BTPLC Annual Report 2006 - Consolidated financial statements - United States generally accepted accounting principles

35. UNITED STATES GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

The group’s consolidated financial statements are prepared in accordance with International Financial Reporting Standards as adopted by the European Union (IFRS), which differ in certain respects from those applicable in the United States. For BT there are no differences between IFRS as adopted for use in the EU and IFRS as published by the IASB.

(I) DIFFERENCES BETWEEN IFRS AND UNITED STATES GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (US GAAP)
The following are the main differences between IFRS and US GAAP which are relevant to the group’s consolidated financial statements.

(a) Sale and leaseback of properties

Under IFRS, the sale of BT’s property portfolio is treated as a disposal and the vast majority of the subsequent leaseback is an operating lease. Under US GAAP as BT has a continuing interest in the properties, these properties are recorded on the balance sheet at their net book value, a leasing obligation is recognised and the gain on disposal is deferred until the properties are sold and vacated by BT and the corresponding lease obligation is terminated. Rental payments made by BT are reversed and replaced by a finance lease interest charge and a depreciation charge.

(b) Pension costs

Under IFRS, pension costs are accounted for in accordance with IAS 19. Under US GAAP, pension costs are determined in accordance with the requirements of US Statements of Financial Accounting Standards (SFAS) Nos. 87 ‘Employers’ Accounting for Pensions’ and 88 ‘Employer’s Accounting for Settlements and Curtailments of Defined Benefit Plans and for Termination Benefits’. Differences between the IFRS and US GAAP amounts arise primarily due to differences in the recognition of actuarial gains and losses and the application of different measurement dates. Under IFRS, actuarial gains and losses are recognised in the statement of recognised income and expense whereas under US GAAP actuarial gains and losses are amortised over the average remaining service period.
Under US GAAP, if the accumulated benefit obligation (ABO) exceeds the fair value of plan assets, the employer is required to recognise a liability that is at least equal to the unfunded ABO.

(c) Capitalisation of interest

Under IFRS, the group has chosen not to capitalise interest. Under US GAAP, the estimated amount of interest incurred whilst constructing major capital projects is included in property, plant and equipment, and depreciated over the lives of the related assets. The amount of interest capitalised is determined by reference to the average interest rates on outstanding borrowings. At 31 March 2006 under US GAAP, gross capitalised interest of £350 million (2005 – £349 million) was subject to depreciation over periods of 3 to 25 years determined by the nature of the related asset.

(d) Financial instruments

The group exercised the exemption available under IFRS 1 to adopt IAS 32, ‘Financial Instruments: Disclosure and Presentation’ and IAS 39, ‘Financial Instruments: Recognition and Measurement’ from 1 April 2005. The comparative periods are therefore presented in accordance with UK GAAP.
     Under UK GAAP, investments are held on the balance sheet at historical cost. Gains and losses on instruments used for hedges are not recognised until the exposure being hedged is recognised. Certain derivative financial instruments which qualify for hedge accounting under UK GAAP do not qualify or were not designated as hedges under US GAAP.
     From 1 April 2005 the group adopted IAS 32 and IAS 39 which gave rise to differences in accounting treatments applied under US GAAP SFAS No. 133 ‘Accounting for Derivative Instruments and Hedging Activities’. On adoption of IAS 39, all derivative financial instruments and the fair value of the hedged risks, where a hedged item is in a fair value hedge, were recognised as a one time transition adjustment to equity and resulted in a transitional difference between US GAAP and IFRS.
     Under IFRS, certain cash flow hedges result in a hedged non-financial asset or liability being adjusted from the equity reserve for the applicable hedged amount. US GAAP does not allow the amounts taken to equity to be transferred to the initial carrying amount of the non-financial asset or liability. The amounts remain in equity and are recognised in earnings as the non-financial asset is depreciated or disposed.
     The group did not claim hedge accounting under US GAAP for certain items designated as hedges under IFRS. As a result, certain gains or losses on derivatives held in the cash flow reserve or translation reserve are credited or charged to the income statement under US GAAP. In addition, under IFRS, the hedged risk associated with a hedged item is fair valued where the item has been designated in a fair value hedge. As hedge accounting has not been claimed for those items under US GAAP, this fair value adjustment will not be reflected. These differences will reverse out as the derivatives or hedged items mature, are sold or expire.
     The fair value and book value of derivative instruments as at 31 March 2006 and 31 March 2005 is disclosed in note 33.
     IFRS prescribes four investment categories, namely held for trading, available-for-sale, loans and receivables and held to maturity. US GAAP prescribes only three categories, namely held for trading, available-for-sale and held to maturity. Whilst the held for trading and available for sale categories are similar under both GAAPs, items held in loans and receivables under IFRS are generally classified as held to maturity under US GAAP.

(e) Foreign exchange

Under US GAAP, on the sale of a foreign enterprise, foreign exchange differences within the cumulative translation adjustment (CTA) are included in net income in arriving at a gain or loss on disposal. Although IFRS also requires inclusion of the cumulative translation differences held in reserves as part of the calculation of gains or losses on disposal, they were reset to zero on transition to IFRS on 1 April 2004.

(f) Deferred taxation

Under both IFRS and US GAAP, provision for deferred income tax is required on a full provision basis in accordance with IAS 12 ‘Income taxes’ and SFAS No. 109 ‘Accounting for Income Taxes’.
     Under IFRS, deferred tax is recorded for temporary differences and deferred tax assets are recognised only to the extent that it is probable that taxable profits will be available against which the deductible temporary difference can be utilised. Deferred tax assets not recognised are disclosed in note 22.
     Under US GAAP deferred taxes are recorded on all temporary differences and a valuation allowance is established in respect of those deferred tax assets where it is more likely than not that some portion will remain unrealised. Additionally, assets and liabilities are presented separately where the timing of further recognition does not match and deferred tax balances are split where applicable between current and non current.
     Deferred tax adjustments in the IFRS to US GAAP reconciliation are primarily the result of the deferred tax impact of the other US GAAP adjustments made in the reconciliation. However, tax adjustments also arise in respect of the timing of recognition of deferred tax on share options and current tax benefits.
     At 31 March 2006, total deferred tax liabilities were £1,767 million primarily in respect of accelerated capital allowances and total deferred tax assets were £1,454 million, primarily in respect of pension obligations.
     The total valuation allowance recognised for deferred tax assets was as follows:

	2006	2005	Movement in year
	£m	£m	£m

Capital losses	5,493	4,436	1,057
Operating losses not utilised	775	860	(85	)
Other	271	705	(434	)

Total	6,539	6,001	538

(g) Impairment of property, plant and equipment

Certain network assets previously impaired did not meet the US GAAP criteria for impairment under SFAS No. 144 ‘Accounting for the Impairment or Disposal of Long-Lived Assets’.
US GAAP requires that an entity assess whether impairment has occurred based on the undiscounted future cash flows. An impairment exists if the sum of these cash flows is less than the carrying amount of the asset. The impairment loss recognised in the income statement is based on the asset’s fair value, being either market value or the sum of discounted future cash flows. The assets that were not impaired under US GAAP are continuing to be depreciated over their remaining useful lives.

(h) Revenue

Under IFRS, long-term contracts to design, build and operate software solutions are accounted for under IAS 18 ‘Revenue’ under which revenue is recognised as earned over the contract period.
Under US GAAP these contracts are accounted for as multiple element arrangements under EITF 00-21 and SOP 97-2, ‘Software Revenue Recognition’. As vendor specific objective evidence to support the fair value of the separate elements to be delivered is unavailable, revenue of £109 million under certain contracts is deferred in the 2006 financial year (2005: £162 million). There was no impact on net income due to the deferral of costs on these contracts. Total deferred revenue and costs recorded under US GAAP at 31 March 2006 was £348 million (2005: £239 million).

(i) Share-Based Payments

Under IFRS 2 ‘Share Based Payment’, share options are fair valued at their grant date and the cost is charged to the income statement over the relevant vesting periods.
     BT early adopted SFAS No. 123 (R) ‘Share-Based Payment’ on 1 April 2005 using the modified prospective transition method. Previously the company adopted the disclosure-only provisions in SFAS No. 123 ‘Accounting for Stock Based Compensation’ and accounted for share options in accordance with APB Opinion No. 25 ‘Accounting for Stock Issued to Employees’.
     Under the transition method, compensation cost recognised during the year ended 31 March 2006 includes (a) compensation cost for all share based payments granted prior to but not yet vested at 1 April 2005 based on the grant date fair value estimated in accordance with the original provisions of SFAS 123 and (b) compensation cost for all share based payments granted subsequent to 1 April 2005 based on the grant date fair value estimated in accordance with the original provisions of SFAS 123 (R).
     Results for prior periods have not been restated.
     As required by SFAS 123(R) the following table illustrates the effects on income from continuing operations, income before tax, net income and basic and diluted earnings per share in respect of the 2005 financial year, when share-based payment arrangements were accounted for under Accounting Principles Board Opinion No.25. There were no impacts from adoption on the cash flows of the Group.

	2005
	£m

Net income as reported	1,297
Share-based employee compensation cost included in net income	26
Share-based employee compensation cost that would have been included in net income if the fair-value-based method had been applied to all awards	(37	)
Deferred tax	3

Pro forma net income as if the fair-value-based method had been applied to all awards	1,289

Basic and diluted earnings per share as reported were 15.2p and 15.1p respectively. Pro forma basic and diluted earnings per share as if the fair-value-based method had been applied to all awards were 15.1p and 15.0p respectively.

(j) Goodwill

The group wrote off goodwill arising from the purchase of subsidiary undertakings, associates and joint ventures on acquisition prior to 1 April 1998, against retained earnings. Goodwill arising on acquisitions completed after 1 April 1998 was capitalised and amortised on a straight line basis over its useful economic life. Following transition to IFRS, goodwill is no longer amortised but tested annually for impairment and the amount of goodwill previously recorded at the transition date was carried forward under IFRS.
Under US GAAP up to 31 March 2002, goodwill arising on the acquisition of subsidiaries, associates and joint ventures was capitalised as an intangible asset and amortised over its useful life. BT adopted SFAS No. 142 on 1 April 2002 and goodwill is no longer amortised but tested annually for impairment. There was no goodwill impairment charge in the year ended 31 March 2006 (2005: nil).

(k) Property rationalisation provision

In the 2003 financial year, a provision in connection with the rationalisation of the group’s London office property portfolio was recorded. Under US GAAP, in accordance with SFAS No 146, these costs are not recognised until the group fully exits and therefore ceases to use the affected properties. All these properties were exited by 31 December 2004.

(l) Contingent consideration

Under IFRS contingent consideration in respect of acquisitions is recorded when the outcome of the contingency is considered more likely than not. Under US GAAP the consideration is recorded when the contingent event has occurred.

(m) Termination benefits

Under US GAAP the fair value of termination benefits for employees who are to be retained beyond their minimum contractual retention period is recognised on a straight line basis over the future service period. Under IFRS these costs are recognised when the employees agree to leave the group.

(II) NET INCOME AND SHAREHOLDERS’ EQUITY RECONCILIATION STATEMENTS
The following statements summarise the material estimated adjustments, gross of their tax effect, which reconcile net income and shareholders’ equity from that reported under IFRS to that which would have been reported had US GAAP been applied.

Net income		2006		2005
Years ended 31 March	Note	£m		£m

Profit attributable to equity shareholders of the parent under IFRS		1,547		1,830
Adjustment for:
Sale and leaseback of properties	a	(18	)	21
Pension costs	b	(220	)	(333	)
Capitalisation of interest	c	(16	)	(13	)
Financial instruments	d	(436	)	(415	)
Foreign exchange	e	39		–
Impairment of property, plant and equipment	g	(38	)	(24	)
Share based payment	i	(1	)	13
Property rationalisation provision	k	–		(5	)
Termination benefits	m	–		(20	)
Deferred taxation	f	3		3

		860		1,057
Tax effect of US GAAP adjustments		203		240

Net income as adjusted for US GAAP		1,063		1,297

Basic earnings per American Depositary Share as adjusted for US GAAP^a		£1.26		£1.52
Diluted earnings per American Depositary Share as adjusted for US GAAP^a		£1.25		£1.51

^a Each American Depositary Share is equivalent to ten ordinary shares.

Shareholders’ equity		2006		2005
At 31 March	Note	£m		£m

Total parent shareholders’ equity under IFRS		1,555		45
Adjustment for:
Sale and leaseback of properties	a	(1,067	)	(1,049	)
Pension costs	b	(1,228	)	636
Capitalisation of interest	c	164		178
Goodwill	j	107		113
Financial instruments	d	3		(371	)
Impairment of property, plant and equipment	g	40		77
Current liabilities	c	7		–
Deferred taxation	f	(53	)	(56	)

		(472	)	(427	)
Tax effect of US GAAP adjustments		314		(157	)

Shareholders’ equity as adjusted for US GAAP		(158	)	(584	)

Reclassifications The following reclassifications would need to be made in addition to those disclosed elsewhere and in the above reconciliation of shareholders’ equity in order to present amounts in accordance with US GAAP.
•	A pensions intangible asset of £31 million (2005 – £55 million) would be recognised separately from retirement obligations.
•	The current portion of pension obligations of £630 million (2005 – £459 million) would be shown as a current liability.
•	Cash and cash equivalents and current liabilities would increase by £181 million (2005 – £2 million) in respect of bank overdrafts.
•	Trade and other receivables and trade and other payables would be £348 million higher (2005 – £239 million) – see note (h).
•	A finance lease obligation of £2,325 million and property, plant and equipment of £780 million would be shown and trade and other payables would be £478 million lower in respect of the property sale and finance leaseback transaction as described in note (a).
•	Current assets would be £11 million lower (2005 – £6 million lower), current liabilities would be £2 million lower (2005 –£135 million higher) and long term borrowings would be £12 million lower (2005 – £230 million higher) in respect of financial instruments.

(III) CONSOLIDATED STATEMENTS OF CASH FLOWS
The group cash flow statements are presented in accordance with IAS 7. The statements prepared under IAS 7 present substantially the same information as that required under SFAS No. 95, ‘Statement of Cash Flows’.
If the cash flow statement had been prepared in accordance with SFAS No 95, the net increase in cash and cash equivalents would have been higher by £179 million (2005: unchanged). This is because under IAS 7, bank overdrafts are classified as a movement in cash and cash equivalents, while under US GAAP, the movements in bank overdrafts are classified as a financing activity.

(IV) PENSION COSTS
The following position for the main pension scheme (BTPS) is computed in accordance with US GAAP pension accounting rules under SFAS No. 87 and SFAS No. 88, the effect of which is shown in the above reconciliation statements. The liabilities of the BTPS represent substantially all of the group’s pension obligations.
The pension cost determined under SFAS No. 87 was calculated by reference to an expected long-term rate of return on scheme assets of 7.11% (2005 – 7.27%). The components of the net periodic pension cost for the main pension scheme comprised:

	2006		2005
	£m		£m

Service cost	538		507
Interest cost	1,784		1,745
Expected return on scheme assets	(2,042	)	(1,897	)
Amortisation of prior service costs	24		24
Amortisation of loss	215		263

Net periodic pension cost under US GAAP	519		642

The information required to be disclosed in accordance with SFAS No. 132(R), ‘Employers’ Disclosures about Pensions and Other Post Retirement Benefits’ concerning the funded status of the main scheme at 31 March 2005 and 31 March 2006, based on the valuations at 1 January 2005 and 1 January 2006, respectively, is given below.

	2006		2005
	£m		£m

Minimum liability, intangible asset and other comprehensive income
Plan assets at fair value	34,293		29,169
Accumulated benefit obligation	37,850		33,160

Minimum liability	3,557		3,991
Net amount recognised at end of year	(2,604	)	(2,535	)

Minimum additional liability	953		1,456
Intangible asset as at 31 March
Unrecognised prior service cost	(31	)	(55	)

Accumulated other comprehensive income	922		1,401

	2006		2005
	£m		£m

Changes in benefit obligation
Benefit obligation at the beginning of the year	34,336		32,448
Service cost	538		507
Interest cost	1,783		1,745
Employee contributions	21		50
Actuarial movement	3,438		943
Other changes	–		7
Benefits paid or payable	(1,385	)	(1,364	)
Translation	(1	)	–

Benefit obligation at the end of the year	38,730		34,336

The benefit obligation and pension cost for the main pension scheme were determined using the following assumptions at 1 January 2004, 2005 and 2006:

	2006	2005	2004
	per annum	per annum	per annum
	%	%	%

Discount rate	4.7	5.3	5.5
Rate of future pay increases	3.4	3.6	3.6
Rate of future pension increases	2.6	2.6	2.6

Contributions expected to be paid to the BTPS during the 2007 financial year are estimated at £630 million, including £232 million of deficiency contributions.

Estimated future benefit payments are as follows:

	£m

Year ending 31 March 2007	1,421
Year ending 31 March 2008	1,458
Year ending 31 March 2009	1,512
Year ending 31 March 2010	1,577
Year ending 31 March 2011	1,655
1 April 2011 to 31 March 2016	9,491

	2006		2005
	£m		£m

Changes in scheme assets
Fair value of scheme assets at the beginning of the year	29,169		26,675
Actual return on scheme assets	6,039		3,419
Employer contributions^a	450		382
Employee contributions	21		50
Other changes	–		7
Benefits paid or payable	(1,385	)	(1,364	)
Translation	(1	)	–

Fair value of scheme assets at the end of the year	34,293		29,169

	2006		2005
	£m		£m

Funded status under US GAAP
Projected benefit obligation in excess of scheme assets	(4,437	)	(5,167	)
Unrecognised prior service costs^b	31		55
Other unrecognised net actuarial losses	1,802		2,577

Net amount recognised under US GAAP	(2,604	)	(2,535	)

^a	The employer contributions for the year ended 31 March 2006 includes special contributions of £54 million (2005 – £6 million).
^b	Unrecognised prior service costs on scheme benefit improvements are being amortised over periods of 15 or 16 years commencing in the years of the introduction of the improvements.

Asset allocation

The Trustees of the main pension scheme approve the target asset allocation as well as deviation limits. The objective of the investment activities is to maximise investment returns within an acceptable level of risk, taking into consideration the liabilities of the main pension scheme.

	Year ended 31 December 2005
	Fair value		Target
	£bn	%	%

Equities	20.3	59	58
Fixed interest bonds	5.4	16	16
Index linked securities	3.2	9	9
Property	4.2	12	12
Cash and other	1.2	4	5

	34.3	100	100

	Year ended 31 December 2005
	Fair value		Target
	£bn	%	%

Equities	18.3	63	63
Fixed interest bonds	4.4	15	16
Index linked securities	2.7	9	9
Property	3.8	13	12

	29.2	100	100

The assumption for the expected return in scheme assets is a weighted average based on an assumed expected return for each asset class and the proportions held of each asset class at the beginning of the year. The expected returns on bonds are based on the gross redemption yields at the start of the year. Expected returns on equities and property are based on a combination of an estimate of the risk premium above, yields on government bonds and consensus economic forecasts of future returns. The expected return of 7.11% per annum used for the calculation of pension costs for the year ended 31 March 2006 is consistent with that adopted for IAS 19.

(V) INCOME STATEMENT IN US GAAP FORMAT
The group income statements on page 73 comply with IFRS and the directors believe they are in the most appropriate format for shareholders to understand the results of our business. We believe that it is important to show our results before deducting specific items because these items predominantly relate to corporate transactions rather than the trading activities of the group. For SEC reporting purposes this presentation may be considered ‘non GAAP’ and therefore the group has also prepared the following income statement which meets the SEC reporting format set forth in Item 10 of Regulation S-X. The numbers disclosed in the following income statement are prepared under IFRS.

	2006		2005
	£m		£m

Revenue	19,514		18,429
Operating expenses:
Payroll costs	4,066		3,832
Depreciation and amortisation	2,884		2,844
Payments to telecommunication operators	4,045		3,725
Other operating expenses	6,251		5,587

Total operating expenses	17,246		15,988

Net operating income	2,268		2,441
Other income, net	228		551
Net interest expense	(472	)	(599	)
Income taxes	(492	)	(525	)
Equity in earnings (losses) of investees	16		(39	)
Minority interests	(1	)	1

Net income	1,547		1,830

Earnings per share – basic	18.4	p	21.5	p
Earnings per share – diluted	18.1	p	21.3	p

(VI) US GAAP DEVELOPMENTS
In November 2005, the FASB issued Financial Staff Position (‘FSP’) FAS 115-1 and FAS 124-1, ‘The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,’ which nullifies certain requirements of Emerging Issues Task Force (‘EITF’) Issue No. 03-1, ‘The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments’ and supersedes EITF Abstracts Topic No. D-44, ‘Recognition of Other-Than-Temporary Impairment Upon the Planned Sale of a Security whose Cost Exceeds Fair Value.’ The guidance in this FSP is applied to reporting periods beginning after 15 December 2005. BT does not expect that the adoption of this guidance will have a material effect on its financial position, results of operations or cash flows.
     In May 2005, the FASB issued SFAS No. 154 ‘Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3’. SFAS No. 154 requires retrospective application of prior periods’ financial statements for changes in accounting principles. SFAS No. 154 applies to accounting periods beginning after 15 December 2005. The adoption of SFAS No. 154 is not expected to have a material effect on the results or net assets of the group.
     In February 2006, the FASB issued FASB Staff Position No. FAS 123(R)-4, ‘Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event’ (‘FSP FAS 123(R)-4’). FSP FAS 123(R)-4 addresses the classification of options and similar instruments issued as employee compensation that allow for cash settlement upon the occurrence of a contingent event. An option or similar instrument that is classified as equity, but subsequently becomes a liability because the contingent cash settlement event is probable of occurring, shall be accounted for similar to a modification from an equity to liability award. The application of this FSP did not have a material impact on the results or net assets of the group.
     In February 2006, the FASB issued SFAS No. 155, ‘Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statements No. 133 and 140’, that amends SFAS No. 133, ‘Accounting for Derivative Instruments and Hedging Activities’, and No. 140, ‘Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities’. This Statement resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, ‘Application of Statement 133 to Beneficial Interests in Securitised Financial Assets’. The Statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. Additionally it clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133. SFAS No. 155 also establishes a requirement to evaluate interests in securitised financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. It clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. Also SFAS No. 155 amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for BT for all financial instruments acquired or issued after 31 March 2007. BT is currently evaluating the impact of this statement.
     In March 2006 the FASB issued SFAS No. 156, ‘Accounting for Servicing of Financial Assets: an amendment of FASB Statement No. 140’ that amends SFAS No. 140, ‘Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities’, with respect to the accounting for separately recognised servicing assets and servicing liabilities. SFAS No. 156 is effective for BT on 1 April 2007. BT does not anticipate that the adoption of this new statement at the required effective date will have a significant effect on its results of operations, financial position or cash flows.

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