £m	Year ended December 31, 2004 £m
Income statement
Changes to deferred tax charge resulting from differences in the basis of calculation		1
Adjustment to profit after taxation		1
Net assets
Changes to deferred tax balance resulting from differences in the basis of calculation	(45)	(44)
Adjustment to net assets	(45)	(44)

 

Financial instruments (applicable from January 1, 2005)

IAS 32 and IAS 39 Financial Instruments address the accounting for, and financial reporting of, financial instruments. IAS 32 covers disclosure and presentation, while IAS 39 covers recognition and measurement including detailed rules for hedge accounting. These include the requirements to match the hedged item to the hedging instrument and to measure hedge effectiveness. IAS 39 requires certain financial assets and certain financial liabilities to be recognised at fair value. Accounting for movements in fair value is dependent on the designation of the relevant financial instrument and whether hedge accounting is adopted.

The Group has applied the exemption, granted by IFRS 1, not to apply IAS 32 and IAS 39 to its comparative figures for 2004. On January 1, 2005, the fair value of foreign exchange and commodity derivatives were included in a transition hedging reserve. As the Group has not adopted cash flow hedge accounting for future foreign exchange transactions under IAS 39 from January 1, 2005, the reserve was frozen and will be released to the income statement based on the designated maturities on that date.

The impact on the Group's derivative financial instruments is described below.

Foreign exchange derivatives

A large element of the Group's trading is denominated in US dollars and a significant portion of its costs is incurred in sterling and Euros. In order to protect itself from the associated currency volatility, the Group takes significant levels of forward cover. Under UK GAAP, gains or losses on this cover are not recognised in the income statement until realised, matching them with the underlying transactions. As contracts may be signed several years in advance of delivery, delivery dates may change and meeting the strict criteria for hedge accounting in IAS 39 is not considered to be practicable within the current risk management practices. Rolls-Royce considers that it could amend its risk management practices to achieve hedge accounting. However, Rolls-Royce believes that its current risk management practices are in the best economic interests of shareholders and should not be amended purely to achieve a particular accounting treatment. Accordingly, Rolls-Royce has decided not to adopt cash flow hedge accounting for forecast foreign exchange transactions. Rolls-Royce will continue to hedge its future forecast US dollar income on a portfolio basis, which it considers is the most efficient economic basis for doing so.

As a result of not hedge accounting for forecast foreign exchange transactions, the movements on the fair value of derivative contracts held for the purpose of hedging these transactions will be recognised in the income statement. The size of this movement in fair values will be largely dependent on movements in spot exchange rates.

Under UK GAAP, as part of its hedging policy, Rolls-Royce:

• recognised revenues and costs at the average exchange rate achieved in the year;
• recognised monetary assets and liabilities at the rate expected to be achieved in settling these items, taking account of the foreign exchange cover in place;
• incorporated rates achieved on forward cover in its assessment of the profitability of service and long-term contracts.

Under IFRS, Rolls-Royce will:

• recognise revenues and costs at the exchange rate at the time of the transaction;
• recognise monetary assets and liabilities at the spot exchange rate on the reporting date; and
• assess the profitability of service and long-term contracts without including the impact of forward exchange rate contracts.

Rolls-Royce will adopt fair value hedge accounting for foreign exchange derivatives entered into for the purposes of hedging the fair values of borrowings denominated in a foreign currency. Under fair value hedge accounting, the borrowings being hedged will be measured at fair value in respect of the foreign exchange risk, with movements in fair values of both the derivatives and the borrowings being included in the income statement.

Rolls-Royce will adopt net investment hedge accounting in respect of foreign subsidiaries and foreign currency denominated borrowings. Under net investment hedging, foreign exchange gains and losses arising on the fair value of the borrowings are included in equity to the extent they offset equivalent losses and gains arising on the consolidation of the subsidiary. This policy is unchanged from UK GAAP.

Interest rate derivatives

Rolls-Royce will adopt hedge accounting for hedges entered into for the purposes of managing its exposure to movements in interest rates. Fair value hedge accounting will be used for the hedging of fixed rate borrowings and cash flow hedge accounting will be used where the underlying borrowing is a floating rate instrument. Where fair value hedge accounting is used, the debt being hedged will be measured at fair value in respect of the interest rate risk, with movements in the fair values of both the derivative and the debt being included in the income statement. Where cash flow hedge accounting is used, the effective element of the fair value of the derivative will be included in a hedging reserve in equity. This hedging reserve will be released to the income statement to offset changes in interest rates on the hedged floating rate borrowings.

Risk and revenue sharing partnerships

Risk and revenue sharing partnership (RRSP) agreements are a standard form of co-operation in the civil aero-engine industry. In general, partners share: investment in the programme; market risk as they receive their return from future sales; currency risk as their returns are denominated in US dollars; sales financing obligations; warranty costs; and, where they are manufacturing or development partners, technical and cost risk.

As part of the IFRS transition project, RRSP arrangements have been reviewed to assess whether they are financial instruments as defined by IAS 32. Following this review, certain partnerships, where the arrangement is not part of an overall supplier arrangement, will be reclassified as financial instruments on transition to IFRS.

Reclassified RRSP arrangements are accounted for using the amortised cost method, based on the effective interest rate at the inception of the transaction.

Government investment

In the past, Rolls-Royce has received investment in certain projects from the UK Government. Under UK GAAP, these amounts were recognised as income when they were received with the levies being recognised as they became due on engine delivery. A similar review to that for RRSPs concluded that these arrangements were not financial instruments and that no changes are required to the accounting treatment.

Other financial derivatives

The Group has an ongoing exposure to the price of jet fuel from business operations. For reasons similar to those described for foreign exchange above, Rolls-Royce will not adopt hedge accounting for its exposures to changes in the price of jet fuel. These are hedged using commodity swaps.

The Group has entered into forward contracts to purchase its own shares for the purposes of meeting obligations to issue shares under employee share schemes. Under UK GAAP, these contracts were not recognised until the shares were purchased and issued to employees. Under IAS 32, these contracts are categorised as financial liabilities and accounted for on the amortised cost basis.

The Company has issued non-cumulative redeemable convertible preference shares (B Shares) as an alternative to paying a cash dividend. Under IAS 32 these shares are categorised as financial liabilities.

The impact of the transition to IFRS on the net assets in respect of financial instruments as at January 1, 2005 is summarised as follows:

	£m	£m
Net assets
Amortised cost value of risk and revenue sharing partnerships	(455)
Related taxation effect	130	(325)
Fair value of foreign exchange derivatives	996
Revaluation of monetary assets and liabilities to spot rate	(91)
Foreign exchange within service and other long-term contracts	(54)
Related taxation effect	(242)	609
Fair value of interest rate derivatives	(15)
Related taxation effect	4	(11)
Fair value of commodity derivatives	9
Related taxation effect	(3)	6
Amortised cost value of contracts to purchase own shares	(115)
Related taxation effect	(8)	(123)
Reclassification of B Shares as a liability	(5)	(5)
Adjustment to net assets		151

Contingent liabilities

The Group's customer financing arrangements fall into two categories that need to be considered separately for IFRS purposes:

Credit Based Guarantees

Credit based guarantees are specifically exempt from being treated as financial derivatives under IAS 39. They are required to be treated as insurance contracts in accordance with IFRS 4 Insurance Contracts. Under IFRS 4 the existing UK GAAP treatment (FRS 12) is 'grandfathered' until such time as the new Insurance Contracts standard comes into effect.

Asset Value Guarantees (AVGs)

The treatment of AVGs is less well defined under IFRS. The Group has treated AVGs as insurance contracts in accordance with IFRS 4, as it considers that this treatment best reflects the underlying nature of the arrangements.

There are no material changes to the treatment of contingent liabilities upon transitioning from UK GAAP to IFRS.

Other

The Group's banking covenants are not affected by the transition to IFRS as they are based on UK GAAP prevailing at the time the relevant borrowing facility was entered into ('frozen UK GAAP').

The Group's borrowing powers under its Articles of Association were amended at the 2004 AGM to a fixed limit in anticipation of the transition to IFRS.

The Scheme of Arrangement and the reduction in share capital undertaken in 2003 provides Rolls-Royce Group plc with a buffer in respect of Distributable Reserves available inter alia for the purposes of making payments to shareholders.