The principal accounting policies adopted in the preparation of these financial statements are set out below. Further detail can be found in note A7.
Basis of preparation
The financial statements have been prepared in accordance with International Financial Reporting Standards (IFRSs) as adopted by the European Union (EU). They have been prepared on the historical cost basis, except for the revaluation of financial instruments, accounting for the transfer of assets from customers and the revaluation of infrastructure assets to fair value on transition to IFRS.
The preparation of financial statements, in conformity with IFRS, requires management to make estimates and assumptions that affect the amounts of assets and liabilities at the date of the financial statements and the amounts of revenues and expenses during the reporting periods presented. Although these estimates are based on management's best knowledge of the amount, event or actions, actual results ultimately may differ from these estimates.
The financial statements have been prepared on the going concern basis as the directors have a reasonable expectation that the group has adequate resources for a period of at least 12 months from the date of the approval of the financial statements, and that there are no material uncertainties to disclose.
In assessing the appropriateness of the going concern basis of accounting, the directors have reviewed the resources available to the group, taking account of the group's financial projections, together with available cash and committed borrowing facilities as well as consideration of the group's capital adequacy. The board has also considered the magnitude of potential impacts resulting from uncertain future events or changes in conditions, the likelihood of their occurrence and the likely effectiveness of mitigating actions that the directors would consider undertaking.
Adoption of new and revised standards
The following standards, interpretations and amendments, effective for the year ended 31 March 2018, have had no material impact on the group's financial statements:
- Amendments to IAS 12 'Income Taxes', clarifying how to account for deferred tax assets related to debt instruments measured at fair value;
- Amendments to IAS 7 'Statement of Cash Flows', requiring disclosures that enable evaluation of changes in liabilities arising from financing activities; and
- Improvements to IFRS (2016) (Amendment to IFRS 12 'Disclosure of Interests in Other Entities', effective date 1 January 2018).
Critical accounting judgements and key sources of estimation uncertainty
In the process of applying its accounting policies set out in note A7, the group is required to make certain estimates, judgements and assumptions that it believes are reasonable based on the information available. These judgements, estimates and assumptions affect the amounts of assets and liabilities at the date of the financial statements and the amounts of revenues and expenses recognised during the reporting periods presented. Changes to these estimates, judgements and assumptions could have a material effect on the financial statements.
On an ongoing basis, the group evaluates its estimates using historical experience, consultation with experts and other methods considered reasonable in the particular circumstances. Actual results may differ significantly from the estimates, the effect of which is recognised in the period in which the facts that give rise to the revision become known.
The following paragraphs detail the estimates and judgements the group believes to have the most significant impact on the annual results under IFRS.
Revenue recognition and allowance for doubtful receivables
Accounting judgement – The group recognises revenue generally at the time of delivery and when collection of the resulting receivable is reasonably assured. When the group considers that the criteria for revenue recognition are not met for a transaction, revenue recognition is delayed until such time as collectability is reasonably assured. Management considers that where customers have not paid their bills within the last two years, or have not cleared previously outstanding arrears aged more than two years, collectability is not deemed to be reasonably assured, and therefore amounts billed to these customers are not recognised as revenue. This resulted in £20.3 million of amounts billed not being recognised as revenue during the year (net of cash receipts and credits). Had management made an alternative judgement that collectability was not reasonably assured where customers had not paid within one year or within three years, or had not cleared previously outstanding arrears within these time frames, this would have resulted in £0.9 million of revenue not being recognised during the year or£9.4 million additional revenue being recognised during the year respectively. Payments received in advance of revenue recognition are recorded as deferred income.
Accounting estimate – At each reporting date, the company and each of its subsidiaries evaluate the estimated recoverability of trade receivables and record allowances for doubtful receivables based on experience. Judgements associated with these allowances are based on, amongst other things, a consideration of actual collection history. The actual level of receivables collected may differ from the estimated levels of recovery, which could impact operating results positively or negatively. At 31 March 2018, the allowance for doubtful receivables of £63.4 million was supported by a six-year cash collection projection. Based on a five-year or seven-year cash collection projection the allowance for doubtful receivables would have been £64.3 million or £62.4 million respectively.
Accounting estimate – United Utilities Water Limited raises bills in accordance with its entitlement to receive revenue in line with the limits established by the periodic regulatory price review processes. For water and wastewater customers with water meters, the receivable billed is dependent on the volume supplied including the sales value of an estimate of the units supplied between the date of the last meter reading and the billing date. Meters are read on a cyclical basis and the group recognises revenue for unbilled amounts based on estimated usage from the last billing through to each reporting date. The estimated usage is based on historical data, judgement and assumptions; actual results could differ from these estimates, which would result in operating revenues being adjusted in the period that the revision to the estimates is determined. Revenue recognised for unbilled amounts for these customers at 31 March 2018 was £40.2 million. Had actual consumption been five per cent higher or lower than the estimate of units supplied this would have resulted in revenue recognised for unbilled amounts being £3.8 million higher or lower respectively. For customers who do not have a meter, the receivable billed and revenue recognised is dependent on the rateable value of the property, as assessed by an independent rating officer.
Property, plant and equipment
Accounting judgement – The group recognises property, plant and equipment (PPE) on its water and wastewater infrastructure assets where such expenditure enhances or increases the capacity of the network, whereas any expenditure classed as maintenance is expensed in the period it is incurred. Determining enhancement from maintenance expenditure requires an accounting judgement, particularly when projects have both elements within them. Enhancement spend was30 per cent of total spend in relation to infrastructure assets during the year. A change of +/- one per cent would have resulted in £2.3 million less/more expenditure being charged to the income statement during the period. In addition, management capitalises time and resources incurred by the group's support functions on capital programmes, which requires accounting judgements to be made in relation to the appropriate capitalisation rates. Support costs allocated to PPE represent 58 per cent of total support costs. A change in allocation of +/- one per cent would have resulted in £0.9 million less/more expenditure being charged to the income statement during the period.
Accounting estimate – The estimated useful economic lives of PPE and intangible assets is based on management's experience. When management identifies that actual useful economic lives differ materially from the estimates used to calculate depreciation, that charge is adjusted prospectively. Due to the significance of PPE and intangibles investment to the group, variations between actual and estimated useful economic lives could impact operating results both positively and negatively. As such, this is a key source of estimation uncertainty, although historically few changes to estimated useful economic lives have been required. The depreciation and amortisation expense for the year was £376.8 million. A 10 per cent increase in average asset lives would have resulted in a £33.6 million reduction in this figure and a10 per cent decrease in average asset lives would have resulted in a £42.3 million increase in this figure.
Accounting estimate – The group operates two defined benefit schemes which are independent of the group's finances. Actuarial valuations of the schemes are carried out as determined by the trustees at intervals of not more than three years. Profit before tax and net assets are affected by the actuarial assumptions used. The key assumptions include: discount rates, pay growth, mortality, and increases to pensions in payment and deferred pensions. It should be noted that actual rates may differ from the assumptions used due to changing market and economic conditions and longer or shorter lives of participants and, as such, this represents a key source of estimation uncertainty. Sensitivities in respect of the assumptions used during the year are disclosed in note A5.
Accounting estimate – The group has interests relating to its joint ventures in the form of equity investments and loans receivable, the recoverability of which are considered with reference to the present value of the estimated future cash flows of the joint ventures. Management tests whether any impairment exists in relation to the equity investments and loans receivable if adverse changes in conditions associated with the joint ventures suggest that this is appropriate. The estimated present value of these future cash flows is sensitive to the discount rate and terminal growth rate used in the calculation, together with the normalised level of working capital in the joint venture, all of which require management judgement. Testing of the carrying value has been performed during the year, which has involved a number of scenarios being modelled. Based on this testing, management believes there is sufficient headroom to support the carrying value of the group's interests in joint ventures, although it is possible, on the basis of existing knowledge, that outcomes within the next financial year that are different from the assumptions used could require a material adjustment to the carrying amount of assets.
Derivative financial instruments
Accounting estimate – The model used to fair value the group's derivative financial instruments requires management to estimate future cash flows based on applicable interest rate curves. Projected cash flows are then discounted back using discount factors which are derived from the applicable interest rate curves adjusted for management's estimate of counterparty and own credit risk, where appropriate. Sensitivities relating to derivative financial instruments are included in note A4.
Provisions and contingencies
Accounting estimates – The group is subject to a number of claims incidental to the normal conduct of its business, relating to and including commercial, contractual, employment and environmental matters, which are handled and defended in the ordinary course of business. The group routinely assesses the likelihood of any adverse judgements or outcomes to these matters as well as ranges of probable and reasonably estimated losses. Reasonable estimates are made by management after considering information including notifications, settlements, estimates performed by independent parties and legal counsel, available facts, identification of other potentially responsible parties and their ability to contribute, and prior experience. A provision is recognised when it is probable that an obligation exists for which a reliable estimate can be made after careful analysis of the individual matter. The required provision may change in the future due to new developments and as additional information becomes available. The provisions in respect of these claims, based on management's best estimates, totalled £19.5 million as at 31 March 2018 as set out in the 'Other' category in note 19; due to an inherent level of estimation uncertainty management estimate that there is an 80 per cent probability that the outcomes of these items will fall within a range of £10 million to £25 million. Matters that either are possible obligations or do not meet the recognition criteria for a provision are disclosed as contingent liabilities in note 23, unless the possibility of transferring economic benefits is remote.
New and revised standards not yet effective
At the date of authorisation of these financial statements, the following relevant major standards were in issue but not yet effective. The directors anticipate that the group will adopt these standards on their effective dates.
IFRS 9 'Financial Instruments'
The standard is effective for periods commencing on or after 1 January 2018. Under the provisions of this standard, where the group has chosen to measure borrowings at fair value through profit or loss, the portion of the change in fair value due to changes in the group's own credit risk will be recognised in other comprehensive income rather than within profit or loss. If this standard had been adopted in the current year, a £24.0 million loss would have been recognised in other comprehensive income rather than within the income statement.
The new standard has moved to a principles-based approach to align hedge accounting to the risk management activities of the entity, broadening the scope of what can be included within a hedge relationship. This change will see the requirement for cross currency basis spread adjustments to be incorporated in the test for the effectiveness of a hedge to be removed. The portion of the change in fair value due to changes in the cross currency basis spread will be recognised in other comprehensive income rather than within profit or loss. If the standard had been adopted in the current year, an £8.2 million gain would have been recognised in other comprehensive income rather than within the income statement.
The changes in hedge accounting may present increased opportunities in the future to put non-financial risks into hedge relationships; however, we do not expect this to have any material impact on the financial statements in the period of initial application.
In addition, the standard requires entities to use an expected credit loss model for impairment of financial assets instead of an incurred credit loss model. Consequently, judgement will be required in forming an expectation of future credit losses, particularly in relation to the group's trade receivable balances. The group currently employs a model that uses historic cash collection rates to form an expectation of the estimated recoverability of trade receivables at a point in time as this is the best information available on which an expectation can be formed. As such, there will be no significant change to the model currently used, although the group will continue to explore ways in which it might be further refined, and will take into consideration any significant economic changes that may have a bearing on expected credit losses. This is not expected to have a material impact on the overall level of allowances for bad and doubtful receivables.
The group is not required to restate 2018 comparative information for balances affected by the adoption of IFRS 9 in the year of transition.
IFRS 15 'Revenue from Contracts with Customers'
The standard is effective for periods commencing on or after 1 January 2018. This standard introduces a new revenue recognition model and replaces IAS 18 'Revenue', IAS 11 'Construction Contracts', IFRIC 13 'Customer Loyalty Programmes', IFRIC 15 'Agreements for the Construction of Real Estate', IFRIC 18 'Transfer of Assets from Customers' and SIC-31 'Revenue – Barter Transactions Involving Advertising Services'. The standard requires revenue to be recognised in line with the satisfaction of performance obligations identified within contracts between an entity and its customers, at an amount that reflects the transaction price allocated to each performance obligation.
Particular challenges exist within the water industry as formal written contracts do not exist for most transactions with customers. Contracts are instead implied through statute and regulation. Judgement is therefore required in identifying the services contained within the contract and the customer with whom the contract is entered into, which in turn impacts on how the performance obligations are considered and therefore revenue recognised.
There are two main areas of the group's activities that will be impacted by the adoption of IFRS 15:
- Core water and wastewater services, accounting for more than 97 per cent of the group's revenue under current accounting standards; and
- Capital income streams accounting for less than 2 per cent of the group's revenue in the income statement under current accounting standards, but where around £600 million of balances are currently included within deferred grants and contributions on the statement of financial position.
Other ancillary revenue streams are not expected to be significantly impacted, and no significant judgements are required in relation to these.
Core water and wastewater services – These services relate to:(i) the supply of clean water; and (ii) the removal and treatment of wastewater, with provision of each of these services deemed to be a distinct performance obligation under the contract with customers, though following the same pattern of transfer to the customer who simultaneously receives and consumes both of these services over time. No significant judgements are required in identifying customers of these services. In accordance with IFRS 15, revenue relating to these activities will be recognised over time as these performance obligations are satisfied. The adoption of the new standard is not expected to have any impact on the timing and amount of revenue recognised in these services.
Capital income – Capital income refers to the group's income streams relating to transactions, typically with property developers, which impact the group's capital network assets. It should be noted that this area remains under active consideration within the industry and the accounting profession more broadly, and that the accounting treatment ultimately adopted by the group in this area could therefore be impacted by the outcome of these ongoing discussions. We set out below our current assessment of the impact of IFRS 15 in relation to the transactions.
There are two categories of capital income, both of which will be impacted by the adoption of IFRS 15:
- Diversions relating to the relocation of water and wastewater assets; and
- Activities that facilitate the creation of an authorised connection through which properties can obtain water and wastewater services.
The adoption of IFRS 15 will not result in any net income statement impact relating to diversions, where income is currently recognised in line with the completion of diversion work. However, whereas this income is currently included in the income statement as a credit within infrastructure renewals expenditure (IRE) due to it representing a contribution towards these costs, under IFRS 15 it will be recognised within revenue resulting in an increase in both the revenue and IRE expense balances. If the standard had been adopted in the current year this would have resulted in revenue and IRE both increasing by £7.9 million.
Significant judgement is required in relation to accounting for activities that facilitate an authorised network connection through which water and wastewater services can be delivered. Establishing such an authorised connection can involve a number of activities performed opposite developers which are considered to be neither separable nor distinct and instead form a bundle of activities necessary to establish an authorised connection from which network access can be obtained and water and wastewater services can be provided. These are considered to form part of the group's ordinary activities associated with the operation, maintenance and expansion of a water and wastewater network and, because they are deemed to result in an exchange transaction, we have determined that they fall within the scope of IFRS 15 as transactions arising from contracts with customers.
In addition, as the group has a legal obligation to keep a connection in place for as long as a property requires water and wastewater services, these initial connection activities are deemed to result in a broader ongoing performance obligation that is not distinct from the ongoing supply of water and wastewater services. The right to benefit from this connection, and obtain water and wastewater services through it, is deemed to be transferable from the initial developer to subsequent occupants of a connected property. Accordingly, under IFRS 15, the element of the performance obligation associated with the connection activities will be deemed to be satisfied over the period of time that water and wastewater services are expected to be provided through the connection, compared with the current treatment under which deferred amounts are released to the income statement over the useful economic life of the related assets or, for certain items, immediately to the income statement. This estimated period is a matter of judgement. We estimate that an average connection will be in place for a period of around 60 years and therefore revenue associated with connection activities will be recognised evenly over this period.
We intend to apply IFRS 15 retrospectively with the cumulative effect of initially applying the standard recognised as an adjustment to the opening retained earnings balance at the date of initial application. The standard permits that, where this approach is used, contracts that have been completed in accordance with current accounting standards at the date of initial application will not be restated on an IFRS 15 basis.
Based on the deferred balance held on the statement of financial position relating to connection activities where the contract has not been completed as at 31 March 2018, the adjustment to retained earnings on the transition date of 1 April 2018 is expected to be a reduction in deferred grants and contributions and a corresponding increase in retained earnings of £2.7 million. In the year of adoption, revenue of £12.3 million is expected to be recognised in the income statement in relation to the updated deferred balances held on the statement of financial position relating to connection activities at 1 April 2018, compared with £8.9 million under current accounting standards. In addition, around £0.1 million of revenue is expected to be recognised in relation to balances that will be newly deferred under IFRS 15, compared with around £4 million that would have been expected to be recognised in the year ending 31 March 2019 under accounting standards adopted at 31 March 2018.
The net effect of these changes is that the total amount of annual revenue recognised in relation to these items is expected to fall by around £0.5 million as a result of the adoption of IFRS 15, compared with the group's treatment under accounting standards adopted at the reporting date.
IFRS 16 'Leases'
The standard is effective for periods commencing on or after 1 January 2019. Under the provisions of the standard, most leases, including the majority of those previously classified as operating leases, will be brought onto the statement of financial position, as both a right-of-use asset and a largely offsetting lease liability. The right-of-use asset and lease liability are both based on the present value of lease payments due over the term of the lease, with the asset being depreciated in accordance with IAS 16 'Property, Plant and Equipment' and the liability increased for the accretion of interest and reduced by lease payments.
The key judgements associated with adoption of this standard relate to the identification and classification of contracts containing a lease within the scope of IFRS 16, and the discount rate to use in calculating the present value of future lease payments on which the reported lease liability and right-of-use asset is based when the rate is not implicit in the lease contract.
Work to ensure the correct identification and classification of leases remains ongoing and will continue over the course of the coming year.
The discount rate is a key determinant in calculating the present value of future lease payments. The appropriate rate to use remains an area of active discussion, the outcome of which is likely to have a material impact on the valuation of the right-of-use asset and lease liability on adoption. Accordingly, as we do not yet have clarification on this point, we have not sought to quantify the impact of adoption at this stage.
We intend to use the modified retrospective transitional approach permitted by the standard in which the right-of-use asset and lease liability brought onto the balance sheet will be based on the present value of future lease payments at the adoption date calculated using the appropriate discount rate. The discount rate will be based on the company's incremental cost of borrowing at the point of adoption where the interest rate is not implicit in the lease contract. As such, the impact on adoption will be sensitive to the group's incremental borrowing costs as at the 1 April 2019 adoption date.
All other standards, interpretations and amendments, which are in issue but not yet effective, are not expected to have a material impact on the group's financial statements.