Rolls-Royce Annual Report 2019

Plain-text annual report

2019 ANNUAL REPORT Rolls-Royce Holdings plc PIONEERS OF POWER Rolls-Royce pioneers cutting-edge technologies that deliver clean, safe and competitive solutions to meet our planet’s vital power needs. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Financial Highlights and Contents 01 Group Financial Highlights Free cash flow £873m 2018: £568m Full year payment to shareholders 11.7p 2018: 11.7p Underlying revenue Reported revenue £15,450m 2018: £15,067m £16,587m 2018: £15,729m Underlying operating profit Reported operating (loss) £808m 2018: £616m £(852)m 2018: £(1,161)m Underlying profit before tax Reported (loss) before tax £583m 2018: £466m £(891)m 2018: £(2,947)m Underlying earnings per share Reported earnings per share (69.1)p 2018: (129.2)p 15.9p 2018: 16.0p Net funds ø £1,361m 2018: £840m Free cash flow is defined in note 28 on page 180. ø Net funds (excluding lease liabilities) is defined on page 121. Use of underlying performance measures in the Annual Report All figures in the narrative of the Strategic Report are underlying unless otherwise stated. We believe this is the most appropriate basis to measure our in-year performance as underlying results reflect the substance of trading activity, including the impact of the Group’s foreign exchange forward contracts, which lock in transactions at predetermined exchange rates. In addition, underlying results exclude the accounting impact of business acquisitions and disposals, impairment charges and exceptional items. A full definition of underlying and the reconciliation to the reported figures are in note 2 of the Consolidated Financial Statements on page 134. All references to organic change are at constant translational currency and exclude M&A. Forward-looking statements This Annual Report contains forward-looking statements. Any statements that express forecasts, expectations and projections are not guarantees of future performance and guidance may be updated from time to time. This report is intended to provide information to shareholders, and is not designed to be relied upon by any other party or for any other purpose, and the Company and its Directors accept no liability to any other person other than that required under English law. Latest information will be made available on the Group’s website. By their nature, these statements involve risk and uncertainty, and a number of factors could cause material differences to the actual results or developments. Contents Strategic Report Group at a Glance Chairman’s Statement Chief Executive’s Review Purpose, Vision and Strategy Business Model Key Performance Indicators Financial Review Business Review Civil Aerospace Power Systems Defence ITP Aero Sustainability Non-Financial Information Statement Climate Change Technology Impacts from Operations People and Culture Ethics and Compliance Principal Risks Going Concern and Viability Statements s172 Statement Directors’ Report Compliance with the Code Chairman’s Introduction Board of Directors Corporate Governance Committee Reports Nominations & Governance Audit Remuneration Remuneration Policy from 2020 Safety, Ethics & Sustainability Science & Technology Responsibility Statements Financial Statements Financial Statements Contents Consolidated Financial Statements Company Financial Statements Subsidiaries Joint Ventures and Associates Other Information Independent Auditors’ Report Sustainability Assurance Statement Other Financial Information Other Statutory Information Shareholder Information Glossary 02 04 06 10 12 14 16 24 24 29 33 37 40 40 41 42 44 45 49 50 55 56 58 59 62 65 75 75 79 85 88 105 111 114 115 116 183 187 192 194 203 204 206 210 212 Front Cover: The Rolls-Royce ionBird: a test airframe for our ACCEL project, which is developing the world’s fastest all-electric aircraft. Our Spirit of Innovation aircraft, developed with YASA and Electroflight and partly funded by Aerospace Technology Institute (ATI), will be powered by the world’s most power-dense flying battery pack, with the aim of reaching speeds of over 300mph. STRATEGIC REPORT02 Strategic Report Group at a Glance Rolls-Royce Holdings plc Annual Report 2019 GROUP AT A GLANCE At Rolls-Royce, we pioneer the power that matters to connect, power and protect society. Underlying revenue by business in 2019 ITP Aero 6% Non-core businesses 1% Defence 20% Power Systems 22% Civil Aerospace 51% Free cash flow £873m Underlying revenue £15,450m Underlying operating profit £808m Reported revenue £16,587m Reported operating (loss) £(852)m See note 2 on page 139 for a reconciliation between underlying and reported results. Order backlog Patents approved for filing Gross R&D expenditure Countries with Rolls-Royce presence Employees (monthly average) £60.9bn 830 £1.46bn 50 51,700 Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Group at a Glance 03 Our core businesses in 2019 CIVIL AEROSPACE Civil Aerospace is a major manufacturer of aero engines for the large commercial aircraft, regional jet and business aviation markets. The business uses engineering expertise, in-depth knowledge and capabilities to provide through-life support solutions for its customers. £8,107m Underlying revenue £44m Underlying operating profit See page 24 POWER SYSTEMS See page 29 DEFENCE See page 33 ITP AERO See page 37 Power Systems is a leading provider of high-speed and medium-speed reciprocating engines, and complete propulsion and power generation systems. It serves the marine, defence, power generation and industrial markets and includes civil nuclear operations that supply safety-critical systems. £3,545m Underlying revenue £357m Underlying operating profit Defence is a market leader in aero engines for military transport and patrol aircraft with strong positions in combat and helicopter applications. It has significant scale in naval and is the technical authority for through-life support of the nuclear power plant for the Royal Navy’s submarine fleet. £3,250m Underlying revenue £415m Underlying operating profit ITP Aero is a global leader in aero-engine design, manufacture and maintenance. Alongside the development, manufacturing, assembly and testing of engines, it provides MRO services for regional airlines, business aviation, industrial and defence applications. £936m Underlying revenue £111m Underlying operating profit Underlying revenue mix 1. Large Engines ........................71% 2. Business Aviation ................. 14% 3. Regional .................................... 4% 4. V2500 ........................................ 11% Underlying revenue mix 1. Marine ......................................28% 2. Industrial .................................25% 3. Power Generation ...............35% 4. Defence .....................................9% 5. Civil Nuclear ............................ 3% Underlying revenue mix 1. Transport ................................ 36% 2. Combat ....................................23% 3. Submarines............................. 19% 4. Naval .........................................10% 5. Other..........................................12% Underlying revenue mix 1. Civil ............................................77% 2. Defence ....................................13% 3. In-Service Support .............10% STRATEGIC REPORT4321453214532123104 Strategic Report Chairman’s Statement Rolls-Royce Holdings plc Annual Report 2019 CHAIRMAN’S STATEMENT SIR IAN DAVIS, CHAIRMAN This was a year of progress across the Group, despite the technical and operational challenge of the Trent 1000. Strategically, good progress is being made on new low carbon technologies and capabilities. This was a year of progress across the Group, despite the challenges we experienced with the Trent 1000 engine. We took further significant strategic steps towards realising our long-term goal to be the world’s leading industrial technology company while continuing our cultural transformation. In our Civil Aerospace business, the technical and operational challenge of fixing the Trent 1000 has been both costly and resource intensive. Most importantly, it has led to significant and deeply regrettable disruption for our customers. But we have made progress and are taking further proactive steps to improve the situation in 2020. Ensuring engine availability and the service levels our customers expect are our highest short-term priorities. Our Power Systems and Defence businesses sustained the financial and strategic momentum of previous years. Strategically, good progress is being made in the development of new technologies and capabilities with the focus on more efficient and environmentally friendly engines and propulsion systems. 2019 Review We delivered a record number of widebody engines in 2019, almost double the number delivered five years ago. This has enabled the continuous growth of our installed engine base in the civil aerospace market which, because of the nature of our service contracts and business model, is the bedrock of our long-term future profits and cash flow. We are very encouraged by the sustained successful introduction and reliable performance of our crucial Trent XWB engine. Our Power Systems business is performing well despite challenging external market conditions. In line with strategy, it continues to increase revenues and market share as it moves towards integrated systems and solutions and to new, more environmentally sustainable technologies. We are particularly pleased with the strong progress in China made by Power Systems and proud of the development of pioneering new hybrid- electric engines for the rail market. Our Defence business performed strongly, achieving a record level of new orders, with particular strength in the US where we see significant future opportunities. I would like to single out the greatly improved customer service and delivery performance in our submarines propulsion unit. Consistent with the long-term needs and nature of the business, we have sustained technology and R&D investments. The focus of these investments has been on new technologies and capabilities that will improve engine efficiency, significantly reduce carbon emissions and minimise adverse environmental impacts – including noise. I would highlight, as examples, the acquisition of Siemens’ eAircraft business and our investments in electric propulsion more broadly. These include the pioneering development of an all-electric aircraft, the testing of a new hybrid-electric propulsion system, as well as microgrid technologies for power generation. We are investing heavily in digital and artificial intelligence (AI) technologies. The industries we operate in are, and will increasingly be, at the centre of the data revolution and the integration of complex systems and technologies. During the year, we faced unprecedented challenges with our Trent 1000 engine. We are working tirelessly to fix the problems and improve the engine’s underlying Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Chairman’s Statement 05 durability. We have seen signs of progress with the roll-out of fixes and have a detailed operational plan to mitigate the disruption to our customers. As a result of the cost of the programme, however, we recognised a significant exceptional charge in the year. Despite progress on our restructuring and transformation programme, there remains a lot more to be done to reduce the cost base of the business, to simplify our processes and to provide a more agile culture. This is a competitive and investor necessity. It is essential to generate the cash flow, shareholder returns and investment funds required for the long-term health of the business. It is also a huge opportunity, and consistent with our long-term aspiration to be the world leading industrial technology company. At the time of writing, there are macro risks to navigate in the coming year, notably the outbreak of the COVID-19 virus which is currently having an effect on world trade, travel, and supply chains. We are actively monitoring the situation, following international health advice and giving our people as much support as they need. Purpose, strategy and governance Purpose has been, and always will be, fundamental to any company with long-term aspirations or enduring ambition. We have spent significant time refining our purpose to ensure it is relevant to our stakeholders, not least our employees. At its core, our purpose is to connect, power and protect society. We will do this while minimising our impact on the environment. Purpose manifests itself in strategy and behaviour. I hope this report will clarify our strategic intent and the actions we are taking to make our purpose real, and measurable, to all our stakeholders. Technology and capital allocation will be at its heart. We have to be at the forefront of technologies such as electrification, hybrid propulsion systems and microgrids that can dramatically reduce emissions. Long haul aviation is technologically challenging from a carbon emissions perspective. Improved engine efficiency will continue to play a very important role in emissions reduction as will alternative non-fossil fuels. We are committed to reducing greenhouse gas emissions from our operations and facilities to zero by 2030. Beyond that, we are working hard to determine how we can mitigate the emissions impact of our product portfolio and product testing in order to get the whole of Rolls-Royce to a net zero emissions position by 2050. Large scale aviation is a potentially very challenging sector and to achieve this, we will have to continue to work in partnership with governments, suppliers, customers, technology providers, fuel companies, non-governmental organisations (NGOs) and civil society. We cannot do it alone. Climate change is a risk to our business – indeed a principal risk – but more importantly, it is a real opportunity which could see us create disruptive new technologies and solutions. We have continued to develop the governance innovations highlighted in previous reports. Irene Dorner, our Employee Champion on the Board, continued her sterling efforts during the year, while Beverly Goulet visited a number of our smaller sites as our North American Employee Champion and Lee Hsien Yang held a series of town hall meetings with employees and partners in China. We held further Meet the Board events and continued our Board apprentice programme. We have introduced a new tool to track employee engagement with increased focus on key topics such as engagement with our purpose and strategy. Statistically and culturally we still have a way to go on diversity, particularly at the most senior levels. But we are making good progress elsewhere from a talent pipeline perspective and I believe we are on the right path. Finally, we continue to focus attention and oversight on ethical compliance and, above all, on safety. This is an ongoing challenge, particularly at times of disruption and stress, for all companies in our industries. Shareholder payments During the year, further steps were taken to simplify the portfolio and improve our net funds position. We completed the sale of our Commercial Marine business and finalised the transfer of a significant portion of our pension liabilities to Legal & General Assurance Society. This move will increase overall security for Rolls-Royce pensioners and reduce risk to our business. Strengthening the balance sheet understandably remains a priority. The costs associated with the Trent 1000 have impacted investor confidence. Our firm intent is to turn this around. While we have made progress in delivering the sustainable free cash flow from our business that would be the foundation for increased shareholder payments, there is more to be done. As a consequence, we are not proposing an increase in the final shareholder payment for 2019. This will be held flat at 7.1p per share. Taken together with the interim payment, this brings the full payment to 11.7p per share. Despite the challenges of 2019, our underlying financial performance has shown improvement over the last few years. It remains our objective to progressively rebuild distributions to shareholders while investing for the long-term. Board developments During the year, we announced the appointment of George Culmer as a Non-Executive Director. He joined at the start of 2020 and is a member of the Nominations & Governance Committee, the Audit Committee and the Safety, Ethics & Sustainability Committee. A chartered accountant, George was until recently chief financial officer at Lloyds Banking Group and is also the senior independent director at Aviva. We were really sorry to see the departure of Ruth Cairnie as a Non-Executive Director at the end of the year following her appointment as chair of Babcock International Group. Ruth made extraordinary contributions to the Board and to the Group, not least in her role as Chairman of the Remuneration Committee. Brad Singer, a partner and chief operating officer of ValueAct Capital, stepped down as a Non-Executive Director in December. Since joining us in 2016, Brad has been an active member of the Board, offering a valued external perspective and helping us to drive progress in our efforts to transform Rolls-Royce. My colleagues and I have greatly appreciated Brad’s insight and commitment to the Company and it has been a pleasure to work alongside him. We have recently announced the appointment of Dame Angela Strank as a Non-Executive Director. She will join the Board on 1 May 2020 and will be a member of the Nominations & Governance Committee, the Safety, Ethics & Sustainability Committee and the Science & Technology Committee. Dame Angela is currently chief scientist and head of downstream technology at BP and a member of their Executive Management Team. I am delighted to welcome her to our Board. Looking forward Our Group continues to operate in markets where the long-term trajectory is one of growing demand for power and the services that will support it. To capitalise on the opportunities, however, we must continue to focus on improving our cost competitiveness; pursue purposeful, disciplined capital allocation; and drive innovation in sustainable, lower carbon power solutions. We must also continue on the cultural transformation journey that helps accelerate our trajectory and attract and retain the talent on which we will depend. Sir Ian Davis Chairman STRATEGIC REPORT06 Strategic Report Chief Executive’s Review Rolls-Royce Holdings plc Annual Report 2019 CHIEF EXECUTIVE’S REVIEW WARREN EAST, CHIEF EXECUTIVE Despite the challenges of the Trent 1000, the progress seen across the Group in the year gives me increased confidence that the changes we are implementing are creating a tangible and sustainable cultural and performance shift within our business. Progress in 2019 To draw an analogy to describe the year that might be familiar to many of our aerospace customers: the journey is sometimes more important than the destination. In 2019, how we got to our destination – strong progress across the Group – gives me increased confidence that the changes we have been implementing over the past two years are creating a tangible and sustainable cultural and performance shift within our business. We had a good end to the year including strong Civil Aerospace aftermarket performance, record widebody engine deliveries, and better trading in Power Systems despite tough market conditions. Defence performed well throughout the year with a record order intake and healthy cash performance. As a result, we delivered improved financial results including a 25% increase in underlying operating profit and further strong improvement in Civil Aerospace. This contributed to strong Group free cash flow of £873m, another significant step towards achieving at least £1bn in 2020. We also continued to invest in the new technologies which are so vital to remaining competitive. This was all achieved despite the in-service challenges with the Trent 1000, which could have derailed our progress. The fact that they did not is thanks to the focus of our people on their roles in delivering for the business. I spoke last year of needing to build beyond the breakthrough we could see occurring as we launched our restructuring and adopted our new operating structure. We have generated real momentum during 2019, not least in respect to costs, as we scrutinised our spending with intense rigour and really challenged ourselves to act differently. There is, however, no denying the fact that the durability issues with the Trent 1000 weighed heavily on 2019, in terms of the financial cost of returning the fleet to the levels of service our customers expect and dealing with the unacceptable disruption we have caused them. As a result of the Trent 1000 and as announced in November, we are recognising a net exceptional charge of £1,361m within our financials, contributing to a reported operating loss of £(852)m. We have fixes designed for all but one of the issues identified and are well advanced on certification and rolling them out into the fleet. As the year drew to a close, we carried out a detailed technical re-evaluation of our progress on the final fix, a new high pressure turbine blade for the Trent 1000 TEN. Based upon that work and test activity, we reset our financial and operational expectations for the engine in November, based on a revised estimate of final blade durability, in order to provide certainty for customers and greater clarity for investors. Since then, we have made good progress on the design of this blade, and continue to expect certification of this component in the first half of 2021. Lower carbon power We believe in the positive transforming potential of technology and have a passion for solving difficult problems. Today, one of our society’s greatest technological challenges is the need for lower carbon power and we have a crucial role to play Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Chief Executive’s Review 07 2019 priorities Customers – Increase production volume – Expand service network – Mitigate disruption from in-service issues People and culture – Build a resilient business – Continue restructuring programme – Further simplify processes – Diversity & inclusion Technology – Revitalise service – Develop new engine architecture – Advance electrification projects Financial – Continue improving free cash flow – Further strengthen balance sheet – Enhance capital allocation discipline in decarbonising the sectors in which we operate. Firstly, we are committed to further reducing the environmental impacts of our products and services. We are following up our success as the developer of the world’s most efficient civil large engine in service today, the Trent XWB, with our next generation UltraFan. We are also heavily involved in the drive for sustainable alternative fuels. Secondly, we are committed to developing new low emission technologies. During 2019, we made significant progress, including the acquisition of Siemens’ eAircraft business and ground tests of our megawatt generator for the E-Fan X demonstrator with Airbus. Thirdly, we are working to reduce the greenhouse gas emissions from our own operations and facilities to zero by 2030. Our ability to pioneer the decarbonisation of aviation builds upon the experience of our Power Systems business in hybrid and electrical power across a range of sectors. During the year, we signed customer contracts and framework agreements for hybrid solutions for the rail and yacht markets. In early 2020, we further enhanced our capabilities with the acquisition of a majority holding in power storage specialist Qinous, which will enhance our microgrid development activities. Climate change is a risk for our business and playing a pivotal role in combating it presents us with a very significant opportunity to become a disrupter. Inaction is not an option. Progress on restructuring In 2019, we made further progress on our restructuring programme. Since it was announced in mid-2018, we have implemented productivity improvements enabling us to achieve 2,900 of the planned 4,600 indirect headcount reduction and we remain on track to realise the full benefits of the programme by the end of 2020. Reducing our workforce is not a decision we take lightly, but we must fundamentally change the way we operate. We have completed the majority of the changes within Civil Aerospace and Defence, including unwinding an overly complex corporate structure and introducing new automated tools and methods which have helped streamline processes. Progress within Power Systems was more limited as we completed planned strategic investments. Our Group Business Services operation, meanwhile, is now providing more effective and efficient transactional processing across the Group. We have focused on driving value through reducing other indirect spend beyond salary costs and on improving the effectiveness of our cash management processes. These foundations will be developed further in 2020 to provide additional productivity improvements in the future. Delivery on 2019 priorities We set out four key priorities for the year: Customers During the year, we delivered a record 510 widebody engines from Civil Aerospace, increasing our installed base by 6% to more than 5,000 engines and growing engine flying hours by 7%. The Trent XWB became our second-largest Trent programme by volume, with the fleet having amassed more than five million flying hours and its leading engines already achieving our expectations for time-on-wing (see page 26). We revamped our Civil Aerospace services business and undertook a record number of scheduled major overhauls, in spite of increased check and repair visits driven by the Trent 1000. During the year, we took the decision to accelerate the installation of fixes within a small proportion of the Trent 1000 fleet following an incident. As a result, we revised our target to reduce aircraft on ground (AOG) to single digits from the end of 2019 to the end of the second quarter of 2020. To help alleviate disruption, we took further action to increase our maintenance, repair and overhaul (MRO) capabilities and increased our pool of spare engines to get our customers flying again. Our Power Systems business continued to capitalise on its extensive installed base of engines by increasing revenues from services, including through the introduction of digital monitoring tools, initially targeting the mining industry. Defence had a very successful year, securing a record order intake of £5.3bn boosted by services. Notable wins included a five-year contract worth over $1bn with the US Marine Corps to maintain the AE1107 engines that power the Bell Boeing V-22 Osprey. We delivered just under 500 aero engines and now have over 16,000 in service across more than 100 countries. We also made good progress on developing new technologies ahead of a number of attractive opportunities in coming years. Technology Technology is the lifeblood of our business and, during the year, we passed a number of significant milestones on our new engine programmes. We successfully tested all the composite elements of our advanced low pressure system (ALPS) – including fan blades and fan cases – which is a key component of our UltraFan engine design. In Defence, our work as part of Team Tempest in the UK continued. In the US, our dedicated defence development team, LibertyWorks, demonstrated an integrated power and thermal management system for high-power directed energy applications STRATEGIC REPORT08 Strategic Report Chief Executive’s Review Rolls-Royce Holdings plc Annual Report 2019 and we refined our F130 engine for the competition to re-engine the US Air Force’s (USAF) Boeing B-52s. Our efforts in electrification included the introduction of microgrids from Power Systems (see page 30) and breakthroughs in aviation including the roll-out of the all-electric plane we hope will set new speed records (see page 42). People and culture We have continued to embed our values and behaviours across the Group (see page 45). Improving diversity & inclusion remains a priority for us and during the year we refreshed our strategy and looked to accelerate its implementation. We have a lot of work to do if we are to hit our gender diversity target of 23% for our Executive Team. During the year, we reviewed our succession plans and increased the proportion of females from 35% to 44%. Financial We delivered significant financial progress with a strong level of free cash flow, despite £578m of in-service costs from the Trent 1000 which were partially offset by £173m of related insurance receipts. In Civil Aerospace, we reduced widebody OE losses and generated a healthy increase in the net cash flow driven by our widebody in-service fleet. We also saw an increase in margins in Power Systems, although Defence was lower as we had signalled, reflecting its OE product mix. After a poor first half performance, we delivered a material reduction in inventory as the year progressed, although further work is required here in 2020. We focused hard on costs, with good progress achieved in the second half of the year. We still have work to do in 2020, however, to further grow the quality and scale of our cash flow. 2020 priorities and longer-term outlook Building on the strength of our performance in 2019, we enter 2020 with conviction and confidence. The momentum we saw as the year progressed must be maintained in 2020 in order to achieve at least £1bn in free cash flow. The fact that we have remained on course for this target despite the Trent 1000 situation is due to the determination, drive and resolve of our people. In the coming year, we will push for further improvements in execution, delivery and overall business performance. FIXING THE TRENT 1000 Returning the Trent 1000 fleet to the level of service which our customers expect is the top priority of senior management and the Board. We believe 2019 was a pivotal year. We have now designed fixes for all but one of the significant technical challenges we have faced and have a clear path to resolving the final issue. We have announced actions to boost our maintenance capacity and add additional spare engines to reduce customer disruption. We also carried out an extensive review that resulted in greater certainty for customers and clarity for investors. Our focus is now on executing this clear plan. We have been dealing with three significant technical issues affecting each of the three variants of the Trent 1000 (Package B, Package C and TEN). Of the nine fixes required, we have so far designed eight and certified seven which are now being incorporated into the fleet. A new high pressure turbine (HPT) blade for the Trent 1000 TEN variant is the final modification required. During the year, we carried out a detailed technical re-evaluation of our progress. Based upon that work and test activity, we reset our financial and operational expectations for the Trent 1000 TEN based on a revised estimate of final blade durability. This allowed us to be clearer with customers on the engine’s long-term servicing requirements, giving them greater certainty when planning schedules. It also enabled us to assess the associated exceptional cost and provide investors with a clearer view of future costs (see page 19). The Board continued to scrutinise the issue, receiving regular updates on progress. The Audit Committee reviewed the accounting treatment of the cost (see page 82) and the Board carried out a full technical review (see page 68). To underpin our target to reduce AOG to less than ten by mid-2020, we are increasing our stock of spare engines and accelerating growth in our MRO network. This comes on top of a tripling of MRO capacity over the past three years, the introduction of new servicing techniques and a 50% increase in our turbine blade manufacturing capacity. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Chief Executive’s Review 09 25 YEARS CONNECTING THE WORLD In 2020, our family of Trent engines will pass a major milestone: a quarter of a century powering commercial airlines around the world, connecting people and cultures and delivering goods and services. Having completed more than 145 million engine flying hours since the very first engine, a Trent 700, went into service in 1995, our Trent engines are the bedrock of Rolls-Royce. We have been celebrating the vital role that these engines play in our growth and our future with our #poweroftrent campaign across all our digital channels. More than a year since it entered service in November 2018, the latest member of the family, the Trent 7000, has performed well. This follows the smoothest entry into service of any widebody engine, the Trent XWB, which became our second largest Trent programme by volume during the year. The Trent XWB fleet has now flown more than five million flying hours since it took to the skies in early 2015. It remains the world’s most efficient large aero engine in service today. In 2019, we won 64% of all new widebody engine orders and now hold 55% of the widebody industry order backlog. Now that we are two years into our new simplified structure of business units – operating within a clear framework and supported by a lean centre – it is appropriate to set priorities which are solely Group level, from which we determine the priorities for our businesses and functions. Our first priority is to deliver on our commitments to customers. Secondly, we must deliver the full benefit of our transformation by constantly seeking simpler, more efficient ways of working across the Group. While headcount reduction is a consequence, our transformation must primarily be about changing the way we operate. We have made good progress in 2018 and 2019, and during 2020 we must push for even greater pace and simplicity. Thirdly, our financial target as a Group is clear: to generate at least £1bn of free cash flow in 2020. Sustainable and growing cash flow is the foundation upon which our long-term future, and returns to investors, will be built. Finally, our most important differentiator is our people and we must continue to embed the behaviours we need from everyone who works at Rolls-Royce in order to create the culture we need to continue to win. I believe the coming year will mark another important step towards generating significant returns from the market positions Rolls-Royce has spent many years securing. The value embedded within our business, most obviously within our installed base of widebody engines and order book, must be fully unlocked. Our sights are firmly set upon a mid-term ambition to exceed £1 of free cash flow per share, which translates to at least £1.9bn of free cash flow. To secure this in a sustainable way means reinforcing behavioural change across our business, driving pace and simplicity, developing a thirst for continuous improvement and ensuring disciplined investment in the new technologies we require to exploit the opportunities that we can see across all our markets. We will push harder and further in 2020, towards becoming the world’s leading industrial technology company. 2020 priorities p u o r G s e i t i r o i r p e r o C s e u l a v Customers Exceed customer commitment metrics Operations Annual efficiency improvements of over £400m (from launch of restructuring) Financial Free cash flow of at least £1bn People and culture Improved employee engagement as measured through Gallup Q12 Safety Quality Ethics Operate safely Trusted to deliver excellence Act with integrity STRATEGIC REPORT 10 Strategic Report Purpose, Vision and Strategy Rolls-Royce Holdings plc Annual Report 2019 PURPOSE, VISION AND STRATEGY We are one of the world’s leading industrial technology companies. We pioneer the power that matters to connect, power and protect society. This requires us to anticipate the opportunities and challenges our customers will face. OUR VISION OUR STRATEGY Pioneering the power that matters Rolls-Royce pioneers cutting-edge technologies that deliver clean, safe and competitive solutions to meet our planet’s vital power needs. Our strategy reflects three horizons: Horizon 1 Maintain and defend core businesses Horizon 2 Nurture emerging businesses Horizon 3 Create genuinely new businesses At the same time we need to manage the transition of technologies, capabilities, resources and value across business horizons. Transform our business Champion electrification Vitalise existing capabilities Reinvent with digital Build a balanced portfolio Trends shaping our markets We believe three key trends will define the world’s future power needs: the growing demand for cleaner, more sustainable power; electrification; and digitalisation. As we move to a low carbon global economy, our engines will become part of broader, hybrid-electrical systems with lower emissions and environmental impact. Our progress in 2O19 Horizon 1 Vitalise existing capabilities We are developing next-generation technologies to sustain and grow our current competitiveness; investing in our existing thermo-mechanical products to ensure that they provide clean, safe and competitive solutions for our customers. Our installed base of Civil Aerospace widebody engines exceeded 5,000 in the year, up more than 50% over the past decade. The Trent XWB is meeting our expectations, with the first Trent XWB-84 engines now entering their fifth year in service without requiring shop visits. The Trent 700, a leading member of the Trent family for almost 25 years, continued to perform well and received certification to power a small fleet of new Airbus BelugaXL aircraft. Our ambitions for the UltraFan demonstrator programme remain strong as we target engine maturity towards the end of the 2020s. During 2019, we successfully tested the composite elements of the ALPS, including fan blades and fan cases. In business aviation, we unveiled the Pearl 700 for the new Gulfstream G700 and the first member of the Pearl family, the Pearl 15, entered into service (see page 28). In Power Systems, we secured an innovative ten-year service agreement with Svitzer that connects maintenance services to engine availability; and signed a new agreement for the supply of MTU engines with British luxury yacht manufacturer Sunseeker. In Defence, we successfully completed early engine tests of the F130 which we are offering as a new engine for the USAF’s Boeing B-52. We were also awarded a contract, alongside industry partners, to develop hypersonic propulsion by the UK’s Ministry of Defence as part of a suite of technologies being developed in parallel with Project Tempest. In the US, our LibertyWorks team saw the culmination of ten years of research and development by demonstrating an integrated power and thermal management system for defensive high-power directed energy applications. During the year, both our AE1107 engines on the Bell Boeing V-22 Osprey and RR300 engines on the Robinson R66 helicopter exceeded one million engine flying hours. Horizon 2 Champion electrification We are investing in new power solutions for our long-term success, building on our strong heritage in thermo-mechanical engineering to produce state-of-the-art electro-mechanical and hybrid power systems. It is just one of the steps we are taking towards the provision of lower carbon power (see page 42). During the year, we secured orders from Irish Rail and Porterbrook, the UK’s largest rolling stock leasing company, for our hybrid powerpacks. We also signed a global microgrid partnership to offer Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Purpose, Vision and Strategy 11 energy-efficient solutions for utility and industrial companies, and opened a microgrid validation centre (see page 30). In aviation, we completed the acquisition of Siemen’s eAircraft business (see below) and carried out successful ground tests of a hybrid system using our M250 gas turbine, paving the way for test flights in 2021. We gained support for our hybrid-electric ambitions from the German State of Brandenburg and announced plans to work with partners, including the Brandenburg University of Technology to develop a hybrid-electric flight demonstrator based on the M250 system. In the UK, where the government is already supporting the E-Fan X and ACCEL programmes (see page 42), it is also supporting us on Project Fresson, which plans to design, manufacture and integrate a hybrid-electric propulsion system into a small aircraft for island-hopping routes. We also launched a joint programme to research zero-emissions aviation with Widerøe, the largest regional airline in Scandinavia, which plans to replace and electrify its regional fleet by 2030. Reinvent with digital We are using digital technologies across our activities to generate new insights, new solutions and new opportunities; increasingly partnering with start-ups and established players. We expanded the digital solutions team within Power Systems and set up a new data and analytics competence centre in the year. We announced that ferry company Förde Reederei Seetouristik will test a new electronic monitoring system that collects and analyses data from our engines and other systems at sea. We also unveiled plans to develop an autonomous machinery control system for naval vessels. R2 Data Labs continued to build its digital ecosystem through a tie-up with venture capital fund, BrightCap Ventures, to attract start-ups to work with us on solving industrial challenges using digital technologies. We also launched our first collaborative digital technology project with Singapore’s Defence Science and Technology Agency (DSTA). Horizon 3 Transform our business We are advancing new opportunities that could capture substantial growth and value for the Group in the future. We have received initial match funding from the UK government to progress a new type of compact smart nuclear power station based around our Small Modular Reactor (SMR) concept (see page 43). Power Systems signed a letter of intent for the construction of a demonstration plant that uses electric power generated in photovoltaic and wind power plants for the production of synthetic fuels. We also set up a power-to-x competence centre at the Brandenburg University of Technology, Germany, to explore the potential of synthetic fuels. Build a balanced portfolio We actively manage our portfolio of activities to focus on key activities that are aligned with our strategy and business model. As a result, during the year, we completed the sale of our Commercial Marine business and, in January 2020, completed the sale of our Civil Nuclear North America Services business. ACCELERATING OUR ELECTRICAL STRATEGY During the year, we took a significant stride towards meeting our strategic ambition to champion electrification with the completion of the acquisition of Siemens’ eAircraft business. This business has been developing a range of all-electric and hybrid-electric propulsion solutions. Around 180 specialist electrical designers and engineers based in Germany and Hungary, have now joined us. Electrification is set to have as dramatic an impact on aviation as the replacement of piston engines by gas turbines. We are at the dawn of the third era of aviation, which will bring a new class of quieter and cleaner air transport to the skies. The acquisition of eAircraft accelerates our ambitions in aerospace by adding vital skills and technology to our portfolio. It brings us increased scale and additional expertise as we develop a product range of hybrid power and propulsion systems. STRATEGIC REPORT12 Strategic Report Business Model Rolls-Royce Holdings plc Annual Report 2019 BUSINESS MODEL Our competitive advantage comes from: Cutting-edge technologies System solutions System life We apply cutting-edge technologies to provide clean, safe and competitive solutions. Our technologies ensure that our customers have the vital power that meets their emerging needs. We package technologies into systems that provide complete solutions for our customers. Our solutions mean that our customers have power from a single, trusted partner. We care about the performance of our solutions throughout their lives. Our through-life capabilities maximise availability and enable us to meet changing customer needs. 1 Anticipate the needs of our customers Link to risks C D H I J DISCIPLINED CAPITAL ALLOCATION 7 Generate stakeholder value Link to risks A B C D E F H I Capture through- life value of in-service products 6 Link to risks A B D F 2 Develop cutting-edge technologies Link to risks A C D E F I K Design solutions Link to risks A C D E F G K 3 Grow installed original equipment base Develop world- class production capability Link to risks A B C D E G J Link to risks A B C D E F G J K 5 4 Principal risks A Safety B Business continuity C Climate change D Competitive environment E Compliance F Cyber threat G Major product programme delivery H Market and financial shock I Political risk J Strategic transformation K Talent and capability Principal Risks page 50. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Business Model 13 We believe we have a sustainable business model which will create value for all our stakeholders over the long term. See our viability statement on page 55. 1 Anticipate the needs of our customers 5 Grow installed original equipment base We maintain a high degree of customer intimacy in order to anticipate and understand the future power needs of our customers, building on our years of experience in delivering for our markets. Our strategic planning processes match customer expectations with market insight to forecast trends, opportunities and threats which we must adapt to meet. 2 Develop cutting-edge technologies We act as a global technology sponsor, drawing upon expertise inside and outside our organisation. In 2019, we invested £1.46bn in gross R&D, supported by governments around the world, enabling our engineers to generate cutting-edge technologies, vital intellectual property, and 830 new patents approved for filing. We draw upon the skills of our 29 University Technology Centres and utilise the expertise of our partners, with over 500 companies within our digital ecosystem. 3 Design solutions We harness the potential of digital technologies and design thinking to create solutions that generate the greatest value from our cutting-edge technologies. This activity is supported by the team within our data innovation catalyst R2 Data Labs. We produce digital twins in order to test our hypotheses and then validate our results through a rigorous physical testing regime. Dynamic technology management enables us to leverage, attract and recycle capital for innovation. 4 Develop world-class production capability We generate value from our cutting-edge technologies and innovative solution designs through effective and efficient delivery of final products. We use our production expertise and network of seven Advanced Manufacturing Research Centres, alongside our supply chain partners, to harness new manufacturing techniques and technologies. Increasing our installed base of products generates both in-year growth and the potential for our business to capture long-term service revenue. To give our business access to these growth opportunities, we strive to deliver new product introductions on time and on budget. In line with our strategic aim to vitalise existing capabilities, we also continually look for ways to reduce the time and resource expended on producing existing products, and roll-back new technologies from new programmes into legacy products as appropriate. Operational excellence is key throughout. In our Civil Aerospace business, we have been growing our in-service fleet for over two decades and, towards the end of 2019, we had over 5,000 widebody engines in service, more than a 50% increase in a decade. 6 Capture through-life value of in-service products Our customer relationships are our greatest strength. We offer our customers a combination of advanced technologies, in a complete systems solution, optimised throughout its life. The service innovation we introduced with TotalCare into the Civil Aerospace widebody market gave us expertise which we drew upon to create innovative aftermarket solutions in other parts of the Group, generating returns over many years. These include CorporateCare in business aviation and MissionCare in Defence. Power Systems is now also leveraging the aftermarket potential of its installed base. In legacy products, we also offer more traditional aftermarket services, such as spare parts. 7 Generate stakeholder value Our activities are global, complex and touch upon a wide variety of stakeholders. From investors, employees, customers, suppliers and partners, to communities, local and national authorities, regulatory bodies and armed forces, we aim to create trusted relationships. We must understand the needs of all our stakeholders and continue to deliver value, to build a resilient business. Value creation for our stakeholders Customers We develop product solutions that improve the competitiveness of our customers. Gross R&D expenditure £1.46bn See Technology page 42. Investors We generate attractive returns for investors over the long term. Three-year total shareholder return 11% See Remuneration Committee Report page 102. Employees We create an environment where our employees are able to be at their best. Invested in training and development £28.7m See People and Culture page 45 and Non-Financial KPIs page 15. Partners We create partnerships based on collaboration where each partner benefits from the relationship. Spend with external suppliers £8.3bn Communities We improve the communities that we impact locally, nationally and globally. Hours of employee time volunteered 96,000 See People and Culture page 45. See Stakeholder Engagement page 70. STRATEGIC REPORT14 Strategic Report Key Performance Indicators Rolls-Royce Holdings plc Annual Report 2019 KEY PERFORMANCE INDICATORS Financial key performance indicators *,† See Other Financial Information page 205 for additional commentary on our financial KPIs. Order backlog £60.9bn 2019 2018 2017 2016 2015 60.9 63.1 55.0 80.9 76.4 Underlying revenue £15,450m 2019 2018 2017 2016 2015 15,450 15,067 13,671 13,783 13,354 Underlying operating profit Free cash flow per share Cash return on invested capital (CROIC) £808m 808 616 306 915 2019 2018 2017 2016 2015 1,492 How we define it Total value of firm orders placed by customers for delivery of products and services. This KPI is the same as the statutory measure for order backlog. Why it is important Order backlog provides visibility of future business activity. Link to remuneration Customer orders drive future revenue growth which in turn, enables profit and cash flow growth. Profit and free cash flow performance are the key financial metrics in both the annual bonus plan and long-term incentive plan (LTIP). How we define it Revenue generated from operations at actual rates of foreign exchange including achieved hedge rates in the year. See note 2 on page 139 for a reconciliation to statutory reported revenue. Why it is important Underlying revenue provides a measure of business growth and activity. Link to remuneration Underlying revenue growth maximises the opportunity to improve profit and free cash flow performance in the year, both of which are key financial metrics in the annual bonus plan and LTIP. How we define it Profit generated from operations at actual rates of foreign exchange including achieved hedge rates in the year. It excludes exceptional and one-off items. See note 2 on page 139 for a reconciliation to statutory reported operating profit. Why it is important Underlying operating profit indicates how the effect of growing revenue and control of our costs delivers value for our shareholders. Link to remuneration Profit and EPS are key financial performance measures for our annual bonus plan and LTIP. Capital expenditure as a proportion of underlying revenue Self-funded R&D as a proportion of underlying revenue 5.0% 2019 2018 2017 2016 2015 5.0 6.0 5.3 4.2 3.6 7.2% 2019 2018 2017 2016 2015 7.2 7.6 7.6 6.8 6.2 Free cash flow £873m 873 568 2019 2018 2017 2016 2015 259 100 179 How we define it Cash purchases of property, plant and equipment in the year relative to underlying revenue. There is no statutory equivalent to this KPI. How we define it In-year self-funded cash expenditure on R&D before any capitalisation or amortisation relative to underlying revenue. There is no statutory equivalent to this KPI. Why it is important This measure demonstrates the balance between essential investments in infrastructure and delivering short-term shareholder returns. Why it is important This measure demonstrates the balance between long-term strategic investments and delivering short-term shareholder returns. Link to remuneration Disciplined allocation of capital expenditure optimises in-year profit and cash flow performance without compromising longer-term growth. Metrics in our LTIP reward strong financial performance through EPS, CPS and TSR over the three-year life of the plan. Link to remuneration Disciplined control and allocation of R&D expenditure optimises in-year profit and cash flow performance without compromising long-term growth through innovation. There is a balance of metrics in our LTIP which reward strong financial performance through EPS, CPS and also relative returns to our shareholders through TSR over the three-year life of the plan. How we define it Cash flow generated from our business activities in the year before M&A, SFO payments, foreign exchange and payments to shareholders. Cash flow is our statutory equivalent, see note 28 on page 179. Why it is important Free cash flow is the principal metric to measure the performance of our business and how effectively we are creating value for our shareholders. It enables the business to fund growth, reduce debt and make shareholder payments. Link to remuneration Free cash flow is our key financial metric in the annual bonus plan, accounting for 50% of the overall targets. CPS is a key driver for our LTIP. * Following the adoption of IFRS 15 Revenue from Contracts with Customers in 2018, the 2017 figures have been restated. Dotted lines separate pre and post IFRS 15 figures on all affected KPIs. † The adoption of IFRS 16 Leases in 2019 had no material impact on our financial KPIs, see page 181 for more information. 45.9p 12% 2019 2018 2017 45.9 30.6 14.1 2019 2018 2017 12% 12% 13% How we define it How we define it Free cash flow in the year divided by the CROIC is calculated as free cash flow divided average number of shares in issue in the year. by invested capital in the year. See page 205 This measure was introduced in 2018. There is for a full definition of invested capital. This no statutory equivalent to this KPI. measure was introduced in 2018. There is no statutory equivalent to this KPI. Why it is important Cash flow per share ensures alignment with Why it is important shareholder interests and is a key measure of CROIC ensures we invest in programmes and the economic performance of our business. projects which optimise returns for our Link to remuneration CPS is the largest driver of the LTIP at 60% of the total. shareholders with the correct balance between long-term and short-term value. Link to remuneration A key driver of CROIC is free cash flow, which is also an important financial performance measure for our annual bonus plan and LTIP. Non-financial key performance indicators Customer metric 38% * Employee engagement 3.53 How we define it How we define it In 2019, we introduced a new balanced In 2019, we introduced a new survey, Gallup scorecard of metrics for each business. The Q12. Responses are scored on a scale of one scorecard includes on-time delivery, aircraft to five. The employee engagement score on ground and engine availability amongst averages the responses to all 12 questions other indicators. The aggregate outturn is in the survey. See page 46 for more on our used to determine the customer element change of approach this year. of our bonus plan. See page 96 for more information. Why it is important Why is it important Our people are crucial to delivering future business success. This is an objective way to Customer satisfaction demonstrates whether assess how engaged our employees are with we are meeting our commitments to our the business and its leaders. customers across our businesses. This, in turn, drives our cash and profitability. Link to remuneration The customer metric accounts for 12.5% of bonus plan. the target bonus in our annual bonus plan. * Metric is 38% of target (100%), 19% of maximum (200%). Link to remuneration Employee engagement performance against our target accounts for 12.5% of our annual Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Key Performance Indicators 15 Underlying operating profit Free cash flow per share Cash return on invested capital (CROIC) 45.9p 12% 2019 2018 2017 45.9 30.6 14.1 2019 2018 2017 12% 12% 13% How we define it Free cash flow in the year divided by the average number of shares in issue in the year. This measure was introduced in 2018. There is no statutory equivalent to this KPI. Why it is important Cash flow per share ensures alignment with shareholder interests and is a key measure of the economic performance of our business. Link to remuneration CPS is the largest driver of the LTIP at 60% of the total. How we define it CROIC is calculated as free cash flow divided by invested capital in the year. See page 205 for a full definition of invested capital. This measure was introduced in 2018. There is no statutory equivalent to this KPI. Why it is important CROIC ensures we invest in programmes and projects which optimise returns for our shareholders with the correct balance between long-term and short-term value. Link to remuneration A key driver of CROIC is free cash flow, which is also an important financial performance measure for our annual bonus plan and LTIP. Non-financial key performance indicators Customer metric 38% * Employee engagement 3.53 How we define it In 2019, we introduced a new balanced scorecard of metrics for each business. The scorecard includes on-time delivery, aircraft on ground and engine availability amongst other indicators. The aggregate outturn is used to determine the customer element of our bonus plan. See page 96 for more information. Why it is important Customer satisfaction demonstrates whether we are meeting our commitments to our customers across our businesses. This, in turn, drives our cash and profitability. Link to remuneration The customer metric accounts for 12.5% of the target bonus in our annual bonus plan. * Metric is 38% of target (100%), 19% of maximum (200%). How we define it In 2019, we introduced a new survey, Gallup Q12. Responses are scored on a scale of one to five. The employee engagement score averages the responses to all 12 questions in the survey. See page 46 for more on our change of approach this year. Why is it important Our people are crucial to delivering future business success. This is an objective way to assess how engaged our employees are with the business and its leaders. Link to remuneration Employee engagement performance against our target accounts for 12.5% of our annual bonus plan. Order backlog £60.9bn 2019 2018 2017 2016 2015 60.9 63.1 55.0 80.9 76.4 order backlog. Why it is important business activity. Link to remuneration Financial key performance indicators *,† See Other Financial Information page 205 for additional commentary on our financial KPIs. Underlying revenue £15,450m 2019 2018 2017 2016 2015 15,450 15,067 13,671 13,783 13,354 £808m 808 616 306 915 2019 2018 2017 2016 2015 1,492 How we define it How we define it How we define it Total value of firm orders placed by customers Revenue generated from operations at Profit generated from operations at actual for delivery of products and services. This actual rates of foreign exchange including rates of foreign exchange including achieved KPI is the same as the statutory measure for achieved hedge rates in the year. See note 2 hedge rates in the year. It excludes exceptional Order backlog provides visibility of future Why it is important on page 139 for a reconciliation to statutory and one-off items. See note 2 on page 139 for reported revenue. a reconciliation to statutory reported operating profit. Underlying revenue provides a measure of Why it is important business growth and activity. Underlying operating profit indicates how the effect of growing revenue and control of our costs delivers value for our shareholders. Customer orders drive future revenue growth Link to remuneration which in turn, enables profit and cash flow Underlying revenue growth maximises the growth. Profit and free cash flow performance opportunity to improve profit and free cash Link to remuneration are the key financial metrics in both the annual flow performance in the year, both of which Profit and EPS are key financial performance bonus plan and long-term incentive plan (LTIP). are key financial metrics in the annual bonus measures for our annual bonus plan and LTIP. plan and LTIP. Capital expenditure as a proportion Self-funded R&D as a proportion of underlying revenue of underlying revenue 5.0% 2019 2018 2017 2016 2015 5.0 6.0 5.3 4.2 3.6 7.2% 2019 2018 2017 2016 2015 7.2 7.6 7.6 6.8 6.2 Free cash flow £873m 2019 2018 2017 2016 2015 259 100 179 873 568 How we define it How we define it How we define it Cash purchases of property, plant and In-year self-funded cash expenditure on R&D Cash flow generated from our business equipment in the year relative to underlying before any capitalisation or amortisation activities in the year before M&A, SFO revenue. There is no statutory equivalent relative to underlying revenue. There is no payments, foreign exchange and payments to this KPI. Why it is important statutory equivalent to this KPI. Why it is important to shareholders. Cash flow is our statutory equivalent, see note 28 on page 179. This measure demonstrates the balance This measure demonstrates the balance Why it is important between essential investments in infrastructure between long-term strategic investments and Free cash flow is the principal metric to and delivering short-term shareholder returns. delivering short-term shareholder returns. measure the performance of our business Link to remuneration Link to remuneration Disciplined allocation of capital expenditure Disciplined control and allocation of R&D optimises in-year profit and cash flow performance without compromising expenditure optimises in-year profit and cash flow performance without compromising and how effectively we are creating value for our shareholders. It enables the business to fund growth, reduce debt and make shareholder payments. longer-term growth. Metrics in our LTIP reward long-term growth through innovation. There Link to remuneration strong financial performance through EPS, is a balance of metrics in our LTIP which reward Free cash flow is our key financial metric in CPS and TSR over the three-year life strong financial performance through EPS, CPS the annual bonus plan, accounting for 50% of the plan. and also relative returns to our shareholders of the overall targets. CPS is a key driver for through TSR over the three-year life of the plan. our LTIP. STRATEGIC REPORT16 Strategic Report Financial Review Rolls-Royce Holdings plc Annual Report 2019 FINANCIAL REVIEW STEPHEN DAINTITH, CHIEF FINANCIAL OFFICER Although much remains to be done on our journey to transform and improve the Group, 2019 was a year of good progress and a critical step towards our 2020 and mid-term ambitions. Overview 2019 After a challenging first half of the year, we had a good end to the year and generated a strong level of free cash flow of £873m, delivered on our restructuring plan and made good progress on the key value drivers in Civil Aerospace. These achievements were made despite the ongoing operational and financial headwinds caused by in-service issues with the Trent 1000. Overall, Group revenue rose by 7% with Group operating profit of £808m, an increase of £192m versus 2018. We achieved or exceeded our revenue growth and profit margin guidance for each of our core businesses. Civil Aerospace achieved a record number of widebody engine deliveries and returned to profitability. Power Systems demonstrated resilient revenue growth and good margin expansion despite certain end-market challenges. Defence achieved an impressive 1.6x book-to-bill ratio and healthy cash performance while ITP Aero achieved good progress. Although progress on inventory reduction fell short of our ambitions, we delivered further improvements on the fundamental drivers that underpin our improving cash flows and returns: — in Civil Aerospace further steps were made in reducing OE unit losses on widebody engines, which fell by 14% to £1.2m, led by 22% progress on Trent XWB-84 unit losses; — our large engine aftermarket cash margin improved by £0.3bn, led by the 7% growth in large engine flying hours allied to the strength in spare parts sales, which more than outstripped higher shop visit volumes; and — we delivered a 4% reduction in commercial and administrative (C&A) costs and we maintained disciplined capital allocation with combined R&D and capital expenditure 11% lower at £1.9bn reflecting lower capital spend due to completion of several facility modernisation projects. We achieved further progress on our restructuring plan, with a further 1,600 net reduction in headcount in 2019 across a variety of overhead functions. Our cumulative headcount reduction since the start of the programme has now reached 2,900 and we remain committed to our ambition of a total 4,600 reduction by the end of 2020. Finance has embraced its own role in the drive to transform our organisation; we have rolled out new, more agile forecasting tools across our businesses, improved the quality of our finance data and management information and improved a number of key processes. An area of particular focus is simplifying the structure of our underlying systems and improving our data flow to enable better management information. We still have much to do and I am determined that we will build further on this in 2020. We delivered another step in 2019 to improve the Group’s net funds position, which reached £1.4bn (excluding lease liabilities), up from £0.8bn in 2018. We made further progress on refining our portfolio, completing the disposal of Commercial Marine, with net proceeds of £350m, and Power Development. We also announced the sale of two further small businesses. We completed the acquisition of Siemens’ eAircraft business in October and since the year-end we have announced the acquisition of a majority stake in Qinous. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Financial Review 17 Both of these deals are helping us to accelerate our electrification and hybrid capabilities. Although our credit rating currently sits below our aspiration of single A, we have strong levels of liquidity and, led by improving cash generation, we are confident in our ability to strengthen our rating over the coming 12 to 18 months. Our ambition is to return shareholder payments to a more appropriate level over time. 2020 outlook Building on the strength of our performance in 2019, we are well positioned to deliver further progress in 2020. We expect around 15% growth in operating profit with at least £1bn of free cash flow. There are macro risks to navigate in 2020, notably the outbreak of the COVID-19 virus which is currently having an effect on world trade, travel, and supply chains. We are actively Progress on restructuring Headcount (# FTEs) Indirect & engineering Net cumulative reduction Run-rate savings at period end FY17 actual 29,529 FY18 actual 28,147 ~1,300 £81m FY19 actual 26,606 ~2,900 £269m FY20 (programme total) <25,000 ~4,600 £400m monitoring the situation and taking appropriate actions. Our guidance excludes any material impact from COVID-19 as the situation is still evolving. Longer-term outlook We remain committed to delivering significantly higher levels of returns in terms of operating profit margin, free cash flow and cash flow return on invested capital (CROIC). Key drivers of this remain: further reduction in widebody OE engine losses in Civil Aerospace; future increases in our aftermarket cash margin; and ongoing growth in Power Systems and Defence. Improved returns must be achieved despite our ongoing investment in new, more efficient aero engines in Civil Aerospace and the pursuit of programme and market opportunities in Power Systems and Defence. After our strong 2019 performance, we remain confident in our mid-term ambition to deliver free cash flow per share of over £1, more than £1.9bn, and to generate annual CROIC of 15% through the cycle. DEFINING OUR ALTERNATIVE PERFORMANCE MEASURES Revenue £m Reported measure Reported revenue Business performance is reviewed and managed on an underlying basis. These alternative performance measures reflect the economic substance of trading in the year, including the impact of the Group’s foreign exchange activities. The tables to the right summarise the adjustments between reported and underlying results for revenue and operating profit. For more information on these reconciliations, see note 2 on page 139. Similarly, you can find reconciliations to statutory measures for free cash flow in note 28 on page 179 and underlying EPS in note 26 on page 144. Underlying performance measure Reported revenue Derivative and FX adjustments Other underlying adjustments Underlying revenue Profit £m Reported measure Reported operating (loss) Free cash flow Cash flow generated from our business activities in the year before M&A, SFO payments, foreign exchange and payments to shareholders. Underlying EPS Underlying profit after tax in the year divided by the average number of shares in issue in the year. Underlying performance measure Reported operating (loss) Business disposals (Loss) before financing & taxation Derivative & FX adjustments Programme exceptional charges Restructuring exceptional charges Acquisition accounting & M&A Impairments & asset write-offs Other underlying adjustments Underlying operating profit 2019 2018 16,587 15,729 16,587 (1,137) – 15,450 15,729 (781) 119 15,067 2019 2018 (852) (1,161) (852) 139 (713) (144) 1,409 136 24 84 12 808 (1,161) 358 (803) 24 976 317 (183) 155 130 616 STRATEGIC REPORT18 Strategic Report Financial Review Rolls-Royce Holdings plc Annual Report 2019 Core trading summary The income statement table below and all commentary relate to the underlying performance of our core business and percentage or absolute change figures in this document are on an organic basis, unless otherwise stated. Summary income statement – Core businesses 1 £m Underlying revenue Underlying OE revenue Underlying services revenue Underlying gross profit Gross margin % Commercial and administration costs Restructuring Research and development charge Joint ventures and associates Underlying operating profit Underlying operating margin Financing costs Underlying profit before tax Tax Underlying effective tax rate Underlying profit Underlying earnings per share 2019 2 15,261 7,373 7,888 2,342 15.3% (938) (15) (688) 109 810 5.3% (223) 587 (281) 47.9% 306 15.9 2018 2,3 Change Organic change ⁴ 14,286 7,172 7,114 2,240 15.7% (977) (14) (650) 32 631 4.4% (148) 483 (153) 31.7% 330 17.3 +7% +3% +11% +5% -40bps -4% +7% +6% +241% +28% +90bps +51% +22% +84% – -7% -1.4p +6% +3% +10% +4% -40bps -4% +7% +5% +222% +25% +80bps +49% +17% – – -12% -2.4p 1 Core includes Civil Aerospace, Power Systems, Defence and ITP Aero. 2 Underlying: for definition see note 2 on page 134. 3 The financial information for the prior period has been restated to reflect the treatment of our North America Civil Nuclear business as non-core. See note 1 on page 125 for more details. 4 Organic change at constant translational currency (constant currency) by applying FY 2018 average rates to 2019 and 2018 numbers excluding M&A. All commentary is provided on an organic basis unless otherwise stated. Revenue up 6% Revenue increased by 6% to £15,261m reflecting growth in both OE and services, led by Civil Aerospace and Power Systems. Civil Aerospace delivered OE revenue growth of 4% reflecting higher widebody engine volumes. Services revenue in Civil Aerospace rose 14% with increased shop visit volumes and higher sales of spare parts. Power Systems achieved 4% OE revenue growth due to strength in power generation markets, notably for data centres, and 4% services growth including increased long-term service agreement (LTSA) penetration. Defence revenue was 1% higher led by 4% growth in services driven by increased activity in transport and combat. ITP Aero revenue increased 21% reflecting volume growth largely across its civil programmes. Gross profit up 4% Gross profit was £2,342m, up 4%. Civil Aerospace gross profit improved by 25% reflecting several key factors: — increased sales of spare parts and higher LTSA servicing activity; — a material improvement in the net impact of contract catch-ups to LTSA profits at £33m in 2019 (2018: £(276)m), driven primarily by lower servicing costs in business aviation; and — modestly lower LTSA underlying gross margins, reflecting shop visit mix, and around £70m of FX related headwind principally reflecting the revaluation of USD creditors and deposits. Power Systems generated a 6% gross profit improvement with a gross margin of 26% driven by volume growth and improvements in product mix. As expected, Defence gross profit reduced by 6% with margins 160bps lower, reflecting product mix. ITP Aero gross profit increased by 33% with margin improvement of 200bps, driven by higher OE volumes, improved pricing and a circa £25m benefit from the impact of a change made to simplify ITP Aero’s trading relationship and contractual terms with Civil Aerospace. This was net neutral at the Group level, with a corresponding increase in eliminations. C&A costs down 4% C&A costs reduced by 4% to £938m. This reduction was driven by restructuring programme headcount savings and management actions to reduce discretionary spend, partly offset by cost escalation and higher sales-related activities in Power Systems. Self-funded R&D cash spend up modestly; charge to profit 5% higher Gross R&D spend was up £70m. After funding from customers and other third parties, core self-funded cash spend was £3m higher at £1,108m. Investment in Civil Aerospace widebody and new business aviation programmes was lower following the recent entry into service of several new engine programmes. New technology investment increased by 9%, to develop technologies that underpin UltraFan in Civil Aerospace, a range of new programmes in Defence and electrification in Power Systems. R&D capitalisation of £468m was £28m lower. Capitalisation remains at a significant level due to the current development stage of several Civil Aerospace programmes but is expected to reduce in 2020 and over the coming years. The net charge to profit increased by £35m reflecting higher spend and the reduction in capitalisation. Profit from joint ventures and associates Our share of results from joint ventures was £109m, £71m higher than the prior year. This was driven by increased servicing activity in overhaul bases and higher profit on disposal of engines in Rolls-Royce & Partners Finance (our engine financing joint venture). Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Financial Review 19 Operating profit up 25% Operating profit improved by £157m on the prior year to £810m, led by the £85m increase in gross profit, higher joint venture profit and a £37m reduction in C&A costs, partially offset by the higher R&D charge outlined above. Financing costs Financing costs increased from £(148)m in 2018 to £(223)m in 2019. Within financing costs, net interest payable of £(132)m increased by £60m largely due to the adoption of IFRS 16. Other financing costs were £(91)m in 2019, modestly higher than the previous year (2018: £(76)m). Other financing costs include charges relating to the factoring of receivables and the discounting of prior year provisions. Taxation The core underlying tax charge was £281m (2018: £153m), an underlying tax rate of 47.9% compared with 31.7% in 2018. This increase in rate was primarily driven by the non-recognition of a deferred tax asset on UK losses arising in 2019. Trent 1000 The Trent 1000 is 13% of our widebody engine fleet. We made good progress on resolving the technical issues in 2019; we have now designed eight of the nine component fixes required, seven of which have been certified. The intermediate pressure turbine fix is now fitted to almost 100% of the in-service fleet across all engine variants. The revised intermediate compressor has now been fitted to over 50% of Package C engine variants and has now been certified for the TEN variant with the Package B planned for the second half of 2020. Roll-out of the revised high pressure turbine blade has been embodied into almost 50% of Package B and C engine variants and design work for the TEN high pressure turbine (HPT) blade continues to progress well with certification expected in the first half of 2021. We continue to regret the disruption caused to our customers from these issues. We are taking further positive steps in 2020 to increase availability of spare engines and further expand maintenance capacity to reduce the number of aircraft on the ground (AOG) to below ten by the end of the second quarter 2020. We have seen positive results from our actions in the first two months of 2020 with AOG reduced to the mid-30s from the elevated level of 42 in the second half of 2019, which had resulted from the proactive actions taken in autumn to retrofit the small number of remaining Package B intermediate pressure turbine modules. In November, we announced the outcome of recent testing and a thorough technical and financial review of the Trent 1000 TEN programme following the issues identified during 2019. This resulted in a revised timeline and durability estimate for the improved TEN HPT blade. As a result we expect total in-service cash costs across all Trent 1000 variants of around £2.4bn across 2017–2023, consistent with the trading update in November. In 2019, £578m of cash costs were incurred, partly offset by a £173m insurance receipt. We continue to expect cash costs of £450–£550m in 2020 and a similar level in 2021, before declining significantly thereafter. These primarily comprise the cost of replacing affected parts as well as customer disruption related compensation. Outside of these in-service costs, we are also investing in our engineering function, further expansion of our MRO capacity and our pool of Trent 1000 spare engines. Additionally, the increased costs associated with our revised estimate for HPT blade durability on the TEN has impacted the future margins on our Trent 1000 contracts, including a small number of contracts now becoming loss making (see below). As guided in November, an exceptional charge of £1,361m at underlying FX rates was recorded in 2019 on the Trent 1000 (net of £173m insurance receipts). Within this charge, £703m is due to the additional cash costs associated with customer disruption and remediation shop visits. The remaining £658m relates to the margin impact of our updated HPT blade durability expectations on the TEN, primarily the up-front recognition of future losses on the small number of contracts which are now loss making, as well as related contract accounting adjustments. Exceptional restructuring programme Progress was made in 2019 on our restructuring plan. To date we have achieved a net headcount reduction of around 2,900 with run-rate savings of £269m. Cash costs of £216m were incurred during the year to deliver this plan, which are reported outside of free cash flow. We continue to expect run-rate savings of circa £400m by the end of 2020 and a net headcount reduction of 4,600. Strategic review of Bergen As part of our ongoing efforts to evaluate our portfolio and create a simpler, more efficient Group, on 28 February 2020 we announced the decision to carry out a strategic review of Bergen, our medium-speed gas and diesel engine business. Bergen formed part of Power Systems during 2019, but from 2020 (as a result of this review) it will be reclassified as non-core. Additionally, following a reassessment of the order book, an impairment review has been completed in the second half of the year and a charge of £58m has been recorded outside underlying results in 2019. In 2019, Bergen generated sales of £239m and an underlying operating loss of £(18)m. A380 cessation costs In our full year 2018 results, we took a preliminary view of costs relating to Airbus’ decision to close the A380 production line. During the first half of 2019, we had the opportunity to update our impact assessment and as a result recorded an additional exceptional charge of £59m. This charge has been reduced to £48m at the year-end following the release of £11m relating to supplier amounts recorded in 2018. IFRS 16 Leases IFRS 16 is effective for the year beginning 1 January 2019. Commitments for operating as well as finance leases are now recognised on the balance sheet. The impact of the standard is as follows: — on 1 January 2019 an additional lease liability of £2,248m and lease assets of £2,213m were recorded on the balance sheet; — in the income statement rental payments (previously included within operating costs) are now replaced with a depreciation charge on the leased assets. Underlying financing costs on lease liabilities increased from £5m in 2018 to £77m in 2019 due to the new liability; — there is no impact on free cash flow resulting from the implementation of IFRS 16; and — we estimate the overall impact of the adoption of IFRS 16 in 2019 was approximately a 2p reduction in underlying EPS. Group trading summary Group results include core and non-core businesses. Group underlying revenue rose 7% to £15,450m, primarily driven by growth in Civil Aerospace, offsetting a (76)% decline in non-core revenue. Group underlying operating profit improved by 25% to £808m as a result of improved gross profit, lower C&A costs and higher profit from joint ventures offsetting an increased R&D charge. STRATEGIC REPORT20 Strategic Report Financial Review Rolls-Royce Holdings plc Annual Report 2019 Group funds flow Summary funds flow statement 1 £m Underlying operating profit Depreciation and amortisation Lease payments (capital plus interest) Expenditure on intangible assets Capital expenditure (property, plant and equipment) Change in inventory Change in receivables/payables Civil Aerospace net LTSA balance change Of which: underlying change Of which: impact of contract catch-ups Movement on provisions Net interest received and paid Trent 1000 insurance receipt Other Trading cash flow Contributions to defined benefit pensions in excess of underlying PBT charge Taxation paid Group free cash flow Of which: Disposed entities 2 Group free cash flow (pre disposed entities) Of which: Non-core businesses 3 Core free cash flow Shareholder payments Disposals and acquisitions Exceptional group restructuring Payment of financial penalties Foreign exchange Pension fund contribution Other Change in net funds/(debt) excluding lease liabilities 2019 808 1,068 (319) (591) (747) (43) 574 754 654 100 (506) (73) 173 (41) 1,057 (9) (175) 873 (41) 914 3 911 (224) 410 (216) (102) (98) (35) (87) 521 2018 616 756 – (680) (905) (616) 1,197 679 376 303 (242) (70) – 22 757 59 (248) 568 (78) 646 (2) 648 (219) 573 (70) – 54 – 10 916 Change 192 312 (319) 89 158 573 (623) 75 278 (203) (264) (3) 173 (63) 300 (68) 73 305 37 268 5 263 (5) (163) (146) (102) (152) (35) (97) (395) 1 The derivation of the summary funds flow statement above from the reported cash flow statement is included on note 28 on page 179. 2 Disposed entities include Commercial Marine and Power Development in 2019 and both of these plus L’Orange in 2018. 3 Non-core businesses include the former Energy businesses not sold to Siemens and North America Civil Nuclear business. Free cash flow Group free cash flow of £873m improved materially from £568m in 2018. This was driven by strong profit growth across most of our core businesses, increased engine flying hour receipts and spare parts sales in Civil Aerospace, as well as reduced capital expenditure on several capacity and facility modernisation projects which had neared completion in 2018. Trent 1000 in-service cash costs were £578m (2018: £431m), partially offset by receipt of £173m of related insurance proceeds. R&D investments increased modestly. In 2019, there was an inflow of £574m (2018: £1,197m) from the movement in receivables and payables, reflecting higher trade payables due to increased trading activity, actions taken to improve overdue debt collection, together with a number of customer deposits notably in Defence. This was partly offset by a £(43)m increase in inventory (2018: £(616)m). We continue to strive to increase transparency around our financial performance and reported results. As part of this effort, additional information is now provided in note 14 on the sale of trade receivables. For many years, the Group has undertaken the sale of trade receivables, without recourse, to help normalise Group cash flows in line with physical delivery volumes. This practice is commonplace in the aerospace industry. Over the last three years, this has averaged around £1,037m at the year-end. At 31 December 2019, £1,117m had been drawn under factoring facilities, £95m higher than December 2018, which is reflected within working capital. Given the one-off nature of the restructuring announced in 2018, the £(216)m cash costs relating to this restructuring programme (2018: £(70)m) are reported outside of Group free cash flow. Depreciation and amortisation The £312m increase in depreciation and amortisation to £1,068m was largely due to an additional circa £340m charge relating to right-of-use assets following the adoption of IFRS 16 from 1 January 2019. Lease payments Lease payments of £(319)m reflect the cash cost of leases in 2019. In 2018, prior to the adoption of IFRS 16, the equivalent lease payments were reflected within underlying operating profit. Under IFRS 16 the depreciation charge is recorded in underlying operating profit. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Financial Review 21 Expenditure on intangible assets Intangible asset expenditure of £(591)m was incurred in 2019. This included £(481)m of R&D capitalisation (2018: £498m) largely reflecting ongoing investment in Civil Aerospace programmes including the Trent 7000, Trent XWB and Pearl engine programmes. Change in receivables/payables The change in receivables/payables of £574m in 2019 was significantly reduced year-on-year, and reflected: — higher trade and other payables due to increased trading activity led by Civil Aerospace; Capital expenditure on property, plant and equipment Investment of £(747)m in 2019 reduced by £158m (2018: (£905m)) due to several capacity and modernisation programmes nearing completion in 2018. Spend in 2019 reflects our ongoing investment in manufacturing capability, projects to modernise our facilities, and spare engines to support our growing in-service fleet in Civil Aerospace. Change in inventory Inventory increased by £(43)m (2018: £(616)m) in 2019 due to volume growth in Civil Aerospace and Power Systems, with a significant improvement in the second half following a £(433)m increase in the first half. This inventory position was driven by a high level of assembled engines and aftermarket parts held in Civil Aerospace, as well as growth in Power Systems due to programme delays, production relocation projects, and product mix. Higher delivery volumes and greater focus on supply chain management in the second half of the year drove a significant reduction in inventory, with a strong improvement in Civil Aerospace in particular. — a number of customer deposits, notably in Defence driven by strong order intake; and — an increase in trade and other receivables, which reflected volume-related growth partially offset by actions taken to reduce overdue customer receivables. Movement in underlying Civil Aerospace net LTSA balance The net LTSA balance represents deferred revenue and is a core part of our business model where we receive payments from our customers in respect of our long-term service and overhaul agreements. In 2019, the LTSA net balance increased by £754m. This movement included a £100m increase driven by negative contract catch-ups to revenue (2018: £303m). The underlying change, net of these catch-ups, was £654m. This reflected invoiced engine flying hour receipts in excess of revenue traded together with customer deposits received in the year. Movement in provisions The movement in provisions of £(506)m in 2019 largely included utilisation of the Trent 1000 exceptional provision. The remainder primarily covered cash costs from onerous contracts and restructuring activity. Pensions Cash contributions were in line with the profit and loss charge in 2019. There was a £(68)m year-on-year movement, reflecting the non-recurrence of a 2018 benefit from changing to quarterly payments. Taxation The decrease in cash tax in 2019 from £(248)m to £(175)m reflected lower payments in Germany compared to 2018, largely due to timing. Shareholder payments Payments to shareholders of £224m in 2019 remained in line with the prior year. Acquisitions and disposals In 2019, we completed the disposals of Commercial Marine and Power Development with combined net proceeds of £453m. The £573m cash inflow in 2018 related to the disposal of the L’Orange business, previously within Power Systems. Costs of £43m were incurred in 2019 relating to the acquisition of Siemens’ eAircraft business. Payment of financial penalties Following the agreements reached with investigating authorities in January 2017, a payment schedule was established. No payments were due in 2018 and a payment of £102m was made in 2019. In 2020 and 2021, £130m and £148m (plus interest) are due respectively. Consistent with prior years this payment is reported outside of free cash flow. STRATEGIC REPORT22 Strategic Report Financial Review Rolls-Royce Holdings plc Annual Report 2019 Balance sheet Summary balance sheet £m Intangible assets Property, plant and equipment Right-of-use assets Joint ventures and associates Contract assets and liabilities Working capital 1 Provisions Net funds 2 Net financial assets and liabilities 2 Net post-retirement scheme (deficit)/ surplus Tax Held for sale Other net assets and liabilities Net liabilities Other items US$ hedge book (US$bn) Civil Aerospace LTSA asset Civil Aerospace LTSA liability Civil Aerospace net LTSA liability 31 December 2018 Civil Nuclear 17 10 – – 1 8 (1) (20) – – 2 (17) – – 31 Dec 2019 5,442 4,803 2,009 402 (8,745) (1,136) (2,804) (993) (3,277) (208) 1,136 3 14 (3,354) 37 1,086 (6,784) (5,698) Excluding Civil Nuclear 5,278 4,919 – 412 (7,074) (1,263) (1,916) 631 (4,117) 641 1,024 391 22 (1,052) 37 1,097 (5,584) (4,487) Change excluding Civil Nuclear 164 (116) 2,009 (10) (1,671) 127 (888) (1,624) 840 (849) 112 (388) (8) (2,302) – (11) (1,200) (1,211) Total 5,295 4,929 – 412 (7,073) (1,255) (1,917) 611 (4,117) 641 1,026 374 22 (1,052) 37 1,097 (5,584) (4,487) 1 Net working capital includes inventory, trade receivables and payables and similar assets and liabilities. 2 Net funds includes £243m (2018: £293m) of the fair value of financial instruments which are held to hedge the fair value of borrowings. Intangible assets The net increase of £164m includes R&D additions of £481m, primarily related to engine programmes in Civil Aerospace £(426)m, together with further investment in software applications of £101m. These were offset by impairment charges of £54m following the announcement of the strategic review of the Bergen business and the sale of the North America Civil Nuclear business in Power Systems. Amortisation for the period was £(318)m. Property, plant and equipment Following the adoption of IFRS 16, finance leased assets previously held in PPE have been transferred to right-of-use assets. Capital additions of £767m related to investments in MRO capacity in Civil Aerospace and the modernisation of facilities including our Defence facility in Indianapolis. We also expanded our spare engine lease pool to support our growing in-service widebody engine fleet. These were offset by depreciation of £(491)m. Right-of-use assets IFRS 16 was adopted effective 1 January 2019 resulting in the recognition of leased assets with a value of £2.2bn. See notes 1 and 29 in the Consolidated Financial Statements for more information. Investments in joint ventures and associates There was no material change in our investment in joint ventures and associates year-on-year. Contract assets and liabilities This represents deferred revenue and is a core part of our business model where we receive payments from our customers in respect of our long-term service and overhaul agreements. In 2019, this increased by £(1,671)m, of which £(1,211)m related to the Civil Aerospace LTSA balance. The remainder largely covered advance payments in several businesses. The movement in the Civil Aerospace LTSA balance of £(1,211)m included non-cash items of £557m, primarily related to foreign exchange and the cumulative negative impact of contract catch-ups to LTSA revenue. The change, net of these items, of £(654m) reflected invoiced engine flying hour receipts and customer deposits in excess of underlying revenue traded in the income statement. Working capital Working capital increased by £127m. This reflected a financial penalty payment of £102m related to agreements reached with investigating authorities in January 2017, and a £245m reduction in working capital from the settlement of deferred consideration for the acquisition of ITP Aero. These factors offset the reduction in working capital seen in the funds flow. Provisions Provisions increased by £888m largely driven by the incremental exceptional charge related to Trent 1000 disruption and related onerous contract losses, partly offset by utilisation. Net funds Net funds have moved from a net cash position of £611m in at 31 December 2018 to a net debt position of £(993)m. This was driven by the adoption of IFRS 16, which increased lease liabilities by £(2,248)m. Excluding lease liabilities, net cash stood at £1,361m at 31 December 2019. For other movements see funds flow commentary in note 28. Net financial assets and liabilities These items principally relate to the fair value of foreign exchange, commodity and interest rate contracts. The reduction in the net liability of £840m largely reflected settlement of derivative contracts in 2019. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Financial Review 23 Net post-retirement scheme deficits The £(849)m movement was primarily driven by the buy-in agreement with Legal & General Assurance Society Limited, which resulted in a decrease in the surplus of the UK pension plan of around £(600)m. There were also changes in financial and demographic assumptions. USD hedge book The US hedge book at 31 December 2019 was $37bn. It extends to 2028 on a declining basis and remains sufficient to cover our medium-term requirements. Group Reported Results The changes resulting from underlying trading are described in the trading summary below. Consistent with past practice, we provide both reported and underlying figures. As the Group does not generally hedge account for forecast transactions in accordance with IFRS 9 Financial Instruments, we believe underlying figures are more representative of the trading performance by excluding the impact of period-end mark-to-market adjustments. In particular, the USD:GBP hedge book has a significant impact on the reported results. In 2019, the GBP:USD rate rose from 1.28 to 1.32 while the GBP:EUR rose from 1.12 to 1.18. The adjustments between the underlying income statement and the reported income statement are set out in note 2 to the Consolidated Financial Statements. This basis of presentation has been applied consistently. Reconciliation between underlying and reported results £m Underlying * 1 Foreign exchange and derivatives 2 Exceptional programme charges 3 Impact of discount rate charges 4 Exceptional restructuring charges 5 M&A gains & effects of acquisition accounting 6 Impairments and asset write-offs 7 Net post-retirement scheme financing, pension equalisation & other Reported * See note 2 on page 139 for further details. The most significant items included in the reported income statement, but not in underlying are summarised below. 1. Foreign exchange and derivatives included the impact of the following: — the impact of measuring revenue and profit before financing at spot rates rather than achieved hedge rates — mark-to-market adjustments on the Group’s net hedge book of £(7)m (2018: £(2,145)m). At each period end, our foreign exchange hedge book is included in the balance sheet at fair value (mark-to-market) and the movement in the year included in reported financing costs; and — losses on derivatives settled during the period and the impact of valuation of assets and liabilities using the spot exchange rate rather than the exchange rate that is expected to be achieved by the use of the hedge book 2. Exceptional programme charges relating to the Trent 1000 of £1,361m and Trent 900 of £48m are excluded from the underlying results. These have been explained in note 2. 3. Included in discount rate changes is £30m relating to Trent 900 and £10m relating to Trent 1000 Revenue Profit before financing Financing Profit/(loss) before tax 2019 15,450 1,137 – – – 2018 15,067 781 (119) – – – – – – – 16,587 – 15,729 2019 808 144 (1,409) – (136) (24) (84) (12) (713) 2018 616 (24) (976) – (317) 183 (155) (130) (803) 2019 (225) 75 – (40) – (8) – 2018 (150) (1,984) (15) – – 2019 583 219 (1,409) (40) (136) 2018 466 (2,008) (991) – (317) (8) – (32) (84) 175 (155) 20 (178) 13 (2,144) 8 (891) (117) (2,947) 4. Exceptional restructuring costs of £136m (2018: £317m). These are costs associated with the substantial closure or exit of a site, facility or activity related to the significant transformation project that the business is currently undertaking. A number of the projects within the transformation programme are for multiple years. Of the 2019 costs, £88m (2018: £223m) relate to the Group restructuring programme announced in June 2018. 5. The loss before tax of £(32)m (2018: £175m profit) relates to the effects of acquisition accounting £171m (2018: £183m) that principally relate to the amortisation of intangible assets arising on the acquisition of Power Systems in 2013 and ITP Aero in 2017. The Group completed the sale of the Commercial Marine business to KONGSBERG on 1 April 2019 and recognised a profit of £106m in 2019. Rolls Royce Power Development Limited was sold on 15 April 2019 with a gain arising on disposal of £33m. In 2018, we recognised a gain on the sale of L’Orange of £358m. Together with the £183m acquisition accounting effect relating to ITP Aero, this resulted in the £175m profit before tax in 2018. Further details can be found in note 27. 6. On 26 September 2019, the Group announced the sale of the North America Civil Nuclear business and recognised an impairment charge and asset write offs of £26m. Following a reassessment of the Bergen order book and subsequent impairment review, we have recorded a charge of £58m in 2019. Further details can be found in note 2. In our 2018 financial statements, we reported an impairment charge of £155m in relation to the Commercial Marine business being disclosed as held for sale. 7. Following a High Court judgement in October 2018, the estimated costs of equalising UK pension benefits for men and women was recognised as a past-service charge. There is no equivalent charge in 2019. Tax affecting these adjustments resulted in a tax charge of £143m (2018: tax credit of £715m). The charge in 2019 is due to the non-recognition of deferred tax in respect of UK losses in the year. The 2019 charge also includes £86m relating to the derecognition of UK deferred tax assets on foreign exchange and commodity financial assets and liabilities. In 2018, deferred tax was recognised on UK losses resulting in an overall credit in that year. STRATEGIC REPORT24 Strategic Report Business Review – Civil Aerospace Rolls-Royce Holdings plc Annual Report 2019 BUSINESS REVIEW Civil Aerospace Civil Aerospace is a major manufacturer of aero engines for the large commercial aircraft, regional jets and business aviation markets. The business uses its engineering expertise, in-depth knowledge and capabilities to provide through-life support solutions for its customers. Underlying revenue mix 1 2 1. OE .................................................................40% 2. Services ......................................................60% 4 3 2 Progress against our 2019 Group priorities Customers People and Culture 1 Delivered 510 widebody engines to customers (up from 469 in 2018). Accelerated efforts to return Trent 1000 fleet to full health, investing in additional spare engines and MRO capacity expansion. Successful transition to Trent 7000, smooth EIS and production ramp-up on plan. Launched the Pearl 700 engine on Gulfstream G700. Pearl 15 entered service on Bombardier Global 6500. Launched Civil Aerospace women’s leadership programme targeting leaders who are in their early careers to help them build confidence and capability to succeed. Improvements to tools, methods and processes are delivering sustainable engineering efficiencies. Restructuring programme on track. 1. Large Engines ............................................71% 2. Business Aviation ......................................14% 3. Regional ........................................................4% 4. V2500 ...........................................................11% Underlying revenue £8,107m 2018: £7,378m Technology Financial UltraFan design freeze and successful Delivered operating profit of £44m. Underlying operating profit tests of the composite fan system. Continued testing of the Advance3 demonstrator. Completed acquisition of Siemens’ eAircraft business. Announced partnership with Widerøe Reduced large engine OE unit loss by 14%, including Trent XWB-84 improvement of 22%. Increased large engine flying hours by 7%, despite in-service issues on Trent 1000. to further zero carbon aviation. Provided investors with greater Invested in a new flying testbed for next-generation widebody and business jet engines. clarity on the Trent 1000 programme after detailed engineering and financial review. £44m 2018: £(162)m Order backlog £48.5bn Growth in UltraFan and new technology 2018: £52.3bn investment. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Business Review – Civil Aerospace 25 Civil Aerospace overview 2019 Civil Aerospace delivered a record 510 widebody engines in 2019. We have continued to make progress reducing widebody average OE losses, down by 14% year-on-year to £1.2m. Our large engine installed fleet increased to over 5,000 engines in service, driving a 7% growth in widebody engine flying hours and an increase in aftermarket cash margin of £0.3bn. 2019 saw strong revenue growth of 10% and further significant improvement in underlying operating profit for the business. Financial overview Underlying revenue Underlying revenue increased 10%, reflecting good growth in OE, up 4% to £3,246m and strong growth in services, up 14% to £4,861m. Large engine OE growth of 8% was driven by an increase of 41 in widebody engine delivery volumes to 510. This reflected strong growth in Trent 7000 engines for the Airbus A330neo production ramp-up. Large engine service revenue increased 20% to £3,205m (2018: £2,666m), driven by higher servicing volumes. Major LTSA shop visits rose 7% to 306 and check and repair visits, led by Trent 1000 activity, increased 16% to 660. Sales of spare parts not covered by LTSAs increased year-on-year. There was also a material reduction in negative contract catch-ups to revenues. In business aviation, OE sales were 5% higher with deliveries broadly stable at 219 engines (2018: 217 engines) reflecting improved mix, while service revenue increased 2%. Regional aviation service revenue increased 19%, driven by the AE3007 and Tay-powered fleets. V2500 OE revenue was down 72%, due to end-of-life production on the Airbus A320ceo. The 2% reduction in V2500 service revenue reflected a modest reduction in spare parts sales, with the payment from Pratt & Whitney Aero Engines International relating to engine flying hours remaining stable. Underlying operating result The underlying operating profit of £44m was an improvement of £195m, reflecting higher gross profit, increased profit from joint ventures and lower C&A costs more than offsetting a 13% higher R&D charge. Gross profit improved by £121m and gross margin by 90bps. This was driven by increased servicing activity, higher spare parts sales, and a material improvement in the net impact of contract catch-ups to LTSA profits. In 2019, catch-ups had a £33m positive impact on profit (2018: £(276)m). Financial overview £m Engine deliveries Underlying revenue Underlying OE revenue Underlying services revenue Underlying gross profit Gross margin % Commercial and administrative Restructuring Research and development cost Joint ventures and associates Underlying operating result Underlying operating margin % Underlying revenue £m Original Equipment Large engine Business aviation V2500 Services Large engine Business aviation Regional V2500 Metrics 2019 729 8,107 3,246 4,861 622 7.7% (299) (7) (374) 102 44 0.5% 2019 3,246 2,568 643 35 4,861 3,205 477 355 824 Widebody engine deliveries Average loss per widebody OE (£m) Large engine in-service fleet Large engine invoiced flying hours Large engine LTSA major refurbs Large engine LTSA check & repair This was driven by improvements in servicing costs in business aviation, which was partly offset by a reassessment of costs and utilisation across various widebody programmes. Gross profit was negatively affected by a modestly lower LTSA underlying margin due to the mix of shop visits, circa £70m of FX related headwind principally relating to the revaluation of USD creditors and deposits, and a modest impact from higher customer charges. The profit contribution from spare engine sales was relatively stable year-on-year. Self-funded R&D cash spend reduced by £18m to £(767)m reflecting lower investment in existing widebody and business aviation programmes and an increase in next generation technology, including the UltraFan demonstrator. Net R&D capitalisation was £60m lower, driven by widebody and 2018 Change 686 7,378 3,119 4,259 493 6.7% (336) (8) (332) 21 (162) -2.2% +6% +10% +4% +14% +26% +100bps -11% -13% +13% +81 +206 +270bps 2018 Change 3,119 2,373 620 126 4,259 2,666 464 292 837 +4% +8% +4% -72% +14% +20% +3% +22% -2% 2019 510 1.2 5,029 15.3m 306 660 Organic change +6% +10% +4% +14% +25% +90bps -11% -13% +13% +78 +195 +260bps Organic change +4% +8% +5% -72% +14% +20% +2% +19% -2% 2018 469 1.4 4,757 14.3m 286 569 business aviation development programme maturity. Overall, the R&D charge to profit increased to £(374)m from £(332)m in 2018. Underlying C&A costs were 11% lower year-on-year. Joint venture profit of £102m (2018: £21m) reflected increased servicing activity in overhaul bases and higher profit on disposal of engines in Rolls-Royce & Partners Finance Limited (our engine financing joint venture). STRATEGIC REPORT26 Strategic Report Business Review – Civil Aerospace Rolls-Royce Holdings plc Annual Report 2019 TESTING FOR THE FUTURE Work continued during the year on our UltraFan demonstrator; a world-beating suite of technologies that will redefine the Rolls-Royce jet engine, delivering significant reductions in fuel burn, emissions and noise. Successful worldwide tests of key technologies have already been completed, ready for flight and ground testing over the coming years. Next generation engines require next generation testbeds. Testbed 80, the largest testbed in the world, is currently taking shape in Derby, UK. Equipped with precision x-ray equipment, state-of-the-art data systems and the ability to test engines using sustainable aviation fuels, it will allow us to monitor and validate our engines better than ever before. Testbed 80 will be commissioned in 2020. We are also bolstering our test capabilities in the sky, with the addition of a new flying testbed. In October, we took delivery of a Boeing 747-400 from Qantas, which will now be transformed from a passenger aircraft into an airborne laboratory, capable of testing both widebody and business jet engines. It joins our existing flying testbed, a Boeing 747-200 based in Tucson, Arizona. Trading cash flow Civil Aerospace trading cash flow improved £201m to £419m, driven by increased flying hour receipts from our growing in-service engine fleet, increased spare parts sales and lower capital expenditure. Cash costs on Trent 1000 in-service issues of £578m (2018: £431m) were partly offset by insurance receipts of £173m. Cash inflow from working capital was significantly lower in 2019 notably due to the non-recurrence of a circa £400m benefit from standardisation of supplier payments in 2018. Year-on-year growth in inventory was significantly lower. Operational and strategic review Our top priority in 2019 remained securing the return of the Trent 1000 fleet to full health. We made major steps forward in rolling out fixes, expanding maintenance capacity and providing additional clarity to our customers. Much more work remains to be done in 2020. Importantly, we did not allow the Trent 1000 challenge to derail the much needed transformation of our business. Significant progress was also made on near-term operational improvement and we achieved a number of milestones in our longer term strategy to become a leader in the lower carbon future of aviation. In 2019, we delivered 510 widebody engines, in line with guidance and a record figure for Rolls-Royce. This included the successful ramp-up of the Trent 7000, with 106 engines delivered compared with just eight engines in 2018. We continued to make progress in reducing our large engine average OE unit losses, which fell by 14% to £1.2m during the year, helped by a 22% improvement on the Trent XWB-84. We continue to expect to deliver our first breakeven Trent XWB-84 by the end of 2020. Thanks to these record engine deliveries, our large engine installed base grew by 6% in 2019 and crossed the 5,000 mark to 5,029 engines. Overall, the performance of our fleet continues to be very strong, with invoiced engine flying hours increasing by 7% to 15.3 million. The Trent 700, the largest part of our installed base at 32%, has crossed 55 million flying hours and continues to deliver excellent performance in fuel burn, reliability and durability. The Trent XWB became our second largest Trent programme by volume in 2019, and has now flown over 5 million hours. As we highlighted in November, fleet-leading Trent XWB-84 engines have reached our original expectations for time-on-wing. The Trent 7000 has made an excellent entry into service, with 80 engines now flying and a dispatch reliability of 99.9%. The Trent 1000 is 13% of our widebody fleet and we continue to work to improve durability and reduce customer disruption. To this end, we announced actions to boost our maintenance capacity and add additional spare engines, with a significant investment in 2020 set to drive around 50% increase in our Trent 1000 spare engine pool. We also gave greater certainty to customers and clarity to investors following an extensive review of the programme. Our focus is now on executing the clear plan we have to reduce AOG and return the fleet to the level of service which our customers expect. In business aviation, 2019 was a year of milestones. The Bombardier Global 5500 and Global 6500, both powered by our Pearl 15 engine, received EASA and FAA certification. In November, we also announced the new Pearl 700 to power the upcoming Gulfstream G700. The Pearl family now powers two airframer platforms, bolstering our position as the leader in the large cabin, long-range market. Our transformation and cost reduction efforts accelerated during the year, and Civil Aerospace made the largest contribution towards the Group’s 1,600 net headcount reduction in 2019. The removal of roles was enabled by increased use of digital Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Business Review – Civil Aerospace 27 technologies, largely in engineering, simplification of processes and removal of duplication. We are determined to seize the opportunity to become a leader in the provision of lower carbon air power. This means not only improving our existing gas turbine technology to be more fuel efficient with lower carbon emissions, but also pioneering future technologies that will enable a low carbon future for aviation. We reached an important milestone with a design freeze on UltraFan, which will be 25% more efficient than original Trent engines and 10% more efficient than the Trent XWB, the world’s most efficient large engine in service today. We also carried out successful tests of the composite fan system, a key technology enabler for UltraFan to reduce weight and increase fuel efficiency. On future technologies, we have taken significant steps towards increasing our capabilities in hybrid electric propulsion. During the year we acquired Siemens’ eAircraft business and achieved major milestones in three of our key electric demonstrator programmes: — in August, we began ground tests of our 2.5MW generator in Norway. This forms part of our E-Fan X project with Airbus, the largest hybrid aircraft demonstrator in the world; — in November, we announced a flight demonstrator based on our hybrid M250 propulsion system with APUS and the Brandenburg University of Technology, paving the way for experimental flights after 2021; and — in December, we unveiled the plane which will seek to break the speed record for an all-electric aircraft in 2020 as part of our ACCEL programme (see page 42). Civil Aerospace outlook During the year, we booked a net widebody order intake of 213 engines. As a result, our widebody backlog at the end of 2019 was 1,978 engines, providing good visibility on our deliveries in the coming years and driving continued growth in our installed base. The long-term trends supporting air traffic growth remain intact, though the outbreak of COVID-19 represents a near-term macro risk. In 2019, approximately 20% of our invoiced engine flying hours were derived from the greater China region. We have a small number of tier one suppliers in the Greater China region, all of whom have resumed operations at the time of writing. Although currently subdued, we expect an improvement in widebody orders driven by a replacement cycle in the coming years as a growing number of aircraft reach retirement age, including Boeing 777s, Boeing 767s and older Airbus A330s. We believe we are well positioned to continue to win a large share of these orders, having captured 64% of gross order intake and 52% of net orders for widebody engines in 2019. The increase in retirements in the coming years represents a challenge for the industry, but we are favourably positioned due to the younger age distribution of our fleet relative to our competitors. The average age of our widebody in-service fleet is less than eight years, compared to the industry average of 13 years, excluding Rolls-Royce. As a result, we continue to expect strong growth in our installed base in the coming years, which supports growth in our engine flying hours and the widebody aftermarket cash margin. In 2020, we expect stable to low-single- digit sales growth in Civil Aerospace and operating margins 50–100bps higher year-on-year, despite a £100–150m reduction in the level of R&D capitalisation. DELIVERING INTELLIGENT CARE Our IntelligentEngine vision of a civil aerospace world in which our products and services are increasingly bound together by data, is spurring us on to develop new service innovations that harness digital capabilities to deliver intelligent care to our customers. At the heart of this work is our aircraft availability centre, which proudly celebrated 15 years of providing 24-hour care during the year. We have evolved the capability of this centre during that period, further improving our ability to provide proactive support through advanced analytics and inspection techniques that help us ensure every Rolls-Royce powered engine takes off on time, every time. In 2019, we announced further global expansion of our CareNetwork. This included the development of an additional network of overhaul bases and in-field maintenance, alongside the introduction of innovative repair providers who use new tooling and technology to provide more responsive services closer to customer operations. STRATEGIC REPORT28 Strategic Report Business Review – Civil Aerospace Rolls-Royce Holdings plc Annual Report 2019 PEARL TAKES TO THE SKY The Pearl 15, the first member of the state-of- the-art Pearl engine family for business jets, officially entered service in September. The engine, which was developed at our facility in Dahlewitz, Germany, is the exclusive engine option for the newest members of Bombardier’s Global business jet family, the Global 5500 and the Global 6500. Operating environment Rolls-Royce key differentiators Our continued development of advanced world-leading technology, culture of partnership with customers, and innovation in services are attributes that Civil Aerospace customers value and are difficult to imitate. These differentiators will maintain our position at the forefront of the civil aerospace industry. Market dynamics — Following a period of historically high growth rates, passenger air traffic reverted in 2019 to the long-run average of 4–5% growth per annum. This level is supportive of continued strong engine flying hour growth with utilisation across the Trent fleet remaining high during the year. — Although currently subdued, we expect an improvement in widebody orders driven by a replacement cycle in the coming years. — In business aviation, the long-term fundamental drivers of the large-class business aircraft market are good and will be sustained. In the short term, demand has softened in anticipation of customers awaiting new aircraft derivatives, and our airframers’ current focus on ramping up deliveries of non-Rolls-Royce powered aircraft. — 2019 has seen an increased focus on climate change across the world and within the airline industry. We are working with industry bodies towards more sustainable aviation through a number of initiatives. Opportunities — The business has a strong and growing market share on widebody aircraft produced by the world’s two major aircraft manufacturers: Airbus and Boeing. We believe we are well placed to win a large share of these orders. Our current share of the widebody engine market is 38% of the in-service passenger fleet and is expected to approach 50% by the mid-2020s. — We expect strong growth in our installed base leading to growth in services and widebody aftermarket cash margin. 90% of the current Rolls-Royce widebody fleet is covered by TotalCare service agreements. — The Pearl family of engines won its second application with Gulfstream and, alongside the Bombardier aircraft, reinforces and secures our long-term position in the business aviation sector. — China’s COMAC and Russia’s UAC joint venture, the China Russia Commercial Aircraft International Corporate (CRAIC) has been formally incorporated. CRAIC plans to develop the CR929, a long-haul widebody aircraft. Rolls-Royce is actively exploring this opportunity. Business risks — If our products do not achieve their required technical attributes and maturity, then customer satisfaction, unit costs and aftermarket costs may be impacted and could result in financial and reputational damage. — If a major product failure in service is experienced, then this could result in loss of life and significant financial and reputational damage. — If an external event or severe economic downturn significantly reduces air travel, then financial performance may be impacted. — If aircraft manufacturers significantly reduce production rates or delay increases, or we cannot ramp up capacity to deliver planned production and services, then financial performance may be impacted. — If our internal or external supply chain is not sufficiently resilient to events that affect our operations, then this could result in significant financial and reputational damage. — If the business experiences significant pricing pressure in key markets, then financial performance may be impacted. — If there are significant changes to the regulatory environment for the airline industry, then the market position of the Civil Aerospace business may be impacted. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Business Review – Power Systems 29 BUSINESS REVIEW Power Systems Power Systems is a leading provider of high-speed and medium-speed reciprocating engines and complete propulsion and power generation systems. It serves the marine, defence, power generation and industrial markets, and includes civil nuclear operations that supply safety-critical systems. Progress against our 2019 Group priorities Customers People and Culture Increased engine production by 8%. Increased diversity in Power Systems Continued uptake of long-term service agreements; LTSA revenue grew by 6%. Opened four new customer care centres and expanded digital service capability. Established a dedicated support centre for yacht customers. senior leadership. Women now account for 30% of the senior management team. Launched our Pioneer Academy to build electrical engineering skills. A first cohort of 100 engineers have started a two-year training programme. Opened a new vocational training centre in Friedrichshafen and celebrated 100 years of Power Systems apprenticeships. Technology Financial First off-grid microgrid contract secured. OE revenue growth of 4% driven by strong demand in power generation. Strategic cooperation agreements Services revenue growth of 4% signed with GETEC and ABB. First orders for hybrid-rail PowerPacks from Iarnród Éireann (Irish Rail) and Porterbrook. reflecting growth in both spare parts and LTSAs. Book-to-bill of 1.0x despite challenging market conditions. Partnership with Sunseeker 90bps improvement in operating International to introduce hybrid technology to the yacht market. Announced a cooperation with Mercedes Benz innovation lab to pilot fuel cell solutions. profit margins to 10.1%. Increased spend on hybrid, gas, and hydrogen technology development. Underlying revenue mix 2 1 1. OE .................................................................67% 2. Services ......................................................33% 5 4 3 1 2 1. Marine .........................................................28% 2. Industrial .................................................... 25% 3. Power Generation ...................................35% 4. Defence ........................................................ 9% 5. Civil Nuclear ................................................3% Underlying revenue £3,545m 2018: £3,434m * Underlying operating profit £357m 2018: £315m * Order backlog £2.9bn 2018: £3.1bn * 2018 figure restated to exclude the North America Civil Nuclear business STRATEGIC REPORT 30 Strategic Report Business Review – Power Systems Rolls-Royce Holdings plc Annual Report 2019 Power Systems overview 2019 Power Systems made good progress in 2019, with sales continuing to outgrow global GDP and gross margins improving due to operating leverage and a better product mix. We continued to advance our services strategy, with strong growth in LTSA sales a particular highlight. Order intake was good at £3,415m, a book-to-bill ratio of 1.0x. Financial overview Underlying revenue Underlying revenue of £3,545 increased by 4%, OE revenue was up 4% driven by strong demand for mission critical power generation products, notably to serve the data centre market. This growth more than offset an expected reduction in demand from the construction and agriculture sectors, following the non-recurrence of the emissions-led pre-buy effect seen in 2018. Services revenue rose 4%, reflecting higher spare parts sales and 6% growth in LTSAs. We continue our focus on generating greater value from our large installed base, both through a more proactive approach to Financial overview ^ £m Underlying revenue Underlying OE revenue Underlying services revenue Underlying gross profit Gross margin % Commercial and administrative Restructuring Research and development cost Joint ventures and associates Underlying operating profit Underlying operating margin % 2019 3,545 2,386 1,159 909 25.6% (374) – (176) (2) 357 10.1% 2018 3,434 2,310 1,124 866 25.2% (363) (1) (188) 1 315 9.2% Change +3% +3% +3% +5% +40bps +3% – -6% – +13% +90bps Organic change +4% +4% +4% +6% +50bps +4% – -6% – +15% +90bps ^ Commentary and figures exclude the Civil Nuclear North America Services business which has been treated as non-core following its disposal in February 2020. spare parts sales and a greater emphasis on LTSA sales which now account for circa 12% of total service revenues. Underlying operating profit Underlying operating profit rose by 15% to £357m, led by revenue growth. Gross profit was 6% higher at £909m, helped by a 50bps increase in gross margins to 25.6%, due to better product mix. C&A costs of £(374)m were 4% higher year-on-year reflecting cost escalation, additional spend on digital solutions, and higher sales-related activities. The R&D charge reduced by £11m reflecting the timing of key projects, with cash spend modestly higher. In the coming years we expect R&D spend in Power Systems to increase as we ramp up activity on new programme investment and our electrification strategy. PLUGGING INTO MICROGRIDS Microgrids have a vital role to play in assisting the world’s transition to lower carbon power, by providing security of supply from power generation systems that use renewable energy sources that can be intermittent. Microgrids are small-scale local power networks in which various energy sources and storage systems – from solar cells, wind turbines and batteries to diesel or gas-powered generator sets – are integrated by means of a smart master controller. To expand our knowledge of how microgrids function in power generation, during the year we commissioned a microgrid validation centre in Friedrichshafen, Germany, to carry out close-to-reality simulations of a variety of possible configurations. We are already running our own microgrid at Plant 1 in Friedrichshafen. It consists of photovoltaic panels with 500 kW peak power capacity as well as gas-powered and diesel- powered gensets and an MTU battery container with 2 MWh capacity. It currently delivers 30% of the energy needed at Plant 1 during normal working hours and full coverage at weekends. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Business Review – Power Systems 31 MILESTONE FOR INDIAN JOINT VENTURE Force MTU Power Systems, the joint-venture between India’s Force Motors Limited and Rolls-Royce, delivered its first Series 1600 genset to customer Perennial Technologies in 2019. We have partnered with Force Motors to move the manufacturing of the entire line of MTU Series 1600 engines from Germany to a new manufacturing facility at Chakan, near Pune, India. The construction of the facility is nearing completion and the first locally made engine is expected to be manufactured by mid-2020. On completion, the facility will produce MTU 10 and 12-cylinder Series 1600 units. These engines are already well-established in the market for power generation and rail applications. Operational and strategic review Conditions across our markets were challenging in 2019. Despite this, our financial performance remained robust, supported by a strong order book. A combination of rising energy demand in developing countries and the expansion of renewable energy sources drove orders for flexible power solutions and products such as microgrids, hybrid and gas engines, electrification and energy storage. In 2019, we delivered 6,580 engines, excluding smaller off-highway engines. This compares to 5,976 deliveries in 2018. Our installed base increased to approximately 146,000 engines (from approximately 142,000 in 2018) which will continue to support replacement demand and drive our growing services revenue. Power Systems has a key role to play in our drive towards low carbon power across the Group. A number of technologies that will have applications in civil aerospace markets, notably hybrid, electric, and fuel cells, are already being developed and adopted in Power Systems. Significantly, 2019 marked the last year in which Power Systems sold only fossil fuel based power solutions as we reached several important strategic milestones on this journey, including the signing of customer contracts and framework agreements to implement hybrid engine solutions for the rail sector, where we are first to market, and the yacht market, building on our leadership position with the MTU Series engines. Since October, Power Systems has been operating its own microgrid in Friedrichshafen, which provides over 30% of the energy required for the weekly running of the plant. We successfully received the first orders for our new battery container and microgrid solutions, delivering cleaner and decentralised energy. Together with Lab1886, an innovation lab within the Daimler Group, we started a pilot project to test the use of Mercedes-Benz fuel cell technology for backup power and the supply of energy to data centres. This technology will provide safe, sustainable and emission free energy to one of the world’s most significant power consuming industries. Power Systems is also researching more sustainable fuels. During the year, we signed an agreement to construct a demonstration plant to produce synthetic fuels in Brandenburg, Germany. Continuing our push into life-cycle services, we are placing increased focus on digital services and predictive maintenance. Our digital solutions team was expanded during the year and we established a data and analytics competence centre in Munich, Germany. We also expanded our service network for yachts in La Spezia, Italy. These actions have helped to drive a steady increase in LTSAs, including the signing of a ten-year agreement with Svitzer, a global towage and marine services operator. Expanding our geographic footprint is a key driver of our ability to outgrow underlying markets. In 2019, we strengthened our position in China, signing agreements for the delivery of more than 700 MTU engines. These included the largest ever single order of MTU gas gensets to supply over 200 MTU Series 4000s to China’s VPower. In India, our Force MTU Power Systems joint venture will begin local assembly of Series 1600 engines in the first half of 2020. This enables us to be closer to our customers and to reduce operating costs. In anticipation of this move, we have ceased assembly of MTU Series 1600 engines in Überlingen, Germany. Investing in our people is vital if we are to continue to position ourselves for growth in new markets including hybrid power. To meet our need for increased electrical engineering capability, 100 mechanical engineers undertook a course in electrical engineering as part of a new project at Karlsruhe University, Germany. Power Systems outlook As we enter 2020, the early indication is that conditions in a number of our end markets will remain challenging. However, we aim to out-perform our markets, driven by our strategy to increase services sales and the shift towards new technologies and STRATEGIC REPORT32 Strategic Report Business Review – Power Systems Rolls-Royce Holdings plc Annual Report 2019 integrated solutions. We are also continuing our efforts to gain market share in Asia, where Power Systems has previously been underexposed. As a result, we expect to deliver low-single-digit organic revenue growth in 2020 despite this challenging backdrop. We expect margins to improve again in 2020, increasing by 0–100bps as we take another step towards our medium-term target of mid-teens. The outbreak of COVID-19 represents a near term macro risk. In 2019, approximately 10% of Power Systems revenues were derived from the greater China region. As part of our ongoing efforts to evaluate our portfolio and create a simpler, more efficient Group, we have taken the decision to carry out a strategic review of Bergen, our medium-speed gas and diesel engine business. In 2019, Bergen generated revenues of £239m with an operating loss of £(18)m. From 2020, Bergen will be reported within non-core businesses and has therefore been excluded from our guidance. Operating environment Rolls-Royce key differentiators Power Systems will retain its strong position through technology leadership and a reputation for market-leading product performance and innovation; combined with a systems approach that allows high levels of customisation, supplemented by full lifecycle solutions. Market dynamics — Power Systems’ presence in a diversity of end markets has helped the business navigate successfully against the backdrop of an increasingly challenging macroeconomic environment; negatively influenced by political developments leading to deferment in investment. — Uncertainty in the resource markets, especially US fracking, after a strong 2018 dampened the opportunity for new equipment sales, however high utilisation continued to drive aftermarket service opportunities. — Government regulations with regard to diesel engine emissions in most markets are driving the industry towards innovation. The focus is shifting towards hybrid, hydrogen and electric power solutions as well as renewable energy solutions. — The civil nuclear market continues to have mixed fortunes, strengthening in areas with set energy policy and financing mechanisms but weakening in other areas where greenhouse gas reductions or security of supply are not being prioritised. Opportunities — Rising energy demand in emerging economies, particularly India and China (both large markets despite some recent softening) continue to grow and present significant opportunities for Power Systems. — Tightening emission regulations in several regions are beneficial to the competitive position of Power Systems’ high-end products, such as our Series 4000. — The trend towards intermittent renewables such as solar and wind as part of a ‘green grid’ is creating demand for flexible, low-emission gas reciprocating engines. Increasing interest in flexible local energy solutions to reduce carbon emissions also presents significant new opportunities for adjacent growth in areas such as energy storage and microgrids. — As digital information becomes essential to many economies, the data centre market is witnessing strong growth. Due to its reliability, Power Systems back-up solutions are highly regarded and the opportunity to integrate new product and service offerings into this market is significant. — Power Systems is well placed to respond to increasing customer demand for new service offerings and propositions such as ValueCare agreements supported by decades of experience in service model innovation. — Nuclear energy demand remains significant but large-scale projects are proving problematic to finance and construct. Industry interest in new nuclear technology is increasing and we are well placed to respond to this trend. Business risks — If the macroeconomic environment worsens (for example a trade war between the US and China), then this could have a material impact on the business. — If requirements on export licenses and/or local content increase, then this may affect our ability to export to certain markets. — If other players in the industry consolidate, then they may generate synergies or capabilities that outpace the ability of the business to get new products and services to market. — If the CO2 price rises above our expectations and/or the demand for fossil-free power develops faster than anticipated, then this may affect demand for Power Systems products and/or affect margins. — If new technologies or alternative propulsion concepts emerge, then this may lead to partial substitution or downsizing of diesel engines in certain applications. — If there is not clarity on UK energy policy and the willingness of UK Government to continue support of SMR development, then continued investment may be called into question. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Business Review – Defence 33 BUSINESS REVIEW Defence Underlying revenue mix Defence is a market leader in aero engines for military transport and patrol aircraft with strong positions in combat and helicopter applications. It has significant scale in naval and is the technical authority for through-life support of the nuclear power plant for the Royal Navy’s submarine fleet. 1 2 1. OE .................................................................45% 2. Services ......................................................55% Progress against our 2019 Group priorities Customers People and Culture Ramped up LiftSystem production to meet Lookheed Martin F-35B programme demand. Increased output from our submarines primary components operations by 300% since 2015; zero arrears in 2018 and 2019. Maiden flight of Boeing MQ-25 unmanned tanker, powered by the AE 3007. Developing cyber and digital solutions for Boeing B-52 re-engining competition. Launch of Defence diversity & inclusion charter. Signed up to the UK’s Women in Defence Charter. UK Armed Services Covenant Gold Award. Approximately 1,400 employees involved in social projects as part of Indianapolis community care week. 5 1 4 3 2 1. Transport ....................................................36% 2. Combat ....................................................... 23% 3. Submarines .................................................19% 4. Naval ........................................................... 10% 5. Other ............................................................12% Underlying revenue £3,250m 2018: £3,124m Technology Financial Launch of a new foreign object Record order intake, with book-to-bill Underlying operating profit debris recording app for NAVAIR and the US Marine Corps. Development of aerothermal and electrical power take-off capability in support of Tempest, the UK-led next-generation fighter programme. MAPS (Military High Mach Advanced Propulsion System) contract signed with the UK MOD. Development of an integrated power and thermal management system for defensive directed energy applications. ratio of 1.6x, including propulsion system contract for the Royal Navy’s four Dreadnought class submarines. Revitalisation of Indianapolis, US facilities nearing completion, on-time and on-budget. Continued footprint optimisation with closure of Oakland, US facility. R&D investment increased by 5% to support future growth opportunities. £415m 2018: £427m Order backlog £8.6bn 2018: £6.8bn STRATEGIC REPORT 34 Strategic Report Business Review – Defence Rolls-Royce Holdings plc Annual Report 2019 Defence overview 2019 Defence had an excellent year for both order intake and cash flows. Record order intake and a 1.6x book-to-bill ratio helped to drive strong cash flow performance and 26% growth in the order book in 2019. Sales were broadly stable and operating profit margins declined by 110bps, as expected, driven largely by a less profitable OE mix and increased investment in R&D to support a number of major new programme opportunities in the coming years. Financial overview Underlying revenue Underlying revenue of £3,250m was up 1% on an organic basis. OE revenue was 2% lower year-on-year driven by fewer deliveries of transport engines due to the phasing of orders, including lower volumes of Trent 700s for multi-role tanker transport (MRTT) aircraft and AE series engines for the C-130J and V-22. These were partly offset by increased volumes for LiftSystem hardware for the F-35B. Service revenue was up 4%, driven by higher LTSA volume for the AE1107 and AE2100 transport engines, together with increased time and materials revenue from EJ200 services. Financial overview £m Underlying revenue Underlying OE revenue Underlying services revenue Underlying gross profit Gross margin % Commercial and administrative Restructuring Research and development cost Joint ventures and associates Underlying operating profit Underlying operating margin % 2019 3,250 1,461 1,789 669 20.6% (151) (7) (105) 9 415 12.8% 2018 3,124 1,452 1,672 690 22.1% (170) (3) (100) 10 427 13.7% Change +4% +1% +7% -3% -150bps -11% +133% +5% -10% -3% -90bps Organic change +1% -2% +4% -6% -160bps -13% +133% +4% -10% -7% -110bps Underlying operating profit Underlying operating profit of £415m was £28m lower than the prior year, in line with expectations. Gross profit of £669m fell 6%, driven by the lower OE volumes in transport, particularly on the Trent 700 MRTTs, and lower LTSA margins due to the non-repeat of one-off customer settlements in the prior year. A modest increase in R&D spend of £4m reflected ongoing investment to support future programmes across our Defence portfolio, with a number of attractive growth opportunities in the coming years. C&A costs were £22m lower year-on-year at £(151)m. Operational and strategic review 2019 was a very successful year for Defence, with record order intake, strong operational execution, and the achievement of significant milestones in our ongoing R&D projects, which will position the business to grow in the coming years in both transport and combat markets. Our markets remained stable in 2019. The US continues to represent nearly half of the addressable defence spend globally, while the UK and Europe also remain key markets. We expect higher growth in Asia and the Middle East, driven by regional tensions. While the budget backdrop in our markets TEMPEST GAINING STRENGTH Rolls-Royce is playing an integral role in Team Tempest following its launch at the Farnborough Air Show in 2018, with international momentum gathering in 2019 as both Sweden and Italy signed agreements with the UK Government to partner on future combat air requirements. The programme enables us to continue as pioneers in the combat market, building on technology developments already being demonstrated through successful tests and trials. As part of Tempest, we will deliver a power and propulsion system capability which will provide fully integrated power and thermal management capabilities. The gas turbine remains at the forefront of our contribution and the use of advanced composite materials, additive layer manufacturing techniques and new technologies will deliver a lightweight, more power dense configuration capable of operating at higher temperatures. This enhanced integrated system will result in a more intelligent, more powerful and more electric system, capable of delivering the future power needs of the air vehicle. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Business Review – Defence 35 CALMER SEAS FOR SUBMARINES Our submarines business has surfaced into calmer waters after several years of intense work to improve performance. The submarines primary components operations is responsible for manufacturing key reactor components to support the Astute and Dreadnought nuclear submarine build. In 2015, its delivery performance was impacting the overall programme with around 250 arrears and zero products delivered on time to the boatyard in Barrow-in-Furness, UK, change had to happen. In 2016, a three-year fundamental improvement programme was launched with three main focus areas: creating additional capacity by repurposing existing factory space; creating an efficient value chain, fully aligned with the in-week delivery plan; and creating an operational engagement activity to drive incremental improvement at a local level. In 2019, after three years of sustained improvement, the primary components operation celebrated increasing production output to the customer by over 300% compared with 2015. It has also achieved the targeted level of on-the-day delivery with zero arrears. The year saw much needed stability driven back into both the Astute and Dreadnought submarine programmes. is relatively stable, we see a number of exciting programme opportunities in the coming years, notably in the Tempest combat programme in the UK and in multiple upcoming campaigns in the US market. Defence had a record order intake of £5.3bn, driving 26% growth in the order book. Book-to-bill in 2019 was 1.6x, taking the cumulative book-to-bill ratio over the last five years to 1.2x. The strength in 2019 was led by services, highlighting the demand driven by our installed base of over 16,000 engines. Key highlights included a five-year contract worth over $1bn to maintain AE1107 engines for the US Marine Corps, which have now reached the service milestone of over one million flying hours. Two UK MOD support contracts were signed; one for Spey naval engines, and one for the maintenance of the EJ200. A multi-year spare parts order was additionally confirmed for our Adour engines in India. OE orders grew, including four Dreadnought powerplants in submarines and a LiftFan OE order for LRIP 12 of the F-35 programme. We continued to leverage our existing installed base with the Series 3.5 upgrade kit for the T56 engine, which secured further orders from the USAF. Fewer than 5% of the C-130 aircraft in service with the US Air Force currently have the Series 3.5 upgrade kit fitted, presenting a significant opportunity for future orders. We delivered 499 aero engines in 2019. In aerospace, three Bombardier Global 6000s, powered by our BR710 engines, were delivered to the German Special Air Mission Wing and German Air Force. LiftSystem production ramped up to meet F-35B programme demand and the Boeing MQ-25 unmanned aerial refuelling tanker, powered by the AE 3007, completed its maiden flight. In maritime, our 50th MT30 gas turbine came off the production line and we delivered key early components for the first Dreadnought submarine. Operationally, our submarines business implemented a management restructure, reducing complexity and aligning to the needs of the customer. We continued to invest in US facilities; the revitalisation of our Indianapolis site is nearing completion while a new 24,000 sqft facility in Walpole, Massachusetts is due to be commissioned in late 2020. These actions to improve efficiency are helping us meet customer demand for cost-effective solutions while minimising the impact on our margins. R&D investment stepped up in 2019 ahead of a period of important upcoming opportunities. We made good progress as part of Team Tempest, for which we are developing a power and propulsion system which will provide fully integrated power and thermal management. We were also awarded a two-year contract by the UK MOD to develop hypersonic propulsion systems. LibertyWorks, our dedicated US defence development unit, successfully demonstrated an integrated power and thermal management system for high-power directed energy applications. We announced an agreement with Bell Helicopter to exclusively develop an optimised propulsion system for the V280 Valor. Over 50,000 hours of engineering analysis, including digital engineering, were devoted to refine our offering for the Boeing B-52 re-engining competition and early engine tests were successfully completed in Indianapolis, US. Defence outlook We expect Defence to deliver stable to low-single-digit sales growth in 2020, with stable operating margins. Longer term, supported by the order intake in 2019 and the pipeline of upcoming new programme opportunities, we expect Defence growth to accelerate. STRATEGIC REPORT36 Strategic Report Business Review – Defence Rolls-Royce Holdings plc Annual Report 2019 NO PILOT, NO PROBLEM Boeing and the US Navy successfully completed the first test flight of the Boeing MQ-25 Stingray unmanned aerial refueler in 2019. The MQ-25 is powered by a single Rolls-Royce AE 3007N engine and flew under the direction of Boeing test pilots operating from a ground control station in the US. The MQ-25 will provide the Navy with a carrier-based, unmanned, aerial refueling capability. Operating environment Rolls-Royce key differentiators Advanced technology, innovation, and collaboration with partners and customers are unique hallmarks of Defence. These differentiators enable successful delivery of products and services tailored to our customers’ evolving needs. — In transport, Defence is well positioned for various next generation opportunities, including with Bell on the V-280 Valor for the US Army’s Future Vertical Lift programme. — Building on our success as the preferred gas turbine provider on Australian SEA 5000 and Canadian frigate programmes, Defence is well positioned to capture other large maritime opportunities with the MT30. Market dynamics — Long-term defence investment is tied to economic growth while threat levels and politics drive near-term spend; the business expects to see modest growth across the globe in the coming years. — While higher growth areas exist in Asia and the Middle East, driven by indigenisation and regional threats, the US represents nearly half of addressable defence spend globally. — Programme wins are generally long-term and as a result barriers to entry are high, which leads to entrenched competitors and aggressive competition for new opportunities. Opportunities — There is strong interest in electrification across land, sea, and air platforms; the business is exploring more electric and hybrid-electric propulsion technologies as well as power generation and thermal management for the growing directed energy systems market. — Combat propulsion remains the largest market segment, with opportunities for current products (LiftSystem and EJ200), UK investment in future combat air technologies (Combat Air Acquisition Programme), and a large US opportunity in the Boeing B-52 re-engining competition. — There continues to be strong service growth potential via technology insertion and emerging service opportunities using digital technology and data analytics to generate new solutions. Business risks — If a major product failure in service is experienced, then this may result in loss of life and significant financial and reputational damage. — If global defence spending experiences a significant downturn, then financial performance would be impacted. — If we do not continue to invest in improving the performance and cost of Rolls-Royce products, then market share may be lost. — If the business suffers a major disruption in its supply chain, then delivery schedules would be delayed, damaging financial performance and reputation. — If new applications are not secured, then the business may have to increase investment or accept erosion in capabilities. — If electrification and digitalisation technology proceeds at a faster rate than expected, then the business may not be positioned to fully capitalise on this potential growth. — If geopolitical issues arise impacting government-to-government relations or export controls, then our routes to market and regional sales may be impacted. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Business Review – ITP Aero 37 BUSINESS REVIEW ITP Aero ITP Aero is a global leader in aero-engine design, manufacture and maintenance. Alongside the development, manufacturing, assembly and testing of engines, it provides MRO services for regional airlines, business aviation, industrial and defence applications. Progress against our 2019 Group priorities Customers People and Culture Increased civil aviation module delivery: – 20% for Rolls-Royce – 40% for other customers Launched transformation project to drive continued improvement of our operating model: – increased standardisation across Invested in a new facility to offer more the organisation complex engine externals product capability to customers. Certified as only the second company worldwide capable of providing support to the MTR390-E engine. – simplified processes to increase efficiency Held CEO engagement sessions at every ITP Aero site around the globe. Technology Financial Completed aerodynamic testing of the multi-stage intermediate pressure turbine for UltraFan. Demonstrated enhanced additive manufacturing capability: – delivery of shroud segments for the Trent XWB-84K – design of the TP400 rear structure vanes – potential for component weight reduction of up to 40% and significant cost savings. OE sales up 19% led by higher volumes on civil aerospace programmes. Operating margin grew to 11.9%. Investing in capacity expansion in Queretaro, Mexico. Actions to improve manufacturing efficiency, including roll-out of additive layer manufacturing capability at Zamudio, Spain. Underlying revenue mix 2 1 1. OE .................................................................84% 2. Services .......................................................16% 3 2 1 1. Civil .............................................................. 77% 2. Defence .......................................................13% 3. In-Service Support .................................. 10% Underlying revenue £936m 2018: £779m Underlying operating profit £111m 2018: £67m Order backlog £0.9bn 2018: £0.9bn STRATEGIC REPORT 38 Strategic Report Business Review – ITP Aero Rolls-Royce Holdings plc Annual Report 2019 ITP Aero overview 2019 ITP Aero had a strong year. Underlying revenue grew 21% year-on-year, driven by increases in both aftermarket and OE sales for civil aerospace, both on Trent and non-Rolls-Royce engine programmes. Operating profit increased materially to £111m, reflecting revenue growth and improved pricing. ITP Aero’s 2019 performance also benefitted from a change made to simplify its trading relationship and contractual terms with Civil Aerospace. This change was net neutral at Group level. Financial overview Underlying revenue Underlying revenue was £936m, an increase of 21% over 2018. OE growth of 19% was driven by higher engine volumes on civil programmes, with ITP Aero module deliveries up 20% on Trent engine programmes and 40% higher for non-Rolls-Royce programmes. This was partially offset by a reduction in defence sales. Aftermarket revenue increased by 37% due to higher spare parts sales, largely from Rolls-Royce engine programmes. Revenues also benefitted by circa £50m from a change made to simplify ITP Aero’s trading relationship and contractual terms Financial overview £m Underlying revenue Underlying OE revenue Underlying services revenue Underlying gross profit Gross margin % Commercial and administration Restructuring Research and development costs Underlying operating profit Underlying operating margin 2019 936 782 154 206 22.0% (61) (1) (33) 111 11.9% 2018 Change 779 666 113 156 20.0% (57) (2) (30) 67 8.6% +20% +17% +36% +32% +200bps +7% -50% +10% +66% +330bps Organic change +21% +19% +37% +33% +200bps +9% -50% +10% +67% +330bps with Civil Aerospace. This was net neutral at Group level. Underlying operating profit Operating profit increased materially, by 67% to £111m, led by higher gross profit. This increase was driven by higher OE volumes and improved pricing. Profit also benefitted by circa £25m from the change in ITP Aero’s trading terms with Civil Aerospace, with a corresponding negative impact in Group eliminations. C&A costs increased by 9% to £(61)m, and R&D rose by 10% to £(33)m reflecting ongoing investment in aerospace programmes. Operational and strategic review In November, ITP Aero celebrated its 30th anniversary. The business continued to grow, underpinned by strong positions across a range of large commercial aircraft and business jet platforms. In large commercial, we delivered a 20% increase in engine module deliveries for Rolls-Royce widebody programmes and a 40% increase in deliveries to other customers. In business aviation, we continued to see growth through our positions on engine programmes including the PW800 and HTF700. LOSING WEIGHT WITH ADDITIVE LAYER TECHNOLOGY During the year, we completed the design process and began production of the first components manufactured by ITP Aero using additive technology – often referred to as 3D printing. The first parts to emerge are low pressure turbine seal segments for the Trent XWB-84 engine for the Airbus A350 XWB aircraft, and non-structural vanes for the TP400 engine that powers the Airbus A400M military transport aircraft. ITP Aero has an additive layer manufacturing cell and a team of professionals dedicated exclusively to this technology at our facility at Zamudio, Spain. Thanks to investment in collaborative technology development projects, ITP Aero is able to apply in-house standards and specifications to the application of this technology in aircraft engine components that are subjected to high temperatures in-service. The proprietary design criteria used by ITP Aero is expected to result in a component weight reduction of up to 40% as well as generating significant cost savings. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Business Review – ITP Aero 39 Good progress was made during the year in the expansion of production facilities to meet rising demand for ITP Aero products. Investment included a new externals facility in Biscay, Spain, focusing on high technology products, and the extension of the externals facility in Queretaro, Mexico. Both sites are now open and fully operational. In addition to adding new capacity, these facilities will further improve our manufacturing efficiency, driving cost reduction across civil and defence engine programmes. Other significant milestones in 2019 included producing the first components designed and manufactured using additive technology. Our new additive layer manufacturing cell in Zamudio, Spain, manufactured both the low pressure turbine seal segments for the Trent XWB-84 engine and non-structural vanes for the TP400 engine. Additionally, earlier in the year we were certified as only the second provider of servicing globally for the MTR390-E engine for the Tiger helicopter. We also achieved important technology milestones in 2019. In June, the first aerodynamic tests of the intermediate pressure turbine for UltraFan were successfully carried out. UltraFan will be 25% more efficient than the first generation of Rolls-Royce Trent engines and 10% more efficient than the Trent XWB, the most efficient civil large engine in service globally. At the end of the year, we strengthened our board and management, including the promotion of Carlos Alzola to CEO and ITP Aero board member. ITP Aero outlook We expect continued demand growth on newer, more fuel-efficient engine programmes in both narrowbody and widebody aircraft. We are well placed with strong positions on newer Rolls-Royce Trent engines, as well as the Pratt & Whitney 1000G engines and other non-Rolls-Royce programmes. Longer term, we have secured participation in technology projects that will contribute significantly to sustainable aviation and efficient digital transformation of production processes. These include the investigation and maturation of technologies for hybrid electric propulsion (IMOTHEP), within the EU’s Horizon 2020 framework, which is focused on assessing the potential of hybrid-electric propulsion. Following the very strong performance in 2019, we expect to deliver stable sales and margin improvement of 50–100bps in 2020. Longer term the trends outlined above will drive further good growth in profitability and cash flow. Operating environment Rolls-Royce key differentiators ITP Aero will sustain its strong position through the development of advanced, world-leading technology, a culture of partnership with customers and suppliers, our broad programme portfolio and market access, and well-invested global facilities with advanced and efficient manufacturing. Market dynamics — The long-term trends driving demand growth in passenger aircraft remain strong. Growth in air travel is expected to stabilise close to the long-term average of 4–5%. — Through 2019, the market has seen short-term downward pressure on widebody aircraft but the longer-term outlook remains positive. — The short-term prospects in the narrowbody and regional markets accessed through involvement in the PW1000G programme are positive. Growth in those markets is driven by the Airbus A320neo ramp up, a trend towards airlines using the longer range A321 on routes previously served by widebody aircraft and the introduction of new regional aircraft products including Airbus A220 and the Embraer E2 family. — In business aviation, ITP Aero enjoys a route to market as a partner on a number of engine programmes, including the PW800 which powers the Gulfstream G500/600 and Dassault Falcon 6X and the HTF7000 which now also powers the Embraer Praetor 500/600 and Cessna Longitude. Short-term demand in the business aviation sector has softened with the uncertain macro-economic environment but the long-term fundamental drivers are strong. — With defence budgets rising and the emergence of a number of new programmes, there is potential for growth in the sector. Opportunities — Expected growth in widebody installed base driven by Trent engine deliveries. — Expected growth in single aisle installed based on PW1000G engine deliveries. — Expected participation in the next generation European Fighter (FCAS) following Spain joining France and Germany on the programme. Business risks — If our products do not achieve their required technical attributes and maturity, then product performance, customer satisfaction, unit costs and aftermarket costs may be impacted and could result in financial and reputational damage. — If a product failed in service, then this could result in loss of life and significant financial and reputational damage. — If the business suffered a major disruption in its supply chain, then delivery schedules would be delayed, damaging financial performance and reputation. — If customer programmes were to be delayed into service or experience a cut to production rates, then our financial performance might be negatively impacted. — If global defence spending experiences a significant downturn, then our financial performance would be impacted. STRATEGIC REPORT40 Strategic Report Sustainability – Non-Financial Information Statement Rolls-Royce Holdings plc Annual Report 2019 SUSTAINABILITY As a leading industrial technology company, our activities have a significant impact on society and the environment. We understand this impact and use that understanding to inform our strategy and decision making. We believe in the positive power of technology: the products and services we provide play a vital role in connecting, protecting and powering society. The most significant contribution we can make to a more sustainable society is to reduce the environmental impacts of our product portfolio and accelerate the decarbonisation of the sectors in which we operate, in line with global ambitions to mitigate climate change. This is an integral part of our business strategy. Our sustainability approach focuses also on the wider impacts we have on society, including environmental, social, ethical and cultural factors. We know we cannot consider these in isolation of each other. We seek to understand and prioritise the issues that matter most to us and our stakeholders, including employees, investors, and broader society. We identify and prioritise topics in terms of potential impact and also take into consideration our ability to influence the issue. Non-financial information statement The following chart summarises where you can find further information on each of the key areas of disclosure required by the EU Non-Financial Reporting Directive. Environmental matters See pages 41 to 44 Employees See pages 45 to 48 Social matters See page 46 Human rights See page 49 Anti-bribery and corruption See page 49 Related Group policies — Health, Safety & Environment — Security — People — Charitable Contributions & Social Sponsorships — People — Human Rights — Anti-Bribery & Corruption Related principal risks — Climate Change — Safety — Talent and Capability — Safety — Political Risk — Compliance — Our business model provides an insight into the key resources and relationships that support the generation and preservation of value within Rolls-Royce. See pages 12 and 13. — Non-financial key performance indicators allow us to assess progress against objectives and monitor the development and performance of specific areas of the business. These are set out on page 15. — Further information on Group policies can be found on www.rolls-royce.com. — Full details of the Group’s principal risks can be found on pages 50 to 54. — Disclosures in line with the Taskforce on Climate Related Financial Disclosures (TCFD) are detailed on page 41. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Sustainability – Climate Change 41 POSITION ON CLIMATE CHANGE We have an irrefutable role to play in enabling the transition towards a low carbon economy. Successful and just transition will require technological solutions that we are well placed to provide. We have always pursued clean, safe and competitive solutions to deliver society’s vital power needs. Rising global population and increased wealth is driving further demand for power and mobility. Coupled with increased understanding of the potential impacts of climate change, we recognise that future power must be low carbon. Governance Our framework sets out how we govern our business, manage risk and maintain consistent operating standards across the Group. Sustainability and the consideration of climate change is a core component of this. The Safety, Ethics & Sustainability Committee oversees our approach (see pages 105 to 110). Our executive-level environment & sustainability committee, chaired by the Chief Technology Officer, is responsible for environmental and climate-related policy, strategy and co-ordinating related activities. Our independent environmental advisory committee, comprising leading academics from the environmental, materials and climate-related fields, complements our in-house expertise. Strategy Climate change and its associated impacts will play a pivotal role in determining the long-term success of our organisation: it presents a variety of opportunities and risks that drive our strategic decisions. Our ability to develop technological solutions will deliver future competitive advantage over the longer-term (see pages 42 and 43). We have a three-part approach to reducing our environmental impacts, embedded within our business strategy: continuing to pursue incremental improvements of existing products and services; developing novel low carbon technologies, including electrification; and minimising the impacts of our operations and facilities. Managing risk and opportunity We recognise the substantial potential risks and opportunities presented by climate change. These include risks and opportunities associated with both the physical impact of global temperature rises and the transition to a low carbon global economy. The assessment and management of climate-related risk and opportunity is an integral part of our enterprise risk management process (see Principal Risks, pages 50 to 54). During 2019, we continued to review our exposure to climate-related risk, including considering the growing scientific understanding of the potential impacts of climate change, coupled with our position as a manufacturer of complex equipment that is currently heavily dependent on fossil fuels. In light of these changes, we have included the risk of climate change to future revenue growth as an additional principal risk. PREPARING FOR THE FUTURE Understanding how the business may be impacted by climate change is a key component of mitigating longer-term risk. We have used scenario planning techniques to explore the resilience of our business model and strategy in the context of future climate change and the transition to a low carbon global economy. Three scenarios were developed based on varying global temperature increases and societal responses – one of which aligned to the temperature rise limit of 1.5oC set out by the Intergovernmental Panel on Climate Change (IPCC). The outputs from this have been used to inform strategic decision making and risk management. STRATEGIC REPORT42 Strategic Report Sustainability – Technology Rolls-Royce Holdings plc Annual Report 2019 POWERING THE LOW CARBON TRANSITION We are pioneering sustainable power through technology. We continue to invest in improving performance and reducing the impacts of our products and services, as well as developing low carbon technologies for the future. The transition to a low carbon global economy will be dependent on the development of technological solutions that Rolls-Royce is well positioned to provide. We have a long-standing history of pioneering products and services that deliver society’s power and propulsion needs. In 2019, our technology priorities have included: supporting the operation of today’s products through revitalising our service capabilities; continuing the development of a new aero engine architecture to deliver further emissions reductions into the next decade; and continuing to advance our electrification strategy. This balance between continuous efficiency gains and the introduction of novel technologies will help ensure a structured transition to a low carbon global economy. During the year, we invested £1.46bn in gross R&D expenditure, with a total of 830 patents approved for filing. Over two-thirds of this R&D expenditure is dedicated to improving the environmental performance of our products and services. Decarbonising aviation in particular will require cross-sector collaboration: our technologies operate as part of a wider system. During 2019, our Chief Technology Officer brought together counterparts from seven major aerospace companies to announce a joint statement on the future sustainability of aviation, including a commitment to work together pre-competitively to meet industry-level targets for reducing the sector’s CO2 impacts and support the commercialisation of sustainable alternative fuels. Engineering and technology capabilities Our global engineering population supports our research and technology programmes. During the year, we have taken steps to simplify our approach to engineering competencies, enabling more flexibility in skills development and increasing our engineers’ capabilities in systems thinking, electrification and digital. Our global network of 29 University Technology Centres (UTCs) and seven Advanced Manufacturing Research Centres (AMRCs) continue to develop advanced research that can be applied in our technology portfolio and across our manufacturing operations. 830 Patents approved for filing £1.46bn Gross R&D expenditure 2019 Gross R&D expenditure (£m) 6 5 4 3 2 1 1. Rolls-Royce ...........................................1,118 2. UK government ....................................253 3. EU funding ..................................................21 4. US government ........................................37 5. German government ..............................12 6. Other............................................................ 18 A RECORD BREAKER TAKES TO THE SKIES Inside an airport hanger in Gloucestershire, UK a team of engineers, designers and data specialists recruited from inside and outside Rolls-Royce are setting out to make history. During 2019, we began the design and build of a high-speed, fully electric aeroplane unlike any seen before. Scheduled to fly in 2020, the aircraft will reach speeds of over 300mph, making it the fastest all-electric plane in history. This Rolls-Royce project is called ACCEL, Accelerating the Electrification of Flight, and is intended to pioneer a third era of aviation and support our electrification strategy. Through the project we are developing new skills and capabilities in electrical aviation. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Sustainability – Technology 43 SMALL REACTOR, BIG POTENTIAL Rolls-Royce is leading a consortium of world-class companies in designing an affordable, compact nuclear power station to meet increasing demands for low carbon electricity. We believe our compact power station design can make a significant contribution to the UK and other nations’ ambitions to reach net zero carbon emissions by 2050. The UK government’s Research and Innovation agency has granted £18m initial funding, matched by the consortium, to complete vital elements of the preliminary design concept. A full UK programme could create 40,000 UK jobs and generate £52bn value for the economy, with tremendous commercial potential and an estimated global export market worth £250bn by 2050. Revitalising service capabilities Our services packages help our customers to maximise the availability of their engines. With growth of our in-service fleet of engines and power systems, our services innovations have provided significant additional capacity to maintain their operation in field and increase throughput in repair and overhauls. This is particularly important as we continue to work through in-service issues with the Trent 1000. We are increasing the use of digital tools to enhance our service offerings, including using imaging technologies to automate the assessment of the condition of critical engine parts whilst the engine remains on-wing, extending engine availability. This year, we introduced rapid new near-wing component swap procedures, avoiding the need to bring engines into repair and overhaul centres. These new methods were validated and introduced 90% faster than traditional procedure changes. Used engines and parts are collected at each of our centres worldwide. Up to 90% of a used aero engine can now be recycled, reducing our demand for resource intensive, virgin materials. Developing new engine architecture Looking forward, we continue to take big strides towards maturing a new aero engine architecture and related technologies. Our UltraFan design will deliver a 25% reduction in emissions relative to the first generation of Trent engines; an unprecedented efficiency leap. In 2019, we made good progress on a series of important sub-system validations, including testing our advanced organic matrix composite fan system and the world’s most high power aero gearbox, validating operability and thermal efficiency. Advancing electrification Rolls-Royce is leading the transition towards electrification in all our markets. The application of hybrid and electric technologies has the potential to decarbonise our technology portfolio over the longer term, particularly in ground-based transportation and power, and regional aviation. Our self-contained business unit, Rolls-Royce Electrical, has celebrated a number of successes during the year, including: ground testing of our M250- based hybrid electric system for urban air mobility and eVTOL applications; full speed testing of the 2.5 MW generator that, coupled with our AE2100 aero gas turbine, will power the E-Fan X hybrid flight demonstrator in 2021; and making significant progress with the development of all-electric flight technologies within our ACCEL programme. The acquisition of the eAircraft business, from Siemens, has given us a leading position in electrical technologies for aero applications and provides a basis for increasing the delivery of advanced electrical components to a range of customers. Within Power Systems, we are increasing the production of mobile hybrid power systems for rail and marine applications. We are also applying our electrical competencies within our microgrid solutions, which are supporting the accelerated uptake of renewable energy as well as providing vital back-up power and storage. STRATEGIC REPORT44 Strategic Report Sustainability – Impacts from Operations Rolls-Royce Holdings plc Annual Report 2019 IMPACTS FROM OPERATIONS AND FACILITIES Understanding and managing the environmental impact of our operations is a key part of being a responsible and resilient business. We seek to consider and mitigate the environmental impact of our activities and major business decisions. During the year, we have taken steps to strengthen our understanding of materials consumption across our operations, identifying opportunities to optimise use and avoid wastage. Half of our top 20 waste-producing sites have completed waste-mapping reviews, identifying and prioritising areas for improvement with an estimated cost saving of approximately £1.6m identified to date. We continue to invest in installing low carbon and renewable energy sources across our global estates, including completing a solar PV installation in Friedrichshafen, Germany. Coupled with a Rolls-Royce microgrid to provide stability of supply, this installation will deliver 30% of the site’s energy demand, as well as acting as a showcase for our microgrid technology. During 2019, we made significant progress towards our long-term zero carbon operations target, entering into a green power purchase agreement (PPA) part way through the year for all our UK purchased electricity, decreasing our scope 1 & 2 emissions by 21%. At the same time, we have continued to invest in energy efficiency opportunities to reduce our overall power demand, including upgrading lighting and heating systems. CLEANING UP ON COOLANT We continue to strengthen our waste management processes, with a particular focus this year on alternative treatments for liquid waste. Almost all our manufacturing sites rely on using coolant as a vital part of our machining processes. During 2019, we worked with one of our AMRCs to introduce novel technologies to clean and filter ‘used’ coolant, doubling its useable life. This reduces our coolant waste by 50%, contributing to our waste reduction target, as well as decreasing cutting fluid spend. These technologies and improved working practices developed in the UK trial are now being rolled out worldwide. We intend to share this capability with our supply chain. Absolute GHG emissions (ktCO2e) Energy consumption (MWh/£m) Total solid and liquid waste (t/£m) 285 ktCO2e 2030 TARGET 0 2019 2018 2017 2016 2015 2014 BASELINE 89 MWh/£m 2025 TARGET 63 4.22 t/£m 2025 TARGET 285 360 377 395 420 472 2019 2018 2017 2016 2015 2014 89 93 97 98 BASELINE 110 126 2019 2018 2017 2016 2015 2014 BASELINE 3.44 4.22 4.79 4.60 3.99 4.04 4.59 Waste to landfill (000 tonnes) 2.3 kilotonnes 2020 TARGET 0 2019 2018 2017 2016 2015 2014 2.3 2.7 3.6 4.5 BASELINE 6.6 7.8 Target: Achieve zero scope 1 + 2 GHG emissions by 2030 1,2,3 Target: Reduce energy consumption by 50% by 2025 1,2,3 Target: Reduce solid and liquid waste by 25% by 2025 1,2,3 Target: Achieve zero waste to landfill by 2020 1,2 The emissions associated with our operations has reduced by 40% since 2014. This has been achieved through continued decarbonising of our energy systems and increased use of generated or purchased renewable energy. Our energy consumption has reduced by 26% since 2014 as we continue to invest in improving the energy efficiency of our offices and manufacturing facilities. This includes heating and lighting upgrades. Total waste generated in our operations has reduced by 13% since 2014. We continue to focus on identifying opportunities to prevent the creation of waste at source in our manufacturing processes. The amount of waste sent to landfill has reduced by 71% since 2014. This has been achieved through continued investment in waste management improvements and the use of alternative recovery and recycling options. 1 External assurance over the STEM, energy, GHG, waste and TRI rate data provided by Bureau Veritas. See page 203 for their sustainability assurance statement. 2 Data has been reported in accordance with our basis of reporting, available at www.rolls-royce.com/sustainability. Data for prior years has been restated to reflect the disposal of the Commercial Marine business. Data associated with ITP Aero is included in the GHG, energy and total waste targets from 2017 only. 3 Emissions associated with product test and development, critical to ensuring product safety, and power generation are excluded from our GHG target. Statutory GHG emissions data, including emissions from these sources, are detailed on page 209. Our energy and total waste reduction targets are normalised by revenue. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Sustainability – People and Culture 45 PEOPLE AND CULTURE It is through our people that we fulfil our potential, achieve our vision and deliver our strategy. We continue to focus on driving the right culture through embedding our values and behaviours. We are committed to creating the right working environment where each of us is able to be at our best. This continues to be a critical lever in all we do. Progressing our transformation From the outset our transformation programme has been designed as more than a headcount reduction exercise (see page 17). It is a strategic change in our culture, our people, and our ways of working. Embedding our people framework is a core element in achieving this. During 2019, our efforts have focused in three areas: enhancing leadership capability; embedding our values and behaviours; and eradicating bullying and harassment. We have made progress on embedding our values and behaviours through actions like a robust communications campaign, leading activities to engage our population and hosting ‘let’s talk’ sessions (see page 46). Our values and behaviours are now integrated into our processes and systems, including performance management, reward and employee learning. Enhancing our leadership In 2018, we refreshed our enterprise leadership group (ELG) through restructuring, and we continue to refresh the whole leadership population through internal movements and external hiring. During 2019, we introduced our leadership expectations, an extension of our people framework, which provide clear indicators of success for our leaders to live up to our values and behaviours. We continue to refresh our leadership learning and development programmes. This includes updating our core leadership learning programmes, including a licence to operate curriculum, and building key capabilities in coaching, driving performance and being inclusive. This is a critical investment in ensuring our leadership remains fit for the future. Capabilities and skills We work hard to ensure we have the right skills and capabilities in place to execute our strategy. During 2019, we invested £28.7m in employee learning and development (2018: £27.1m), delivering 1.4m hours of 51,700 employees total (monthly average) * 4 56 3 2 1 1. Civil Aerospace ..................................................26,100 2. Power Systems ................................................... 10,400 3. Defence ..................................................................9,900 4 ITP Aero ..................................................................3,900 5. Head office ................................................................100 6. Non-core businesses .......................................... 1,300 Employees in 50 countries (monthly average) * 5 4 3 6 2 1 1. UK ............................................................................23,300 2. Germany ................................................................. 9,800 3. USA & Canada .......................................................7,000 4 Nordics .................................................................... 1,300 5. Spain .........................................................................3,200 6. Rest of World .........................................................7,100 Embedding our people framework Our people framework provides the backbone of our employee development and engagement activities. This is particularly important as we progress our restructuring programme and continue to embed and evolve our culture to support our purpose, vision and strategy. Care Growing capabilities Creating a working environment where each of us is able to be at our best. Key capabilities needed to secure emerging opportunities: — systems integration — electrical engineering — data sciences Growing behaviours Key behaviours needed to secure emerging opportunities: — embrace agility — be bold — pursue collaboration — seek simplicity Core competencies Key competencies needed to safeguard our competitiveness: — engineering pre-eminence — programme management — business acumen Core values Key values needed to safeguard our competitiveness: — operate safely — trusted to deliver excellence — act with integrity * Employee headcount data is calculated as the average number of full time equivalents throughout the year. STRATEGIC REPORT46 Strategic Report Sustainability – People and Culture Rolls-Royce Holdings plc Annual Report 2019 LET’S TALK Between May and September our enterprise leadership group hosted over 110 engagement sessions with small groups of employees selected through a ballot process. These ‘let’s talk’ sessions were introduced to create opportunities for meaningful dialogue with our leadership group. The informal format and small group size allowed people to be seen, heard and understood. These sessions generated valuable insights into how our restructuring and cultural change programmes are landing and how employees see the future. In total, more than 3,000 people took part across 17 sites. training (2018: 1m hours). We have focused on developing skills in business acumen, digital and data sciences, and programme management. Interactive learning opportunities, forums and online platforms have been utilised to develop these capabilities throughout the organisation. We are investing circa £4m in a new learning proposition that brings together all our learning offerings in one place. We continue to acquire talent to support our electrical strategy, including through the acquisition of Siemens’ eAircraft business and the introduction of a specialist learning offering within our Power Systems business. Talent management Developing our talent strategy and future pipelines continues to be a core focus. We have considerably improved succession planning through the implementation of a new talent review process. This has standardised our approach to assessing potential and managing development needs, as well as proactive engagement of external talent, to improve the quality and diversity of our succession planning. In 2018, we began work to launch our career framework, a refreshed approach to the way we manage careers and talent. Our management job levels have been broadened to remove complexity and enable greater movement between roles. In 2019, 1,150 managers were promoted internally (2018: 1,340) and our employee turnover rate remained stable at 7.5% (2018: 7.6%). We have introduced practical tools for managers to help drive their own careers and to better support their teams. This encourages individuals to take more ownership of their personal development. We have also introduced training and tools to enable leaders to have career conversations that offer broader and more agile career development options for all. Employee engagement We believe that positive engagement is a result of our leadership and working environment. Our approach to engagement is founded on the premise that engagement happens locally and should be owned and driven by local teams and leaders. We provide a variety of channels to communicate and engage with our employees and their representatives. This includes employee newsletters, magazines and team briefings, as well as our digital communication channels. We work closely with elected employee representatives through well-established frameworks, including our European Works Council. Our employee forums ensure everyone has the opportunity to contribute their views. This year, we introduced a new employee opinion survey, in partnership with Gallup. This survey is more streamlined, moving from 64 questions to 12, encouraging participation by removing the burden of responding. We ran two surveys during the year as we embedded this new approach and increased our focus on measuring and actioning the results; 58% of employees completed the survey in April, and 72% in November. The results from the surveys are a key measure in our annual bonus plan, see page 15 and 89. We also monitor feedback from current and past employees through Glassdoor, who awarded us #30 on their ‘Best Places to Work in the UK’. Our Chief Executive also ranks #9 on their ‘Top CEOs in the UK’, with an 85% approval rating. STEM and communities Our ability to attract and recruit the right people with the right skills in the future is dependent on there being a pipeline of available talent. To support this we focus on building awareness and engagement in science, technology, engineering and maths (STEM) with young people from an early age, as well as those who may have influence over their future career choices such as teachers, parents and carers. We are now 27% towards our 2030 target to reach 25 million of tomorrow’s pioneers through our STEM programmes, with 1.25m people engaged in STEM activities during 2019 1. These activities vary from individual classroom activities and community group workshops, to flagship initiatives such as the Rolls-Royce science prize. Our broader community investment activities are intended to build positive relationships and engagement opportunities in communities local to our operations, with a focus on environment, education, arts and culture. During 2019, we invested £7m in supporting local communities, including £3.4m in cash contributions and sponsorships. Over 96,000 hours of employee time was committed to community and STEM projects as part of our wider employee engagement approach. 1 External assurance over the STEM, energy, GHG, waste and TRI rate data provided by Bureau Veritas. See page 203 for their sustainability assurance statement. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Sustainability – People and Culture 47 UK PENSIONS REVIEW During 2019, we undertook two actions to manage our pension obligations for current and former UK employees. The Group carries significant post-retirement liabilities on our balance sheet. During the year, we supported the Trustee of the UK pension plan to fully insure liabilities for around 33,000 former employees with Legal & General Assurance Society. This removes future risk for the Group whilst providing former employees with greater certainty over the delivery of their benefits. Our UK pension plan closed to new hires in 2007. In 2019 we consulted on changes to the plan, impacting 2,700 managers. This was undertaken in consideration of increasing future service costs, the balance sheet risk of future pension liabilities, as well as the increasing imbalance of overall reward for UK employees who joined the Company before or after 2007. The proposed changes have been agreed and will take effect from 1 March 2020. The Board supported each of these actions after considering in detail the impact on current and former employees and the financial impact on the Group. Health, safety and wellbeing Ensuring the wellbeing of our people and those who work with us through providing a safe place of work and minimising potential exposure to harm is a key component of our care promise. This year we introduced mandatory HSE training for all managers. Additional leadership training has been conducted for the Executive Team. In 2018, we initiated a programme of comprehensive safety reviews following a series of major and high potential incidents, including two fatalities in 2017. The programme remains on track, with 88% of sites in scope having been reviewed and a systematic approach to managing identified areas for improvement implemented. The objectives of this programme are to identify latent risks across our operations and to assess individual sites’ HSE maturity, providing site based leadership with greater visibility and understanding of hazards, controls and residual risks. LiveWell is our internal global accreditation scheme for site-based wellbeing provisions; this acts as a framework for sites to identify specific health and wellbeing requirements in their workplace, and implement improvements. At the end of 2019, 86% of our sites have achieved LiveWell accreditation, recognising the steps they have taken to support employees in making healthy and sustainable lifestyle choices in the workplace. More than 44,000 employees worldwide have benefited from these workplace interventions. Mental wellbeing continues to receive a high public profile and our analysis confirms this is a significant source of concern for our employees and a cost to the business. In 2019, we introduced a new toolkit to enable teams to assess their workplace mental health and develop action plans to address any concerns. Our mental health champions programme continues to grow and we now have over 580 trained mental health first aiders. For more information on our safety performance, including TRI rates, see the Safety, Ethics & Sustainability Committee Report, pages 105 to 110. Accelerating diversity & inclusion Improving diversity & inclusion remains a strategic priority for the Group. During 2019, we have refreshed our strategy and associated policies and sought to accelerate progress in its implementation. Our approach focuses on four key areas: leadership and governance; attraction and recruitment; retention; and development. We continue to leverage external partners to substantiate our approach, including participation in the Women in Aviation and Aerospace Charter; National Action Council for Minority Engineers; and the General Counsel Diversity Charter. Our Executive Team currently comprises nine members, all of whom are male. The Group has a 2020 gender diversity target for the Executive Team of 23%. The detailed succession plan for the Executive Team currently comprises 44% females (2018: 35%). The Executive Team, Company Secretary and their direct reports comprise 82 individuals, 21 (26%) of whom are female. Currently 20% of our ELG are female (2018: 14.7%), as are half our Board apprentices. In 2019, we revised our diversity & inclusion and anti-bullying and harassment policies to align to our strategy and values and behaviours. Our policies ensure that all employees, regardless of gender, race, religion, physical abilities or any other characteristics, are treated with dignity and respect, and feel safe and empowered to work without fear of bullying and harassment. We give full and fair consideration to all employment applications from people with disabilities and support disabled employees in the workplace, helping them to make best use of their skills and expertise to reach their full potential. For more information on the Board diversity policy, see Nominations & Governance Committee Report, page 78. STRATEGIC REPORT48 Strategic Report Sustainability – People and Culture Rolls-Royce Holdings plc Annual Report 2019 Progress against our 2020 targets We are taking deliberate action to create a more balanced and representative employee population, in which everyone can be at their best. We have targets in place to increase the representation of women at all levels by the end of 2020. These are supported by additional local and business targets to address local diversity challenges. We are currently working towards developing a new set of diversity targets out to 2025, to be published during 2020. Female employee population 1 Female senior manager population 2 2020 TARGET 17% 2020 TARGET 2019 2018 2017 2016 2015 2014 16% (8,300) 15.5% (8,300) 15.1% (7,400) 14.8% (7,400) 15.2% (7,700) 14.8% (8,000) 2019 2018 2017 2016 2015 2014 25% 20% (19) 14.7% (13) 13.6% (18) 11.4% (16) 7.3% (14) 6.7% (12) Female graduate population 3 Female high potentials population 3 Due to the introduction of the new employee engagement survey, Gallup Q12, we no longer measure a separate inclusiveness score. This is now embedded within our broader measures of employee engagement, linked to our remuneration approach. For more information on our employee engagement measure, see KPIs on page 15. 2020 TARGET 2019 2018 2017 2016 2015 2014 30% 30% 26% 23% 24% 26% 25% 2020 TARGET 2019 2018 2017 2016 2015 2014 30% 30% 26% 25% 25% 25% 24% 1 2 Employee headcount data is calculated as the average number of full time equivalents throughout the year. Certain joint ventures are classified as joint operations, 1,300 employees associated with joint operations are not included within our overall headcount or diversity data. Senior manager population for 2018 and 2019 is calculated as Executive Team and ELG population (2019 total: 94, 2018 total: 88), prior years data refers to the senior leadership team that was replaced by the ELG through restructuring in 2018. 3 The graduate and high potentials targets refer to the percentage of employees on these development programmes as at 31 December each year. BUILDING A DIVERSE TALENT PIPELINE We continue to focus on early careers recruitment as an opportunity to bring more diverse talent into the organisation. In 2019, 184 graduates and 353 apprentices joined Rolls-Royce on early career development programmes. These provide a vital pipeline of talent into engineering and other functions, including finance, procurement and project management. Our graduate intake was 32% female (2018: 32%). Apprentice starters were 16% female (2018: 21%), this decline was driven in part by the fact we only recruited engineering apprentices this year. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Sustainability – Ethics and Compliance 49 ETHICS AND COMPLIANCE Maintaining high standards of ethics and compliance are fundamental to our continued success. We work hard to create a working environment where everyone at Rolls-Royce and everyone we work with can be at their best. We are committed to maintaining the highest ethical standards and have a suite of global policies and processes in place to avoid any potential complicity in misconduct. Our Code of Conduct (Our Code) and associated policies set out the values and behaviours we expect everyone to demonstrate. They also provide guidance on how to apply these principles in our daily decisions. In 2019, 99% of managers certified their commitment to adhere to the principles set out in Our Code (2018: 99%). We flow these principles to our suppliers through our Supplier Code of Conduct. All suppliers are contractually required to adhere to this, or a mutually agreed alternative. We encourage speaking up in the event of a question or concern and provide a variety of channels through which to do so. For example, we now have 150 employees trained as local ethics advisors who can act as first point of call. During the year, we have focused on supporting our leadership population in how to listen to someone raising a concern and how to follow up. We have a zero tolerance approach to misconduct of any kind and will take disciplinary action, up to and including dismissal, in the event of a breach of Our Code. In 2019, 85 employees (2018: 59) left the business for reasons related to breaches of Our Code. Anti-bribery and corruption Our Code and associated policies clearly set out our commitment not to tolerate bribery or corruption of any form. In 2019, our ongoing anti-corruption programme focused particularly on managing conflicts of interest and confidential information. This has targeted training for higher-risk teams and individuals. In addition, we have continued to strengthen our anti-bribery due diligence approach. The level of due diligence activity carried out is dependent on the level of risk that a particular third party provides and may include in-person interviews and site visits, as well as external due diligence reports from specialist corporate intelligence providers. We also conduct extensive due diligence into potential joint ventures as well as supporting existing joint ventures in their ethics and compliance programmes. Human rights and anti-slavery Our commitment to protecting and preserving the human rights of our employees, and those whom may be impacted by our business operations or supply chain, is embedded within Our Code, our Human Rights policy and our Supplier Code of Conduct. Our approach to identifying and assessing modern slavery risk is embedded within our broader risk management approach. Due diligence is embedded within our operating systems and processes, including recruitment and procurement processes. More information on our approach can be found in our anti-slavery and human trafficking statement, available at www.rolls-royce.com. For more information on our ethics approach see the Safety, Ethics & Sustainability Committee Report, pages 105 to 110. TREATING OTHERS WITH DIGNITY AND RESPECT This year’s mandatory ethics training focused on treating others with dignity and respect, linked to our anti-bullying and harassment campaign. This comprised individual study and team discussions on real-life cases of bullying and harassment experienced in the Group. 97% of in-scope employees completed the training (2018: 98%). We have strengthened our investigation process for allegations related to bullying and harrassment. During the year, five employees left the organisation as a result of these investigations. STRATEGIC REPORT50 Strategic Report Principal Risks Rolls-Royce Holdings plc Annual Report 2019 PRINCIPAL RISKS Our risk and internal control system The Board has established procedures to manage risk and oversee the risk management system (RMS). The Board has also established procedures to determine the nature and extent of the principal and emerging risks the Group is willing to take in order to optimise its commercial opportunities and achieve its long-term strategic objectives. The Audit Committee reviews the Group’s internal financial controls which form a subset of the broader set of controls, and also reviews the RMS and its effectiveness. During the year, the Board completed a robust assessment of both our principal and emerging risks. Our RMS is designed to identify and manage, rather than eliminate, the risk of failure to achieve business objectives and to provide reasonable, but not absolute, assurance against material misstatement or loss. How we manage risk Risks are identified by individuals across all businesses and functions and at many layers of the organisation by considering what could stop us achieving our strategic, operational or compliance objectives or impact the sustainability of our business model. Risk owners assess the risks, likelihood and impact, taking into account current mitigating control activities, identifying where additional activities may be needed to bring the risk within our risk appetite. Risk owners take into account the effectiveness of current mitigating control activities in their assessment, supported by different assurance providers including internal audit. These considerations are recorded using a variety of systems and tools depending on the risk area. Risk owners bring the results of their assessment, current risk status and action plans to business, function and other management review forums as often as is required depending on the nature of the risk, for support, challenge and oversight. These forums include the monthly Executive Team and regular Board and Board committee meetings. During the year, we continued to refine our risk appetite metrics and to use these more systematically in concluding on the effectiveness of mitigating activities. We also continued to strengthen the controls in place over risks at remote sites. Our plans for 2020 include simplification of our risk policies and guidance and additional support for risk owners in assessing the effectiveness of mitigating control activities. Principal risks Our principal risks are identified and managed in the same way. Principal risks are owned by at least one member of the Executive Team and subject to a deep dive at an Executive Team meeting at least once each year, before a review by the Board or a Board committee. The Board has completed a review of the principal risks and concluded that there are no changes Our risk and internal control system Risk Management Risks facing the business are identified and assessed on a regular basis. Internal control Internal controls are designed and deployed to mitigate these risks to an accepted level. Assurance Assurance activities assess whether the controls are effective and risks are mitigated to an acceptable level in practice. in nature except for the elevation of the risk of climate change as described below. A description of all of the principal risks, how we manage them, the main mitigating control activities, the change in status and how these underpin our priorities is set out on pages 51 to 54. Emerging risks Our emerging risks are also identified and managed this way. As we committed last year, given the additional focus on emerging risks this year, we have introduced additional activities to identify emerging risks. These include workshops, facilitated together with the central strategy team, and the use of an app, developed with digital support by R² Data Labs, to collect insight from diverse stakeholder groups across the organisation. Questions were posed to identify items that could translate into longer-term issues or opportunities, beyond the period considered for viability, that could significantly impact or challenge our current strategy and business model. Any risks identified have been recorded in RMS and are being managed and monitored alongside our existing risks. Following the UK’s exit from the European Union on 31 January 2020, we continue to monitor the potential outcomes for the UK’s future relationship with the EU through our steering group which has remained active during 2019 and will remain active until the outcome is clear and any necessary mitigation plans are in place. We model potential impacts and include these in our assessment of strategic, operational and compliance risks, adjusting mitigation plans where necessary including where we build or hold inventory, testing additional logistics options and reviewing supplier readiness. We ensure regular dialogue takes place with all stakeholders including customers, suppliers, employees, governments and regulatory agencies. The Board is regularly updated on the latest risk assessment and mitigating activities. Growing appreciation of the potential impact of climate change on the environment combined with our position as a global leader in the manufacture, service and operation of assets that are dependent on the use of fossil fuels, has increased our exposure to a wide variety of climate-related risks. In light of this, we have included the risk of climate change to future revenue growth as an additional principal risk. More detail on how we manage this, the main mitigating control activities and how these underpin our priorities is set out on page 52. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Principal Risks 51 2019 Group priorities Change in risk level in 2019 1 3 Customers People and culture 2 4 Technology Financial progress Increased Static Decreased New risk PRINCIPAL RISK OR UNCERTAINTY HOW WE MANAGE IT KEY CONTROLS CHANGE PRIORITY 1 2 3 1 3 4 SAFETY Failure to meet the expectations of: i) our customers to provide safe products; or ii) the people who work for or with us to provide a safe and healthy place of work which minimises the impact on the environment; would adversely affect our reputation and long-term sustainability. We manage product safety by: — Ensuring clear accountability for safety and a culture that puts safety first. — Applying our engineering design and validation process from initial design, through production and into service to reduce the safety risks so far as is reasonably practicable; always ensuring that we meet or exceed the relevant company, legal, regulatory and industry requirements. — Operating a safety management system, governed by the product safety assurance board, and subject to continual improvement based on review of existing and emerging threats, experience, and industry best practice. — Ensuring that our products and those of our suppliers conform to their specifications. — Ensuring that everyone receives appropriate product safety awareness training. We manage people’s safety and wellbeing by: — Ensuring clear accountability for HSE and a culture that puts operating safely first. — Refreshing our global HSE policy and introducing our Zero Harm programme. — Operating an HSE management system, including reporting, investigating and learning lessons from incidents. — Driving sustainable use of resources. This principal is subject to review by the Safety, Ethics & Sustainability Committee. For the safety of our products: — Company product safety assurance committee — Business product safety committee — Quality compliance audit — Engineering technical audit — Crisis management team For people’s safety and wellbeing: — HSE management system — HSE accountability framework — HSE committee — Crisis management team — Environment & sustainability committee BUSINESS CONTINUITY The major disruption of the Group’s operations, which results in our failure to meet agreed customer commitments and damages our prospects of winning future orders. Disruption could be caused by a range of events, for example: extreme weather or natural hazards (for example, earthquakes, floods); political events; financial insolvency of a critical supplier; scarcity of materials; loss of data; fire; or infectious disease. The consequences of these events could have adverse impact on our people, our internal facilities or our external supply chain. — Sustaining investment in adequate capacity, modern equipment and facilities, dual sources of supply and researching alternative materials. — Promoting and developing resilience within our external supplier partners. — Providing a supplier finance programme in partnership with banks to enable our suppliers to benefit from the Rolls-Royce credit rating and access funds at low interest rates. — Building a resilient culture through flexible and collaborative working, using our single Group-wide incident management framework. — Developing, maintaining and regularly exercising effective business continuity and crisis management plans to prepare our people to respond quickly and confidently to any business disruption. — Sharing lessons learned identified through exercises or incidents. — Incident management framework — Business continuity readiness assessment — External supplier audits and robust contractual agreements — Training and exercising in incident response and recovery — Environment & sustainability committee — Scanning the horizon to provide awareness of emerging risks/potential incidents. This principal risk is subject to review by the Audit Committee. STRATEGIC REPORT52 Strategic Report Principal Risks Rolls-Royce Holdings plc Annual Report 2019 PRINCIPAL RISK OR UNCERTAINTY HOW WE MANAGE IT KEY CONTROLS CHANGE PRIORITY 1 2 3 4 1 2 4 3 4 CLIMATE CHANGE Understanding the impact of climate change and our products increases our susceptibility to physical and transitional climate-related risks. We will need to transition our products and services to a lower carbon economy. Failure to consider changes in atmospheric conditions could result in changes in maintenance and overhaul requirements, affecting revenues generated by our in-service fleet and jeopardising the viability of a services-based business model. Failure to transition from carbon-intensive products and services at pace could impact our ability to win future business; achieve operating results; attract and retain talent; secure access to funding; realise future growth opportunities; or force government intervention to limit emissions. COMPETITIVE ENVIRONMENT The presence of competitors in the majority of our markets means that the Group is susceptible to significant price pressure for original equipment or services. Our main competitors have access to significant government funding programmes as well as the ability to invest heavily in technology and industrial capability. Disruptive technologies or new entrants with alternative business models could also reduce our ability to sustainably win future business, achieve operating results and realise future growth opportunities. COMPLIANCE Non-compliance by the Group with legislation, the terms of the DPAs or other regulatory requirements in the heavily regulated environment in which we operate (for example, export controls; use of controlled chemicals and substances; anti-bribery and corruption; and tax and customs legislation). This could affect our ability to conduct business in certain jurisdictions and would potentially expose the Group to: reputational damage; financial penalties; debarment from government contracts for a period of time; and suspension of export privileges (including export credit financing), each of which could have a material adverse effect. — Strategic reviews — Science & Technology Committee — Environment and sustainability committee — Investment in our existing product range to reduce its carbon impact, and in zero carbon technologies to replace our existing products. — Partnering programme to introduce the skills, capability and hunger to rapidly develop class-leading solutions. — Seeking a balanced portfolio of products, customers and revenue streams to reduce our dependence on any one product, customer or carbon emitting fuel source. — Clear communication and acknowledgment of our role in the problem and the solution, and the actions we are taking to enact a credible plan of action in line with societal expectations. This principal risk is subject to review by the Board and the Safety, Ethics & Sustainability Committee. — Horizon scanning for emerging technology and other — Financial competitive threats, including patent searches. — Establishing our Innovation Hub to invest in innovation, manufacturing and production, and ensure continuing governance of technology programmes. — Enhancing our capabilities to access, invest in and develop key technologies and innovative service offerings which differentiate us competitively. — Improving the quality, delivery and durability of our products and services through investment in innovation, manufacturing and production capabilities. — Forming strategic partnerships and conducting joint performance review — Strategic planning process — Investment review committee — Science & Technology Committee — Data Security Committee research programmes with our partners. — Driving down cost to improve margins. — Protecting credit lines. — Strengthening our balance sheet to enable access to cost-effective sources of third party funding. This principal risk is subject to review by the Board. — Taking an uncompromising approach to compliance. — Governance model — Compliance and export control teams — Governance team — Legal team — Operating an extensive compliance programme. Global mandatory policies, processes and training are disseminated throughout the Group and are updated from time to time to ensure their continued relevance, and to ensure that they are complied with, both in spirit and to the letter. — Regular reviews of the strength of relevant teams including the ethics, anti-bribery and corruption, compliance, tax, sustainability and export control teams. — A legal team is in place to manage any ongoing regulatory investigations. — Engaging with all relevant external regulatory authorities. — Implementing a comprehensive REACH compliance programme. This includes ensuring that we and our supply chain are covered by REACH authorisations for a number of chemicals needed for our products, establishing appropriate data systems and processes and working with our suppliers, customers and trade associations. This principal risk is subject to review by the Safety, Ethics & Sustainability Committee. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Principal Risks 53 PRINCIPAL RISK OR UNCERTAINTY HOW WE MANAGE IT KEY CONTROLS CHANGE PRIORITY 1 2 3 1 2 4 4 CYBER THREAT An attempt to cause harm to the Group, its customers, suppliers and partners through the unauthorised access, manipulation, corruption, or destruction of data, systems or products through cyberspace. — Implementing defence in depth through deployment of multiple layers of software and processes including web gateways, filtering, firewalls, intrusion, advanced persistent threat detectors and integrated reporting. — Running security and network operations centres. — Actively sharing cyber security information through industry, government and security forums. — Data Security Committee — IT executive — Product cyber security working groups in high risk areas — Information and product assurance processes. — Information MAJOR PRODUCT PROGRAMME DELIVERY Failure to deliver a major programme on time, within budget, to technical specification or falling significantly short of customer expectations, or not delivering the planned business benefits, would have potentially significant adverse financial and reputational consequences, including the risk of impairment of the carrying value of the Group’s intangible assets and the impact of potential litigation. MARKET AND FINANCIAL SHOCK The Group is exposed to a number of market risks, some of which are of a macro-economic nature (for example, foreign currency, oil price, interest rates) and some of which are more specific to the Group (for example, liquidity and credit risks, reduction in air travel or disruption to other customer operations). Significant extraneous market events could also materially damage the Group’s competitiveness and/or creditworthiness. This would affect operational results or the outcomes of financial transactions. — Training and awareness to improve cyber security culture. This principal risk is subject to review by the Audit Committee through its Data Security Committee. assurance and engineering processes — Crisis management team — Major programmes are subject to Board approval. — Reviewing major programmes at levels and frequencies appropriate to their criticality and performance, against key financial and non-financial deliverables and potential risks throughout the programmes lifecycle. — Investing in facilities and people to manage the level — Rolls-Royce management system — Operational performance review of disruption to our customers from Trent 1000 in-service issues and developing longer-term solutions to these issues. — Project audit and risk assurance reviews — Conducting technical audits at pre-defined points which are performed by a team that is independent from the programme. — Gated business and technical reviews — Requiring programmes to address the actions arising — Quality compliance from reviews and audits and monitoring and controlling progress through to closure. audit — Quality committee — Applying knowledge management principles to provide benefit to current and future programmes. This principal risk is subject to review by the Board. — Maintaining a strong balance sheet, through managing — Financial performance review — Financial risk committee — Operational performance review — Group finance, treasury and tax teams cash balances and debt levels. — Providing financial flexibility by maintaining high levels of liquidity and an investment grade credit rating. — Sustaining a balanced portfolio through earning revenue both from the sale of original equipment and aftermarket services, providing a broad product range and addressing diverse markets that have differing business cycles. — Deciding where and what currencies to source in, and where and how much credit risk is extended or taken. The Group has a number of treasury policies that are designed to hedge residual risks using financial derivatives (foreign exchange, interest rates and commodity price risk). — Review debt financing and hedging in light of volatility in external financial markets caused by external events, such as Brexit or other geopolitical changes. This principal risk is subject to review by the Audit Committee. STRATEGIC REPORT54 Strategic Report Principal Risks Rolls-Royce Holdings plc Annual Report 2019 PRINCIPAL RISK OR UNCERTAINTY HOW WE MANAGE IT KEY CONTROLS CHANGE PRIORITY POLITICAL RISK Geopolitical factors that lead to an unfavourable business climate and significant tensions between major trading parties or blocs which could impact the Group’s operations. Examples include: changes in key political relationships; explicit trade protectionism, differing tax or regulatory regimes, potential for conflict or broader political issues; and heightened political tensions. STRATEGIC TRANSFORMATION Failure to deliver our strategic transformation, including changing our behaviours could result in: missed opportunities; dissatisfied customers; disengaged employees; ineffective use of our scarce resources; and increasing the likelihood of other principal risks occurring. This could lead to a business that is overly dependent on a small number of products and customers; failure to achieve our vision; non- delivery of financial targets; and not meeting investor expectations. TALENT AND CAPABILITY Inability to identify, attract, retain and apply the critical capabilities and skills needed in appropriate numbers to effectively organise, deploy and incentivise our people would threaten the delivery of our strategies, business plans and projects. 1 2 3 4 1 2 3 4 1 2 3 4 — Where possible, diversifying our global operations to avoid excessive concentration of risks in particular areas. — Global government relations network — The Group’s businesses, strategic marketing network and global government relations teams proactively monitoring local situations. — Group tax and export control teams — We develop and maintain relationships with governments and stakeholders and proactively influence policy, regulation and legislation where it affects us. — Steering committee to co-ordinate activities across the Group and minimise the impact of Brexit. — Strategic planning process — Brexit steering committee This principal risk is subject to review by the Board. — Implementing a new organisational operating model. — Executive Team — Focusing on behaviours to drive cultural change. — Gated reviews — Simplifying the processes in our Rolls-Royce management system, whilst ensuring we comply with our legal, contractual and regulatory requirements. — Horizon scanning and scenario planning. — Investing in products with lower emissions, reducing our impact on climate change. — Employee innovation portal. This principal risk is subject to review by the Board and the Safety, Ethics & Sustainability Committee. — Remuneration Committee — Executive Team — ELG — People leadership team — Attracting, rewarding and retaining the right people with the right skills globally and locally in a planned and targeted way, including regular benchmarking of remuneration. — Developing and enhancing organisational, leadership, technical and functional capability to deliver global programmes. — Continuing a strong focus on individual development and succession planning, recognising the changing nature of careers and expectations of work. — Proactively monitoring retirement in key areas and actively managing the development and career paths of our people with a special focus on employees with the highest potential. — Embedding a lean, agile, high-performance culture where everyone can be at their best that tightly aligns Group strategy with individual and team objectives. — Incentivising and effectively deploying the critical capabilities, skills and people needed to deliver our strategic priorities, plans and projects whilst implementing the Group’s major programme to transform its business, to be resilient and to act with pace and simplicity. — Tracking engagement through regular employee opinion surveys and a commitment to drive year-on-year improvement to employee engagement. This principal risk is subject to review by the Nominations & Governance Committee. Rolls-Royce Holdings plc Annual Report 2019 Strategic Report Going Concern and Viability Statements 55 — the Group’s medium and long-term financing plans are designed to allow for periods of adverse conditions in world capital markets but not a prolonged period (say 12 months) where debt markets were effectively closed to the Group and the RCF not available; — that in the event of one or more risks occurring, which has a particularly severe effect on the Group, all potential actions, such as constraining capital spending and reducing or suspending payments to shareholders, would be taken on a timely basis. The Group believes it has the early warning mechanisms to identify the need for such actions and the ability to implement them on a timely basis if necessary; and — that implausible scenarios, whether involving multiple risks occurring at the same time or the impact of individual risks occurring that cannot be mitigated by management actions to the degree assumed, do not occur. GOING CONCERN AND VIABILITY STATEMENTS Introduction Viability Rolls-Royce operates an annual planning process. Our plans and risks to their achievement are reviewed by the Board and, once approved, are cascaded throughout the Group and are used as the basis for monitoring our performance, incentivising employees and providing external guidance to our shareholders. The viability assessment considers solvency and liquidity over a longer period than the going concern assessment. Consistent with previous years, we have assessed our viability over a five-year period which is in line with our five-year medium-term planning process. Inevitably, the degree of certainty reduces over this longer period. The processes for identifying and managing risk are described on pages 50 to 54. As described on these pages, the risk management process, and the going concern and viability statements, are designed to provide reasonable but not absolute assurance. Going concern The going concern assessment considers whether it is appropriate to prepare the financial statements on a going concern basis. The Board has also considered the net liability position at 31 December 2019 and the going concern status of the Group’s material subsidiaries. As described on page 204, the Group meets its funding requirements through a mixture of shareholders’ funds, bank borrowings, bonds and notes. At 31 December 2019, the Group had borrowing facilities of £5.6bn (excluding lease liabilities of £2.4bn) and total liquidity of £6.9bn, including cash and cash equivalents of £4.4bn and undrawn facilities of £2.5bn. £435m of the facilities mature in 2020 (excluding lease liabilities of £340m). The Group’s forecasts and projections, taking into account reasonably possible changes in trading performance, show that the Group has sufficient financial resources. The Directors have reasonable expectations that the Company and the Group are well placed to manage business risks and to continue in operational existence for the foreseeable future (which accounting standards require to be at least a year from the date of this report) and have not identified any material uncertainties to the Company’s and the Group’s ability to do so. On the basis described above, the Directors consider it appropriate to adopt the going concern basis in preparing the Consolidated Financial Statements (in accordance with the Guidance on Risk Management, Internal Control and Related Financial and Business Reporting published by the FRC in September 2014). In making the assessment, severe but plausible scenarios have been considered that estimate the potential impact of principal risks arising over the assessment period, for example: the loss of a key element of the supply chain, the impact on aircraft travel of a global pandemic, a trade war between major trading blocs or worsening or new in-service issues on Civil Aerospace programmes. The scenarios assume an appropriate management response to the specific event, but not broader mitigating actions which could be undertaken, which have been considered separately. The cash flow impacts of these scenarios were overlaid on the five-year forecast to assess how the Group’s liquidity and solvency would be affected. Reverse stress testing has also been performed to assess the severity of scenario that would have to occur to exceed headroom, including a scenario where existing borrowing facilities could not be refinanced as they mature. The assessment took account of the Group’s current funding, forecast requirements and existing committed borrowing facilities. On the basis described above, the Board confirms that it has a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the next five years. In making this statement, the Directors have made the following key assumptions: — that maturing facilities, including the Group’s revolving credit facility (RCF), will be refinanced and the Group is able to drawdown its existing facilities as required; — the Group currently has access to global debt markets and expects to be able to refinance these facilities on commercially acceptable terms; STRATEGIC REPORT56 Strategic report s172 Statement Rolls-Royce Holdings plc Annual Report 2019 s172 STATEMENT The Board believes that, individually and together, they have acted in the way they consider, in good faith, would be most likely to promote the success of the Company for the benefit of its members as a whole, having regard to the stakeholders and matters set out in s172(1)(a–f) of the Companies Act 2006 in the decisions taken during the year ended 31 December 2019. This illustration sets out the Board’s approach to decision making, its stakeholder engagement, why its stakeholders matter and some key decisions made during 2019. To give greater understanding to this, we have provided clear cross-referencing to where more detailed information can be found in this Annual Report. The Board’s approach We remain a particularly active Board, seeking opportunities outside the boardroom to find out what is happening across the organisation Purpose, vision and strategy (see page 10) — clearly articulated purpose recognising our role in society — corporate narrative aligned with both vision and strategy Group policies (see page 40) — annual review of Group policies — new mandatory training introduced in 2019 (see page 1110) Culture and people (see page 45) — review of the culture change agenda (see page 67) — Code of Conduct clearly communicated and enforced (see page 49) — continued support for the people framework (see page 45) Board’s structure (see page 65) — role of the Board and its matters reserved, reviewed annually — clear focus of the Board’s committees, annual review of terms of reference — clearly defined roles and responsibilities for Board members and the Company Secretary ‘freedom within a framework’ (see page 61) — communication of freedom within a framework culture — Rolls-Royce management system simplification — new decision rights model Risk and internal control framework – see page 50 — all risks and mitigating actions subject to a detailed annual review at Board level (see pages 68 and 80) — reviewed process for the preparation of both going concern and viability statements (see page 55) Rolls-Royce Holdings plc Annual Report 2019 Strategic Report s172 Statement 57 OUR PURPOSE At Rolls-Royce we pioneer the power that matters to connect, power and protect society DELIVERED WITH INTEGRITY We discuss how we maintain high standards of ethics and compliance and their fundamental importance to our continued success on page 49 Our stakeholder engagement Our activities are global and complex. Touching upon a wide variety of stakeholders, we aim to create trusted relationships to understand the needs of all our stakeholders so we can continue to deliver value and build a resilient business See page 70 for the Board’s engagement with our stakeholders. See page 12 for our business model Customers Focusing on the needs of our customers is critical to the success of our business. We maintain a high degree of customer intimacy in order to anticipate and understand the future power needs of our customers, building on our years of experience in delivering for our markets. We collaborate and innovate with our customers to improve product performance and value Investors Continued access to capital is vital to the long-term performance of our business. We work to ensure that our investors and investment analysts have a strong understanding of our strategy, performance, ambition and culture Employees Employee engagement is critical to our success. We work to create a diverse and inclusive workplace where every employee can reach their full potential and be at their best. We engage with our people to ensure we are delivering to their expectations, supporting wellbeing and making the right business decisions. This ensures we can retain and develop the best talent Our principal decisions during 2019 More discussion on these decisions can be found in the Board focus on page 67 UK pensions review (see pages 47 and 67) — transfer of certain pension risk liability and balance sheet impact — changes to the defined benefit pension scheme for UK managers Climate change impact (see pages 52 and 68) — elevation of risk of climate change to future revenue growth New midsize airplane platform (NMA) — withdrawal from engine competition to power Boeing’s NMA platform (see page 67) — continue to focus on our UltraFan demonstrator programme (see page 26) Trent 1000 mitigation actions (see pages 8 and 68) — strong focus on customer and accounting impact of technical and operational challenges including risks to the programme — increased stock of spare engines and accelerated growth in the MRO network to meet long-term servicing demands Partners Our external supply chain and our suppliers are vital to our performance. We engage with them to build trusting relationships from which we can mutually benefit and to ensure they are performing to our standards and conducting business to our expectations Enhanced capital allocation discipline — set as a 2019 priority (see page 7) — agreed approach and overview of capital allocation as part of our freedom within a framework culture (see page 61) — strengthening the balance sheet and monitoring our credit rating risk (see page 17) Communities We are committed to building positive relations with the communities in which we operate. We support communities and groups, local and relevant to our operations, particularly educational outreach Governing bodies and regulators We engage with national governments, national/transnational agencies and key politicians and regulators to ensure that we can help shape policy, have licence to operate, attract funding, enable markets and ultimately win business. We work with governments globally where we have operations or future business opportunities Payments to shareholders — continued policy and recommendation to shareholders of final shareholder payment (see page 5) Strategic Report signed on behalf of the Board Warren East Chief Executive 28 February 2020 STRATEGIC REPORT58 Directors’ Report Compliance with the Code Rolls-Royce Holdings plc Annual Report 2019 DIRECTORS’ REPORT Our focus on the UK Corporate Governance Code 2018 Compliance with the UK Corporate Governance Code 2018 The Company is subject to the principles and provisions of the UK Corporate Governance Code 2018 (the Code), a copy of which is available at www.frc.org.uk. For the year ended 31 December 2019, the Board considers that it has complied in full with the provisions of the Code with the exception of provision 32 regarding Irene Dorner’s appointment as Chairman of the Remuneration Committee. An explanation of this can be found on page 59. Composition, Succession and Evaluation — We have a clear process when considering appointments to the Board (see page 77). — As part of our focus on succession planning, we review the skills and attributes required. — Our Board biographies and related charts demonstrate the skills, experience and knowledge of our Directors (see pages 62 to 64). — In 2019, Belinda Hudson Limited carried out an annual evaluation of the Board. The methodology and progress can be found on page 74. Board Leadership and Company Purpose — We believe our Board is particularly active. Our Directors’ report provides examples of our leadership and engagement with our stakeholders (see page 70). — We developed the corporate narrative during the year to further define and articulate the Group’s purpose (see page 67). — Our transformation programme is designed to ensure we have the right resources and skills to execute our strategy (see pages 45 and 67). — Our Code and associated policies ensure our workforce can meet our expected values and behaviours. We encourage speaking up through our Ethics Line (see page 49). Remuneration — Our remuneration policy has been revised this year and will be put to the shareholders for approval at our 2020 AGM. Key changes are set out on page 89 and clear links to our KPIs can be found on page 14. — The Remuneration Committee, comprising only NEDs, is responsible for developing the policy and determining executive and senior management remuneration. This is discussed in the Remuneration Report on page 85. — No Director is involved when deciding their own remuneration outcome. Division of Responsibilities — We clearly define the roles of the Chairman and the Chief Executive and fully support the separation of the two roles. — The Board believes it operates effectively with the appropriate balance of independent Non- Executive Directors (NEDs) and executive directors (see pages 62 to 64). — When considering external appointments for our NEDs, prior Board approval is required to ensure there is no compromise on time commitment (see page 77). — Our Board evaluation highlighted the quality of the information provided to the Board (see page 74). Audit, Risk and Internal Control — We recognise the importance and benefits of ensuring both the internal audit function and the external auditors remain independent. See pages 83 to 84. — The Board presents a fair, balanced and understandable (FBU) assessment of the Company’s position and prospects. To enable us to do so, the Audit Committee review the processes used to prepare and verify the FBU statement (see page 81). — Our risk and control environment is reviewed by the Audit Committee. The Board considered both emerging and principal risks during the year (see page 68). Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Chairman’s Introduction 59 CHAIRMAN’S INTRODUCTION TO DIRECTORS’ REPORT This means that all our employees are enabled to act with integrity and are able to speak up via our Ethics Line and to call on the support of their local ethics advisers. The Board reviewed the speak-up cases reported through the Ethics Line twice during the year. These are the subject of prior review by the Safety, Ethics & Sustainability Committee, who support the Board in our deliberations in this area. You can read more about this on pages 67 and 1110. HSE, occupational safety and wellbeing remain priorities for the Group. Whist there was improvement in some areas of the business, we were disappointed that the overall total reportable injury (TRI) rate remained flat year-on-year. This will be an area of particular focus in 2020. Product safety has been an important issue for our industry this year. We have focused on our product safety training and on how safety risk is managed through a time of transformation. We continue to pursue our goal of continuous product safety improvement – this is fundamental to our licence to operate and to the sustainability of our business. For more information on D&I and employee engagement see People and Culture on page 45. Board developments We are very sorry that Ruth Cairnie stepped down from the Board at the end of 2019 to allow her more time to focus on her other commitments, following her appointment as chair of Babcock International Group PLC. Following Ruth’s departure, Irene Dorner was appointed as Chairman of the Remuneration Committee, with effect from 1 January 2020. While we note the Code requirement that remuneration committee chairs should have served on a remuneration committee for at least 12 months prior to their appointment, we have every confidence that Irene has the appropriate experience and skills to carry out the role. She formally joined the Remuneration Committee on 1 August 2019. Irene is Employee Champion on the Board, a role she has held for three years. Her role on the Audit Committee over the last four years gives her excellent insights into the financial performance measures and targets for the long and short-term incentive schemes. She has also attended six Remuneration Committee meetings since joining the Board and is therefore familiar with the discussions and workings of the Committee. Irene also has experience of HR SIR IAN DAVIS Chairman Introduction In early 2019, we considered the key trends in UK governance and this created a background for our discussions throughout the year. We recognised the increasing emphasis on corporate purpose, culture, risk and the scrutiny of financial, audit and ethical integrity. Environmental, social and governance (ESG) issues are areas of increasing importance to investors and society. There are more calls for democratisation of companies and boards particularly through emphasis on worker engagement and transparency of everything. We have responded by clearly articulating our purpose, with supporting communications to all key stakeholders. We have reviewed our plans to manage and mitigate our risks and we have found ways of assessing and calibrating culture and behaviours, maintaining focus through a period of transformation and restructuring. We have also spent time ensuring that our accountabilities and expectations are clearly articulated internally under our ‘freedom within a framework’ concept (see page 61). Diversity & inclusion (D&I) remain a priority. We have high ambitions but also clear targets which are tracked by the Board to ensure they are achieved. Each member of the Executive Team has personal accountability for diversity in their own area. The Board is temporarily not meeting our stated Board diversity policy objective but we have a very clear aim to rectify this. We remain a particularly active Board. We seek opportunities outside the boardroom to find out what is happening across the organisation and gain assurance that the Group is operating responsibly and effectively. You will see examples of this as you read through the Directors’ Report. Corporate culture We continue to create a working environment where every employee at Rolls-Royce is able to be at their best. As a Board, we take every opportunity to assess progress and impacts on culture and behaviour. This has included how we look at talent and succession (see page 77), governance initiatives (page 78), diversity and inclusion, employee engagement and our career framework (pages 67 and 71) in the Directors’ Report and the People and Culture report on page 45. We rolled out anti-bullying and harassment training across the Group in reaction to a trend that was beginning to emerge from feedback to our Ethics Line in 2018 (see page 49). Lord Gold presented his final report to the Serious Fraud Office in August 2019, in which he noted the exemplary progress made in improving the Company’s approach to ethics and anti-bribery and corruption compliance. This concludes Lord Gold’s work with us and I would like to thank him for his diligence and commitment which has helped us shape our ethics and compliance programmes. We are committed to continuing our communication and training to employees as well as our monitoring and assurance work. DIRECTORS’ REPORT60 Directors’ Report Chairman’s Introduction Rolls-Royce Holdings plc Annual Report 2019 in her executive career having spent two years as general manager, human resources for a UK unionised workforce of 55,000 at HSBC. Irene joined Ruth to consult with shareholders on the remuneration policy that will be voted on by shareholders at the 2020 AGM and both attended the joint briefing during the year on wider workforce engagement (see page 86). Irene stepped down from the Audit Committee in December 2019. Ruth’s unexpected departure from the Board temporarily left us short of our own Board diversity targets. However, I am pleased that we have recently announced the appointment of Dame Angela Strank, currently chief scientist and head of downstream technology at BP and a member of their executive management team. Dame Angela will join our Board on 1 May 2020. Brad Singer also stepped down from the Board in December 2019. As a partner and chief operating officer of ValueAct Capital, he offered a valued external perspective during his time as a Director. We have continued to push for increased financial and accounting transparency and the reports that follow demonstrate this. We have enhanced our Board expertise on finance and accounting with the appointment of George Culmer in January 2020. Nick Luff will take over as Chairman of the Audit Committee following the 2020 AGM The Audit Committee looks at our principal risk regarding cyber threat and has formed a sub-committee focused on data security, on which both Nick and George sit. The sub-committee met for the first time in January 2020 and the Audit Committee look forward to hearing their insights during the course of the coming year. We have decided to retain both Lewis Booth and Sir Frank Chapman for a further period. This is discussed on page 77. ESG We have raised the profile of environmental and sustainability issues and aligned the transparency on these issues across the Safety, Ethics & Sustainability Committee and the Science & Technology Committee, as we said we would do last year. We also held our first ESG event in April with investors, on which you can read more on page 78. Sir Frank Chapman and I also attended executive-level committee meetings on the environment and sustainability, enabling us to gain deeper insights while visibly supporting management’s goals in these areas. Our purpose clearly reflects the important role we play in society with pioneering sustainable power (see page 10). Governance While the Directors have always engaged with and had the best interests of all our stakeholders at the centre of our discussions, the revisions to the Code in 2018 have brought the reporting into more focus and our activities as a Board are reported on page 67. In addition, each of our Non-Executive Directors does much to contribute and represent Rolls-Royce as they go around the world. We have continued with our governance agenda and gave particular focus in 2019 to our internal governance, developing and articulating our freedom within a framework concept. This defines the framework in which the businesses have the maximum freedom, responsibility and accountability for their performance. Within this are a set of core non-negotiables including common safety standards, Our Code and mandatory Group policies as well as our common approach to talent and performance management and processes, reward and career development. A key element of our transformation programme has been the simplification of the Rolls-Royce management system and the Board’s focus has been to ensure that the key principles which keep our products safe are retained. The framework supports the management focus on culture and behaviours by reinforcing the need for simplification and stripping out unnecessary duplication and bureaucracy, making accountabilities and expectations clear. You can read more about our framework on pages 61 and 78. Looking forward We will continue to focus on culture and behaviour as we look to stabilise the operational performance of the business and our cost base. While we pride ourselves on innovative governance, what drives us is the need for governance to fit the needs of the business and to ensure we add value in all that we do. We will continue to do this throughout 2020. Sir Ian Davis Chairman Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Chairman’s Introduction 61 FREEDOM WITHIN A FRAMEWORK The Executive Team has defined the framework in which the Businesses have the maximum freedom, responsibility and accountability for their performance. The framework sets out how we are organised as a Group. Having the framework in place enables us to manage risk, drive critical business decisions and maintain standards across the Group. It means we can act with pace and confidence in a way that meets the expectations of our stakeholders. The framework sets out the roles of the businesses, the Head Office, Group Businesses Services and the Innovation Hub and defines what we mean by empowered businesses. Our people section sets out the capabilities, behaviours, competencies and values which enable us to deliver our strategy. The governance model clarifies decision-making rights and points of accountability and includes a tool for all key decision-makers to access, to support them in their decision-making. It includes details of all governance bodies and decision-making committees within the Group that they may need to consult or seek approval from. It also provides access and an overview of our mandatory Group policies which define the requirements for all our people when they are carrying out their day-to-day activities, and sets out our risk management and internal control systems and assurance activities. The Rolls-Royce management system (RRMS) promotes end-to-end value stream processes that standardise and simplify the way we deliver products and services across the Group – and it is an important strand in our governance of product safety. Together, these are set within the context of our vision and strategy and also link to our business model. All our people can see how everything joins together and how they are contributing to one of the world’s leading industrial technology companies, connecting, powering and protecting society. You can read more about our framework on pages 60 and 78. Board Executive Team Head Of�ce Civil Aerospace ITP Aero Power Systems Defence Group Business Services Innovation Hub Our Purpose Our Vision and Strategy Role of the Group and the Business Business Model Our People Governance Model Decision Rights Group Policies Rolls-Royce management system (RRMS) DIRECTORS’ REPORT62 Directors’ Report Board of Directors Rolls-Royce Holdings plc Annual Report 2019 BOARD OF DIRECTORS 1 2 3 1. SIR IAN DAVIS Chairman of the Board Chairman, Nominations & Governance Committee NG Appointed to the Board in March 2013 and as Chairman in May 2013. Career Sir Ian was a partner at McKinsey for 31 years and, during his time, served as chairman and worldwide managing director. Sir Ian was knighted in 2019 for services to business. Board skills and experience Sir Ian brings significant financial and strategic experience and has worked with and advised global organisations and companies. This enables him to draw on knowledge of diverse issues and outcomes to assist the Board. Other principal roles BP p.l.c., senior independent director; Johnson & Johnson Inc., non-executive director; McKinsey & Company, senior partner emeritus 2. WARREN EAST CBE Chief Executive Appointed to the Board in January 2014 and as Chief Executive in July 2015. Career Warren is an engineer and joined ARM Holdings plc in 1994 where he was CEO from 2001 until 2013. He is a fellow of the Institute of Engineering and Technology; the Royal Academy of Engineering; the Royal Society; and the Royal Aeronautical Society. He was awarded a CBE in 2014 for services to the technology industry. Board skills and experience Warren brings a deep understanding of technology and developing long-term partnerships. He also has proven strategic and leadership skills within a global business and a strong record of value creation. Other principal roles ASML Holdings NV, member of the supervisory board (with effect from 22 April 2020) 3. STEPHEN DAINTITH Chief Financial Officer Appointed in April 2017. Career Stephen is a chartered accountant. His previous roles include CFO of Daily Mail and General Trust plc from 2011 to 2017. He was CFO and COO of Dow Jones in New York and CFO of News International in London, both part of News Corporation. Prior to this, he held executive positions at British American Tobacco p.l.c. Board skills and experience Stephen has a strong understanding of international business and an appreciation for looking beyond numbers to help improve performance. His change management experience allows him to make a significant contribution to the long-term growth of the business. Other principal roles 3i Group plc, non-executive director Composition of the Board (at 28 February 2020) Board skills and experience Board members by gender Balance of the Board Female 3 Executive Directors 2 11 11 8 8 8 8 6 6 6 6 3 3 Number of Directors with: ■ Chairman/CEO/CFO experience Number of Directors with: ■ Related industry/operational ■ Chairman/CEO/CFO experience ■ Financial ■ Related industry/operational ■ Engineering/technology ■ Financial ■ Safety/regulatory/risk ■ Engineering/technology ■ Safety/regulatory/risk ■ Remuneration/HR ■ Remuneration/HR Male 9 Non-Executive Directors 10 Board members by nationality * Non-Executive Directors’ tenure German 1 Singaporean 1 American 1 6–9 years 5 0–3 years 3 3–6 years 2 * According to the Company’s Articles, at least 50% of our Directors must be British citizens. British 9 Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Board of Directors 63 4 7 5 8 6 9 4. LEWIS BOOTH CBE Independent Non-Executive Director Chairman, Audit Committee NG A R Appointed in May 2011. Career After gaining a bachelor of engineering degree with honours in mechanical engineering, Lewis began his career with British Leyland. He spent 34 years at Ford Motor Company including as executive vice president and CFO. He was awarded a CBE in 2012 for services to the UK automotive and manufacturing industries. Board skills and experience Lewis has considerable financial expertise and experience, of great benefit to both the Board and in his role as Chairman of the Audit Committee. He brings a global perspective and is recognised as one of the strongest and most experienced international leaders in his sector. Other principal roles Mondelez International Inc., director 5. SIR FRANK CHAPMAN Independent Non-Executive Director Chairman, Safety, Ethics & Sustainability Committee NG SES ST Appointed in November 2011. Career Sir Frank is a chartered engineer. With more than 40 years spent in the oil & gas sector, he was chief executive of BG Group plc for 12 years and chairman of Golar LNG Limited. He is a fellow of the Royal Academy of Engineering, the Institute of Mechanical Engineers and the Energy Institute. He was knighted in 2011 for services to the oil & gas industry. Board skills and experience Sir Frank has an outstanding record of business achievement, a life-long passion for engineering and innovation and a deep understanding of technology. His significant industrial and safety experience are invaluable to the Board and its committees. 6. GEORGE CULMER Independent Non-Executive Director NG A SES Appointed in January 2020. Career George is a chartered accountant. Having started his career with Coopers & Lybrand, he has held senior financial positions with Prudential, Zurich Financial Services and RSA Insurance Group where he was chief financial officer. Until August 2019, George was CFO at Lloyds Banking Group, a position he held for 7 years. Board skills and experience George has significant experience gained in large, international, highly regulated groups and has proven business leadership credentials. Together with this, he brings to the Board and its committees change leadership and transformation experience gained from within complex groups. Other principal roles NextDecade Corporation, non-executive director; Myeloma UK, vice chairman Other principal roles Aviva plc, senior independent non-executive director NG R SES 8. BEVERLY GOULET Independent Non-Executive Director Employee Champion, North America NG A R 9. LEE HSIEN YANG Independent Non-Executive Director NG A SES 7. IRENE DORNER Independent Non-Executive Director Chairman, Remuneration Committee Employee Champion Appointed in July 2015. Career Irene was CEO and president of HSBC, US until retiring in 2014. During her 30-year career with HSBC, she held a number of international roles including CEO of HSBC in Malaysia. Irene is an honorary fellow of St Anne’s College Oxford. She qualified as a barrister-at-law in London and from 2015 to 2016, was a consultant at PwC. Board skills and experience With a strong background in risk management, gained from the financial sector, Irene brings valuable insight as part of her role on our Board committees. As a passionate advocate of diversity & inclusion, she has embraced the role of Employee Champion and ensures the views of the workforce are properly reflected in the Board’s discussions. Other principal roles Taylor Wimpey, chair; AXA SA, director; Control Risks Group, chair Appointed in July 2017. Career Beverly, a US national, started her career as a securities and M&A lawyer and has spent a considerable amount of her career in the airline industry. From 1993, Beverly was a key member of the executive team of American Airlines where she served in a number of senior roles. Board skills and experience Beverly brings valuable knowledge and operational experience gained from within the airline sector. Together with her expertise in finance, treasury, strategy, legal and governance matters, she actively takes part in the development and strengthening of our business. Other principal roles Xenia Hotels and Resorts Inc., non-executive director; Texas Women’s Foundation, board member; American Airlines Federal Credit Union, board chair; Rolls-Royce North America Holdings, Inc., board member Appointed in January 2014. Career A Singaporean, Hsien Yang was chief executive of Singapore Telecommunications Limited for 12 years. He was a former member of the Rolls-Royce International Advisory Board, he served as chairman and non-executive director of Fraser and Neave Limited from 2007 to 2013 and Chairman of the Civil Aviation Authority of Singapore. Board skills and experience Hsien Yang combines a strong background in engineering with extensive international business and management experience in a key market for the Company. His significant industrial and financial skills prove valuable in his committee memberships. Other principal roles INSEAD South East Asia Council, president DIRECTORS’ REPORT64 Directors’ Report Board of Directors Rolls-Royce Holdings plc Annual Report 2019 10 13 12 Key NG Nominations & Governance Committee A Audit Committee R Remuneration Committee SES Safety, Ethics & Sustainability Committee ST Science & Technology Committee 11 14 10. NICK LUFF Independent Non-Executive Director NG A SES Appointed in May 2018. Career Nick is a chartered accountant. He is chief financial officer of RELX plc, playing a key role in driving shareholder returns as the company transforms its business and simplifies its corporate structure. Nick was previously CFO of Centrica plc for seven years and, prior to that, P&O Group. Nick has formerly been audit committee chairman and a non-executive director of both Lloyds Banking Group plc and QinetiQ Group plc. Boards skills and experience Nick has broad financial skills and a track record of driving business performance. In addition, he has extensive non-executive experience. This exposure together with both financial and accounting expertise and a passion for engineering is invaluable to the Board. 11. SIR KEVIN SMITH CBE Senior Independent Director Chairman, Science & Technology Committee NG R ST Appointed in November 2015. Career Sir Kevin was group chief executive of GKN plc for nine years. Before GKN, he spent nearly 20 years with BAE Systems in a number of senior executive positions. He has an honorary fellowship doctorate from Cranfield University and is an honorary fellow of the University of Central Lancashire. He was awarded a CBE in 1997 and knighted in 2006 for services to industry. Board skills and experience Sir Kevin has extensive industrial leadership experience and a deep knowledge of engineering and manufacturing businesses, as well as the aerospace industry. He makes a significant contribution to the growth and development of our key strategies, both as a member of the Board and as Chairman of the Science & Technology Committee. 12. PAMELA COLES Company Secretary Chief Governance Officer Appointed in October 2014. Career Pamela is a fellow of The Chartered Governance Institute. She joined Rolls-Royce from Centrica plc, where she was head of secretariat. Pamela’s previous roles also include group company secretary and a member of the executive committee at The Rank Group plc and company secretary and head of legal at RAC plc. Skills and experience Pamela is an expert in corporate governance and company law. With a pragmatic approach to how the Governance Team supports the business, she has been instrumental in supporting the Chairman and the Non-Executive Directors to build strong relationships with the management team and has been able to offer advice and guidance on a wide range of topics. Other principal roles RELX plc, chief financial officer Other principal roles L.E.K. Consulting, European advisory board member Other principal roles E-ACT, non-executive director 13. JASMIN STAIBLIN Independent Non-Executive Director NG ST 14. DAME ANGELA STRANK Independent Non-Executive Director NG SES ST Board committee membership * Appointed in May 2012. To join the Board in May 2020. NG A R SES ST Career A German national, Jasmin was the CEO of Alpiq Holding AG from 2013 to 2018. Prior to this, she held a number of senior positions in the ABB Group working in Switzerland, Sweden and Australia, becoming CEO of ABB Switzerland from 2006 until 2012. Board skills and experience Jasmin combines a strong background in advanced engineering and deep technology knowledge with extensive international business experience in the industrial sector. With a background dominated by science and technology, she makes a significant contribution both to the Board and as a member of the Science & Technology Committee. Other principal roles Zurich Insurance Group, non-executive director; NXP Semiconductors N.V., non-executive director; Georg Fischer AG, non-executive director Career Dame Angela is a chartered engineer and is currently chief scientist and head of downstream technology at BP and a member of their executive management team. She joined BP in 1982 and has held a number of senior executive roles. She is a fellow of the UK Energy Institute, the Institute of Chemical Engineers, the Royal Academy of Engineers and the Royal Society. Dame Angela received a DBE in 2017 for services to the oil & gas industry and for encouraging women into STEM careers. Skills and experience Dame Angela brings a proven track record in managing engineering operations and technology and digital research and development programmes. She is a recognised role model for women in both the energy industry and STEM careers in business and industry. Other principal roles Severn Trent plc, non-executive director Sir Ian Davis C Lewis Booth C Sir Frank Chapman C George Culmer Irene Dorner Beverly Goulet Lee Hsien Yang Nick Luff Sir Kevin Smith Jasmin Staiblin C Chairman * at 28 February 2020 C C Full Directors’ biographies can be found at www.rolls-royce.com Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Corporate Governance 65 CORPORATE GOVERNANCE The Board The role of the Board Key matters reserved to the Board The Board is ultimately responsible to shareholders for the direction, management, performance and long-term sustainable success of the Company. It sets the Group’s strategy and objectives and oversees and monitors internal controls, risk management, principal risks, governance and viability of the Company. In doing so, the Directors comply with their duties under section 172 of the Companies Act 2006 (see page 56). The Board has established certain principal committees to assist it in fulfilling its oversight responsibilities, providing dedicated focus on particular areas, as set out below. Each committee chairman reports to the Board on the committee’s activities after each meeting. In addition to the Board’s principal committees, it has established a sub-committee of Directors who each hold an appropriate level of UK national security clearance for the purpose of receiving and considering, on behalf of the Board, any UK classified information relating to the Group’s programmes and activities. Beverly Goulet, a US national and independent Non-Executive Director, also sits on the board of Rolls-Royce North America Holdings, Inc. to create a link between the Board and the Group’s North American governance structure. The Group’s long-term objectives, strategy and risk appetite The Group’s organisation and capability Stakeholder engagement Overall corporate governance arrangements including Board and committee composition, committee terms of reference, Directors’ independence and conflicts of interest Internal controls, governance and risk management frameworks Changes to the corporate or capital structure of the Company Annual Report and financial and regulatory announcements Significant changes in accounting policies or practices Annual budgets and financial expenditure and commitments above levels set by the Board Overview of speak up cases reported through the Ethics Line The Board committees Nominations & Governance Committee Audit Committee Remuneration Committee Safety, Ethics & Sustainability Committee Science & Technology Committee Board and committee composition Financial reporting Remuneration policy Product safety Technology strategy Board nominations Succession planning for Directors and senior management Internal controls and risk management Internal audit Corporate governance External audit Oversight of principal risk – talent and capability Oversight of principal risks – business continuity, market and financial shock, cyber threat Incentive design and setting of targets Executive and senior management remuneration review Workforce remuneration review and related policies HSE Sustainability Cross-sector technology Technology capabilities and skills Ethics and compliance Technology trends and risks Oversight of principal risks – safety, compliance, climate change, strategic transformation Roles and responsibilities The roles of the Chairman and Chief Executive are clearly defined and the Board supports the separation of the two roles. The Chairman is responsible for the leadership and effectiveness of the Board. The Chief Executive is responsible for the running of the Group’s business and leads the Executive Team which comes together to communicate, review and agree on issues and actions of Group-wide significance. Non-Executive Directors support the Chairman and provide objective and constructive challenge to management. The Senior Independent Director (SID) provides a sounding board for the Chairman and serves as an intermediary for the Chief Executive, other Directors and shareholders when required. The Company Secretary makes sure that appropriate and timely information is provided to the Board and its committees and is responsible for advising and supporting the Chairman and Board on all governance matters. All Directors have access to the Company Secretary and may take independent professional advice at the Company’s expense in conducting their duties. DIRECTORS’ REPORT 66 Directors’ Report Corporate Governance Rolls-Royce Holdings plc Annual Report 2019 Board and committee meetings held in 2019 R ST SE R A A NG B B B ST R NG A B A B SE R A NG B ST R NG B B ST R A NG B SE R A NG B February March April May June July August September October November December R Remuneration Committee R B Denotes unscheduled meeting R B January Key B Board NG Nominations & Governance Committee SE Safety, Ethics & Sustainability Committee A Audit Committee ST Science & Technology Committee At the end of most scheduled meetings, the Chairman holds meetings with the Non-Executive Directors without the Executive Directors or management present. The Remuneration Committee also held an unscheduled meeting in February to follow up on discussions at the January meeting regarding executive reward. Two additional scheduled meetings of the Audit Committee were added to the 2019 calendar, one additional meeting ahead of both the 2018 preliminary and 2019 interim results, to ensure the Committee was appropriately briefed ahead of time. The Board held an unscheduled meeting in March to review the future opportunities for ITP Aero and in October to follow up on discussions raised at the meeting in September. Non-attendance Board members are sometimes unable to participate in certain Board and committee meetings due to other business commitments. For 2019, attendance was 100% for all directors. However, if any Directors were unable to attend a meeting, they would communicate their opinions and comments on the matters to be considered via the Chairman of the Board or the relevant committee chairman. Board and committee members and attendance at scheduled meetings in 2019 Sir Ian Davis Warren East Stephen Daintith Lewis Booth Ruth Cairnie (stepped down 31 December 2019) Sir Frank Chapman Irene Dorner Beverly Goulet Lee Hsien Yang Nick Luff Brad Singer (stepped down 9 December 2019) Sir Kevin Smith Jasmin Staiblin Board (9 meetings) 9/9 9/9 9/9 9/9 9/9 9/9 9/9 9/9 9/9 9/9 8/8 9/9 9/9 Nominations & Governance (6 meetings) 6/6 Audit (7 meetings) Remuneration (7 meetings) Safety, Ethics & Sustainability (3 meetings) Science & Technology (4 meetings) 6/6 6/6 6/6 6/6 6/6 6/6 6/6 6/6 6/6 7/7 7/7 7/7 7/7 7/7 7/7 7/7 3/3 ¹ 7/7 7/7 3/3 3/3 3/3 3/3 4/4 4/4 4/4 4/4 4/4 1 Irene Dorner was appointed to the Remuneration Committee in August 2019. She stepped down from the Audit Committee at the end of 2019. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Corporate Governance 67 Board’s focus during the year Area of focus Key matters considered Outcome Group purpose Strategy Corporate narrative During the year, the Executive Team developed the corporate narrative to further define and articulate the Group’s purpose – to connect, power and protect society (see page 10). The corporate narrative aligned with the Group’s vision and strategy and with the Board’s engagement and focus on ESG issues, as demonstrated through the ESG shareholder event (see page 78). Review of the Group’s strategy and acquisition of Siemens’ eAircraft business The Board received regular updates on strategy throughout the year and, in September, held a two-day meeting with the Executive Team focused on operational and financial progress against the Group’s short and long-term plans. The Board received detailed updates on progress with the execution of the transformation programme, particularly with the simplification initiatives, cost reduction, skills alignment to future requirements and the cultural agenda. In May, the Board held its meetings in Bristol, UK at our main UK-based Defence site and received an update on the Defence business strategy. At that meeting, the Board also received an update on the Group’s Services strategy across both the Defence and Civil Aerospace businesses. The agreement to acquire Siemens’ eAircraft business in June accelerated the delivery of the Group’s electrification strategy. Withdrawal from engine competition for new midsize airplane platform (NMA) In February, the Board confirmed the decision to withdraw from the competition to power Boeing’s proposed middle of the market, or NMA, platform. We were unable to commit to the proposed timetable to ensure we had a sufficiently mature product which would support Boeing’s ambition for the aircraft and which would satisfy our own internal requirements for technical maturity at entry into service. The Board agreed it was important to deliver on the current engine programmes and focus on the development of new technologies such as our next generation UltraFan. Culture Review of the culture change agenda UK pensions The transformation programme has a cultural change agenda at its core and the Board has sought ways to track progress and seek feedback on how the behaviours articulated in the people framework (see page 45) are embedding. This included: — presentations from the Group People Director on diversity & inclusion, talent and succession and the leadership learning, performance management and career frameworks; — feedback from the Employee Champions, much of which was focused on simplification and leadership of culture change; — progress report on the anti-bullying and harassment campaign and training (see page 49); — updates on engagement with the UK Trade Unions and European Works Council and their reactions to restructuring proposals; — delivery of the safety agenda; — noting of Lord Gold’s final report on the Group’s approach to ethics and anti-bribery and corruption (see page 109); — progress report on the simplification processes (for example, RRMS, finance transformation, Civil Aerospace transformation); — reviews from the Ethics Line; — outcome from the employee surveys; — feedback from the ‘let’s talk’ engagement sessions led by the Executive Team (see page 46); and — interaction from the Meet the Board, site visits and other engagement sessions (see page 71). The Board considered the transfer of certain pension risk liabilities to Legal & General Assurance Society Ltd by the Group’s UK pension trustees which would reduce the Group’s post-retirement obligations by around £4.1bn (see page 47). In order to complete the transaction, which the Board agreed was in the best interests of former and current employees, as well as for the financial strength of the Group, the Board agreed to make an exceptional cash contribution of around £30m. The Board also noted the changes to the defined benefit pension scheme for UK managers. More details of this review can also be found on page 47. The Board also considered issues that were raised in respect of this review through the Ethics Line (see page 110). DIRECTORS’ REPORT68 Directors’ Report Corporate Governance Rolls-Royce Holdings plc Annual Report 2019 Area of focus Key matters considered Outcome Risk Operational performance/ challenges Financial Performance Governance Review of risk appetite and principal risks, with a focus on major product programme delivery. During the year the Board: — reviewed emerging and principal risks — added climate change as a stand-alone principal risk — set up a Board-level data security committee Civil Aerospace operational delivery programme ramp-up The Board reviewed and approved the effectiveness of the Group’s risk management system and carried out a robust assessment of the principal risks facing the Company, set out on pages 50 to 54, including those that would threaten its business model, future performance, solvency or liquidity. The Board received an update on the effectiveness of risk management from the Audit Committee in December and agreed with the inclusion of the risk of climate change to future revenue growth as an additional principal risk. The implications of Brexit were kept under review throughout the year. For more information on our approach to emerging risks, including Brexit, see page 50. The Trent 1000 programme was the subject of discussion at each Board meeting throughout the year and the risks to the programme and impact on customers were considered at each meeting. The Board completed a robust assessment of the Company’s emerging and principal risks (see page 50). It was agreed that it was appropriate to elevate the executive committee looking at data security to a Board-level committee, and this committee, which is a sub-committee of the Audit Committee, held its first meeting in January 2020. The Business President for Civil Aerospace attended each Board meeting to provide a business review including progress against key operational milestones. The operations director attended the September meeting to present an in-depth review of the operations improvement programmes. Civil Aerospace programme challenges The Board maintained a strong focus on the operational and technical challenges within the Trent 1000 fleet and worked closely with the Civil Aerospace team to develop a dashboard of key metrics for review at each Board meeting. A detailed technical update was presented by the engineering & technology director in December. Balance sheet review The Board has been focusing on strengthening the balance sheet, retaining the proceeds from the sale of Commercial Marine and Power Developments; and also from two further small disposals (see page 16) and on improving the quality and sustainability of our cash flow, keeping a close watch on our credit ratings. Payment to shareholders The Board is not proposing an increase in the final dividend payment for 2019. This will be held flat at 7.1p per share and brings the full payment for the year to 11.7p per share. Capital allocation The Board also reviewed and agreed its approach and overview of capital allocation which had been refined as part of the governance model. Introduction of new accounting standard IFRS 16 Finance transformation Stakeholder engagement and governance The Board was assured that the judgements and estimates made in preparation for the financial statements were consistent with the new requirements. Updates were received on progress with: the drive to transform and simplify the reporting and forecasting processes; and the introduction of Group Business Services, the new shared services environment that went live from January 2019. The Board considered how it engaged with all its stakeholders and continued with its own programmes, such as the ESG shareholder event, Meet the Board, Employee Champion schedules and individual Non-Executive Director site visits and town hall meetings. Details can be found in our s172 statement on page 56 and our stakeholder engagement report on pages 70 to 72. The Board also reviewed investor feedback following our full and half-year financial results, feedback from the Ethics Line in August and December, payment practices for the Group’s subsidiaries, gender pay gap reporting and the Group’s modern slavery statement. Non-financial controls The Board considered an updated framework, including core decision rights and the simplification of the RRMS – articulating our freedom within a framework culture (see page 61). Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Corporate Governance 69 Area of focus Key matters considered Outcome Succession and leadership Succession planning During the course of the year, the Board considered the principal risk relating to talent and capability and reviewed succession at the most senior levels of the business (see page 77). Effectiveness of the Board, Chairman and Chief Executive A light touch external evaluation was undertaken, following on from the comprehensive evaluation in 2018, and it concluded that the Board continued to operate effectively in 2019 (see page 74). The Chairman and Chief Executive received constructive feedback on their respective performance. The Board’s area of focus in 2020 are expected to include: continued monitoring of financial and operational performance the safety agenda the Group’s culture through continued transformation execution of strategic priorities principal risk reviews Our Board apprentice programme defined Participant programme induction Board member briefing Board experience Assigned to core committee Executive leadership development Wider learning opportunities Networking & mentoring You can read more about our Board apprentice programme on pages 71 and 77. Audit Committee Safety, Ethics & Sustainability Science & Technology Supplementary rotations Remuneration Committee Employee Stakeholder Committee Data Security Committee Environment & Sustainability Committee Additional elements Two Board mentors and Executive Team sponsor AGM and Meet the Board event Masterclasses and networking opportunities DIRECTORS’ REPORT70 Directors’ Report Corporate Governance Rolls-Royce Holdings plc Annual Report 2019 Stakeholder engagement At Rolls-Royce, we understand that who we are and how we behave matters not only to our people but to the many stakeholders who have an interest in our business. We believe that stakeholder engagement remains vital to building a sustainable business and we interact with many stakeholders at different levels of the organisation. Engagement is carried out by those most relevant to the stakeholder group or issue. The table below identifies some of our stakeholders and how both the Company and the Board engage with them. More details can be found on www.rolls-royce.com. The Board considers the different stakeholder groups and our engagement programmes and identifies opportunities for strengthening both its relationships and understanding to facilitate the decisions and contributions made by the Board to the success of the business. Customers Investors The Board recognises that the quality of the Group’s customer relationships is based on mutual trust as well as its engineering expertise. In April, Sir Ian Davis and Lee Hsien Yang travelled to China for meetings with customers, both existing and prospective. In October, Sir Frank Chapman and Irene Dorner met with customers during their visit to Singapore. Sir Ian Davis also met with Airbus in both November and January 2020 to support the Executive Team in their dialogue with them. The sale of the Group’s Commercial Marine business to KONGSBERG, completed on 1 April 2019, and the importance of maintaining strong relationships with them was noted and discussed by the Board as KONGSBERG became the largest customer of the Power Systems business. The Board regularly receives operational updates, including customer metrics and feedback, from each of the businesses at every meeting with the Business Presidents regularly presenting to the Board. During the operational challenges experienced by our affected airline customers as a result of the in-service issues with the Trent 1000, the Board has kept very close to our customer engagement throughout the year and received specific feedback from the Civil Aerospace Business President on the issues and mitigation plans and their impacts on our customers, which greatly influenced the Board’s deliberations and support for the Executive Team when considering: our strategy and the transition of technologies, capabilities, resources and value to meet our business horizons (see page 10) increasing our stock of spare engines and accelerating growth in our MRO network (see page 8) future technologies, specifically our withdrawal from the competition to power Boeing’s NMA platform, enabling us to focus on the development of innovating new technologies, such as UltraFan (see page 26) and accelerating our electrical strategy (see page 11) product safety and asset integrity throughout the transformation (see page 107) the introduction of a new balanced scorecard of metrics for each business which would demonstrate whether we are meeting our commitments to our customers across our businesses (see page 15) key auditing judgements and estimates in respect of customer loss-making contracts and restructuring costs as a result of the Trent 1000 in-service issues (see page 82) The Investor Relations team is in constant dialogue with investors and reports regularly to the Board on shareholder feedback, especially post results. The Chief Executive and Chief Financial Officer, supported by members of the Executive Team, meet with investors, following both the preliminary and interim results, as well as at various times throughout the year. We held an event in April for our institutional investors focused on environmental, social and governance (ESG) matters which was very well received. The Chairman, together with the relevant committee chairmen, the Company Secretary and one of our Board apprentices, provided insights into our ESG initiatives which were followed by engaging and interactive sessions in smaller groups. In addition, Ruth Cairnie and Irene Dorner met with a number of shareholders as part of the consultation on our remuneration policy. The Chairman, Senior Independent Director and members of the Board make themselves available to meet with institutional investors when requested and the Board hold our AGM in different locations in order to reach a wider shareholder base. We recognise the importance of our investors as a key stakeholder in our discussions and ensure that we are able to create confidence in our Company through: financial performance and the economic impact of our decisions robust governance and transparency of reporting delivering a sustainable, stable and predictable performance Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Corporate Governance 71 OUR BOARD APPRENTICES Our current Board apprentice cohort comprises six individuals from different parts of the Group including Civil Aerospace, Defence, corporate functions and one of our joint ventures. They are based in France, Singapore, US and UK and have been selected through our talent and succession process. We intend to extend this successful programme to a third cohort which will start during the course of 2020. You can read more about how the programme operates on pages 69 and 77. Employees The Board recognises that it is through our people that we fulfil our potential, achieve our vision and execute our strategy. For this reason, we take the role of Employee Champion very seriously to ensure there is a voice of the employees in the boardroom. Irene Dorner has continued in her role as Employee Champion for a third year and meets with employee groups and attends employee stakeholder engagement meetings. Irene has a programme of events which, during the year, included attendance at: the launch of EAST, our Asian employee resource group; two UK Council meetings; a meeting of our local ethics advisers; a meeting with the ethics and compliance and case management teams; the diversity & inclusion and sustainability focus groups in Singapore; and an event hosted by PRISM, our LBGT+ employee resource group on how to make the workplace more inclusive. Irene also has regular dialogue with the Group People Director and together they review the outcomes from the employee surveys and Ethics Line reports. Irene can be contacted by any employee by email. Beverley Goulet also continued in her role as the Board’s Employee Champion for our North American employees, this year concentrating on our smaller sites, holding roundtables with groups of employees at each one. The Board Champions are supported by an employee stakeholder engagement group where we discuss what we have learnt and plan future schedules. Having now run this programme for a few years, we are considering ways to develop it further. This will include a three-year programme of meetings and events to reach across all our employee groups and to engage with more employees in planning how the programme is structured. Irene and Beverly regularly provide feedback to the Board on employee topics of interest and/or concern. The direct link that they provide between the employees and the Directors is proving to be extremely valuable, particularly through this period of extensive change. The main themes that they reported this year were on transformation and culture; the importance of the relationship with the UK unions; progress with the anti-bullying and harassment campaign; leadership capability; communications; and stress and mental wellbeing. Irene and Sir Frank Chapman also requested a report from the head of ethics and compliance on the proposed changes to the UK defined benefit pension scheme (see page 110). During the year, our now regular Meet the Board event was held in Bristol, UK and smaller town hall events were held in Singapore, Hong Kong, Beijing and Xi’an, China. We also held a ‘Yammer’ session with Lewis Booth and Stephen Daintith during which any employee could ask questions live, online. The Directors take every opportunity to meet with local employees when visiting different business locations. For example, when visiting Dahlewitz, Germany three of our Non-Executive Directors took the opportunity to have lunch with a group of our high-potentials and young engineers. The Board discusses employee relations regularly and this year, particularly, in relation to transformation and the culture agenda. As can be read in the People and Culture report (pages 45 to 48) and the committee reports, the Board reviews both the behaviours and statistics on safety and diversity & inclusion as well as the talent management agenda at all levels across the Group. Finally, when considering M&A activity, the Board always remains mindful of any impacts on employees. DIRECTORS’ REPORT72 Directors’ Report Corporate Governance Rolls-Royce Holdings plc Annual Report 2019 Partners The Group’s global supply chain is a vital contribution to its performance, with significant investment in resources to ensure the complex global supply chain is resilient and efficient. Suppliers’ interests are considered as part of the Board’s discussions on manufacturing strategy and when reviewing specific projects. Critical suppliers are, of course, considered as part of the assessment of the business continuity risks. The Board supports our Executive Team who work collaboratively with our suppliers to continue to improve operational performance through various means: Sir Kevin Smith’s ongoing meetings with companies in our supply chain to hear their views first hand the Board’s assessment of the business continuity risk including critical suppliers (see pages 51 and 80) a full review of the Group’s supplier payment terms as part of the decision to withdraw from the UK Government’s prompt payment code following a change in the assessment approach. This in no way changes the Group’s demonstrable commitment to the fair and appropriate treatment of all our suppliers endorsement of our global supplier code of conduct which sets out the behaviours, practices and standards we expect to see demonstrated and complied with, together with our associated certification and risk monitoring processes (see page 49) availability of our value chain competitiveness improvement framework to our industry partners, providing a suite of lean, best practice principles and tools required to operate and improve manufacturing value chains (see www.rolls-royce.com) Communities On their site visits, Directors will meet with relevant community groups whenever possible and will engage with certain community programmes should they be requested to do so. Irene Dorner and Beverly Goulet will always take the opportunity to meet with relevant community groups as part of their roles as Employee Champions. Details of the Group’s outreach in 2019 are set out on page 46 and include: Governing bodies and regulators STEM activities, including the Rolls-Royce Schools Prize for Science & Technology at the Science Museum in London, UK, attended by both Sir Ian Davis and Irene Dorner investments, both time and money, in communities local to our operations, with all employees encouraged to commit Company time to community and STEM projects The Board recognise the importance of governments and regulators as stakeholders. Not only are governments across the world customers but they also support the Group’s investment in infrastructure and technology. The focus on regulators benefits from the previous experience of Lee Hsien Yang, having been chairman of the Singapore CAA. The General Counsel provides regular updates to the Board on compliance with regulators and the Safety, Ethics & Sustainability Committee discusses how the business engages with airworthiness regulators as well as receiving updates on the continuing dialogue and co-operation with prosecutors, regulators and government agencies. The Board is updated on the Group’s engagement with the tax authorities and the related regulatory landscape is discussed by both the Board and the Audit Committee. In addition, meetings with ministers and senior officials are held as relevant throughout the year, with the Chairman supporting the Chief Executive’s engagement programme at various airshows. Of particular note during 2019: Lewis Booth and Pamela Coles met with Sir Donald Brydon to discuss his independent review on the quality and effectiveness of audit in the UK market Irene Dorner and Pamela Coles met with the Trades Union Congress, ‘the voice of Britain at work’, to share ideas on employee engagement initiatives in large corporates Sir Ian Davis and Lee Hsien Yang held meetings with HM Ambassador to the People’s Republic of China (PRC) and the Ministry of Industry and Information Technology of PRC to gain a perspective on relations between the UK and China and to discuss the Group’s strategic direction both Sir Frank Chapman and Irene Dorner travelled to Singapore in September and met, amongst others, with the Economic Development Board and the British Chamber of Commerce the creation of a government relations centre of excellence, as part of the transformation programme, to bring together the global government relations team into a community to shape how government relations are delivered and how it adds value for the Group Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Corporate Governance 73 Board induction and development The Chairman and Company Secretary arrange a comprehensive, tailored induction programme for newly-appointed Non-Executive Directors, which includes dedicated time with the Executive Team and senior management and scheduled trips to business operations. The programme is tailored based on experience and background and the requirements of the role. All Directors visit the Group’s main operating sites as part of their induction and are encouraged to make at least one visit to other sites each year throughout their tenure. In 2019, Board members visited locations including: Dahlewitz and Friedrichshafen, Germany; Derby and Bristol, UK; Pascagoula, Novi and Mankato, US; Beijing, Xi’an and Shanghai, China; Hong Kong and Singapore. We regard these site visits as an important part of continuing education as well as an essential part of the induction process. They help Directors understand the Group’s activities through direct experience of seeing processes in operation and by having discussions with a range of employees. Board induction programme for George Culmer George Culmer was appointed to the Board in January 2020 and at that time joined the Nominations & Governance, Audit, and Safety, Ethics & Sustainability Committees. Since his appointment, he has embarked on his induction programme and met with members of the Executive Team. George has visited Civil Aerospace in Derby, UK and will be visiting both Defence in Bristol, UK and Rolls-Royce Power Systems in Friedrichshafen, Germany in early April 2020. It is important that the Directors continue to develop and refresh their understanding of the Group’s activities. To facilitate this, the Board met local management at its meeting in May in Bristol, UK. More detail of the Board’s engagement with its stakeholders is set out on pages 70 to 72. It is also important that the Directors regularly refresh and update their skills and knowledge and receive relevant training when necessary. Members of the Board also attend relevant seminars, conferences and training events to keep up-to-date on developments in key areas. Timing People to meet Key topics covered Within first three months Chairman Overview of the Board Nominations & Governance Committee Committee chairmen Chief Executive Chief Financial Officer Company Secretary Executive Team members and senior management Internal and external auditors Overview of committees Plan of work for the year Current issues Business model Current strategic priorities Opportunities/risks Current issues Finance, treasury, M&A and tax overviews Budget Accounting issues UK Corporate Governance Code and directors’ duties UK listed company requirements Rolls-Royce framework Board arrangements and meeting dates Overview of each area of responsibility, including: — markets and competition — operational and financial performance including KPIs — functional responsibility — current issues Audit report and findings Financial and non-financial controls Accounting judgements DIRECTORS’ REPORT74 Directors’ Report Corporate Governance Rolls-Royce Holdings plc Annual Report 2019 Board effectiveness Board and committee review In 2018, having undertaken both benchmarking and tender exercises, Belinda Hudson Limited (BHL), expert in enhancing board effectiveness, was appointed for a three-year term to undertake our externally-facilitated effectiveness reviews. BHL’s appointment was based on cultural fit, the research that BHL had undertaken which highlighted the areas that needed addressing, and commercial competitiveness. BHL had no other connection with the Company nor its Directors. Following a comprehensive review in 2018, a slightly less in-depth review was conducted in 2019. As in 2018, it covered Board composition and dynamics, the Board’s role and the Board at work but with particular focus on those areas identified as requiring further development during the previous year’s review. The effectiveness of each of the Board’s committees was taken into account as part of the evaluation. This review took the form of: confidential one-to-one discussions between BHL and members of the Board and several senior management executives; and BHL’s attendance at the Board’s two-day meeting in September to review the Group’s operational and financial performance. The Board discussed the findings of the report at its meeting in December which BHL attended. BHL has reviewed and agreed this disclosure of Board effectiveness. At a private meeting of the Non-Executive Directors, Sir Kevin Smith, Senior Independent Director, led a review of the Chairman’s performance without the Chairman present. The Nominations & Governance Committee also met without Progress on key areas Stages of the Board and committee effectiveness review December Priorities and action plans agreed for the Board and each committee December Board discussion with BHL 6 5 July Briefing and areas of focus identified 1 4 October Results evaluated and report compiled 2 3 July to September Review of Board and committee papers and attendance at meetings September One-to-one discussions with Board members and senior management any management present to discuss the performance of the Chief Executive. The meetings concluded that both the Chairman and the Chief Executive continued to be effective and constructive feedback was shared with each of them. Areas of focus Focus for 2019 Progress in 2019 Focus for 2020 Board composition and dynamics The Board’s role The Board at work Continued focus on the Board succession programme and skills matrix together with a review of the composition of the Board’s committees to maximise co-ordination across their respective duties and to prepare for future Board changes. The 2019 evaluation concluded that one of the Chairman’s strengths is his approach to Board composition and succession planning and that Rolls-Royce has the ability to attract very strong candidates as Non-Executive Directors. The Board could be clearer in the communication of their priorities and expectations with the Executive Team. With engagement from different parts of the business, a restructuring update to be provided at each Board meeting with a watchful eye on the cultural impact as the transformation programme continues to be embedded across the Group. The evaluation showed that the agendas have been well structured throughout 2019 and the focus has shifted to the necessary issues. Continued close scrutiny of the plans and risks relating to the transformation programme. There is scope for the Board to add more value as the focus is increased on strategic issues and opportunities. Emphasis on the co-ordination of agendas and papers between the Board and its committees and the Executive Team to strengthen further the linkage and feedback mechanisms. The quality of the information provided to the Board has improved during 2019, particularly for the operational and financial review day in September and on the competitive environment. Continued support and linkage between the work of the Executive Team and the Board to ensure they are aligned for success. The evaluation also identified that the work of each of the committees remained effective. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Nominations & Governance Committee Report 75 NOMINATIONS & GOVERNANCE Other attendees In addition to the members of the Committee, the Chief Executive attends when it is considered appropriate. Committee evaluation review Belinda Hudson Limited (BHL) was appointed for a second year to undertake a light touch review of the Board and committees, following a full review in 2018. The effectiveness review process of the Board and its committees is discussed in greater detail on page 74 together with overall findings. Principal responsibilities Board and committee composition Review the structure, size and composition of the Board and its committees regularly. Evaluate and consider the Directors’ conflicts of interest. SIR IAN DAVIS Chairman of the Nominations & Governance Committee Key highlights Re-appointment of Sir Ian Davis and Lee Hsien Yang, each for a further three-year term Board nominations Recommend new appointments to the Board. Appointments of George Culmer and Dame Angela Strank Oversee the induction plans, training and site visits for the Directors. Succession planning Consider succession plans for Directors and senior management. Oversee the development of a diverse pipeline for succession. Review implementation of diversity & inclusion policy. Evaluation of Chairman, Chief Executive and Non-Executive Directors Evaluate annually the Chairman and Chief Executive. Review the independence of the Non-Executive Directors. Corporate governance Review the Group’s global governance framework. Keep up-to-date with the changing governance landscape and report on the Group’s corporate governance practices. Principal risk Talent and capability. Areas of focus for 2020 Culture and behaviour Internal governance – embedding the changes Board succession Diversity & inclusion as Non-Executive Directors Updated framework Diversity & inclusion and career framework reviewed Introduction The Committee ensures that the composition of the Board is appropriate and relevant so that the Board is in the best position to oversee operational performance and to drive the Group’s strategy. We have considerably improved Executive Team succession with a broader list of credible successors with improved diversity. The Committee also keeps the Group’s corporate governance arrangements under review. We strive to take an innovative approach in all that we do and that includes our approach to governance. During the year, we updated our framework expanding it to include our core decision rights and the restructuring of our RRMS, aligning and simplifying them as part of the Group’s transformation programme and the articulation of our freedom within a framework culture. We have continued with our Meet the Board events, with a very well attended meeting in May following our AGM as well as smaller events scheduled for when the Non-Executive Directors are visiting our sites. Our Board apprentice programme has matured and we have just completed our third year since the introduction of our Board Employee Champion role. In April, we held a very well attended ESG event for our investors. Membership and operation of the Committee All members of the Committee are independent Non-Executive Directors. Our biographies are on pages 62 to 64 and meeting attendance is on page 66. No Director attends discussions relating to their own appointment. The Committee’s responsibilities are outlined in its terms of reference which can be found at www.rolls-royce.com. We review these annually and refer them to the Board for approval. No changes have been made in 2019. This follows a detailed review in 2018 to ensure alignment with the principles of the Code. DIRECTORS’ REPORT76 Directors’ Report Nominations & Governance Committee Report Rolls-Royce Holdings plc Annual Report 2019 Nominations & Governance Committee focus during 2019 Area of focus Matters considered Outcome Employee champion update. Culture and behaviour and employee engagement Career and governance framework reviews. Update on diversity & inclusion (D&I). The principal risk is considered when discussing talent and capability. Reviews of the composition of the Board and committee membership. Diversity & inclusion Oversight of principal risk – talent and capability Board and committee composition Board nominations Re-appointment of the Chairman for a further three-year term. Re-appointment of Lee Hsien Yang as a Non-Executive Director. The appointment of Irene Dorner as Chairman of the Remuneration Committee. The appointments of George Culmer and Dame Angela Strank as Non-Executive Directors. Succession planning Progress on succession planning. Consideration of the Board composition. Evaluation of Chairman, Chief Executive and Non-Executive Directors Annual review of the effectiveness of the Chairman and the Chief Executive, led by the Senior Independent Director and the Chairman respectively. Annual review of whether the Non-Executive Directors remained independent, in accordance with the Code. Corporate Governance The Committee approved the updated governance framework and Group policies. Irene Dorner, in her role as Employee Champion, reported on her meetings with the UK Council and on the relationships with the UK Unions as well as the views across the middle management population on simplification and restructuring. Beverly Goulet also reported on her increasing activities across North America. When reviewing the work in these areas the Committee particularly considered the impact of the changes on culture and behaviours. The Committee received a detailed update on the work on our D&I agenda across the Group. You can read more about our diversity & inclusion programmes on pages 47 and 48. The Board met in full to review talent and capability as development of our leaders is critical to ensuring the right culture and behaviours are embedded; and to ensure we maintain the right skills and capability for future growth. The Committee considers the current skills, experience and tenure of the Directors and assesses future needs against the longer-term strategy of the Group and recommended the re-appointment of Lewis Booth for a further year to provide continuity of support to the Audit Committee, as set out on page 77. Following individual reviews of the Chairman and Lee Hsien Yang the Committee satisfied itself that both continued to be committed and effective. The Committee gave particular consideration to the appointment of Irene Dorner as Chairman of the Remuneration Committee (see pages 59 and 60). Members of the Committee were involved in the interview process for the two new Non-Executive Directors and the Committee recommended the appointments of both George Culmer and Dame Angela Strank to the Board. More detail can be found on page 77. The Committee focused primarily on the approach to Executive Team succession and also received a detailed presentation on the people framework. (See page 45). The Committee gave particular consideration to the composition of the Board through to the AGM in 2021. (See page 77). Feedback from the evaluations was shared directly with the Chairman and Chief Executive and the Chief Executive’s objectives for 2019 were agreed. The review concluded that all Non-Executive Directors remained independent. The Committee approved amendments to the Group’s governance framework which had been enhanced considerably to articulate the freedom within a framework culture (see page 61). The Committee considered the key trends in UK governance and the appropriate responses to them for Rolls-Royce. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Nominations & Governance Committee Report 77 Board and committee composition Both Brad Singer and Ruth Cairnie stepped down from the Board in December 2019. Since Ruth’s departure, this temporarily reduced the number of women on the Board to three. However, we have recently announced that Dame Angela Strank will join the Board from 1 May 2020. We currently have one person of colour on our Board. Irene Dorner was appointed as Chairman of the Remuneration Committee with effect from 1 January 2020, having joined that committee in August 2019. You can read more about our rationale for that appointment on page 59. Lewis Booth will have completed nine years on the Board in May 2020 and will step down as Audit Committee Chairman at that time. However, the Committee recommended to the Board that he remain as an independent member of the Board and as an Audit Committee member. He will provide continuity of support to Nick Luff as he takes over as Chairman of the Audit Committee following the 2020 AGM, particularly at a time of continuing transformation in the finance function. The Committee also agreed to recommend to the Board that Sir Frank Chapman remains as a Director and Chairman of our Safety, Ethics & Sustainability Committee, noting that his nine-year term is currently due to end in November 2020. We consider that he will remain independent and we value his significant support for our safety, ethics and sustainability agenda. Subject to shareholder approval at the 2020 AGM, both Lewis and Sir Frank will step down from the Board no later than the 2021 AGM. Board nominations In February 2019, the Committee recommended to the Board the re-appointment of Sir Ian Davis as Chairman for a further three-year term. This followed the annual evaluation that was carried out by Sir Kevin Smith, Senior Independent Director, and was the subject of a thorough review as it is Sir Ian’s third three-year term. In December 2019, following a detailed review, the Committee also recommended to the Board the re-appointment of Lee Hsien Yang for a third three-year term. Prior to making any new appointments to the Board, the Committee considers the skills and attributes required and, together with the Chairman, agrees a Non-Executive Director profile. The Committee also provides input into a shortlist of candidates for the role. As announced in November 2019, George Culmer was appointed as a Non-Executive Director with effect from January 2020. George is a member of the Nominations & Governance Committee, Audit Committee, its Data Security Committee and the Safety, Ethics & Sustainability Committee. We have also recently announced the appointment of Dame Angela Strank who will join the Board on 1 May 2020 as a Non-Executive Director and a member of the Nominations & Governance Committee, the Safety, Ethics & Sustainability Committee and the Science & Technology Committee. Both George and Dame Angela met with the Chairman and a number of other Non-Executive Directors as well as the Chief Executive and the Chief Financial Officer. You can read the full biographies for George and Dame Angela at www.rolls-royce.com. For both appointments, the Committee appointed MWM Consulting. MWM Consulting has signed up to the voluntary code of conduct for executive search firms and had no other connection to the Company or its Directors during the year. As required under the Code, any additional external appointments taken up by Directors during the year were considered by the Committee and approved by the Board in advance. For instance, during the year consideration was given to the appointment of Irene Dorner as chair-designate of Taylor Wimpey. As part of the Board’s discussions, we considered all of Irene’s appointments and ensured they were not outside the parameters set by ISS, which the Board has found to be a useful gauge when discussing whether there is potentially any impact on Directors’ time commitment when taking on additional external appointments. It was noted that Irene had always maintained an excellent level of attendance at both Board and committee meetings during her tenure as well as embracing fully her role as Employee Champion. The Board concluded that Irene would be able to continue to allocate sufficient time to Rolls-Royce. They therefore approved the appointment. The Company Secretary ensures that new Directors have a thorough and appropriate induction programme. More detail about inductions and continuing development can be found on page 73. Succession planning The Committee regularly reviews succession planning at Board, Executive Team and senior management levels. The Committee plays a vital role in promoting effective Board and leadership succession, making sure it is fully aligned to the Group’s strategy. This year, the Board considered the principal risk relating to talent and capability and reviewed succession at the most senior levels of the business including a number of business-critical roles. The talent process emphasises the need for individuals to have a balance of judgement, drive and influence and the importance of ensuring that the desired culture and behaviours continues to be embedded. We were pleased to note the considerable improvement in succession plans, following the increased focus on leadership talent and the succession pipeline in 2018. The Board also recognised the importance of maintaining the right skills and capability for future growth. Board apprentice programme Our Board apprentice programme is now in its third year. Six individuals from different areas of the Group were selected for the 18-month programme via the talent and succession process. The purpose of the programme is to provide these individuals with leadership development experience and demonstrate our commitment to their career progression and development as leaders in the organisation. Each apprentice joins two Board committees, attending each one for nine months. In addition to this, they are able to participate in supplementary committees to broaden their experience, attend masterclasses on a variety of board-relevant topics and take advantage of frequent networking opportunities. Throughout the programme, each apprentice is mentored by two Board members and sponsored by an Executive Team member as well as attending one-to-one sessions with the Chief People Officer. At the end of the programme, they will have an opportunity to provide feedback in a reverse-mentoring session with the Board (see page 69). Diversity & inclusion D&I continues to be an area of focus for the Board and for the Group as a whole. We support and monitor Group activities to increase the percentage of senior management roles held by women and other under-represented groups across the organisation. In April, the Committee was updated on the Group’s approach to D&I. We fully recognise that diversity in our Executive Team needs to be improved. However, we are pleased to see that we have a broader list of credible successors with improved diversity for this team DIRECTORS’ REPORT78 Directors’ Report Nominations & Governance Committee Report Rolls-Royce Holdings plc Annual Report 2019 Board diversity policy Objective Progress All Board appointments will be made in the context of the skills and experience that are needed for the Board to be effective. Maintain a balance so that, as a minimum, one third of the Directors are women. Support and monitor Group activities to increase the percentage of senior manager population * roles held by women and other under-represented groups to 25% by 2020. (See our current statistics on page 48). Monitor, challenge and support internally-set targets for D&I at all levels across the organisation. The Committee regularly reviews the composition of the Board. The chart on page 62 shows that the current percentage of women on the Board is 25%. Following the appointment of Dame Angela Strank, effective from 1 May 2020, the percentage of women on our Board will be 31%. Our long-term aspiration is to meet and exceed the recommended voluntary target of 33%. Improving D&I remains a priority. We tracked progress against four areas: leadership and governance; attraction and recruitment; retention; and development. We were particularly pleased to note the strong progress made in attracting and recruiting more diverse people and the increase in the number of females in the ELG year-on-year. The charts on page 62 provide a clear picture of our Board diversity. Progress against our 2020 diversity targets across the Group are set out on page 48. We will set new targets out to 2025 during the course of 2020. * Senior manager population is calculated as Executive Team and ELG. This population comprises 94 individuals, 19 (20%) are female. Senior management is described in the Code as the Executive Team, the Company Secretary and their direct reports. This population comprises 82 individuals, 21 (26%) are female. We have excluded administrative personnel and technical assistants from these numbers. You can find the full policy at www.rolls-royce.com (see page 47). More on our D&I strategy can be found on page 47 and progress against our 2020 targets on page 48. Our Board diversity policy remains unchanged and we continue to ensure it remains in line with best practice. We continue to promote an inclusive and diverse culture and the Committee reaffirmed our aspiration to meet and exceed the recommended voluntary target of 33% of Board positions being held by women, while recognising that we will fall short of this target for a temporary period. We have always recognised that there may be periods of change on the Board where we may fall short of our stated aim for periods of time while the Board is refreshed. parameters within which our businesses are expected to operate. Our original governance framework has now been incorporated within the framework and is part of the way the whole Group operates. This includes the introduction of a decision rights model, moving decisions as close to activity as possible. The framework is also the governance mechanism for our subsidiary companies and our response to the Wates principles. Extracts from the framework are available on the website at www.rolls-royce.com. You can read more about our framework on pages 60 and 61. Governance We have kept under review the enhancements put in place in 2018 to ensure we meet both the regulation and the spirit of the new Code. In 2019, we held another successful Meet the Board event, this time in Bristol, UK and the Non-Executive Directors held town hall sessions while on site visits in China, Hong Kong, US and Singapore. Irene Dorner and Beverly Goulet continued in their roles as Employee Champions. More can be read about their activities on page 71. We also held our first ESG-focused event with presentations to investors and their governance teams from the Chairman, chairmen of each of our Board committees, the Company Secretary, Chief Technology Officer, Chief People Officer and one of our Board apprentices. Subjects covered included: the environmental impact of our products; electrification; sustainability; D&I; the Board apprentice programme; culture; and employee engagement. This was followed by Q&A sessions in smaller groups on ESG issues. Feedback from those who attended was very positive. The Committee spent some time during the year considering the improvements being made to the Group’s internal governance arrangements. The framework has been expanded into a number of areas since first being introduced in 2016 and the RRMS has been the subject of significant review and simplification, while ensuring our critical processes are safeguarded. We have an internal concept of freedom within a framework, an articulation of the Conflicts of interest and independence We continue to monitor and note potential conflicts of interest that each Director may have and recommend to the Board whether these should be authorised and whether any conditions should be attached to such authorisations. The Directors are regularly reminded of their continuing obligations in relation to conflicts and are required to review and confirm their external interests at least annually. This helps us to determine whether each of them continues to be considered independent. During the year, no additional conflicts of interest were identified and the Committee advised the Board that it considered each of the Non-Executive Directors to be independent. Looking forward The Committee has made strong progress in a number of areas, particularly improving our internal governance and in ensuring our activities align with our ambitions for our desired culture and behaviours. We have made good progress on our D&I agenda but still have further to go. We will continue to work to ensure our governance initiatives aspire to be best in class and use our innovation in this area to align our governance with the best interests of the Group as a whole, while remaining thoughtful and appropriate for all our stakeholders. Sir Ian Davis Chairman of the Nominations & Governance Committee Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Audit Committee Report 79 AUDIT Directors. For the purposes of the Code and DTR 7.1, George Culmer, Beverly Goulet, Nick Luff and I have recent and relevant financial experience. The Board has confirmed that it believes the Committee as a whole has competence relevant to the Company’s sector. Our biographies are on pages 62 to 64 and our meeting attendance is shown on page 66. The Committee’s responsibilities are outlined in its terms of reference which can be found at www.rolls-royce.com. We review these annually and refer them to the Board for approval. No changes have been made in 2019. This follows a detailed review in 2018 to ensure alignment with the principles of the Code. Other attendees In addition to the members of the Committee, the Chairman, Chief Executive, Chief Financial Officer and any of the Non-Executive Directors may attend one or more meetings at the Committee Chairman’s invitation. The Committee is supported by the General Counsel, the corporate governance director, the group controller, the head of group reporting, the director of risk and internal audit and the external auditors. Committee evaluation review Belinda Hudson Limited (BHL) was appointed to undertake a light touch review of the Board and committees for a second year, following a full review in 2018. The effectiveness review process of the Board and its committees is discussed in greater detail on page 74 together with the overall findings. Principal responsibilities Financial reporting Financial announcements, focusing on: accounting policies, judgements and estimates; inclusion of appropriate disclosures; compliance with relevant regulations; and whether the Annual Report is fair, balanced and understandable. Risk and control environment Monitor the effectiveness of the risk management and internal LEWIS BOOTH Chairman of the Audit Committee Key highlights IFRS 16 embedded Trent 1000 exceptional charges Focus on assessment of onerous contracts Recognition and recoverability of deferred tax assets Focus on risk management and internal control systems, including cyber security Introduction I am pleased to present the 2019 report of the Audit Committee which describes how the Committee has carried out its responsibilities during the year. This will be my last report as the Chair of the Audit Committee and I know I will be leaving the Committee in Nick Luff’s good hands. I would like to thank the members of the Committee, the executive management team and the external auditors for the open discussions that take place at our meetings and the importance they all attach to its work. We have had a number of key issues to consider in 2019, most significantly: control systems. Review concerns of financial fraud. — key judgements and estimates in accounting for the Trent 1000 in-service issues and provisions made in respect of customer loss making contracts and restructuring costs; — assessment of the recognition of UK deferred tax assets; — the balance sheet position of the Group and enhanced cash disclosures; — presentation of the impact of the pension buy-out in the UK; — judgements in respect of various M&A activity in the year; Principal risks Business continuity, market and financial shock and IT vulnerability. Internal audit Scope, resources, results and effectiveness. External audit Relationship with, and effectiveness of, the external auditor. Approve the external auditor’s terms of engagement and fees. — the carrying value of investments, tangible and intangible assets; and Areas for focus in 2020 — the adoption of the new leasing standard, IFRS 16. continuing oversight of the risk management and internal The Audit Committee also participated in a number of deep dives focused on long-term contract accounting judgements and finance transformation. control environment through our Data Security Committee, reviewing our principal risk: cyber threat supporting risk owners to assess the effectiveness of mitigating Membership and operation of the Committee controls In addition to myself, members of the Committee are George Culmer, Beverly Goulet, Lee Hsien Yang and Nick Luff. Irene Dorner served as a member of the Committee during the year, stepping down in December 2019. George Culmer joined the Committee on 1 January 2020. All members of the Committee are independent Non-Executive assessing the impact of changing regulation on our risk management plans keeping appraised of any developments with the audit reforms in the UK DIRECTORS’ REPORT80 Directors’ Report Audit Committee Report Rolls-Royce Holdings plc Annual Report 2019 Audit Committee focus during 2019 Area of focus Matters considered Outcome Financial reporting The appropriateness and disclosure of accounting policies, key judgements and key estimates with a focus on: The accounting policies, judgements and estimates are appropriate and balanced. — the methodology for the identification of abnormal costs on the Trent 1000 programme; — assessment of the costs to be included in the assessment of customer contract losses, in particular the determination of which costs are incremental to the customer; — recognition and disclosure of restructuring costs; — judgements and estimates necessary to assess the recoverability of the UK deferred tax assets; — the accounting for M&A activity in the year including the disposal of Commercial Marine, North America Civil Nuclear business and the acquisition of Siemens’ eAircraft business; — accounting for the pension buy-in/buy-out in the UK; — assessing the recoverability of tangible and intangible assets with a specific focus on programme intangible assets in Civil Aerospace and the carrying value of the investments the Company holds in the underlying Group; — assessing the balance sheet position of the Group and the transparency of our disclosures in respect of cash generation; and — adopting IFRS 16 Leases. Agreed the judgements and estimates to adopt IFRS 16 and the assessment of the impact included on page 82. Confirmed the accounting policies, judgements and estimates are appropriate and balanced. As part of enhancing our disclosures we have provided additional information with regard to the sensitivity of the estimates to changes in key assumptions. These are summarised in note 1 to the Consolidated Financial Statements. Reconciliations of APMs to their statutory equivalents are set out in notes 2 and 28 to the Consolidated Financial Statements. Reviewed the additional information that has been made in respect of our assessment of the carrying value of the Company’s investment in its subsidiaries. Satisfied ourselves with the adequacy of disclosures in respect of cash generation. See notes 1, 14 and 18 to the Consolidated Financial Statements. Reported to the Board that the Annual Report, taken as a whole, is fair, balanced and understandable. Risk and control environment The implementation project for IFRS 16. In particular, the preparation of the restated information on an IFRS 16 basis which is included in note 1 to the Consolidated Financial Statements. The form and content of the Annual Report with a specific focus on APMs and their reconciliation to statutory numbers. Improvements in the approach to risk management and internal control systems, including in relation to financial reporting controls. The processes for identifying and managing risks. The effectiveness of the Group’s risk management and internal control systems. The progress against the commitments under the DPAs as they relate to financial reporting. The process and assumptions underlying the going concern and viability statements. 2019 Principal risks Management’s assessment of the risk of, and activities to manage, a business continuity event. The activities in place or required to prevent, detect and recover from any breaches due to cyber threats. The Group’s policies, procedures and controls for identifying, managing and mitigating a market or financial shock. Recognised improvements in the analysis of risk appetite, risks at remote sites and increased focus on emerging risks, and identified areas for future improvements, including in relation to financial reporting controls. Satisfied ourselves that the processes for identifying and managing risks are appropriate and that all principal risks and mitigating actions had been subject to a detailed review by the Board or a Board committee during the year. Reported to the Board that an appropriate process is in place to make the going concern and viability statements. Particular attention was given to the going concern status of the Group’s material subsidiaries. Processes and plans are in place to manage the risks associated with business continuity, cyber and market or financial shock. Internal audit The effectiveness of the internal audit function, matters and themes arising as a result of the audit work and resolution of any associated actions. The scope, extent and effectiveness of internal audit are appropriate and there is a plan to sustain this. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Audit Committee Report 81 Audit Committee focus during 2019 continued Area of focus Matters considered Outcome External audit The approach, scope and risk assessments of external audit and the effectiveness and independence of the external auditor. The extent of non-audit services provided by the external auditors. No concerns over the nature and amount of the non-audit services provided by PwC. Recommended that PwC be re-appointed as the Group’s auditor at the 2020 AGM. Business audit committees Financial reporting Each of the Group’s businesses has its own risk and audit committee. These committees continue to be chaired by the respective business president or functional leader and comprise business leadership and functional team members, senior finance personnel and PwC. They meet at least twice a year and: — review the effectiveness of business and functional risk management activities including the identification, ownership and assessment of significant risks; — consider the existence and appropriateness of associated mitigating controls; — consider the effectiveness of mitigating controls including with reference to assurance findings or any relevant incidents arising; — review the application of accounting policies, judgements and estimates; and — inform areas for further consideration at our meetings. Members of the Committee are invited to attend the business risk and audit committee meetings and routinely receive reports on themes and any significant matters arising. During 2019, the business risk and audit committees focused on clarification of risk and control ownership in the empowered business structure and assessing the appropriateness of assurance while also undertaking deep dives of specific risks in certain businesses. Business and function presentations In addition to reports from the business risk and audit committees, the businesses and functions attend the Audit Committee to provide a more in-depth view of relevant matters. During 2019, we considered: — Defence – the current business environment, the status of the business internal financial control framework, the effectiveness of business risk management, the status of internal audit findings and other control-related incidents, accounting for long-term contracts; — Power Systems – the status of internal audit findings, changes in the levels of the most significant business risks, the effectiveness of business risk management, key accounting estimates (including in respect of litigation and claims); and As I have previously noted, the Group has complex long-term accounting and every year we spend much of our time reviewing the accounting policies and accounting judgements implicit in our financial results. For 2019, we have focused on the key judgements and estimates underpinning the financial performance of the business and the adequacy of disclosures in respect of the balance sheet and cash generation (see page 82). The Group has an established process for preparing the Consolidated Financial Statements, including: — maintenance of internal financial controls – see page 83; — monitoring of developments in financial reporting; — review of financial statements by local management prior to submission to group finance for further review and explanations; — certification by management of each business unit; — preparation and review of consolidation adjustments; — review of the draft Consolidated Financial Statements prior to submission to the Committee and the Board; and — review of the Consolidated Financial Statements by the Committee and the Board together with reports from management and the auditors on significant judgements, estimates, changes in accounting policies and any other relevant matters. The scope of the external audit is set out in PwC’s report on page 194. A summary of the principal matters we considered in respect of the 2019 Consolidated Financial Statements is set out in the table on page 82. Fair, balanced and understandable Since the year end, we have reviewed the form and content of the Company’s 2019 Annual Report, together with the processes used to prepare and verify it. We have reported to the Board that, taken as a whole, we consider the Annual Report to be fair, balanced and understandable. We further believe the Annual Report provides the necessary information for shareholders to adequately assess the Company’s position and performance, business model and strategy. — Group Tax – the main drivers of the Group’s tax position, key In making this assessment, we considered: judgements and estimates, the main areas of tax risk including consideration of tax audits and disputes and emerging risks including those associated with digitalised businesses, key sources of estimation uncertainty (in particular the recognition of deferred tax assets). We also received regular updates on the finance transformation programme and the current status of certain Civil Aerospace risk mitigation plans, accounting judgements and financial reporting matters including in respect of Trent 1000. — the process for preparing the Annual Report, including a steering committee, the core team, and instructions to contributors; — written representations from management in respect of the business reviews, sustainability, principal risks and Financial Statements; — the completion of a regulatory compliance checklist; — all reviews performed (including the Board, the Executive Team and PwC) and ensured that all feedback was appropriately reflected; and — the presentation and discussion in the Strategic Report of: the underlying as well as reported results; the in-service issues on the Trent 1000 programme; and trends, in particular, the impact of individually significant items. DIRECTORS’ REPORT82 Directors’ Report Audit Committee Report Rolls-Royce Holdings plc Annual Report 2019 Areas of focus for the 2019 Financial Statements Key issue Matters considered Outcome Adoption of IFRS 16 Final judgements on the implementation of IFRS 16 and the appropriateness of the disclosures made in respect of key accounting policies and judgements. Alternative Performance Measures (APMs) The clarity of the definitions and the reconciliations of the APM to its statutory equivalent. Accounting for Trent 1000 in-service issues Refined the methodology for identifying abnormal costs of wasted material, labour and other resources and the application of this to the Trent 1000 in-service issues (see note 1 to the Consolidated Financial Statements). We were satisfied that the judgements and estimates made are appropriate and consistent with the new requirements; that the disclosures of the impact in the Consolidated Financial Statements are appropriate; and that the Group has systems and processes in place to report on the new basis in 2019 (see note 1 to the Consolidated Financial Statements). Definitions refined and full reconciliations provided (see notes 1, 2 and 28 to the Consolidated Financial Statements). We were satisfied with the judgements taken in respect of which costs were included in the exceptional wastage charge and that these were abnormal costs that should be excluded from underlying performance (see notes 2 and 20 to the Consolidated Financial Statements). Consideration of onerous contracts Disclosure of invoice discounting and supply chain financing arrangements Deferred tax assets R&D capitalisation policy and application Carrying value of intangible and tangible assets Going concern and viability statement disclosures Review of the nature of costs included in the assessment of onerous contracts, the discount rates applied in calculating the charge and the sensitivity analysis performed and appropriateness of disclosures. We paid particular attention to those contract losses that were included in the Trent 1000 exceptional charge and the adequacy of the disclosures which are included in notes 2 and 20 to the Consolidated Financial Statements. The nature of the arrangements and the disclosures included in the Consolidated Financial Statements. In line with the Group’s commitment to transparency, additional disclosures have been included in note 14 and note 18 to the Consolidated Financial Statements. Basis for the recognition of further UK deferred tax assets and the assessment of the recoverability of the asset and associated disclosures. We confirmed the approach adopted and the additional disclosures included in note 5 to the Consolidated Financial Statements. In 2017, the Group refreshed the application of its R&D capitalisation policy. This year, we focused on the application of the policy and the consistency of approach across the businesses. The basis on which management assesses the risk of impairment, the methodology for calculating the recoverable amount, including the basis for the key assumptions, the discount rates and long-term growth rates. We also reviewed the sensitivity disclosures made in respect of goodwill and programme intangible assets. The basis for assessing the going concern assumption for the business and the principal risks for the Group and how these were modelled as viability scenarios. We concluded that there were no matters that required additional disclosure in the Consolidated Financial Statements. Confirmed the appropriateness of the conclusions including the sensitivity analysis confirmed. We agreed with the basis of the assessments and the disclosures included on page 55. Risk and control environment In managing the identified risks, judgement is necessary to: Assessment of principal risks All risks are managed through the risk management and internal control framework (the RMS described on page 50) in accordance with policies and guidance approved by the Board. On behalf of the Board, the Committee monitors the RMS, including continued developments and improvements. We continue to pay particular attention to the assessment and management of risks at remote sites and increased our focus on the identification and monitoring of emerging risks. The processes are designed to identify and manage, rather than eliminate, the risk of failure to achieve our business objectives. — evaluate the risks facing the Group in achieving its objectives; — determine the risks that are considered acceptable; — determine the likelihood of those risks materialising; — assess the Group’s ability to reduce the impact of risks that do materialise; and — ensure the costs of operating particular controls are proportionate to the benefit provided. We satisfied ourselves that the processes for identifying and managing the principal risks are appropriate and that all risks and mitigating actions had been subject, during the year, to a detailed review by the Board or an appropriate Board committee. Based on this and on our other activities, including consideration of the work Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Audit Committee Report 83 of internal and external audit and attendance at the Committee by business and functional risk owners, we reported to the Board that a robust assessment of the principal risks facing the Group had been undertaken. The principal risks arising are described on pages 51 to 54. These formed a key element of our assessment of the going concern and viability statements, described further below. Internal control The Board has overall responsibility to shareholders for the Group’s system of internal control over its business and risk management processes and the risks identified through the risk management process. The Committee has responsibility for reviewing the system’s operation and effectiveness. The system is based on business best practice and comprises: — entity-level controls covering leadership and direction from the top; and — specific control activities, covering detailed process controls, and internal and external assurance activities. We have reviewed controls over the Group’s principal risks and the key risks and critical processes in each of the Group’s businesses. In addition, both the business audit committees and this Committee consider the external auditor’s observations on the control environment. During 2019, we reviewed the results of attestation and testing performed by the internal control and internal audit teams to confirm the effective operation of key financial controls across the Group. We also reviewed the progress of the programme to strengthen financial reporting and compliance controls to meet our DPA commitments, including the work to document and assess the process risks and design of controls in our key finance processes. We have made further progress in embedding a financial controls awareness and culture with additional training and guidance provided to our finance teams. We have strengthened our supervisory review and oversight controls with a specific focus on balance sheet integrity, including the development of IT systems to improve the consistency and rigour of manual processes and controls. This will continue to be an area of focus throughout 2020 alongside our broader finance transformation initiatives. We have conducted a review of the effectiveness of the Group’s risk management and internal control systems, including those relating to the financial reporting process, in accordance with the Code. Where opportunities for improvement were identified, action plans have been put in place and progress is monitored by the Committee. We consider that our review of the risk management and internal control systems, in place throughout 2019 and up to the date of this report, meets the requirements of the Code, the DTR and the FRC’s guidance on risk management. Going concern and viability statements Having regard to the net liabilities of £3,354m on the Group’s 2019 balance sheet, we paid particular attention to these assessments. We reviewed the processes and assumptions underlying the statements set out on page 55, considering in particular: — the Group’s forecast funding position over the next five years; — the forecasts for material subsidiaries making up this position; — an analysis of impacts of severe but plausible risk scenarios, ensuring that these were consistent with the risks reviewed by the Board as part of its strategy review; — the impact of multiple risks occurring simultaneously; — additional mitigating actions that could be taken in extreme circumstances; and — the current borrowing facilities in place and the availability of future facilities. As a result, we were satisfied that the going concern and viability statements have been prepared on an appropriate basis. 2019 Principal risks As set out on page 65, the Board allocated certain principal risks to the Committee and we considered these in detail throughout the year. From our discussions, we are satisfied that all of the principal risks that we oversee have received significant management attention during the year. We reviewed: Business continuity In February, the head of risk shared lessons learned from a recent continuity related crisis management exercise. Following regular updates on the status of the mitigation plans in respect of the business continuity risk in Civil Aerospace, the director of risk and internal audit updated the Committee on business continuity risks related to external suppliers and internal facilities across all of the businesses in December. Cyber In May, the chief information officer and the cyber security director updated the Committee on cyber risks including the level of threat and nature of incidents arising, key risk mitigation and related assurance findings, and the status of IT infrastructure. The cyber security strategy was also reviewed. Cyber risk was considered by the Data Security Committee in January 2020. Market and financial shock In July, we considered risks associated with liquidity and our credit ratings focusing on our risk appetite, the nature of the current risks and their associated mitigating activities. Other risks reviewed at the Group’s financial risk committee were also reported. Separately, we have incorporated any market or financial shock that could result from Brexit in the scenario analysis on which the viability statement is based. Our risk management system We satisfied ourselves that improvements have been made in the approach to risk management including further refining of our risk appetite metrics and strengthening of our controls over risks at remote sites as described on page 50. Future improvements should focus on simplification of our risk policies and guidance and additional support for risk owners in assessing the effectiveness of mitigating control activities. Internal audit The director of risk and internal audit regularly attends and reports to the Committee on risk and internal audit matters including: — quarterly – a dashboard identifying key trends and headline findings from internal audit reports issued in the period and the status of related agreed actions; any key themes from internal audit’s work and details of any specific significant findings raised that warrant the Committee’s attention, including in respect of audits conducted as part of the Group’s response to the DPAs; and — annually – compliance with expenses policies for the Directors and the Executive Team; and an internal audit work plan for the following year. I meet the director of risk and internal audit before each meeting and on an adhoc basis throughout the year, as do other members of the Committee, to discuss risk matters and the nature of internal audit findings in more depth. We continue to focus on the nature and number of issues raised by internal audit and the time to complete the related actions which continues to improve. However, the underlying root causes remain largely unchanged and form a critical part of our restructuring plans. The future work plan is DIRECTORS’ REPORT84 Directors’ Report Audit Committee Report Rolls-Royce Holdings plc Annual Report 2019 risk-based, balancing focus on principal risk areas and on business as usual transactional activity where controls are understood to be mature and established. Internal audit also provides assurance to our transformation programmes and restructuring activities and incorporate the activities of our second line assurance functions in their approach. We monitor changes to their plan during the course of the year. We considered and reviewed the effectiveness of the Group’s internal audit function, including resources, plans and performance as well as the function’s interaction with management. Based on the reports and discussion, we are satisfied that the scope, extent and effectiveness of internal audit work are appropriate for the Group and that there is an appropriate plan in place to sustain this. External audit PwC were appointed as the Group’s external auditor for the financial year commencing on 1 January 2018 following a formal tender process in 2016. The external audit contract will be put out to tender at least every ten years. The lead audit partner, Ian Chambers, has been in post since PwC were appointed and he will be required to rotate after five years. Other key audit partners will also be required to rotate every five years. Any future audit tenders will be carried out in line with the FRC’s practice aid for audit committees. Other than the services detailed below, PwC have no other connection with the Company nor its Directors. 2019 audit The Committee reviewed the quality of the external audit throughout the year and considered the performance of PwC, taking into account the Committee’s own assessment and feedback, the results of a survey of senior finance personnel across the Group focusing on a range of factors we considered relevant to audit quality, feedback from the auditors on their performance against their own performance objectives and the firm-wide audit quality inspection report issued by the FRC in June 2018. Based on these reviews, the Committee concluded that there had been appropriate focus and challenge by PwC on the primary areas of the audit and that they had applied robust challenge and scepticism throughout the audit. Consequently, as noted on page 81, the Committee has recommended to the Board that they be reappointed at the 2020 AGM. In May 2019, PwC presented its audit plan, which identified its assessment of the key audit risks and the proposed scope of audit work. We agreed the approach and scope to be undertaken. Subsequently, an updated plan was agreed in November 2019, building on the work undertaken at the half-year. Key risks and the audit approach to these risks are discussed in the Independent Auditor’s Report (pages 194 to 202), which also highlights the other risks that PwC drew to our attention. As part of the reporting of the half-year and full-year results, in July and February 2020, PwC reported to the Committee on its assessment of the Group’s judgements and estimates in respect of these risks and the adequacy of the reporting. Where effective to do so, PwC also reported on its assessment of the Group’s controls. I meet with the lead partner prior to each Committee meeting and the whole Committee has a private meeting with PwC at least once a year. During 2019, the Audit Quality Review Team (AQRT) of the FRC conducted a review of PwC’s audit of the Group's Financial Statements for the year ended 31 December 2018. In January 2020, the AQRT provided their final report and I, as Chairman, have discussed the findings with both the FRC and the audit partner. Whilst there were no significant findings, some matters were identified as requiring improvement. PwC have reported to the Audit Committee their response to the findings and how the suggested improvements have been incorporated into the current audit along with continuation of the areas identified as being of a high standard. Non-audit services In order to safeguard the auditor’s independence and objectivity, and in accordance with the FRC’s ethical standard, we do not engage PwC for any non-audit services except where it is work that they must, or are clearly best-suited to, perform. Accordingly, our policies for the engagement of the auditor to undertake non-audit services broadly limit these to audit-related services such as reporting to lenders and grant providers. Fees paid to PwC are set out in note 7 to the Consolidated Financial Statements. All proposed services must be pre-approved in accordance with the policy which is reviewed and approved annually. Above defined levels, my approval is also required before PwC is engaged. Quarterly, we also review the non-audit fees charged by PwC. Non-audit related fees paid to the auditor during the year were £1.1m (including £0.4m relating to the review of the half-year results) representing 13% (2018: 10%) of the audit fee. Our annual review of the external auditor takes into account the nature and level of all services provided. Non-audit services are provided by PwC where the auditor is required by law or regulation to perform the work. All other non-audit services are considered on a case-by-case basis in light of the requirements of the ethical standards and our own policy. Based on our review of the services provided by PwC and discussion with the lead audit partner, we concluded that neither the nature nor the scale of these services gave any concerns regarding the objectivity or independence of PwC. Compliance During 2019, the Company complied with the relevant provisions of The Statutory Audit Services for Large Companies Market Investigation (Mandatory Use of Competitive Tender Processes and Audit Committee Responsibilities) Order 2014, as disclosed within the external audit section. Looking forward We will continue to monitor our accounting policies whilst also focusing on: — the risk management and internal control environment in relation to the transformation programme; — the continuing finance transformation programme; and — developments with the audit reforms in the UK following the publication of Sir Donald Brydon’s review into the quality and effectiveness of audit in the UK. As I previously mentioned, this is my last report as Chairman of the Audit Committee. I am pleased to be staying on as a member of the Committee and supporting Nick Luff as he takes over the reins during this ongoing period of transformation, particularly in the finance function. Lewis Booth Chairman of the Audit Committee Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Remuneration Committee Report 85 REMUNERATION executives and are introducing a requirement to maintain a significant shareholding for two years post-employment. In addition, coincident with changes being implemented for managers who are participants in our UK defined benefit pension plan, Warren East and Stephen Daintith have agreed to reduce their pension allowances over the next three years to align with the wider UK workforce. These policy changes have been supported by the shareholders with whom we have consulted. 2019 outturns 2019 has been a challenging year, particularly in respect of the continuing Trent 1000 issues. However, while supporting our customers and responding to the Trent 1000 issues, Civil Aerospace improved its underlying profit significantly, with above target levels of free cash flow and profit. We have delivered a record number of widebody engines, introduced new engines into the business jet market and progressed a wide-ranging restructuring programme. Defence delivered strong financial performance and has positioned itself well for future opportunities. Power Systems revenue and profit continued to grow. In determining the outcomes for bonus purposes, the Committee continues to take a rigorous approach to ensuring that executives are being rewarded for sustainable operational improvements in transforming the business and delivering a step change in operational cash flow. Whilst the Committee reviews in detail the underlying performance which underpins the bonus metric outturns, we also consider the outturn in the round. Turning to the metrics first, our key financial metrics are profit and cash, both achieved above target levels due to the hard work and commitment of our people. We delivered a strong free cash flow performance and a significant improvement in profitability, in challenging circumstances. Our non-financial metrics are customer satisfaction and employee engagement. For bonus purposes, whilst our financial metrics delivered good progress, the non-financial elements were not where we would have liked them to be. We adopted a broader scorecard of customer metrics for the first time in 2019 and the below-target outturn reflected the challenges we experienced in Civil Aerospace, particularly on the Trent 1000, and the impact of supply chain challenges in Defence. In terms of our people measure, we continue to recognise the importance of transforming our business and culture. In 2019, we introduced a new survey provided by Gallup and were very pleased to see a record level of participation (72%). However, against a backdrop of transformation and operational headwinds, employee engagement fell short of our targets. In assessing the final bonus awards, the Committee has also considered a number of factors including in particular Trent 1000, as well as HSE performance, quality of financial performance and the experience of our customers and shareholders. Whilst the Trent 1000 disruption already impacts the calculated bonus within the customer metric, the Committee felt that the calculated outturn did not sufficiently reflect the continuing disruption for our customers and financial impact on our shareholders. As a result, we exercised our discretion to reduce the overall bonus outturn for the Group metrics from 61% to 52.5% of maximum. The Committee felt that this was an appropriate adjustment to balance the experience of our customers and shareholders with a year of strong cash generation and effective management action to progress business transformation and address the in-service issues. Our targets for the 2017 long-term incentive plan achieved 53% of maximum. This outcome reflects strong cash performance versus targets for the period, but less progress in terms of profit delivery and a disappointing overall total shareholder return. IRENE DORNER Chairman of the Remuneration Committee Key highlights New remuneration policy Outturns for 2019 Wider workforce remuneration Introduction I am pleased to present my first report as Chairman of the Remuneration Committee, outlining what we have achieved in the year. I would like to take the opportunity to thank Ruth Cairnie for her commitment during her time as Chairman of the Committee. Having joined the Committee last August, I was able to accompany Ruth during our consultation meetings with shareholders on the remuneration policy. Our remuneration policy We undertook a review of our current policy this year, focusing on three key themes: alignment to vision and strategy; supporting the talent agenda; and alignment with the Code. This review built upon the significant changes implemented in 2017, which were strongly supported by shareholders (96% vote in favour). We concluded that limited changes are required to our existing policy; the substantive changes we made three years ago continue to support the delivery of our vision and business strategy. We remain in a period of unprecedented business transformation with a clear focus on increased cash flow generation, so the drivers behind the design of the current policy remain very relevant. We believe that there is strong alignment in our incentive plans between executives and the interests of our shareholders, with the primary focus on improving free cash flow. This is a key performance metric in our incentives and so we have no current plans to change their design. However, as we continue to be at the forefront of developing cleaner power solutions, we expect that future incentive metrics will include environmental aspects and potentially other sustainability measures, subject to such metrics being robustly quantifiable and fully aligned with our business strategy. In terms of our talent agenda, we have always taken a modest approach to executive reward and for the third year running are not proposing any changes in quantum for existing Executive Directors. However, we are mindful of the challenge of recruiting senior individuals from an increasingly global and diverse talent pool and are proposing a small amount of increased flexibility within the bonus quantum in case this is required for any future hire. As part of our review, we have also taken on board the revised requirements of the Code. We have focused in particular on executive pensions and post-employment shareholding requirements. We have reduced the pension contribution rate for newly appointed DIRECTORS’ REPORT86 Directors’ Report Remuneration Committee Report Rolls-Royce Holdings plc Annual Report 2019 Our reflection is that this is an appropriate outturn in the context of positive actions taken by Warren and his team to tackle our business challenges, whilst recognising the further progress needed to enhance the quality of our underlying financial results. 2020 salary review and incentives The Committee has reviewed the salary levels of the Executive Directors and has concluded that there will be no increases in 2020 in line with most of the Group’s management. This will be the third year of zero increases for Executive Directors. Wider workforce The Committee has always had a good appreciation of the Group’s reward practices, including bonus plan design, gender pay and pay practices. During 2019, the Committee held an additional session to focus on reward approaches across the wider workforce, to gain a deeper understanding of the broader context against which we make decisions on total reward for senior management. The Committee will continue to review key metrics on the wider workforce to provide insight and context for our activity. This is the third year that we have reported on our CEO pay ratio. Our reward strategy for the Group’s management population is currently focused on driving performance and behaviours consistent with our values. Incentives and performance enablement activities are structured to reward business and personal objectives, as well as behaviours. We hope shareholders will continue to support our policy and implementation. Membership and operation of the Committee In 2019, members of the Committee were Ruth Cairnie, Lewis Booth, Beverly Goulet, Sir Kevin Smith and myself. I joined the Committee in August and Ruth Cairnie stepped down as Chairman at the end of 2019. All members of the Committee are independent Non-Executive Directors. Our biographies are on pages 62 and 64 and our meeting attendance is shown on page 66. The Committee’s responsibilities are outlined in its terms of reference which can be found at www.rolls-royce.com. We review these annually and refer them to the Board for approval. No changes have been made in 2019. This follows a detailed review in 2018 to ensure alignment with the principles of the Code. Other attendees In addition to the members of the Committee, the Chairman, Chief Executive, Chief Financial Officer and any of the Non-Executive Directors may attend one or more meetings at the Committee Chairman’s invitation, although none were present during discussion of his or her own remuneration package. The Committee is supported by the Company Secretary, the Chief People Officer and the people director, performance and reward. Advisers During the year, the Committee had access to advice from Deloitte LLP’s executive compensation advisory practice. Total fees for advice provided to the Committee during the year by Deloitte were £96,025 (2018: £73,415). Fees are based on a time and materials basis. Deloitte also advised the Company on tax, corporate compliance, employee global mobility, assurance and corporate finance and Deloitte MCS Limited provided consulting services. They also provided personal tax advice to both Sir Ian Davis and Lewis Booth. In addition, Stephen Daintith’s son is employed by Deloitte. The Committee is exclusively responsible for reviewing, selecting and appointing its advisers. Deloitte is a founding member of the Remuneration Consultants Group and adheres to its code in relation to executive remuneration consulting. The Committee requests Deloitte attend meetings periodically during the year and is satisfied that the advice it has received has been objective and independent. Shareholder voting The remuneration policy was last approved by shareholders at our 2017 AGM. The remuneration report was last approved by shareholders at our 2019 AGM. Details of voting are shown in the table below. Principal responsibilities Determine the remuneration policy for the Executive Directors and set the remuneration for the Chairman, the Executive Directors and senior management. Review workforce remuneration and related policies and the alignment of incentives and rewards with our culture. Determine the design, conditions and coverage of annual incentives and LTIPs for senior executives and approve total and individual payments under the plans. Determine targets for any performance-related pay plans. Determine the issue and terms of all-employee share plans. Oversee any major changes in remuneration. Areas of focus for 2020 Continue to review incentive measures and targets to ensure that they remain aligned with performance and strategy, including ongoing consideration of sustainability measures Implement the new remuneration policy, subject to shareholder approval Gain further insights into the remuneration of the workforce to further inform decisions on senior management reward Irene Dorner Chairman of the Remuneration Committee Approval of the Directors’ remuneration policy (4 May 2017) Approval of the Directors’ remuneration report (2 May 2019) 1,357,109,903 1,347,237,842 95.79 96.80 1 Withheld votes are not counted towards the total percentage of votes cast. Number of votes For % Number of votes 59,613,198 44,467,914 Against % 4.21 3.20 Withheld 1 Number of votes 2,505,008 5,452,732 Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Remuneration Committee Report 87 Remuneration Committee focus during 2019 Area of focus Matters considered Outcome Policy review and shareholder consultation Review of remuneration policy to ensure alignment with business strategy and corporate governance requirements. The Committee reviewed the current remuneration policy and concluded that it remained aligned to the business strategy and continued to support the transformation programme and focus on increasing free cash flow generation. A number of incremental changes were proposed and discussed with shareholders and their feedback was incorporated into the final policy design. Consultation with shareholders on proposed policy changes. Base salaries Annual bonus Review of base salaries in accordance with the remuneration policy and the broader employee context. 2019 bonus – review of performance against the 2019 bonus targets. 2020 bonus – review of measures and targets to ensure continued alignment to strategy. Long-term incentive plan 2017 LTIP – review of achievement of performance measures. 2020 LTIP – setting targets that ensure significant stretch. The proposed changes are as follows: — Pensions – the pension contributions for existing Executive Directors will be reduced over the next three years to align with the average wider workforce rate for existing UK employees at 17% of salary. For any newly appointed Executive Directors, the pensions contribution will be 12%, in line with the new hire rate for the wider UK workforce. — Shareholding requirements – a post-employment shareholding requirement will be introduced to retain the lower of the shareholding requirement and actual shareholding at leaving date (based on shares vesting following the introduction of the new policy) at 100% in year one and 50% in year two. — Malus and clawback – additional triggers added. — Recruitment – flexibility to increase the maximum bonus to 200% (from 180%) for newly appointed Executive Directors where required to secure the right talent. Whilst no changes are proposed to the current incentive metrics, the Committee consulted with shareholders on the possibility of introducing a metric based on environmental performance and other sustainability measures in the future, as this continues to be an important focus of future Group performance. In developing the policy, the Committee also reviewed remuneration across the wider workforce as context for any proposed changes. The Committee reviewed the salary levels of the Executive Directors and concluded that no increases would be made in 2020. Warren East and Stephen Daintith received a bonus of 52.5% of maximum. 40% of the awards were deferred into shares. The Committee agreed that for the 2020 bonus plan the same measures would apply as in 2019: — Profit – 25% — Cash – 50% — Customer satisfaction – 12.5% — Employee engagement – 12.5% Awards will be based 80% on Group performance and 20% on individual performance. The maximum opportunities remain at 180% of salary for the Chief Executive and 150% for other Executive Directors. The 2017 LTIP will mature in March 2020 at 53% of maximum. For 2020 grants, targets will continue to be based on CPS (60%), EPS (20%) and TSR (20%). The maximum opportunities remain at 250% of salary for the Chief Executive and 225% of salary for other Executive Directors. DIRECTORS’ REPORT88 Directors’ Report Remuneration Committee Report Rolls-Royce Holdings plc Annual Report 2019 REMUNERATION POLICY FROM 2020 Pensions We will reduce the pension contribution for newly appointed Executive Directors from a maximum of 25% to 12% of salary to align with the new hire rate for the wider UK workforce. The pension contributions for existing Executive Directors will be reduced over the period to 2022 to align with the average wider workforce rate for existing UK employees of 17% of salary. Shareholding requirements We will introduce a requirement for Executive Directors to retain the lower of their shareholding requirement or their actual holding at leaving date in full for 12 months from that date, based on shares vesting following the introduction of the new policy. The requirement will be 50% of this level in the second year. Malus and clawback We are adding further malus and clawback triggers to our requirements, to ensure that we have a robust set of triggers that are relevant and appropriate to our business. Consideration of shareholder feedback During the policy review we have engaged in constructive consultation with our largest shareholders which has reinforced our view that the current policy is working and is well supported. The overall feedback from this consultation was: — recognition that business transformation continues to be the critical focus for the Group; — agreement that cash generation remains the key financial driver; — acknowledgement that environmental measures are becoming a key metric both internally and externally and that quantitative measures that are important to the business strategy might be an appropriate non-financial incentive measure in the future; — understanding of the rationale for increasing the maximum bonus for new hires to support future talent needs if required; and — support for changes to pensions, post-employment shareholding requirements and malus and clawback triggers. These views have been reflected in the final policy design for 2020. Introduction The policy will take effect from 7 May 2020, subject to shareholder approval at the AGM. Key policy themes In 2016, the Committee undertook a wide-ranging review of the remuneration policy, resulting in a number of changes under the themes of supporting transformation, talent, simplicity and stewardship. The Committee believes that these changes have been working well for the Company and remain relevant given that we are still in a period of transformation. As a result, the Committee has focused on three key themes for this review, evolving the existing policy with limited changes. Alignment to vision and strategy There is a continued focus on delivering an unprecedented level of transformation: reducing costs, delivering operational excellence, innovating new products and meeting customer expectations, including dealing with legacy engine issues. The Committee considered a number of alternative incentive measures such as CROIC and new technology milestones. However our main priority continues to be to significantly increase our cash flow generation to ensure that we can deliver sustainable value to our shareholders and invest in new technologies to drive our long-term success. It is therefore important that our incentive measures continue to reflect the significance of cash flow generation. Looking further ahead, the Committee recognises the importance of environmental performance and other sustainability measures and may consider this as a metric at some point in the future, as a key driver to business success. Supporting the talent agenda We must continue to be able to attract and retain the individuals who can drive our long-term business success across an increasingly global and diverse talent pool. The changes we made in the 2017 policy, which were cascaded further down the organisation, have helped with the recruitment of executive talent. However, we are increasingly experiencing a challenge in recruiting key talent from outside the UK at senior levels and need to ensure that we have as much flexibility as possible to make sure we can secure a talented and diverse workforce for the future. Alignment with the Code We recognise the importance of strong corporate governance around executive compensation and are proposing further changes to align with the Code around executive pensions, post- employment shareholding requirements and malus and clawback provisions. Changes to policy design Whilst the existing policy is working well for us, a small number of changes are proposed to our policy for 2020: Recruitment We are not proposing any changes to quantum for existing Executive Directors. Our current policy contains flexibility for a higher LTIP maximum of 300% of salary for new hires and we plan to retain this. In addition, for new hires, given the increasingly global, diverse executive talent pool we propose to increase the maximum bonus to 200% of salary (currently 180% for the Chief Executive and 150% for other Executive Directors) to give us additional flexibility to secure executive talent in the future. This will not be applied for current incumbents and will only be used for recruitment if needed. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Remuneration Committee Report 89 Summary of our revised remuneration policy Fixed pay Base salary Bene�ts Pension Variable pay Annual bonus Long-term incentive plan 80% Group performance + 20% individual performance Financial • Pro�t • Cash Non-�nancial • Customer • Employee engagement 60% CPS 20% EPS 20% TSR 40% deferral for 2 years 3-year performance period plus 2-year holding period Malus and clawback – LTIP awards are subject to malus and clawback provisions where there has been a material misstatement of audited results; serious �nancial irregularity; material �nancial downturn or an event causing a material negative impact on the value of the Group; material failure of risk management; a serious breach of Our Code; individual misconduct or actions that materially damage the Group; a breach of or inadequate response to a signi�cant HSE or other environmental issue; and/or materially incorrect calculation of an award. These provisions apply from the date of grant for six years. The same provisions apply to awards of deferred shares for three years from the date of grant. Shareholding requirement – Executive Directors are required to work towards holding bene�cially-owned shares equivalent in value to a percentage of their salary by retaining at least one half of after-tax shares released from the LTIP until this requirement is met. For the Chief Executive this requirement is 250% of salary and for other Executive Directors this requirement is 200% of salary. In addition, the lower of their shareholding requirement or their actual shareholding at leaving date must normally be retained by Executive Directors for 12 months following leaving date and then 50% of that amount for the following 12 months. Element Fixed pay Annual bonus Commentary No changes are proposed to the salary or benefits elements of the remuneration policy approved by shareholders at the 2017 AGM. Pension contributions will be reduced to align with the average of the wider UK workforce. Performance measures remain appropriate following the introduction of customer and employee metrics in 2016. Bonuses are determined primarily by Group financial performance but the Committee may apply non-financial metrics that support the underlying strategic priorities for the forthcoming year. Executive Director bonuses will continue to be awarded using a simple additive approach: — 80% of the award will be based on Group performance — 20% of the award will be based on individual performance The maximum for existing Executive Directors will be maintained at 180% of salary. The new remuneration policy includes the flexibility for a potential maximum of up to 200% of salary for newly hired Executive Directors. The intention is that this flexibility will only be used for recruitment to secure talent across a global and diverse pool. 40% of any bonus will be deferred into shares for two years. Long-term incentive plan CPS, EPS and TSR remain our long-term measures of success and reflect the strategic focus on profitable growth, the quality of profit, and returns to shareholders. During shareholder consultations, we received strong support for the continued use of cash flow as the central measure of long-term performance. The two-year holding period following the three-year performance period continues. This includes a requirement to continue to hold shares after participants have left the Group. 20% of the maximum award will vest for threshold performance. The remuneration policy continues to include an overall maximum of up to 300% of salary for the Chief Executive and 250% for other Executive Directors. This flexibility will only be used for recruitment to secure talent across a global and diverse talent pool. The intended operational maximum for the three-year period of this policy will continue to be 250% of salary for the Chief Executive and 225% of salary for other Executive Directors. DIRECTORS’ REPORT 90 Directors’ Report Remuneration Committee Report Rolls-Royce Holdings plc Annual Report 2019 Remuneration policy table The table below sets out each element of Executive Directors’ remuneration. Pay element – fixed pay Base salary Purpose and link to strategy Operation Maximum opportunity Benefits Purpose and link to strategy Operation The Company provides competitive salaries suitable to attract and retain individuals of the right calibre to develop and execute the business strategy. Salaries are reviewed, but not necessarily increased, annually. Decisions on salary are informed but not led by reference to companies of a similar size, complexity and international reach. Any salary increases will be assessed annually and will not normally exceed average increases for employees in other appropriate parts of the Group. The Committee may exercise discretion to make larger increases in circumstances where it is necessary to address particular issues or risks, including growth in the role for new appointments. The Company provides competitive benefits suitable to attract and retain individuals of the right calibre to develop and execute the business strategy. Benefits may include car or car allowance and related costs, financial planning assistance, private medical insurance, life assurance and other appropriate benefits at the discretion of the Committee. Relocation support or support for accommodation and travel may be offered to executives where necessary. Executive Directors may participate in all-employee share plans including ShareSave and the Share Incentive Plan. Maximum opportunity Benefits excluding all employee share plans, and any accommodation, relocation and associated tax costs will not exceed £100,000 per annum. Pension Purpose and link to strategy Operation Maximum opportunity The Company provides competitive pension schemes suitable to attract and retain individuals of the right calibre to develop and execute the business strategy. Executive Directors are offered membership of a defined contribution pension plan. A cash allowance may be payable in lieu of pension contributions. For incumbent Executive Directors, the maximum employer contribution to a defined contribution plan (or to be taken as a cash allowance) is currently 25% of salary. This will reduce to 17% of salary, the current average of the wider UK workforce, by March 2022. For newly appointed Executive Directors, the rate will be 12% of salary. Pensions contributions are based on base salary only. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Remuneration Committee Report 91 Pay element – variable pay Annual bonus Purpose and link to strategy Operation To incentivise the execution of the business strategy, delivery of financial targets, and the achievement of personal objectives. Bonuses are determined primarily by Group financial performance, but the Committee may apply non-financial metrics that support the underlying strategic priorities for the forthcoming year and/or adjust the payout level to ensure the outturns reflect performance. The bonuses payable are also linked to personal performance of the Executive Directors. 25% of the maximum opportunity is payable if base performance is achieved and 50% of maximum for target performance. The financial and non-financial metrics are set with reference to the prior year and to the budgets and business plans for the coming year, ensuring the levels to achieve base, on-target and maximum payout are appropriately stretching. At least 40% of the bonus is compulsorily deferred into shares for a further two years, and released subject to continued employment. Deferred shares may attract an issue of C Shares or equivalent during the deferral period. Awards are subject to malus and clawback provisions where there has been a material misstatement of audited results; serious financial irregularity; material financial downturn or an event causing a material negative impact on the value of the Group; material failure of risk management; a serious breach of Our Code; individual misconduct or actions that materially damage the Group; a breach of or inadequate response to a significant HSE or other environmental issue; and/or a materially incorrect calculation of an award. These provisions apply from the date of grant for three years. For awards granted prior to the adoption of this policy, legacy malus and clawback provisions may apply. The Committee has discretion to adjust the formulaic outcome (including down to zero) to ensure alignment of pay with performance and fairness for shareholders and participants. Maximum opportunity The normal annual maximum for the Chief Executive is 180% of salary and 150% for other Executive Directors. A maximum of 200% may be applied for recruitment where it is required to secure individuals with the right skills and experience. This flexibility would not be used for existing Executive Directors. Performance measures The bonus is weighted 80% on Group metrics, and 20% on individual performance. Within the Group metrics: — at least 60% is based on Group financial targets (for example profit and free cash flow) — up to 40% of the bonus is based on non-financial metrics such as employee engagement and customer — individual objectives are set and agreed with the Remuneration Committee at the start of each year, to reflect the prevailing business context — the Committee may, in the context of the underlying business strategy, use different performance measures Long-term incentive plan (LTIP) Purpose and link to strategy To reward the development and execution of the business strategy over a multi-year period. Operation Executive Directors are granted awards over shares annually with a three-year performance period. The number of shares relative to the proportion of the award that vests is determined at the end of the performance period according to the achievement against the performance measures. The resultant shares are then held for a further two-year period. 20% of the maximum award will vest for threshold performance. The Committee has discretion to adjust the formulaic outcome (including down to zero) to ensure alignment of pay with performance and fairness for shareholders and participants. Executive Directors are expected to work towards holding beneficially-owned shares equivalent in value to a percentage of their salary by retaining at least one half of after-tax shares released from the LTIP until this requirement is met (see page 100). Awards are subject to malus and clawback provisions where there has been a material misstatement of audited results; serious financial irregularity; material financial downturn or an event causing a material negative impact on the value of the Group; material failure of risk management; a serious breach of our Code; individual misconduct or actions that materially damage the Group; a breach of or inadequate response to a significant HSE or other environmental issue; and/or a materially incorrect calculation of an award. These provisions apply from the date of the award for six years. For awards granted prior to the adoption of this policy, legacy malus and clawback provisions may apply. DIRECTORS’ REPORT92 Directors’ Report Remuneration Committee Report Rolls-Royce Holdings plc Annual Report 2019 Pay element – variable pay Long-term incentive plan (LTIP) continued Maximum opportunity Normal annual awards: — Chief Executive – 250% of salary — other Executive Directors – 225% of salary The maximum face value of annual awards is 300% of salary for the Chief Executive and 250% for other Executive Directors. This flexibility would only be used for recruitment to secure individuals with the required skills and experience. This flexibility would not be used in the normal course of business. Performance measures Performance measures may include CPS, EPS, TSR and/or sustainability measures, for example environmental performance measures and other similar measures that are important to the success of the business strategy. For 2020 awards, the measures will be weighted 60% CPS, 20% EPS and 20% TSR. No more than 20% of awards will vest for threshold performance. The Committee may, in the context of the underlying business strategy, use different performance measures and/or vary the weightings of the measures. The table below sets out the main elements of Non-Executive Directors’ remuneration. Pay element Fees Purpose and link to strategy To reward individuals for fulfilling their role and attract individuals of the skills and calibre required. Operation The Committee makes recommendations to the Board on the Chairman’s remuneration. The Chairman and the Executive Directors determine the remuneration of the Non-Executive Directors. Levels take into account fees paid by other companies of a similar size and complexity. The Chairman is paid a single fee. Other Non-Executive Directors are paid a base fee covering Board and Board committee membership, with committee chairmen, the Senior Independent Director and the Employee Champion receiving an additional fee. Maximum opportunity The maximum total remuneration payable to Non-Executive Directors, including the Chairman, is £1,600,000 per annum. Benefits Purpose and link to strategy Operation To devote maximum time and attention to the requirements of the role. The Chairman has occasional use of chauffeur services. Travel, hotel and subsistence incurred in attending meetings are reimbursed by the Company. The Group may pay tax on such benefits. It may provide support with tax matters for Non-Executive Directors based outside the UK. Maximum opportunity Maximum value for chauffeur services will not exceed £15,000 per annum. £5,000 maximum towards tax advice and filing per annum. Remuneration policy – worked examples for 2020 Chief Executive £000 Minimum On-target Maximum £1,181 26% 100% 37% 23% 37% £3,209 32% 45% £5,237 Chief Financial Of�cer £000 Minimum On-target Maximum 100% 40% 25% £844 24% 36% £2,119 30% 45% £3,394 ■ Fixed remuneration (including salary, bene�ts and pension) ■ Annual bonus ■ LTIP (this does not include share price growth) Minimum – fixed remuneration (salary, pension, benefits), no bonus award or LTIP vesting. On-target – fixed remuneration, 50% of maximum bonus award, 50% of LTIP vesting. Maximum – fixed remuneration, 100% of maximum bonus award, 100% of LTIP vesting. Maximum assuming 50% growth in share price would be £6,417k for the Chief Executive and £4,159k for the Chief Financial Officer. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Remuneration Committee Report 93 Performance measures and targets Wider workforce considerations The Committee will set Group financial targets for annual bonus and LTIP awards with reference to the prior year and to forward-looking business forecasts, ensuring the levels of performance required to achieve base, on-target and maximum bonus awards are appropriately challenging. When setting remuneration for Executive Directors and the senior management team, the Committee carefully considers wider remuneration across the Group, including salary increases, bonus awards, share plan participation and pay ratios between Executive Directors and other employees. The Committee may, in the context of the underlying business strategy, use different performance measures for incentives and/or vary the weightings of the measures. For example, looking ahead the Committee recognises the importance of environmental performance and other sustainability measures to the success of the business strategy and may wish to include such quantitative measures in the incentive plans. Feedback would be sought from shareholders if the Committee wished to apply this to the LTIP within the three-year period of this policy. The measurement of performance against performance targets is at the Committee’s discretion, which may include appropriate adjustments to financial or non-financial elements and/or consideration of overall performance in the round. Adjustments may be either upwards or downwards. Performance conditions may also be replaced or varied if an event occurs or circumstances arise which cause the Committee to determine that the performance conditions have ceased to be appropriate. If the performance conditions are varied or replaced, the amended conditions must, in the opinion of the Committee, be fair, reasonable and materially no less difficult than the original conditions when set. Policy on new appointments The Committee will appoint new Executive Directors with a package that is in line with the remuneration policy. Base salary may be set at a higher or lower level than the previous incumbent. The Committee may use its discretion to make individual incentive awards up to the maximum policy headroom limits outlined in the policy table. Remuneration forfeited on resignation from a previous employer may be compensated. This will be considered on a case-by-case basis and may comprise cash or shares. In general: — if such remuneration was in the form of shares, compensation will be in the Company’s shares. — if remuneration was subject to achievement of performance conditions, compensation will be normally be subject to performance (either Rolls-Royce performance conditions or actual/forecast performance outturns from the previous company); and — the timing of any compensation will, where practicable, match the vesting schedule of the remuneration forfeited. Legacy terms for internal appointments may be honoured, including any outstanding incentive awards. If an Executive Director is appointed following a merger or an acquisition of a company by Rolls-Royce, legacy terms and conditions may be honoured. During 2019, the Committee held an additional in-depth review session to develop a deeper understanding of demographics across the organisation, the differences in total reward across various employee groups and geographies and key areas of focus on culture and reward. As a result, the Committee will continue to review this information on a more regular basis to help inform its decisions on executive pay. At more senior levels, remuneration is increasingly long-term and larger proportions are dependent on Group and business performance, as well as individual performance and a larger proportion is delivered in the form of shares. In terms of the management population generally, the direction of travel is to re-balance the total reward package from fixed elements to variable performance-related elements. We are committed to sharing business success across the organisation, with all employees participating in a short-term incentive plan. There is strong alignment of business metrics between the Executive Directors bonus plan and those in which the majority of the workforce participate. In addition, the Group offers an all-employee sharesave plan to eligible employees globally every two years which aligns employee interests with those of our shareholders. This continues to be a popular benefit with over 40% of employees joining the most recent plan. The broader workforce has not had direct input into the proposed policy but its application is strongly influenced by remuneration arrangements for all employees. Irene Dorner, who has designated responsibility for engaging with employees and bringing their voice into the boardroom, is now the Chairman of the Remuneration Committee, which further strengthens the link between employees and executive remuneration. Share plans The Committee retains a number of discretions consistent with the relevant share plan rules. In the event of any variation in the share capital of the Company, a demerger, special dividend, distribution or any other transaction which will materially affect the value of shares, the Committee may make an adjustment to the number or class of shares subject to award. The treatment of leavers in our ShareSave and the Share Incentive Plan is covered by the respective plan rules. Change of control provisions in respect of employee share plans are set out on page 207. DIRECTORS’ REPORT94 Directors’ Report Remuneration Committee Report Rolls-Royce Holdings plc Annual Report 2019 Termination The Company is required to give Executive Directors 12 months’ notice under their service contracts. Payment in lieu of notice will not exceed the value of 12 months’ salary, benefits and pension contributions. Both mitigation and the timing of payments through the notice period will be considered by the Committee where appropriate, as will the funding of reasonable outplacement and other professional fees. There is no automatic entitlement to an annual bonus. Taking into account the circumstances, the Committee has discretion to award a bonus in respect of performance in the financial year with appropriate consideration of time pro-rating. Deferred shares will generally be released in cases such as retirement, death, injury, ill-health, redundancy or any other reason at the discretion of the Committee. In these cases any annual bonus awarded immediately prior to leaving may be delivered in cash rather than deferred shares. For the LTIP, the rules state that unvested awards may be preserved at the Committee’s discretion according to the circumstances. In such cases vesting will be at the normal date, subject to the established performance conditions, and pro-rated to employment in the performance period. In cases such as death and terminal illness, the Committee also has the discretion to vest the awards immediately using an estimate of future outturn. If an individual leaves after the LTIP shares have vested but during the holding period, shares will not be forfeited but the holding period will remain in force. The Committee also has the discretion to mitigate or clawback awards where an Executive Director retires and then becomes employed or engaged by another business in a non- voluntary capacity within 12 months. Post-employment Post-employment, an Executive Director will normally be required to retain the lower of their shareholding requirement or their actual shareholding at leaving date (based on shares vesting following the Section 40 disclosures introduction of the new policy) for one year after leaving, and 50% of this level for a second year. The Committee can waive or modify this requirement (for example in compassionate circumstances). Service contracts The service contract for Warren East, includes 12 months’ notice of termination from the Company and six months’ notice from the Executive Director. The service contracts of Stephen Daintith, and any new appointee, will include 12 months’ notice from the Company and 12 months’ notice from the Executive Director. All contracts include the entitlement to paid holidays, sick pay, and other standard employment terms including reimbursement of reasonable business expenses. The Chairman and Non-Executive Directors have letters of appointment. No compensation is payable to the Chairman or to any Non-Executive Director if the appointment is terminated early or if they fail to be re-elected at an AGM. Legacy commitments Any remuneration payments and/or payments for loss of office made under legacy arrangements prior to the approval of the Company’s remuneration policy may be paid out subject to the terms of the remuneration policy in place at the time they were agreed. For these purposes, ‘payments’ include the Company satisfying awards of variable remuneration and, in relation to an award over shares, the terms of the payment are agreed at the time the award is granted. Minor amendments The Committee may make minor amendments to the policy (for regulatory, exchange control, tax or administrative purposes or to take account of a change in legislation) without obtaining shareholder approval. When developing the proposed remuneration policy and considering its implementation for 2020, the Committee was mindful of the Code and considers that the executive remuneration framework appropriately addresses the following factors: Clarity Simplicity Predictability We provide open and transparent disclosures regarding our executive remuneration arrangements. We have explained the changes to our proposed remuneration policy in a way that highlights their alignment to both our vision and strategy as well as the provisions of the Code. Remuneration arrangements for our Executives and our wider workforce are simple in nature and well understood by both participants and shareholders. Our remuneration policy contains details of maximum opportunity levels for each component of pay, with actual incentive outcomes varying depending on the level of performance achieved against specific measures. Proportionality, risk, and alignment to culture The metrics used to measure performance for annual bonus and LTIP awards drive behaviours that are closely aligned to our vision and strategy. In particular our variable pay arrangements continue to focus on delivering an unprecedented level of transformation. The Committee considers that our variable pay structures do not encourage inappropriate risk-taking. The annual bonus and the LTIP are subject to the achievement of stretching performance targets, and the Committee’s holistic assessment of performance that can result in the application of discretion. The use of annual bonus deferral, LTIP holding periods and our shareholding requirements (including after leaving employment with Rolls-Royce) provide a clear link to the ongoing performance of the business and therefore alignment with shareholders. Malus and clawback provisions also apply for both the annual bonus and LTIP. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Remuneration Committee Report 95 Executive Directors’ remuneration The following pages show how we have applied our remuneration policy during 2019 and disclose all elements of remuneration received by our Executive Directors. Details of remuneration received by our Non-Executive Directors during 2019 can be found on pages 103 and 104. Executive Directors’ single figure of remuneration (audited) Executive Directors Warren East Stephen Daintith Salary (a) ¹ £000 Benefits (b) £000 Bonus (c) £000 Long-term incentives (d) ²,³ £000 Pension (e) £000 Total remuneration £000 2019 2018 2019 2018 2019 2018 2019 2018 restated 2019 2018 2019 2018 944 680 944 680 17 20 17 19 883 530 1,012 608 1,079 714 1,866 1,770 236 150 236 3,159 4,075 3,227 150 2,094 1 Neither Warren East nor Stephen Daintith received a salary increase in 2019. The last increase made to Warren East was in September 2017. 2 The average share price for the three months to 31 December 2019 of 722p has been used to calculate the LTIP value (as the actual value is not known at the date of signing this report). The 2018 long-term incentive value has been updated from the 2018 Annual Report. This value is now based on the share price on vesting on 1 March 2019 of 909p. 3 There is no share appreciation reflected in the 2018 LTIP values as the share price has reduced since the grant date. a) Salary The Company provides suitable competitive salaries to attract and retain individuals of the right calibre to develop and execute the business strategy. The Committee reviewed the salaries of Warren East and Stephen Daintith in early 2020 and agreed there would be no increases for 2020. Executive Director Warren East Stephen Daintith Base salary as at 1 March 2020 £943,500 £680,000 Base salary as at 1 March 2019 £943,500 £680,000 b) Executive Directors’ benefits (audited) Benefits are provided to ensure that remuneration packages remain sufficiently competitive to attract and retain individuals of the right calibre to develop and execute the business strategy and to enable them to devote themselves fully to their roles. The taxable value of all benefits paid to Executive Directors during 2019 is shown below. Executive Directors Warren East Stephen Daintith Car or car allowance inc. fuel allowance £000 Medical insurance £000 Travel and subsistence £000 2019 15 17 2018 15 17 2019 1 2 2018 2 2 2019 1 1 2018 – – 2019 17 20 Total £000 2018 17 19 c) Annual bonus outturn (audited) The Company’s annual bonus scheme is designed to incentivise the execution of the business strategy, delivery of financial targets and the achievement of personal objectives. Executive Directors receive any annual bonus awarded in March following the performance period. 60% of the bonus is paid in cash with the remaining 40% awarded in deferred shares. Deferred shares are held in trust for two years before being released, subject to the recipient still being employed by the Group and include the right to receive an amount equal in value to the C Shares issued during the deferral period. The annual maximum for the Chief Executive is 180% of salary and 150% for the other Executive Director(s): — 80% of the award is based on Group performance — 20% of the award is based on individual performance DIRECTORS’ REPORT96 Directors’ Report Remuneration Committee Report Rolls-Royce Holdings plc Annual Report 2019 c) Annual bonus outturn (audited) continued The Committee reviewed the 2019 outturn against the performance measures; 80% of annual bonus is based on Group performance and 20% is based on individual performance. The Group performance measures are shown below: Weighting Base (25%) Target (50%) Maximum (100%) 2019 performance 3 % of maximum Adjusted % of maximum Profit 25% £334m £434m £634m £628m 98% Cash 50% £610m £760m £1,060m £866m 68% Customer metric 1 12.5% measured as the average of the business scorecards (see below) 38% 19% Employee engagement 2 12.5% 3.59/3.58 3.68/3.61 3.91/3.65 3.56/3.52 0% Total 100% 61% 52.5% 1 Customer metric is measured on the average of the business scorecards (see below). 2 In 2019, a new survey, Gallup Q12, was introduced to measure employee engagement. There were two surveys in 2019, the first weighted at 25% and the second at 75% of the overall metric. Power Systems employees only participated in the second survey. 3 Adjusted to exclude ITP Aero, non-core businesses, FX, exceptional items, the impact of accounting effects and unbudgeted items. The Committee retains overriding discretion on the outturns of the annual bonus and chose to apply that discretion to reduce the 2019 outturns. In assessing the final bonus awards, the Committee considered a number of factors, particularly Trent 1000, as well as HSE performance, quality of financial performance and the experience of customers and shareholders. The Committee exercised discretion to reduce the overall bonus outturn from 61% to 52.5%. Definitions used for performance measures: Profit – adjusted underlying profit before tax for 2019. Cash – free cash flow which is cash flow before acquisitions and disposals, shareholder payments and foreign exchange. Customer metric – Group performance is assessed using an index score based on the average outcome of bespoke customer metrics for each of Civil, Power Systems and Defence. This approach means that each business focuses on the most meaningful customer metrics. See page 15 for more information. The customer metrics for each business are below: Civil Aerospace – OE delivery to purchase order, TotalCare engine availability, CorporateCare engine availability, Trent 1000 aircraft on ground (AOG). Power Systems – OE delivery to purchase order, spares delivery to purchase order, claims per unit, time to solve. Defence – OE delivery to purchase order, spares delivery to purchase order, engine availability, submarines composite delivery. The specific business targets are commercially sensitive. Employee engagement – Is measured through our annual engagement survey. In 2019, we introduced a new employee opinion survey, in partnership with Gallup. We ran two surveys this year to embed the new approach and weighted the first survey at 25% of the bonus metric and the second at 75%. 58% of employees completed the first survey and 72% completed the second survey. We achieved a Group score of 3.56 for the first survey and 3.52 for the second resulting in a weighted average of 3.53. Individual performance Executive Directors have 20% of their bonus based on achievement of their personal objectives. Personal performance objectives are set at the beginning of the year and are aligned with the Group’s internal strategic priorities. For Executive Directors, these have included: — deliver Group revenue, profit and cash, in line with the budget, with specific focus on cash costs and free cash flow; — accelerate progress on diversity and HSE against agreed objectives and metrics; — drive M&A disposals, in particular ensuring a successful completion of the Commercial Marine disposal; — continue to drive the Group restructuring programme, delivering a further 1,500 in headcount reductions and a run rate of £300m by the end of 2019; — drive performance through our values and behaviours, leading by example with a strong focus on safety, diversity & inclusion and the highest ethical and professional standards; and — fix the fleet – manage the legacy engine issues effectively to rebuild trust and confidence with our customers. The Committee assesses performance against the objectives. The overall assessed percentage is based on the Committee’s judgement and may include other factors and achievements in the year. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Remuneration Committee Report 97 The following provides an overview of key achievements during the year for each Executive Director: Stephen Daintith Delivered on all areas of financial guidance for 2020; revenues, margins, profit and cash flow. Fundamental improvement in cash flow with strong free cash flows delivered in 2019 and a clear roadmap to at least £1bn in 2020. Successful disposals of non-core assets (Commercial Marine, North America Civil Nuclear business) with proceeds retained to strengthen the balance sheet. Average net debt has reduced from £1.3bn in 2018 to circa £0.7bn in 2019. Finance systems and management information transformation continued with the introduction of an integrated driver-based budgeting and forecasting tool to improve planning. Restructuring programme progressed in line with expectations with circa 2,900 cumulative headcount reduction and run-rate savings so far of £269m, C&A costs reduced 5% year-on-year, capital expenditure reduced year-on-year by more than £200m. Warren East Delivered business performance ahead of budget on profit and cash with enhanced quality of cash driven by cost control and operational improvements. Healthy growth in Power Systems revenue against a weak market and Defence record backlog. 64% new widebody orders achieved in Civil Aerospace. Increased profitability in all businesses. Majority of Trent 1000 issues addressed and roll out into the fleet in progress. Doubled MRO output in 2019, with further capacity increase in progress. Further management change across all businesses and functions. Group Business Services function established delivering 9% cost reduction in year one. On track to meet targets announced in June 2018. TRI improvement in Civil Aerospace, Power Systems and Defence. Gender diversity strongly improving amongst senior management and in succession plans at most levels. ELG moving from 15% female in 2018 to 20% in 2019. Further balance sheet improvements through completion of non-core asset sales. Improved free cash flow, continuing to drive down net debt. Within flat overall R&D cost, shifting the balance towards future-looking, zero carbon technologies, alongside progress on next generation gas turbines. Acquisition of Siemens’ eAircraft business and investment in microgrids to accelerate electrical capability. Establishing industry leadership position in lower carbon technologies. 2019 annual bonus outturn (to be paid in March 2020) Warren East Stephen Daintith Group performance (% of maximum) 53% 53% Individual performance (% of maximum) 50% 50% Total bonus (% of maximum) 52% 52% Total bonus (% of salary) 94% 78% d) Long-term incentives (audited) Conditional share awards are made to Executive Directors under the LTIP to reward the execution and development of the business strategy over a multi-year period. The conditional shares are then subject to a further two-year holding period. LTIP awards made in March 2019 The performance targets for awards made in March 2019 are shown below. Performance will be measured over three years to 31 December 2021. Threshold (20% vesting) Mid (50% vesting) Maximum (100% vesting) Warren East Stephen Daintith CPS (60%) 112p 150p 187p Number of shares 264,532 171,589 EPS (20%) 81p 95p 109p Relative TSR (20%) Median Between median and upper quartile Upper quartile % of salary 250 225 Face value of award ¹ £000 2,359 1,530 Performance period end date 31 December 2021 31 December 2021 1 Calculated as 250% of salary for Warren East and 225% of salary for Stephen Daintith, divided by share price at date of grant of 891.57p per share. DIRECTORS’ REPORT98 Directors’ Report Remuneration Committee Report Rolls-Royce Holdings plc Annual Report 2019 2017 LTIP awards The following sets out details in respect of the May 2017 LTIP award for which the final year of performance was the 2019 financial year. The performance conditions were assessed to the end of 2019 and the shares are then subject to a two-year holding period. Weighting 60% 20% 10% Threshold (20% vesting) 57p 3p Median Mid (50% vesting) 76p 23p Maximum (100% vesting) 104p 48p Performance achieved 87p 26p Vesting as a % of maximum 69.6% 56.0% Upper quartile Below median 0% 10% Median Upper quartile Below median 0% CPS 1 EPS 2 Relative TSR v FTSE 100 constituents Relative TSR v constituents of the S&P Global Industrials index Total vesting of 53% 1 CPS ranges were adjusted to reflect M&A activity in line with the plan definition. The original targets were minimum 60p; mid 80p; maximum 110p. 2 Over the performance period of the LTIP award the Company was required to change from accounting under IAS 18 to IFRS 15. This had a significant effect on reported profit and EPS. The targets were set on the basis of IAS 18 and, as communicated at the time of the grant, these targets have been restated so that they can be measured on an IFRS 15 basis. The translation has been on a like-for-like basis, applying the absolute cumulative profit growth in the original IAS 18 targets to the restated 2017 IFRS 15 target. e) Pension entitlements (audited) Executive Directors are offered membership of a defined contribution plan. A cash allowance may be payable in lieu of pension contributions. From 2020, any newly appointed Executive Directors will be offered an employer contribution of 12% of salary into the defined contribution pension plan (or cash allowance of equivalent value). This aligns to the new hire rate for the UK workforce. In terms of existing Executive Directors, Warren East receives a cash allowance of 25% of salary and Stephen Daintith 22% of salary. During 2019 the Company embarked on a consultation exercise with UK managers in its legacy defined benefit plan (which has been closed to new members since 2007), to reduce future benefits from that plan. In the context of the reductions in pension benefits for that population, both Stephen and Warren have agreed that their cash allowances should also reduce. The following reductions have therefore been agreed with the Committee to a rate of 17% in 2022: Current pension allowance Proposed change from 1 March 2020 Proposed change from 1 March 2021 Target level by 1 March 2022 Warren East 25% 23% 20% 17% Stephen Daintith 22% 21% 19% 17% In arriving at the 17% contribution rate for existing Executive Directors we have considered our UK population, which represents the largest employee group. Currently almost half of our UK workforce (45%) are active members of our defined benefit plan with a funding cost in excess of 30% of salary (based on the most recent funding valuation in March 2017). Given current financial market conditions, we would expect that cost to increase by the time of the next valuation in March 2020. Our defined contribution employer contribution rate is 12%, which we now offer to all new hires in the UK. As we have such a significant proportion of our UK workforce in a defined benefit plan, we have reviewed the average blended contribution rate across all UK employees, which currently gives an average of 17% of salary. We believe that this is currently a fair reflection of the pension arrangements of the wider workforce. However, to reflect funding costs of defined benefit pensions and the proportion of employees in the defined benefit and defined contribution plans, we plan to keep this rate under review. Other (audited) Payments to past directors An agreement was put in place between the Company and Colin Smith in 2017, for Colin to represent the Company in an ambassadorial capacity. The agreement was for up to 21.5 days for the latter part of 2017, 35 days for 2018 and 2019. This agreement has been extended for 2020 for up to 20 days. Total payments of £159,360 have been made under this agreement, of which £45,360 was paid in 2019. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Remuneration Committee Report 99 Implementation of remuneration policy in 2020 * Base salary Benefits Pensions Annual bonus There will be no change to base salary for 2020; base salaries remain as: Warren East – £943,500 Stephen Daintith – £680,000 There will be no change to our approach to benefits in 2020, which includes car or car allowance, financial planning assistance, insurances and other benefits. Pension cash allowances for existing Executive Directors will be reduced as follows from 1 March 2020: — Warren East – 23% (reduced from 25%) of salary — Stephen Daintith – 21% (reduced from 22%) of salary Further reductions will be made in 2021 and 2022 to bring both allowances to 17%. For 2020, bonuses will continue to be awarded using a simple additive approach: — 80% of the award will be based on Group performance — 20% of the award will be based on individual performance For 2020, the Group measures and weightings will be unchanged: profit (25%); free cash flow (50%); customer (12.5%); and employee engagement (12.5%). Operating profit will however be used as the profit measure rather than profit before tax, to better align our incentive targets with underlying business performance and to maintain consistency with external guidance. Targets are commercially sensitive and will be disclosed following assessment of performance. Maximum opportunities will remain unchanged: — Chief Executive – 180% of salary — Other Executive Directors – 150% of salary LTIP awards For awards to be granted in 2020 performance measures will be weighted: — 60% on CPS — 20% on EPS — 20% on relative TSR (versus FTSE 100 and Global S&P Index, to recognise that Rolls-Royce is a global company) Performance will be measured over three years to 31 December 2022. Performance targets will be: Threshold (20% vesting) Mid (50% vesting) Maximum (100% vesting) CPS 162p 203p 244p EPS IFRS 15 basis 85p 106p 127p Relative TSR Median Between median and upper quartile Upper quartile Performance below threshold will result in that element lapsing in full. The above targets are not an indication of forecast numbers for the three-year period. Methodologies CPS – Calculated as reported cash flow before the cost of business acquisitions or proceeds of disposals, foreign exchange translation effects, special payments into pension schemes and payments to shareholders, divided by the weighted average number of shares in issue. CPS is cumulative over a three-year period. The Committee will review CPS performance to ensure that it is a fair reflection of achievements over the period. EPS – Calculated as cumulative absolute underlying EPS over the three-year performance period on an IFRS 15 basis. Relative TSR – Measured 50% against the constituents of the FTSE 100 and 50% against the constituents of the S&P Global Industrials index. Award sizes for maximum performance — Chief Executive: 250% of salary — Other Executive Directors: 225% of salary Threshold vesting at 20% equates to 50% of salary for the Chief Executive and 45% of salary for other Executive Directors. LTIP awards will be subject to an additional holding period of two years following the three-year performance period. * Subject to approval by shareholders at the 2020 AGM. DIRECTORS’ REPORT100 Directors’ Report Remuneration Committee Report Rolls-Royce Holdings plc Annual Report 2019 Other information Executive Directors’ share interests (audited) The Directors and their connected persons hold the following interests in the ordinary shares of the Company: Options over shares subject to savings contract (ShareSave) 31 December 2019 27 February 2020 31 December 2019 31 December 2019 31 December 2019 31 December 2019 1,264 925 Conditional shares subject to performance conditions (PSP) Conditional shares subject to performance conditions (LTIP) 821,569 536,568 185,208 189,068 185,208 189,068 99,697 53,961 Ordinary shares – – Conditional shares not subject to performance conditions (deferred share bonus) Warren East Stephen Daintith Executive Directors’ interests in vested and unvested share awards (audited) Warren East PSP 2016 1 Total LTIP 2017 LTIP 2018 LTIP 2019 Total Deferred share bonus (2016) Deferred share bonus (2017) Deferred share bonus (2018) Total ShareSave (options) 2 Stephen Daintith PSP 2017 (buy-out award) 1,3 PSP 2017 (buy-out award) 1,3 Total LTIP 2017 LTIP 2018 LTIP 2019 Total Deferred share bonus (2017) Deferred share bonus (2018) Total ShareSave (options) 2 ShareSave (options) 2 31 December 2018 164,202 164,202 281,954 275,083 – 557,037 47,398 53,641 – 101,039 1,264 31 December 2018 70,027 79,726 149,753 186,547 178,432 – 364,979 26,374 – 26,374 925 – Granted during the year – – – – 264,532 264,532 – – 45,376 45,376 – Granted during the year – – – – – 171,589 171,589 – 27,253 27,253 – 292 Vested awards 205,253 205,253 – – – 47,398 – – 47,398 – Vested awards 91,036 103,644 194,680 – – – – – – – – – Lapsed awards – – – – – – – – – – – 31 December 2019 – – 281,954 275,083 264,532 821,569 – 53,641 45,376 99,017 1,264 Lapsed awards – – – – – – – – – – – – 31 December 2019 – – – 186,547 178,432 171,589 536,568 26,374 27,253 53,627 925 292 Market price at date of award (p) 676.00 Date of grant 01/03/16 Vesting date/ lapse date 01/03/19 Market price at vesting (p) 909.00 820.17 05/05/17 05/05/20 08/03/21 857.47 08/03/18 15/03/22 15/03/19 891.67 772.83 01/03/17 857.47 08/03/18 15/03/19 891.67 01/03/19 01/03/20 01/03/21 616.80 12/10/15 01/02/21 – – – – – – Market price at date of Date award (p) of grant 754.70 05/05/17 754.70 05/05/17 Vesting date/ lapse date 01/03/19 31/10/19 Market price at vesting (p) 909.00 711.00 820.17 05/05/17 05/05/20 08/03/21 857.47 08/03/18 15/03/22 15/03/19 891.67 857.47 08/03/18 15/03/19 891.67 01/03/20 01/03/21 758.40 676.50 13/10/17 16/10/19 01/02/21 01/02/23 – – – – – – – 1 The 2016 PSP (which vested in March 2019) included a kicker for above median TSR performance, which generated a multiplier of 1.4 x the original grant value. As disclosed at the time, this multiplier was capped for the 2016 grants, the awards vested at 150% of salary for Warren East and 130% of salary for Stephen Daintith’s buy-out awards that were tied to this plan. 2 For ShareSave, the price shown is the exercise price which was 85% of the market price at the date of the award. 3 The grant price for PSP awards made to Stephen Daintith was the average closing mid-market price calculated over one month, up to 22 September 2016 (the date that his appointment to Rolls-Royce was announced). Shareholding requirement (audited) Executive Directors are required to work towards holding beneficially-owned shares equivalent in value to a percentage of their salary by retaining at least one half of after-tax shares released from the LTIP until this requirement is met. For the Chief Executive this requirement is 250% of salary and for other Executive Directors this requirement is 200% of salary. The current shareholdings, as a percentage of salary, for Warren East and Stephen Daintith are 183% and 232% respectively *. As a result of the policy review, an additional requirement has been added to the shareholding policy which requires Executive Directors to retain the lower of their shareholding requirement (based on shares vesting following the introduction of the new policy) at the date of leaving for one year after leaving and 50% of this level for a second year *. * The percentage of the requirement was calculated by reference to the average share price, over the three months to 31 December 2019, and salary as at the date of the last grant on 15 March 2019. Unvested LTIP awards and ShareSave options are not included in this calculation. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Remuneration Committee Report 101 Pay across the organisation This section of the report enables our remuneration arrangements to be seen in context by providing: — a comparison of the year-on-year percentage change in our Chief Executive’s remuneration with the change in average remuneration across the UK; — a year-on-year comparison of the total amount spent on employment costs across the Group and shareholder payments; — a ten-year history of our Chief Executive’s remuneration; — our TSR performance over the same period; and — an indication of the ratio between our Chief Executive’s remuneration and the remuneration of employees. Percentage change in Chief Executive remuneration The following table compares the percentage change in the Chief Executive’s salary, bonus and benefits (excluding LTIP) to the average percentage change in salary, bonus and benefits for all UK employees from 2018 to 2019. Change in remuneration Chief Executive UK employees average 1 Salary 0% 3.38% Benefits 0% 18.74% Annual bonus (13)% 14.83% 1 UK employees were chosen as a comparator group in order to avoid the impact of exchange rate movements over the year. UK employees including apprentices, graduates and interns, make up 45% of the total employee population. The increase in benefits in the year is due to implementation of a standardised career framework across our management population. The increase in bonus is due to a higher bonus level particularly in Civil Aerospace which accounts for a large proportion of the UK workforce. Chief Executive pay ratio The Committee is mindful of the relationship between the remuneration of the Chief Executive and the wider employee population. This is the third year that we have published our CEO pay ratio and we have continued to use method A, as we believe that this is the most accurate and robust methodology. We have used the full time equivalent total remuneration of all UK employees at 31 December 2019. Year Total Remuneration ¹ 2019 2018 2017 ² Method 25th percentile Median 75th percentile Option A Option A n/a 66:1 92:1 n/a 56:1 77.1 41:1 48:1 72:1 n/a 1 In 2018, we also calculated the ratio based on average salary at 21:1. Using the same basis in 2019, this increased to 22:1. 2 The 2017 ratio was calculated prior to the regulations being issued and so was not fully aligned to the current approach. The elements used to calculate the ratio comprise pay, benefits, pensions, bonuses and long term incentives. The numbers used in the calculations are as follows: Year Salary Total Remuneration 25th percentile £36k £48k Median £44k £56k 75th percentile £53k £65k The pay ratio has reduced this year due to incentive outcomes for Warren East being lower in 2019 than in 2018. 2019 is also the first year that the new LTIP plan introduced in 2017 vested. The majority of other participants in this plan had a mixture of conditional shares with no performance conditions and performance shares. The vesting level for that population is therefore higher. As outlined on page 93, the Committee has considered the wider workforce context in terms of alignment of total reward or the Executive Directors, with the pension changes being one such example from 2019. All employees participate in a bonus plan, with a good degree of alignment of financial measures with the executives’ bonus plan. We also encourage all eligible employees to join our ShareSave plan. For our most recent launch in 2019 approximately 40% of our global population joined the plan, sharing in approximately 14 million shares and stock appreciation rights. Relative importance of spend on pay The following chart sets out the percentage change in payments to shareholders and overall expenditure on pay across the Group. Payment to shareholders (£m) * (Consolidated Cash Flow statement) Group employment costs (£m) (Note 8 – employee information) 2019 2019 2018 2018 -29% -29% 220 0.2% 220 0.2% 216 216 2019 2019 2018 2018 * Value of C Shares redeemed during the year 3,934 -6.2% 3,934 -6.2% 4,192 4,192 DIRECTORS’ REPORT102 Directors’ Report Remuneration Committee Report Rolls-Royce Holdings plc Annual Report 2019 Chief Executive pay Year 2019 2018 2017 2016 2015 2015 2014 2013 2012 2011 2011 2010 Chief Executive 1 Warren East Warren East Warren East Warren East Warren East John Rishton John Rishton John Rishton 2 John Rishton 2 John Rishton Sir John Rose 3 Sir John Rose 3 Single figure of total remuneration £000 3,159 4,075 2,331 2,089 543 754 2,596 6,228 4,577 3,677 3,832 3,914 Annual bonus as a % of maximum 52 60 68 55 – – – 55 85 63 – 100 LTIP as a % of maximum 53 100 – – – – 45 100 – – 75 100 1 On 31 March 2011, Sir John Rose retired and John Rishton was appointed. John Rishton retired on 2 July 2015 and Warren East was appointed as Chief Executive on 3 July 2015. 2 John Rishton received a special grant of shares on joining the Company on 1 March 2011 to mirror the shares he forfeited on resigning from his previous employer. The share price had increased from 483.50p at the time this grant was made to 870p at the end of 2014. These are the main reasons why John Rishton’s remuneration in 2012 and 2013 exceeded that of his predecessor. 3 The remuneration for Sir John Rose does not include any pension accrual or contribution as he received his pension from 1 February 2008. TSR performance The Company’s TSR performance over the previous ten years compared to a broad equity market index is shown in the graph below. The FTSE 100 has been chosen as the comparator because it contains a broad range of other UK-listed companies. The graph shows the growth in value of a hypothetical £100 holding in the Company’s ordinary shares over ten years, relative to the FTSE 100 index. 500 400 300 £ 200 100 Rolls-Royce FTSE 100 2009 2010 2011 2012 2013 2014 Year 2015 2016 2017 2018 2019 Gender pay reporting The Company is committed to creating a diverse and inclusive place to work where our people can be themselves and be at their best. More information about this can be found on pages 45 to 48. We published our UK gender pay gap in December 2019, which showed: Median gender pay gap across all Rolls-Royce employees in the UK Mean gender pay gap across all Rolls-Royce employees in the UK 2019 2019 2018 2018 8.4% 8.4% 8.1% 8.1% 2019 2019 2018 2018 7.1% 7.1% 6.6% 6.6% Overall women currently represent 16% of our workforce. However, we continue to make progress in recruiting more women into senior positions, where 20% is now female. See pages 47 and 48 for further information on what we are doing to address diversity across the organisation. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Remuneration Committee Report 103 Contractual arrangements Each Executive Director has a service agreement that sets out the contract between that Executive Director and the Company. Executive Directors’ service contracts Warren East Stephen Daintith Date of contract 21 April 2015 21 September 2016 Notice period from Company 12 months 12 months Notice period from individual 6 months 12 months Payments received for serving on external boards Executive Directors retain payments received from serving on the boards of external companies, the details of which are given below: Warren East Stephen Daintith Non-Executive Directors’ remuneration Single figure of remuneration (audited) Directorships held – 3i Group plc Payments received and retained £000 – 81 Chairman and Non-Executive Directors Sir Ian Davis Lewis Booth Ruth Cairnie (stepped down 31 December 2019) Sir Frank Chapman Irene Dorner Beverly Goulet Lee Hsien Yang Nick Luff Brad Singer (stepped down 9 December 2019) Sir Kevin Smith Jasmin Staiblin Total Fees (£000) Benefits (£000) Total remuneration (£000) 2019 425 95 90 90 85 70 70 70 66 105 70 1,236 2018 425 95 90 90 76 70 70 46 70 105 70 1,207 2019 3 40 3 3 1 11 40 – 21 2 14 138 2018 2 29 3 5 1 7 4 – 6 2 10 69 2019 428 135 93 93 86 81 110 70 87 107 84 1,374 2018 427 124 93 95 77 77 74 46 76 107 80 1,276 Non-Executive Directors’ fees The Chairman’s fee is reviewed by the Board as a whole on the recommendation of the Committee. The review of the other Non-Executive Directors’ base fees is reserved to the Executive Directors, who consider recommendations from the Chairman. No individual may be involved in setting his or her own fee. The Chairman and the Non-Executive Directors are not eligible to participate in any of the Group’s share schemes, incentive arrangements or pension schemes. A facility is in place which enables Non-Executive Directors (who reside in a permitted dealing territory) to use some or all of their fees, after the appropriate statutory deductions, to make market purchases of shares in the Company on a monthly basis. Sir Ian Davis and Lee Hsien Yang use this facility. DIRECTORS’ REPORT104 Directors’ Report Remuneration Committee Report Rolls-Royce Holdings plc Annual Report 2019 Non-Executive Directors’ fees Chairman Other Non-Executive Directors base fee Chairman of the Audit Committee Chairman of the Remuneration Committee Chairman of the Safety, Ethics & Sustainability Committee Chairman of the Science & Technology Committee Senior Independent Director Employee Champion 2019 £000 425 70 25 20 20 20 15 15 2018 £000 425 70 25 20 20 20 15 15 Non-Executive Directors’ benefits (audited) The benefits for Non-Executive Directors relate predominantly to travel, hotel and subsistence incurred in attending meetings. For Non-Executive Directors based outside the UK, the Company may also pay towards tax advice and the cost of making tax filings. Non-Executive Directors’ share interests (audited) The Non-Executive Directors and their connected persons hold the following interests in the ordinary shares of the Company: Chairman and Non-Executive Directors Sir Ian Davis Lewis Booth Ruth Cairnie (stepped down 31 December 2019) Sir Frank Chapman George Culmer (appointed 2 January 2020) Irene Dorner Beverly Goulet Lee Hsien Yang Nick Luff Sir Kevin Smith Jasmin Staiblin 31 December 2019 79,453 70,000 19,927 33,269 n/a 12,510 9,360 8,397 10,000 26,894 – Non-Executive Directors’ letters of appointment Our Non-Executive Directors serve a maximum of three, three-year terms (nine years in total). Chairman and Non-Executive Directors Sir Ian Davis Lewis Booth 1 Sir Frank Chapman 1 George Culmer Irene Dorner Beverly Goulet Lee Hsien Yang Nick Luff Sir Kevin Smith Jasmin Staiblin Original appointment date 1 March 2013 25 May 2011 10 November 2011 2 January 2020 27 July 2015 3 July 2017 1 January 2014 3 May 2018 1 November 2015 21 May 2012 27 February 2020 79,453 70,000 n/a 33,269 – 12,510 9,360 8,397 10,000 26,894 – Current letter of appointment end date 28 February 2022 24 May 2020 9 November 2020 1 January 2023 26 July 2021 2 July 2020 31 December 2022 2 May 2021 31 October 2021 20 May 2021 1 Subject to shareholder approval, the Board have recommended that both Lewis Booth and Sir Frank Chapman serve as independent Non-Executive Directors and they will step down from the Board no later than the 2021 AGM (see page 77 for further details). Statutory requirements The Committee’s composition, responsibilities and operation comply with the principles of good governance, as set out in the Code, the Listing Rules (of the Financial Conduct Authority) and the Companies Act 2006. The Directors’ remuneration report has been prepared on the basis prescribed in the Large and Medium-sized Companies and Groups (Accounts and Reports) (Amendment) Regulations 2013. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Safety, Ethics & Sustainability Committee Report 105 SAFETY, ETHICS & SUSTAINABILITY Membership and operation of the Committee In addition to myself, members of the Committee during 2019 were Irene Dorner, Nick Luff and Lee Hsien Yang. George Culmer joined the Committee in January 2020. All members of the Committee are independent Non-Executive Directors. Our biographies are on pages 62 to 64 and our meeting attendance is on page 66. The Committee’s responsibilities are outlined in its terms of reference which can be found at www.rolls-royce.com. We review these annually and refer them to the Board for approval. No changes have been made in 2019. This follows a detailed review in 2018 to ensure alignment with the principles of the Code. Committee evaluation review Belinda Hudson Limited (BHL) was appointed for a second year, this time to undertake a light touch review of the Board and committees, following a full review in 2018. The effectiveness review process of the Board and its committees is discussed in greater detail on page 74 together with overall findings. Principal responsibilities Product safety Maintain an understanding of and keep under review the Group’s framework for effective governance of product safety. Monitor product safety performance, the response to product SIR FRANK CHAPMAN Chairman of the Safety, Ethics & Sustainability Committee Key highlights Supporting management with embedding a safety culture Review of product safety management with a particular focus on Civil Aerospace and Power Systems Maintaining focus on product safety and HSE during the period of organisational change Monitoring of compliance with obligations under the SFO and DoJ DPAs and maintaining oversight of the implementation of Lord Gold’s recommendations Overseeing deployment of revised mandatory training with in-service issues and lessons learned. a focus on anti-bullying and harrassment Introduction The Committee has continued to support management’s efforts to embed core values and progress further towards a self-sustaining safety culture. We have sought to assure the safeguarding of these goals against a backdrop of ongoing Group transformation and the operational and financial challenges presented by the in-service issues with the Trent 1000. At the beginning of the year, we re-named the Committee the Safety, Ethics & Sustainability Committee (previously the Safety & Ethics Committee). Although our remit has always been to cover sustainability issues, we wished to highlight our Board oversight role in this area. Key sustainability workstreams such as scientific, technological and engineering innovation fall within the remit of the Science & Technology Committee. However, the impact of this work on the Group’s aggregate sustainability strategy is drawn together by this Committee. We seek to balance scrutiny with support to the management team. I am encouraged by the progress we are making with the simplification and strengthening of our product safety processes; initiatives within HSE to protect the integrity of our assets through a safety case programme; and progress with our anti-bullying and harassment campaign. Site visits were made during the year to Friedrichshafen, Germany; Bristol and Derby, UK; and Singapore to observe first-hand how our safety and ethics ethos is being translated into front-line operations. It was positive to see the impact the safety case programme is having on employee engagement and HSE practices. HSE Oversee HSE governance, review performance, incidents and monitor improvement projects. Guide and support management in the promotion of committed HSE leadership as part of our culture. Sustainability Oversee the Group’s approach to sustainability, and related reporting, including monitoring of progress towards sustainability targets. Understanding the environmental impacts of products and operations. Ethics & compliance Review the Group’s compliance with relevant legislation. Keep Our Code and anti-bribery and corruption policies under review. Support the Board with its review of issues raised through the Ethics Line and other channels including reviewing the results of any investigations into ethical or compliance breaches or allegations of misconduct. Principal risks Safety, compliance and climate change. Areas of focus for 2020 Continued product safety overview including progress to closure of issues in the large engine portfolio Oversight of management’s leadership of HSE performance Continued focus on product safety governance as our transformation and simplification programmes progress In-depth review of climate change principal risk Oversight of the sustainability strategic review and launch of the new sustainability targets DIRECTORS’ REPORT106 Directors’ Report Safety, Ethics & Sustainability Committee Report Rolls-Royce Holdings plc Annual Report 2019 Safety, Ethics & Sustainability Committee focus during 2019 Area of focus Matters considered Outcome Product safety Maintaining safety during organisational change. Product safety policy and processes, training, safety assurance framework and competence in manufacturing. Product safety performance and in-service issues. Product safety management systems. Product safety in Civil Aerospace with periodic review and scrutiny of potential Trent 1000 safety matters and their management. HSE Detailed reviews of serious injury and high potential incidents. Events, key findings, shared learning and actions. HSE ambition, strategy and plans for continuous improvement. HSE performance including incidents, injuries, waste, energy use and GHG emissions metrics. HSE programmes: LiveWell, asset care, waste action. Sustainability Review of the Group’s approach to sustainability and governance and endorsement of ongoing strategic review to strengthen consideration of social and environmental factors in Company policy and decision-making, including development of longer-term targets. Company positioning on sustainability, including external reporting and communications. The Committee was satisfied that product safety governance remained robust during transformation. The safety assurance framework is a sound incremental development. Safety performance remained at expected levels, with safety aspects of in-service issues handled competently and appropriately. The product safety management system in Civil Aerospace is effective and well-operated. Despite some improvement across particular areas of our business, overall Group TRI performance has remained flat. A series of directed campaigns and specialist support for identified areas will be introduced in 2020. HSE continues to be a key leadership priority for Rolls-Royce and our efforts are focused on driving self-sustaining improvement through embedding a safety culture, where everyone understands their role in our Zero Harm programme. Strengthening of HSE leadership, strategies, plans and communications as part of a structured approach to achieve continuous improvement. HSE programmes are at varying maturity levels and improvement trends reflect this. Efforts continue to strengthen programmes with focus on key themes. The purpose and approach to reviewing and revising our sustainability strategy was endorsed by the Committee. Considered and endorsed the introduction of a new sustainability framework. The Committee supported the ESG event in response to increasing investor interest in sustainability approach. Ethics & compliance Compliance with continuing obligations under the DPAs and implementation of Lord Gold’s recommendations. Reviewed detailed plans for, and progress on, compliance. Reviewed the draft final report to DoJ. Deployment of Our Code and Group policies. Resourcing of the ethics and compliance team and effectiveness of compliance officers. Group policies reviewed and new mandatory training introduced in 2019. The ethics and compliance team is effective. Embedding of ethics and compliance culture and behaviours. Review of number and nature of concerns raised through the Ethics Line. Bullying and harassment were prevalent themes and we will be monitoring the effectiveness of management’s campaigns to address this. Management of intermediaries including screening, appointments, payments, termination and settlements. The intermediary processes are effective to manage the risks. Review of pension consultation. Progress with data privacy binding corporate rules application. Principal risks of compliance and safety reviewed. Review of the speak up cases relating to the proposed changes to the UK defined benefit pension scheme. These principal risks are reviewed and discussed at every meeting of the Committee and both continue to be managed effectively. Oversight of 2018 principal risks Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Safety, Ethics & Sustainability Committee Report 107 Product safety We aim to go beyond compliance with regulatory product safety standards, setting a goal of continuous product safety improvement, in common with industry best practice in the markets in which we operate. This is regarded as fundamental to the Group’s licence to operate and to the sustainability of our business. Product safety encompasses the design, manufacture, assembly, installation, in-service operation, maintenance and repair of products, across all of our businesses and regions where we operate. It is critical that product safety processes develop continuously to underpin the science and technological innovation that enables product designs to evolve and extend operational boundaries. We continued to maintain a focus throughout the year on how safety risk was being managed through the Group’s transformation programme. It was also noted that the electrical business was an area of high activity and innovation in the Company, which was progressing at pace with the acquisition of Siemens’ eAircraft business. A particular degree of focus on product safety was warranted to ensure consistency with the standards across other parts of the organisation. This will be a priority for the Committee in 2020. We were briefed in February on the progress of the implementation of the product safety training programme. The Committee noted the continuing commitment to ensuring that all employees are regularly reminded about the importance of product safety and their responsibility to influence it. The new course for senior managers, which the Committee completed in 2018, has continued into 2019 and the target audience was extended. A new classroom-based awareness training was launched in February 2019 with the aim of helping our engineers to understand how their contribution can prevent unsafe products through a series of case studies and discussion. Over 5,000 engineers completed this training in 2019 and feedback from delegates has been very positive. In addition, the approach to our all-employee online training has been completely refreshed and now provides a shorter, more impactful reminder of the importance of product safety and that it is everyone’s responsibility. In all aspects of the training, which forms part of the 2019 mandatory requirement, there has been a focus on giving our people the confidence to speak up if they have any concerns regarding safety in any area of the business. The Committee believes that this is a positive step in driving a culture where safety is considered to be of utmost importance and concerns can be openly raised and addressed appropriately. In February 2019, we also reviewed the overall product safety performance metrics which are used as an indicator of the performance of our product safety management system (PSMS). The metrics gave no indication of any trends of decline in the performance of our products and therefore demonstrate that the businesses continue to manage identified safety issues, with notable improvements in the age of open issues in various parts of the business. The Committee did, however, note a deterioration over the preceding 12 months in the age profile of open safety issues in the large engine portfolio within Civil Aerospace. Whilst it was noted that containment actions against each issue were in place, the Committee sought, and received further insight, into the reasons behind this trend. We reviewed the actions being taken by Civil Aerospace to reverse the trend. This was the subject of review by the Board in December. Further follow-up is planned in 2020. POWER SYSTEMS PRODUCT SAFETY WORKSHOP In order to provide effective oversight of product safety risk, the Committee remains conversant with the Group’s PSMS. In March 2019, we focused our attention on product safety in Power Systems with a visit to the Group’s facilities in Friedrichshafen, Germany. We were briefed by the product safety leadership team on the wide variety of markets and applications which their product range addresses. This, together with a description of the regulatory landscape, set the scene for our review of the approach to product safety. We learned how accountability for product safety is assigned and were briefed on the governance of product safety within Power Systems. Key product safety roles were described, together with how these roles interacted with project teams to ensure the safety of the products as they are developed. We gained an understanding of the PSMS used within the business and were satisfied that this was appropriate for the range of products and applications and we saw how the PSMS was applied throughout the lifecycle of products. We were briefed on how the business approaches the evaluation of a product safety risk and saw their approach to the reporting of safety concerns and to identifying and resolving unsafe conditions. We reviewed high-level product safety performance measures and lastly, we examined in detail a recent product safety event to see how in practice this issue had been evaluated and contained until the point when corrective action could be applied in the field. Overall, the workshop provided a good level of confidence that the PSMS, as operated in Power Systems, was effective, robust and competently operated. DIRECTORS’ REPORT108 Directors’ Report Safety, Ethics & Sustainability Committee Report Rolls-Royce Holdings plc Annual Report 2019 Each year, the Committee reviews particular aspects of the Group’s PSMS to ensure we maintain a good working knowledge of it and understand the continuous improvements that are being introduced. At our meeting in February, we discussed a report on product safety assurance which outlined the key initiatives that had been delivered in 2018 and the current drive to embed the use of the safety assurance framework and further improve safety awareness. A significant element of the Group transformation is the simplification of the RRMS. This represents an opportunity to emphasise the key principles which keep our products safe, at the same time assuring that valuable lessons embedded in existing processes are retained. The Committee will keep this under review during 2020 as it is imperative that our approach to product safety is appropriately defined within the system and our ability to manage it efficiently and effectively is maintained throughout. In July, the Committee undertook its annual review of the product safety policy, which sets out the guiding principles by which we assure product safety and with which all employees must comply. In advance of the Committee meeting, the policy was reviewed at the Company product safety assurance board (CPSAB) and it was deemed to be an accurate and concise summary of our commitment to, and management of, product safety. Following the recommendation from the CPSAB, the Committee concluded that the policy was still fit for purpose and should therefore remain unchanged. We also reviewed the product safety principal risk and were satisfied this was being managed effectively and within the boundaries of the agreed risk appetite. At each meeting, the Committee received an update on in-service incidents and, as part of these reviews, discussed any emerging product safety risks and how these were being identified and managed as part of the PSMS. Following on from the Committee’s deep-dive reviews in 2018, these updates had a particular focus on Trent 1000 issues, and an additional review was held in August to review the response to a Trent 1000 in-flight shutdown on a Norwegian Airlines Boeing 787 on departure from Rome Airport. We were particularly pleased to hear that safety processes are being updated, where appropriate, to reflect any lessons learnt from each root cause analysis. The scope and format of the balanced scorecard was also presented to the Committee in February. It includes five leading indicators, which cover critical activities such as accountability, training and visibility of management and is balanced by two lagging indicators. The emphasis was on ensuring that data could be easily collected, inform performance, drive improvement and align to the Zero Harm strategy. The Committee was pleased to hear that as it matures, the data can be automated and shared with the businesses as a way of driving awareness, improvement and efficiency across the Group. The Group HSE risk profile was discussed at our meeting in July and it was encouraging to hear that all risks are showing an improving or stable control trend. One additional risk, off-site working, has been added to the Group risk profile on the basis that all three businesses have identified it on their individual risk registers. Ensuring that these risks are monitored and managed appropriately continues to be a priority for the Committee. At each of our meetings, we review the Group’s key HSE activities, performance metrics, insights and learning, including the TRI rate. Our TRI rate in 2018 was 0.55 per 100 employees ¹ and we remain committed to achieving the 2020 group target of 0.30. There were a total of 298 TRIs in 2019 which equates to an injury rate of 0.55. Of these, 15 resulted in major injuries. We did, however, see an 18% decrease in the overall number of major and high-potential incidents and a 1% increase in the overall severity index. Analysis of these events has identified that two keys areas will require the businesses’ focus in 2020: slips, trips and falls and hand injuries, as these two classes of injury account for more than half of our reportable injuries. Although there has been a decrease in the number of electrical incidents following a focused campaign on this particular issue in 2018, we were concerned to hear that near misses and high-potential incidents continue to occur. ITP Aero has had a particularly challenging year with injuries and they have initiated a five-part improvement plan to address their HSE performance, which will continue into 2020 and beyond. Total reportable injury (TRI) rate (per 100 employees) 1,2 2020 TARGET 0.3 2019 2018 2017 2016 2015 2014 BASELINE 0.55 0.55 0.61 0.68 0.91 0.74 1 Our TRI rate for prior years has been restated to reflect the disposal of Commercial Marine business on 1 April 2019. ITP Aero data is included for years 2017, 2018 and 2019 only. 2 External assurance over STEM, energy, GHG and TRI rate data provided by Bureau Veritas. See page 203 for the sustainability assurance statement. HSE The Committee and management’s objective remains to drive continuous improvement in HSE performance. HSE matters have been discussed at all our meetings during the year and we have paid particular attention to the levels of maturity in HSE leadership across the businesses of the Group. At the end of 2018, and following a review of the HSE improvement programme, the Committee recommended that governance and reporting on this activity should be strengthened in order to give business leaders and governance committees greater visibility of the Group’s improvement trajectory. At our meeting in February, the Committee heard that significant progress had been made in this area, including: the introduction of an HSE balanced scorecard reported quarterly; mandatory training on our Life Saving Rules including observation-intervention; and a monthly HSE update for the ELG to keep leaders informed and engaged. A head of HSE compliance role has been created to provide support in four key areas: how we define our Zero Harm improvement journey and critical milestones; how we plan more effectively and measure improvement; how we communicate to our stakeholders; and how we help others to understand and embrace their role in the improvement programme. Furthermore, several other new appointments have been made, strengthening both regional and specialist HSE capability. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Safety, Ethics & Sustainability Committee Report 109 We were updated on the Zero Harm safety case programme which was launched in 2018, with the aim of gaining a better understanding of the latent HSE risks within our operations. In total, 42 safety cases have been completed and a range of improvement activities have been initiated at site level to close identified gaps. Of our high consequence hazards, it is clear that the level of control is improving in areas that have been the focus of recent improvement programmes. However over 74% of our sites are still classed as reactive on the five-step maturity model. The programme and associated improvement activity will remain an area of focus for the Committee in 2020. Communication was a priority for the HSE function in 2019 and some significant progress has been made in developing our employees’ awareness of HSE. Interaction with our leadership population has become more regular, through bulletins and online webinars, and this is imperative given the importance of the leadership shadow when it comes to embedding a safety culture. Furthermore, in June the Group introduced the Zero Harm award at the annual excellence awards as a way of highlighting some of the excellent HSE improvement activity being undertaken across the businesses. Sustainability With its broader remit of sustainability the Committee received a detailed overview of the Group’s approach to sustainability and its ambition to be a leading responsible business. We considered and endorsed the role of the Committee in providing Board-level oversight of the sustainability approach and priorities, considering the interface between the Science & Technology Committee and the executive-level environment & sustainability committee. In July, we were briefed on work underway to review and revise the Group’s sustainability strategy, including the development of new longer-term targets. The purpose of this comprehensive review is to identify key decision points across the business where the consideration of social, ethical and environmental factors can be improved, with the aim of embedding sustainability into local decision-making and policies. The Committee endorsed this approach. We recognise that the most significant contribution that Rolls-Royce can make to a more sustainable society is to accelerate the decarbonisation of its business activities and the sectors in which it operates. The Group has a long-standing three-pronged approach to minimising its environmental impacts: continually improving the efficiency of its products and services; developing novel lower carbon technologies such as electrification and the application of alternative fuel sources; and reducing the impacts of our operations and facilities. As a Committee, we appreciate success is only achievable in the context of the wider impacts of the Group, including issues such as human rights; ethics and compliance; and safety and wellbeing. The premise of our sustainability approach is to understand the impacts of the Group’s activities on society, and to use that understanding to inform business decision-making to create shared value for us and our stakeholders. At our December meeting, we considered and endorsed a proposal to put in place a sustainability framework, focused on areas of impact and influence, to help articulate this approach. The framework will act as a means of guiding decision-making. It builds on our purpose, vision and strategy to bring all elements of our broad sustainability approach together into a single framework for the first time. In implementing this framework, we will review sustainability-related policies and identify opportunities to improve further business practices through focused improvement programmes. As an example, the Committee received an update on the Company-wide waste action programme and the significant achievements that have been made in 2019. This programme is designed to help deliver our global waste reduction targets (see page 44). A waste reduction of 29% was achieved across our top ten UK sites, a campaign to remove single-use plastics from our office and catering facilities was introduced and alternative technologies have helped to extend liquid coolant life that would otherwise have to be treated as waste (see page 44). As a Committee, we were delighted to support the ESG event in April. This was the first time we had organised a specific ESG event, in response to increased investor interest in our sustainability approach. Members of the Executive Team joined us in a series of presentations and roundtable discussions and gained valuable insights from the questions and opinions voiced by those in attendance. We are pleased that the Company has maintained its listing in the Dow Jones Sustainability Index (DJSI) for the sixteenth consecutive year. We continue to be one of only five aerospace and defence companies listed in the world index out of 38 invitees. Overall, our score improved slightly from 2018 and we achieved industry-leading scores in the risk and crisis management and environmental reporting sections. You can read more about the Group’s sustainability activities on pages 40 to 44 and at www.rolls-royce.com. Ethics and compliance The Committee’s focus in the year has been on overseeing the Group’s ethics and compliance work plans. More details can be found in the Ethics and Compliance report on page 49. This included obligations to the prosecutors with whom the Company agreed DPAs in January 2017 and ensuring that recommendations put forward by Lord Gold (the Company’s independent compliance adviser) had been implemented. Lord Gold attended the meeting in February to feed back on how he had been overseeing and supporting this work, as well as to report on key activities and areas of focus. He reported that, on recent site visits, he had been able to see how the ethics and compliance programme was working in practice, the right behaviours and attitudes were becoming embedded in the organisation and considerable improvement was evident amongst the teams. Focus remained on ensuring the right level of resource was in place to continue to drive the programme moving forward. In July, Lord Gold presented his draft report to the Committee which was later submitted to the SFO in line with the August deadline. The report noted the exemplary progress made in improving the Company’s approach to ethics and anti-bribery and corruption compliance. At an ethics deep dive session in April, the three-year ethics and compliance workplan from 2019 to 2021 was presented to the Committee. We noted the progress made in enhancing the ethics and compliance teams in each of the businesses and their improved accountability for ethics and compliance as a result. At each of our meetings during the year, we received an update from the General Counsel on the Group’s continuing dialogue and co-operation with prosecutors, regulators and government agencies. We also received regular reports and briefings from the head of ethics and compliance. DIRECTORS’ REPORT110 Directors’ Report Safety, Ethics & Sustainability Committee Report Rolls-Royce Holdings plc Annual Report 2019 Looking forward In the year ahead, we will continue to monitor developments with the Civil Aerospace large engine in-service issues with a particular focus on the age profile of open safety issues. We will provide appropriate oversight to ensure the integrity of product safety governance is maintained as the transformation programme continues and the RRMS is reviewed. We will continue to monitor and support progress and performance as the Zero Harm and LiveWell programmes are further embedded, with a particular interest in seeing injury rates and high-potential incidents reduce so that we can achieve our stated 2020 targets. The Board has included the risk of climate change to future revenue growth as an additional principal risk and we will undertake an in-depth review of this risk during the course of 2020 on behalf of the Board. We will also provide oversight as the Group carries out a sustainability strategic review and agree a new set of sustainability targets, including environmental targets, over the next decade. We will continue to monitor progress of our ethics and compliance programmes as well as the outcomes from our bullying and harassment campaign and reports to our Ethics Line. We will continue to oversee the Company’s compliance with the DPA in the UK and will commission an external assessment of our compliance programme during 2020 to ensure that we have maintained compliance with all of Lord Gold’s recommendations. We look forward to seeing continued tangible progress from the efforts by management to drive the desired behaviours and mindset, reinforcing an ethical, safety-focused and sustainability culture across the organisation. Sir Frank Chapman Chairman of the Safety, Ethics & Sustainability Committee The Committee reviews the operation of the speak up procedures at each meeting; this includes statistics, types of cases raised, and the average completion time. In 2018, we observed that bullying and harassment were prevalent themes and in March this year, the Group-wide anti-bullying and harassment campaign was launched as part of the wider care initiative in respect of our people, with the aim of creating an environment where everyone can be at their best. This included mandatory scenario-based training for all employees and leaders, as well as specific training for our people team and trade union employee representatives, as well as regular updates to the Executive Team and ELG. In July, the Committee also undertook a light version of this training so that we could get a better understanding of the impact and benefit it would have on employees. Focus has also been given to the speed at which a resolution is reached once a bullying and harassment case has been raised and, on average, the time taken to close an investigation is 25 days. Following on from the roll-out in 2018 of Our Code and simplified Group policies, revised mandatory training requirements were launched in 2019 with a completion deadline of the end of October. New modules covering conflicts of interest and binding corporate rules were added to the anti-bullying and harassment and simplified product safety training. A refresher on Zero Harm life-saving rules was also included as was an annual requirement for all managers globally to certify to Our Code. Our Code, which sets out the principles that underpin our values and the way we do business, was developed as a mobile-enabled app and launched at the beginning of the year. It allows our employees and suppliers to access it from wherever they are in the world and it has received positive feedback both internally and externally. We received a report from the head of ethics and compliance who carried out an independent review of the speak up cases which had been received on the proposed changes to the UK defined benefit pension scheme. The Committee received the report and noted the conclusions, which would be shared with elected representatives of the affected employees and all decision makers. While the report found that there had clearly been some room for improvement, particularly in the way the changes had been communicated, the majority of the concerns raised via the speak up channels were not founded. We also monitored our ongoing compliance with the General Data Privacy Regulations and the application for the EU regime of Data Privacy Binding Corporate Rules. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Science & Technology Committee Report 111 SCIENCE & TECHNOLOGY SIR KEVIN SMITH Chairman of the Science & Technology Committee Key highlights Technology strategy, investment and programmes review Review electrical systems strategy Review of UltraFan demonstrator, Advance3 and power gearbox Services strategy review Review of digital strategy and capability Introduction In 2019, the Committee continued to provide dedicated focus to the research and technology part of the Group’s R&D investment that enables the Group to conceive, design and deliver world-class technology that meets our customers’ current and future needs. We provide directional input and oversight of the Group’s scientific and technological strategy, processes and related investments. In addition to our scheduled meetings, we visited the power gearbox (PGB) facility and Civil Aerospace engine assembly and test facility in Germany and the Defence operations and engine test beds in the UK. Membership and operation of the Committee In addition to myself, members of the Committee during 2019 were Ruth Cairnie, Sir Frank Chapman, Brad Singer and Jasmin Staiblin, all Non-Executive Directors. Our biographies are on pages 62 to 64 and meeting attendance is on page 66. Brad Singer stepped down as a member of the Committee in December. Ruth also stepped down at the end of the year. I would like to take this opportunity to thank the Committee for their unstinting enthusiasm and engagement during the year. The Committee’s responsibilities are outlined in its terms of reference, available at www.rolls-royce.com. We review these annually and refer them to the Board for approval. No changes have been made in 2019. This follows a detailed review in 2018 to ensure alignment with the principles of the Code. Other attendees In addition to the members of the Committee, the Chairman, Chief Executive, Chief Financial Officer and any of the Non-Executive Directors may attend one or more meetings at the Committee chairman’s invitation. The Committee is supported by the corporate governance director and the Chief Technology Officer. Committee evaluation review Belinda Hudson Limited (BHL) was appointed for a second year, this time to undertake a light touch review of the Board and committees, following a full review in 2018. The effectiveness review process of the Board and its committees is discussed in greater detail on page 74 together with overall findings. Principal responsibilities Technology strategy Review the strategic direction of the Group’s research, technology and development activities, with consideration to their environmental impact amongst other matters, and ensure investment is allocated appropriately. Keep under review the key technology programmes. Assist the Board in its oversight of major R&D investment and provide assurance on its competitiveness and the adequacy of technology investment, with thorough consideration to the environmental impact of new products and technology. Cross-sector technology Oversee the effectiveness of key engineering and technology processes and operations, including delivery of major product development and technology programmes. Technology capabilities and skills Oversee processes for ensuring effective resourcing and development of required technological capability and skills. Conduct visits to R&D facilities. Technology trends and risks Provide assurance on the identification and management of key technological risks. Review and consider any other topics or risks appropriate to the overall remit of the Committee as delegated by the Board. Principal risk Disruptive technologies and business model, a subset of competitive environment. Areas of focus for 2020 Oversight of the Group’s technology programme with focus on technologies supporting the Group’s approach to low carbon power Reviews of key programmes and business cases including SMRs, UltraFan and hybrid-electric regional aviation Review of digital, electrical and hybrid-electrical and hydrogen fuel based technologies Continued review of efficiency and effectiveness of technology development, assessment of skills and capability development and alignment with the technology strategy DIRECTORS’ REPORT112 Directors’ Report Science & Technology Committee Report Rolls-Royce Holdings plc Annual Report 2019 Science & Technology Committee focus during 2019 Area of focus Matters considered Outcome Technology strategy Cross-sector technology Technology capabilities and skills The Group’s technology strategy. Investment allocation. Review of key technology programmes. Efficiency and effectiveness review. UltraFan demonstrator. The Group’s electrical systems strategy. The strategic objectives and associated investment funding allocations were confirmed to be appropriate. The review of key technology programmes helped shape the Board’s discussions during the year. An in-depth review of the Defence aerospace technology programmes was presented and endorsed by the Committee. The Committee made a number of recommendations to management to improve the efficiency and effectiveness of the Group’s future research and technology programmes. Oversight of the UltraFan demonstrator programme maintained throughout the year and advised the Board on progress. Direction of the Group electrical systems technology development supported. Engineering capabilities of the future. Visits to large engine assembly and test bed sites. Reviewed the engineering resource prioritisation across the Group. Visits provided a good opportunity to evidence physical progress on key technology programmes, together with an invaluable opportunity to meet the local teams. Technology trends and risks Artificial intelligence and internet of things. Endorsement of both the artificial intelligence and internet of things programmes and their part in the Group’s future technology strategy. Oversight of principal risk Disruptive technologies and business model. A subset of the principal risk, competitive environment, the review confirmed that the identification of disruptive technology threats and ongoing mitigation activities continued to support the direction for future key activities. 2019 overview In 2019, the Committee continued with our work from the previous year in overseeing the technology strategy, the prioritisation of resources towards technology development and acquisition, and assessing competitiveness in key technology and product areas. In doing this, we place importance on ensuring active dialogue with engineering and technology leaders and experts, inviting relevant employees to Committee meetings, meeting with employees during site visits and developing future leaders through the Board apprentice programme. At the first meeting of the year in February, we reviewed the 2019 technology programme and the investment funding allocation. We also received an update on the progress made on technology plans for each business and also in the Innovation Hub. As reported in previous years, significant investment is directed towards aerospace technology demonstrators to validate new architectures and gas turbine technologies vital to supporting future competitiveness and delivering a step change improvement in environmental impact. We conducted several reviews of the UltraFan demonstrator programme over the year, noting progress in its design and testing, and understanding the plans and choices on competitive differentiating technologies which would enable a step change in efficiency. We discussed the UltraFan business case and options for meeting potential customer requirements, the phased investments proposed to deliver the programme and the approach to managing risks and programme dependencies. During the year, we received regular progress updates on key technologies, particularly the PGB, which is a critical component connecting the Advance3 core to the composite front fan system, and is undergoing design maturity testing ahead of the first UltraFan demonstrator engine run in 2021. In April, the Committee visited the PGB test facility and dedicated team area in Dahlewitz, Germany and met with key staff. We also undertook a tour of the Civil Aerospace engine assembly and test facility located on the same site. The Committee advised the Board on progress and funding continuation of the programme. The Committee also reviewed progress on development and maturing key high-temperature gas turbine technology which has applicability across all aero-engine programmes. We received a presentation on the Group’s strategy and competitive position on propulsion for business aviation to understand how the technology was being developed. In September, the Committee was updated on the development of the Group’s technology strategy which includes a growing level of investment in new capability in electrical and digital technologies, and the launch of the study phase of the small modular reactor (SMR) programme, all of which will play a part in the Group’s approach to lower carbon power and the shift to low carbon technologies for the future. We were encouraged to hear that electrical systems technology development is increasingly becoming central to delivering the businesses’ future product plans. In aerospace applications, a number of demonstrator programmes are taking shape, including the E-Fan X megawatt hybrid-electric propulsion programme with Airbus for which a new megawatt generator is being developed, and kilowatt hybrid-electric aero propulsion research and application demonstrators that were announced in the UK and Germany. We were briefed on the acquisition of the aerospace electrical components business from Siemens and its fit to the Group’s electrical technology roadmap. Further electrical technology development will be a focus area for the Committee in the coming year. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Science & Technology Committee Report 113 We also gave our support to further development of the approach to strategic management of technology acquisition and the Company’s approach to technology partnering as a means of obtaining access to co-investment, skilled resources and accelerating technology development. We discussed the risks and opportunities arising from protection/exploitation of intellectual property and have further encouraged increased attention in this area. We further received an update on the Group’s risk appetite and assessment of technologies that enable disruption with regard to the Group’s 2019 principal risk related to the competitive environment. This will remain a live process to ensure awareness of potential shifts. Looking forward The focus for the Committee in 2020 will be on low carbon technologies that are vital to innovation and future products and services and underpin the Group’s sustainability strategy. We will continue to monitor the UltraFan demonstrator and associated technology programmes and progress on the first phase of SMRs for low carbon power generation and review the business case for making use of SMRs to produce sustainable fuels. The continuing development of the Group’s capabilities and technologies in electrical and digital will also feature strongly in our agenda, including the case for hybrid-electrical propulsion for regional aviation as well as the future of reciprocating engines and alternative sustainable fuels. These are exciting times for technologists and engineers in Rolls-Royce as the Company accelerates its drive for sustainable propulsion providing opportunity to acquire new skills, work on new products and to play a full part in securing a low carbon world. I admire their dedication to achieving that goal and cannot help but be a little envious of the opportunities it provides. In closing this year’s report, I would like to pay tribute to the work of our global network of 29 University Technology Centres and seven Advanced Manufacturing Research Centres who play a vital role in the development of our core technology and science base. The 1,300 people, including 500 PHDs, in those institutions who work in partnership with our employees are a crucial part of the extended Rolls-Royce family and I thank them on behalf of the Board for the major contribution they make to building the future of Rolls-Royce. Sir Kevin Smith Chairman of the Science & Technology Committee The Committee received a presentation on the digital strategy and five-year roadmap for digital capability and the digital thread across engineering design, manufacturing and services, and reviewed the current status of transitioning away from legacy systems. We were updated regarding the progress with how the IT and engineering systems were supporting the transformation programme for engineering. We received specific presentations on the Company’s strategy on artificial intelligence (AI) and the internet of things (IoT). We were taken through how specialists from the R² Data Labs team facilitate the application of AI and IoT and were briefed on the broad training provided to enhance the workforce’s skills through the Digital Academy. We also discussed the Group’s approach to an ecosystem to access these rapidly advancing technologies and how the strategy of in-house skills and capabilities would affect competitiveness. The Committee reviewed the proposal to develop a new generation of SMRs that would leverage the Company’s advanced manufacturing capabilities as well as its nuclear power design expertise to develop a near-zero carbon source of power generation by the early 2030s at a competitive levelised cost of electricity. We were given an overview of potential for a very large market demand including the potential for future net-zero carbon fuel production at scale. We received a briefing on consortium partnerships, potential business models and the business case, to understand the opportunity which has now been launched in a first phase with UK Government funding support. We reviewed the technology across the Defence business and received a presentation on opportunities and programmes in the US and the UK. We also visited the Company’s operations and engine test beds in Bristol, UK where, among other things, integrated electrical systems are validated. We discussed near-term defence market opportunities and how our core gas turbine technologies and digital engineering design systems and approach could enhance our position to win competitive contracts. The requirements for future defence systems and solutions are driving development of a combination of technologies, such as electrical, power and thermal management and advanced specialised combat propulsion technologies which are being developed under the UK Tempest advanced combat fighter programme. We were also briefed on the progress on the integrated power systems for directed energy systems, which have growth potential for land, sea and airborne applications. Finally, we reviewed the planned investment and resourcing roadmap that will enable the business to continue to pursue, develop and grow its defence markets. Further, the Committee received an update on the Group’s services strategy and associated technology development plans. We were pleased to see real progress and significant value delivered by application of digital, inspection and repair technologies. We encouraged management to continue to pursue new technology and ways of working in these areas, noting that this is critical in addition to the product investments to improve engine durability in service. To get an understanding of the investment choices across all engineering activities and related skill sets, the Committee undertook a detailed review of the full engineering investment and resource prioritisation across the Group. We were briefed on spend and resourcing relating to new product development, technology development and in-service product support needs. The Committee supports the changes that have been introduced to improve the visibility of investment choices and how they relate to the application of key skilled resources. This provided a better understanding of the overall technology investments and technology choices. DIRECTORS’ REPORT114 Directors’ Report Responsibility Statements Rolls-Royce Holdings plc Annual Report 2019 RESPONSIBILITY STATEMENTS Statement of Directors’ responsibilities in respect of the Financial Statements The Directors are responsible for preparing the Annual Report and the Financial Statements in accordance with applicable law and regulation. Directors’ confirmations The Directors consider that the Annual Report, taken as a whole, is fair, balanced and understandable and provides the information necessary for shareholders to assess the Group and parent company’s position and performance, business model and strategy. Each of the Directors, whose names and functions are listed in the Directors’ Report, confirm that to the best of his or her knowledge: — the Group Financial Statements, which have been prepared in accordance with IFRSs as adopted by the European Union, give a true and fair view of the assets, liabilities, financial position and loss of the Group; — the parent company Financial Statements, which have been prepared in accordance with United Kingdom Generally Accepted Accounting Practice (United Kingdom Accounting Standards, comprising FRS 101 Reduced Disclosure Framework, and applicable law), give a true and fair view of the assets, liabilities, financial position and result of the Company; and — the Strategic Report includes a fair review of the development and performance of the business and the position of the Group and parent company, together with a description of the principal risks and uncertainties that it faces. By order of the Board Pamela Coles Company Secretary 28 February 2020 Company law requires the Directors to prepare financial statements for each financial year. Under that law the Directors have prepared the Group Financial Statements in accordance with International Financial Reporting Standards (IFRSs) as adopted by the European Union and the parent company Financial Statements in accordance with United Kingdom Generally Accepted Accounting Practice (United Kingdom Accounting Standards, comprising FRS 101 Reduced Disclosure Framework, and applicable law). Under company law, the Directors must not approve the Financial Statements unless they are satisfied that they give a true and fair view of the state of affairs of the Group and parent company and of the profit or loss of the Group and parent company for that period. In preparing the Financial Statements, the Directors are required to: — select suitable accounting policies and then apply them consistently; — state whether applicable IFRSs, as adopted by the European Union, have been followed for the Group Financial Statements and United Kingdom Accounting Standards comprising FRS 101, have been followed for the Company Financial Statements, subject to any material departures disclosed and explained in the Financial Statements; — make judgements and accounting estimates that are reasonable and prudent; and — prepare the Financial Statements on the going concern basis unless it is inappropriate to presume that the Group and parent company will continue in business. The Directors are also responsible for safeguarding the assets of the Group and parent company and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities. The Directors are responsible for keeping adequate accounting records that are sufficient to show and explain the Group and parent company’s transactions and disclose with reasonable accuracy at any time the financial position of the Group and parent company. This enables them to ensure that the Financial Statements and the Directors’ Remuneration Report comply with the Companies Act 2006 and, as regards the Group’s Consolidated Financial Statements, Article 4 of the IAS Regulation. The Directors are responsible for the maintenance and integrity of the parent company’s website. Legislation in the United Kingdom governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements 115 FINANCIAL STATEMENTS Consolidated Financial Statements Company Financial Statements Company Balance Sheet Company Statement of Changes in Equity Investments – subsidiary undertakings Notes to the Company Financial Statements 1 Accounting policies 2 3 Trade receivables and other assets 4 Trade payables and other liabilities 5 Financial liabilities 6 Share capital 7 Reconciliation of net assets between Rolls-Royce Holdings plc Group and Company 8 Contingent liabilities 9 Other information Subsidiaries Joint Ventures and Associates 183 183 184 184 185 185 185 185 186 186 186 187 192 Consolidated Income Statement Consolidated Statement of Comprehensive Income Consolidated Balance Sheet Consolidated Cash Flow Statement Consolidated Statement of Changes in Equity Research and development Notes to the Consolidated Financial Statements 1 Accounting policies 2 Segmental analysis 3 4 Net financing 5 Taxation 6 Earnings per ordinary share 7 Auditors’ remuneration 8 Employee information 9 Intangible assets 10 Property, plant and equipment 11 Right-of-use assets 12 Investments 13 Inventories 14 Trade receivables and other assets 15 Contract assets and liabilities 16 Cash and cash equivalents 17 Borrowings and lease liabilities 18 Trade payables and other liabilities 19 Financial instruments 20 Provisions for liabilities and charges 21 Post-retirement benefits 22 Share capital 23 Share-based payments 24 Leases 25 Contingent liabilities 26 Related party transactions 27 Acquisitions and disposals 28 Derivation of summary funds flow statement 29 Impact of adopting IFRS 16 Leases 116 117 118 119 122 123 134 140 141 141 144 145 145 146 149 150 151 153 153 154 155 155 156 157 166 168 172 173 174 176 176 177 179 181 FINANCIAL STATEMENTS 116 Financial Statements Consolidated Income Statement Rolls-Royce Holdings plc Annual Report 2019 CONSOLIDATED INCOME STATEMENT For the year ended 31 December 2019 Revenue 1 Cost of sales 1 Gross profit Commercial and administrative costs 1 Research and development costs Share of results of joint ventures and associates Operating loss Gain arising on disposal of businesses 2 Loss before financing and taxation Financing income Financing costs Net financing costs Loss before taxation 3 Taxation Loss for the year Attributable to: Ordinary shareholders Non-controlling interests Loss for the year Other comprehensive (expense)/income Total comprehensive expense for the year Loss per ordinary share attributable to ordinary shareholders: Basic Diluted Payments to ordinary shareholders in respect of the year: Pence per share Total Underlying profit before taxation 3 Notes 2 3 12 27 2 4 4 5 6 19 2 2019 £m 16,587 (15,645) 942 (1,128) (770) 104 (852) 139 (713) 252 (430) (178) (891) (420) (1,311) (1,315) 4 (1,311) (1,013) (2,324) 2018 £m 15,729 (14,531) 1,198 (1,595) (768) 4 (1,161) 358 (803) 271 (2,415) (2,144) (2,947) 554 (2,393) (2,401) 8 (2,393) 182 (2,211) (69.07)p (69.07)p (129.15)p (129.15)p 11.7p 224 11.7p 220 583 466 1 Included within revenue, cost of sales and commercial and administrative costs are exceptional charges relating to Civil Aerospace programmes, impairment charges and restructuring costs. Further details can be found in note 2. 2 Commercial Marine was disposed of on 1 April 2019 and Rolls-Royce Power Development Limited was disposed of on 15 April 2019. L’Orange was disposed of on 1 June 2018. 3 (Loss)/profit before taxation disclosed on a statutory and underlying basis. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Consolidated Statement of Comprehensive Income 117 CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME For the year ended 31 December 2019 Loss for the year Other comprehensive (expense)/income (OCI) Actuarial movements on post-retirement schemes 1 Share of OCI of joint ventures and associates Related tax movements Items that will not be reclassified to profit or loss Foreign exchange translation differences on foreign operations Reclassified to income statement on disposal of businesses Cash flow hedge reserve movements Share of OCI of joint ventures and associates Related tax movements Items that may be reclassified to profit or loss Total other comprehensive (expense)/income Total comprehensive expense for the year Attributable to: Ordinary shareholders Non-controlling interests Total comprehensive expense for the year Notes 21 12 5 27 12 5 2019 £m (1,311) (934) (1) 324 (611) (313) (98) 22 (7) (6) (402) (1,013) 2018 £m (2,393) 27 (1) (2) 24 171 (19) (17) 18 5 158 182 (2,324) (2,211) (2,328) 4 (2,324) (2,219) 8 (2,211) 1 Includes an asset re-measurement net loss estimated at £600m following the agreement to transfer the future pension obligations of circa 33,000 pensions in the UK scheme to Legal & General Assurance Society Limited. See note 21 for further information. FINANCIAL STATEMENTS118 Financial Statements Consolidated Balance Sheet Rolls-Royce Holdings plc Annual Report 2019 CONSOLIDATED BALANCE SHEET At 31 December 2019 ASSETS Intangible assets Property, plant and equipment Right-of-use assets 1 Investments – joint ventures and associates Investments – other Other financial assets Deferred tax assets Post-retirement scheme surpluses Non-current assets Inventories Trade receivables and other assets Contract assets Taxation recoverable Other financial assets Short-term investments Cash and cash equivalents Current assets Assets held for sale TOTAL ASSETS LIABILITIES Borrowings and lease liabilities Other financial liabilities Trade payables and other liabilities Contract liabilities Current tax liabilities Provisions for liabilities and charges Current liabilities Borrowings and lease liabilities Other financial liabilities Trade payables and other liabilities Contract liabilities Deferred tax liabilities Provisions for liabilities and charges Post-retirement scheme deficits Non-current liabilities Liabilities associated with assets held for sale TOTAL LIABILITIES NET LIABILITIES EQUITY Called-up share capital Share premium account Capital redemption reserve Cash flow hedging reserve Merger reserve Translation reserve Accumulated losses Equity attributable to ordinary shareholders Non-controlling interests TOTAL EQUITY Notes 2019 £m 2018 £m 9 10 11 12 12 19 5 21 13 14 15 19 19 16 27 17 19 18 15 20 17 19 18 15 5 20 21 27 22 5,442 4,803 2,009 402 14 467 1,887 1,170 16,194 4,320 5,065 2,095 39 86 6 4,443 16,054 18 32,266 (775) (493) (8,450) (4,228) (172) (858) (14,976) (4,910) (3,094) (2,071) (6,612) (618) (1,946) (1,378) (20,629) (15) (35,620) 5,295 4,929 – 412 22 343 2,092 1,944 15,037 4,287 4,690 2,057 34 22 6 4,974 16,070 750 31,857 (858) (647) (8,292) (3,794) (138) (1,122) (14,851) (3,804) (3,542) (1,940) (5,336) (962) (795) (1,303) (17,682) (376) (32,909) (3,354) (1,052) 386 319 159 (96) 650 397 (5,191) (3,376) 22 (3,354) 379 268 161 (106) 406 809 (2,991) (1,074) 22 (1,052) 1 IFRS 16 Leases has been adopted from 1 January 2019 and under the transitional arrangements the Group has adopted IFRS 16 on a modified retrospective basis. There has been no restatement of 2018 comparatives. See notes 1 and 29 for more details. The financial statements on pages 116 to 182 were approved by the Board on 28 February 2020 and signed on its behalf by: Warren East Chief Executive Stephen Daintith Chief Financial Officer Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Consolidated Cash Flow Statement 119 CONSOLIDATED CASH FLOW STATEMENT For the year ended 31 December 2019 Reconciliation of cash flows from operating activities Operating loss (Profit)/loss on disposal of property, plant and equipment Share of results of joint ventures and associates Dividends received from joint ventures and associates Amortisation and impairment of intangible assets 1 Depreciation and impairment of property, plant and equipment 1 Depreciation and impairment of right-of-use assets Impairment of and other movements on investments Increase in provisions Increase in inventories Increase in trade receivables and other assets Increase in contract assets Penalties paid on agreements with investigating bodies Increase in trade payables and other liabilities Increase in contract liabilities Cash flows on other financial assets and liabilities held for operating purposes Interest received Net defined benefit post-retirement cost recognised in loss before financing Cash funding of defined benefit post-retirement schemes Share-based payments Net cash inflow from operating activities before taxation Taxation paid Net cash inflow from operating activities 2 Cash flows from investing activities Net movement in unlisted investments Additions of intangible assets Disposals of intangible assets Purchases of property, plant and equipment Disposals of property, plant and equipment Acquisitions of businesses Disposal of businesses Movement in investments in joint ventures and associates and other movements on investments Disposals of joint ventures Net cash outflow from investing activities Cash flows from financing activities Repayment of loans Proceeds from increase in loans Capital element of lease payments (2018: Capital element of finance lease payments) Net cash flow from (decrease)/increase in borrowings and leases Interest received Interest paid Interest element of lease payments (2018: Interest element of finance lease payments) Increase in short-term investments Issue of ordinary shares (net of expenses) Purchase of ordinary shares Dividends to NCI Redemption of C Shares Net cash (outflow)/inflow from financing activities Change in cash and cash equivalents Cash and cash equivalents at 1 January Exchange (losses)/gains on cash and cash equivalents Cash and cash equivalents at 31 December 3 Notes 12 12 9 10 11 12 21 21 23 12 9 9 27 27 12 2019 £m (852) (13) (104) 92 372 532 411 1 1,108 (43) (610) (41) (102) 683 1,778 (757) 31 222 (266) 30 2,472 (175) 2,297 3 (640) 13 (747) 50 (43) 453 (8) 1 (918) (1,136) 22 (271) (1,385) – (104) (88) – 24 (15) (4) (220) (1,792) (413) 4,952 (104) 4,435 2018 £m (1,161) 11 (4) 105 565 521 – 6 1,003 (616) (469) (112) – 1,732 1,419 (732) – 352 (181) 35 2,474 (248) 2,226 (6) (680) 13 (905) 43 – 573 (13) – (975) (37) 1,054 (23) 994 27 (92) (5) (3) 1 (1) (3) (216) 702 1,953 2,933 66 4,952 In 2019, an impairment of £58m in respect of Bergen Engines AS was included in these lines (2018: £160m in respect of Commercial Marine). 1 2 Operating cash flow includes Trent 1000 insurance receipts of £173m. 3 The Group considers overdrafts (repayable on demand) to be an integral part of its cash management activities and these are included in cash and cash equivalents for the purposes of the cash flow statement. In deriving the consolidated cash flow statement, movements in balance sheet line items have been adjusted for non-cash items. The cash flow in the year includes the sale of goods and services to joint ventures and associates – see note 26. FINANCIAL STATEMENTS120 Financial Statements Consolidated Cash Flow Statement Rolls-Royce Holdings plc Annual Report 2019 CONSOLIDATED CASH FLOW STATEMENT CONTINUED For the year ended 31 December 2019 Reconciliation of movements in cash and cash equivalents to movements in net funds/(debt) Change in cash and cash equivalents Cash flow from decrease/(increase) in borrowings and leases Cash flow from increase in short-term investments Change in net funds resulting from cash flows New leases in the year (2018: new finance leases in the year) Net debt (excluding cash and cash equivalents) of previously unconsolidated subsidiary Exchange (losses)/gains on net funds Fair value adjustments Transferred to liabilities associated with assets held for sale Movement in net funds Net funds/(debt) at 1 January excluding the fair value of swaps Reclassifications 1 Adoption of IFRS 16 (see note 29) Net debt at 1 January restated Net (debt)/funds at 31 December excluding the fair value of swaps Fair value of swaps hedging fixed rate borrowings Net (debt)/funds at 31 December 2019 £m 2018 £m (413) 1,385 – 972 (217) (1) (32) 48 3 773 318 (79) (2,248) (2,009) (1,236) 243 (993) 1,953 (994) 3 962 (97) – 54 (69) – 850 (532) – – (532) 318 293 611 1 In 2019, the Group has reclassified £79m as borrowings previously included in other financial liabilities. These borrowings mature between 2019 and 2029 – see note 17. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Consolidated Cash Flow Statement 121 CONSOLIDATED CASH FLOW STATEMENT CONTINUED For the year ended 31 December 2019 The movement in net funds/(debt) (defined by the Group as including the items shown below) is as follows: Transition to IFRS 16 and reclassi- fications 1 £m At 31 December 2018 £m At 1 January £m Funds flow £m Net funds on acquisition/ disposal £m Exchange differences £m Fair value adjustments £m Reclassi- fications £m Other movements on leases £m At 31 December £m 2019 Cash at bank and in hand Money market funds Short-term deposits Cash and cash equivalents 2 (per balance sheet) Overdrafts Cash and cash equivalents (per cash flow statement) Short-term investments Other current borrowings Non-current borrowings Finance leases Lease liabilities Financial liabilities Net funds/(debt) excluding fair value swaps Fair value of swaps hedging fixed rate borrowings 3 Net funds/(debt) Net funds (excluding lease liabilities) 2018 Cash at bank and in hand Money market funds Short-term deposits Cash and cash equivalents (per balance sheet) Overdrafts Cash and cash equivalents (per cash flow statement) Short-term investments Other current borrowings Non-current borrowings Finance leases Financial liabilities Net (debt)/funds excluding fair value swaps Fair value of swaps hedging fixed rate borrowings 3 Net (debt)/funds 1,023 1,222 2,729 4,974 (22) 4,952 6 (802) (3,609) (229) – (4,640) – – – – – 1,023 1,222 2,729 (179) (124) (124) 4,974 (22) (427) 14 – – (14) (65) 229 (2,477) (2,327) 4,952 6 (816) (3,674) – (2,477) (6,967) (413) – 799 315 – 271 1,385 318 (2,327) (2,009) 972 293 611 840 – (2,327) (79) 293 (1,716) 761 – 972 838 589 1,526 170 630 1,155 2,953 (20) 1,955 (2) 2,933 3 (39) (3,292) (137) (3,468) 1,953 3 (38) (972) (81) (1,091) (532) 865 227 (305) – 865 – – – – – – – – (1) – – (1) (1) – (1) – – – – – – – – – – – – – – (19) (3) (82) (104) – (104) – 2 4 – 66 72 (32) – (32) 15 3 48 66 – 66 – (1) – (11) (12) 54 – 54 – – – – – – – 5 43 – – 48 48 (50) (2) – – – – – – – 15 (84) – (69) (69) 66 (3) – – – – – – – (417) 417 – 3 3 3 – 3 – – – – – – – (739) 739 – – – – – – – – – – – – – – – (217) (217) 825 1,095 2,523 4,443 (8) 4,435 6 (427) (2,896) – (2,354) (5,677) (217) (1,236) – (217) – – – – – – – – – – – – – – 243 (993) 1,361 1,023 1,222 2,729 4,974 (22) 4,952 6 (802) (3,609) (229) (4,640) 318 293 611 1 In 2019, the Group has reclassified £79m as borrowings previously included in other financial liabilities. These borrowings mature between 2019 and 2029 – see note 17. 2 Includes Trent 1000 insurance receipts of £173m. 3 All interest rate swaps are entered into for risk management purposes, although these may not be designated into hedging relationships for accounting purposes – see note 19. FINANCIAL STATEMENTS122 Financial Statements Consolidated Statement of Changes in Equity Rolls-Royce Holdings plc Annual Report 2019 CONSOLIDATED STATEMENT OF CHANGES IN EQUITY For the year ended 31 December 2019 At 31 December 2017 Impact of adopting IFRS 9 At 1 January 2018 (Loss)/profit for the year Foreign exchange translation differences on foreign operations Reclassified to income statement on disposal of L’Orange Movements on post-retirement schemes Debited to cash flow hedge reserve OCI of joint ventures and associates Related tax movements Total comprehensive income/(expense) for the year Shares issued in respect of acquisition of ITP Aero Other issues of ordinary shares Issue of C Shares 3 Redemption of C Shares Shares issued to employee share trust Share-based payments – direct to equity 4 Transfer of joint operations to subsidiaries Transactions with NCI Related tax movements Other changes in equity in the year At 31 December 2018 Impact of adopting IFRS 16 At 1 January 2019 (Loss)/profit for the year Foreign exchange translation differences on foreign operations Reclassified to income statement on disposal of Commercial Marine Movements on post-retirement schemes Credited to cash flow hedge reserve OCI of joint ventures and associates Related tax movements Total comprehensive income/(expense) for the year Arising on issues of ordinary shares Shares issued in respect of acquisition of ITP Aero Issue of C Shares 3 Redemption of C Shares Ordinary shares purchased Shares issued to employee share trust Share-based payments – direct to equity 4 Transactions with NCI Related tax movements Other changes in equity in the year At 31 December 2019 Attributable to ordinary shareholders Notes Share capital £m 368 – 368 – Share premium £m 195 – 195 – Capital redemption reserve £m 162 – 162 – Cash flow hedging reserve 1 £m (112) – (112) – Merger reserve £m 3 – 3 – Translation reserve £m 657 – 657 – Accum- ulated losses 2 £m (343) (15) (358) (2,401) Non- controlling Total interests equity (NCI) £m £m 933 3 (15) – 3 918 8 (2,393) Total £m 930 (15) 915 (2,401) – – – – – – – 10 1 – – – – – – – 11 379 – 379 – – – – – – – 1 6 – – – – – – – 7 386 21 12 5 22 5 21 12 5 22 5 – – – – – – – – 73 – – – – – – – 73 268 – 268 – – – – – – – – 51 – – – – – – – – 51 319 – – – – – – – – – (217) 216 – – – – – (1) 161 – 161 – – – – – – – – – – (222) 220 – – – – – (2) 159 – – – (17) 18 5 6 – – – – – – – – – – (106) – (106) – – – – 22 (7) (5) 10 – – – – – – – – – – (96) – – – – – – – 403 – – – – – – – – 403 406 – 406 – – – – – – – – – 244 – – – – – – – 244 650 171 (19) – – – – – 171 – 27 – (1) (2) (19) 27 (17) 17 3 – – – – – – 171 (19) 27 (17) 17 3 152 (2,377) (2,219) 8 (2,211) – – – – – – – – – – 809 – – – 1 (216) (75) 32 – – 2 (256) (2,991) (40) 809 (3,031) (1,315) – 413 74 (216) – (75) 32 – – 2 230 (1,074) (40) (1,114) (1,315) (313) – (313) (98) – – – (1) – (934) – (1) 324 (98) (934) 22 (8) 318 (412) (1,926) (2,328) 52 – – – – – – – – – – – 397 250 – (221) 1 – (220) (15) (15) (51) (51) 50 50 – – 1 1 (234) 66 (5,191) (3,376) – – – – – – 15 (4) – 11 22 – 413 74 (216) – (75) 32 15 (4) 2 241 (1,052) (40) 22 (1,092) (1,311) 4 – – – – – – (313) (98) (934) 22 (8) 318 4 (2,324) 52 – 250 – (221) – – – (15) – (51) – 50 – (4) (4) 1 – 62 (4) 22 (3,354) 1 See accounting policies note 1. 2 At 31 December 2019, 12,476,576 ordinary shares with a net book value of £108m (2018: 13,538,921, 2017: 6,466,153 ordinary shares with net book values of £123m and £52m respectively) were held for the purpose of share-based payment plans and included in accumulated losses. During the year, 8,984,219 ordinary shares with a net book value of £82m (2018: 468,165 shares with a net book value of £4m) vested in share-based payment plans. During the year, the Company acquired 118,831 (2018: 80,810) of its ordinary shares via reinvestment of dividends received on its own shares and purchased 1,673,143 (2018: nil) of its ordinary shares through purchases on the London Stock Exchange. During the year, the Company issued 28,973,262 new ordinary shares relating to the remaining three instalments for the acquisition of ITP Aero (2018: 47,556,914 new ordinary shares relating to the first five installments) and 7,803,043 new ordinary shares (2018: 7,460,173) to the Group’s share trust for its employee share-based payment plans with a net book value of £66m (2018: £74m). 3 In Rolls-Royce Holdings plc’s Company Financial Statements, C Shares are issued from the merger reserve, this reserve was created by a scheme of arrangement in 2011. As this reserve is eliminated on consolidation, in the Consolidated Financial Statements, the C Shares are shown as being issued from the capital redemption reserve. 4 Share-based payments – direct to equity is the share-based payment charge for the year less the actual cost of vesting excluding those vesting from own shares and cash received on share-based schemes vesting. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 123 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1 Accounting policies The Company Rolls-Royce Holdings plc (the ‘Company’) is a public company incorporated under the Companies Act 2006 and domiciled in the United Kingdom. The Consolidated Financial Statements of the Company for the year ended 31 December 2019 consist of the consolidation of the Financial Statements of the Company and its subsidiaries (together referred to as the Group) and include the Group’s interest in jointly controlled and associated entities. Basis of preparation and statement of compliance In accordance with the Companies Act 2006 and European Union (EU) regulations, these Consolidated Financial Statements have been prepared in accordance with International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) and interpretations issued by the IFRS Interpretations Committee (IFRIC), as adopted for use in the EU effective at 31 December 2019 (Adopted IFRS). The Company has elected to prepare its individual Company Financial Statements under FRS 101 Reduced Disclosure Framework. They are set out on pages 183 to 186 and the accounting policies in respect of its individual Company Financial Statements are set out on page 184. The Consolidated Financial Statements have been prepared on the historical cost basis except where Adopted IFRS requires the revaluation of financial instruments to fair value and certain other assets and liabilities on an alternative basis – most significantly post-retirement scheme obligations are valued on the basis required by IAS 19 Employee Benefits – and on a going concern basis as described on page 55. The Consolidated Financial Statements are presented in sterling which is the Company’s functional currency. The preparation of Consolidated Financial Statements in conformity with Adopted IFRS requires management to make judgements and estimates that affect the reported amounts of assets and liabilities at the date of the Consolidated Financial Statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Revisions to Adopted IFRS in 2019 IFRS 16 Leases The Group adopted IFRS 16 on 1 January 2019 using the modified retrospective approach. Under the specific transitional provisions in the standard, comparative information has not been restated. The reclassifications and the adjustments arising from the new leasing rules have been recognised in the opening balance sheet on 1 January 2019 (see note 29). Until 31 December 2018, leases of aircraft and engines, plant and equipment and land and buildings were classified as either finance or operating leases. Payments made under operating leases were charged to profit or loss on a straight-line basis over the period of the lease. From 1 January 2019, leases are recognised as a right-of-use asset and a corresponding liability at the date at which the leased asset is available for use by the Group. Each lease payment is allocated between reducing the liability and a finance cost. The finance cost is charged to the income statement over the lease period so as to produce a constant periodic rate of interest on the remaining balance of the liability for each period. On adoption of IFRS 16, the Group recognised additional lease liabilities in relation to leases which had previously been classified as operating leases under the previous principles of IAS 17 Leases. These liabilities were measured at the present value of the remaining lease payments, discounted using the Group’s incremental borrowing rate as of 1 January 2019. The weighted average incremental borrowing rate applied by the Group to the lease liabilities on 1 January 2019 was 3.7%. The associated right-of-use assets for certain high value property leases are measured on a retrospective basis as if the new rules had always been applied. As above, the Group’s incremental borrowing rate has been used. Other right-of-use assets are measured at the amount equal to the lease liability, adjusted by the amount of any prepaid or accrued lease payments relating to that lease recognised in the balance sheet as at 1 January 2019. In applying IFRS 16 for the first time, the Group has used the following practical expedients permitted by the standard: – on initial application, IFRS 16 was only applied to contracts that were previously classified as leases, the Group has elected not to reassess whether a contract is, or contains, a lease at the date of initial application. Instead, for contracts entered into before the transition date the Group has relied on its assessment made applying IAS 17 and IFRIC 4 Determining whether an Arrangement contains a Lease; – lease contracts with a duration of less than 12 months will continue to be expensed to the income statement on a straight-line basis over the lease term; – the lease term has been determined with the use of hindsight where the contract contains options to extend the lease; and – reliance on previous assessments on whether or not leases are onerous. Note 29 sets out the adjustments made on transition to IFRS 16 on 1 January 2019. The most significant changes are where the Group is a lessee as the standard has not significantly changed the accounting where the Group is a lessor in a lease arrangement. IFRIC 23 Uncertainty over Income Tax Treatment The Group adopted IFRIC 23 on 1 January 2019. The interpretation clarifies how to apply the recognition and measurement requirements in IAS 12 Income Taxes when there is uncertainty over income tax treatments. Adoption of this interpretation did not have a material impact on the Group’s financial statements. Amendments to IFRS 9, IAS 39 and IFRS 7 Interest Rate Benchmark Reform The Group has elected to early adopt the amendments in accordance with the transition provisions. Details of the impact to the Group are given on page 129. FINANCIAL STATEMENTS124 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 1 Accounting policies continued Key areas of judgement and sources of estimation uncertainty The determination of the Group’s accounting policies requires judgement. The subsequent application of these policies requires estimates; the actual outcome may differ from that calculated. The key judgements and key sources of estimation uncertainty at the balance sheet date, that have a significant risk of causing material adjustment to the carrying amounts of assets and liabilities within the next financial year, are summarised below. Further details are included within the significant accounting policies as indicated. Area Revenue recognition Key judgements – Whether Civil Aerospace OE and aftermarket Key sources of estimation uncertainty Estimates of future revenue and costs of long-term contractual arrangements Page 125 Risk and revenue sharing arrangements Taxation Financial instruments Business combinations Research and development contracts should be combined – How performance on long-term aftermarket contracts should be measured – Whether any costs should be treated as wastage – Whether sales of spare engines to joint ventures are at fair value Determination of the nature of entry fees received Whether deferred tax assets should be recognised Application of the business model and ‘solely principal and interest’ test Identification of acquired assets and liabilities – Determination of the point in time where costs incurred on an internal programme development meet the criteria for capitalisation or ceasing capitalisation – Determination of the basis for amortising Estimates necessary to assess whether it is probable that sufficient suitable taxable profits will arise in the UK to utilise the deferred tax assets Leases capitalised development costs Determination of lease term Impairment of goodwill Impairment of intangible assets (including programme-related intangible assets) Provisions Post-retirement benefits Determination of cash-generating units for assessing impairment of goodwill Assessment of satisfying the criteria for the recognition and measurement of provisions Estimates of the payments required to meet residual value guarantees at the end of engine leases Estimates of cash flow forecasts and discount rates to support the carrying value of intangible assets (including programme-related intangible assets) Estimates of expenditure required to settle the obligation relating to Trent 1000 claims and to settle long-term contracts assessed as onerous Estimates of the assumptions applied for valuing the defined benefit obligation Sensitivities for key sources of estimation risk are disclosed in the relevant notes where this is appropriate and practicable. Significant accounting policies The Group’s significant accounting policies are set out below. With the exception of IFRS 16 and IFRIC 23, which have been adopted with effect from 1 January 2019, these accounting policies have been applied consistently to all periods presented in these Consolidated Financial Statements. Presentation of underlying results We measure financial performance on an underlying basis. We believe this is the most appropriate basis to measure our in-year performance as underlying results reflect the substance of trading activity, including the impact of the Group’s foreign exchange forward contracts, which lock in transactions at predetermined exchange rates. In addition, underlying results exclude the accounting impact of business acquisitions and disposals, impairment charges and exceptional items. It is also consistent with the way that financial performance is measured by management and reported to the Board in accordance with IFRS 8 Operating Segments. Further details are given in note 2. Basis of consolidation The Consolidated Financial Statements include the Company Financial Statements and its subsidiary undertakings together with the Group’s share of the results in joint arrangements and associates made up to 31 December. A subsidiary is an entity controlled by the Company. Control exists when the Company has power over an entity, exposure to variable returns from its involvement with an entity and the ability to use its power over an entity so as to affect the Company’s returns. 127 127 128 129 130 131 131 131 132 133 Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 125 1 Accounting policies continued A joint arrangement is an entity in which the Group holds a long-term interest and which is jointly controlled by the Group and one or more other venturers under a contractual arrangement. Joint arrangements may be either joint ventures or joint operations. An associate is an entity, being neither a subsidiary nor a joint arrangement, in which the Group holds a long-term interest and where the Group has a significant influence. The results of joint ventures and associates are accounted for using the equity method of accounting. Joint operations are accounted for using proportionate accounting. Any subsidiary undertaking, joint arrangement or associate sold or acquired during the year are included up to, or from, the date of change of control. Transactions with non-controlling interests are recorded directly in equity. The Commercial Marine business was disposed of on 1 April 2019 and Rolls-Royce Power Development Limited was disposed of on 15 April 2019. We announced the proposed disposal of the North America Civil Nuclear business on 26 September 2019, and the Knowledge Management System business on 17 December 2019. Both North America Civil Nuclear and Knowledge Management System have been treated as a disposal group held for sale at 31 December 2019, with their assets and liabilities presented separately in the balance sheet. These disposals were completed on 31 January 2020 and 3 February 2020 respectively. In 2018, L’Orange was disposed of on 1 June and Commercial Marine was treated as a disposal group and held for sale (see note 27). On 30 September 2019, we acquired Siemens’ eAircraft business and in accordance with IFRS 3 Business Combinations, the fair value of the assets and liabilities acquired have been consolidated in the Group’s results from the date of acquisition (see note 27). All intra-group transactions, balances, income and expenses are eliminated on consolidation. Adjustments are made to eliminate the profit or loss arising on transactions with joint arrangements and associates to the extent of the Group’s interest in the entity. Revenue recognition Key judgement – Whether Civil Aerospace OE and aftermarket contracts should be combined In the Civil Aerospace business, OE contracts are with the airframers (except for spare engines), while the aftermarket contracts are with the aircraft operators, although there may be interdependencies between them. IFRS 15 Revenue from Contracts with Customers includes guidance on the combination of contracts, in particular that contracts with unrelated parties should not be combined. Notwithstanding the interdependencies, the Directors consider that, as the operators are ultimately purchasing an aircraft from the airframer, of which the engines are part, the engine contract should be considered separately from the aftermarket contract. In making this judgement, they also took account of industry practice. Key judgement – How performance on long-term aftermarket contracts should be measured The Group generates a significant proportion of its revenue from aftermarket arrangements. These aftermarket contracts, such as TotalCare and CorporateCare agreements in the Civil Aerospace business, cover a range of services and generally have contractual terms covering more than one year. Under these contracts, the Group’s primary obligation is to maintain customers’ engines in an operational condition and this is achieved by undertaking various activities, such as maintenance, repair and overhaul, and engine monitoring over the period of the contract. Revenue on these contracts is recognised over the period of the contract and the basis for measuring progress is a matter of judgement. The Directors consider that the stage of completion of the contract is best measured by using the actual costs incurred to date compared to the estimated costs to complete the performance obligations, as this reflects the extent of completion of the activities performed. Key judgement – Whether any costs should be treated as wastage In rare circumstances, the Group may incur costs of wasted material, labour or other resources to fulfil a contract where the level of cost was not reflected in the contract price. The identification of such costs is a matter of judgement and would only be expected to arise where there has been a series of abnormal events which give rise to a significant level of cost which is also of a nature that the Group would not expect to incur and hence is not reflected in the contract price. For example: where there are technical issues that require resolution to meet regulatory requirements; have a wide-ranging impact across a product type; and cause significant operational disruption to customers. Similarly, in these rare circumstances, significant disruption costs to support customers resulting from the actual performance of a delivered good or service may be treated as a cost in the period. Any costs identified as wastage are expensed when the obligation to incur them arises – see note 2. Key judgement – Whether sales of spare engines to joint ventures are at fair value The Civil Aerospace business maintains a pool of spare engines to support its customers. Some of these engines are sold to, and held by, joint venture companies. The assessment of whether the sales price reflects fair value is a key judgement. The Group considers that based upon its assessment, and by comparison to the sales price of spare engines to other third parties, the sales made to joint ventures reflect the fair value of the goods sold. Key estimate – Estimates of future revenue and costs on long-term contractual arrangements The Group has long-term contracts that fall into different accounting periods and which can extend over significant periods (generally up to 25 years) – the most significant of these are long-term service arrangements (LTSAs) in the Civil Aerospace business. The estimated revenue and costs are inherently imprecise and significant estimates are required to assess: engine flying hours, time-on-wing and other operating parameters; the pattern of future maintenance activity and the costs to be incurred; lifecycle cost improvements over the term of the contracts; and escalation of revenue and costs. The estimates take account of the inherent uncertainties, constraining the expected level of revenue as appropriate. In addition, many of the revenues and costs are denominated in currencies other than that of the relevant Group undertaking. These are translated at an estimated long-term exchange rates, based on historical trends and economic forecasts. FINANCIAL STATEMENTS126 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 1 Accounting policies continued Key estimate – Estimates of future revenue and costs on long-term contractual arrangements (continued) As previously explained, under IFRS 15 the Group, most significantly in Civil Aerospace, experiences volatility in revenue recognition and contract accounting adjustments of £33m have been recognised in 2019 (2018: £(276)m). Based upon the stage of completion of all widebody programmes as at 31 December 2019 within Civil Aerospace, the following changes in key estimates would result in the following catch-up adjustments recognised in 2020 (at underlying rates): – 5% increase/decrease in shop visit costs over the life of the programmes – £142m impact – 2% increase/decrease in revenue over the life of the programmes – £200m impact Revenue recognised comprises sales to the Group’s customers after discounts and amounts payable to customers. Revenue excludes value added taxes. The transaction price of a contract is typically clearly stated within the contract, although the absolute amount may be dependent on escalation indices and long-term contracts require the key estimates highlighted above. Refund liabilities where sales are made with a right of return are not typical in the Group’s contracts. Where they do exist, and consideration has been received, a portion, based on an assessment of the expected refund liability is recognised within other payables. The Group has elected to use the practical expedient not to adjust revenue for the effect of financing components, where the expectation is that the period between the transfer of goods and services to customers and the receipt of payment is less than a year. Sales of standard OE, spare parts and time and material overhaul services are generally recognised on transfer of control to the customer. This is generally on delivery to the customer, unless the specific contractual terms indicate a different point. The Directors consider whether there is a need to constrain the amount of revenue to be recognised on delivery based on the contractual position and any relevant facts, however, this is not typically required. Sales of services and OE specifically designed for the contract (most significantly in the Defence business) are recognised by reference to the progress towards completion of the performance obligation, using the cost method described in the key judgements, provided the outcome of contracts can be assessed with reasonable certainty. The Group generates a significant portion of its revenue and profit on aftermarket arrangements arising from the installed OE fleet. As a consequence, in particular in the Civil Aerospace large engine business, the Group will often agree contractual prices for OE deliveries that take into account the anticipated aftermarket arrangements and therefore sometimes this may result in losses being incurred on OE. As described in the key judgements, these contracts are not combined. The consideration in the OE contract is therefore allocated to OE performance obligations and the consideration in the aftermarket contract to aftermarket performance obligations. – Future variable revenue from long-term contracts is constrained to take account of the risk of non-recovery of resulting contract balances from reduced utilisation e.g. engine flying hours, based on historical forecasting experience and the risk of aircraft being parked by the customer. – A significant amount of revenue and cost related to long-term contract accounting is denominated in currencies other than that of the relevant Group undertaking, most significantly US dollar transactions in sterling and euro denominated undertakings. These are translated at estimated long-term exchange rates. – The assessment of stage of completion is generally measured for each contract. However, in certain cases, such as for CorporateCare agreements where there are many contracts covering aftermarket services, each for a small number of engines, the Group accounts for a portfolio of contracts together as the effect on the Consolidated Financial Statements would not differ materially from applying the standard to the individual contracts in the portfolio. When accounting for a portfolio of long-term service arrangements the Group uses estimates and assumptions that reflect the size and composition of the portfolio. – A contract asset/liability is recognised where payment is received in arrears/advance of the costs incurred to meet performance obligations. – Where material, wastage costs (see key judgements on page 125) are recorded as an exceptional non-underlying expense. If the expected costs to fulfil a contract exceed the expected revenue, a contract loss provision is recognised for the excess costs. The Group pays participation fees to airframe manufacturers, its customers for OE, on certain programmes. Amounts paid are initially treated as contract assets and subsequently charged as a reduction to the OE revenue when the engine is transferred to the customer. The Group has elected to use the practical expedient to expense as incurred any incremental costs of obtaining or fulfilling a contract if the amortisation period of an asset created would have been one year or less. Where costs to obtain a contract are recognised in the balance sheet they are amortised over the performance of the related contract (average of three years). Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 127 1 Accounting policies continued Risk and revenue sharing arrangements (RRSAs) Key judgement – Determination of the nature of entry fees received RRSAs with key suppliers (workshare partners) are a feature of the Civil Aerospace business. Under these contractual arrangements, the key commercial objectives are that: (i) during the development phase the workshare partner shares in the risks of developing an engine by performing its own development work, providing development parts and paying a non-refundable cash entry fee; and (ii) during the production phase it supplies components in return for a share of the programme cash flows as a ‘life of type’ supplier (i.e. as long as the engine remains in service). The non-refundable cash entry fee is judged by the Group to be a contribution towards the development expenditure incurred. These receipts are deferred on the balance sheet and recognised against the cost of sales over the estimated number of units to be delivered. The payments to suppliers of their shares of the programme cash flows for their production components are charged to cost of sales as programme revenue arises. Cash entry fees received are initially deferred on the balance sheet and recognised as a reduction in cost of sales incurred, on a 15-year straight-line basis pro rata over the estimated number of units produced. The Group has arrangements with third parties who invest in a programme and receive a return based on its performance, but do not undertake development work or supply parts. Such arrangements (financial RRSAs) are financial instruments as defined by IAS 32 Financial Instruments: Presentation and are accounted for using the amortised cost method. Royalty payments Where a government or similar body has previously acquired an interest in the intellectual property of a programme, royalty payments are matched to the related sales. Government grants Government grants are recognised in the income statement so as to match them with the related expenses that they are intended to compensate. Where grants are received in advance of the related expenses, they are initially recognised in the balance sheet and released to match the related expenditure. Non-monetary grants are recognised at fair value. Interest Interest receivable/payable is credited/charged to the income statement using the effective interest method. Where borrowing costs are attributable to the acquisition, construction or production of a qualifying asset, such costs are capitalised as part of the specific asset. Taxation Key judgement – Whether deferred tax assets should be recognised Deferred tax assets are recognised to the extent it is probable that future taxable profits will be available, against which the deductible temporary difference can be utilised, based on management’s assumptions relating to the quantum of future taxable profits. Key estimate – Estimates necessary to assess whether it is probable that sufficient suitable taxable profits will arise in the UK to utilise the deferred tax assets Future taxable profits require significant estimates to be made, including: the pattern of future maintenance activity and the costs to be incurred; lifecycle cost improvements over the term of the contracts; and escalation of revenue and costs. The estimates take account of the inherent uncertainties, constraining the expected level of profit as appropriate. Changes in these estimates will affect future profits and therefore the recoverability of the deferred tax assets. Further details can be found in note 5. A 5% change in margin in the main Civil Aerospace widebody programmes would result in an increase/decrease in profits by circa £2bn (increase/decrease the deferred tax asset by £170m). The tax charge/credit on the profit or loss for the year comprises current and deferred tax: – Current tax is the expected tax payable for the year, using tax rates enacted or substantively enacted at the balance sheet date, and any adjustment to tax payable in respect of previous years. – Deferred tax is provided using the balance sheet liability method, providing for temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and the amounts used for tax purposes and is calculated using the enacted or substantively enacted rates that are expected to apply when the asset or liability is settled. In the UK, the deferred tax liability on the pension scheme surplus is recognised consistently with the basis for recognising the surplus, i.e. at the rate applicable to refunds from a trust. Tax is charged or credited to the income statement or OCI as appropriate, except when it relates to items credited or charged directly to equity in which case the tax is also dealt with in equity. Deferred tax liabilities are recognised for taxable temporary differences arising on investments in subsidiaries and joint arrangements, except where the Group is able to control the reversal of the temporary difference and it is probable that the temporary difference will not reverse in the foreseeable future. Deferred tax is not recognised on taxable temporary differences arising on the initial recognition of goodwill or for temporary differences arising from the initial recognition of assets and liabilities in a transaction that is not a business combination and that affects neither accounting nor taxable profit. FINANCIAL STATEMENTS128 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 1 Accounting policies continued Deferred tax assets are recognised only to the extent that it is probable that future taxable profits will be available against which the assets can be utilised. Further details on the Group’s tax position can be found on page 204. Foreign currency translation Transactions denominated in currencies other than the functional currency of the transacting Group undertaking are translated into the functional currency at the average monthly exchange rate when the transaction occurs. Monetary assets and liabilities denominated in foreign currencies are translated into the relevant functional currency at the rate prevailing at the year end. Exchange differences arising on foreign exchange transactions and the retranslation of assets and liabilities into functional currencies at the rate prevailing at the year end are included in profit/(loss) before taxation. The trading results of Group undertakings are translated into sterling at the average exchange rates for the year. The assets and liabilities of overseas undertakings, including goodwill and fair value adjustments arising on acquisition, are translated at the exchange rates prevailing at the year end. Exchange adjustments arising from the retranslation of the opening net investments, and from the translation of the profits or losses at average rates, are recognised in OCI. The cumulative amount of exchange adjustments was, on transition to IFRS in 2004, deemed to be nil. Financial instruments Key judgement – Application of the business model and ‘solely payments of principal and interest’ test The Group’s customer invoices have relatively short payment terms and the related contracts are exposed to basic credit risk and time value of money and therefore the associated financial assets are held as payments of principal and interest. The Group’s customer invoices are ordinarily settled at their due date, in accordance with the contractual payment terms. For certain customers, the Group has the right to discount invoices before their due date to accelerate payment. Where this occurs, customer balances are classified as ‘held to collect and sell’. Fair value movements are recognised in OCI, if material (see note 14). Financial instruments – Classification and measurement Financial assets Financial assets primarily include trade receivables, cash and cash equivalents (comprising cash at bank, money market funds and short-term deposits), short-term investments, derivatives (foreign exchange, commodity and interest rate contracts), and unlisted investments. – Trade receivables are classified either as held to collect and measured at amortised cost or as held to collect and sell and measured at fair value through other comprehensive income (FVOCI). The Group may sell trade receivables due from certain customers before the due date. Any trade receivables from such customers that are not sold at the reporting date are classified as ‘held to collect and sell’. – Cash and cash equivalents (consisting of balances with banks and other financial institutions, money-market funds, short-term deposits) and short-term investments are subject to low market risk. Cash balances and short-term investments are measured at fair value through profit and loss (FVPL). Money market funds and short-term deposits are measured at FVOCI. – Derivatives and unlisted investments are measured at FVPL. Financial liabilities Financial liabilities primarily consist of trade payables, borrowings, derivatives, financial RRSAs and C Shares. – Derivatives are classified and measured at FVPL. – All other financial liabilities are classified and measured at amortised cost. Financial instruments – Impairment of financial assets and contract assets IFRS 9 Financial Instruments sets out the basis for the accounting of expected credit losses (ECLs) on financial assets and contract assets resulting from transactions within the scope of IFRS 15. The Group has adopted the simplified approach to provide for ECLs, measuring the loss allowance at a probability weighted amount that considers reasonable and supportable information about past events, current conditions and forecasts of future economic conditions of customers. These are incorporated in the simplified model adopted by using credit ratings which are publicly available or through internal risk assessments derived using the customer’s latest available financial information. The ECLs are updated at each reporting date to reflect changes in credit risk since initial recognition. ECLs are calculated for all financial assets in scope, regardless of whether or not they are overdue. Financial instruments – Hedge accounting Forward foreign exchange contracts and commodity swaps (derivative financial instruments) are held to manage the cash flow exposures of forecast transactions denominated in foreign currencies or in commodities respectively. In general, the Group has chosen to not apply hedge accounting in respect of these exposures. Prior to its acquisition in 2017, ITP Aero adopted hedge accounting for its equivalent exposures. It has continued to do so, although the value of the derivatives is not material, relative to those held by the rest of the Group. The Group economically hedges the fair value and cash flow exposures of its borrowings. Cross-currency interest rate swaps are held to manage the fair value exposures of borrowings denominated in foreign currencies and are designated as fair value hedges. Interest rate swaps are held to manage the interest rate exposures of fixed and floating rate borrowings and may be designated as fair value hedges, cash flow hedges or FVPL as appropriate. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 129 1 Accounting policies continued Derivative financial instruments qualify for hedge accounting when: (i) there is a formal designation and documentation at inception of the hedge of the hedging relationship and the Group’s risk management objective and strategy for undertaking the hedge; and (ii) the hedge is expected to be effective. Changes in the fair values of derivatives that are designated as fair value hedges are recognised directly in the income statement. The fair value changes of effective cash flow hedge derivatives are recognised in OCI and subsequently recycled in the income statement to match the recognition of the hedged item. Any ineffectiveness in the hedging relationships is included in the income statement. Hedge accounting is discontinued when the hedging instrument expires or is sold, terminated, exercised, or no longer qualifies for hedge accounting. At that time, for cash flow hedges and if the forecast transaction remains probable, any cumulative gain or loss on the hedging instrument recognised in OCI is retained until the forecast transaction occurs. If a hedged transaction is no longer expected to occur, the net cumulative gain or loss is recycled to the income statement. Financial instruments – Replacement of benchmark interest rates Following the financial crisis, the reform and replacement of benchmark interest rates such as GBP LIBOR and other interbank offered rates (IBORs) has become a priority for global regulators. There is currently uncertainty around the timing and precise nature of these changes. The Group’s risk exposure that is directly affected by the interest rate benchmark reform is its portfolio of long-term borrowings of £3.0bn. These borrowings are hedged, using interest rate swaps and cross-currency interest rate swaps, for changes in fair value attributable to the relevant benchmark interest rate. However, as part of the reforms noted above, the UK Financial Conduct Authority has decided to no longer compel panel banks to participate in the IBOR submission process after the end of 2021 and to cease oversight of these benchmark interest rates. Regulatory authorities and private sector working groups have been discussing alternative benchmark rates for IBOR. It is currently anticipated that IBOR rates will be replaced with a backward looking risk-free rate based on actual transactions. Management is in the process of establishing a committee to oversee the Group’s IBOR transition plan. This transition project will include changes to systems, processes, risk and valuation models, as well as managing related tax and accounting implications. The Group currently anticipates that the areas of greatest change will be amendments to the contractual terms of IBOR-referenced floating-rate debt and swaps, and updating hedge designations. Due to the uncertainty around these changes the Group has elected to early adopt the Amendments to IFRS 9, IAS 39 and IFRS 7 Interest Rate Benchmark Reform issued in September 2019. In accordance with the transition provisions, the amendments have been adopted retrospectively to hedging relationships that existed at the start of the reporting period or were designated thereafter. The amendments provide temporary relief from applying specific hedge accounting requirements to hedging relationships directly affected by IBOR reform. The reliefs have the effect that IBOR reform should not generally cause hedge accounting to terminate. However, any hedge ineffectiveness should continue to be recorded in the income statement. Furthermore, the amendments set out triggers for when the reliefs will end, which include the uncertainty arising from interest rate benchmark reform no longer being present. In summary, the reliefs provided by the amendments that apply to the Group are: – In assessing whether the hedge is expected to be highly effective on a forward-looking basis, the Group has assumed that the relevant IBOR interest rate on which the cash flows of the interest rate swap that hedges fixed-rate borrowings is not altered by IBOR reform. – The Group has assessed whether the hedged IBOR risk component is a separately identifiable risk only when it first designates a borrowing as included in a hedging relationship and not on an ongoing basis. Any hedge ineffectiveness relating to fair value hedges is recognised immediately in the income statement. Business combinations and goodwill Key judgement – Identification of acquired assets and liabilities In allocating the purchase price to the acquired assets and liabilities, such as technology, patents and licences, customer relationships, trademarks and in-process development, judgement is required. The allocations based on the Group’s industry experience and the advice of third party valuers, if required. Goodwill recognised represents the excess of the fair value of the purchase consideration over the fair value to the Group of the net of the identifiable assets acquired and the liabilities assumed. On transition to IFRS on 1 January 2004, business combinations were not retrospectively adjusted to comply with Adopted IFRS and goodwill was recognised based on the carrying value under the previous accounting policies. Goodwill in respect of the acquisition of a subsidiary is recognised as an intangible asset. Goodwill arising on the acquisition of joint arrangements and associates is included in the carrying value of the investment. Customer relationships The fair value of customer relationships recognised as a result of a business combination relate to the acquired company’s established relationships with its existing customers that result in repeat purchases and customer loyalty. Amortisation is charged on a straight-line basis over its useful economic life, up to a maximum of 15 years. Certification costs Costs incurred in respect of meeting regulatory certification requirements for new Civil Aerospace aero engine/aircraft combinations including payments made to airframe manufacturers for this are recognised as intangible assets to the extent that they can be recovered out of future sales. They are charged to the income statement over the programme life on a 15-year straight-line basis pro rata over the estimated number of units produced. FINANCIAL STATEMENTS130 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 1 Accounting policies continued Research and development Key judgement – Determination of the point in time where costs incurred on an internal programme development meet the criteria for capitalisation or ceasing capitalisation The Group incurs significant research and development expenditure in respect of various development programmes. Determining when capitalisation should commence and cease is a critical judgement, as is the determination of when subsequent expenditure on the programme assets should be capitalised. Within the Group there is an established Product Introduction and Lifecycle Management process (PILM) in place. Within this process, the technical feasibility, the commercial viability and financial assessment of the programme is assessed at certain milestones. When these are met, development expenditure is capitalised. Prior to this, expenditure is expensed as incurred. Subsequent expenditure after entry into service which enhances the performance of the engine and the economic benefits to the Group is capitalised. This expenditure is referred to as enhanced performance and is governed by the PILM process referred to above. All other development costs are expensed as incurred. Key judgement – Determination of the basis for amortising capitalised development costs The economic benefits of the development costs are primarily those cash inflows arising from long-term service agreements, which are expected to be relatively consistent for each engine. Amortisation of development costs is recognised on a straight-line basis over 15 years on a proportional basis to aircraft delivery. Expenditure incurred on research and development is distinguished as relating either to a research phase or to a development phase. All research phase expenditure is charged to the income statement. Development expenditure is recognised as an internally generated intangible asset (programme asset) only if it meets strict criteria, relating in particular to technical feasibility and generation of future economic benefits. More specifically, development costs are capitalised from the point at which the following conditions have been met: – the technical feasibility of completing the programme and the intention and ability (availability of technical, financial and other resources) to complete the programme asset and use or sell it; – the probability that future economic benefits will flow from the programme asset; and – the ability to measure reliably the expenditure attributable to the programme asset during its development. Capitalisation continues until the point at which the programme asset meets its originally contracted technical specification (defined internally as the point at which the asset is capable of operating in the manner intended by management). Subsequent expenditure is capitalised where it enhances the functionality of the programme asset and demonstrably generates an enhanced economic benefit to the Group. All other subsequent expenditure on programme assets is expensed as incurred. The development costs associated with each engine are amortised on a straight-line basis, over a 15-year period from its delivery. The period of 15 years is an estimate of the period of operation of the engine by its initial operator. In accordance with IAS 38, the basis on which programme assets are amortised is assessed annually. Software Software that is not specific to an item of property, plant and equipment is classified as an intangible asset, recognised at its acquisition cost and amortised on a straight-line basis over its useful economic life, up to a maximum of five years. The cost of internally developed software includes direct labour and an appropriate proportion of overheads. Other intangible assets These principally include intangible assets arising on acquisition of businesses, such as technology, patents and licences which are amortised on a straight-line basis over a maximum of 15 years and trademarks which are not amortised. Property, plant and equipment Property, plant and equipment are stated at acquisition cost less accumulated depreciation and any provision for impairment in value. The cost of self-constructed assets includes the cost of materials, direct labour and an appropriate proportion of overheads and, where appropriate, interest. Depreciation is provided on a straight-line basis to write off the cost, less the estimated residual value, of property, plant and equipment over their estimated useful lives. No depreciation is recorded on assets in the course of construction. Estimated useful lives are reassessed annually and are as follows: – Land and buildings, as advised by the Group’s professional advisers: – freehold buildings – five to 45 years (average 25 years); – leasehold buildings – lower of adviser’s estimates or period of lease; and – no depreciation is provided on freehold land. – Plant and equipment – five to 25 years (average 12 years). – Aircraft and engines – five to 20 years (average 14 years). Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 131 1 Accounting policies continued Leases Key judgement – Determination of lease term In determining the lease term, the Group considers all facts and circumstances that create an economic incentive to exercise an extension option, or not exercise a termination option. Extension options (or periods after termination) are only included in the lease term if the lease is reasonably certain to be extended (or not terminated). Certain land and building leases have renewal options with renewal dates for the most significant property leases evenly spread between 2022–2028 and in 2041. The Group reviews its judgements on lease terms annually, including the operational significance of the site, especially where utilised for manufacturing activities. Key estimates – Estimates of the payments required to meet residual value guarantees at the end of engine leases Engine leases in the Civil Aerospace segment often include clauses that require the engines to be returned to the lessor with specific levels of useable life remaining or cash payments to the lessor. The costs of meeting these requirements are included in the lease payments. The amounts payable are calculated based upon an estimate of the utilisation of the engines over the lease term, whether the engine is restored to the required condition by performing an overhaul at our own cost or through the payments of amounts specified in the contract and any new contractual arrangements arising when the current lease contracts end. At 31 December 2019, the lease liability included £401m relating to the cost of meeting these residual value guarantees, with up to £80m in 2020 and £112m due over the following four years. Where estimates of payments change, an adjustment is made to the lease liability and the right-of-use asset. Assets and liabilities arising from a lease are initially measured on a present value basis. Lease liabilities include the net present value of the following lease payments: – fixed payments less any lease incentive receivable; – variable lease payments that are based on an index or a rate; – amounts expected to be payable by the Group under residual value guarantees; – the exercise price of a purchase option if the Group is reasonably certain to exercise that option; and – payments of penalties for termination of the lease, if the lease term reflects the Group exercising that option. Where leases commence after the initial transition date, the lease payments are discounted using the interest rate implicit in the lease. If that rate cannot be determined, the Group’s incremental borrowing rate is used, being the rate that the Group would have to pay to borrow the funds necessary to obtain an asset of similar value in a similar economic environment with similar terms and conditions. Lease liabilities are revalued at each reporting date using the spot exchange rate. Right-of-use assets are measured at cost comprising the following: – the amount of the initial measurement of lease liability or a revaluation of the liability; – any lease payments made at or before the commencement date less any lease incentives received; – any initial direct costs; and – restoration costs. Each right-of-use asset is depreciated over the shorter of its useful economic life and the lease term on a straight-line basis unless the lease is expected to transfer ownership of the underlying asset to the Group, in which case the asset is depreciated to the end of the useful life of the asset. Payments associated with the short-term leases are recognised on a straight-line basis as an expense in the income statement. Short-term leases are leases with a lease term of 12 months or less. Impairment of non-current assets Key judgement – Determination of cash-generating units for assessing impairment of goodwill The Group conducts impairment reviews at the cash generating unit (CGU) level. As permitted by IAS 36 Impairment of assets, impairment reviews for goodwill are performed at the groups of CGUs level, representing the lowest level at which the Group monitors goodwill for internal management purposes and no higher than the Group’s operating segments. The level at which goodwill impairment reviews was performed was at the Rolls-Royce Deutschland Ltd & Co KG and Rolls-Royce Power Systems AG aggregated level. Key estimate – Estimates of cash flow forecasts and discount rates to support the carrying value of intangible assets (including programme related intangible assets) The carrying value of intangible assets on the balance sheet is dependent on the estimates of future cash flows arising from the Group’s operations, in particular: – The assessment as to whether there are any indications of impairment of development expenditure, certification costs, and customer relationships recognised as intangible assets (31 December 2019: £3,612m, 31 December 2018: £3,427m) is dependent on estimates of cash flows generated by the relevant programme, the discount rate used to calculate a present value and assumptions on foreign exchange rates. – In addition, in relation to programme intangible assets, estimates comprise: product performance related estimates (including flying hours and time-on-wing); and estimates for future market share, pricing and cost for uncontracted business. Sensitivities have been disclosed in note 9. FINANCIAL STATEMENTS132 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 1 Accounting policies continued Impairment of non-current assets is considered in accordance with IAS 36. Where the asset does not generate cash flows that are independent of other assets, impairment is considered for the cash-generating unit to which the asset belongs. Goodwill, indefinite life intangible assets and intangible assets not yet available for use are tested for impairment annually. Other intangible assets (including programme related intangible assets), property, plant and equipment and investments are assessed for any indications of impairment annually. If any indication of impairment is identified, an impairment test is performed to estimate the recoverable amount. If the recoverable amount of an asset (or cash-generating unit) is estimated to be below the carrying value, the carrying value is reduced to the recoverable amount and the impairment loss is recognised as an expense. The recoverable amount is the higher of value in use or fair value less costs to dispose, if this is readily available. The value in use is the present value of future cash flows using a pre-tax discount rate that reflects the time value of money and the risk specific to the asset. Inventories Inventories are valued on a first-in, first-out basis, at the lower of cost and net realisable value. Cost comprises direct materials and, where applicable, direct labour costs and those direct and indirect overheads, including depreciation of property, plant and equipment, that have been incurred in bringing the inventories to their present location and condition. Net realisable value represents the estimated selling prices less all estimated costs of completion and costs to be incurred in marketing, selling and distribution. All inventories are classified as current as it is expected that they will be used in the Group’s operating cycle, regardless of whether this is expected to be within 12 months of the balance sheet date. Cash and cash equivalents Cash and cash equivalents include cash at bank and in hand, investments in money-market funds and short-term deposits with a maturity of three months or less on inception. The Group considers overdrafts (repayable on demand) to be an integral part of its cash management activities and these are included in cash and cash equivalents for the purposes of the cash flow statement. Where the Group operates pooled banking arrangements across multiple accounts, these are presented on a net basis when it has both a legal right and intention to settle the balances on a net basis. Invoice discounting – The Group on a periodic basis undertakes the sale of certain trade receivables to banks. These trade receivables are factored on a non-recourse basis and therefore are derecognised from the Group’s balance sheet at the point of sale to the bank. Further details are disclosed in note 14. Supply chain financing (SCF) – The Group offers a SCF programme in partnership with banks to enable suppliers who are on our standard 75 day or more payment terms to receive their payment sooner. As the Group continues to have a contractual obligation to pay its suppliers and it does not retain any ongoing involvement in the SCF, the related payables are retained on the Group’s balance sheet and classified as trade payables. Further details are disclosed in note 18. Provisions Key judgement – Assessment of satisfying the criteria for the recognition and measurement of provisions Judgement is required to determine whether a valid expectation has been created and what costs are allowable to be provided for (especially when measuring contract loss provisions). Key estimate – Estimates of expenditure required to settle the obligation relating to Trent 1000 claims and to settle long-term contracts assessed as onerous The Group has provisions at 31 December 2019 of £2,804m (31 December 2018: £1,917m). These represent the Directors’ best estimate of the expenditure required to settle the obligations at the balance sheet date. These estimates take account of information available and different possible outcomes. The Group considers that at 31 December 2019, the contract loss provision and the Trent 1000 exceptional cost provision are most sensitive to changes in estimates. The Group has considered two sensitivities which are the impact of a three-month delay on achieving single digit AOGs and a 12-month delay in the availability of the final HPT blade. If either of these two sensitivities materialised the financial impact could be in the range of £60m–£100m. Provisions are recognised when the Group has a present obligation as a result of a past event, and it is probable that the Group will be required to settle that obligation and are discounted to present value where the effect is material. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 133 1 Accounting policies continued The principal provisions are recognised as follows: – Trent 1000 in-service issues – when wastage costs are identified as described on page 125; – contract losses – based on an assessment of whether the direct costs to fulfil a contract are greater than the expected revenue; – warranties and guarantees – based on an assessment of future claims with reference to past experience and recognised at the earlier of when the underlying products and services are sold and when the likelihood of a future cost is identified; and – restructuring – when the Group has approved a detailed and formal restructuring plan, and the restructuring has either commenced or has been publicly announced. Post-retirement benefits Key estimate – Estimates of the assumptions for valuing the defined benefit obligation The Group’s defined benefit pension schemes and similar arrangements are assessed annually in accordance with IAS 19 Employee Benefits. The valuation, which is based on assumptions determined with independent actuarial advice, resulted in a net deficit of £208m before deferred taxation being recognised on the balance sheet at 31 December 2019 (31 December 2018: surplus of £641m). The size of the net surplus/deficit is sensitive to the actuarial assumptions, which include the discount rate, price inflation, pension and salary increases, transfers, mortality and other demographic assumptions and the levels of contributions. Further details and sensitivities are included in note 21. Pensions and similar benefits (principally healthcare) are accounted for under IAS 19. For defined benefit plans, obligations are measured at discounted present value, using a discount rate derived from high-quality corporate bonds denominated in the currency of the plan, whilst plan assets are recorded at fair value. Surpluses in schemes are recognised as assets only if they represent economic benefits available to the Group in the future. The service and financing costs of such plans are recognised separately in the income statement: – current service costs are spread systematically over the lives of employees; – past-service costs and settlements are recognised immediately; and – financing costs are recognised in the periods in which they arise. Actuarial gains and losses are recognised immediately in OCI. In 2018, following clarification provided by the High Court judgement on the Lloyds Banking Group on 26 October 2018, in the UK, the Group recognised the estimated impact of the obligation to equalise pensions for men and women as a past-service cost – see note 21. Payments to defined contribution schemes are charged as an expense as they fall due. Share-based payments The Group provides share-based payment arrangements to certain employees. These are principally equity-settled arrangements and are measured at fair value (excluding the effect of non-market based vesting conditions) at the date of grant. The fair value is expensed on a straight-line basis over the vesting period. The amount recognised as an expense is adjusted to reflect the actual number of shares or options that will vest, except where additional shares vest as a result of the total shareholder return (TSR) performance condition in the long-term incentive plan (LTIP). Cash-settled share options (grants in the International ShareSave plan) are measured at fair value at the balance sheet date. The Group recognises a liability at the balance sheet date based on these fair values, taking into account the estimated number of options that will actually vest and the relative completion of the vesting period. Changes in the value of this liability are recognised in the income statement for the year. The cost of shares of Rolls-Royce Holdings plc held by the Group for the purpose of fulfilling obligations in respect of employee share plans is deducted from equity in the consolidated balance sheet. See note 23 for a further description of the share-based payment plans. Customer financing support In connection with the sale of its products, the Group will, on occasion, provide financing support for its customers. These arrangements fall into two categories: credit-based guarantees and asset-value guarantees. In accordance with the requirements of IFRS 9 and IFRS 4 Insurance Contracts, credit-based guarantees are treated as insurance contracts. The Group considers asset-value guarantees to be non-financial liabilities and accordingly these are also treated as insurance contracts. As described on page 167, the Directors consider the likelihood of crystallisation in assessing whether provision is required for any contingent liabilities. The Group’s contingent liabilities relating to financing arrangements are spread over many years and relate to a number of customers and a broad product portfolio, and are reported on a discounted basis. Post balance sheet events Non-adjusting post balance sheet events in relation to pensions and mergers and acquisitions activity are disclosed in notes 21 and 27 respectively. FINANCIAL STATEMENTS134 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 1 Accounting policies continued Revisions to IFRS not applicable in 2019 Standards and interpretations issued by the IASB are only applicable if endorsed by the EU. Other than IFRS 17 Insurance Contracts described below, the Group does not consider that any standards, amendments or interpretations issued by the IASB, but not yet applicable will have a significant impact on the Consolidated Financial Statements. IFRS 17 Insurance Contracts IFRS 17 is effective from the beginning of 1 January 2021 (although the IASB proposed to delay the effective date by one year to 1 January 2022). IFRS 17 establishes the principles for the recognition, measurement, presentation and disclosure of insurance contracts within the scope of the Standard. The objective of IFRS 17 is to ensure that an entity provides relevant information that faithfully represents those contracts. The Group is in the process of assessing whether the new standard will impact on the Consolidated Financial Statements. 2 Segmental analysis The analysis by divisions (business segment) is presented in accordance with IFRS 8 Operating Segments, on the basis of those segments whose operating results are regularly reviewed by the Board (which acts as the Chief Operating Decision Maker as defined by IFRS 8). Our four divisions are set out below and referred to collectively as the core businesses. Civil Aerospace – development, manufacture, marketing and sales of commercial aero engines and aftermarket services Power Systems – development, manufacture, marketing and sales of reciprocating engines, power systems and nuclear systems for civil power generation Defence – development, manufacture, marketing and sales of military aero engines, naval engines, submarine nuclear power plants and ITP Aero – design, research and development, manufacture and casting, assembly and testing of aeronautical engines and gas turbines, aftermarket services and MRO services Non-core businesses include the trading results of the North America Civil Nuclear business and the Knowledge Management System business which have been treated as a disposal group held for sale at 31 December 2019, the Commercial Marine business until the date of disposal on 1 April 2019, Rolls-Royce Power Development Limited (RRPD) until the date of disposal on 15 April 2019, L’Orange until the date of disposal on 1 June 2018 and other smaller businesses including former Energy businesses not included in the disposal to Siemens in 2014 (Retained Energy). Segmental analysis for 2018 has been restated to reflect the 2019 definition of non-core. Underlying results We present the financial performance of our businesses in accordance with IFRS 8 and consistently with the basis on which performance is communicated to the Board each month. Underlying results are presented to reflect the economic impact of the Group’s foreign exchange and interest rate risk management activities with interest receivable/(payable) on interest rate swaps not designated into hedging relationships for accounting purposes reclassified from fair value movement on a reported basis to interest receivable/(payable) on an underlying basis – see note 4. Underlying performance excludes the following: – the effect of acquisition accounting and business disposals; – impairment of goodwill and other non-current assets where the reasons for impairment are outside of normal operating activities; – exceptional items; and – other items which are market driven and outside the control of management. Acquisition accounting, business disposals and impairment We exclude these so that the current year and comparative results are directly comparable. Exceptional items We classify items as exceptional where the Directors believe that presentation of our results in this way is more relevant to an understanding of our financial performance, as exceptional items are identified by virtue of their size, nature or incidence. In determining whether an event or transaction is exceptional, management considers quantitative as well as qualitative factors such as the frequency or predictability of occurrence. Examples of exceptional items include one-time costs and charges in respect of aerospace programmes, costs of restructuring programmes and one-time past-service charges and credits on our post-retirement schemes. In 2019, the risk-free discount rate we applied to exceptional onerous contract provisions reduced from between 4%–5% to 2%–3%. This was largely driven by movements in US bonds in the last quarter of 2019. The change in the risk-free rate (US bonds) is market driven and the impact of the reduction in the rate has been included as a reconciling difference between underlying performance and reported performance. Exceptional items are not allocated to segments and may not be comparable to similarly titled measures used by other companies. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 135 2 Segmental analysis continued Other items The financing component of the defined benefit pension scheme cost is determined by market conditions and has therefore been included as a reconciling difference between underlying performance and reported performance. Penalties paid on agreements with investigating bodies are considered to be one-off in nature and are therefore excluded from underlying performance. The tax effects of the adjustments above are excluded from the underlying tax charge. In addition, changes in tax rates or changes in the amount of recoverable advance corporation tax recognised are also excluded. See page 139 for the reconciliation between underlying performance and reported performance. The following analysis sets out the results of the core businesses on the basis described above and also includes a reconciliation of the underlying results to those reported in the consolidated income statement. Civil Aerospace £m Power Systems 1 £m Defence £m ITP Aero £m Corporate and inter-segment £m Core businesses £m Year ended 31 December 2019 Underlying revenue from sale of original equipment Underlying revenue from aftermarket services Total underlying revenue Gross profit/(loss) Commercial and administrative costs Restructuring Research and development costs Share of results of joint ventures and associates Underlying operating profit/(loss) Segment assets Interests in joint ventures and associates Segment liabilities Net (liabilities)/assets Investment in intangible assets, property, plant and equipment, right-of-use assets and joint ventures and associates Depreciation, amortisation and impairment Year ended 31 December 2018 Underlying revenue from sale of original equipment Underlying revenue from aftermarket services Total underlying revenue Gross profit Commercial and administrative costs Restructuring Research and development costs Share of results of joint ventures and associates Underlying operating (loss)/profit Segment assets Interests in joint ventures and associates Segment liabilities Net (liabilities)/assets Investment in intangible assets, property, plant and equipment and joint ventures and associates Depreciation, amortisation and impairment 3,246 4,861 8,107 622 (299) (7) (374) 102 44 17,954 365 (24,819) (6,500) 1,274 807 3,119 4,259 7,378 493 (336) (8) (332) 21 (162) 14,271 380 (21,309) (6,658) 1,283 500 2,386 1,159 3,545 909 (374) – (176) (2) 357 3,587 18 (1,450) 2,155 197 278 2,310 1,124 3,434 866 (363) (1) (188) 1 315 3,692 14 (1,651) 2,055 119 234 1,461 1,789 3,250 669 (151) (7) (105) 9 415 2,743 19 (2,950) (188) 110 109 1,452 1,672 3,124 690 (170) (3) (100) 10 427 2,612 16 (2,924) (296) 151 92 782 154 936 206 (61) (1) (33) – 111 2,160 – (1,129) 1,031 53 88 666 113 779 156 (57) (2) (30) – 67 2,210 – (1,168) 1,042 74 87 1 The underlying results for Power Systems for 31 December 2018 have been restated to reclassify the North America Civil Nuclear business as non-core. (502) (75) (577) (64) (53) – – – (117) 7,373 7,888 15,261 2,342 (938) (15) (688) 109 810 (2,476) – 2,645 169 23,968 402 (27,703) (3,333) – – 1,634 1,282 (375) (54) (429) 35 (51) – – – (16) 7,172 7,114 14,286 2,240 (977) (14) (650) 32 631 (1,621) – 1,743 122 21,164 410 (25,309) (3,735) – – 1,627 913 FINANCIAL STATEMENTS136 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 2 Segmental analysis continued Reconciliation to reported results Year ended 31 December 2019 Revenue from sale of original equipment Revenue from aftermarket services Total revenue Gross profit/(loss) Commercial and administrative costs Restructuring Research and development costs Share of results of joint ventures and associates Operating profit/(loss) Gain arising on disposal of businesses Profit/(loss) before financing and taxation Net financing Profit/(loss) before taxation Taxation Profit/(loss) for the year Attributable to: Ordinary shareholders Non-controlling interests Year ended 31 December 2018 Revenue from sale of original equipment Revenue from aftermarket services Total revenue Gross profit/(loss) Commercial and administrative costs Restructuring Research and development costs Share of results of joint ventures and associates Operating profit/(loss) Gain arising on the disposal of L’Orange Profit/(loss) before financing and taxation Net financing Profit/(loss) before taxation Taxation Profit/(loss) for the year Attributable to: Ordinary shareholders Non-controlling interests Core businesses £m Non-core businesses 1,2 £m Total underlying £m Underlying adjustments and adjustments to foreign exchange £m Group at actual exchange rates £m 7,373 7,888 15,261 2,342 (938) (15) (688) 109 810 – 810 (223) 587 (281) 306 7,172 7,114 14,286 2,240 (977) (14) (650) 32 631 – 631 (148) 483 (153) 330 83 106 189 45 (41) 1 (8) 1 (2) – (2) (2) (4) 4 – 358 423 781 210 (184) (2) (39) – (15) – (15) (2) (17) (8) (25) 7,456 7,994 15,450 2,387 (979) (14) (696) 110 808 – 808 (225) 583 (277) 306 302 4 7,530 7,537 15,067 2,450 (1,161) (16) (689) 32 616 – 616 (150) 466 (161) 305 297 8 596 541 1,137 (1,445) (149) 14 (74) (6) (1,660) 139 (1,521) 47 (1,474) (143) (1,617) (1,617) – 285 377 662 (1,252) (434) 16 (79) (28) (1,777) 358 (1,419) (1,994) (3,413) 715 (2,698) (2,698) – 8,052 8,535 16,587 942 (1,128) – (770) 104 (852) 139 (713) (178) (891) (420) (1,311) (1,315) 4 7,815 7,914 15,729 1,198 (1,595) – (768) 4 (1,161) 358 (803) (2,144) (2,947) 554 (2,393) (2,401) 8 1 Includes the North America Civil Nuclear business and the Knowledge Management System business which have been treated as a disposal group held for sale at 31 December 2019, the Commercial Marine business disposed of on the 1 April 2019, RRPD disposed of on the 15 April 2019, L’Orange until the date of disposal on 1 June 2018 and other smaller non-core businesses including former Energy businesses not included in the disposal to Siemens in 2014 (Retained Energy). See note 27 for more details. 2 Non-core businesses for 31 December 2018 has been restated to include the North America Civil Nuclear business. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 137 2 Segmental analysis continued Disaggregation of revenue from contracts with customers Analysis by type and basis of recognition Year ended 31 December 2019 Original equipment recognised at a point in time Original equipment recognised over time Aftermarket services recognised at a point in time Aftermarket services recognised over time Total underlying customer contract revenue 3 Other underlying revenue Total underlying revenue Year ended 31 December 2018 Original equipment recognised at a point in time Original equipment recognised over time Aftermarket services recognised at a point in time Aftermarket services recognised over time Total underlying customer contract revenue 3 Other underlying revenue Total underlying revenue Civil Aerospace £m Power Systems 1 £m Defence £m ITP Aero 2 £m Corporate and inter-segment £m Core businesses £m 3,246 – 1,599 3,138 7,983 124 8,107 3,119 – 1,575 2,630 7,324 54 7,378 2,285 101 1,026 133 3,545 – 3,545 2,257 53 996 128 3,434 – 3,434 567 894 696 1,093 3,250 – 3,250 694 758 718 954 3,124 – 3,124 702 80 48 106 936 – 936 585 81 (4) 117 779 – 779 (478) (24) (32) (43) (577) – (577) (355) (20) 21 (75) (429) – (429) 6,322 1,051 3,337 4,427 15,137 124 15,261 6,300 872 3,306 3,754 14,232 54 14,286 The underlying revenue for Power Systems for 31 December 2018 has been re-presented to reclassify the North America Civil Nuclear business as non-core. 1 2 ITP Aero prior year disaggregation of revenue has been restated to be consistent with current year presentation. 3 Includes £(93)m (2018: £(196)m) of revenue recognised in the year relating to performance obligations satisfied in previous years. Year ended 31 December 2019 Original equipment recognised at a point in time Original equipment recognised over time Aftermarket services recognised at a point in time Aftermarket services recognised over time Total customer contract revenue Other revenue Total revenue Year ended 31 December 2018 Original equipment recognised at a point in time Original equipment recognised over time Aftermarket services recognised at a point in time Aftermarket services recognised over time Total customer contract revenue Other revenue Total revenue Core businesses £m Non-core businesses 1,2 £m Total underlying £m Underlying adjustments and adjustments to foreign exchange 3 £m Group at actual exchange rates £m 6,322 1,051 3,337 4,427 15,137 124 15,261 6,300 872 3,306 3,754 14,232 54 14,286 40 43 94 12 189 – 189 64 294 388 35 781 – 781 6,362 1,094 3,431 4,439 15,326 124 15,450 6,364 1,166 3,694 3,789 15,013 54 15,067 596 – 313 228 1,137 – 1,137 283 2 148 229 662 – 662 6,958 1,094 3,744 4,667 16,463 124 16,587 6,647 1,168 3,842 4,018 15,675 54 15,729 1 Includes the North America Civil Nuclear business and the Knowledge Management System business which have been treated as a disposal group held for sale at 31 December 2019, the Commercial Marine business disposed of on the 1 April 2019, RRPD disposed of on 15 April 2019, L’Orange until the date of disposal on 1 June 2018 and other smaller non-core businesses including former Energy businesses not included in the disposal to Siemens in 2014 (Retained Energy). See note 27 for more details. 2 Non-core businesses for 31 December 2018 has been restated to include North America Civil Nuclear business. 3 Includes £(187)m (2018: £nil) of revenue recognised relating to performance obligations satisfied in previous years over and above that in underlying revenue. FINANCIAL STATEMENTS138 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 2 Segmental analysis continued Analysis by geographical destination The Group’s revenue by destination of the ultimate operator is as follows: United Kingdom Germany Switzerland Spain France Italy Russia Norway Rest of Europe Europe United States Canada North America South America United Arab Emirates Rest of Middle East Middle East China Singapore Japan South Korea India Malaysia Rest of Asia Asia Africa Australasia Other 2019 £m 1,805 961 520 375 284 235 106 87 979 5,352 4,720 298 5,018 377 438 714 1,152 1,698 702 607 252 82 32 590 3,963 246 361 118 16,587 2018 £m 1,505 1,177 675 343 251 304 79 246 815 5,395 5,041 366 5,407 351 105 584 689 1,483 452 365 334 82 111 588 3,415 152 229 91 15,729 Order backlog Contracted consideration that is expected to be recognised as revenue when performance obligations are satisfied in the future (referred to as order backlog) is as follows: Civil Aerospace Power Systems Defence ITP Aero Within five years £bn 22.9 2.6 7.7 0.7 33.9 2019 After five years £bn 25.6 0.3 0.9 0.2 27.0 Total £bn 48.5 2.9 8.6 0.9 60.9 Within five years £bn 22.1 2.9 6.3 0.8 32.1 2018 After five years £bn 30.2 0.2 0.5 0.1 31.0 Total £bn 52.3 3.1 6.8 0.9 63.1 The parties to these contracts have approved the contract and our customers do not have a unilateral enforceable right to terminate the contract without compensation. We exclude Civil Aerospace OE orders (for deliveries beyond the next 7–12 months) that our customers have placed where they retain a right to cancel. Our expectation based on historical experience is that these orders will be fulfilled. Within the 0–5 years category, contracted revenue in: Defence will largely be recognised in the next three years; Power Systems will be recognised over the next two years as it is a short cycle business; and ITP Aero (where internal Group revenues have been eliminated) evenly spread over the next five years. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 139 2 Segmental analysis continued Underlying adjustments Underlying performance Transactions recognised at exchange rate on date of cash flow and revaluation of trading assets/liabilities 1 Impact of unrealised fair value changes to derivative contracts held for trading 2 Impact of unrealised fair value changes to derivative contracts held for financing 3 Exceptional programme charges 4,5 Impact of discount rate changes 6 Exceptional restructuring charges 4,7 (Loss)/gains arising on the acquisitions and disposals 8 Impairments and asset write-offs 9 Other 10 Total underlying adjustments Reported per consolidated income statement 2019 2018 Revenue £m 15,450 Profit before financing £m 808 Net financing £m (225) Revenue £m 15,067 Profit before financing £m 616 Net financing £m (150) 1,137 145 – (1) – – – – – – – 1,137 16,587 – (1,409) – (136) (24) (84) (12) (1,521) (713) 80 (6) 1 – (40) – (8) – 20 47 (178) 781 – – (119) – – – – – 662 15,729 (23) 163 (1) (2,144) – (976) – (317) 183 (155) (130) (1,419) (803) (3) (15) – – (8) – 13 (1,994) (2,144) The adjustments for realised gains/(losses) on settled derivative contracts include adjustments to reflect the gains/(losses) in the same period as the related trading cash flows. 1 2 The adjustments for unrealised fair value changes to derivative contracts contain those included in equity accounted joint ventures and exclude those for which the related trading contracts have been cancelled when the fair value changes are recognised immediately in underlying profit before taxation. 3 Includes the losses on hedge ineffectiveness in the period of £13m (2018: losses £3m). 4 The table below summarises the exceptional items recorded in 2019 and 2018. Programme charges and associated contract losses 5 Related foreign exchange impact 5 Restructuring charges 7 Pension charges 10 Year to 31 December 2019 £m 1,409 171 136 – 1,716 2018 £m 976 147 317 121 1,561 5 Included within programme exceptional items is £1,361m (2018: £790m), £1,531m (2018: £905m) at prevailing exchange rates, in respect of the abnormal wastage costs on the Trent 1000. This includes £0.2bn of insurance receipts in respect of the Trent 1000 in-service issues. In addition, there is an exceptional item of £48m (2018: 186m), £49m (2018: £218m) at prevailing exchange rates that relates to the decision by Airbus to cease A380 deliveries in 2021. For information on the associated provisions – see note 20. 6 Included within discount rate changes is £30m relating to Trent 900 and £10m relating to Trent 1000 for the impact from the change in discount rates on contract losses recorded in exceptional items in prior years as a result of the fall in US bonds, which drives the calculation of the risk-free rate. 7 The Group recorded an exceptional restructuring charge of £136m (2018: £317m) in the year. The costs include: £88m (2018: £223m) in respect of the Group-wide restructuring programme announced on 14 June 2018; costs relating to ongoing multi-year significant restructuring programmes including restructuring at Power Systems and in respect of Defence, reflecting actions to remove cost and improve operational efficiency. 8 (Loss)/gains arising on the acquisitions and disposals of businesses. See note 27 for more details (also including the amortisation of intangible assets arising on previous acquisitions). 9 In 2019, there has been an impairment of £58m relating to Bergen Engines AS, and impairment charge and asset write offs of £26m following the announcement to sell the North America Civil Nuclear business within the Power Systems business segment. The impairment charge in 2018 of £155m related to Commercial Marine. 10 Other includes the 2018 cost of equalisation of pension benefits between men and women – see note 21. Appropriate rates of tax have been applied to adjustments made to profit before tax in the table above. Adjustments in 2019 which impact the UK tax loss have an effective tax rate of zero. See note 5 for more details. The total underlying adjustments to profit before tax in 2019 are a charge of £143m (2018: credit £715m). The charge in 2019 was £57m plus an additional charge of £86m relating to the derecognition of UK deferred tax assets on foreign exchange and commodity financial assets and liabilities. The credit in 2018 was £672m plus an additional credit of £43m relating to the reduction in the Spanish Basque region tax rate. FINANCIAL STATEMENTS140 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 2 Segmental analysis continued Reconciliation to the balance sheet Reportable segment assets Interests in joint ventures and associates Non-core businesses Assets held for sale Cash and cash equivalents and short-term investments Fair value of swaps hedging fixed rate borrowings Deferred and income tax assets Post-retirement scheme surpluses Total assets Reportable segment liabilities Non-core businesses Liabilities associated with assets held for sale Borrowings and lease liabilities Fair value of swaps hedging fixed rate borrowings Deferred and income tax liabilities Post-retirement scheme deficits Total liabilities Net liabilities 2019 £m 23,968 402 84 18 4,449 249 1,926 1,170 32,266 (27,703) (43) (15) (5,685) (6) (790) (1,378) (35,620) (3,354) 2018 £m 21,164 412 188 750 4,980 293 2,126 1,944 31,857 (25,309) (159) (376) (4,662) – (1,100) (1,303) (32,909) (1,052) The carrying amounts of the Group’s non-current assets including investments but excluding financial instruments, deferred tax assets and post-employment benefit surpluses, by the geographical area in which the assets are located, are as follows: United Kingdom Germany United States Spain Other 3 Research and development Expenditure in the year Capitalised as intangible assets Amortisation and impairment of capitalised costs 1 Net cost recognised in the income statement Underlying adjustments relating to effects of acquisition accounting and foreign exchange Net underlying cost recognised in the income statement 1 See note 9 for analysis of amortisation and impairment. 2019 £m 6,446 2,568 1,506 1,324 826 12,670 2019 £m (1,118) 481 (133) (770) 74 (696) 2018 £m 4,626 2,604 1,338 1,380 710 10,658 2018 £m (1,145) 498 (121) (768) 79 (689) Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 141 4 Net financing Interest receivable Net fair value gains on non-hedge accounted interest rate swaps 2 Financial RRSAs – foreign exchange differences and changes in forecast payments Net fair value gains on commodity contracts Financing on post-retirement scheme surpluses Net foreign exchange gains Financing income Interest payable Net fair value losses on foreign currency contracts Financial RRSAs – foreign exchange differences and changes in forecast payments Financial charge relating to financial RRSAs Net fair value losses on commodity contracts Financing on post-retirement scheme deficits Other financing charges Financing costs Net financing costs Analysed as: Net interest payable Net fair value gains/(losses) on derivative contracts Net post-retirement scheme financing Net other financing Net financing costs Note 19 19 19 21 19 19 19 19 21 2019 2018 Per consolidated income statement £m 31 14 Per consolidated income statement £m 27 – Underlying financing 1 £m 31 – Underlying financing 1 £m 27 – 11 36 60 100 252 (182) (43) (10) (3) – (37) (155) (430) – – – – 31 (163) – – (3) – – (90) 25 – 56 163 271 (107) (2,122) (27) (8) (22) (33) (96) (256) (2,415) – – – – 27 (99) – – (8) – – (70) (177) (178) (225) (2,144) (150) (151) 7 23 (57) (178) (132) – – (93) (225) (80) (2,144) 23 57 (2,144) (72) – – (78) (150) See note 2 for definition of underlying results. 1 2 The consolidated income statement shows the net fair value gain on any interest rate swaps not designated into hedging relationships for accounting purposes. Underlying financing reclassifies the interest receivable on these interest rates swaps from fair value movement to interest payable. 5 Taxation Current tax charge for the year Adjustments in respect of prior years Current tax Deferred tax charge/(credit) for the year Adjustments in respect of prior years Derecognition of deferred tax Deferred tax credit resulting from reduction in tax rates Deferred tax UK Overseas Total 2019 £m 15 (4) 11 117 20 86 – 223 2018 £m 13 (13) – (630) 22 – – (608) 2019 £m 228 (3) 225 (24) (15) – – (39) 186 2018 £m 167 15 182 (43) (42) – (43) (128) 54 2019 £m 243 (7) 236 93 5 86 – 184 2018 £m 180 2 182 (673) (20) – (43) (736) 420 (554) Charged/(credited) in the income statement 234 (608) FINANCIAL STATEMENTS142 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 5 Taxation continued Other tax credits/(charges) Deferred tax: Movement in post-retirement schemes Share-based payments – direct to equity Cash flow hedge Net investment hedge Other tax credits/(charges) Tax reconciliation OCI Equity Items that will not be reclassified Items that may be reclassified 2019 £m 324 – – – 324 2018 £m 2019 £m 2018 £m 2019 £m 2018 £m (2) – – – (2) – – (5) (1) (6) – – 5 – 5 – 1 – – 1 – 2 – – 2 Loss before taxation Less share of results of joint ventures and associates (note 12) Loss before taxation excluding joint ventures and associates Nominal tax credit at UK corporation tax rate 19% (2018: 19%) UK tax rate differential 1 Overseas rate differences 2 Impairment of goodwill Exempt gain on the disposal of Commercial Marine Exempt gain on the disposal of L’Orange R&D credits Other permanent differences Tax losses in year not recognised in deferred tax 3 Derecognition of deferred tax 4 Adjustments in respect of prior years Reduction in closing deferred taxes resulting from decrease in tax rate in the Spanish Basque region Underlying items (note 2) Non-underlying items The UK tax rate differential arises on the difference between the deferred tax rate and the UK statutory tax rate. 1 2 Overseas rate differences mainly relate to tax on profits in countries, such as the US and Germany, which have higher tax rates than the UK. 3 Tax losses not recognised mainly relate to the UK in 2019 – see pages 143 to 144. 4 Derecognition of deferred tax assets relating to foreign exchange and commodity financial assets and liabilities – see page 144. Deferred taxation assets and liabilities At 1 January Impact of adopting IFRS 16 (2018: Impact of adopting IFRS 9) Amount (charged)/credited to income statement Amount credited/(charged) to other comprehensive income Amount (charged)/credited to cash flow hedge reserve Amount credited to equity On disposal/acquisition of businesses 1 Transferred to assets held for sale 2 Exchange differences At 31 December Deferred tax assets Deferred tax liabilities 2019 £m (891) (141) (1,032) 2018 £m (2,947) (114) (3,061) (196) 56 58 1 (20) – (34) 8 463 86 (2) – 420 277 143 420 2019 £m 1,130 8 (184) 323 (5) 1 (3) (2) 1 1,269 1,887 (618) 1,269 (582) 51 91 29 – (117) (23) 36 22 – (18) (43) (554) 161 (715) (554) 2018 £m 380 2 736 (2) 5 2 6 (4) 5 1,130 2,092 (962) 1,130 The 2019 deferred tax on disposal of businesses relates to Commercial Marine. The 2018 comparative relates to the disposal of L’Orange. 1 2 The 2019 deferred tax transferred to assets held for sale relates to the North America Civil Nuclear business. The 2018 comparative relates to Commercial Marine. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 143 5 Taxation continued The analysis of the deferred tax position is as follows: 2019 Intangible assets Property, plant and equipment Other temporary differences Net contract liabilities Pensions and other post-retirement scheme benefits Foreign exchange and commodity financial assets and liabilities Losses R&D credit Advance corporation tax At 1 January £m Impact of adopting IFRS 16 £m At 1 January restated £m Recognised in income statement £m Recognised in OCI £m Recognised in equity £m Merger and acquisition related activity £m Exchange differences £m At 31 December £m (620) (85) 164 57 (461) 625 1,010 277 163 1,130 – (74) 82 – – – – – – 8 (620) (159) 246 57 (135) 10 147 (2) – – (6) – (461) (1) 324 625 1,010 277 163 1,138 (200) 9 (12) – (184) – – – – 318 – – 1 – – – – – – 1 (2) (1) 2 – (3) – (1) – – (5) 31 12 (16) – (13) – (1) (12) – 1 (726) (138) 374 55 (154) 425 1,017 253 163 1,269 At 1 January £m Impact of adopting IFRS 9 £m At 1 January restated £m Recognised in income statement £m Recognised in OCI £m Recognised in equity £m Merger and acquisition related activity £m Exchange differences £m At 31 December £m 2018 Intangible assets Property, plant and equipment Other temporary differences Net contract liabilities Pensions and other post-retirement scheme benefits Foreign exchange and commodity financial assets and liabilities Losses R&D credit Advance corporation tax Unrecognised deferred tax assets (419) (158) 258 63 (482) 381 306 268 163 380 – – 2 – – – – – – 2 (419) (158) 260 63 (203) 77 (106) (6) (482) 19 381 306 268 163 382 244 704 7 – 736 – – 5 – (2) – – – – 3 – – 2 – – – – – – 2 5 1 (1) – (3) – – – – 2 Advance corporation tax UK losses Foreign exchange and commodity financial assets and liabilities Losses and other unrecognised deferred tax assets Deferred tax not recognised on unused tax losses and other items on the basis that future economic benefit is uncertain (3) (5) 4 – 7 – – 2 – 5 2019 £m 19 438 86 68 611 (620) (85) 164 57 (461) 625 1,010 277 163 1,130 2018 £m 19 – – 111 130 Deferred tax assets of £1,887m include £1,010m (2018: £998m) relating to tax losses in the UK and £163m (2018: £163m) relating to Advance Corporation Tax (ACT). These assets have been recognised based on the expectation that the UK business will generate taxable profits and tax liabilities in the future against which the losses and ACT can be utilised. Most of the tax losses relate to the Group’s Civil Aerospace widebody business in the UK which makes initial losses through the investment period of a programme and then makes a profit through its contracts for services. The programme lifecycles typically range between 30 and 55 years with more of the widebody engine programmes forecast at the upper end of that range. In the past few years there have been four new engines that have entered into service (Trent 1000 TEN, Trent 7000, Trent XWB-84 and Trent XWB-97), all of which are still in the investment stage. Deferred tax assets are recognised only to the extent that it is probable that future taxable profits will be available against which the assets can be utilised. A recoverability assessment has been undertaken, taking account of deferred tax liabilities against which the reversal can be offset and using latest UK forecasts, which are mainly driven by the Group’s Civil Aerospace widebody business, to assess the level of future taxable profits. FINANCIAL STATEMENTS144 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 5 Taxation continued The recoverability of UK deferred tax assets relating to UK tax losses and ACT has been assessed in 2019 on the following basis: – using the most recent UK profit forecasts prepared by management, which are consistent with past experience and external sources on market conditions. These forecasts cover the next five years; – the long-term forecast profit profile of certain of the major widebody engine programmes which is typically between 30 and 55 years from initial investment to retirement of the fleet, including the aftermarket revenue earned from airline customers; and – the long-term forecast profit and cost profile of the other parts of the Group’s UK business. The assessment takes into account UK tax laws that, in broad terms, restrict the offset of the carried forward tax losses to 50% of current year profits. Based on this assessment, the Group has recognised a deferred tax asset of £1,010m relating to losses and £163m relating to ACT. This reflects the Group’s conclusions that: – It is probable that the UK business will generate taxable income and tax liabilities in the future against which these losses and the ACT can be utilised. – Based on current forecasts and using various scenarios these losses and the ACT will be used in full within the next 20 to 30 years which is within the expected widebody engine programme lifecycles. A deferred tax asset of £438m has not been recognised. This is based on management’s assumptions relating to the amounts and timing of future taxable profits and takes into account that higher losses were incurred in 2019 than expected, primarily due to the recognition of a £1.4bn exceptional charge in respect of the Trent 1000. Changes in future profits will impact the recoverability of the deferred tax assets, and as explained in note 1, the key assumptions impact contract margins. A 5% change in such margins would result in around a £2bn change in UK profits over the remaining life of the programmes against which the recovery of the tax losses and ACT would be assessed. Such a variance could result in a change of up to £170m in the related deferred tax balances recorded on the Group balance sheet, assuming a 17% tax rate and the 50% loss offset restriction mentioned above. The Group has also reassessed the recovery of other deferred tax assets, including those arising on unrealised losses on derivative contracts. Whilst the deferred tax asset has reduced anyway as a result of the reduction in the unrealised losses in 2019, the Group has also derecognised £86m in line with the approach outlined above. The impact of this is non-underlying. Any future changes in tax law or the structure of the Group could have a significant effect on the use of losses and ACT, including the period over which they can be used. In view of this and the significant judgement involved, the Board continuously reassesses this area. The 2016 Budget announced that the UK tax rate will reduce to 17% with effect from 1 April 2020. The rate reduction to 17% has been substantively enacted on 6 September 2016. The deferred tax assets and liabilities of UK companies within the Group have therefore been calculated at 17%. The temporary differences associated with investments in subsidiaries, joint ventures and associates, for which a deferred tax liability has not been recognised, aggregate to £108m (2018: £99m). No deferred tax liability has been recognised on the potential withholding tax due on the remittance of undistributed profits as the Group is able to control the timing of such remittances and it is probable that consent will not be given in the foreseeable future. 6 Earnings per ordinary share Basic earnings per ordinary share (EPS) is calculated by dividing the loss attributable to ordinary shareholders by the weighted average number of ordinary shares in issue during the year, excluding ordinary shares held under trust, which have been treated as if they had been cancelled. Diluted EPS is calculated by adjusting the weighted average number of ordinary shares in issue during the year for the bonus element of share options. Loss attributable to ordinary shareholders (£m) Weighted average number of ordinary shares (millions) EPS (pence) 2019 Potentially dilutive share options 1 − − Basic (1,315) 1,904 (69.07p) Diluted (1,315) 1,904 (69.07p) Basic (2,401) 1,859 (129.15p) 2018 Potentially dilutive share options 1 – – 1 As there is a loss, the effect of potentially dilutive ordinary shares is antidilutive. The reconciliation between underlying EPS and basic EPS is as follows: Underlying EPS/underlying profit attributable to ordinary shareholders Total underlying adjustments to loss before tax (note 2) Related tax effects EPS/loss attributable to ordinary shareholders Diluted underlying EPS 2019 2018 Pence 15.86 (77.42) (7.51) (69.07) 15.86 £m 302 (1,474) (143) (1,315) Pence 15.98 (183.59) 38.46 (129.15) 15.98 Diluted (2,401) 1,859 (129.15p) £m 297 (3,413) 715 (2,401) Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 145 7 Auditors’ remuneration Fees payable to the Company’s auditors and its associates for the audit of the Parent Company and Consolidated Financial Statements Fees payable to the Company’s auditor and its associates for the audit of the Company’s subsidiaries pursuant to legislation 1 Total fees payable for audit services Fees payable to the Company’s auditor and its associates for other services: Audit related assurance services 2 Other assurance services 3 Total fees payable to the Company’s auditor and its associates 4 Fees payable in respect of the Group’s pension schemes: Audit 2019 £m 2.8 7.0 9.8 0.5 0.6 10.9 0.1 2018 £m 1.8 7.3 9.1 0.5 0.4 10.0 0.1 1 The level of fees payable to the Company’s auditor for the audit of the Company’s Financial Statements reflects the fact that limited incremental work is required in respect of the audit of these financial statements. Rolls-Royce plc, a subsidiary of the Company, is also required to prepare Consolidated Financial Statements and the fees payable to the Company’s auditor for the audit of those financial statements, including the audit of the sub-consolidation, is included in the audit of the Company’s subsidiaries pursuant to legislation. 2 This includes £0.5m (2018: £0.5m) for the review of the half-year report. 3 This relates to the audit of grant claims. 4 Audit fees for overseas entities are reported at the average exchange rate for the year. 8 Employee information United Kingdom Germany United States Spain Nordics Singapore Canada India Italy France Rest of world Monthly average number of employees Civil Aerospace Power Systems Defence ITP Aero Corporate 1 Core businesses Non-core businesses 2 Monthly average number of employees Wages, salaries and benefits Social security costs Share-based payments (note 23) Pensions and other post-retirement scheme benefits (note 21) Group employment costs 3 2019 Number 23,300 9,800 6,000 3,200 1,300 1,300 1,000 1,000 900 700 3,200 51,700 26,100 10,400 9,900 3,900 100 50,400 1,300 51,700 2019 £m 3,075 473 30 356 3,934 2018 Number 23,400 10,000 6,300 2,800 3,000 1,400 1,000 1,000 800 700 4,100 54,500 25,500 10,500 10,500 3,700 100 50,300 4,200 54,500 2018 £m 3,208 479 35 470 4,192 1 Corporate consists of employees who do not provide a shared service to the business segments. Where corporate functions provide such a service, employees have been allocated to the business segments on an appropriate basis. 2 Includes the North America Civil Nuclear business (disposal group held for sale), Commercial Marine (disposed of on 1 April 2019), RRPD (disposed of on 15 April 2019), L’Orange (disposed of on 1 June 2018) and Retained Energy. See note 27 for more details. 3 Remuneration of key management personnel is shown in note 26. FINANCIAL STATEMENTS 146 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 9 Intangible assets Cost At 1 January 2018 Additions Transferred to assets held for sale 1 Disposal of L’Orange 2 Disposals Reclassifications Exchange differences At 31 December 2018 Additions Acquisition of businesses Transferred to assets held for sale 1 Disposals Reclassifications from PPE Exchange differences At 31 December 2019 Accumulated amortisation and impairment At 1 January 2018 Charge for the year 3 Impairment Transferred to assets held for sale 1 Disposal of L’Orange 2 Disposals Reclassifications Exchange differences At 31 December 2018 Charge for the year 3 Impairment Transferred to assets held for sale 1 Disposals Reclassifications from PPE Exchange differences At 31 December 2019 Net book value At 31 December 2019 At 31 December 2018 Goodwill £m Certification costs £m Development expenditure £m Customer relationships £m Software £m Other £m Total £m 1,869 – (666) (136) – 5 15 1,087 – 11 (34) – – (40) 1,024 324 – 155 (439) – – 5 (3) 42 – 18 (34) – – 4 30 994 1,045 917 35 – – (4) – – 948 15 – – – – (1) 962 339 35 – – – – (1) – 373 19 – – – – – 392 570 575 2,459 498 (38) (48) (1) – 13 2,883 481 – (11) (8) 17 (68) 3,294 1,045 114 7 (29) (31) – – 5 1,111 113 20 (11) (7) – (25) 1,201 1,432 – (26) (40) – – 18 1,384 – – (16) (1) – (64) 1,303 256 90 – (21) (27) – – 6 304 72 9 (16) (1) – (14) 354 2,093 1,772 949 1,080 869 110 (6) – (16) 3 4 964 101 4 (3) (111) 19 (7) 967 488 103 22 (1) – (8) 1 2 607 88 7 (3) (99) 10 (5) 605 362 357 794 37 (12) (11) – (3) 6 811 43 23 (11) (19) (18) (26) 803 323 39 – (12) (8) – – 3 345 26 – (11) (19) (1) (11) 329 8,340 680 (748) (235) (21) 5 56 8,077 640 38 (75) (139) 18 (206) 8,353 2,775 381 184 (502) (66) (8) 5 13 2,782 318 54 (75) (126) 9 (51) 2,911 474 466 5,442 5,295 1 The North America Civil Nuclear business was classified as a disposal group held for sale on 26 September 2019, prior to this an impairment of goodwill of £15m was recognised. The Commercial Marine business was classified as a disposal group held for sale on 30 June 2018 – see note 27. 2 The disposal of the L’Orange business to Woodward Inc. was completed on 1 June 2018 – see note 27. 3 Charged to cost of sales and commercial and administrative costs except development costs, which are charged to research and development costs. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 147 9 Intangible assets continued Goodwill In accordance with the requirements of IAS 36 Impairment of Assets, goodwill is allocated to the Group’s cash-generating units (CGUs), or groups of CGUs, that are expected to benefit from the synergies of the business combination that gave rise to the goodwill as follows: Rolls-Royce Power Systems AG Rolls-Royce Deutschland Ltd & Co KG Other Primary reporting segment Power Systems Civil Aerospace Various 2019 £m 718 234 42 994 2018 £m 750 246 49 1,045 Goodwill has been tested for impairment during 2019 on the following basis: – The carrying values of goodwill have been assessed by reference to value in use. These have been estimated using cash flows from the most recent forecasts prepared by management, which are consistent with past experience and external sources of information on market conditions. These forecasts generally cover the next five years. Growth rates for the period not covered by the forecasts are based on a range of growth rates between 1.0%–2.5% that reflect the products, industries and countries in which the relevant CGU or group of CGUs operate. – The key assumptions for the impairment tests are the discount rate and, in the cash flow projections, the programme assumptions, the growth rates and the impact of foreign exchange rates on the relationship between selling prices and costs. Impairment tests are performed using prevailing exchange rates. The principal value in use assumptions for goodwill balances considered to be individually significant are: Rolls-Royce Power Systems AG – trading assumptions (e.g. volume of equipment deliveries, pricing achieved and cost escalation) are based on current and known future programmes, estimates of capture of market share and long-term economic forecasts; – cash flows beyond the five-year forecasts are assumed to grow at 1.0% (2018: 1.8%); and – pre-tax discount rate 12% (2018: 12%). The Directors do not consider that any reasonably possible changes in the key assumptions would cause the value in use of the goodwill to fall below its carrying value. Rolls-Royce Deutschland Ltd & Co KG – trading assumptions (e.g. volume of engine deliveries, flying hours of installed fleet and cost escalation) are based on current and known future programmes, estimates of customers’ fleet requirements and long-term economic forecasts; – cash flows beyond the five-year forecasts are assumed to grow at 2.5% (2018: 2.5%); and – pre-tax discount rate 14% (2018: 13%). The Directors do not consider that any reasonably possible changes in the key assumptions would cause the value in use of the goodwill to fall below its carrying value. Commercial Marine On 6 July 2018, the Group announced the sale of Commercial Marine to KONGSBERG. The disposal met the criteria of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations that where the carrying value of a disposal group is expected to be recovered through a sale transaction, the disposal group should be treated as held for sale, with assets and liabilities presented separately on the balance sheet measured at the lower of carrying value or fair value less costs to sell. As a result of the classification of the Commercial Marine business as a disposal group, its carrying value was assessed against the anticipated proceeds and the disposal costs. An impairment charge of £155m for the related goodwill (with an additional £5m impairment charge to property, plant and equipment) was recognised in the income statement at 31 December 2018 and the remaining net balance of £227m transferred to assets held for sale and associated liabilities. The Commercial Marine business was disposed of on 1 April 2019 – see note 27. FINANCIAL STATEMENTS148 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 9 Intangible assets continued Other intangible assets (including programme-related intangible assets) Other intangible assets have been reviewed for impairment in accordance with the requirements of IAS 36 Impairment of Assets. Where an impairment test was considered necessary, it has been performed on the following basis: – The carrying values have been assessed by reference to value in use. These have been estimated using cash flows from the most recent forecasts prepared by management, which are consistent with past experience and external sources of information on market conditions over the lives of the respective programmes. – The key assumptions underlying cash flow projections are assumed market share, programme timings, unit cost assumptions, discount rates, and foreign exchange rates. – The pre-tax cash flow projections have been discounted at 7%–15% (2018: 7%–13%), based on the Group’s weighted average cost of capital, adjusted for the estimated programme risk, for example taking account of whether or not the forecast cash flows arise from contracted business. In addition, for programme-related intangible assets, these have been reviewed for impairment in accordance with the requirements of IAS 36. Where there is a triggering event, an impairment test has been performed on the following basis: – The programme related intangible asset’s carrying value as at 31 December is compared to the asset’s recoverable amount. The Group has determined that the recoverable amount of the asset should be calculated on a value in use basis as this represents the highest value to the Group in terms of the future cash flows that it can generate. – Future cash flows used in the value in use calculations are based on our most recent forecasts prepared by management and are discounted using a pre-tax discount rate that reflects current market assessment of the time value of money. These forecasts include contracted business together with management’s expectation of speculative business over the life of the programme together with cash outflows that are necessary to maintain the current level of economic benefit expected to arise from the asset in its current condition. – The key programme assumptions underlying cash flow projections are forecast market share and pricing, engine flying hours, number of shop visits/cost of shop visits, R&D, capital investment and foreign exchange rates. – The pre-tax cash flow projections have been discounted at 7%–15% (2018: 7%–13%). No impairment was identified (2018: no impairment). For programmes where the headroom could be significantly reduced over the next 12 months any of the following changes in assumptions, in isolation, would cause the recoverable amount of the programme assets to equal its carrying value: – an increase in discount rates by 36% – an increase in costs of 10% The carrying amount and the residual life of the material intangible assets (excluding goodwill) for the Group is as follows: Trent programme intangible assets 1 Business Aviation programme intangible assets 2 Customer relationship assets on acquisition of ITP Aero Intangible assets from acquisition of Power Systems 3 Residual life Net book value 7–15 years 15 years typically 13–35 years 2019 £m 1,720 587 676 489 3,472 2018 £m 1,524 393 740 578 3,235 1 Included within the Trent programmes are the Trent 1000, Trent 7000 and Trent XWB. 2 Included within Business Aviation are the Pearl 700 and Pearl 15. 3 Includes £109m in respect of a brand intangible asset which is not amortised. Remaining assets are amortised over a range of 2–10 years. The carrying amount of goodwill or intangible assets allocated across multiple cash-generating units is not significant in comparison with the Group’s total carrying amount of goodwill or intangible assets with indefinite useful lives. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 149 10 Property, plant and equipment Land and buildings £m Plant and equipment £m Aircraft and engines £m In course of construction £m Cost At 1 January 2018 Additions Transferred to assets held for sale 1 Disposal of L’Orange 2 Disposals/write-offs Reclassifications Exchange differences At 31 December 2018 Impact of adopting IFRS 16 (note 29) At 1 January 2019 Additions Acquisition of businesses Transferred to assets held for sale 1 Disposal of businesses Disposals/write-offs Reclassifications 3 Reclassification of joint venture to joint operations Exchange differences At 31 December 2019 Accumulated depreciation At 1 January 2018 Charge for the year 4 Impairment Transferred to assets held for sale 1 Disposal of L’Orange 2 Disposals/write-offs Exchange differences At 31 December 2018 Impact of adopting of IFRS 16 (note 29) At 1 January 2019 Charge for the year 4 Impairment Transferred to assets held for sale 1 Disposal of businesses Disposals/write-offs Reclassifications 3 Reclassification of joint venture to joint operations Exchange differences At 31 December 2019 Net book value At 31 December 2019 At 1 January 2019 At 31 December 2018 1,842 54 (91) (23) (29) 140 23 1,916 (12) 1,904 27 – (5) (4) (54) 186 5 (39) 2,020 5,022 273 (138) (72) (140) 287 64 5,296 (11) 5,285 286 3 (9) (168) (187) 390 3 (106) 5,497 554 2,984 67 – (26) (4) (19) 7 579 (7) 572 67 1 (5) – (45) 9 1 (10) 590 376 2 (96) (34) (123) 33 3,142 (13) 3,129 381 29 (9) (165) (150) 6 3 (57) 3,167 1,430 1,332 1,337 2,330 2,156 2,154 734 251 – – (19) (3) 4 967 (205) 762 126 – – – (17) 11 – (6) 876 173 80 – – – (9) – 244 (40) 204 43 – – – (5) (19) – – 223 653 558 723 Total £m 8,371 974 (259) (99) (188) – 102 8,901 (257) 8,644 767 3 (16) (172) (262) (18) 8 (160) 8,794 3,713 523 7 (122) (38) (151) 40 3,972 (60) 3,912 491 41 (15) (165) (201) (9) 4 (67) 3,991 773 396 (30) (4) – (424) 11 722 (29) 693 328 – (2) – (4) (605) – (9) 401 2 – 5 – – – – 7 – 7 – 11 (1) – (1) (5) – – 11 390 686 715 4,803 4,732 4,929 1 The North America Civil Nuclear business was classified as a disposal group held for sale on 26 September 2019. The Commercial Marine business was classified as a disposal group held for sale on 30 June 2018 – see note 27. 2 The disposal of the L’Orange business to Woodward Inc. was completed on 1 June 2018 – see note 27. 3 Includes reclassifications for assets under construction and to intangible assets. 4 Depreciation charged during the year is presented in the income statement or included in the cost of inventory as appropriate. FINANCIAL STATEMENTS 150 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 10 Property, plant and equipment continued Property, plant and equipment includes: Assets held for use in operating leases Cost Depreciation Net book value Capital expenditure commitments Cost of fully depreciated assets Cost of fully depreciated assets included in assets held for sale The Group’s share of equity accounted entities’ capital commitments is £30m (2018: £9m). 2019 £m 720 (214) 506 317 1,666 2 11 Right-of-use assets Cost At 31 December 2018 Impact of adopting IFRS 16 (see note 29) Transferred to assets held for sale 1 At 1 January 2019 Additions/modifications of leases Transferred to assets held for sale 1 Disposals Exchange differences At 31 December 2019 Accumulated depreciation and impairment At 1 January 2019 Charge for the year Impairment Transferred to assets held for sale 1 Disposals Exchange differences At 31 December 2019 Net book value At 31 December 2019 At 1 January 2019 At 31 December 2018 Right-of-use assets held for use in operating leases Cost Depreciation Net book value at 31 December 2019 Land and buildings £m Plant and equipment £m Aircraft and engines £m – 493 (40) 453 70 (4) (2) (13) 504 – 58 1 (1) (2) (1) 55 449 453 – 4 (2) 2 – 107 (1) 106 28 – (4) (2) 128 – 32 1 – (4) – 29 99 106 – 2 (1) 1 – 1,654 – 1,654 129 – (13) (3) 1,767 – 309 10 – (13) – 306 1,461 1,654 – 1,767 (306) 1,461 2018 £m 813 (192) 621 362 1,498 75 Total £m – 2,254 (41) 2,213 227 (4) (19) (18) 2,399 – 399 12 (1) (19) (1) 390 2,009 2,213 – 1,773 (309) 1,464 1 The North America Civil Nuclear business was classified as a disposal group held for sale on 26 September 2019. The Commercial Marine business was classified as a disposal group held for sale on 30 June 2018 – see note 27. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 151 12 Investments Composition of the Group The entities contributing to the Group’s financial results are listed on pages 187 to 193. Where the Group does not own 100% of the shares of a Group undertaking, there are a number of arrangements with the other shareholder(s) that give the Group the option or potential obligation to acquire the third parties’ shares. These arrangements have been assessed and are not considered to have a significant value, individually or in aggregate. Non-controlling interests The Group does not have any material non-wholly owned subsidiaries. Equity accounted and other investments At 1 January 2018 Additions Disposals Impairment Consolidation of previously non-consolidated subsidiary Share of retained loss 1 Reclassification of deferred profit to deferred income 2 Exchange differences Share of OCI At 1 January 2019 Additions Disposals Transfer from joint venture to joint operation Impairment Consolidation of previously non-consolidated subsidiary Share of retained profit 1 Reclassification of deferred profit to deferred income 2 Exchange differences Share of OCI At 31 December 2019 Equity accounted Joint ventures £m 375 17 Associates £m – – – (7) – (101) 70 41 17 412 8 (4) (3) – – 12 4 (19) (8) 402 – – – – – – – – – – – – – – – – – – Total £m 375 17 – (7) – (101) 70 41 17 412 8 (4) (3) – – 12 4 (19) (8) 402 Other Unlisted £m 26 6 (3) (2) (5) – – – – 22 2 (6) – (1) (4) – – 1 – 14 1 See table below. 2 The Group’s share of unrealised profit on sales to joint ventures is eliminated against the carrying value of the investment in the entity. Any excess amount, once the carrying value is reduced to nil, is recorded as deferred income. Reconciliation of share of retained profit/(loss) to the income statement and cash flow statement: Share of results of joint ventures and associates Adjustments for intercompany trading Share of results of joint ventures and associates to the Group (income statement) Dividends paid by joint ventures and associates to the Group (cash flow statement) Share of retained profit/(loss) above 1 1 During the year, we sold spare engines to Rolls-Royce & Partners Finance, a joint venture company. The following joint ventures are considered to be individually material to the Group: 2019 £m 141 (37) 104 (92) 12 2018 £m 114 (110) 4 (105) (101) Alpha Partners Leasing Limited (APL) Hong Kong Aero Engine Services Limited (HAESL) Singapore Aero Engine Services Pte Limited (SAESL) Principal location Activity UK Hong Kong Singapore Aero engine leasing Aero engine repair and overhaul Aero engine repair and overhaul Ownership interest 50.0% 50.0% 50.0% FINANCIAL STATEMENTS152 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 12 Investments continued Summarised financial information of the Group’s individually material joint ventures is as follows: Revenue Profit and total comprehensive income for the year Dividends paid during the year Profit for the year included the following: Depreciation and amortisation Interest income Interest expense Income tax expense Current assets Non-current assets Current liabilities Non-current liabilities Net assets Included in the above: Cash and cash equivalents Current financial liabilities 1 Non-current financial liabilities 1 Reconciliation to the carrying amount recognised in the Consolidated Financial Statements Ownership interest Group share of net assets above Goodwill Adjustments for intercompany trading Included in the balance sheet 1 Excluding trade payables and other liabilities. APL HAESL SAESL 2019 £m 322 107 (29) (146) 4 (89) (22) 119 3,319 (230) (2,617) 591 25 (182) (2,364) 50.0% 296 – (296) – 2018 £m 254 61 (47) (110) 1 (58) (14) 355 2,759 (755) (1,825) 534 103 (702) (1,603) 50.0% 267 – (267) – 2019 £m 1,907 81 (76) (15) – (3) (16) 453 113 (269) (103) 194 4 – (89) 2018 £m 1,497 72 (65) (13) – (2) (14) 421 124 (248) (101) 196 46 – (88) 2019 £m 1,529 47 (42) (16) – (6) (3) 433 172 (264) (163) 178 14 – (163) 2018 £m 1,141 41 (43) (12) – (3) (4) 379 161 (207) (164) 169 17 – (164) 50.0% 97 35 (7) 125 50.0% 98 36 (3) 131 50.0% 89 94 (1) 182 50.0% 85 97 – 182 The summarised aggregated results of the Group’s share of equity accounted investments is as follows: Individually material joint ventures (above) Other joint ventures Associates Assets: Non-current assets Current assets Liabilities: 1 Current liabilities Non-current liabilities Group adjustment for goodwill Adjustment for intercompany trading 1 Liabilities include borrowings of 2019 £m 1,802 503 (382) (1,441) 2018 * £m 1,522 578 (605) (1,045) 129 133 (304) 307 (1,399) (270) 313 (1,278) 2019 £m 745 456 (322) (703) – (81) 95 (627) 2018 * £m 911 467 (262) (802) – (215) 99 (650) 2019 £m 2018 £m – – – – – – – – – – – – – – – – Total 2019 £m 2,547 959 (704) (2,144) 2018 * £m 2,433 1,045 (867) (1,847) 129 133 (385) 402 (2,026) (485) 412 (1,928) * The summarised results for 2018 have been re-presented to include the Group’s share of all its individually material joint ventures on a gross basis. Previously, the assets and liabilities of certain joint ventures were shown on a net basis. Disclosure of Group adjustments for intercompany trading and goodwill upon consolidation have been disclosed separately to provide greater transparency. The carrying amounts at 31 December 2018 remain the same as previously reported. This enhanced presentation does not impact the Group consolidated results or financial position previously reported. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 153 13 Inventories Raw materials Work in progress Finished goods Payments on account Inventories stated at net realisable value Amount of inventory write-down Reversal of inventory write-down 14 Trade receivables and other assets Trade receivables 1 Amounts owed by joint ventures and associates 1 Costs to obtain contracts with customers 2 Other receivables 3 Prepayments Trade receivables and other assets are analysed as follows: Financial instruments (note 19): Trade receivables and similar items Other non-derivative financial assets Non-financial instruments 2019 £m 522 1,652 2,119 27 4,320 227 69 12 Current Non-current Total 2019 £m 2,538 197 10 1,490 356 4,591 2018 * £m 2,680 229 8 1,218 367 4,502 2019 £m – 12 33 181 248 474 2018 * £m – – 34 145 9 188 2019 £m 2,538 209 43 1,671 604 5,065 3,477 726 862 5,065 2018 £m 553 1,551 2,168 15 4,287 223 69 21 2018 * £m 2,680 229 42 1,363 376 4,690 3,578 489 623 4,690 * Balances at 31 December 2018 have been re-presented to move £217m from prepayments to other receivables to better reflect the nature of these balances. 1 Includes £267m (2018: £146m) of trade receivables held to collect or sell and £76m (2018: nil) receivables from joint ventures and associates held to collect or sell. 2 These are amortised over the term of the related contract, resulting in amortisation of £8m (2018: £13m) in the year. There were no impairment losses recognised in either year. 3 Other receivables includes the RRSA component of the LTSA which is held separately on the basis of differing counterparties, together with receivables arising from overhaul activity outside of LTSA coverage. The expected credit losses for trade receivables and other assets has increased by £12m to £138m (2018: £126m). Amounts included are considered as current so no ageing of expected credit losses is disclosed. For many years the Group has undertaken the sale of trade receivables, without recourse, to banks. This is commonly known as invoice discounting or factoring, and is common place in the aerospace industry. The absolute amount carried out in any given year depends on specific engine delivery volumes and phasing. This activity has been used to normalise customer receipts as certain aerospace customers have extended their payment terms. This in turn has helped to normalise our Group cash flows in line with physical delivery volumes. Over the last three years the sale of trade receivables has averaged £1,037m at the year end. Trade receivables factored are generally due within the following quarter. At 31 December 2019 £1,117m was drawn under factoring facilities, an increase of £95m compared to December 2018, representing cash collected before it was contractually due from the customer. In exceptional circumstances, the sale of trade receivables has taken place where amounts contractually due from aerospace customers before the period end have been deferred into the following period. There was £504m relating to this activity at the 2018 year end. There were no equivalent amounts in 2019. The assumption and inputs used for the estimation of the expected credit losses are disclosed in the table below: Investment grade Non-investment grade Without credit rating Trade receivables and other financial assets £m 1,230 271 2,636 4,137 2019 Loss allowance £m (40) (2) (96) (138) Range of expected credit loss rate % 0%–2.45% 0%–2.51% 0%–54% 3% Trade receivables and other financial assets £m 976 348 2,653 3,977 2018 Loss allowance £m (34) (5) (87) (126) Range of expected credit loss rate % 0%–2.06% 0%–2.06% 0%–47% 3% FINANCIAL STATEMENTS154 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 14 Trade receivables and other assets continued The movements of the Group expected credit losses provision are as follows: At 1 January Increases in loss allowance recognised in the income statement during the year Other net movements At 31 December 15 Contract assets and liabilities Contract assets Contract assets with operators Participation fee contract assets Contract assets are analysed as follows: Financial instruments (note 19) Non-financial instruments Current Non-current 2019 £m 404 57 461 2018 £m 295 49 344 2019 £m 1,092 542 1,634 2018 £m 1,108 605 1,713 2019 £m (126) (27) 14 (139) Total 2019 £m 1,496 599 2,095 – 2,095 2,095 2018 £m (95) (15) (16) (126) 2018 £m 1,403 654 2,057 – 2,057 2,057 Contract assets include £1,086m (2018: £1,097m) of Civil Aerospace LTSA assets, with most of the remainder relating to Defence. The main driver of the increase is driven by Defence which increased by £90m due to the timing differences between revenue being recognised on a stage of completion basis and when customers are billed, as well as the timing of the flow down of amounts received in prior years from programme partners. Revenue from performance obligations satisfied in previous years has been adjusted by £(166)m. Participation fee contract assets have reduced by £(55)m due to amortisation exceeding additions by £(35)m and FX on consolidation of overseas entities of £(20)m. No impairment losses (2018: none) of contract assets have arisen during the year. The expected credit losses for contract assets has decreased by £9m in relation to normal business cycle to £13m (2018: £22m). Contract liabilities Contract liabilities are analysed as follows: Financial instruments (note 19) Non-financial instruments Current Non-current Total 2019 £m 4,228 2018 £m 3,794 2019 £m 6,612 2018 £m 5,336 2019 £m 10,840 131 10,709 10,840 2018 £m 9,130 – 9,130 9,130 During the year, £3,491m (2018: £2,823m) of the opening contract liability was recognised as revenue and contract liabilities have increased by £1,710m. The main reasons for the increase being a £1,199m growth in Civil Aerospace LTSA liabilities to £6,783m (2018: £5,584m) driven by an overall growth in engine flying hour receipts. Our installed base increased by 6% in 2019 compared with 2018. In addition, engine flying hours increased by 7% year-on-year. Revenue from performance obligations satisfied in previous years has been adjusted by £(114)m. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 155 16 Cash and cash equivalents Cash at bank and in hand Money-market funds Short-term deposits Cash and cash equivalents per the balance sheet Overdrafts (note 17) Cash and cash equivalents per cash flow statement (page 119) Cash held as collateral against third party obligations (note 20) 2019 £m 825 1,095 2,523 4,443 (8) 4,435 – 2018 £m 1,023 1,222 2,729 4,974 (22) 4,952 4 Cash and cash equivalents at 31 December 2019 includes £34m (2018: £31m) that is not available for general use by the Group. This balance predominantly relates to cash held in non-wholly owned subsidiaries and joint arrangements. Balances are presented on a net basis when the Group has both a legal right of offset and the intention to either settle on a net basis or realise the asset and settle the liability simultaneously. 17 Borrowings and lease liabilities Unsecured Overdrafts Bank loans 6.75% Notes 2019 £500m 1 2.375% Notes 2020 US$500m 2 2.125% Notes 2021 €750m 2 0.875% Notes 2024 €550m 3 3.625% Notes 2025 US$1,000m 3 3.375% Notes 2026 £375m 4 1.625% Notes 2028 €550m 3 Other loans 5 Total unsecured Secured 6 Lease liabilities – property Lease liabilities – aero engines Lease liabilities – equipment Obligations under finance leases Total secured Total borrowings and lease liabilities Current 2019 £m 8 27 – 378 – – – – – 22 435 50 261 29 – 340 775 2018 £m 22 298 504 – – – – – – – 824 – – – 34 34 Non-current 2019 £m – 16 – – 655 481 781 410 501 52 2,896 473 1,463 78 – 2,014 2018 £m – 354 – 383 699 498 765 403 502 5 3,609 – – – 195 195 Total 2019 £m 8 43 – 378 655 481 781 410 501 74 3,331 523 1,724 107 – 2,354 2018 £m 22 652 504 383 699 498 765 403 502 5 4,433 – – – 229 229 858 4,910 3,804 5,685 4,662 These notes are the subject of interest rate swap agreements under which the Group has undertaken to pay ﬂoating rates of interest, which form a fair value hedge. 1 2 These notes are the subject of cross-currency interest rate swap agreements under which the Group has undertaken to pay ﬂoating rates of GBP interest, which form a fair value hedge. 3 These notes are the subject of cross-currency interest rate swap agreements under which the Group has undertaken to pay ﬂoating rates of GBP interest, which form a fair value hedge. They are also subject to interest rate swap agreements under which the Group has undertaken to pay fixed rates of interest, which are classified as fair value through profit and loss. 4 These notes are the subject of interest rate swap agreements under which the Group has undertaken to pay ﬂoating rates of interest, which form a fair value hedge. They are also subject to interest rate swap agreements under which the Group has undertaken to pay fixed rates of interest, which are classified as fair value through profit and loss. 5 In 2019, the Group reclassified £79m as borrowings previously included in other financial liabilities. Other loans of £8m (2018: £5m) are held by entities classified as joint operations. The loans are disclosed after adjustments have been made on consolidation to eliminate the extent of the Group’s interest in the entity. 6 Obligations under leases are secured by related leased assets. FINANCIAL STATEMENTS 156 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 18 Trade payables and other liabilities Current Non-current Total 2019 £m 2,300 798 1,751 17 12 128 3,444 8,450 2018 £m 2,520 635 1,673 9 14 125 3,316 8,292 2019 £m – 36 89 516 71 – 1,359 2,071 2018 £m – 18 109 520 85 – 1,208 1,940 Trade payables Amounts owed to joint ventures and associates Accruals Deferred receipts from RRSA workshare partners Government grants 1 Other taxation and social security Other payables 2 Trade payables and other liabilities are analysed as follows: Financial instruments (note 19): Trade payables and similar items Other non-derivative financial liabilities Non-financial instruments 2019 £m 2,300 834 1,840 533 83 128 4,803 10,521 5,849 1,541 3,131 10,521 2018 £m 2,520 653 1,782 529 99 125 4,524 10,232 5,659 1,754 2,819 10,232 1 During the year £12m (2018: £8m) of government grants were released to the income statement. 2 Other payables include £280m (2018: £378m) for financial penalties from agreements with investigating bodies and £nil (2018: £245m) for deferred consideration in relation to the acquisition of ITP Aero. In addition, other payables includes amounts due to RRSA concessions, warranty credits and other sundry payables. Our payment terms with suppliers vary on the products and services being sourced, the competitive global markets we operate in and other commercial aspects of suppliers’ relationships. Industry average payment terms vary between 90–120 days. We offer reduced payment terms for smaller suppliers, so that they are paid in 30 days. In line with aerospace industry practice, we offer a SCF programme in partnership with banks to enable suppliers who are on our standard 75-day payment terms to receive their payment sooner. The SCF programme is available to suppliers at their discretion and does not change our rights and obligations with suppliers nor the timing of our payment to suppliers. At 31 December 2019, suppliers had drawn £859m under the SCF scheme (31 December 2018: £817m). Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 157 19 Financial instruments Carrying values and fair values of financial instruments 2019 Unlisted non-current asset investments Trade receivables and similar items Other non-derivative financial assets Other assets Derivative financial assets 1 Short-term investments Cash and cash equivalents Borrowings Lease liabilities Derivative financial liabilities 1 Financial RRSAs Other liabilities C Shares Trade payables and similar items Other non-derivative financial liabilities Contract liabilities 2018 * Unlisted non-current asset investments Trade receivables and similar items Other non-derivative financial assets Derivative financial assets 1 Short-term investments Cash and cash equivalents Borrowings Derivative financial liabilities 1 Financial RRSAs Other liabilities C Shares Trade payables and similar items Other non-derivative financial liabilities Assets Liabilities Total Basis for determining fair value Fair value through profit or loss £m Fair value through OCI £m Amortised cost £m Fair value through profit or loss £m Notes Other £m £m 12 14 14 16 17 17 18 18 15 12 14 14 16 17 18 18 A B/C B D C B B E/F G C H H B B B B A B/C B C B B E/F C H H B B B 14 – – 28 525 – 1,095 – – – – – – – – – 1,662 22 – – 365 – 1,222 – – – – – – – 1,609 – 344 – – – – – – – – – – – – – – 344 – 146 – – – – – – – – – – – 146 – 3,133 726 – – 6 3,348 – – – – – – – – – 7,213 – 3,432 489 – 6 3,752 – – – – – – – 7,679 – – – – – – – – – (3,374) – – – – – – (3,374) – – – – – – – (3,871) – – – – – (3,871) – – – – – – – (3,331) (2,354) – (110) (72) (31) (5,849) (1,541) (131) (13,419) – – – – – – (4,662) – (227) (62) (29) (5,659) (1,754) (12,393) 14 3,477 726 28 525 6 4,443 (3,331) (2,354) (3,374) (110) (72) (31) (5,849) (1,541) (131) (7,574) 22 3,578 489 365 6 4,974 (4,662) (3,871) (227) (62) (29) (5,659) (1,754) (6,830) * Disclosures relating to 31 December 2018 have been re-presented in this table and the other related tables in this note to reflect the changes explained in note 14. 1 In the event of counterparty default relating to derivative financial assets and liabilities, offsetting would apply and financial assets and liabilities held with the same counterparty would net off. If this occurred with every counterparty, total financial assets would be £13m (2018: £11m) and liabilities £2,862m (2018: £3,517m). Fair values equate to book values for both 2019 and 2018, with the following exceptions: Borrowings Borrowings Financial RRSAs 2019 2018 Basis for determining fair value Book value £m Fair value £m Book value £m Fair value £m E F H (3,206) (125) (110) (3,147) (130) (112) (3,754) (908) (227) (3,634) (887) (235) The fair value of a financial instrument is the price at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms-length transaction. Fair values have been determined with reference to available market information at the balance sheet date, using the methodologies described on page 158. FINANCIAL STATEMENTS158 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 19 Financial instruments continued A These primarily comprise unconsolidated companies where fair value approximates to the book value. B Fair values are assumed to approximate to cost either due to the short-term maturity of the instruments or because the interest rate of the investments is reset after periods not exceeding six months. C Fair values of derivative financial assets and liabilities and trade receivables held to collect or sell are estimated by discounting expected future contractual cash ﬂows using prevailing interest rate curves. Amounts denominated in foreign currencies are valued at the exchange rate prevailing at the balance sheet date. These financial instruments are included on the balance sheet at fair value, derived from observable market prices (Level 2 as defined by IFRS 13 Fair Value Measurement). D Other assets are included on the balance sheet at fair value, derived from observable market prices or latest forecast (Level 2/Level 3 as defined by IFRS 13). E Borrowings are carried at amortised cost. Amounts denominated in foreign currencies are valued at the exchange rate prevailing at the balance sheet date. The fair value of borrowings is estimated using quoted prices. (Level 1 as defined by IFRS 13). Borrowings are carried at amortised cost. Amounts denominated in foreign currencies are valued at the exchange rate prevailing at the balance sheet date. The fair value of borrowings is estimated by discounting contractual future cash flows. (Level 2 as defined by IFRS 13). F G The fair value of lease liabilities are estimated by discounting future contractual cash flows using either the interest rate implicit in the lease or the Group’s incremental cost of borrowing (Level 2 as defined by IFRS 13). H The fair value of RRSAs and other liabilities are estimated by discounting expected future cash flows. The contractual cash flows are based on future trading activity, which is estimated based on latest forecasts (Level 3 as defined by IFRS 13). IFRS 13 defines a three level valuation hierarchy: Level 1 – quoted prices for similar instruments Level 2 – directly observable market inputs other than Level 1 inputs Level 3 – inputs not based on observable market data Carrying values of other financial assets and liabilities 2019 Non-current assets Current assets Assets Current liabilities Non-current liabilities Liabilities 2018 Non-current assets Current assets Assets Current liabilities Non-current liabilities Liabilities Foreign exchange contracts £m 234 16 250 (394) (2,960) (3,354) (3,104) 47 16 63 (523) (3,304) (3,827) (3,764) Commodity contracts £m Interest rate contracts 1 £m Total derivatives £m Financial RRSAs £m Other £m C Shares £m Total £m 14 9 23 (5) (6) (11) 12 4 2 6 (15) (25) (40) (34) 203 49 252 – (9) (9) 243 292 4 296 – (4) (4) 292 451 74 525 (399) (2,975) (3,374) (2,849) 343 22 365 (538) (3,333) (3,871) (3,506) – – – (31) (79) (110) (110) – – – (52) (175) (227) (227) 16 12 28 (32) (40) (72) (44) – – – (28) (34) (62) (62) – – – (31) – (31) (31) – – – (29) – (29) (29) 467 86 553 (493) (3,094) (3,587) (3,034) 343 22 365 (647) (3,542) (4,189) (3,824) 1 Includes the foreign exchange impact of cross-currency interest rate swaps. Derivative financial instruments The Group uses various financial instruments to manage its exposure to movements in foreign exchange rates. Where the effectiveness of a hedging relationship in a cash flow hedge is demonstrated, changes in the fair value that are deemed effective are included in the cash flow hedge reserve and released to match actual payments on the hedged item. The Group uses commodity swaps to manage its exposure to movements in the price of commodities (jet fuel and base metals). To hedge the currency risk associated with a borrowing denominated in a foreign currency, the Group has currency derivatives designated as part of fair value hedges. The Group uses interest rate swaps and forward rate agreements to manage its exposure to movements in interest rates. Movements in the fair values of derivative financial assets and liabilities were as follows: Foreign exchange instruments 2019 £m (3,764) 2018 £m (2,312) – (4) – (14) (43) 707 (3,104) (2,122) 684 (3,764) Commodity instruments Interest rate instruments – hedge accounted Interest rate instruments – non-hedge accounted Total 2019 £m (34) – 13 36 (3) 12 2018 £m 1 – (9) (22) (4) (34) 2019 £m 292 2018 * £m 227 2019 £m – 2018 £m – 2019 £m (3,506) 2018 £m (2,084) (27) 101 – (1) – (36) 229 – (35) 292 – – 14 – 14 – – – – – (27) 9 101 (24) 7 668 (2,849) (2,144) 645 (3,506) At 1 January Movements in fair value hedges Movements in cash flow hedges Movements in other derivative contracts 1 Contracts settled At 31 December * Prior year balances have been re-presented in order to give a more accurate reflection of the cash flows associated with interest rate instruments. 1 Included in financing. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 159 19 Financial instruments continued Financial risk and revenue sharing arrangements (RRSAs) and other financial liabilities The Group has financial liabilities arising from financial RRSAs. These financial liabilities are valued at each reporting date using the amortised cost method. This involves calculating the present value of the forecast cash flows of the arrangements using the internal rate of return at the inception of the arrangements as the discount rate. Movements in the carrying values were as follows: Financial RRSAs Other liabilities Other assets At 1 January as previously reported Reclassification to borrowings 1 At 1 January restated Exchange adjustments included in OCI Additions Financing charge 2 Excluded from underlying profit: Changes in forecast payments 2 Exchange adjustments 2 Cash paid Reclassification from trade receivables At 31 December 2019 £m (227) 79 (148) 10 (4) (3) 1 6 28 – (110) 2018 £m (247) – (247) (3) (3) (8) (2) – 36 – (227) 2019 £m (62) – (62) 1 (37) (3) – – 29 – (72) 2018 £m (57) – (57) (1) (25) (1) – – 22 – (62) 2019 £m – – – – – – – – – 16 16 2018 £m – – – – – – – – – – – 1 In 2019, the Group reclassified £79m as borrowings previously included in other financial liabilities. 2 Included in financing. Effect of hedging instruments on the financial position and performance To manage the risk of changes in the fair values of fixed rate borrowings (the hedged items) the Group has entered into fixed-to-floating interest rate swaps and cross-currency interest rate swaps (the hedging instruments) which for accounting purposes are designated as fair value hedges. Although the hedging instruments have similar critical terms to the hedged item, some ineffectiveness, predominantly due to cross currency basis, will still remain. The impact of any hedge ineffectiveness on the financial position and performance of the Group is as follows: At 31 December 2019 Sterling US Dollar Euro At 31 December 2018 Sterling US Dollar Euro Nominal £m (375) (987) (1,607) (875) (987) (1,607) Hedged item 1 FV adjustment in the period £m FV adjustment since inception £m Hedging instrument 2 Carrying amount £m Nominal £m Carrying amount asset £m Carrying amount liability £m FV movement in the period £m Hedge ineffect- iveness in the period 3 £m Weighted average FX rate Weighted average interest rate (3) (10) 63 25 (61) (33) (36) (410) 375 (175) (1,159) 987 (34) (1,637) 1,607 (34) (907) 875 (165) (1,148) 987 (97) (1,699) 1,607 36 172 27 34 169 90 – – (6) – – – 3 2 (69) (25) 65 26 – (8) (6) – 4 (7) 1.00 1.52 1.15 1.00 1.52 1.15 GBP LIBOR + 0.893 GBP LIBOR + 1.2575 GBP LIBOR + 0.8301 GBP LIBOR + 2.0867 GBP LIBOR + 1.2575 GBP LIBOR + 0.8301 1 Hedged items are included in borrowings in the balance sheet. 2 Hedging instruments are included in other financial assets or liabilities in the balance sheet. 3 Hedge ineffectiveness is included in net financing in the income statement. The Group has elected to early adopt the amendments to IFRS 9, IAS 39 and IFRS 7 Interest Rate Benchmark Reform issued in September 2019. In calculating the change in fair value attributable to the hedged risk for the fixed-rate borrowings, the Group has made the following assumptions that reflect its current expectations: – the Group has assumed that pre-existing fallback provisions in the borrowings do not apply to IBOR reform; – borrowings move to a risk-free rate during 2022, and the spread will be similar to the spread included in the interest rate swaps used as hedging instruments; and – no other changes to the terms of the hedged borrowings are anticipated. FINANCIAL STATEMENTS 160 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 19 Financial instruments continued Risk management policies and hedging activities The principal financial risks to which the Group is exposed are: foreign currency exchange rate risk; liquidity risk; credit risk; interest rate risk; and commodity price risk. The Board has approved policies for the management of these risks. Foreign currency exchange rate risk – The Group has significant cash flows (most significantly US dollars, followed by the euro) denominated in currencies other than the functional currency of the relevant trading entity. To manage its exposures to changes in values of future foreign currency cash flows, so as to maintain relatively stable long-term foreign exchange rates on settled transactions, the Group enters into derivative forward foreign currency transactions. The Group economically hedges its GBP/USD exposure by forecasting highly probable net USD receipts up to ten years forward. Hedges are taken out within prescribed maximum and minimum hedge positions set out in the Group FX policy. The maximum and minimum policy bands decline gradually over the ten-year horizon and are calculated as a percentage of forecast net income. A similar policy is operated for the Group’s EUR/USD exposure. For accounting purposes, these derivative contracts are not designated in hedging relationships with the exception of those taken out by the Group’s Spanish subsidiary, ITP Aero, where they are designated in cash flow hedges. ITP Aero is exposed predominantly to net USD receipts that it hedges against EUR using foreign exchange forward contracts. The Group regards its interests in overseas subsidiary companies as long-term investments. The Group aims to match its translational exposures by matching the currencies of assets and liabilities. Liquidity risk – The Group’s policy is to hold financial investments and maintain undrawn committed facilities at a level sufficient to ensure that the Group has available funds to meet its medium-term capital and funding obligations and to meet any unforeseen obligations and opportunities. The Group holds cash and short-term investments, which together with the undrawn committed facilities, enable the Group to manage its liquidity risk. Credit risk – The Group is exposed to credit risk to the extent of non-payment by either its customers or the counterparties of its financial instruments. The effective monitoring and controlling of credit risk is a key component of the Group’s risk management activities. The Group has credit policies covering both trading and financial exposures. Credit risks arising from treasury activities are managed by a central treasury function in accordance with the Group credit policy. The objective of the policy is to diversify and minimise the Group’s exposure to credit risk from its treasury activities by ensuring the Group transacts strictly with ‘BBB’ or higher rated financial institutions based on pre-established limits per financial institution. At the balance sheet date, there were no significant concentrations of credit risk to individual customers or counterparties. The Group’s revenue is generated from customers located across multiple geographical locations (see note 2), these customers are typically: airframers and airline operators relating to Civil Aerospace; government defence departments for the UK and US; multiple smaller entities for Power Systems; and aero engine manufacturers for ITP Aero. Whilst there are a limited number of customers related to Civil Aerospace and Defence, they are spread across various geographical locations. The maximum exposure to credit risk at the balance sheet date is represented by the carrying value of each financial asset, including derivative financial instruments. Interest rate risk – The Group’s interest rate risk is primarily in relation to its fixed rate borrowings (fair value risk), floating rate borrowings and cash and cash equivalents (cash flow risk). Interest rate derivatives are used to manage the overall interest rate profile of the Group. The fixed or floating rate interest rate decision on long-term borrowings is determined for each new agreement at the point it is entered into. The aggregate interest rate position of the Group is reviewed regularly and can be revised at any time in order to react to changes in market conditions or circumstances. The Group also has exposures to the fair values of non-derivative financial instruments such as USD, EUR and GBP and fixed rate borrowings. To manage the risk of changes in these fair values, the Group has entered into fixed-to-floating interest rate swaps and cross-currency interest rate swaps which for accounting purposes are designated as fair value hedges. The swaps have similar critical terms to the hedged items, such as the reference rate, reset dates, notional amounts, payment dates and maturities. Therefore there is an economic relationship and the hedge ratio is established as 1:1. Possible sources of ineffectiveness in the fair value hedge relationship are changes in the credit risk of either party to the interest rate swap and, for cross-currency interest rate swaps, the cross-currency basis risk as this risk is present in the hedging instrument only. Another possible source of ineffectiveness would be if the notional of the borrowings is less than the notional of the derivative, for example in the event of a partial repayment of hedged debt prior to its maturity. The Group has exposure to changes in cash flows due to changes in interest rates. To manage this risk the Group has entered into floating-to-fixed interest rate swaps to hedge a proportion of its floating rate exposure to fixed rates. The swaps have similar critical terms to the floating leg of swaps that form part of the fair value hedges, such as the reference rate, reset dates, notional amounts, payment dates and maturities. For accounting purposes, these derivative contracts are generally not designated as hedging instruments. The Group’s Spanish subsidiary, ITP Aero, has also entered into a floating-to-fixed interest rate swap to hedge the cash flow risk on a floating rate borrowing which for accounting purposes is designated as a cash flow hedge. Commodity risk – The Group has exposures to the price of jet fuel and base metals arising from business operations. To minimise its cash flow exposures to changes in commodity prices, the Group enters into derivative commodity transactions. The commodity hedging policy is similar to the Group FX policy, in that the Group forecasts highly probable exposures to commodities, and takes out hedges within prescribed maximum and minimum levels as set out in the policy. The maximum and minimum policy bands decline gradually over time. For accounting purposes, these derivative contracts are generally not designated in hedging relationships. Other price risk – The Group’s cash equivalent balances represent investments in money-market instruments, with a term of up to three months. The Group does not consider that these are subject to significant price risk. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 161 19 Financial instruments continued Derivative financial instruments The nominal amounts, analysed by year of expected maturity, and fair values of derivative financial instruments are as follows: At 31 December 2019 Foreign exchange contracts: Cash flow hedges Non-hedge accounted Interest rate contracts: Fair value hedges Cash flow hedges Non-hedge accounted Commodity contracts: Cash flow hedges Non-hedge accounted At 31 December 2018 Foreign exchange contracts: Cash flow hedges Non-hedge accounted Interest rate contracts: Fair value hedges Cash flow hedges Non-hedge accounted Commodity contracts: Cash flow hedges Non-hedge accounted Expected maturity Fair value Nominal amount £m Within one year £m Between one and two years £m Between two and five years £m After five years £m Assets £m Liabilities £m 646 29,878 2,969 15 2,001 54 342 35,905 335 29,080 3,469 19 – 6 250 33,159 266 5,151 329 4 – 11 125 5,886 162 5,528 500 4 – 2 92 6,288 206 4,704 174 13,300 639 4 – 9 101 5,663 120 5,113 329 4 – 1 79 5,646 484 7 484 21 116 14,586 53 14,808 639 11 – 1 77 15,589 – 6,723 1,517 – 1,517 13 – 9,770 – 3,631 2,001 – – 2 2 5,636 13 237 235 – 17 8 15 525 4 59 293 – 3 1 5 365 (17) (3,337) (6) – (3) (1) (10) (3,374) (11) (3,816) – (1) (3) (8) (32) (3,871) As described above, all derivative financial instruments are entered into for risk management purposes, although these may not be designated into hedging relationships for accounting purposes. Currency analysis Foreign exchange contracts are denominated in the following currencies: At 31 December 2019 Currencies sold forward: Sterling US dollar Euro Other At 31 December 2018 Currencies sold forward: Sterling US dollar Euro Other Nominal amount of currencies purchased forward Sterling £m US dollar £m Euro £m Other £m Total £m – 24,411 21 8 – 24,376 84 87 4 – 297 91 – – 119 39 – 4,468 – 152 63 3,280 – 94 221 581 264 6 230 753 274 16 225 29,460 582 257 293 28,409 477 236 FINANCIAL STATEMENTS 162 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 19 Financial instruments continued The nominal value of interest rate and commodity contracts are denominated in the following currencies: Sterling US dollar Euro 2019 £m 2,376 1,370 1,635 2018 £m 875 1,233 1,636 Non-derivative financial instruments are denominated in the following currencies: Sterling £m US dollar £m Euro £m Other £m Total £m At 31 December 2019 Unlisted non-current investments Trade receivables and similar items Other non-derivative financial assets Other assets Short-term investments Cash and cash equivalents Assets Borrowings Lease liabilities Financial RRSAs Other liabilities C Shares Trade payables and similar items Other non-derivative financial liabilities Contract liabilities Liabilities At 31 December 2018 Unlisted non-current investments Trade receivables and similar items Other non-derivative financial assets Short-term investments Cash and cash equivalents Assets Borrowings Financial RRSAs Other liabilities C Shares Trade payables and similar items Other non-derivative financial liabilities Liabilities 4 139 33 – – 2,269 2,445 (416) (225) – (29) (31) (1,802) (758) – (3,261) (816) 2 376 72 – 2,008 2,458 (1,441) – (24) (29) (2,099) (854) (4,447) (1,989) 8 2,735 649 28 – 853 4,273 (1,172) (1,784) (25) (43) – (3,244) (576) (131) (6,975) (2,702) 7 2,463 341 – 928 3,739 (1,435) (47) (38) – (2,600) (421) (4,541) (802) 2 541 23 – 6 1,224 1,796 (1,739) (76) (85) – – (730) (136) – (2,766) (970) 13 687 47 – 1,792 2,539 (1,753) (180) – – (860) (379) (3,172) (633) – 62 21 – – 97 180 (4) (269) – – – (73) (71) – (417) (237) – 52 29 6 246 333 (33) – – – (100) (100) (233) 100 14 3,477 726 28 6 4,443 8,694 (3,331) (2,354) (110) (72) (31) (5,849) (1,541) (131) (13,419) (4,725) 22 3,578 489 6 4,974 9,069 (4,662) (227) (62) (29) (5,659) (1,754) (12,393) (3,324) Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 163 19 Financial instruments continued Currency exposures The Group’s actual currency exposure on financial instruments after taking account of derivative foreign currency contracts, which are not designated as hedging instruments for accounting purposes are as follows: Functional currency of Group operations At 31 December 2019 Sterling US dollar Euro Other At 31 December 2018 Sterling 1 US dollar Euro Other Sterling £m US dollar £m Euro £m Other £m – – 1 70 – (2) 2 – 2 – (3) 12 3 – (14) 10 2 (1) – 69 (237) (5) – 13 (4) – (1) 4 6 5 12 – Total £m – (1) (3) 155 (228) (2) – 23 1 The euro exposure primarily relates to deferred consideration on the acquisition of ITP Aero. Movements in this balance in relation to foreign exchange (recognised through the consolidated income statement) are partially matched by the related foreign exchange movement in the subsidiary’s net assets, recognised through the consolidated statement of other comprehensive income. Ageing beyond contractual due date of financial assets At 31 December 2019 Unlisted non-current asset investments Trade receivables and similar items Other non-derivative financial assets Other assets Derivative financial assets Short-term investments Cash and cash equivalents At 31 December 2018 Unlisted non-current asset investments Trade receivables and similar items Other non-derivative financial assets Derivative financial assets Short-term investments Cash and cash equivalents Up to three months overdue £m Between three months and one year overdue £m More than one year overdue £m – 210 2 – – – – 212 – 265 – – – – 265 – 92 1 – – – – 93 – 132 – – – – 132 – 73 1 – – – – 74 – 73 – – – – 73 Within terms £m 14 3,102 722 28 525 6 4,443 8,840 22 3,108 489 365 6 4,974 8,964 Total £m 14 3,477 726 28 525 6 4,443 9,219 22 3,578 489 365 6 4,974 9,434 FINANCIAL STATEMENTS164 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 19 Financial instruments continued Contractual maturity analysis of non-derivative financial liabilities At 31 December 2019 Borrowings Lease liabilities Financial RRSAs Other liabilities C Shares Trade payables and similar items Other non-derivative financial liabilities Contract liabilities At 31 December 2018 Borrowings Financial RRSAs Other liabilities C Shares Trade payables and similar items Other non-derivative financial liabilities Gross values Between one and two years £m Between two and five years £m After five years £m Carrying value £m (722) (306) (7) (23) – (62) (308) – (1,428) (520) (62) (3) – (51) (150) (786) (662) (872) (14) (10) – (20) (35) – (1,613) (1,014) (59) (25) – (40) (259) (1,397) (1,704) (1,258) (63) (5) – (90) (36) – (3,156) (2,699) (73) (7) – (26) (72) (2,877) (3,331) (2,354) (110) (72) (31) (5,849) (1,541) (131) (13,419) (4,662) (227) (62) (29) (5,659) (1,754) (12,393) Within one year £m (511) (425) (35) (34) (31) (5,677) (1,162) (131) (8,006) (983) (48) (27) (29) (5,542) (1,273) (7,902) Expected maturity analysis of derivative financial instruments At 31 December 2019 Derivative financial assets: Cash inflows Cash outflows Other net cash flows 1 Derivative financial liabilities: Cash inflows Cash outflows Other net cash flows 1 At 31 December 2018 Derivative financial assets: Cash inflows Cash outflows Other net cash flows 1 Derivative financial liabilities: Cash inflows Cash outflows Other net cash flows 1 Gross values Between one and two years £m Between two and five years £m After five years £m Carrying value £m 1,487 (1,448) 12 51 4,113 (4,737) (5) (629) 934 (869) 7 72 4,753 (5,656) (12) (915) 2,072 (2,035) 34 71 11,987 (13,872) (4) (1,889) 2,187 (2,185) 15 17 13,481 (16,298) (12) (2,829) 3,202 (3,085) 24 141 4,804 (6,186) – (1,382) 2,061 (1,934) 16 143 3,437 (4,257) – (820) 525 (3,374) 365 (3,871) Within one year £m 1,475 (1,376) 17 116 4,383 (4,960) (5) (582) 1,001 (979) 24 46 4,753 (5,531) (14) (792) 1 Derivative financial assets and liabilities settled on a net cash basis. The Group regularly renegotiates the contractual maturities of its foreign exchange contracts. In general, the effect of such negotiations is the settlement of derivative financial liabilities somewhat earlier than the contractual maturity date. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 165 19 Financial instruments continued Interest rate risk In respect of income-earning financial assets and interest-bearing financial liabilities, the following table indicates their effective interest rates. The value shown is the carrying amount, before taking account of swaps. 2019 2018 Short-term investments Cash and cash equivalents 1 Borrowings Lease liabilities (2018: finance lease liabilities) Weighted average interest rates Borrowings Lease liabilities 2 Fixed rate £m – – (2,252) (1,578) (3,830) Floating rate £m 6 4,443 (1,079) (776) 2,594 1.9% 3.6% 1.6% 3.1% Total £m 6 4,443 (3,331) (2,354) (1,236) Fixed rate £m – – (99) (229) (328) Floating rate £m 6 4,974 (4,334) – 646 Total £m 6 4,974 (4,433) (229) 318 1.5% 4.1% 2.1% 1 Cash and cash equivalents comprises bank balances and term deposits and earn interest based on short-term floating market interest rates. 2 Interest rates for lease liabilities are considered to be the discount rates at the balance sheet date. Some of the Group’s borrowings are subject to the Group meeting certain obligations, including customary financial covenants. If the Group fails to meet its obligations these arrangements give rights to the lenders, upon agreement, to accelerate repayment of the facilities. At 31 December 2019, none of these were in breach (2018: none). There are no rating triggers contained in any of the Group’s facilities that could require the Group to accelerate or repay any facility for a given movement in the Group’s credit rating. In addition, the Group has £2,500m (2018: £2,500m) of undrawn committed borrowing facilities which are available for at least the next four years. Sensitivity analysis Sensitivities at 31 December (all other variables held constant) – impact on profit after tax and equity Sterling 10% weaker against the US dollar Sterling 10% stronger against the US dollar Euro 10% weaker against the US dollar Euro 10% stronger against the US dollar Sterling 10% weaker against the Euro Sterling 10% stronger against the Euro Commodity prices 10% lower Commodity prices 10% higher Interest rates 50 basis points lower Interest rates 50 basis points higher 2019 £m (2,557) 2,105 (376) 307 (32) 26 (32) 32 (82) 85 2018 £m (2,401) 1,998 (268) 219 (32) 26 (21) 21 – – FINANCIAL STATEMENTS166 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 19 Financial instruments continued C Shares and payments to shareholders The Company issues non-cumulative redeemable preference shares (C Shares) as an alternative to paying a cash dividend. C Shares in respect of a year are issued in the following year. Shareholders are able to redeem any number of their C Shares for cash. Any C Shares retained attract a dividend of 75% of LIBOR on the 0.1p nominal value of each share, paid on a twice-yearly basis, and have limited voting rights. The Company has the option to compulsorily redeem the C Shares, at any time, if the aggregate number of C Shares in issue is less than 10% of the aggregate number of C Shares issued, or on the acquisition or capital restructuring of the Company. Movements in issued and fully paid C Shares during the year were as follows: At 1 January Issued Redeemed At 31 December 2019 2018 Millions 29,071 221,954 (220,417) 30,608 Nominal value £m 29 222 (220) 31 Millions 28,429 216,717 (216,075) 29,071 Nominal value £m 28 217 (216) 29 Payments to shareholders in respect of the year represent the value of C Shares to be issued in respect of the results for the year. Issues of C Shares were declared as follows: Interim Final 2019 2018 Pence per share 4.60 7.10 11.70 £m 87 137 224 Pence per share 4.60 7.10 11.70 £m 86 135 221 20 Provisions for liabilities and charges Trent 1000 exceptional costs 1 Contract losses 2 Warranties and guarantees Customer financing Restructuring Insurance Tax related interest and penalties Employer liability claims Other Current liabilities Non-current liabilities Reclassified to lease liabilities (IFRS 16) £m – – – – (8) – – – (67) (75) At 1 January 2019 £m 779 206 373 17 204 87 62 48 141 1,917 1,122 795 Charged to income statement £m 1,275 592 129 12 49 25 14 4 33 2,133 Reversed £m – (4) (19) – (48) (17) (19) – (34) (141) Utilised £m (672) (78) (123) (7) (128) (25) (1) (3) (21) (1,058) Transfers £m – 62 – – – – – – (9) 53 Exchange differences £m – (5) (15) – (1) – (1) – (3) (25) At 31 December 2019 £m 1,382 773 345 22 68 70 55 49 40 2,804 858 1,946 The charge to the income statement for Trent 1000 includes £15m as a result of discount unwind. 1 2 The charge to the income statement for contract losses includes a £40m impact from the change in discount rates on contract losses recorded in prior years as a result of the fall in US bonds, which drives the calculation of the risk-free discount rate. In November, we announced the outcome of recent testing and a thorough technical and financial review of the Trent 1000 TEN programme, following technical issues which were identified in 2019. This resulted in a revised timeline and a more conservative estimate of durability for the improved HP turbine blade for the TEN variant. An exceptional charge of £1,361m (at underlying exchange rates) has been recorded in the income statement. The charge is £1,531m at prevailing exchange rates and net of £203m reflecting insurance receipts and contract accounting adjustments. Of the charge, £1,275m has been recorded in relation to Trent 1000 exceptional costs, and a further £459m in relation to contract losses (see below). See note 2 for further details. During 2019, we have utilised £672m of the Trent 1000 exceptional costs provision. This represents customer disruption costs settled in cash and credit notes, and remediation shop visit costs. We expect to use this provision over the period 2020 to 2023. Provisions for contract losses are recorded when the direct costs to fulfil a contract are assessed as being greater than the expected revenue. Included within the provision charged of £592m, is £459m (at prevailing exchange rates) relating to the upfront recognition of future losses on a small number of contracts which are now loss making as a result of the margin impact of our updated HP turbine durability expectations on the Trent 1000 TEN. Provisions for contract losses are expected to be utilised over the term of the customer contracts, typically within 10–15 years. Provisions for warranties and guarantees primarily relate to products sold and generally cover a period of up to three years. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 167 20 Provisions for liabilities and charges continued Customer financing provisions cover guarantees provided for asset value and/or financing. In connection with the sale of its products the Group will, on some occasions, provide financing support for its customers – generally in respect of civil aircraft. The Group’s commitments relating to these financing arrangements are spread over many years, relate to a number of customers and a broad product portfolio and are generally secured on the asset subject to the financing. These include commitments of US$2.8bn (2018: US$2.3bn) (on a discounted basis) to provide facilities to enable customers to purchase aircraft (of which approximately US$656m could be called during 2020). These facilities may only be used if the customer is unable to obtain financing elsewhere and are priced at a premium to the market rate. Consequently, the Directors do not consider that there is a significant exposure arising from the provision of these facilities. Commitments on delivered aircraft in excess of the amounts provided are shown in the table below. These are reported on a discounted basis at the Group’s borrowing rate to reflect better the time span over which these exposures could arise. These amounts do not represent values that are expected to crystallise. The commitments are denominated in US dollars. As the Group does not generally adopt cash flow hedge accounting for future foreign exchange transactions, this amount is reported, together with the sterling equivalent at the reporting date spot rate. The values of aircraft providing security are based on advice from a specialist aircraft appraiser. Gross commitments Value of security 1 Indemnities Net commitments Net commitments with security reduced by 20% 2 1 Security includes unrestricted cash collateral of: 2019 2018 £m 60 (9) (8) 43 43 – $m 79 (11) (11) 57 57 – £m 93 (24) (19) 50 60 4 $m 119 (30) (24) 65 77 6 2 Although sensitivity calculations are complex, the reduction of relevant security by 20% illustrates the sensitivity to changes in this assumption. Restructuring provisions are made for Group approved, formal restructuring programmes where the restructuring has either commenced or has been publicly announced. Included is the Group-wide restructuring programme announced on 14 June 2018, which is an on-going multi-year restructuring programme across the business and reflects the severance costs as well as the consultancy costs that will help deliver the planned reductions. The majority of the provision is expected to be utilised over the next two years. The Group’s captive insurance company retains a portion of the exposures it insures on behalf of the remainder of the Group. Significant delays occur in the notification and settlement of claims and judgement is involved in assessing outstanding liabilities, the ultimate cost and timing of which cannot be known with certainty at the balance sheet date. The insurance provisions are based on information currently available, however it is inherent in the nature of the business that ultimate liabilities may vary. Provisions for outstanding claims are established to cover the outstanding expected liability as well as claims incurred but not yet reported. Provisions for tax related interest and penalties relate to uncertain tax positions in some of the jurisdictions in which the Group operates. Utilisation of the provisions will depend on the timing of resolution of the issues with the relevant tax authorities. The provision relating to employer healthcare liability claims is as a result of an historical insolvency of the previous provider and is expected to be utilised over the next 30 years. Other provisions comprise a number of liabilities with varying expected utilisation rates. FINANCIAL STATEMENTS168 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 21 Post-retirement benefits The Group operates a number of defined benefit and defined contribution schemes: – The UK defined benefit scheme is funded, with the assets held in a separate trustee administered fund. Employees are entitled to retirement benefits based on either their final or career average salaries and length of service. – Overseas defined benefit schemes are a mixture of funded and unfunded plans and provide benefits in line with local practice. Additionally in the US, and to a lesser extent in some other countries, the Group’s employment practices include the provision of healthcare and life insurance benefits for retired employees. These schemes are unfunded. The valuations of the defined benefit schemes are based on the most recent funding valuations, where relevant, updated by the scheme actuaries to 31 December 2019. The defined benefit schemes expose the Group to actuarial risks such as longevity, interest rate, inflation and investment risks. In the UK, and in the principal US and Canadian pension schemes, the Group has adopted investment policies to mitigate some of these risks. This involves investing a significant proportion of the schemes’ assets in liability driven investment (LDI) portfolios, which hold investments designed to offset interest rate and inflation rate risks. In addition, during the year, the scheme has completed a buy-in/buy-out of UK pensioner liabilities – see page 169. Amounts recognised in the income statement Defined benefit schemes: Current service cost and administrative expenses Past-service cost in respect of equalisation 1 Other past-service cost/(credit) 2 Defined contribution schemes Operating cost Net financing (credit)/charge in respect of defined benefit schemes Total income statement charge UK schemes £m 2019 Overseas schemes £m 164 – – 164 66 230 (59) 171 52 – 6 58 91 149 36 185 UK schemes £m 2018 Overseas schemes £m 183 121 (9) 295 41 336 (55) 281 58 – (1) 57 100 157 32 189 Total £m 216 – 6 222 157 379 (23) 356 Total £m 241 121 (10) 352 141 493 (23) 470 1 In the UK in 2018, past-service costs of £121m were recognised relating to the estimated cost of equalising benefits earned after May 1990 between men and women. The UK scheme (Rolls-Royce UK Pension Fund) has to provide Guaranteed Minimum Pensions (GMPs) which, as a result of statutory rules, have been calculated differently for men and women. Although equal treatment in pension provision for males and females has been required since 1990, there has been uncertainty on whether and how pension schemes are required to equalise GMPs. A High Court judgement on the Lloyds Banking Group hearing was published on 26 October 2018. The judgement confirmed that GMPs earned from 1990 must be equalised and highlighted an acceptable range of methods. The estimated cost of this equalisation was £97m. In addition, a cost of £24m was recognised in relation to obligations to equalise certain other post-1990 benefits between men and women. The total cost of £121m represents the Directors’ best estimate of the cost, based on actuarial advice. However, the final cost will differ from this amount when the final method of equalisation is agreed with the Trustee and subsequently implemented. 2 In addition in 2018, a past-service credit of £9m arose related to the restructuring activities. This credit was offset against the restructuring costs. All amounts were excluded from the underlying results. The operating cost is charged as follows: Cost of sales Commercial and administrative costs Research and development costs Defined benefit Defined contribution Total 2019 £m 158 40 24 222 2018 £m 176 148 28 352 2019 £m 113 26 18 157 2018 £m 104 21 16 141 2019 £m 271 66 42 379 2018 £m 280 169 44 493 Pension contributions to UK pension arrangements are generally paid via a salary sacrifice scheme under which employees agree to a reduction in gross contractual pay in return for the Group making additional pension contributions on their behalf. As a result, there is a decrease in wages and salaries and a corresponding increase in pension costs of £47m (2018: £31m) in the year. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 169 21 Post-retirement benefits continued Net financing comprises: Financing on scheme obligations Financing on scheme assets Net financing (income)/charge in respect of defined benefit schemes Financing income on scheme surpluses Financing cost on scheme deficits UK schemes £m 303 (362) (59) (59) – 2019 Overseas schemes £m 66 (30) 36 (1) 37 Amounts recognised in OCI in respect of defined benefit schemes Actuarial gains and losses arising from: Demographic assumptions Financial assumptions Experience adjustments Return on scheme assets excluding financing income UK schemes £m 309 (1,723) 79 456 (879) 2019 Overseas schemes £m 38 (228) 29 106 (55) UK schemes £m 286 (341) (55) (55) – 2018 Overseas schemes £m 59 (27) 32 (1) 33 UK schemes £m 2018 Overseas schemes £m (130) 782 (6) (705) (59) (4) 134 9 (53) 86 Total £m 369 (392) (23) (60) 37 Total £m 347 (1,951) 108 562 (934) Total £m 345 (368) (23) (56) 33 Total £m (134) 916 3 (758) 27 On 5 June 2019, the Group entered into a partial buy-in with Legal & General Assurance Society Limited covering the benefits of circa 33,000 in-payment pensioners. As a result of the transaction, an asset re-measurement net loss estimated at £600m has been recognised within the line ‘Actuarial gains/(losses) recognised in OCI’. The buy-in was in anticipation of a buy-out. On 1 December 2019, 90% of the buy-in liabilities (covering 29,614 pensioners) were transferred, resulting in pension assets and pension liabilities of £3.6bn being derecognised from the Group’s balance sheet. The remaining 10% of the buy-in liabilities (covering 2,261 pensioners) was concluded in January 2020 with the final balancing payment made on 1 February 2020. Pension assets and liabilities of £408m will be derecognised in 2020. There is no impact upon the income statement arising from this transaction. Amounts recognised in the balance sheet in respect of defined benefit schemes Present value of funded obligations Fair value of scheme assets Net asset/(liability) on funded schemes Present value of unfunded obligations Net asset/(liability) recognised in the balance sheet Post-retirement scheme surpluses ¹ Post-retirement scheme deficits Included in liabilities associated with assets held for sale UK schemes £m (8,499) 9,640 1,141 – 1,141 1,141 – – 2019 Overseas schemes £m (842) 845 3 (1,352) (1,349) 29 (1,378) – Total £m (9,341) 10,485 1,144 (1,352) (208) 1,170 (1,378) – UK schemes £m (10,847) 12,773 1,926 – 1,926 1,926 – – 2018 Overseas schemes £m (758) 735 (23) (1,289) (1,312) 18 (1,303) (27) Total £m (11,605) 13,508 1,903 (1,289) 614 1,944 (1,303) (27) 1 The surplus in the UK scheme is recognised as, on ultimate wind-up when there are no longer any remaining members, any surplus would be returned to the Group, which has the power to prevent the surplus being used for other purposes in advance of this event. Overseas schemes are located in the following countries: Canada Germany US pension schemes US healthcare schemes Other Net asset/(liability) recognised in the balance sheet 2019 Obligations £m (275) (853) (635) (420) (11) (2,194) Assets £m 227 2 616 – – 845 Net £m (48) (851) (19) (420) (11) (1,349) 2018 Obligations £m (227) (749) (596) (446) (29) (2,047) Assets £m 186 – 549 – – 735 Net £m (41) (749) (47) (446) (29) (1,312) FINANCIAL STATEMENTS170 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 21 Post-retirement benefits continued Defined benefit schemes Assumptions Significant actuarial assumptions for the UK scheme at the balance sheet date were as follows: Discount rate Inflation assumption (RPI) 1 Rate of increase in salaries Transfer assumption (active/deferred) Life expectancy from age 65: current male pensioner future male pensioner currently aged 45 current female pensioner future female pensioner currently aged 45 2019 2.15% 3.15% 3.15% 2018 2.95% 3.40% 3.65% 45%/35% 40%/32.5% 22.1 years 21.8 years 23.4 years 23.1 years 23.4 years 23.1 years 25.2 years 25.0 years 1 This is the assumption for the Retail Price Index. The Consumer Price Index is assumed to be 1.0% lower (2018: 1.1% lower). Discount rates are determined by reference to the market yields on AA rated corporate bonds. The rate is determined by using the profile of forecast benefit payments to derive a weighted average discount rate from the yield curve. The inflation assumption is determined by the market-implied assumption based on the yields on long-term index-linked government securities and increases in salaries are based on actual experience, allowing for promotion, of the real increase above inflation. The mortality assumptions adopted for the UK pension schemes are derived from the SAPS S2 ‘All’ actuarial tables, with future improvements in line with the CMI 2018 core projections updated to reflect use of an ‘A’ parameter of 0.25% for future improvements and long-term improvements of 1.25%. Where appropriate, these are adjusted to take account of the scheme’s actual experience. Other assumptions have been set on advice from the actuary, having regard to the latest trends in scheme experience and the assumptions used in the most recent funding valuation. The rate of increase of pensions in payment is based on the rules of the scheme, combined with the inflation assumption where the increase is capped. Assumptions for overseas schemes are less significant and are based on advice from local actuaries. The principal assumptions are: Discount rate Inflation assumption Long-term healthcare cost trend rate Male life expectancy from age 65: current pensioner Changes in present value of defined benefit obligations future pensioner currently aged 45 2019 2.40% 1.90% 4.80% 21.4 years 21.7 years 2018 3.40% 2.90% 4.80% 21.1 years 23.1 years At 1 January Exchange differences Current service cost Past-service cost Finance cost Contributions by employees Benefits paid out Acquisition of businesses Disposal of businesses Actuarial (losses)/gains Transfers Settlement At 31 December Funded schemes Unfunded schemes The defined benefit obligations are in respect of: Active plan participants Deferred plan participants Pensioners Weighted average duration of obligations (years) UK schemes £m (10,847) – (158) – (303) (2) 571 – – (1,335) – 3,575 (8,499) (8,499) – (4,751) (2,154) (1,594) 23 2019 Overseas schemes £m (2,047) 71 (50) – (65) (3) 79 (2) 28 (168) (37) – (2,194) (842) (1,352) (1,185) (171) (838) 16 Total £m (12,894) 71 (208) – (368) (5) 650 (2) 28 (1,503) (37) 3,575 (10,693) (9,341) (1,352) (5,936) (2,325) (2,432) 22 UK schemes £m (11,499) – (179) (112) (286) (2) 585 – – 646 – – (10,847) (10,847) – (4,229) (1,975) (4,643) 19 2018 Overseas schemes £m (2,120) (56) (56) – (59) (3) 78 – 31 140 (2) – (2,047) (758) (1,289) (1,088) (157) (802) 15 Total £m (13,619) (56) (235) (112) (345) (5) 663 – 31 786 (2) – (12,894) (11,605) (1,289) (5,317) (2,132) (5,445) 18 Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 171 21 Post-retirement benefits continued Changes in fair value of scheme assets At 1 January Exchange differences Administrative expenses Financing Return on plan assets excluding financing Contributions by employer Contributions by employees Benefits paid out Acquisition of businesses Settlement At 31 December Total return on scheme assets Fair value of scheme assets at 31 December Sovereign debt Corporate debt instruments Interest rate swaps Inflation swaps Cash and similar instruments 1 Liability driven investment (LDI) portfolios 2 Longevity swap 3 Listed equities Unlisted equities Synthetic equities 4 Sovereign debt Corporate debt instruments Cash Partial buy-in insurance policy Other At 31 December UK schemes £m 12,773 – (6) 362 456 199 2 (571) – (3,575) 9,640 818 UK schemes £m 5,799 3,135 14 (18) (784) 8,146 – 323 95 3 – 662 – 408 3 9,640 2019 Overseas schemes £m 735 (17) (2) 30 106 67 3 (79) 2 – 845 136 2019 Overseas schemes £m 277 467 – – 13 757 – 76 – 5 – 4 4 – (1) 845 UK schemes £m 13,607 – (4) 341 (705) 117 2 (585) – – 12,773 (364) UK schemes £m 9,388 3,447 1,342 (375) (1,991) 11,811 (292) 592 128 (13) – 548 – – (1) 12,773 2018 Overseas schemes £m 750 24 (2) 27 (53) 64 3 (78) – – 735 (26) 2018 Overseas schemes £m 315 356 – – 22 693 – 39 – (4) 5 – 2 – – 735 Total £m 13,508 (17) (8) 392 562 266 5 (650) 2 (3,575) 10,485 954 Total £m 6,076 3,602 14 (18) (771) 8,903 – 399 95 8 – 666 4 408 2 10,485 Total £m 14,357 24 (6) 368 (758) 181 5 (663) – – 13,508 (390) Total £m 9,703 3,803 1,342 (375) (1,969) 12,504 (292) 631 128 (17) 5 548 2 – (1) 13,508 1 Cash and similar instruments include repurchase agreements on UK Government bonds amounting to £(1,308)m (2018: £(1,991)m). The latest maturity date for these short-term borrowings is 12 October 2020. 2 A portfolio of gilt and swap contracts, backed by investment-grade credit instruments and LIBOR generating assets, that is designed to hedge the majority of the interest rate and inflation risks associated with the schemes’ obligations. 3 The longevity swap was transferred to Legal & General Assurance Society Limited as part of the partial buy-in described on page 169. 4 A portfolio of swap contracts designed to provide investment returns in line with global equity markets. The maximum exposure (notional value and accrued returns) on the portfolios was £328m (2018: £281m). The investment strategy for the UK scheme is controlled by the Trustee in consultation with the Group. The scheme assets do not directly include any of the Group’s own financial instruments, nor any property occupied by, or other assets used by, the Group. At 31 December 2019, there was an indirect holding of £0.1m of the Group’s financial instruments (2018: £0.3m). Future contributions The Group expects to contribute approximately £170m to its defined benefit schemes in 2020 (2019: £220m): UK: £100m, Overseas: £70m (2019: UK: £140m, Overseas: £80m). In the UK, the funding is based on a statutory triennial funding valuation process. This includes a negotiation between the Group and the Trustee on actuarial assumptions used to value obligations (Technical Provisions) which may differ from those used for accounting set out above. The assumptions used to value Technical Provisions must be prudent rather than a best estimate of the liability. Most notably, the Technical Provision discount rate is currently based upon UK Government yields plus 0.5% rather than being based on yields of AA corporate bonds. Following the triennial valuation process, a Schedule of Contributions (SoC) must be agreed which sets out the required contribution for current service cost and any contributions from the employer to eliminate a deficit. The most recent valuation, as at 31 March 2017, agreed by the Trustee in December 2017, showed that the UK scheme was estimated to be 112% funded on the Technical FINANCIAL STATEMENTS172 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 21 Post-retirement benefits continued Provisions basis. Employer contributions (inclusive of employee contributions paid by a salary sacrifice arrangement) will subsequently be paid at a rate of 28.5% during 2020 until a new SoC is agreed (2019: 27%). The current SoC includes an arrangement for a potential increase in contributions during 2021 to 2023 (capped at £48.3m a year) if the Technical Provisions funding position is below 107% at 31 March 2020. As at 31 December 2019, the Technical Provisions funding position was estimated to be 112% (2018: 111%). Changes to UK defined benefit scheme A consultation with active managers in the UK scheme was concluded in January 2020. The consultation process agreed certain changes for future accrual for the relevant manager group which will mitigate future funding cost increases. The accounting impact of this change will occur in 2020 rather than 2019. The change is expected to be immaterial to these accounts. The triennial valuation due at 31 March 2020 for the UK scheme will take these changes into account. Sensitivities The calculations of the defined benefit obligations are sensitive to the assumptions set out above. The following table summarises how the estimated impact of a change in a significant assumption would affect the UK defined benefit obligation at 31 December 2019, while holding all other assumptions constant. This sensitivity analysis may not be representative of the actual change in the defined benefit obligation as it is unlikely that the change in assumptions would occur in isolation of one another as some of the assumptions may be correlated. For the most significant funded schemes, the investment strategies hedge the risks from interest rates and inflation measured on a proxy solvency basis. For the UK scheme, the interest rate and inflation hedging is currently based on UK Government bond yields without any adjustment for any credit spread. The sensitivity analysis set out below has been determined based on a method that estimates the impact on the defined benefit obligation as a result of reasonable changes in key assumptions occurring at the end of the reporting period. Reduction in the discount rate of 0.25% 1 Increase in inflation of 0.25% 1 Real increase in salaries of 0.25% Increase of 1% in transfer value assumption One year increase in life expectancy Obligation Plan assets (LDI portfolio) Obligation Plan assets (LDI portfolio) Obligations Obligations Obligations 2019 £m (495) 502 (290) 235 (80) (64) (408) 2018 £m (510) 624 (275) 272 (90) (56) (465) 1 The differences between the sensitivities on obligations and plan assets arise largely due to differences in the methods used to value the obligations for accounting purposes and the adopted proxy solvency basis. 22 Share capital Issued and fully paid At 1 January 2018 Shares issued to employee share trust Shares issued in relation to the acquisition of ITP Aero At 31 December 2018 Shares issued to employee share trust Shares issued in relation to the acquisition of ITP Aero At 31 December 2019 Non-equity Equity Special Share of £1 Nominal value £m Ordinary shares of 20p each Millions Nominal value £m 1 – – 1 – – 1 – – – – – – – 1,840 8 48 1,896 6 29 1,931 368 2 9 379 1 6 386 The rights attaching to each class of share are set out on page 206. In accordance with IAS 32 Financial Instruments: Presentation, the Company’s non-cumulative redeemable preference shares (C Shares) are classified as financial liabilities. Accordingly, movements in C Shares are included in note 19. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 173 23 Share-based payments Effect of share-based payment transactions on the Group’s results and financial position Total expense recognised for equity-settled share-based payment transactions Total expense recognised for cash-settled share-based payment transactions Share-based payments recognised in the consolidated income statement Liability for cash-settled share-based payment transactions 2019 £m 30 – 30 1 2018 £m 32 3 35 6 A description of the share-based payment plans is included in the Directors’ Remuneration Report on pages 95 to 104. Movements in the Group’s share-based payment plans during the year ShareSave LTIP and PSP APRA Outstanding at 1 January 2018 Granted Forfeited Exercised Outstanding at 1 January 2019 Granted Forfeited Exercised Outstanding at 31 December 2019 Exercisable at 31 December 2019 Exercisable at 31 December 2018 Weighted average exercise price Pence 714 – 738 656 713 677 814 627 693 – – Number Millions 27.5 – (1.3) (0.1) 26.1 16.6 (5.1) (5.7) 31.9 – – Number Millions 13.0 5.7 (4.4) (0.4) 13.9 5.3 (0.9) (5.1) 13.2 – – Number Millions 0.2 0.2 – – 0.4 0.2 – (0.2) 0.4 – – The weighted average share price at the date share options were exercised was 906p (2018: 883p). The closing price at 31 December 2019 was 683p (2018: 830p). The weighted average remaining contractual life for the cash settled options at 31 December 2019 was one year (2018: two years). Fair values of share-based payment plans The weighted average fair value per share of equity-settled share-based payment plans granted during the year, estimated at the date of grant, are as follows: LTIP LTIP (ELT & Board) ShareSave – three year grant ShareSave – five year grant APRA 2019 851p 774p 165p 176p 892p 2018 815p 739p n/a n/a 858p LTIP and PSP The fair value of shares awarded is calculated using a pricing model that takes account of the non-entitlement to dividends (or equivalent) during the vesting period and the market-based performance condition based on expectations about volatility and the correlation of share price returns in the group of FTSE 100 companies and which incorporates into the valuation the interdependency between share price performance and TSR vesting. This adjustment decreases the fair value of the award relative to the share price at the date of grant. ShareSave The fair value of the options granted is calculated using a pricing model that assumes that participants will exercise their options at the beginning of the six-month window if the share price is greater than the exercise price. Otherwise it assumes that options are held until the expiration of their contractual term. This results in an expected life that falls somewhere between the start and end of the exercise window. APRA The fair value of shares awarded under APRA is calculated as the share price on the date of the award, excluding expected dividends (or equivalent). FINANCIAL STATEMENTS 174 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 24 Leases Leases as lessee The net book value of right-of-use assets at 31 December 2019 was £2,009m (see note 11) with a lease liability of £2,354m (as per note 17). Leases that have not yet commenced to which the Group is committed have a future liability of £5m and consists of factory equipment and a single property. The consolidated income statement shows the following amounts relating to leases: Land and buildings depreciation and impairment 1 Plant and equipment depreciation 2 Aircraft and engines depreciation and impairment 3 Total depreciation and impairment charge for right-of-use assets Interest expense 4 Expense relating to short-term leases of 12 months or less recognised as an expense on a straight-line basis 2 Expense relating to variable lease payments not included in lease liabilities 3,5 Total lease expense Income from sub-leasing right-of-use assets Total amount recognised in the income statement 2019 £m (59) (33) (319) (411) (88) (23) (1) (523) 79 (444) 1 Included in cost of sales and commercial and administration costs depending on the nature and use of the right-of-use asset. 2 Included in cost of sales, commercial and administration costs, or research and development depending on the nature and use of the right-of-use asset. 3 Included in cost of sales. 4 Included in financing costs. 5 Variable lease payments primarily arise on a small number of contracts where engine lease payments are solely dependent upon utilisation rather than a periodic charge. The total cash outflow for leases in 2019 was £383m. Of this: £359m related to leases reflected in the lease liability; £23m to short-term leases where lease payments are expensed on a straight-line basis; and £1m for variable lease payments where obligations are only due when the right-of-use assets are used. The timing difference between the income statement charge and cash flow relates to costs incurred at the end of leases for residual value guarantees that are recognised within depreciation over the term of the lease, the most significant amounts relate to engine leases. The Group’s leasing activities as a lessee and how they are accounted for The Group leases aero engines that are used to support customers’ aircraft fleets; land and buildings used for production, administration or training purposes; and equipment used in the manufacturing process and to support commercial and administrative activities. Lease terms are negotiated on an individual basis and contain a wide range of different terms and conditions. The lease arrangements do not impose any covenants, but leased assets may not be used as security for borrowing purposes. Until 31 December 2018, leases were classified as either finance or operating leases. Payments made under operating leases and residual value guarantees were charged to the income statement on a straight-line basis over the period of the lease. From 1 January 2019, leases are recognised as a right-of-use asset and a corresponding lease liability at the date at which the leased asset is available for use by the Group. Each lease payment is allocated between reducing the liability and a finance cost. The finance cost is charged to the income statement over the lease period so as to produce a constant periodic rate of interest on the remaining balance of the liability for each period. Right-of-use assets and lease liabilities arising over the lease term are now initially measured on a present value basis. The lease term represented is the non-cancellable period of the lease together with periods covered by an option to extend the lease where the Group is reasonably certain to extend. Lease liabilities include the net present value of the following lease payments where such flows exist: – fixed payments less any lease incentive; – variable lease payments that are based on an index or a rate; – amounts expected to be payable by the Group under residual value guarantees; – the exercise price of a purchase option if the Group is reasonably certain to exercise that option; and – payments of penalties for terminating the lease, if the lease term reflects the Group exercising that option. Leases for engines typically contain no specific contractual right to renew. Certain land and building leases have renewal options with renewal dates for the most significant property leases evenly spread over 2022–2028 and in 2041. Such judgements on lease terms are made each period end and consider the specific terms of the lease and the operational significance of the site, especially where utilised for manufacturing activities. Lease obligations beyond the renewal dates are included in the lease liability where we are reasonably certain to extend the lease. Engine leases in the Civil Aerospace business often include clauses that require the engines to be returned to the lessor with specific levels of useable life remaining. The cost of meeting these requirements are included in the estimate of the lease payments set out above. The amount payable is dependent upon the utilisation of the engines over the lease term, whether the engine is restored to the required condition by performing an overhaul at our own cost or through the payment of amounts specified in the contract and any new contractual arrangements arising when the current lease contracts end. Where estimates of payments change, an adjustment is made to the lease liability and the right-of-use asset. Liabilities in USD and other non-functional currencies are reported at the closing spot rates with changes arising from a change in exchange rates reported within financing. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 175 24 Leases continued On transition to IFRS 16 on 1 January 2019, finance leases continued to be recognised at their 2018 closing value and operating leases were measured at the present value of the remaining lease payments discounted using an incremental borrowing rate appropriate to the lease. For new leases, the lease payments are discounted using the interest rate implicit in the lease or if that rate cannot be readily determined, which is generally the case for leases in the Group, the incremental borrowing rate, being the rate required to pay to borrow the funds necessary to obtain an asset of similar value to the right-of-use asset in a similar economic environment with similar terms, security and conditions. To determine the incremental borrowing rate, the Group uses a build-up approach that starts with the risk-free interest rate which is then adjusted for credit risk to reflect the nature of the borrowing based on empirical evidence of similar external borrowings undertaken by the Group. The rate used reflects the term and currency of the lease. The Group is exposed to potential future increases or reductions in lease payments where the amount paid is based on an index (such as LIBOR) or rate, which are not included in the lease liability until it takes effect. When adjustments to lease payments based on an index or rate take effect, the lease liability is remeasured and an equivalent adjustment is made to the right-of-use asset except where the change results from a change in floating interest rates when a revised discount rate is used that reflects changes in the interest rate. Right-of-use assets are measured at cost comprising the following: – the amount of the initial measurement of the lease liability or a revaluation of the liability; – any lease payments made at or before the commencement date less any lease incentives received; – any initial direct costs; and – restoration costs. Each right-of-use asset is depreciated over the shorter of its useful life and the lease term on a straight-line basis unless the lease is expected to transfer ownership of the underlying asset to the Group, in which case the asset is depreciated to the end of the useful life of the asset. There was a single onerous lease contract where as a permitted practical expedient the Group has adjusted the right-of-use asset at the date of initial application by the amount of the provision on the balance sheet at 31 December 2018. Income from sub-leasing right-of-use assets is primarily generated from the use of engines by our Civil Aerospace customers. In a small number of circumstances current excess property capacity is sub-let at market rates. Leases as lessor The Group acts as lessor for engines to Civil Aerospace customers when they require engines to support their fleets. Lease agreements with the lessee provide protection over our assets. Usage in excess of specified limits and damage to the engine while on lease are covered by variable lease payment structures. Lessee bankruptcy risk is managed through the Cape Town Convention on International Interests in Mobile Equipment (including a specific protocol relating to aircraft equipment); an international treaty that creates common standards for the registration of lease contracts and establishes various legal remedies for default in financing agreements, including repossession and the effect of particular states’ bankruptcy laws. Engines are only leased once we confirm that appropriate insurance documentation is established that covers the engine assets to pre-agreed amounts. The Group also leases out a small number of properties, or parts of properties, where there is excess capacity. All contracts where we are lessor are operating leases. Operating lease income – credited within revenue from aftermarket services 1, 2 1 Includes variable lease payments of £97m that do not depend on an index or a rate. 2 Items of property, plant and equipment subject to an operating lease are disclosed in note 10. Non-cancellable undiscounted operating lease rentals are receivable as follows: Within one year Between one and two years Between two and three years Between three and four years Between four and five years After five years 2019 £m 127 2019 £m 13 14 12 8 5 17 69 2018 £m 64 2018 £m 23 22 22 21 17 55 160 FINANCIAL STATEMENTS176 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 25 Contingent liabilities Contingent liabilities in respect of customer financing commitments are described in note 20. In January 2017, after full cooperation, the Company concluded deferred prosecution agreements with the SFO and the US Department of Justice and a leniency agreement with the MPF, the Brazilian federal prosecutors. Other authorities are investigating members of the Group for matters relating to misconduct in relation to historical matters. The Group is responding appropriately. Action may be taken by further authorities against the Company or individuals. In addition, we could still be affected by actions from customers and customers’ financiers. The Directors are not currently aware of any matters that are likely to lead to a material financial loss over and above the penalties imposed to date, but cannot anticipate all the possible actions that may be taken or their potential consequences. Contingent liabilities exist in respect of guarantees provided by the Group in the ordinary course of business for product delivery, performance and reliability. The Group has, in the normal course of business, entered into arrangements in respect of export finance, performance bonds, countertrade obligations and minor miscellaneous items. Various Group undertakings are parties to legal actions and claims which arise in the ordinary course of business, some of which are for substantial amounts. As a consequence of the insolvency of an insurer as previously reported, the Group is no longer fully insured against known and potential claims from employees who worked for certain of the Group’s UK based businesses for a period prior to the acquisition of those businesses by the Group. While the outcome of some of these matters cannot precisely be foreseen, the Directors do not expect any of these arrangements, legal actions or claims, after allowing for provisions already made, to result in significant loss to the Group. The Group’s share of equity accounted entities’ contingent liabilities is nil (2018: nil). 26 Related party transactions Sales of goods and services to joint ventures and associates Purchases of goods and services from joint ventures and associates Lease payments to joint ventures and associates Guarantees of joint arrangements’ and associates’ borrowings Guarantees of non-wholly owned subsidiaries’ borrowings Dividends received from joint ventures and associates Other income received from joint ventures and associates 2019 £m 3,776 (3,685) (210) 1 3 92 1 2018 £m 3,237 (2,957) (189) – 3 105 2 Included in sales of goods and services to joint ventures and associates are sales of spare engines amounting to £277m (2018: £563m). Profit recognised in the year on such sales amounted to £93m (2018: £157m), including profit on current year sales and recognition of profit deferred on sales in previous years. On an underlying basis (at actual achieved rates on settled derivative transactions), the amounts were £78m (2018: £132m). Cash receipts relating to the sale of spare engines amounted to £414m (2018: £563m). The aggregated balances with joint ventures are shown in notes 14 and 18. Transactions with Group pension schemes are shown in note 21. In the course of normal operations, related party transactions entered into by the Group have been contracted on an arms-length basis. Key management personnel are deemed to be the Directors (pages 62 to 64) and the members of the Executive Team (described on page 65). Remuneration for key management personnel is shown below: Salaries and short-term benefits Post-retirement schemes Share-based payments 2019 £m 9 – 5 14 2018 £m 19 – 5 24 More detailed information regarding the Directors’ remuneration, shareholdings, pension entitlements, share options and other long-term incentive plans is shown in the Directors’ Remuneration Report on pages 95 to 104. The charge for share-based payments above is based on when the award is charged to the income statement in accordance with IFRS 2 Share-Based Payments, rather than when the shares vest, which is the basis used in the Directors’ Remuneration Report. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 177 27 Acquisitions and disposals Acquisitions Siemens’ eAircraft business On the 30 September 2019, the Group completed the acquisition of the electric and hybrid-electric aerospace propulsion activities of Siemens. On acquisition the book value of assets acquired consisted of £2.8m of property, plant and equipment and £0.2m of other assets and liabilities. Of the £43m (€48.5m) acquisition cost, which was settled in cash, £38m has been allocated to identifiable intangible assets and £5m to other assets and liabilities. Goodwill of £11m was recognised on the transaction. The Group increased its shareholding in the Berlin-based electricity storage specialist, Qinous GmbH from 19.9% to 73.1% on 15 January 2020 for a consideration of €10m. The acquisition will be incorporated within our Power Systems business. Disposals Commercial Marine and Rolls-Royce Power Development Limited On the 1 April 2019, the Group completed the sale of its Commercial Marine business to KONGSBERG for £547m. The business was disclosed as a disposal group held for sale from 30 June 2018. In our 2018 half-year financial statements, we reported an impairment charge of £160m as a result of the decision to classify Commercial Marine as a business held for sale. Upon the disposal of Commercial Marine on 1 April 2019, and in accordance with IAS 21 The Effects of Changes in Foreign Exchange Rates we have recycled the cumulative currency translation reserve through the income statement in 2019. This has resulted in a cumulative currency translation gain of £98m. On the 15 April 2019, the Group sold its shareholding in Rolls-Royce Power Development Limited to Rockland Capital Partners for £46m. The principal activity of this company was to operate a fleet of six industrial Trent power stations in the UK. Proceeds Cash consideration Cash and cash equivalents disposed Net cash consideration Disposal costs paid Cash inflow per cash flow statement Assets and liabilities disposed Intangible assets Property, plant and equipment Right-of-use assets Deferred tax assets Inventory Trade receivables and other assets Current tax assets Lease liabilities Trade payables and other liabilities Deposits (payments received on account) Provisions for liabilities and charges Post-retirement scheme deficits Net assets disposed The gain on disposal of businesses totalled £139m. Income statement Net cash consideration Less: carrying amount of net assets sold Profit on disposal before disposal costs Disposal costs Profit on disposal on business before tax Tax on disposal Profit on disposal of business after tax Cumulative currency translation gain recycled from other comprehensive income Gain recognised in the income statement Commercial Marine £m Rolls-Royce Power Development Limited £m 547 (118) 429 (21) 408 236 139 40 7 207 210 1 (39) (274) (74) (27) (28) 398 46 – 46 (1) 45 – 7 – – 4 4 – – (5) – – – 10 Commercial Marine £m Rolls-Royce Power Development Limited £m 429 (398) 31 (23) 8 – 8 98 106 46 (10) 36 (3) 33 – 33 – 33 Total £m 593 (118) 475 (22) 453 236 146 40 7 211 214 1 (39) (279) (74) (27) (28) 408 Total £m 475 (408) 67 (26) 41 – 41 98 139 FINANCIAL STATEMENTS178 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 27 Acquisitions and disposals continued Disposals continued Trigno Energy S.r.l. On 29 January 2020, the Group exercised its put option to sell 100% of the shares held in Trigno Energy S.r.l. The transaction is expected to complete in the first quarter of 2020. The shares will be transferred to Pilkington Italia S.r.l. for an estimated consideration of €5.6m. Businesses held for sale On 26 September 2019, the Group signed an agreement for the sale of the North America Civil Nuclear business to Westinghouse Electric Company LLC. for a cash consideration of approximately $18m. The sale was completed on 31 January 2020. As a result of the decision to classify the business as a disposal group held for sale, in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations, its carrying value was assessed against the anticipated proceeds and the disposal costs. An impairment charge of £25m has been recognised in the income statement, of which £15m relates to goodwill and an additional £10m impairment charge to property, plant and equipment and intangible assets. The impairment charge was allocated to the non-core businesses. The remaining assets of £17m have been transferred to assets held for sale, together with associated liabilities of £14m at 31 December 2019. On 17 December 2019, the Group signed a share purchase agreement with Valsoft Corp. for the sale of the Knowledge Management System business. The consideration for the disposal is expected to be $2.6m. The sale was completed on 3 February 2020. Disposal – 2018 L’Orange On 1 June 2018, the Group sold its L’Orange business, part of Rolls-Royce Power Systems, to Woodward Inc. for €673m. Under the sale agreement, the cash consideration may be adjusted by up to +/-€44m, based on L’Orange aftermarket sales over the five-year period to 31 May 2023 and this will be reviewed at each reporting date over the adjustment period, based on actual sales. No significant change has been identified to the cash consideration at 31 December 2019. Profit on disposal of the business (net of disposal costs) was £358m. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 179 28 Derivation of summary funds flow statement The table below shows the derivation of the summary funds flow statement (lines marked *) on page 20 from the cash flow statement (CFS) on page 119. * Underlying operating profit (see note 2) Depreciation and impairment of property, plant and equipment Amortisation and impairment of intangible assets Depreciation and impairment of right-of-use assets Impairment of goodwill Acquisition accounting * Depreciation and amortisation * Lease payments (capital plus interest) * Additions of intangible assets * Purchases of property, plant and equipment * Increase in inventories Movement in receivables/payables Movement in contract balances Realised derivatives in financing Revaluation of trading assets (excluding exceptional items) * Movement on receivables/payables/contract balances (excluding Civil LTSA) * Underlying Civil Aerospace LTSA contract balances * Movement on provisions * Trent 1000 insurance * Net interest received and paid * Other * Trading cash flow * Contributions to defined benefit schemes in excess of underlying PBT charge * Tax * Group free cash flow Of which: Disposed entities Group free cash flow (pre disposed entities) Of which: Non-core businesses Core free cash flow * Shareholder payments * Acquisition of eAircraft * Disposal of Commercial Marine and RRPD (2018: Disposal of L’Orange) * Exceptional restructuring costs * DPA payments * Pension fund contribution * IFRS 16 * Other * Foreign exchange * Change in net funds Change in net funds IFRS 16 impact (non cash) Reclassification of other financial liabilities to borrowings Change in net funds excluding IFRS 16 2019 £m £m 808 2018 † £m £m 616 521 565 – (155) (175) 1,129 363 (465) 170 532 372 411 (84) (163) 77 526 (187) 158 1,068 (319) (591) (747) (43) 574 754 (506) 173 (73) (41) 1,057 (9) (175) 873 (41) 914 3 911 (224) (43) 453 (216) (102) (35) 123 (8) (98) 723 723 (123) (79) 521 756 – (680) (905) (616) 1,197 679 (242) – (70) 22 757 59 (248) 568 (78) 646 (2) 648 (219) – 573 (70) – – – 10 54 916 916 – – 916 † The comparative information for the year ended 31 December 2018 has been re-presented to be on a comparable basis with the presentation adopted for the year ended 31 December 2019. There is no change to trading or group free cash flow. In summary, items previously included in ‘other’ within ‘trading cash flow’, which related to ‘movements in receivables/payables’ or movements in ‘contract balances’ have been included within those items. During the year ended 31 December 2019, the Group received insurance receipts of £173m relating to the Trent 1000 in-service issues. This amount has been recognised within the Group’s underlying results – see note 2. FINANCIAL STATEMENTS180 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 28 Derivation of summary funds flow statement continued Free cash flow is a measure of financial performance of the business’ cash flow to see what is available for distribution among those stakeholders funding the business (including debt holders and shareholders). Free cash flow is calculated as trading cash flow less recurring tax and post-employment benefit expenses. It excludes payments made to shareholders, amounts spent (or received) on business acquisitions, SFO payments and foreign exchange changes on net funds. The Board considers that free cash flow reflects cash generated from the Group’s underlying trading. The table below shows a reconciliation of free cash flow to the change in cash and cash equivalents presented in the cash flow statement on page 119. Change in cash and cash equivalents Returns to shareholders Net cash flow from changes in borrowings and lease liabilities (2018: finance leases) Increase in short-term investments Acquisition of Siemens’ eAircraft business Disposal of Commercial Marine and RRPD (2018: Disposal of L’Orange) Other acquisitions and disposals Changes in group structure Payments of financial penalties from agreements with investigating bodies Exceptional restructuring expenditure Pension fund contribution Other Capital element of lease repayments 1 Free cash flow 2019 £m 43 (453) 1 £m (413) 224 1,385 – (409) 102 216 35 4 (271) 873 2018 £m – (573) (10) £m 1,953 219 (1,091) 3 (583) – 70 – (3) – 568 Source A A A A A A B A B B B A 1 As IFRS 16 has been adopted with effect from 1 January 2019, no adjustments have been made to present the comparative period on a consistent basis. Sources: A Cash flow statement B Cash flow statement adjusted for non-underlying items including exchange differences Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Notes to the Consolidated Financial Statements 181 29 Impact of adopting IFRS 16 Leases For leases previously classified as finance leases, the Group recognised the carrying amount of the lease asset and lease liability immediately before transition as the carrying amount of the right-of-use asset and the lease liability at the date of initial application. The measurement principles of IFRS 16 are only applied after that date. The following table reconciles the operating lease obligations under the previous accounting standard, IAS 17 Leases, to the lease liability recorded under IFRS 16 on transition: Operating lease commitments as reported at 31 December 2018 Lease commitments at end of aero engines lease contracts previously reflected in provisions and other liabilities Discounted using the incremental borrowing rate at the date of initial application Additional commitments recognised during final data review 1 Impact of adopting IFRS 16 Commitments relating to disposal groups At 1 January 2019 Finance lease liabilities recognised as at 31 December 2018 Lease liability recognised as at 1 January 2019 Of which are: Current lease liabilities Non-current lease liabilities 1 These have been offset by right-of-use assets with an equivalent value. The recognised right-of-use assets relate to the following types of asset: Land and buildings Plant and equipment Aircraft and engines Total right-of-use assets £m 2,343 515 (749) 180 2,289 (41) 2,248 229 2,477 322 2,155 1 January 2019 £m 453 106 1,654 2,213 FINANCIAL STATEMENTS 182 Financial Statements Notes to the Consolidated Financial Statements Rolls-Royce Holdings plc Annual Report 2019 29 Impact of adopting IFRS 16 Leases continued Condensed consolidated balance sheet The change in accounting policy affected the following items in the balance sheet on 1 January 2019: ASSETS Property, plant and equipment 2 Right-of-use assets 3 Deferred tax assets 4 Other non-current assets Non-current assets Current assets Assets held for sale TOTAL ASSETS LIABILITIES Borrowings and lease liabilities Trade payables and other liabilities 5 Provisions for liabilities and charges 6 Other current liabilities Current liabilities Borrowings and lease liabilities Trade payables and other liabilities 5 Deferred tax liabilities 4 Provisions for liabilities and charges 6 Other non-current liabilities Non-current liabilities Liabilities associated with assets held for sale TOTAL LIABILITIES NET LIABILITIES EQUITY Accumulated losses 7 Other equity attributable to ordinary shareholders Equity attributable to ordinary shareholders Non-controlling interests TOTAL EQUITY Previous accounting as at 31 December 2018 £m IFRS 16 impact £m Transferred to assets held for sale 1 £m As at 1 January 2019 £m 4,929 – 2,092 8,016 15,037 16,070 750 31,857 (858) (8,292) (1,122) (4,579) (14,851) (3,804) (1,940) (962) (795) (10,181) (17,682) (376) (32,909) (197) 2,254 2 – 2,059 – – 2,059 (295) 49 30 – (216) (1,994) 60 6 45 – (1,883) – (2,099) (1,052) (40) (2,991) 1,917 (1,074) 22 (1,052) (40) – (40) – (40) – (41) – – (41) – 41 – 7 – – – 7 34 – – – – 34 (41) – – – – – – – 4,732 2,213 2,094 8,016 17,055 16,070 791 33,916 (1,146) (8,243) (1,092) (4,579) (15,060) (5,764) (1,880) (956) (750) (10,181) (19,531) (417) (35,008) (1,092) (3,031) 1,917 (1,114) 22 (1,092) 1 Relates to the Commercial Marine business which was classified as held for sale at 31 December 2018. See note 27 for more details. 2 Transfer of net book value of finance leased assets to right-of-use assets. 3 Initial recognition of right-of-use assets accounted for under IFRS 16. 4 Deferred tax on the difference between the right-of-use assets measured on a retrospective basis at the Group’s incremental borrowing rate and the lease liabilities at transition date. 5 Lease-related creditors reclassified against the IFRS 16 right-of-use assets on transition. 6 Provisions related to engine residual value guarantees reclassified against IFRS 16 right-of-use assets. 7 Post-tax difference between right-of-use assets measured on a retrospective basis and the lease liabilities at the transition date. Rolls-Royce Holdings plc Annual Report 2019 Financial statements Company Balance Sheet Company Statement of Changes in Equity 183 COMPANY BALANCE SHEET At 31 December 2019 ASSETS Investments – subsidiary undertakings Trade receivables and other assets Cash and cash equivalents Current assets TOTAL ASSETS LIABILITIES Trade payables and other liabilities Other financial liabilities Current liabilities NET ASSETS EQUITY Called-up share capital Share premium account Merger reserve Capital redemption reserve Other reserve Retained earnings TOTAL EQUITY Notes 2019 £m 2018 £m 2 3 4 5 6 12,801 12,521 1,870 9 1,879 14,680 371 – 371 12,892 (2,228) (31) (2,259) (2,008) (29) (2,037) 12,421 10,855 386 319 7,051 2,652 248 1,765 12,421 379 268 7,029 2,432 218 529 10,855 The Company has elected to take the exemption under section 408 of the Companies Act 2006 from presenting the parent company income statement. The profit for the Company for the year was £1,498m (2018: £nil). The Financial Statements on pages 183 to 186 were approved by the Board on 28 February 2020 and signed on its behalf by Warren East Chief Executive Stephen Daintith Chief Financial Officer Company’s registered number: 7524813 COMPANY STATEMENT OF CHANGES IN EQUITY For the year ended 31 December 2019 At 1 January 2019 Profit for the year ³ Arising on issues of ordinary shares ⁴ Issue of C Shares Redemption of C Shares Share-based payments – direct to equity At 31 December 2019 Attributable to ordinary shareholders Share capital £m 379 – 7 – – – 386 Share premium £m 268 – 51 – – – 319 Merger reserve £m 7,029 – 244 (222) – – 7,051 Capital redemption reserve £m 2,432 – – – 220 – 2,652 Other reserve 1 £m 218 – – – – 30 248 Retained earnings 2 £m 529 1,498 – – (220) (42) 1,765 Total equity £m 10,855 1,498 302 (222) – (12) 12,421 1 Other reserve represents the value of the share-based payments in respect of employees of subsidiary undertakings for which payment has not been received. 2 Retained earnings represents the Company’s distributable reserves as defined under the Companies Act 2006. 3 During the year, the Company received an interim dividend of £1,500m (2018: nil) from its subsidiary undertaking. 4 During the year, the Company issued 28,973,262 new ordinary shares relating to the remaining three instalments for the acquisition of ITP Aero (2018: 47,556,914 new ordinary shares relating to the first five instalments) and 7,803,043 new ordinary shares (2018: 7,460,173) to the Group’s share trust for its employee share-based payment plans with a net book value of £66m (2018: £74m). FINANCIAL STATEMENTS 184 Financial statements Notes to the Company Financial Statements Rolls-Royce Holdings plc Annual Report 2019 NOTES TO THE COMPANY FINANCIAL STATEMENTS 1 Accounting policies Basis of accounting Rolls-Royce Holdings plc (the Company) is a company incorporated and domiciled in the United Kingdom. These Financial Statements have been prepared in accordance with Financial Reporting Standard 101 Reduced Disclosure Framework (FRS 101) on the historical cost basis. In preparing these Financial Statements, the Company applied the recognition, measurement and disclosure requirements of International Financial Reporting Standards as adopted by the EU (Adopted IFRS), but makes amendments where necessary in order to comply with the Companies Act 2006. In these Financial Statements the Company has applied the exemptions available under FRS 101 in respect of the following disclosures: – a cash flow statement and related notes; – comparative period reconciliations for share capital; – the effects of new, but not yet effective accounting standards; and – the requirements of IAS 24 Related Party Transactions and has, therefore, not disclosed transactions between the Company and its wholly-owned subsidiaries. The accounting policies set out below have, unless otherwise stated, been applied consistently to all periods presented in these Financial Statements. There were no changes to accounting standards that had a material impact on these Financial Statements. The Company’s Financial Statements are presented in sterling, which is the Company’s functional currency. As permitted by section 408 of the Companies Act 2006, a separate income statement for the Company has not been included in these Financial Statements. As permitted by the audit fee disclosure regulations, disclosure of non-audit fees information is not included in respect of the Company. Investments in subsidiary undertakings Investments included in fixed assets are investments in subsidiary companies and these are held at historical cost less provision for impairment which is considered annually by the Directors. Trade receivables Trade receivables are recognised initially at the transaction price. They are subsequently measured at amortised cost using the effective interest method, less provision for impairment. A provision for the impairment of trade receivables is established when there is objective evidence that the Company will not be able to collect all amounts due according to the original terms of the receivables. The Company applies the IFRS 9 Financial Instruments simplified approach to measuring expected credit losses which uses a lifetime expected loss allowance for all trade receivables. Trade payables Trade payables are recognised initially at the transaction price and subsequently measured at amortised cost using the effective interest method. Equity Ordinary shares are classified as equity. Equity instruments are measured at the fair value of the cash or other resources received or receivable, net of the direct costs of issuing the equity instruments. Share-based payments As described in the Directors’ Remuneration Report on pages 95 to 104, the Company grants awards of its own shares to employees of its subsidiary undertakings (see note 23 of the Consolidated Financial Statements). The costs of share-based payments in respect of these awards are accounted for, by the Company, as an additional investment in its subsidiary undertakings. The costs are determined in accordance with IFRS 2 Share-based Payment. Any payments made by the subsidiary undertakings in respect of these arrangements are treated as a return of this investment. Financial instruments In accordance with IAS 32 Financial Instruments: Presentation, the Company’s C Shares are classified as financial liabilities and held at amortised cost from the date of issue until redeemed. 2 Investments – subsidiary undertakings Cost: At 1 January 2019 Additions 1 Cost of share-based payments in respect of employees of subsidiary undertakings less receipts from subsidiaries in respect of those payments At 31 December 2019 1 Additions relate to investments in Rolls-Royce plc, relating to the remaining three instalments for the Group’s acquisition of ITP Aero. Details of the Company’s subsidiary undertakings and joint venture and associates undertakings are listed on pages 187 to 193. £m 12,521 250 30 12,801 Rolls-Royce Holdings plc Annual Report 2019 Financial statements Notes to the Company Financial Statements 185 2 Investments – subsidiary undertakings continued The carrying value of the Company’s investments in subsidiary undertakings has been tested for impairment in accordance with IAS 36 Impairment of Assets. The carrying value is compared to the asset’s recoverable amount and has been assessed by reference to value in use. The value in use has been calculated based upon a discounted cash flow methodology using the most recent forecast prepared by management of the Rolls-Royce Holdings plc group. Cash flows beyond the five-year period have been assumed to grow at 2.0% and discounted using a pre-tax discount rate of 12.6%. The key underlying assumptions in the cash flow projections are assumed market share, programme timings, unit cost assumptions, discount rates and foreign exchange rates. No impairment was identified. The Directors do not consider that any reasonably possible changes in the key assumptions would cause the value in use of the investment in subsidiary undertakings to fall below its carrying value. 3 Trade receivables and other assets Amounts owed by – subsidiary undertakings 2019 £m 1,870 2018 £m 371 Amounts owed by subsidiary undertakings are related to dividends receivable from Rolls-Royce Group Limited (formerly Rolls-Royce Group plc). The balance is short term in nature and Rolls-Royce Group Limited is the immediate parent undertaking of the Rolls-Royce plc group. In accordance with IFRS 9, a provision for impairment of £1m has been recognised as at 31 December 2019 (2018: £nil) in respect of this balance. 4 Trade payables and other liabilities Amounts owed to – subsidiary undertakings Amounts owed to subsidiary undertakings are interest-free and repayable on demand. 5 Financial liabilities C Shares Movements during the year were as follows: At 1 January 2019 Issued Redeemed At 31 December 2019 The rights attaching to C Shares are set out on page 206. 6 Share capital Issued and fully paid At 1 January 2019 Shares issued to employee share trust Shares issued in relation to the acquisition of ITP Aero At 31 December 2019 The rights attaching to each class of share are set out on page 206. 2019 £m 2,228 2018 £m 2,008 C Shares of 0.1p millions 29,071 221,954 (220,417) 30,608 Nominal value £m 29 222 (220) 31 Non-equity Equity Special Share of £1 Preference shares of £1 each Nominal value £m Ordinary shares of 20p each Millions Nominal value £m 1 – – 1 – – – – – – – – 1,896 6 29 1,931 379 1 6 386 In accordance with IAS 32, the Company’s non-cumulative redeemable preference shares (C Shares) are classified as financial liabilities. Accordingly, movements in C Shares are included in note 5. FINANCIAL STATEMENTS186 Financial statements Notes to the Company Financial Statements Rolls-Royce Holdings plc Annual Report 2019 7 Reconciliation of net assets between Rolls-Royce Holdings plc Group and Company At 31 December 2019, the Rolls-Royce Holdings plc consolidated group had net liabilities of £3.4bn (2018: £1.1bn) compared to £12.4bn (2018: £10.9bn) of net assets of the Company. The Company is a holding company and does not trade in its own right. As set out in note 2 we have assessed the carrying value of the Company’s investment in subsidiaries, which supports the recovery of those investments. The key drivers of the difference between the Company and consolidated group net balance sheet positions are as follows: – The Company was created through a Scheme of Arrangement and incorporated in 2011. On incorporation, the value of the Company’s investment in subsidiaries was based on the market capitalisation of the Rolls-Royce group. The Group’s consolidated financial statements are prepared on a historical cost basis except where Adopted IFRS requires a valuation basis to be applied. See page 123 for further details. – The adoption of IFRS 15 at 1 January 2017 reduced the Group’s net balance sheet position by £5.3bn and the pension buy-in (see note 21 in the Consolidated Financial Statements) reduced the Group’s net balance sheet position by circa £600m in 2019. Neither of these impacted the Company; and – The mark-to-market loss on the foreign exchange hedge book of £3.1bn is recorded in a subsidiary of the Company and not in the Company itself. 8 Contingent liabilities Where the Company enters into financial guarantee contracts to guarantee the indebtedness of other companies within its group, the Company considers these to be insurance arrangements, and accounts for them as such. In this respect, the Company treats the guarantee contract as a contingent liability until such time as it becomes probable that the Company will be required to make a payment under the guarantee. At 31 December 2019, these guarantees amounted to £3,085m (2018: £3,982m). 9 Other information Employees The Company had no employees in 2019 (2018: none). Share-based payments Shares in the Company have been granted to employees of the Group as part of share-based payment plans, and are charged in the employing company. Emoluments of Directors The remuneration of the Directors of the Company is shown below, further information is in the Directors’ Remuneration Report on pages 95 to 104. Remuneration Gains made on share options Company contributions to pension schemes Highest paid director £000 2,080 1,079 – 3,159 2019 Other directors £000 2,754 714 – 3,468 Total £000 4,834 1,793 – 6,627 Highest paid director £000 2,209 1,734 – 3,943 2018 Other directors £000 2,733 1,644 – 4,377 Total £000 4,942 3,378 – 8,320 No Director accrued any retirement benefits in the year (2018: nil). Rolls-Royce Holdings plc Annual Report 2019 SUBSIDIARIES Financial Statements Subsidiaries 187 As at 31 December 2019, the companies listed below and on the following pages are indirectly held by Rolls-Royce Holdings plc except Rolls-Royce Group Limited # which is 100% directly owned by Rolls-Royce Holdings plc. The financial year end of each company is 31 December unless otherwise indicated. Company name Aeromaritime America, Inc. Address M&H Agent Services, Inc., 1850 North Central Avenue, Suite 2100, Phoenix, Arizona 85004, United States Aeromaritime Mediterranean Limited 7 Industrial Estate, Hal Far, Birzebbuga, BBG 3000, Malta Aerospace Transmission Technologies GmbH ** Adelheidstrasse 40, D-88046, Friedrichshafen, Germany Derby 1 Amalgamated Power Engineering Limited * Bergen Engines AS Bergen Engines Bangladesh Private Limited Green Grandeur, 6th Floor, Plot no.58 E, Kamal Ataturk Avenue Hordvikneset 125, N-5108, Hordvik, Bergen 1201, Norway Class of shares Common Ordinary Capital Stock Deferred Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Social Participation Social Capital Ordinary Ordinary Ordinary Partnership (no equity) Ordinary Ordinary Ordinary Class A Banani, C/A Dhaka, 1213, Bangladesh Werfdijk 2, 3195HV Pernis, Rotterdam, Netherlands Østre Havnepromenade 34 9000 Ålborg, Denmark 52-b, 2nd Floor, Okhla Industrial Estate, Phase III, New Delhi 110020, India Derby 1 Hordvikneset 125, N-5108, Hordvik, Bergen 1201, Norway Calle Dinamarca s/n (esquina Calle Alemania), Poligono Industrial de Constanti, 43120 Constanti, Tarragona, Spain Via Castel Morrone 13, 16161, Genoa, Italy Derby 1 Taxiway, Hillend Industrial Estate, Dalgety Bay, Dunfermline, Fife, KY11 9JT, Scotland Derby 1 Wilmington 2 Ordinary Derby 1 Zona Industriale AS1, 83040 Morra de Sanctis, Avellino, Italy Derby 1 Acceso IV, No.6B, Zona Industrial Benito Juárez, Querétaro, 76120, Mexico Pabellón Industrial, Torrelarrgoiti, Parcela 5H, Naves 7 a 10, Zamudia, Vizcaya, Spain Parque Technológico Edificio 300, 48170 Zamudio, Vizcaya, Spain Ordinary Ordinary The Whittle Estate, Cambridge Road, Whetstone, Leicester, LE8 6LH, England Plot 60/A, IDA Gandhi Nagar, Hyderabad, 500037, India Pabellón Industrial, Polígono Ugaldeguren I, PIIIA, Pab 1–2 Zamudio, Vizcaya, Spain Acceso IV, No.6D, Zona Industrial Benito Juárez, Querétaro, 76120, Mexico Acceso IV, No.6, Zona Industrial Benito Juárez, Querétaro, 76120, Mexico Acceso IV, No.6, Zona Industrial Benito Juárez, Querétaro, 76120, Mexico Class A Class B Class A Ordinary Ordinary Parque Technológico Edificio 300, 48170 Zamudio, Vizcaya, Spain Ordinary Taxiway, Hillend Industrial Estate, Dalgety Bay, Dunfermline, Fife, KY11 9JT, Scotland Fixed capital B Variable capital B 6% Cumulative Preference Ordinary Ordinary Ordinary % of class held 100 100 50 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 Bergen Engines BV Bergen Engines Denmark A/S Bergen Engines India Private Limited 3 Bergen Engines Limited Bergen Engines PropertyCo AS Bergen Engines S.L. Bergen Engines S.r.l. Bristol Siddeley Engines Limited * Brown Brothers & Company Limited C.A. Parsons & Company Limited * Data Systems & Solutions, LLC 4 Derby Specialist Fabrications Limited * Europea Microfusioni Aerospaziali S.p.A. Heaton Power Limited * Industria de Tuberías Aeronáuticas México S.A. de C.V. Industria de Tuberías Aeronáuticas S.A.U. Industria de Turbo Propulsores S.A. ITP Engines UK Limited ITP Externals India Private Ltd ITP Externals S.L.U. ITP Ingeniería y Fabricación S.A. de C.V. ITP México Fabricación S.A. de C.V. ITP México S.A. de C.V. ITP Next Generation Turbines S.L.U. John Thompson Cochran Limited * Kamewa AB * (in liquidation) Kamewa Holding AB * (in liquidation) Box 1010, S-68129, Kristinehamn, Sweden Box 1010, S-68129, Kristinehamn, Sweden # Re-registered as a private company on 5 December 2019. * Dormant entity. ** Though the interest held is 50%, the Company controls the entity (see note 1 accounting policies) and, as a result, consolidates the entity and records a non-controlling interest. 1 Moor Lane, Derby, DE24 8BJ, England. 2 Corporation Service Company, 251 Little Falls Drive, Wilmington, Delaware 19808, United States. 3 Reporting year end is 31 March. 4 Sold to Westinghouse with effect from 31 January 2020 (see page 178). FINANCIAL STATEMENTS188 Financial Statements Subsidiaries Rolls-Royce Holdings plc Annual Report 2019 Class of shares Capital Stock Capital Stock % of class held 100 100 Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Capital Stock Ordinary Company name Karl Maybach-Hilfe GmbH MTU Africa (Proprietary) Limited MTU America Inc. MTU Asia PTE Limited MTU Benelux B.V. MTU China Company Limited Address Maybachplatz 1, 88045, Friedrichshafen, Germany 36 Marconi Street, Montague Gardens, Cape Town, 7441, South Africa Wilmington 2 10 Tukang Innovation Drive, Singapore 618302 Merwedestraat 86, 3313 CS, Dordrecht, Netherlands Room 1803 18/F Ascendas Plaza, No.333 Tian Yao Qiao Road, Xuhai Distrcit, Shanghai, 200030, China Via Anhanguera, KM 29203, 05276-000 Sao Paulo – SP, Brazil MTU do Brasil Limitada MTU Engineering (Suzhou) Company Limited 9 Long Yun Road, Suzhou Industrial Park, Suzhou 215024, MTU France S.A.S. MTU Friedrichshafen GmbH MTU Hong Kong Limited MTU Ibérica Propulsión y Energia S.L. MTU India Private Limited 3 MTU Israel Limited MTU Italia S.r.l. MTU Japan Co. Limited MTU Korea Limited MTU Middle East FZE MTU Motor Türbin Sanayi ve Ticaret. A.Ş. MTU Onsite Energy GmbH MTU Onsite Energy Systems GmbH MTU Polska Sp. z o.o. MTU Power Systems Sdn. Bhd MTU Reman Technologies GmbH MTU Rus Limited Liability Company MTU South Africa (Proprietary) Limited MTU UK Limited NEI International Combustion Limited * NEI Mining Equipment Limited * NEI Nuclear Systems Limited * NEI Parsons Limited * NEI Peebles Limited * NEI Power Projects Limited * Nightingale Insurance Limited PKMJ Technical Services, Inc. 4 Power Jets (Research and Development) Limited * Powerfield Limited Precision Casting Bilbao S.A.U. Capital Stock Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Jiang Su, China Immeuble Colorado, 8/10 rue de Rosa Luxembourg-Parc des Bellevues 95610, Erangy-sur-Oise, France Maybachplatz 1, 88045, Friedrichshafen, Germany Room 1006, 10/F, Hang Seng Tsimshatsui Building, 18 Carnarvon Road, Tsimshatsui, Kowloon, Hong Kong Calle Copérnico 26–28, 28823 Coslada, Madrid, Spain 6th Floor, RMZ Galleria, S/Y No. 144 Bengaluru, Bangalore, Kamataka 560,064, India 4 Ha’Alon Street, South Building, Third Floor, 4059300 Kfar Neter, Israel Via Aurelia Nord, 328, 19021 Arcola (SP), Italy Resorttrust Building 4-14-3, Nishitenma Kita-ku, Osaka 530-0047, Japan 22nd Floor, Olive Tower, 41 Sejongdaero 9 gil, Junggu, 100-737 Seoul, Republic of Korea S3B5SR06, Jebel Ali Free Zone, South P.O. Box 61141, Dubai, United Arab Emirates Hatira Sokak, No. 5, Ömerli Mahellesi, 34555 Arnavutköy, Istanbul, Turkey Dasinger Strasse 11, 86165, Augsburg, Germany Rotthofer Strasse 8, 94099 Ruhstorf a.d. Rott, Germany Ul. Śląska, Nr 9. Raum, Ort: Stargard Szczeciński, Plz: 73–110, Poland Ordinary Ordinary Level 10 Menara LGB, 1 Jalan Wan Kadir Taman Tun Dr Ismail, 6000 Kuala Lumpur, Malaysia Friedrich-List-Strasse 8, 39122 Magdeburg, Germany Shabolovka Street 2, 119049, Moscow, Russian Federation 36 Marconi Street, Montague Gardens, Cape Town, 7441, South Africa Derby 1 Derby 1 Derby 1 Derby 1 Derby 1 Derby 1 Derby 1 Maison Trinity, Trinity Square, St. Peter Port, GY1 4AT, Guernsey Wilmington 2 The Whittle Estate, Cambridge Road, Whetstone, Leicester, LE8 6LH, England Derby 1 Calle El Barracón 1, Baracaldo, Vizcaya, 48910 Spain Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Capital Stock Capital Stock Capital Stock Ordinary Ordinary * Dormant entity. 1 Moor Lane, Derby, DE24 8BJ, England. 2 Corporation Service Company, 251 Little Falls Drive, Wilmington, Delaware 19808, United States. 3 Reporting year end is 31 March. 4 Sold to Westinghouse with effect from 31 January 2020 (see page 178). 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Subsidiaries 189 Class of shares Ordinary Ordinary Ordinary Address Secure Building Blok B, Jl. Raya Protokol Halim, Perdanakusuma, Jakarta, 13610, Indonesia Secure Building Blok B, Jl. Raya Protokol Halim, Perdanakusuma, Jakarta, 13610, Indonesia Ulster International Finance, 1st Floor IFSC House, IFSC, Dublin 1, Ireland 4, 4.5 Level 12, Suite 1299, Rajdamri Road, Pathumwan, Bangkok, 10330, Thailand Derby 1 Ordinary Suite 102, 2–4 Lyonpark Road, Macquarie Park, NSW 2113, Australia Ordinary Suite 102, 2–4 Lyonpark Road, Macquarie Park, NSW 2113, Australia Ordinary Rua drive Cincinato Braga No. 47, Planalto District, São Bernando do Campo, SP, 09890-900, Brazil 9500 Côte de Liesse, Lachine, Québec H8T 1A2, Canada Alcantra 200 office 601, Piso 6, C.O, 7550159 Las Condes, Santiago, Chile 305–306 Indigo Building 1, 20 Jiuxianqiao Road, Beijing, 100016, China 597 The Queensway, Peterborough Ontario K9J 7J6, Canada 23 chemin du Vieux Chêne, 38240, Meylan, France Derby 1 Ordinary Quotas Common Stock Ordinary Registered Capital Common Shares Ordinary Ordinary Wilmington 2 c/o Deloitte, 80 Queen Street, Auckland Central, Auckland 1010, New Zealand Derby 1 Company name PT MTU Indonesia PT Rolls-Royce Rolls-Royce (Ireland) Unlimited Company * Rolls-Royce (Thailand) Limited Rolls-Royce Aero Engine Services Limited * Rolls-Royce Australia Pty Limited Rolls-Royce Australia Services Pty Limited Rolls-Royce Brasil Limitada Rolls-Royce Canada Limited Rolls-Royce Chile SpA Rolls-Royce China Holding Limited Rolls-Royce Civil Nuclear Canada Limited 4 Rolls-Royce Civil Nuclear S.A.S. Rolls-Royce Commercial Aero Engines Limited * Rolls-Royce Control Systems Holdings Co Rolls-Royce Controls and Data Services (NZ) Limited Rolls-Royce Controls and Data Services (UK) Limited Rolls-Royce Controls and Data Services, Inc. 5 Wilmington 2 Rolls-Royce Controls and Data Services Limited* Rolls-Royce Corporation Rolls-Royce Crosspointe LLC Wilmington 2 Wilmington 2 Derby 1 Rolls-Royce Defense Products and Solutions, Inc. Rolls-Royce Defense Services, Inc. Rolls-Royce Deutschland Ltd & Co KG Rolls-Royce Electrical Norway AS Rolls-Royce Energy Angola, Limitada * Rolls-Royce Energy Systems Inc. Rolls-Royce Engine Services Holdings Co. Rolls-Royce Engine Services Limitada Inc. (in liquidation) Rolls-Royce Erste Beteiligungs GmbH Rolls-Royce Finance Company Limited Wilmington 2 Wilmington 2 Eschenweg 11, 15827 Blankenfelde-Mahlow, Germany Jarleveien 8A, 7041, Trondheim 500, Norway Rua Rei Katyavala, Edificio Rei Katyavala, Entrada B, Piso 8, Luanda, Angola Wilmington 2 Wilmington 2 Bldg. 06 Berthaphil Compound, Jose Abad Santos Avenue, Clark Special Economic Zone, Clark, Pampanga, Philippines Eschenweg 11, 15827 Blankenfelde-Mahlow, Germany Derby 1 Rolls-Royce Finance Holdings Co. Rolls-Royce Fuel Cell Systems Limited Rolls-Royce General Partner Limited * Rolls-Royce General Partner (Ireland) Limited 29 Earlshot Terrace, Dublin 2, Ireland Wilmington 2 Derby 1 Derby 1 * Dormant entity. 1 Moor Lane, Derby, DE24 8BJ, England. 2 Corporation Service Company, 251 Little Falls Drive, Wilmington, Delaware 19808, United States. 4 Sold to Westinghouse with effect from 31 January 2020 (see page 178). 5 Sold to Valsoft Corporation Inc on 3 February 2020. % of class held 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 Common Stock Ordinary Ordinary Common Stock Ordinary Common Stock Partnership (no equity) Common Stock Common Stock Capital Stock Ordinary Quota Common Stock Common Stock Capital Stock Capital Stock Deferred Ordinary Common Stock Ordinary Ordinary Ordinary FINANCIAL STATEMENTS190 Financial Statements Subsidiaries Rolls-Royce Holdings plc Annual Report 2019 Company name Rolls-Royce Group Limited # Address Kings Place, 90 York Way, London, N1 9FX, England Rolls-Royce High Temperature Composites, Inc. Rolls-Royce Holdings Canada Inc. Rolls-Royce Hungary Kft Rolls-Royce India Limited *,3 Rolls-Royce India Private Limited 3 Corporation Service Company, 2710 Gateway Oaks Drive, Suite 150N, Sacramento, California 95833, United States 9500 Côte de Liesse, Lachine, Québec H8T 1A2, Canada Gizella U. 51–57, 1143 Budapest, Hungary Derby 1 Birla Tower West, 2nd Floor 25, Barakhamba Road, New Delhi, 110001, India Derby 1 Rolls-Royce Industrial & Marine Power Limited * Rolls-Royce Industrial Power (India) Limited *,3 Derby 1 Derby 1 Rolls-Royce Industrial Power Engineering (Overseas Projects) Limited Rolls-Royce Industries Limited * Rolls-Royce International Limited Rolls-Royce International s.r.o. Rolls-Royce Japan Co., Limited Rolls-Royce Leasing Limited Rolls-Royce Malaysia Sdn. Bhd. Rolls-Royce Marine North America, Inc. Rolls-Royce Mexico Administration S. de R.L. de C.V. Rolls-Royce Mexico S. de R.L. de C.V. Derby 1 Derby 1 Pobřežní 620/3, Postal code 186 00, Karlin – Prague 8, Czech Republic 31st Floor, Kasumigaseki Building, 3-2-5 Kasumigaseki, Chiyoda-Ku, Tokyo, 100-6031, Japan Derby 1 C-2-3A TTDI Plaza, Jalan Wan Kadir 3, Taman Tun Dr Ismail, 6000 Kuala Lumpur, Malaysia Wilmington 2 Boulevard Adolfo Ruiz Cortinez 3642-403, Fracc Costa de Oro, Verzcruz CP 94299 6, Mexico Boulevard Adolfo Ruiz Cortinez 3642-403, Fracc Costa de Oro, Verzcruz CP 94299 6, Mexico Rolls-Royce Military Aero Engines Limited *,3 Derby 1 Rolls-Royce New Zealand Limited c/o Deloitte, 80 Queen Street, Auckland Central, Auckland 1010, New Zealand Rolls-Royce North America (USA) Holdings Co. Wilmington 2 Wilmington 2 Rolls-Royce North America Holdings, Inc. Wilmington 2 Rolls-Royce North America, Inc. Wilmington 2 Rolls-Royce North America Ventures, Inc. Rolls-Royce North American Technologies, Inc. Wilmington 2 Rolls-Royce Nuclear Field Services France S.A.S. 4 Rolls-Royce Nuclear Field Services, Inc. 4 ZA Notre-Dame, 84430, Mondragon, France Corporation Service Company, 80 State Street, Albany, New York 12207, United States Bait Al Reem, Business Office #131, Building No 81, Way No 3409, Block No 234, Al Thaqafa Street, Al Khuwair, PO Box 20, Postal Code 103, Oman Rolls-Royce Oman LLC Class of shares Ordinary Ordinary A Ordinary Common C Cash shares Ordinary Equity Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary Common Stock Ordinary Ordinary Ordinary Ordinary Common Stock Common Stock Common Stock Common Stock Common Stock Ordinary % of class held 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 Common Stock 100 Ordinary 100 Rolls-Royce Operations (India) Private Limited Birla Tower West, 2nd Floor, 25 Barakhamba Road, New Delhi, Ordinary Rolls-Royce Overseas Holdings Limited 110001, India Derby 1 Rolls-Royce Overseas Investments Limited Rolls-Royce Placements Limited Rolls-Royce plc Rolls-Royce Power Engineering plc Rolls-Royce Power Systems AG Derby 1 Derby 1 Kings Place, 90 York Way, London, N1 9FX, England Derby 1 Maybachplatz 1, 88045, Friedrichshafen, Germany # Re-registered as a private company on 5 December 2019. * Dormant entity. 1 Moor Lane, Derby, DE24 8BJ, England. 2 Corporation Service Company, 251 Little Falls Drive, Wilmington, Delaware 19808, United States. 3 Reporting year end is 31 March. 4 Sold to Westinghouse with effect from 31 January 2020 (see page 178). Ordinary Ordinary A Ordinary Ordinary Ordinary Ordinary Ordinary 100 100 100 100 100 100 100 100 Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Subsidiaries 191 Company name Rolls-Royce Saudi Arabia Limited Rolls-Royce Retirement Savings Trust Limited *,3 Rolls-Royce Singapore Pte. Limited Rolls-Royce Sp z.o.o. Rolls-Royce Submarines Limited Rolls-Royce Technical Support Sarl Rolls-Royce Total Care Services Limited Rolls-Royce Turkey Power Solutions Industry and Trade Limited Rolls-Royce UK Pension Fund Trustees Limited * Rolls-Royce Zweite Beteiligungs GmbH Ross Ceramics Limited Sharing in Growth UK Limited ** Address PO Box 88545, Riyadh, 11672, Saudi Arabia Derby 1 Class of shares Cash shares Ordinary % of class held 100 100 Ordinary 6 Shenton Way, #33-00 OUE, Downtown Singapore 068809, Singapore Ordinary Opolska 100 31-323, Krakow, Poland Atlantic House, Raynesway, Derby, DE21 7BE, Derbyshire, England Ordinary Ordinary Centreda I, Avenue Didier Daurat, 31700 Blagnac, Toulouse, France Derby 1 Levazim Mahellesi, Koru Sokagi, Zorlu Center, No. 2 Teras Evler T2 D:204, Zincirlikuyu, Besiktas, Istanbul 34340, Turkey Derby 1 Ordinary Ordinary Cash shares Eschenweg 11, 15827 Blankenfelde-Mahlow, Germany Derby 1 Derby 1 Spare IPG 20 Limited * Spare IPG 21 Limited * Spare IPG 24 Limited * Spare IPG 32 Limited * Derby 1 Derby 1 Derby 1 Derby 1 Spare IPG 4 Limited * The Bushing Company Limited * Timec 1487 Limited * Trigno Energy S.R.L. Turbine Surface Technologies Limited ** Derby 1 Derby 1 Derby 1 Zona Industriale, San Salvo, 66050, Italy Derby 1 Turborreactores S.A. de C.V. Vessel Lifter, Inc. * Vinters Defence Systems Limited * Vinters Engineering Limited Vinters International Limited Vinters Limited Vinters-Armstrongs (Engineers) Limited * Vinters-Armstrongs Limited * Acceso IV, No.6C, Zona Industrial Benito Juárez, Querétaro, 76120, Mexico Corporation Service Company, 1201 Hays Street, Tallahassee, Florida 32301, United States Derby 1 Derby 1 Derby 1 Derby 1 Derby 1 Derby 1 * Dormant entity. ** The entity is not included in the consolidation as Rolls-Royce plc does not have a beneficial interest in the net assets of the entity. 1 Moor Lane, Derby, DE24 8BJ, England. 3 Reporting year end is 31 March. 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 Nil 100 100 100 100 100 100 100 100 100 100 Capital Stock Ordinary Limited by guarantee Ordinary Ordinary Ordinary 7.25% Cumulative Preference Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary A Ordinary B Class A Class B Common Stock Ordinary Ordinary Ordinary Ordinary Ordinary Ordinary B FINANCIAL STATEMENTS192 Financial Statements Joint Ventures and Associates Rolls-Royce Holdings plc Annual Report 2019 JOINT VENTURES AND ASSOCIATES Class of shares Ordinary Ordinary % of class held 50 20 Ordinary 22 Partnership (no equity held) Partnership (no equity held) Partnership (no equity held) Partnership (no equity held) Partnership (no equity held) Partnership (no equity held) Partnership (no equity held) Ordinary A Limited by guarantee Ordinary A Partnership (no equity held) – – – – – – – 100 – 100 – – 50 44 – 46 49 100 50 50 50 – Group interest held % 50 20 22 50 50 50 50 50 50 50 50 50 50 50 50 50 44 50 46 49 50 50 50 50 50 Company name Aero Gearbox International SAS ** Airtanker Holdings Limited Airtanker Services Limited Alpha Leasing (US) (No.2) LLC Address 18 Boulevard Louis Sequin, 92700 Colombes, France Airtanker Hub, RAF Brize Norton, Carterton, Oxfordshire, OX18 3LX, England Airtanker Hub, RAF Brize Norton, Carterton, Oxfordshire, OX18 3LX, England Wilmington 2 Alpha Leasing (US) (No.4) LLC Wilmington 2 Alpha Leasing (US) (No.5) LLC Wilmington 2 Alpha Leasing (US) (No.6) LLC Wilmington 2 Alpha Leasing (US) (No.7) LLC Wilmington 2 Alpha Leasing (US) (No.8) LLC Wilmington 2 Alpha Leasing (US) LLC Wilmington 2 Alpha Partners Leasing Limited CFMS Limited 1 Brewer’s Green, London, SW1H 0RH, England 43 Queen Street, Bristol, BS1 4QP, England Maritime Centre, Port of Liverpool, Liverpool, L21 1LA, England Avda. de Aragón 404, 28022 Madrid, Spain Paseo de John Lennon, s/n, edificio T22, 2ª planta, Getafe, Madrid, Spain Partnership (no equity held) EgyptAir Engine Workshop, Cairo International Airport, Cairo, Egypt Dachauer Strasse 655, 80995, Munich, Germany The Corporation Trust Company, 1209 Orange Street, Wilmington, Delaware 19801, United States Lilienthalstrasse 2b, 85399 Halbergmoos, Germany Mumbai Pune Road, Akurdi, Pune, Maharashtra 411035, India Derby 1 1000 Marie-Victorin Boulevard, Longueuil Québec J4G 1A1, Canada 33rd Floor, One Pacific Place, 88 Queensway, Hong Kong Survey No. 3 Kempapura Village, Varthur Hobli, Bangalore, KA 560037, India Suite 119, 9238 Madison Boulevard, Madison, Alabama 35758, United States Ordinary Capital Stock Partnership (no equity held) Capital Stock Capital Stock Ordinary A Ordinary Ordinary Ordinary Partnership (no equity held) Clarke Chapman Portia Port Services Limited Consorcio Español para el Desarrollo Industrial del Helicóptero de Ataque Tigre, A.I.E. Consorcio Español para el Desarrollo Industrial del Programa Eurofighter, A.I.E. Egypt Aero Management Services (in liquidation) EPI Europrop International GmbH EPIX Power Systems, LLC Eurojet Turbo GmbH Force MTU Power Systems Private Limited Genistics Holdings Limited Global Aerospace Centre for Icing and Environmental Research Inc. ** Hong Kong Aero Engine Services Limited International Aerospace Manufacturing Private Limited **,3 Light Helicopter Turbine Engine Company (unincorporated partnership) MEST Co., Limited Metlase Limited MTU Power Systems Sdn. Bhd. MTU Turbomeca Rolls-Royce GmbH 97 Bukjeonggongdan 2-gil, Yangsan-si, Gyeongsangnam-do, 50571, Republic of Korea Unipart House, Garsington Road, Cowley, Oxford, OX4 2PG, England Level 10 Menara LGB, 1 Jalan Wan Kadir Taman Tun Dr Ismail 6000 Kuala Lumpur, Malaysia Am Söldnermoos 17, 85399 Hallbergmoos, Germany Normal 46.8 46.8 Ordinary B Ordinary A 100 100 20 49 Capital Stock 33.3 33.3 ** These entities are accounted for as joint operations (see note 1 accounting policies). 1 Moor Lane, Derby, Derbyshire DE24 8BJ, England. 2 Corporation Service Company, 251 Little Falls Drive, Wilmington, Delaware 19808, United States. 3 Reporting year end is 31 March. Rolls-Royce Holdings plc Annual Report 2019 Financial Statements Joint Ventures and Associates 193 Gerhard-Höltje-Strasse 1, D-99310, Arnstadt, Germany Capital Stock Company name MTU Turbomeca Rolls-Royce ITP GmbH MTU Yuchai Power Company Limited No 7 Danan Road, Yuzhou, Yulin, Guangxi, China, Address Am Söldnermoos 17, 85399 Hallbergmoos, Germany 537005, China Gerhard-Höltje-Strasse 1, D-99310, Arnstadt, Germany N3 Engine Overhaul Services GmbH & Co KG N3 Engine Overhaul Services Verwaltungsgesellschaft Mbh Qinous GmbH Villa Rathenau, Wilhelminenhofstrasse 75, 12459 Berlin, Germany Rolls Laval Heat Exchangers Limited * Derby 1 Rolls-Royce & Partners Finance (US) (No 2) LLC Rolls-Royce & Partners Finance (US) LLC SAFYRR Propulsion Limited Shanxi North MTU Diesel Co. Limited No.97 Daqing West Road, Datong City, Wilmington 2 Wilmington 2 Derby 1 Singapore Aero Engine Services Private Limited Taec Ucak Motor Sanayi AS Techjet Aerofoils Limited ** Texas Aero Engine Services LLC TRT Limited Turbo-Union GmbH UK Nuclear Restoration Limited * Xian XR Aero Components Co., Limited ** Shanxi Province, China 11 Calshot Road, 509932, Singapore Buyukdere Caddesi, Prof. Ahmet Kemal Aru, Sokagi Kaleseramik, Binasi Levent No. 4, Besiktas, Istanbul, Turkey Tefen Industrial Zone, PO Box 16, 24959, Israel The Corporation Trust Company, 1209, Orange Street, Wilmington, Delaware 19801, United States Derby 1 Lilienthalstrasse 2b, 85399 Hallbergmoos, Munich, Germany Booths Park, Chelford Road, Knutsford, Cheshire, WA16 8QZ, England Xujiawan, Beijiao, Po Box 13, Xian 710021, Shaanxi, China * Dormant company. ** These entities are accounted for as joint operations (see note 1 accounting policies). 1 Moor Lane, Derby, DE24 8BJ, England. 2 Corporation Service Company, 251 Little Falls Drive, Wilmington, Delaware 19808, United States. Class of shares Capital Stock % of class held 50 Group interest held % 50 Capital Stock Capital Stock Preference Ordinary Partnership (no equity held) Partnership (no equity held) B Shares Ordinary Ordinary Cash Shares Ordinary A Ordinary B Partnership (no equity held) Ordinary B Capital Stock Ordinary Ordinary 50 50 50 22 50 – – 100 49 50 49 50 50 – 100 40 20 49 50 50 50 22 50 50 50 50 49 50 49 50 50 49.9 40 20 49 FINANCIAL STATEMENTS194 Other Information Independent Auditors’ Report Rolls-Royce Holdings plc Annual Report 2019 INDEPENDENT AUDITORS’ REPORT to the members of Rolls-Royce Holdings plc Report on the audit of the financial statements Opinion In our opinion: – Rolls-Royce Holdings plc’s Consolidated Financial Statements and Company Financial Statements (the “financial statements”) give a true and fair view of the state of the Group’s and of the Company’s affairs as at 31 December 2019 and of the Group’s loss and cash flows for the year then ended; – the Consolidated Financial Statements have been properly prepared in accordance with International Financial Reporting Standards (IFRSs) as adopted by the European Union; – the Company Financial Statements have been properly prepared in accordance with United Kingdom Generally Accepted Accounting Practice (United Kingdom Accounting Standards, comprising FRS 101 “Reduced Disclosure Framework”, and applicable law); and – the financial statements have been prepared in accordance with the requirements of the Companies Act 2006 and, as regards the Group financial statements, Article 4 of the IAS Regulation. We have audited the financial statements, included within the Annual Report, which comprise: the Consolidated and Company Balance Sheets at 31 December 2019; the Consolidated Income Statement and Consolidated Statement of Comprehensive Income; the Consolidated Cash Flow Statement for the year then ended; the Our audit approach Consolidated and Company Statements of Changes in Equity for the year then ended; and the notes to the Consolidated and Company Financial Statements, which include a description of the significant accounting policies. Our opinion is consistent with our reporting to the Audit Committee. Basis for opinion We conducted our audit in accordance with International Standards on Auditing (UK) (“ISAs (UK)”) and applicable law. Our responsibilities under ISAs (UK) are further described in the Auditors’ responsibilities for the audit of the financial statements section of our report. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion. Independence We remained independent of the Group in accordance with the ethical requirements that are relevant to our audit of the financial statements in the UK, which includes the FRC’s Ethical Standard, as applicable to listed public interest entities, and we have fulfilled our other ethical responsibilities in accordance with these requirements. To the best of our knowledge and belief, we declare that non-audit services prohibited by the FRC’s Ethical Standard were not provided to the Group or the Company. Other than those disclosed in note 7 on page 145, we have provided no non-audit services to the Group or the Company in the period from 1 January 2019 to 31 December 2019. Materiality Audit Scope Key Audit Matters Overview — Overall Group materiality: £75 million (2018: £56 million), based on 0.5% of total underlying revenue. — Overall Company materiality: £126 million (2018: £128 million), based on 1.0% of total assets. This exceeds Group materiality as it is determined on a different basis given the nature of the Company’s operations. For the purposes of the audit of the Consolidated Financial Statements, our procedures, including those on balances in the Company, are undertaken with reference to Group materiality. — Following our assessment of the risks of material misstatement of the Consolidated Financial Statements we subjected 30 individual components (including three joint ventures) to full scope audits for Group purposes, which following an element of consolidation, equates to 14 Group reporting opinions. In addition seven components performed targeted specified procedures. — In addition, the Group engagement team audited the Company and other centralised functions including those covering the Group treasury operations, corporate costs, corporate taxation, post-retirement benefits and goodwill and intangible asset impairment assessments. — The components on which full scope audits, targeted specified procedures and centralised work was performed accounted for 90% of revenue, 86% of loss before tax and 85% of total assets. — Central audit testing was performed where appropriate for reporting components in Group audit scope supported by the Group’s Finance Service Centres (FSCs). — As part of the supervision process, the Group engagement team has visited 14 components as well as the FSCs. Interactions with component auditors also included formal written instructions, meetings and reviewing selected audit papers. Our assessment of the risk of material misstatement also informed our views of the areas of particular focus of our work which are listed below: — Long-term contract accounting and associated provisions (Group); — The recognition of deferred tax assets (Group); — The translation of foreign-currency denominated transactions and balances (Group); — The presentation and accuracy of underlying results and disclosure of other one-off items (including exceptional items) (Group); — Implementation of IFRS 16: Leases (Group); — Response to deferred prosecution and leniency agreements in connection with alleged bribery and corruption in overseas markets (Group); and — Recoverability of the Company’s investment in subsidiary undertakings (Company). Rolls-Royce Holdings plc Annual Report 2019 Other Information Independent Auditors’ Report 195 The scope of our audit As part of designing our audit, we determined materiality and assessed the risks of material misstatement in the financial statements. In particular, we looked at where the Directors made subjective judgements, for example in respect of significant accounting estimates that involved making assumptions and considering future events that are inherently uncertain. Capability of the audit in detecting irregularities, including fraud Based on our understanding of the Group and industries in which it operates, we identified that the principal risks of non-compliance with laws and regulations related to international tax legislation, Civil Aviation Authority regulations, import and export restrictions (including International Traffic in Arms Regulations), UK Bribery Act, US Foreign Corrupt Practices Act and the requirements of the deferred prosecution and leniency agreements the Group previously entered into and we considered the extent to which non-compliance might have a material effect on the financial statements. We also considered those laws and regulations that have a direct impact on the preparation of the financial statements such as the Companies Act 2006. We evaluated management’s incentives and opportunities for fraudulent manipulation of the financial statements (including the risk of override of controls) and determined that the principal risks were related to posting journal entries to increase profits or reclassify costs, management bias in accounting estimates especially long-term contract accounting and associated provisions, sale of engines to joint ventures for no clear commercial purpose or above market prices and inappropriately including or excluding transactions from underlying or free cash flow metrics. The Group engagement team shared this risk assessment with the component auditors so that they could include appropriate audit procedures in response to such risks in their work. Audit procedures performed by the Group engagement team and/or component auditors included: – Discussions with management, internal audit and the Group’s internal and external legal counsel, including consideration of known or suspected instances of non-compliance with laws and regulation and fraud; assessed risks of material misstatement (whether or not due to fraud) identified by the auditors, including those which had the greatest effect on: the overall audit strategy; the allocation of resources in the audit; and directing the efforts of the engagement team. These matters, and any comments we make on the results of our procedures thereon, were addressed in the context of our audit of the financial statements as a whole, and in forming our opinion thereon, and we do not provide a separate opinion on these matters. We have presented the key audit matters and the other risks subject to audit focus in the graph and table below. This is not a complete list of all risks identified by our audit. t n e m e t a t s s i m l a i t n e t o p f o d o o h i l e k i L 1 C 7 12 F 4 2 5 9 8 3 10 6 11 Potential magnitude of misstatement ■ Key audit matters – Group ■ Other audit risks – Group ■ Key audit matters – Company Change from prior year – Assessment of matters reported on the Group’s whistle-blowing Risks helpline and the results of management’s investigation of such matters; – Challenging assumptions and judgements made by management in determining significant accounting estimates, in particular in relation to long-term contract accounting and associated provisions (see related key audit matters below); – Identifying and testing journal entries, in particular journal entries posted with unusual account combinations; and – Challenging why certain items are excluded or included from underlying profit or free cash flow and review of disclosures included in the Annual Report explaining and reconciling alternative performance measures to statutory metrics. There are inherent limitations in the audit procedures described above and the further removed non-compliance with laws and regulations is from the events and transactions reflected in the financial statements, the less likely we would become aware of it. Also, the risk of not detecting a material misstatement due to fraud is higher than the risk of not detecting one resulting from error, as fraud may involve deliberate concealment by, for example, forgery or intentional misrepresentations, or through collusion. Key audit matters Key audit matters are those matters that, in the auditors’ professional judgement, were of most significance in the audit of the financial statements of the current period and include the most significant Key audit matters – Group 1 2 3 4 5 6 Long-term contract accounting and associated provisions The recognition of deferred tax assets Presentation of underlying results and disclosure of other one-off items (including exceptional items) Translation of foreign currency denominated transactions and balances Response of the Group to the deferred prosecution and leniency agreements in connection with alleged bribery and corruption in overseas markets Implementation of IFRS 16 new Other audit risks – Group 7 8 9 10 11 Accounting for complex treasury instruments Measurement of post-retirement benefits Recoverability of programme assets Consolidation process and joint venture accounting Uncertain tax positions Key audit matters – Company 12 Recoverability of the Company’s investments in subsidiary undertakings new OTHER INFORMATION 196 Other Information Independent Auditors’ Report Rolls-Royce Holdings plc Annual Report 2019 Key changes in the assessment of audit risks for the current period compared to the prior period are: – Capitalisation and amortisation of development costs is no longer considered a key audit matter after no material issues were identified in the 2018 audit following changes in methodology for starting and subsequently ceasing the capitalisation of development costs which became effective on 1 January 2018; – Implementation of IFRS 15: Revenue from Contracts with Customers is no longer considered a key audit matter as 2019 is the second year that the accounting standard has been applied by the Group. A new key audit matter has been included for IFRS 16: Leases which was adopted on 1 January 2019 and resulted in material right-of-use assets and lease liabilities being recognised on the Consolidated Balance Sheet; – The valuation of ITP Aero is no longer considered a key audit matter after the finalisation of the purchase price allocation in 2018; and – A new key audit matter has been included for the recoverability of the Company’s investments in subsidiary undertakings reflecting the decline in the market capitalisation of the Group and the net liability position of the Consolidated Balance Sheet, which represent potential indicators of impairment. Key audit matter How our audit addressed the key audit matter Long-term contract accounting and associated provisions (relevant to the Consolidated Financial Statements) Page 82 (Audit Committee report) and page 125 (note 1 to the Consolidated Financial Statements – Accounting policies – Revenue recognition) The Civil Aerospace and Defence businesses operate primarily with long-term customer contracts that span multiple periods. These long-term contracts require a number of assumptions to be made in order to determine the level of revenue and profit that is recognised in each period. For Civil Aerospace aftermarket contracts, the profitability typically assumes that there will be significant cost improvements over the lifetime (15–25 years) of the contracts. Significant judgement needs to be applied in determining the engine flying hours, time-on-wing, whether incremental costs should be treated as wastage or are part of the ongoing cost of servicing a contract, and other operating parameters used to calculate the projected life cycle. These future costs are also risk adjusted to take into account forecasting accuracy which represents an additional judgement. Small adjustments can have a significant impact on the results of an individual financial year. In addition, changes to the operating condition of engines such as changes in route structure can result in different performance assumptions and hence cost profiles which impact the profitability of a contract. The Group continues to experience significant in-service issues on the Trent 1000 programme with an additional exceptional charge booked in the year. The assessment of the total cost of delivering this programme, the cost of the proposed engineering solutions, changes in the shop visit profile, speed of implementation of design, manufacture and installation of improved parts and the level of customer disruption which was not expected at the inception of the contract are all significant judgements which impact the value and timing of revenue and profit recognition. In addition, certain contracts may become onerous as a result and require immediate recognition of the loss. At the development stage of a programme, agreements are entered into with certain suppliers to share in the risk and rewards of the contracts (Risk and Revenue Sharing Partners – ‘RRSP’). This can involve upfront participation fees from the RRSP that are amortised over the engine production phase. In addition, specified revenue and costs are recorded in the Consolidated Income Statement net of the RRSP’s share. The nature of the Civil Aerospace business gives rise to a number of contractual guarantees, warranties and potential claims. The accounting for these can be complex and judgemental and may impact the Consolidated Income Statement immediately or over the life of the contract. Our procedures over the long-term contract accounting applied in the Civil Aerospace and Defence businesses are largely substantive in nature and included: – We attended meetings with Civil Aerospace and Defence programme and contract managers in order to understand the operational matters impacting the performance of specific contracts and any amendments to contractual arrangements; required by changes to underlying expectations of the contract performance; – We obtained and read the relevant sections of a sample of contracts to understand the key terms including performance obligations and pricing structures; – We re-performed the calculations used to determine the degree of completion for a sample of contracts and this was also used in assessing the magnitude of any catch-up adjustments; – We compared the previously forecast results of a sample of contracts with the actual results to assess the performance of the contract and the historical accuracy of forecasting; – We verified a sample of costs incurred to third party documentation in order to assess the validity of the forecast costs to complete; – We challenged management’s judgement around whether incremental contract costs arising from in-service issues should be accounted for over the expected duration of the underlying contract or recognised immediately; – Where the disruption has resulted in payments to customers we have validated the settlement to contractual agreements, considered the terms of previous settlements, correspondence with customers, the forecast period of further aircraft being on the ground and the completeness of the liability; – We assessed the assumptions relating to life cycle cost reductions to determine the likelihood of realisation and where relevant the speed at which they would be achieved, including the impact on the number of shop visits, validating these assumptions directly with the senior programme engineers; – Where the revision of assumptions has resulted in catch-up adjustments we have understood the driver of the adjustments and validated the impact to appropriate source information; – We obtained support for the risk adjustments made in respect of future costs and challenged management’s assumptions through assessment against historical performance, known technical issues and the stage of completion of the programme; – We challenged the assessment of provisions for loss making or onerous contracts to determine the completeness of the unavoidable costs to fulfil the contractual obligations; – We assessed the sensitivity of the Trent 1000 provision to reasonable changes in estimates, particularly in respect of the repair and overhaul facility capacity, technical cost creep on the known issues and cost outturns against previous provisions, in determining whether the provision was sufficient; Rolls-Royce Holdings plc Annual Report 2019 Other Information Independent Auditors’ Report 197 Key audit matter How our audit addressed the key audit matter Long-term contract accounting and associated provisions continued The valuation of associated amounts may be highly judgemental and needs to be considered on a contract by contract basis. The recognition of deferred tax assets (relevant to the Consolidated Financial Statements) Page 82 (Audit Committee report), page 127 (note 1 to the Consolidated Financial Statements – Accounting policies – Taxation), and pages 141 to 144 (note 5 to the Consolidated Financial Statements – Taxation) The recognition and recoverability of deferred tax assets is a significant judgement. The Group has recognised significant deferred tax assets on the basis of future levels of profitability in the relevant tax jurisdiction. The magnitude of the assets recognised necessitates the need for significant judgement in assessing the future levels of profitability over an extended period. The loss reported for 2019 in the UK presents a heightened risk that deferred tax assets are recognised inappropriately. Further there is an inherent increased level of uncertainty in the level of forecast profits over an extended period. The translation of foreign-currency denominated transactions and balances (relevant to the Consolidated Financial Statements) Page 128 (note 1 to the Consolidated Financial Statements – Accounting policies – Foreign currency translation) Foreign exchange rate movements influence the reported Consolidated Income Statement, the Consolidated Cash Flow Statement and closing net funds balance. One of the Group’s primary accounting systems translates transactions denominated in foreign currencies at a fixed rate. Foreign currency denominated transactions and balances are then re-translated to actual average and spot rates through manual adjustments. Due to the manual nature of the process and significance of the recurring adjustment there is a risk that transactions and balances denominated in foreign currencies are inappropriately translated in the Consolidated Financial Statements. – We reviewed a sample of RRSP contracts to assess whether revenue and costs had been appropriately reflected, net of the share attributable to the RRSP in the Consolidated Income Statement; – We considered whether there were any indicators of management override of controls or bias in arriving at their reported position; and – We also assessed the adequacy of disclosures in note 1 of the key judgements and estimates involved in long-term contract accounting. Overall we concluded that the key estimates and judgements used by management in the long-term contract accounting were supportable and the balances recorded in the financial statements to be materially correct. We evaluated management’s assessment as to the availability of sufficient taxable profits in future periods to support the recognition of deferred tax assets, taking into account both business model and the tax jurisdiction. We assessed the future profit forecasts and the underpinning assumptions including management’s risk weighting of particular profit streams in the UK where the largest deferred tax asset is recognised. The right of offset of certain deferred tax liabilities and deferred tax assets was also assessed. Where applicable we reconciled the forecasts used to justify the recognition of deferred tax assets to those used elsewhere in the business including for long-term contract accounting, impairment assessments, or for the Directors’ viability and going concern statements. We also assessed the adequacy of disclosures over this area, particularly the impact of changes in key estimates of the asset recognised and this has been disclosed in note 1. We did not identify any material uncorrected exceptions from our audit work. In addition to our testing in other areas of the various financial statement line items, we performed the following specific audit procedures over this area: – Obtained an understanding of the process employed by management to correctly report the translation of foreign currency balances and transactions; – Tested system reports identifying transactions and balances in source currency by agreeing these to general ledger balances; – Reperformed manual calculations of the adjustment needed to correctly report the translation of the foreign currency denominated transactions and balances; – We reconciled the balances and transactions requiring adjustment by source currency to source data and assessed the completeness of these balances and transactions; – For exchange rates used in management’s calculations for the translation adjustments we agreed these to an independent source; and – For each adjustment sampled we assessed whether the foreign currency denominated balance or transaction was translated at the appropriate exchange rate depending on its nature. We did not identify any material uncorrected exceptions from our audit work. OTHER INFORMATION198 Other Information Independent Auditors’ Report Rolls-Royce Holdings plc Annual Report 2019 Key audit matter How our audit addressed the key audit matter Presentation of underlying results and disclosure of other one-off items (including exceptional items) (relevant to the Consolidated Financial Statements) Page 124 (note 1 to the Consolidated Financial Statements – Accounting policies – Presentation of underlying results), page 134 (Note 2 to the Consolidated Financial Statements – Segmental analysis) and page 179 (note 28 to the Consolidated Financial Statements – Derivation of summary of funds flow statement. In addition to the performance measures prescribed by International Financial Reporting Standards, the Group also presents the results on an “underlying” basis, as the Directors believe this better reflects the performance of the Group during the year. The Group also presents a free cash flow metric which the Directors believe reflects the cash generated from underlying trading, which differs from the cash flows presented in the Consolidated Cash Flow Statement. A key adjustment between the statutory results and the underlying results relates to the foreign exchange rates used to translate foreign currency transactions. The underlying results reflect the achieved rate on foreign currency contracts settled in the period and retranslates assets and liabilities at the foreign currency rates expected to be achieved in the future. As the Group can influence which contracts are settled in each reporting period it has the ability to influence the achieved rate and hence the underlying result. The underlying results differ significantly from the reported statutory results and are used extensively to explain performance to the shareholders. Alternative performance measures can provide investors with a better understanding of the Group’s performance if properly used and presented. However, when improperly used and presented, these kinds of measures can mislead investors by masking the real financial performance and position. Implementation of IFRS 16: Leases (relevant to the Consolidated Financial Statements) Page 181 to 182 (note 29 to the Consolidated Financial Statements) At 1 January 2019, the Group adopted IFRS 16: Leases. This accounting standard required operating leases to be brought onto the Consolidated Balance Sheet for the first time and resulted in right-of-use assets of £2,254 million and lease liabilities of £2,289 million being recognised on adoption. The right-of-use assets and lease liabilities are estimated based on the discounted future lease payments. There is judgement over the period that the balances are calculated where lease agreements contain options for the contract to be extended or terminated early. Furthermore, there is judgement over the discount rate applied to the forecast cash flows, determining the lease term and where lease agreements contain residual value guarantees, the refurbishment costs that will be required to settle these. There is also a risk that the lease liabilities or right-of-use asset balances do not include all of the lease arrangements that the Group is party to. We considered the judgements taken by management to determine what should be treated as a one-off or exceptional item and the translation of foreign currency amounts and obtained corroborative evidence for these. We also considered whether there were items that were recorded within underlying profit that we consider are exceptional in nature and should be reported as an exceptional item. No such material items were identified. As part of this assessment we challenged management’s rationale for the designation of certain items as exceptional or one-off and assessed such items against the Group’s accounting policy considering the nature and value of those items. We tested management’s calculation to translate foreign currency transactions to reflect the achieved foreign exchange rates based on foreign currency contracts settled in the year, and to translate year end assets and liabilities at foreign currency rates that are expected to be achieved in the future. We corroborated these rates to the Group’s hedging contracts. We also assessed whether the discretion used by management over the date on which forward foreign exchange contracts are settled indicated any evidence of bias. We audited the reconciling items between the underlying profit before tax and free cash flow disclosed in note 28 including verifying that the items adjusted for are consistent with the prior period. We also considered whether free cash flow contains material one-off items which require further disclosure. We also assessed the appropriateness and completeness of the disclosures of the impact of one-off or non-underlying items in note 1 and note 2 and other related notes to the Consolidated Financial Statements and found them to be appropriate. Overall we found that the classification judgements made by management were in line with their policy for underlying results and exceptional items, had been consistently applied and found no material exceptions from our testing. For a sample of leases, we recalculated the right-of-use asset and associated lease liability and validated the characteristics that determine these to the underlying lease agreements. Our internal experts compared the rate used to discount future lease payments against corporate bond yields, adjusted property yields and borrowing costs and found that the rate was a reasonable approximation of the incremental borrowing rate of the lessee. We tested management’s reconciliation between the operating lease commitments at 31 December 2018 and the lease liability recognised on adoption disclosed in note 29 and compared lease expenses for the year ended 31 December 2018 to leases included in management’s calculations for IFRS 16 adoption to validate that management’s list of leases was complete. Where leases contained an option for early termination or extension, we considered how likely it was to be exercised, based on the nature of the assets and the terms including charges in the period under option. Certain engine leases also contain clauses that guarantee the value of the engine when it is returned to the lessor. This charge is included in lease liabilities. We validated management’s estimate of this charge based on the flying hours and forecast shop visit costs, including comparing these costs to historical charges. We also considered the adequacy of the Group’s disclosure of the impacting on the adoption of IFRS 16 as set out in notes 1 and 29 which we found to be appropriate. As a result of our work, we did not identify any material differences in the adjustments recorded on the implementation of IFRS 16. Rolls-Royce Holdings plc Annual Report 2019 Other Information Independent Auditors’ Report 199 Key audit matter How our audit addressed the key audit matter Response to deferred prosecution and leniency agreements in connection with alleged bribery and corruption in overseas markets (relevant to the Consolidated Financial Statements) Page 176 (note 25 to the Consolidated Financial Statements – Contingent Liabilities) We planned and designed our audit approach to this area in conjunction with our in-house forensic specialists and after reading the Agreements and compliance reports made to the SFO and DoJ during the year. Where applicable we vouched the assertions made by management to objective evidence. In January 2017, the Group became party to deferred prosecution agreements with the UK Serious Fraud Office (“SFO”) and the US Department of Justice (“DoJ”), and a leniency agreement with the Brazilian Federal Prosecution Service (“MPF”) (collectively the “Agreements”) as a consequence of allegations of fraudulent payments to overseas intermediaries. Prosecution was deferred provided that the Group fulfils certain requirements, including the settlement of a financial penalty. The Group operates in industries which are characterised by competition for individually significant contracts with customers which are often directly or indirectly associated with governments, and in a number of territories where the use of intermediaries is viewed as normal practice. This means the risk of future instances of corruption remains present. The possible implications of these high profile and sensitive Agreements on the future business if the terms are not met, including additional fines and prosecution, are significant. There is also the risk that historical activities could result in allegations and penalties in other territories not subject to the Agreements. We assessed the overall control environment and ‘tone at the top’, including understanding and assessing the Group’s internal investigations processes which identify and assess possible non-compliance, such as whistle-blowing hotlines. We evaluated key controls over the appointment, monitoring and payments made to intermediaries. We independently circularised and spoke with the Group’s external legal counsel to obtain their views about the status of the Agreements and to test management’s assertions of the likely outcome. Together with our forensic specialists, we designed questionnaires to be performed in certain markets not otherwise included in Group audit scope to assess the risk of arrangements being in place in those markets which may require follow-up procedures to be performed. Taking into account the findings from our audit procedures, we assessed the appropriateness of the contingent liability disclosure in note 25 of the Consolidated Financial Statements and found it to be reasonable and consistent with the information we obtained during the course of our audit. We evaluated management’s assessment whether any indicators of impairment existed by comparing the carrying value of investments in subsidiary undertakings to the market capitalisation of the Group at 31 December 2019 and post year-end. To determine the recoverable value, management prepared a valuation based on the discounted future cash flows of the Group. We have tested the reasonableness of key assumptions, including revenue, profit and cash flow growth rates, terminal growth rates and the discount rate management has applied. Deploying our valuations experts, we assessed the terminal growth rate and discount rate applied to the cash flow investment compared with third party information, past performance, the Group’s cost of capital and relevant risk factors. We also compared the valuation implied by the discounted cash flow model to third party analyst reports. We performed our own independent sensitivity analysis to understand if reasonably possible changes in management’s assumptions would result in an impairment. As a result of our work, we did not identify any material impairments and consider the carrying value of the investments in subsidiary undertakings to be supportable in the context of the Company Financial Statements taken as a whole. Recoverability of the Company’s investments in subsidiary undertakings (relevant to the Company Financial Statements) Page 184 to 186 (note 2 to the Company Financial Statements – Investments – Subsidiary Undertakings) Investments in subsidiaries of £12,801 million (2018: £12,521 million) are accounted for at cost less provision for impairment in the Company Balance Sheet at 31 December 2019. Investments are tested for impairment if impairment indicators exist. If such indicators exist, the recoverable amounts of the investments in subsidiaries are estimated in order to determine the extent of the impairment loss, if any. Any such impairment loss is recognised in the income statement. At certain points following 31 December 2019, the market capitalisation of the Group fell to below the carrying value of the Company’s investment in subsidiary undertakings. This and the consolidated net liability position of the Consolidated Balance Sheet represent potential indicators of impairment and necessitated an impairment review to be performed. Management judgement is required in the area of impairment testing, particularly in assessing: (1) whether an event has occurred that may indicate that the related asset values may not be recoverable; (2) whether the carrying value of an asset can be supported by the recoverable value, being the higher of fair value less cost of disposal or the net present value of future cash flows which are estimated based on the continued use of the asset in the business; and (3) key assumptions to be applied in preparing cash flow projections including whether these cash flow projections are discounted using an appropriate rate. Changing the assumptions selected by management to determine the level of any impairment, including the discount rates or the growth rate assumptions in the cash flow projections, could materially affect the recoverable value determined by the impairment test and as a result affect the Company’s financial condition and results of operations. OTHER INFORMATION200 Other Information Independent Auditors’ Report Rolls-Royce Holdings plc Annual Report 2019 How we tailored the audit scope We tailored the scope of our audit to ensure that we performed enough work to be able to give an opinion on the financial statements as a whole, taking into account the structure of the Group and the Company, the accounting processes and controls, and the industry in which they operate. Our scoping is based on the Group’s consolidation structure. We define a component as a single reporting unit which feeds into the Group consolidation. Of the Group’s 437 reporting components, 30 individual components (including three joint ventures) were subject to full scope audits for Group purposes, which following an element of consolidation, equates to 14 Group reporting opinions; and seven components performed targeted specified procedures. In order to achieve audit coverage over the financial statements, under our audit methodology, we test both the design and operation of relevant business process controls and perform substantive testing over each financial statement line item. The Group operates Finance Service Centres (FSCs) to bulk process financial transactions in Derby (UK), Indianapolis (US) and Bangalore (India). Based on our assessment with management it is not possible to fully test revenue and profit centrally as certain key processes, such as long-term contracting, remain within the business due to their nature. Our audit covered 90% of revenue, 86% of loss before tax and 85% of total assets. All entities that contribute in excess of 4% of the Group’s revenue were included in full scope. Further specific audit procedures over central functions, the Group consolidation and areas of significant judgement (including corporate costs, taxation, goodwill, intangible assets, treasury and post-retirement benefits) were directly led by the Group audit team. Where work was performed by component auditors, we determined the level of involvement we needed to have in the audit work at those reporting units to be able to conclude whether sufficient appropriate audit evidence had been obtained as a basis for our opinion on the Consolidated Financial Statements. We issued formal written instructions to all component auditors setting out the audit work to be performed by each of them and maintained regular communication with the component auditors throughout the audit cycle. These interactions included attending certain component clearance meetings and holding regular conference calls, as well as reviewing and assessing any matters reported. The Group engagement team also reviewed selected audit working papers for certain component teams. In addition, senior members of the Group engagement team visited component teams across all group segments in the United Kingdom, United States of America, Germany, Spain, Hong Kong and Singapore. These visits included meetings with local management and with the component auditors. Materiality The scope of our audit was influenced by our application of materiality. We set certain quantitative thresholds for materiality. These, together with qualitative considerations, helped us to determine the scope of our audit and the nature, timing and extent of our audit procedures on the individual financial statement line items and disclosures and in evaluating the effect of misstatements, both individually and in aggregate on the financial statements as a whole. Based on our professional judgement, we determined materiality for the financial statements as a whole as follows: Group Financial Statements Company Financial Statements Overall materiality £75 million (2018: £56 million). £126 million (2018: £128 million). How we determined it 0.5% of total underlying revenue. 1% of total assets. Rationale for benchmark applied We have consistently used underlying revenue to determine materiality as opposed to a profit based benchmark. This is because there is considerable volatility in profit before tax as a result of revenue recognition under IFRS 15 and from the fair value movement in the Group’s derivatives. Underlying revenue continues to be a key performance metric for the Group and is much less volatile than the profit metric. We determined our materiality based on total assets, which is more applicable than a performance-related measure as the Company is an investment holding company for Group. Where there were balances and transactions within the Company accounts that were within the scope of the audit of the Group financial statements, our procedures were undertaken using the lower materiality level applying to the Group audit. For each component in the scope of our Group audit, we allocated a materiality that is less than our overall Group materiality. The range of materiality allocated across components was between £5 million and £67.5 million. Certain components were audited to a local statutory audit materiality that was also less than our overall Group materiality. We agreed with the Audit Committee that we would report to them misstatements identified during our audit above £3 million (Group audit) (2018: £2 million) and £6 million (Company audit) (2018: £2 million) as well as misstatements below those amounts that, in our view, warranted reporting for qualitative reasons. Rolls-Royce Holdings plc Annual Report 2019 Other Information Independent Auditors’ Report 201 Going concern In accordance with ISAs (UK) we report as follows: Reporting obligation Outcome We are required to report if we have anything material to add or draw attention to in respect of the Directors’ statement in the financial statements about whether the Directors considered it appropriate to adopt the going concern basis of accounting in preparing the financial statements and the Directors’ identification of any material uncertainties to the Group’s and the Company’s ability to continue as a going concern over a period of at least twelve months from the date of approval of the financial statements. We have nothing material to add or to draw attention to. However, because not all future events or conditions can be predicted, this statement is not a guarantee as to the Group’s and Company’s ability to continue as a going concern. For example, the terms of the United Kingdom’s withdrawal from the European Union are not clear, and it is difficult to evaluate all of the potential implications on the Group’s and Company’s trade, customers, suppliers and the wider economy. We are required to report if the Directors’ statement relating to Going Concern in accordance with Listing Rule 9.8.6R(3) is materially inconsistent with our knowledge obtained in the audit. We have nothing to report. Reporting on other information The other information comprises all of the information in the Annual Report other than the financial statements and our auditors’ report thereon. The Directors are responsible for the other information. Our opinion on the financial statements does not cover the other information and, accordingly, we do not express an audit opinion or, except to the extent otherwise explicitly stated in this report, any form of assurance thereon. In connection with our audit of the financial statements, our responsibility is to read the other information and, in doing so, consider whether the other information is materially inconsistent with the financial statements or our knowledge obtained in the audit, or otherwise appears to be materially misstated. If we identify an apparent material inconsistency or material misstatement, we are required to perform procedures to conclude whether there is a material misstatement of the financial statements or a material misstatement of the other information. If, based on the work we have performed, we conclude that there is a material misstatement of this other information, we are required to report that fact. We have nothing to report based on these responsibilities. With respect to the Strategic Report and Directors’ Report, we also considered whether the disclosures required by the UK Companies Act 2006 have been included. Based on the responsibilities described above and our work undertaken in the course of the audit, the Companies Act 2006 (CA06), ISAs (UK) and the Listing Rules of the Financial Conduct Authority (FCA) require us also to report certain opinions and matters as described below (required by ISAs (UK) unless otherwise stated). Strategic Report and Directors’ Report In our opinion, based on the work undertaken in the course of the audit, the information given in the Strategic Report and Directors’ Report for the year ended 31 December 2019 is consistent with the financial statements and has been prepared in accordance with applicable legal requirements. (CA06) In light of the knowledge and understanding of the Group and Company and their environment obtained in the course of the audit, we did not identify any material misstatements in the Strategic Report and Directors’ Report. (CA06) The Directors’ assessment of the prospects of the Group and of the principal risks that would threaten the solvency or liquidity of the Group We have nothing material to add or draw attention to regarding: – The Directors’ confirmation on page 68 of the Annual Report that they have carried out a robust assessment of the principal risks facing the Group, including those that would threaten its business model, future performance, solvency or liquidity. – The disclosures in the Annual Report that describe those risks and explain how they are being managed or mitigated. – The Directors’ explanation on page 55 of the Annual Report as to how they have assessed the prospects of the Group, over what period they have done so and why they consider that period to be appropriate, and their statement as to whether they have a reasonable expectation that the Group will be able to continue in operation and meet its liabilities as they fall due over the period of their assessment, including any related disclosures drawing attention to any necessary qualifications or assumptions. We have nothing to report having performed a review of the Directors’ statement that they have carried out a robust assessment of the principal risks facing the Group and statement in relation to the longer-term viability of the Group. Our review was substantially less in scope than an audit and only consisted of making inquiries and considering the Directors’ process supporting their statements; checking that the statements are in alignment with the relevant provisions of the UK Corporate Governance Code (the “Code”); and considering whether the statements are consistent with the knowledge and understanding of the Group and Company and their environment obtained in the course of the audit. (Listing Rules) OTHER INFORMATION202 Other Information Independent Auditors’ Report Rolls-Royce Holdings plc Annual Report 2019 Other Code Provisions We have nothing to report in respect of our responsibility to report when: – The statement given by the Directors, on page 114, that they consider the Annual Report taken as a whole to be fair, balanced and understandable, and provides the information necessary for the members to assess the Group’s and Company’s position and performance, business model and strategy is materially inconsistent with our knowledge of the Group and Company obtained in the course of performing our audit. – The section of the Annual Report on pages 79 to 84 describing the work of the Audit Committee does not appropriately address matters communicated by us to the Audit Committee. – The Directors’ statement relating to the Company’s compliance with the Code does not properly disclose a departure from a relevant provision of the Code specified, under the Listing Rules, for review by the auditors. Directors’ Remuneration In our opinion, the part of the Directors’ Remuneration Report to be audited has been properly prepared in accordance with the Companies Act 2006. (CA06) Responsibilities for the financial statements and the audit Other required reporting Responsibilities of the directors for the financial statements As explained more fully in the Statement of Directors’ responsibilities set out on page 114, the Directors are responsible for the preparation of the financial statements in accordance with the applicable framework and for being satisfied that they give a true and fair view. The Directors are also responsible for such internal control as they determine is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, the Directors are responsible for assessing the Group’s and the Company’s ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the going concern basis of accounting unless the Directors either intend to liquidate the Group or the Company or to cease operations, or have no realistic alternative but to do so. Auditors’ responsibilities for the audit of the financial statements Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditors’ report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with ISAs (UK) will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements. A further description of our responsibilities for the audit of the financial statements is located on the FRC’s website at: www.frc.org. uk/auditorsresponsibilities. This description forms part of our auditors’ report. Use of this report This report, including the opinions, has been prepared for and only for the Company’s members as a body in accordance with Chapter 3 of Part 16 of the Companies Act 2006 and for no other purpose. We do not, in giving these opinions, accept or assume responsibility for any other purpose or to any other person to whom this report is shown or into whose hands it may come save where expressly agreed by our prior consent in writing. Companies Act 2006 exception reporting Under the Companies Act 2006 we are required to report to you if, in our opinion: – we have not received all the information and explanations we require for our audit; or – adequate accounting records have not been kept by the Company, or returns adequate for our audit have not been received from branches not visited by us; or – certain disclosures of Directors’ remuneration specified by law are not made; or – the Company financial statements and the part of the Directors’ Remuneration Report to be audited are not in agreement with the accounting records and returns. We have no exceptions to report arising from this responsibility. Appointment Following the recommendation of the Audit Committee, we were appointed by the members on 3 May 2018 to audit the financial statements for the year ended 31 December 2018 and subsequent financial periods. The period of total uninterrupted engagement is two years, covering the years ended 31 December 2018 to 31 December 2019. Ian Chambers (Senior Statutory Auditor) for and on behalf of PricewaterhouseCoopers LLP Chartered Accountants and Statutory Auditors London 28 February 2020 Rolls-Royce Holdings plc Annual Report 2019 Sustainability Assurance Statement 203 Other Information SUSTAINABILITY ASSURANCE STATEMENT To the stakeholders of Rolls-Royce Holdings plc Independent limited assurance statement Introduction and objectives of work Bureau Veritas UK Limited (Bureau Veritas) has been engaged by Rolls-Royce Holdings plc (Rolls-Royce) to provide limited assurance over selected sustainability performance indicators for inclusion in its 2019 Annual Report and website. This assurance statement applies to the related information included within the scope of work described below. Scope of work The scope of our work was limited to assurance over the following information included within Rolls-Royce’s 2019 Annual Report (the Report) for the period 1 January to the 31 December 2019 (the Selected Information): – energy consumption; – scope 1 & 2 greenhouse gases (GHG) emissions; – total solid and liquid waste; – total reportable injury; and – the number of people reached through the science, technology, engineering and mathematics (STEM) education outreach programmes. Reporting criteria The Selected Information is reported according to the Rolls-Royce ‘Basis of Reporting’, a copy of which is available from www.rolls-royce.com/sustainability. Limitations and exclusions Excluded from the scope of our work is verification of any information relating to: – activities outside the defined verification period; and – other information included in the Report. This limited assurance engagement relies on a risk-based selected sample of sustainability data and the associated limitations that this entails. This independent statement should not be relied upon to detect all errors, omissions or misstatements that may exist. Responsibilities This preparation and presentation of the Selected Information in the Report are the sole responsibility of the management of Rolls-Royce. Bureau Veritas was not involved in the drafting of the Report or of the reporting criteria. Our responsibilities were to: – obtain limited assurance about whether the Selected Information has been prepared in accordance with the reporting criteria; – form an independent conclusion based on the assurance procedures performed and evidence obtained; and – report our conclusions to the management of Rolls-Royce. Assessment standard We performed our work to a limited level of assurance in accordance with the International Standard on Assurance Engagements (ISAE) 3000 Revised, Assurance Engagements Other than Audits or Reviews of Historical Financial Information (effective for assurance reports dated on or after 15 December 2015), and in accordance with the main requirements of ISO 14064:2006 Part 3 – Specification with Guidance for the Validation and Verification of Greenhouse Gas Assertions. Summary of work performed As part of its independent verification, Bureau Veritas undertook the following activities: – assessed the appropriateness of the reporting criteria for the Selected Information; – conducted interviews with relevant personnel of Rolls-Royce; – carried out nine site visits, selected employing a risk-based approach, in the UK, US, Canada, France, Germany and Spain; – reviewed the data collection and consolidation processes used to compile the Selected Information, including assessing assumptions made, the data scope and reporting boundaries; – reviewed documentary evidence produced by Rolls-Royce; – agreed a sample of the Selected Information to the corresponding source documentation; and – re-performed aggregation calculations of the Selected Information. Conclusion On the basis of our methodology and the activities described above, nothing has come to our attention to indicate that the Selected Information has not been properly prepared, in all material respects, in accordance with the reporting criteria. Further detailed recommendations are provided in the form of an internal management report to be issued to Rolls-Royce. Statement of independence, integrity and competence Bureau Veritas is an independent professional services company that specialises in quality, environmental, health, safety and social accountability with over 185 years of history. Its assurance team has extensive experience in conducting verification over environmental, social, ethical and health and safety information, systems and processes. Bureau Veritas operates a certified 1 quality management system which complies with the requirements of ISO 9001:2015, and accordingly maintains a comprehensive system of quality control including documented policies and procedures regarding compliance with ethical requirements, professional standards and applicable legal and regulatory requirements. Bureau Veritas has implemented and applies a code of ethics, which meets the requirements of the International Federation of Inspections Agencies (IFIA) 2 across the business to ensure that its employees maintain integrity, objectivity, professional competence and due care, confidentiality, professional behaviour and high ethical standards in their day-to-day business activities. The assurance team for this work does not have any involvement in any other Bureau Veritas projects with Rolls-Royce. Bureau Veritas UK Limited London 26 February 2020 1 Certificate of registration can be provided on request. 2 International Federation of Inspection Agencies – compliance code – third edition. OTHER INFORMATION204 Directors’ Report Other Financial Information Rolls-Royce Holdings plc Annual Report 2019 OTHER FINANCIAL INFORMATION Foreign exchange Foreign exchange rate movements influence the reported income statement, the cash flow and closing net funds balance. The average and spot rates for the principal trading currencies of the Group are shown in the table below: USD per GBP Year-end spot rate Average spot rate EUR per GBP Year-end spot rate Average spot rate 2019 1.32 1.28 1.18 1.14 2018 1.28 1.33 1.12 1.13 Change +3% -4% +5% +1% The Group’s global corporate income tax contribution The Group’s total corporation tax payments in 2019 were £175m. Around 85% of this was paid in the US, Germany, UK and Singapore which reflects the fact that the majority of the Group’s business is undertaken, and employees are based, in these countries. The balance was paid in around 40 other countries. In common with most multinational groups, the total of all profits in respect of which corporate income tax is paid is not the same as the consolidated loss before tax reported on page 116. The main reasons for this are: (i) the consolidated income statement is prepared under Adopted IFRS, whereas tax is paid on the profits of each Group company, which are determined by local accounting rules; (ii) accounting rules require certain income and costs relating to our commercial activities to be eliminated from, or added to, the aggregate of all the profits of the Group companies when preparing the consolidated income statement (consolidation adjustments); and (iii) specific tax rules including exemptions or incentives as determined by the tax laws in each country. The level of tax paid in each country is impacted by the above. In most cases, (i) and (ii) are only a matter of timing and therefore tax will be paid in an earlier or later year. As a result they only have a negligible impact on the Group’s underlying tax rate. The core underlying tax rate can be found on page 19. This is due to deferred tax accounting, details of which can be found in note 5 to the Consolidated Financial Statements. The impact of (iii) will often be permanent depending on the relevant tax law. Further information on the tax position of the Group can be found as follows: – Audit Committee Report (page 81) – The group tax director gave a presentation to the Audit Committee during the year which covered various matters including tax risks and how they are managed and key sources of estimation uncertainty (in particular the recognition of deferred tax assets); – note 1 to the Consolidated Financial Statements (page 127) – Details of key areas of uncertainty and accounting policies for tax; and – note 5 to the Consolidated Financial Statements (pages 141 to 144) – Details of the tax balances in the Consolidated Financial Statements together with a tax reconciliation. This explains the main drivers of the tax rate and the impact of our assessment on the recovery of UK deferred tax assets. At this stage we expect these items to continue to influence the underlying tax rate. The reported tax rate is more difficult to forecast due to the impact of significant adjustments to reported profits, in particular the net unrealised fair value changes to derivative contracts and the recognition of losses and advance corporation tax. Information on the Group’s approach to managing its tax affairs can be found at www.rolls-royce.com. Investments and capital expenditure The Group subjects all major investments and capital expenditure to a rigorous examination of risks and future cash flows to ensure that they create shareholder value. All major investments, including the launch of major programmes, require Board approval. The Group has a portfolio of projects at different stages of their lifecycles. All of our major investments and projects are assessed using a range of financial metrics, including discounted cash flow and return on investment. Financial risk management The Board has established a structured approach to financial risk management. The Financial risk committee (Frc) is accountable for managing, reporting and mitigating the Group’s financial risks and exposures. These risks include the Group’s principal counterparty, currency, interest rate, commodity price, liquidity and credit rating risks outlined in more depth in note 19. The Frc is chaired by the Chief Financial Officer or group controller. The Group has a comprehensive financial risk policy that advocates the use of financial instruments to manage and hedge business operations risks that arise from movements in financial, commodities, credit or money markets. The Group’s policy is not to engage in speculative financial transactions. The Frc sits quarterly to review and assess the key risks and agree any mitigating actions required. Capital structure £m Total equity Cash flow hedges Group capital Net funds (excluding lease liabilities) 2019 (3,354) 96 (3,258) 1,361 2018 (1,052) 106 (946) 840 Operations are funded through various shareholders’ funds, bank borrowings, bonds and notes. The capital structure of the Group reflects the judgement of the Board as to the appropriate balance of funding required. Funding is secured by the Group’s continued access to the global debt markets. Borrowings are funded in various currencies using derivatives where appropriate to achieve a required currency and interest rate profile. The Board’s objective is to retain sufficient financial investments and undrawn facilities to ensure that the Group can both meet its medium-term operational commitments and cope with unforeseen obligations and opportunities. The Group holds cash and short-term investments which, together with the undrawn committed facilities, enable it to manage its liquidity risk. During the year, the Group extended the maturity of the £2,500m committed bank borrowing facility from 2023 to 2024. This facility was undrawn at the period end. The Group also repaid £1.1bn of Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Other Financial Information 205 borrowings during the year. At the year end, the Group retained aggregate liquidity of £6.9bn, including cash and cash equivalents of £4.4bn and undrawn borrowing facilities of £2.5bn. The Group subscribes to Moody’s, Standard & Poor’s and Fitch for independent long-term credit ratings. At the date of this report, the Group maintained investment-grade rating from all three agencies. Circa £435m of drawn borrowings mature in 2020 (£775m including lease liabilities). The maturity profile of the borrowing facilities is regularly reviewed to ensure that refinancing levels are manageable in the context of the business and market conditions. There are no rating triggers in any borrowing facility that would require the facility to be accelerated or repaid due to an adverse movement in the Group’s credit rating. The Group conducts some of its business through a number of joint ventures. A major proportion of the debt of these joint ventures is secured on the assets of the respective companies and is non-recourse to the Group. This debt is further outlined in note 12. Credit rating Moody’s Investors Service Standard & Poor’s Fitch Rating Baa2 BBB- BBB+ Outlook Negative Stable Stable Grade Investment Investment Investment As a capital-intensive business making long-term commitments to its customers, the Group attaches significant importance to maintaining or improving the current investment-grade credit ratings. Accounting The Consolidated Financial Statements have been prepared in accordance with International Financial Reporting Standards (IFRS), as adopted by the EU. IFRS 16 Leases was adopted from 1 January 2019 and the impact is described in notes 1 and 29 of the Consolidated Financial Statements. The adoption of IFRS 16 has resulted in the recognition of additional lease liabilities in relation to leases which had previously been classified as operating leases under the principles of IAS 17 Leases, with the associated right-of-use assets recognised in non-current assets. The net impact on adoption of IFRS 16 was a £40m reduction in total equity. Additional commentary on key performance indicators Order backlog, also known as unrecognised revenue, is the amount of revenue on current contracts that is expected to be recognised in future periods. Civil Aerospace OE orders where the customer has retained the right to cancel (for deliveries in the next 7-12 months) are excluded. Further details are included in note 2 on page 138. Underlying revenue is used as it reflects the impact of our foreign exchange (FX) hedging policy by valuing foreign currency revenue at the actual exchange rates achieved as a result of settling FX contracts in the year. This provides a clearer measure of our year-on-year performance. Further details and reconciliation to reported revenue are included in note 2 on page 139. Self-funded R&D as a proportion of underlying revenue – We expect to spend approximately 5% of underlying revenue on R&D although this proportion will fluctuate depending on the stage of development of current programmes. We expect this proportion will reduce modestly over the medium term. Further details are included in note 3 on page 140. Capital expenditure as a proportion of underlying revenue – All proposed investments are subject to rigorous review to ensure that they are consistent with forecast activity and will provide value for money. We measure annual capital expenditure as the cash purchases of property, plant and equipment acquired during the period; over the medium-term we expect a proportion of around 4%. Further details are included in note 10 on page 149. Underlying operating profit includes: (a) revenue and costs denominated in US dollars and euros on the basis of the exchange rates achieved based on our FX hedge book; (b) similar adjustments in respect of commodity derivatives; (c) consequential adjustments to reflect the impact of exchange rates on trading assets and liabilities, and long-term contracts, on a consistent basis; and (d) items of a one-off nature. Further details and reconciliation to reported operating profit are included in note 2 on page 139. Free cash flow is the movement in net funds excluding lease liabilities during the year, before movements arising from payments to shareholders, acquisitions and disposals, and FX. It excludes the cash cost of the restructuring plan and SFO payments. Further details and reconciliation to reported cash flow are included in note 28 on page 179. Cash flow per share is calculated using free cash flow (as defined above) and the average number of shares in issue during the year, consistent with the EPS calculations in note 6 on page 144. Cash return on invested capital (CROIC) is calculated as cash flow divided by invested capital. Cash flow is the free cash flow (as defined above), adjusted to remove R&D, PPE and software capital expenditure, certification costs, other intangibles, and working capital (excluding change in the net LTSA balance in Civil Aerospace). Invested capital is defined as the sum of 15 years net R&D investment, PPE and software at cost, certification costs, other intangibles (excluding M&A and goodwill), and working capital (excluding net LTSA balance in Civil Aerospace) and ten times current year lease payments. OTHER INFORMATION206 Directors’ Report Other Statutory Information Rolls-Royce Holdings plc Annual Report 2019 OTHER STATUTORY INFORMATION Share price During the year, the share price reduced by 18% from 830p to 683p, compared to a 14% increase in the FTSE aerospace and defence sector and a 12% increase in the FTSE 100. The Company’s share price ranged from 680p in December 2019 to 1004p in February 2019. Share capital On 31 December 2019, the Company’s issued share capital comprised of: 1,930,995,313 30,607,559,470 1 Ordinary shares C Shares Special Share 20p each 0.1p each £1 The ordinary shares are listed on the London Stock Exchange. Payment to shareholders The Company issues non-cumulative redeemable preference shares (C Shares) as an alternative to paying a cash dividend. Shareholders can choose to: – redeem all C Shares for cash; – redeem all C Shares for cash and reinvest the proceeds in the C Share Reinvestment Plan (CRIP); or – keep the C Shares. The CRIP is operated by Computershare Investor Services PLC (the Registrar). The Registrar will purchase ordinary shares in the market for shareholders electing to reinvest their C Share proceeds. Shareholders wishing to participate in the CRIP or redeem their C Shares in July 2020 must ensure that their instructions are lodged with the Registrar no later than 5.00pm on 1 June 2020 (CREST holders must submit their election in CREST in sufficient time for it to settle before 2.55pm on 1 June 2020). Redemption will take place on 3 July 2020. At the 2020 AGM, the Directors will recommend an issue of 71 C Shares with a total nominal value of 7.1p for each ordinary share. The C Shares will be issued on 1 July 2020 to shareholders on the register on 24 April 2020 and the final day of trading with entitlement to C Shares is 23 April 2020. Together with the interim issue on 3 January 2020 of 46 C Shares for each ordinary share with a total nominal value of 4.6p, this is the equivalent of a total annual payment to ordinary shareholders of 11.7p for each ordinary share. Further information for shareholders is on pages 210 and 211. Share class rights The full share class rights are set out in the Company’s Article, which are available at www.rolls-royce.com. The rights are summarised below. Ordinary shares Each member has one vote for each ordinary share held. Holders of ordinary shares are entitled to: receive the Company’s Annual Report; attend and speak at general meetings of the Company; appoint one or more proxies or, if they are corporations, corporate representatives; and exercise voting rights. Holders of ordinary shares may receive a bonus issue of C Shares or a dividend and on liquidation may share in the assets of the Company. C Shares C Shares have limited voting rights and attract a preferential dividend of 75% of LIBOR on the 0.1p nominal value of each share, paid on a twice-yearly basis. The Company has the option to redeem the C Shares compulsorily, at any time if: the aggregate number of C Shares in issue is less than 10% of the aggregate number of all C Shares issued on or prior to that time or the event of a capital restructuring of the Company; the introduction of a new holding company; the acquisition of the Company by another company; or a demerger from the Group. On a return of capital on a winding-up, the holders of C Shares shall be entitled, in priority to any payment to the holders of ordinary shares, to the repayment of the nominal capital paid-up or credited as paid-up on the C Shares held by them, together with a sum equal to the outstanding preferential dividend which will have been accrued but not paid until the date of return of capital. The holders of C Shares are only entitled to attend, speak and vote at a general meeting if a resolution to wind up the Company is to be considered, in which case they may vote only on that resolution. Special Share Certain rights attach to the special rights non-voting share (Special Share) issued to the UK Secretary of State for Business, Energy & Industrial Strategy (Special Shareholder). These rights are set out in the Articles. Subject to the provisions of the Companies Act 2006 (the Act), the Treasury Solicitor may redeem the Special Share at par value at any time. The Special Share confers no rights to dividends but in the event of a winding-up it shall be repaid at its nominal value in priority to any other shares. Certain provisions of the Articles (in particular those relating to the foreign shareholding limit, disposals and the nationality of the Company’s Directors) that relate to the rights attached to the Special Share may only be altered with the consent of the Special Shareholder. The Special Shareholder is not entitled to vote at any general meeting or any other meeting of any class of shareholders. Restrictions on transfer of shares and limitations on holdings There are no restrictions on transfer or limitations on the holding of the ordinary shares or C Shares other than under the Articles (as described here), under restrictions imposed by law or regulation (for example, insider trading laws) or pursuant to the Company’s share dealing code. The Articles provide that the Company should be and remain under UK control. As such, an individual foreign shareholding limit is set at 15% of the aggregate votes attaching to the share capital of all classes (taken as a whole) and capable of being cast on a poll and to all other shares that the Directors determine are to be included in the calculation of that holding. The Special Share may only be issued to, held by and transferred to the Special Shareholder or his successor or nominee. Shareholder agreements and consent requirements No disposal may be made to a non-Group member which, alone or when aggregated with the same or a connected transaction, constitutes a disposal of the whole or a material part of either the nuclear propulsion business or the assets of the Group as a whole, without the consent of the Special Shareholder. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Other Statutory Information 207 Changes to the Articles of Association Deadlines for exercising voting rights The Articles may be altered or added to or new articles may be adopted by a special resolution of the shareholders of the Company, subject to the provisions of the Act. Electronic and paper proxy appointments, and voting instructions, must be received by the Registrar not less than 48 hours before a general meeting. Authority to issue shares Voting rights for employee share plan shares At the 2019 AGM, authority was given to the Directors to allot new C Shares up to a nominal value of £500m as an alternative to a cash dividend. In addition, an ordinary resolution was passed authorising the Directors to allot new ordinary shares up to a nominal value of £126,387,015 equivalent to one-third of the issued share capital of the Company. This resolution also authorised the Directors to allot up to two-thirds of the total issued share capital of the Company, but only in the case of a rights issue. A further special resolution was passed to effect a disapplication of pre-emption rights for a maximum of 5% of the issued share capital of the Company. These authorities are valid until the 2020 AGM or 30 June 2020, whichever is earlier, and the Directors propose to renew each of them at the 2020 AGM. The Board believes that these authorities will allow the Company to retain flexibility to respond to circumstances and opportunities as they arise. ITP Aero Following approval from the relevant authorities in Spain, on 19 December 2017 the Group acquired a 53.1% shareholding in ITP Aero from SENER resulting in ITP Aero becoming a wholly-owned subsidiary of the Company. The consideration of €718m was settled over a two-year payment period, payable in eight equal instalments, and the agreement with SENER allowed the Company flexibility to settle up to 100% of the consideration in the form of ordinary shares. Three payments were settled in 2019 all in the form of ordinary shares, as follows: Instalment 6th 7th 8th No. of ordinary shares 8,681,110 9,301,958 10,990,194 Date 19 March 2019 19 June 2019 19 September 2019 Shares are held in an employee benefit trust for the purpose of satisfying awards made under the various employee share plans. For shares held in a nominee capacity or if plan/trust rules provide the participant with the right to vote in respect of specifically allocated shares, the trustee votes in line with the participants’ instructions. For shares that are not held absolutely on behalf of specific individuals, the general policy of the trustees, in accordance with investor protection guidelines, is to abstain from voting in respect of those shares. Change of control Contracts and joint venture agreements There are a number of contracts and joint venture agreements which would allow the counterparties to terminate or alter those arrangements in the event of a change of control of the Company. These arrangements are commercially confidential and their disclosure could be seriously prejudicial to the Company. Borrowings and other financial instruments The Group has a number of borrowing facilities provided by various banks. These facilities generally include provisions which may require any outstanding borrowings to be repaid or the alteration or termination of the facility upon the occurrence of a change of control of the Company. At 31 December 2019, these facilities were less than 2% drawn (2018: 19%). The Group has entered into a series of financial instruments to hedge its currency, interest rate and commodity exposures. These contracts provide for termination or alteration in the event that a change of control of the Company materially weakens the creditworthiness of the Group. Employee share plans In the event of a change of control of the Company, the effect on the employee share plans would be as follows: – Deferred share bonus – the shares would be released from Authority to purchase own shares trust immediately. At the 2019 AGM, the Company was authorised by shareholders to purchase up to 189,580,523 of its own ordinary shares representing 10% of its issued ordinary share capital. – ShareSave – options would become exercisable immediately. The new controlling company might offer an equivalent option in exchange for cancellation of the existing option. The authority for the Company to purchase its own shares expires at the conclusion of the 2020 AGM or 30 June 2020, whichever is the earlier. A resolution to renew the authority will be proposed at the 2020 meeting. The Company did not purchase any of its own ordinary shares during 2019. – Share Incentive Plan (SIP) – consideration received as shares would be held within the SIP, if possible, otherwise the consideration would be treated as a disposal from the SIP. – LTIP – awards would vest on the change of control, subject to the Remuneration Committee’s judgement of performance and may be reduced pro rata to service in the vesting period. Any applicable holding period will cease in the event of a change in control. OTHER INFORMATION208 Directors’ Report Other Statutory Information Rolls-Royce Holdings plc Annual Report 2019 Accounting policies, financial instruments and risk Details of the Group’s accounting policies, together with details of financial instruments and risk, are provided in notes 1 and 19 to the Consolidated Financial Statements on pages 123 and 157. Major shareholdings At 31 December 2019, the following shareholders had notified an interest in the issued ordinary share capital of the Company in accordance with section 5.1.2 of the Disclosure and Transparency Rules: Shareholder Blackrock, Inc. Harris Associates L.P. ValueAct Indirect Holdings The Capital Group Companies, Inc Date notified 5 November 2019 21 October 2019 22 March 2019 % of issued ordinary share capital * below 5 5.01 9.48 12 October 2017 5.07 which might not be thought of as political expenditure in the usual sense, could be captured. Activities of this nature would not be thought of as political donations in the ordinary sense of those words. The resolution to be proposed at the 2020 AGM, authorising political donations and expenditure, is to ensure that the Group does not commit any technical breach of the Act. During the year, expenses incurred by Rolls-Royce North America, Inc. in providing administrative support for the Rolls-Royce North America political action committee (PAC) was US$81,866 (2018: US$111,961). PACs are a common feature of the US political system and are governed by the Federal Election Campaign Act. The PAC is independent of the Group and independent of any political party. The PAC funds are contributed voluntarily by employees and the Group cannot affect how they are applied, although under US law, the business expenses are paid by the employee’s company. Such contributions do not count towards the limits for political donations and expenditure for which shareholder approval will be sought at this year’s AGM to renew the authority given at the 2019 AGM. * Percentages are shown as a percentage of the Company’s issued share capital when the Company was notified of the change in holding. Branches As at 27 February 2020, no further changes had been notified. Directors The names of the Directors who held office during the year are set out on pages 62 to 64. In addition, Brad Singer and Ruth Cairnie were directors during the year. They stepped down on 9 December and 31 December respectively. Directors’ Indemnities The Directors have the benefit of an indemnity provision contained in the Articles. In addition, the Directors have been granted a qualifying third party indemnity provision which was in force throughout the financial year and remains in force. Also, throughout the year, the Company purchased and maintained Directors’ and Officers’ liability insurance in respect of itself and for its Directors and Officers. Disclosures in the Strategic Report The Board has taken advantage of section 414C(11) of the Act to include disclosures in the Strategic Report including: – employee involvement; – the employment of disabled people; – information about charitable donations; – the future development, performance and position of the Group; – the financial position of the Group; – R&D activities; – the principal risks and uncertainties; and – particulars of important events affecting the Company since the financial year end. Political donations The Company’s policy is that it does not, directly or through any subsidiary, make what are commonly regarded as donations to any political party. However, the Act defines political donations very broadly and so it is possible that normal business activities, such as sponsorship, subscriptions, payment of expenses, paid leave for employees fulfilling certain public duties and support for bodies representing the business community in policy review or reform, Rolls-Royce is a global company and our activities and interests are operated through subsidiaries, branches of subsidiaries, joint ventures and associates which are subject to the laws and regulations of many different jurisdictions. Our subsidiaries, joint ventures and associates are listed on pages 187 to 193. Financial instruments Details of the Group’s financial instruments are set out in note 19 to the Consolidated Financial Statements. Related party transactions Related party transactions are set out in note 26 to the Consolidated Financial Statements. Information required by UK Listing Rule (LR) 9.8.4 There are no disclosures to be made under LR 9.8.4. Management report The Strategic Report and the Directors’ Report together are the management report for the purposes of Rule 4.1.8R of the DTR. Disclosure of information to auditors Each of the persons who is a Director at the date of approval of this report confirms that so far as the Director is aware, there is no relevant audit information of which the Company’s auditor is unaware. The Director has taken all steps that he or she ought to have taken as a director in order to make himself or herself aware of any relevant audit information and to establish that the Company’s auditor is aware of that information. This confirmation is given, and should be interpreted, in accordance with the provisions of section 418 of the Act. Rolls-Royce Holdings plc Annual Report 2019 Directors’ Report Other Statutory Information 209 Greenhouse gas emissions In 2019, our total net greenhouse gas (GHG) emissions were 586 kilotonnes carbon dioxide equivalent (ktCO2e). This represents a decrease of 3% compared with 602 ktCO2e in 2018. Aspect Emissions from activities for which the Company owns or controls including the combustion of fuel and operation of facilities. Direct GHG emissions (Scope 1) Emissions from the purchase of electricity, heat, steam and cooling purchased for our use. Indirect GHG Emissions (Scope 2) location-based Total gross GHG emissions Energy consumption used to calculate above emissions – kWh Intensity Ratio (total GHG emissions per £m revenue) Emissions from the purchase of electricity, heat, steam and cooling purchased for our use. Indirect GHG emissions (Scope 2) market-based] Outside of Scopes Tonnes CO2e Global (excluding UK) UK Global (excluding UK) UK Global (excluding UK) UK Global (excluding UK) 2015 209,302 2016 229,691 2017 254,032 2018 250,237 2019 247,159 108,325 170,276 103,581 168,849 99,918 161,115 85,120 166,199 91,396 161,035 173,535 379,578 144,334 398,540 122,657 415,147 100,827 416,436 86,548 408,193 281,861 177,944 1,538,198,000 1,639,939,000 1,694,823,000 1,707,642,000 1,648,572,000 222,575 185,947 247,915 UK 885,952,000 832,549,000 0.047 0.054 Total 811,948,000 0.046 762,917,000 0.040 767,701,000 0.038 Global (excluding UK) UK Global (excluding UK) UK – – – – – – – – – – – – – – – – – 874 – 19,336 The above figures include 230,972,000 kWh of renewable energy purchased via a long-term Power Purchase Agreement (PPA) for use by our facilities based in the UK, supplied through a third party. The source includes a proportion of electricity that was generated by the combustion of biofuel. The associated emissions are included above under the location-based Scope 2 emissions (using grid average emission factors). They are also reported separately as market-based Scope 2 emissions (covering the emissions of nitrous oxide and methane) and Outside of Scopes (covering the emissions of carbon dioxide). This has resulted in a net reduction of 39 kilotonnes from our total GHG emissions. In addition, the above figures include 7,354,000 kWh of electricity generated on-site from renewable energy sources. The figures for 2015 through to 2018 inclusive have been restated to remove emissions associated with the Commercial Marine business sold on 1 April 2019. Figures for 2015 exclude emissions associated with ITP Aero (which became a wholly owned subsidiary on 19 December 2017). We have included the reporting of fugitive emissions of hydrofluorocarbons (HFCs), associated with air conditioning equipment, into our GHG emissions figures from 2016. These include emissions from our facilities in the UK, US, Canada and France only. We do not anticipate that emissions from other facilities will have a material impact. With the exceptions noted above, we have reported on the underlying energy use and emission sources required under the Companies (Directors’ Report) and Limited Liability Partnerships (Energy and Carbon Report) Regulations 2018. All these sources fall within the scope of our Consolidated Financial Statements. We have used the GHG Protocol Corporate Accounting and Reporting Standard (revised edition) as of 31 December 2014 utilising the operational control approach and emission factors from the UK Government’s GHG Conversion Factors for Company Reporting 2019. We report our emissions of: carbon dioxide; methane; nitrous oxide; hydrofluorocarbons; and perfluorocarbons on a carbon dioxide equivalent basis. We have no emissions of sulphur hexafluoride or nitrogen trifluoride. Further details on our methodology for reporting and the criteria used can be found within our basis of reporting, available to download at www.rolls-royce.com. OTHER INFORMATION210 Other Information Shareholder Information Rolls-Royce Holdings plc Annual Report 2019 SHAREHOLDER INFORMATION Financial calendar 2020–2021 7 MAY 11.00AM AGM Kings Place 90 York Way London N1 9FX 1 JULY Allotment of C Shares 2 JULY Payment of cash dividend on C Shares 3 JULY Payment of C Share redemption monies 22 JULY New share certificates issued (at the latest) 6 AUGUST Announcement of half-year results 1 DECEMBER Record date for cash dividend on C Shares 5 JANUARY Allotment of C Shares 5 JANUARY Payment of cash dividend on C Shares 6 JANUARY Payment of C Share redemption monies 20 JANUARY New share certificates issued (at the latest) APR 2020 MAY 2020 JUN 2020 JUL 2020 AUG 2020 SEP 2020 OCT 2020 NOV 2020 DEC 2020 JAN 2021 FEB 2021 MAR 2021 23 APRIL Ex-entitlement to C Shares 24 APRIL Record date for entitlement to C Shares 1 JUNE 5.00PM Deadline for receipt by Registrar of C Share instructions (2:55pm for CREST holders) 3 JUNE Record date for cash dividend on C Shares 29 OCTOBER Ex-entitlement to C Shares 30 OCTOBER Record date for entitlement to C Shares 1 DECEMBER 5.00PM Deadline for receipt by Registrar of C Share instructions (2:55pm for CREST holders) 31 DECEMBER Financial year end FEBRUARY/ MARCH Announcement of full-year results and Annual Report published Managing your shareholding Share dealing Your shareholding is managed by Computershare Investor Services PLC (the Registrar). When making contact with the Registrar please quote your Shareholder Reference Number (SRN). This is a 10-digit number prefixed with the letter ‘C’ that can be found on the right-hand side of your share certificate or in any other shareholder correspondence. You can manage your shareholding at www.investorcentre.co.uk, speak to the Registrar on +44 (0)370 703 0162 (8.30am to 5.30pm Monday to Friday) or you can write to the Registrar at Computershare Investor Services PLC, The Pavilions, Bridgwater Road, Bristol BS13 8AE. If you hold your shares in a share dealing account (sometimes referred to as a nominee account) then you must contact your account provider with any questions about your shareholding. Payments to shareholders The Company makes payments to shareholders by issuing redeemable C Shares of 0.1p each. You can redeem C Shares for cash and either take the cash or reinvest the cash to purchase additional ordinary shares providing you complete a payment instruction form, which is available from the Registrar. Once you have submitted your payment instruction form, you will receive cash or additional ordinary shares each time the Company issues C Shares. If you choose to receive cash we strongly recommend that you include your bank details on the payment instruction form and have payments credited directly to your bank account. This removes the risk of a cheque going astray and means that cleared payments will be credited to your bank account on the payment date. The Registrar offers shareholders an internet dealing service at www.computershare.co.uk and a telephone dealing service (+44 (0)370 703 0084). Real-time dealing is available during market hours, 8.00am to 4.30pm, Monday to Friday excluding bank holidays. Orders can still be placed outside of market hours. The fee for internet dealing is 1% of the transaction value subject to a minimum fee of £30. The fee for telephone dealing is 1% of the transaction value plus £50. Stamp duty of 0.5% is payable on all purchases. This service is only available to shareholders resident in certain jurisdictions. Before you can trade you must register to use the service. Other share dealing facilities are available but you should always use a firm regulated by the FCA (see www.fca.org.uk/register). Your share certificate Your share certificate is an important document. If you sell or transfer your shares you must make sure that you have a valid share certificate in the name of Rolls-Royce Holdings plc. If you place an instruction to sell your shares and cannot provide a valid share certificate, the transaction cannot be completed and you may be liable for any costs incurred by the broker. If you are unable to find your share certificate please inform the Registrar immediately. American Depositary Receipts (ADR) ADR holders should contact the depositary, JP Morgan, by calling +1 (800) 990 1135 (toll free within the US) or +1 (651) 453 2128 (outside the US) or emailing adr@jpmorgan.com. Rolls-Royce Holdings plc Annual Report 2019 Other Information Shareholder Information 211 Warning to shareholders – investment scams Visit Rolls-Royce online We are aware that some of our shareholders have received unsolicited telephone calls or correspondence, offering to buy or sell their shares at very favourable terms. The callers can be very persuasive and extremely persistent and often have professional websites and telephone numbers to support their activities. These callers will sometimes imply a connection to Rolls-Royce and provide incorrect or misleading information. This type of call should be treated as an investment scam – the safest thing to do is hang up. You should always check that any firm contacting you about potential investment opportunities is properly authorised by the FCA. If you deal with an unauthorised firm you will not be eligible for compensation under the Financial Services Compensation Scheme. You can find out more about protecting yourself from investment scams by visiting the FCA’s website at www.fca.org.uk/consumers, or by calling the FCA’s consumer helpline on 0800 111 6768 (overseas callers dial +44 20 7066 1000). If you have already paid money to share fraudsters contact Action Fraud immediately on 0300 123 2040, whose website is www.actionfraud.police.uk. Remember: if it sounds too good to be true it probably is. Visit www.rolls-royce.com to find out more about the latest financial results, the share price, payments to shareholders, the financial calendar and shareholder services. Keeping up to date You can sign up to receive the latest news updates to your phone or email address by visiting www.rolls-royce.com and registering for our alert service. Dividends paid on C Shares held C Share calculation period 1 July 2019 – 31 December 2019 1 January 2019 – 30 June 2019 Previous C Share issues C Share dividend rate (%) 0.32 0.39 Record date for C Share dividend 15 November 2019 3 June 2019 Payment date 6 January 2020 2 July 2019 Apportionment values Record date for entitlement to C Shares 25 October 2019 26 April 2019 Latest date for receipt of payment instruction forms by Registrar 2 December 2019 3 June 2019 No. of C Shares issued per ordinary share 46 71 Issue date 3 January 2020 1 July 2019 Price of ordinary shares on first day of trading (p) 677.80 857.40 CGT apportionment Value of C Share issues per ordinary shares (p) Ordinary shares (%) C Shares (%) 4.6 7.1 99.33 99.18 0.67 0.82 Date of redemption of C Shares 6 January 2020 4 July 2019 CRIP purchase date 6 January 2020 4 July 2019 CRIP purchase price (p) 673.203 871.5668 For information on earlier C Share issues, please refer to www.rolls-royce.com. Analysis of ordinary shareholders at 31 December 2019 Type of holder Individuals Institutional and other investors Total Size of holding (number of ordinary shares) 1 – 150 151 – 500 501 – 10,000 10,001 – 100,000 100,001 – 1,000,000 1,000,001 and over Total Number of shareholders 167,391 3,592 170,983 55,622 82,144 31,642 1,078 320 177 170,983 % of total shareholders 97.90 2.10 100.00 32.53 48.04 18.51 0.63 0.19 0.10 100.00 Number of shares 85,147,751 1,845,807,562 1,930,955,313 5,034,073 23,191,006 48,086,670 29,912,513 105,498,096 1,719,272,955 1,930,995,313 % of total shares 4.41 95.59 100.00 0.26 1.20 2.49 1.55 5.46 89.04 100.00 OTHER INFORMATION212 Other Information Glossary GLOSSARY Rolls-Royce Holdings plc Annual Report 2019 ABC ACARE AGM ALPS AMRCs AOG APM Articles bps Brexit C Shares C&A CARs CEO CFO CGT Our Code the Code Company CPS CRIP CROIC D&I DJSI DoJ DPAs DTR EASA EIS ELG EPS ERG ESG EU EUR EVTOL FCA FCF FRC FTE FX GBP GHG Group anti-bribery and corruption Advisory Council for Aviation Research and Innovation in Europe annual general meeting Advanced Low Pressure System Advanced Manufacturing Research Centres aircraft on ground alternative performance measure Articles of Association of Rolls-Royce Holdings plc basis points UK exit from the European Union non-cumulative redeemable preference shares commercial and administrative contractual aftermarket rights chief executive officer chief financial officer capital gains tax Global Code of Conduct UK Corporate Governance Code 2018 Rolls-Royce Holdings plc cash flow per share C Share reinvestment plan cash return on invested capital diversity & inclusion Dow Jones Sustainability Index US Department of Justice deferred prosecution agreements the FCA’s Disclosure Guidance and Transparency Rules European Aviation Safety Agency entry into service Enterprise Leadership Group earnings per share employee resource group environment, social and governance European Union euro electric vertical take-off and landing Financial Conduct Authority free cash flow Financial Reporting Council full time equivalent foreign exchange Great British pound or pound sterling greenhouse gas Rolls-Royce Holdings plc and its subsidiaries Trade marks HPT HSE IASB IFRS KPIs ktCO2e kW LGBT+ LIBOR LRIP LTIP LTPR LTSA M&A MoU MRO MW NCI NOx OCI OE OECD OEM P&L PBT PPE PSMS PSP R&D R&T REACH Registrar RMS RRMS RRSAs SFO SMR STEM TCFD TRI TSR USAF USD/US$ UTCs Credits high pressure turbine health, safety and environment International Accounting Standards Board International financial reporting standards key performance indicators kilotonnes carbon dioxide equivalent kilowatts lesbian, gay, bisexual and transgender London inter-bank offered rate low rate initial production long-term incentive plan long-term planning exchange rate long-term service agreement mergers & acquisitions memorandum of understanding maintenance repair and overhaul megawatts non-controlling interest nitrogen oxide other comprehensive income original equipment Organisation for Economic Co-operation and Development original equipment manufacturer profit and loss profit before tax property, plant and equipment product safety management system performance share plan research and development research and technology registration, evaluation, authorisation and restriction of chemicals Computershare Investor Services PLC risk management system Rolls-Royce management system risk and revenue sharing arrangements UK Serious Fraud Office small modular reactors science, technology, engineering and mathematics Taskforce on Climate-related Financial Disclosures total reportable injuries total shareholder return United States Air Force United States dollar University Technology Centres The following trade marks which appear throughout this Annual Report are trade Designed and produced by CONRAN DESIGN GROUP marks registered and owned by companies within the Rolls-Royce Group: BR710® CorporateCare® Gnome® LiftSystem™ MTU® MTU PowerPacks® Pearl® Pioneering the power that matters™ Pioneers of Power® RB211® Reman® TotalCare® Trent® UltraFan® Photograph credits The Tempest aircraft image shown on page 34 is reproduced courtesy of BAE Systems. The Astute submarine image shown on page 35 is under Crown copyright. It contains public sector information licensed under the Open Government Licence v.3.0. Printed on Innovation Premium which is an FSC® certified paper. The pulps used are Totally Chlorine Free (TCF), and the manufacturing mill has ISO 14001 environmental management certification. The mill’s energy is produced from 100% biomass fuels sourced from local forestry and no fossil fuels are used. The carbon emissions have been measured and offset using the World Land Trust’s Carbon Balanced scheme. using their Printed in the UK by environmental printing technology, using vegetable is a CarbonNeutral® inks throughout. company. Both the paper manufacturing mill and the printer are registered to the Environmental Management System ISO 14001 and are Forest Stewardship Council® (FSC®) chain-of-custody certified. CBP000256 © Rolls-Royce plc 2020 Rolls-Royce Holdings plc Registered office: Kings Place 90 York Way London N1 9FX T +44 (0)20 7222 9020 www.rolls-royce.com Company number 7524813

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