NATIONAL AUDIT OFFICE Report by the Comptroller and Auditor General Ministry of Defence: Incorporation of the Royal Ordnance Factories Ordered by the House of Commons to beprinted 23 April 1985 LONDON HER MAJESTY’S STATIONERY OFFICE E3.80net 343 This report is presented to the House of Commons in accordance with Section 9 of the National Audit Act, 1983. Gordon Downey Comptroller and Auditor General National Audit Office 22 April 1985 ,., Contents Ministry of Defence: Incorporation of the Royal Ordnance Factories Pages Summary and conclusions l-3 Report Part 1: Introduction 4 Part 2: Preparations for incorporation and final Trading Fund account 5-6 Part 3: Arrangementsforincorporation 7-9 Part 4: Postincorporationarrangements 10-11 Glossary of abbreviations 12 Glossary of terms 13 Appendix 14-16 Memorandum of Understanding between the Secretary of State for Defence and the Chairman of Royal Ordnance plc Ministry of Defence: Incorporation of the Royal Ordnance Factories Summary and conclusions 1. This Report records the results of a National Audit Office (NAO) examin- ation of the arrangements for incorporation of the Royal Ordnance Factories (ROFs) and in particular the financial aspects. The Report deals with the action taken and the costs incurred by ROFs and the Ministry of Defence (MOD) in preparation for incorporation; the proposals for valuation of the opening bal- ance sheet of the new company and the possible effects of this on the proposed later introduction of private capital; and the arrangements for control of the new company by the Secretary of State for Defence (Secretary of State) and account- ability to Parliament after incorporation. 2. Specifically, the NAO examination noted that the marketability of the shares of the Company has been enhanced by treating as distributable reserves some El80 million arising from the transfer of net assets from the ROF Trading Fund, in order to meet the special circumstances of the proposed flotation of a pre- viously unincorporated business. The value of the distributable reserves should be reflected in the proceeds on privatisation. These proceeds will not be signifi- cantly affected by balance sheet asset values but will depend essentially on actual and prospective profits and dividends. The Report notes that a number of steps have been taken to improve the efficiency of the ROFs and that sponsors of other Government trading services might consider whether there are any lessons to be learned from these. It also notes that although for the time being the Company is expected to comply with Government guidelines for nationalised industries these do not apply in every respect; nor is there provision for the C&AG to have access to the books of account and records of Royal Ordnance plc. Background 3. In 1974 the ROF organisation became the first service to be financed by means of a trading fund established under the Government Trading Funds (GTF) Act 1973 which was introduced to improve the commercial operation and public accountability of certain Crown services. In May 1982 the Secretary of State announced the Government’s intention to operate the ROFs in a more commer- cial environment under the Companies Acts with a view to involving private capital in due course. The necessary legislation is contained in the Ordnance Factories and Military Services (OFMS) Act 1984. 4. The assets and liabilities of the ROFs, together with certain other MOD assets and liabilities attributable to ROF operations, were transferred under a Scheme made by the Secretary of State to a new Company, Royal Ordnance plc, on 2 January 1985. Initially the Company is wholly Government owned, and during this period the relationship between the Secretary of State as shareholder and the new Company is set out in a Memorandum of Understanding (MOU) (see 1 Appendix). Detailed plans for the introduction of private capital have yet to be made. 5. Resulting from the NAO’s examination of the arrangements for incorpor- ation, the Report draws attention mainly to the matters summarised in the fol- lowing paragraphs. Preparations for incorporation and final Trading Fund accounts 6. The ROF Trading Fund has paid dividends totalling f 116 million to the Con- solid&cd Fund since 1974. The balance of the surpluses on operations, which with MOD and Treasury agreement has been retained as reserves, was expected to exceed f 180 million at 1 January 1985 (paragraphs 2.4,2.5). 7. Costsofmorethanf3.6millionhadbeenincurred byROFsandMODupto 1 January 1985 in preparing the ROFs for incorporation. MOD has also approved the creation of 60 additional posts at an annual cost off 1.5 million to deal with contracts with Royal Ordnance plc which replace the previous simple orders (pa- ragraphs 2.7 to 2.8). 8. After a review of the value of some fixed assetsto the business, a number of assets have been written down or are being considered for write-down by El2 million in total prior to incorporation. These include the TNT plant at ROF Bridgwater, the provision of which MOD justified to the Public Accounts Com- mittee (PAC) of Session 1977-78 (paragraph 2.9). Arrangements for incorporation 9. The marketability of the shares of Royal Ordnanceplc has been enhanced by providing forthereservesofsomef180millionarisingasaresult ofthetransferof net assets from the Trading Fund to be distributable. Distributable reserves are necessary in the special circumstances of the potential flotation of a previously unincorporated business; they will provide flexibility, for example to meet defi- cits and maintain dividends irrespective of trading results, and should be re- flected in the proceeds on privatisation (paragraphs 3.3 to 3.5). 10. The opening balance sheet of the new Company is expected to be published after I have presented the final Trading Fund accounts to Parliament. Both will be based on the historic cost convention but there will be differences between the two (paragraphs 3.6 to 3.9). 11. A firm of chartered surveyors has assessedthe existing use value of the land and the depreciated replacement value of the buildings transferred from the Trading Fund to Royal Ordnance plc at f 129 million on 3 1 March 1984 compared with the depreciated historic cost in the Trading Fund accounts of f35 million. This depreciated replacement cost valuation is not appropriate for the opening balance sheet of the new company but it will be updated and disclosed in any prospectus issued prior to a share flotation. Further assetsat MOD Research and Development (R&D) Establishments, valued at depreciated replacement cost at f25 million, are also being transferred (paragraph 3.11). 12. The Government has made clear that at privatisation the Company will be valued principally by reference to its earnings capability and prospects but chartered accountants’ advice to the ROFs was that this might not differ mater- ially from the historic cost valuation. The proceeds accruing to the Exchequer on privatisation will depend not so much on balance sheet asset values as on the 2 recent profit record and particularly prospective profits and dividends (para- graphs3.12and3.13). 13. The stimulus of incorporation has led to the introduction of a number of steps to improve the efficiency of the ROF organisation. Sponsor departments of other Government trading services might consider whether there are any lessons to be learned from the ROF experience (paragraphs 3.16 and 3.17). Post incorporation arrangements 14. Pending privatisation the MOU states that the Company is expected to comply with Government guidelines for nationalised industries, where relevant to its circumstances and not inconsistent with the MOU, but the Secretary of State has no power to direct the Company on specific matters which appear to him to affect the national interest. Nor does the MOU establish arrangements for setting suitable performance aims and, where appropriate, publishing perform- ance indicators to provide information about the control of costs and improve- ments in efficiency, although MOD have informed me that they are currently developing such arrangements with Royal Ordnance plc (paragraphs 4.1 to 4.5). 15. To secure public accountability sponsoring Ministers of Nationalised In- dustries are required to place the Industries’ annual accounts and reports, includ- ing details of performance aims and achievements, before Parliament. There is no requirement for Parliament to be provided with similar information on Royal Ordnance plc (paragraphs 4.6 and 4.7). 16. There is no provision for the C&AG to have accessto the books of account and records of Royal Ordnance plc (paragraphs 4.8 to 4.10). 17. The Secretary of State has expressed his intention that the Company shall pass into the private sector as soon as commercially and financially appropriate, probably by a public offer for sale of the shares, although sales of assets or subsidiaries to third parties are not excluded; but the arrangements for control- ling the associated costs and ensuring a fair return to the taxpayer have still to be determined (paragraphs 4.11 and 4.12). Ministry of Defence: Incorporation of the Royal Ordnance Factories Report Part 1: Introduction 1.1 The ROFs were until 2 January 1985a part of MOD. 1.4 This Act enabled the Secretary of State to make a Traditionally they have satisfied a substantial part of Scheme transferring the assetsand liabilities of the ROFs, MOD’s requirements for ammunition, land weapons and together with certain other MOD assetsand liabilities at- fighting vehicles. In addition they supply goods and services tributable to ROF operations, to a new company incorpo- to other customers both at home and abroad. rated under the Companies Acts in exchange for fully paid up shares. Accordingly a Schemewas made on 20 December 1.2 The Government Trading Funds (GTF) Act 1973was 1984 and laid before Parliament on 9 January 1985. The introduced to improve the commercial operation and public relevant assets and liabilities were transferred to the new accountability of certain Crown services.