BTPLC Annual Report 2005 - Financial review - Adoption of International Financial Reporting Standards (IFRS)

In compliance with European Union regulations BT will be adopting IFRS as the basis of accounting for the 2006 financial year. This will lead to a number of changes in future reported financial information.
     The group started its IFRS transition project in 2003. The project team is overseen by the Group Finance Director and regular updates have been provided to the Audit Committee. The project has involved a detailed assessment of the impact of IFRS on BT’s accounting policies and reported results; system changes to capture additional data; training of staff and communications. As part of the transition to IFRS, in March 2005, we presented on our investor relations website our view of the pro forma financial impact of adopting IFRS for the 2004 financial year.
     BT continues to report under UK Generally Accepted Accounting Principles (UK GAAP) for the 2005 financial year, but will be presenting financial information in accordance with IFRS for each quarter and the year ending 31 March 2006.
     The following provides additional information on the unaudited pro forma impact of IFRS in advance of the publication of the first IFRS results, and the material changes to BT’s accounting policies used to prepare the financial results for 2005 financial year.
     Whilst some of the changes required by IFRS will impact BT’s reported profits and net assets this has no impact on the cash flows generated by the business or the cash resources available for investment or distribution to shareholders. Furthermore the adoption of IFRS does not affect BT’s strategy or underlying business performance.
     It is important to note that the IFRS position as stated is BT’s current view based on the financial reporting standards currently in issue and changes may arise as new accounting pronouncements are developed and issued. Due to a number of new and revised Standards included within the body of Standards that comprise IFRS, there is not yet a significant body of established practice on which to draw in forming opinions regarding interpretation and application. Accordingly, practice is continuing to evolve. At this stage, therefore, the full financial effect of reporting under IFRS, as it will be applied and reported in the group’s first IFRS financial statements, may be subject to change.
     We estimate that the pro forma impact of adopting IFRS on the reported UK GAAP results for the 2005 financial year would have been negligible on the underlying earnings, being the profit before goodwill amortisation, exceptional items and tax and the earnings per share before goodwill amortisation and exceptional items. However, due to the inherent volatilities introduced by IFRS, no such statement can be made in respect of future years. These estimates exclude the mark to market effects of IAS 39 ‘Financial Instruments: Recognition and Measurement’ which we are not required to apply until 1 April 2005.

Pensions

Under UK GAAP, the group measures pension commitments and other related post-retirement benefits in accordance with SSAP 24 ‘Accounting for Pension Costs’ with additional disclosures provided in accordance with FRS 17 ‘Retirement Benefits’. Under IFRS, the group will measure pension commitments and other related post-retirement benefits in accordance with IAS 19 ‘Employee Benefits’, which takes a similar approach to FRS 17.
     On adoption of IAS 19 the deficit/surplus of defined benefit pension schemes will be recognised on balance sheet. The amended version of IAS 19, which is subject to EU approval, allows companies to choose to recognise actuarial gains and losses immediately in reserves or alternatively to be held on the balance sheet and released to the income statement over a period of time. BT has elected to early adopt the amended version of IAS 19 and reflect the impact of actuarial gains and losses immediately in reserves.
     The income statement charge is split between an operating charge and a net finance charge. The net finance charge relates to the unwinding of the discount applied to the liabilities of the scheme offset by the expected return on the assets of the scheme, based on conditions prevailing at the start of the year.
     Under SSAP 24, the asset on the balance sheet represents the timing differences between the pension charge to the profit and loss account and the payments made to the pension scheme. Under IFRS, the liability/asset on the balance sheet represents the deficit/surplus in the pension scheme. The scheme assets are valued at market value and the liabilities are discounted using a high quality corporate bond rate.
     Under SSAP 24, a pension charge for the 2005 financial year of £465 million, including a charge for the amortisation of the SSAP 24 deficit in the BT Pension Scheme, and an interest credit relating to the balance sheet prepayment was recognised. Under IFRS the estimated total charge of £342 million is split between an operating charge of £540 million and a net finance interest income of £198 million. Accordingly there is an additional £75 million charge to operating profit and a net finance income of £198 million under IFRS.
     A pension liability of £4,781 million (£3,347 million net of tax) would be recognised at 31 March 2005, offset by the reversal of provisions and other creditors of £44 million, and the pension prepayment on the UK GAAP balance sheet of £1,118 million. The tax effect of this reversal is £329 million. The net effect is a reduction in shareholders’ funds of £4,092 million at 31 March 2005.

Share-based payment

Under UK GAAP an expense is recognised for the award of share options and shares based on their intrinsic value (the difference between the exercise price and the market value at date of the award). The majority of BT’s share-based payments are made under all employee Save As You Earn plans which are exempt under UK GAAP and the intrinsic value of many of the senior management schemes is nil.
Under IFRS 2 ‘Share-based payment’, an expense is recognised in the income statement for all share-based payments (both awards of options and awards of shares). This expense is based on the fair value at the date of grant of the award, using option pricing models, and is charged over the related vesting period.
The accounting rules of IFRS 2 will result in an estimated operating charge for the 2005 financial year of £39 million, which is offset by the reversal of the UK GAAP charge of £11 million. The majority of this IFRS charge relates to the group’s all employee Save As You Earn schemes. There is a related tax credit of £9 million, offset by the reversal of the UK GAAP tax credit of £3 million. The credit for the share based payments is recognised directly in reserves as the awards are equity settled.

Goodwill and other intangible assets

UK GAAP requires goodwill to be amortised over its expected useful economic life. Under IFRS 3 ‘Business Combinations’, goodwill is no longer amortised but held at carrying value on the balance sheet and tested annually for impairment. BT has elected to adopt the IFRS 1 exemption, which allows existing UK GAAP goodwill at the transition date not to be restated but to be tested for impairment.
IAS 38 ‘Intangible assets’ requires other intangible assets arising on acquisitions after the transition date to be separately identified and amortised over their useful economic life, often a shorter period than for goodwill. As a result, intangible assets such as customer relationships and trademarks, need to be separately valued and recognised on business combinations, and then amortised over their useful economic lives.
The goodwill amortisation charged in 2005 financial year of £16 million under UK GAAP will be reversed. During the year BT has undertaken a number of acquisitions, detailed in note 15 to the accounts.

Events after the balance sheet date

Under UK GAAP, the dividend charge is recognised in the profit and loss account in the period to which it relates. Under IAS 10 ‘Events after the Balance Sheet Date’, the dividend charge is not recognised in the income statement but is recognised directly in reserves. In addition the dividend is required to be recognised in the period in which it is declared.
The final dividend creditor of £551 million for the 2005 financial year will be reversed as it was not declared at 31 March 2005.

Foreign exchange

Under UK GAAP, exchange differences arising from the translation of inter-company loans, which provide finance or provide a hedge against foreign undertakings, are taken to reserves on consolidation. These exchange differences are reported in the statement of total recognised gains and losses. Under IAS 21 ‘The Effects of Changes in Foreign Exchange Rates’, foreign exchange gains and losses arising on certain inter-company loans are excluded from the amount taken to reserve on consolidation. Foreign exchange gains and losses on these balances are recognised in the profit and loss account under IFRS.
In the 2005 financial year a consolidated foreign exchange gain of £4 million, which was taken directly to the profit and loss reserve under UK GAAP, is reversed into operating profit.

Lease accounting

There is a requirement under IAS 17 ‘Leases’ to view leases of land separately from leases of buildings. Furthermore, there is a requirement to recognise operating lease charges as an expense on a straight line basis. As a result the building elements of a small number of properties have been reclassified from operating leases under UK GAAP to finance leases under IFRS, and lease rentals under BT’s 2001 sale and leaseback transaction are recognised on a straight line basis.
The profit before tax for the 2005 financial year will be reduced by approximately £3 million, as a result of the recognition of depreciation and finance lease interest charges and the removal of the UK GAAP operating lease charges for the properties reclassified as finance leases. The charge for the 2005 financial year will also reduce by approximately £101 million due to operating lease charges being recognised on a straight line basis.

Other adjustments

There are a number of other minor adjustments and reclassification under IFRS, including;

(i)	Computer software that is not an integral part of hardware is treated as an intangible asset. Under UK GAAP, the group’s policy was to categorise all capitalised software as tangible fixed assets. This will result in a balance sheet reclassification.

(ii)

Deferred tax assets and deferred tax liabilities are required to be shown separately on the face of the balance sheet. Under UK GAAP the net deferred tax liability was shown within provisions. This will result in £1,660 million being reclassified to deferred tax assets leaving £1,941 million as deferred tax liabilities.

(iii)

Liquid investments with maturities of less than three months at acquisition are included within cash and cash equivalents rather than current asset investments resulting in a reclassification.

(iv)	Cash flow statements under IFRS have a different presentational format although the underlying cash flows remain unchanged.

Financial instruments

BT has taken the IFRS 1 exemption not to restate comparatives for the adoption of IAS 32 ‘Financial Instruments: Disclosure and Presentation’, and IAS 39 ‘Financial Instruments: Recognition and Measurement’. These standards set out the accounting rules surrounding the recognition, measurement, disclosure and presentation of financial instruments. These standards will be adopted by BT with effect from 1 April 2005.
The fair value of derivative financial instruments, existing at 1 April 2005, will be included on the balance sheet at fair value. Future market interest rate and currency movements will give rise to adjustments to these fair values. Where hedge accounting cannot be applied under the prescriptive rules of IAS 39, changes in market values of financial instruments will impact the profit and loss account. We expect group reserves at 1 April 2005 to be approximately £500 million lower under IFRS, than under UK GAAP, as a result of adopting IAS 39.
The group will present a reconciliation between the closing 31 March 2005 UK GAAP equity and opening 1 April 2005 IFRS equity when the first IFRS results are announced for the first quarter to 30 June 2005.

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