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1. The principal activity of the Ministry of Defence (the Department) is to deliver security for the people of the United Kingdom and the Overseas Territories by defending them, including against terrorism, and to act as a force for good by strengthening international peace and stability. In
2011-12 the Departmental Group was responsible for £38.9 billion of net operating costs and assets of some £132.6 billion mainly consisting of land, buildings, fighting equipment and stores, together with gross liabilities of some £21.8 billion.

2. The Department is required to prepare its financial statements in accordance with the Government Financial Reporting Manual (FReM). Under the FReM, the Department is required to apply International Financial Reporting Standards (IFRS) as adapted or interpreted for the public sector.
The purpose of my report

3. This Report explains the basis for the qualification of my audit opinion on the Department’s 201112 financial statements. This report also provides an update on the actions taken by the Department to address the issues identified in my Report on the 2010-11 Annual Report and Accounts.

Accounting for lease-type arrangements

4. I have qualified my opinion for a third year because the Department has not complied with the required accounting treatment for leases in International Financial Reporting Standards (IFRS) and has therefore omitted a material value of assets and liabilities from its Statement of Financial Position. I cannot quantify the impact of this on the accounts with certainty because, as a result of its accounting policies, the Department has not maintained the records, or obtained the information required to do so.

Accounting requirements

5. In preparing its accounts, the Department must comply with the requirements of the Government Financial Reporting Manual (FReM). Since 2009-10 the FReM has required the adoption of International Financial Reporting Standards (IFRS) by UK central government bodies. IFRS2 requires preparers of accounts to establish whether lease-type contracts are in substance either a finance or operating lease. These decisions have a significant impact on the financial statements because if the contract is classified as a finance lease then, rather than simply recording contract expenditure as it is incurred in year in the Statement of Comprehensive Net Expenditure (SoCNE), the valuation of assets used to deliver the service would be recognised in the Statement of Financial Position (SoFP) alongside a liability for the minimum lease payments due under the contract.

6. The accounting requirements for lease type arrangements are particularly relevant to the Department. It necessarily enters into strategic arrangements with certain contractors to procure specialist defence platforms on a non-competitive basis, for example in relation to surface ships, submarines and aircraft. These arrangements may provide for the exclusive, or near exclusive use of industrial assets and capability which have only limited utility to other customers. Consequently, the contractual terms, which are covered by the Government Profit Formula and its Associated Arrangements (GPFAA)3, may give rise to the Department controlling the significant majority of the outputs of the supplier’s assets involved in the arrangement. For example, where
shipyards are used exclusively on defence contracts and the pricing of the contract recognises this by allowing recovery of fixed costs other than through market rate or unit cost pricing. As such, these arrangements may be considered to contain a lease under IFRS, and may have the characteristics of a finance lease.

Action by the Department

7. As part of the work undertaken in 2009-10 when it first adopted IFRS, the Department assessed its Private Finance Initiatives and Public Private

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