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Financial Review

Adjusted operating profit increased 22% to 509m on a continuing business basis.

Our adjusted earnings exclude other gains and losses on the sale or closure of businesses. We also exclude amortisation of acquired intangible assets (defined under IFRS 3); short-term fluctuations in the market value of financial instruments (as determined under IAS 39) and other currency movements charged to statutory profits (in accordance with IAS 21).

Statutory numbers in 2005 are significantly improved by profits on disposals (notably Recoletos and Marketwatch); statutory profit for the year was 644m, up 360m on 2004, with continuing operations up from 262m to 342m.

This year we saw relatively small effects of exchange on our income statement. The average US dollar rate against sterling strengthened slightly to 1:$1.81 (2004: 1:$1.83) which marginally increased our reported operating profit. However, the strong year end dollar (1:$1.72 vs 1:$1.92 in 2004) clearly had a significant impact on our balance sheet.

Financial statements

These are our first set of consolidated financial statements under International Financial Reporting Standards (IFRS). We have chosen a transition date to IFRS of 1 January 2003, which means we have comparable data under IFRS for both 2004 and 2003 displayed in our financial statements. Where material, the impact of IFRS on our accounts is discussed below.

Interest Net interest payable in 2005 was 77m, up from 74m in 2004. Although we were partly protected by our fixed rate policy (see Treasury Policy below), the strong rise in US dollar floating interest rates had an adverse effect. Year on year, average three month LIBOR (weighted for the Group's borrowings in US dollars, Euro and Sterling) rose by 1.9% to 3.4%. In addition, in 2005 we did not benefit from a one-off credit of 9m for interest on a repayment of tax that occurred in 2004. These increases were offset by the 260m fall in average net debt, reflecting in particular the proceeds from the disposal of Recoletos and good cash generation. The Group's average net interest rate payable rose by 0.9% to 5.9%.

Taxation The tax rate on adjusted earnings has barely changed from 2004 to 2005, reducing from 30.9% to 30.3%. The tax rate on adjusted earnings is very close to the UK statutory rate of 30%. The higher tax rate on US and overseas profits was offset by the use of UK losses and by credits relating to previous years, reflecting continued progress in settlement of the Group's affairs with the authorities.

The total tax charge for the year was 124m, representing a 27% rate on pre-tax profits of 466m (on a statutory basis excluding discontinued operations). This compares with a 2004 rate of 19% (or 63m on a pre-tax profit of 325m). In 2004, the tax charge reflected credits of 48m relating to previous years, a substantial element of which was non-recurring; adjustments relating to previous years in 2005 resulted in a credit of 18m. The 2005 rate benefited from the fact that the profit of 40m on the sale of is free of tax.

Minority interests Following the disposal of our 79% holding in Recoletos in April 2005 and the purchase of the 25% minority stake in Edexcel our minority interests now comprise mainly the 39% minority share in IDC. In January 2006 we increased our stake in IDC by the purchase of 1.1m shares, so the future minority interest will be 38%.

Dividends Under IFRS, dividends are accrued only once approved. Therefore, the dividend accounted for in our 2005 financial statements totalling 205m, represents the final dividend (15.7p) in respect of 2004 and the 2005 interim dividend of 10p.

We are proposing a final dividend for 2005 of 17p, bringing the total paid and payable in respect of 2005 to 27p, a 6.5% increase on 2004. This final 2005 proposed dividend was approved by the board in February 2006, is subject to shareholder approval at the forthcoming AGM and will be charged against 2006 profits. In 2005, the dividend paid (including minorities) is covered 1.9 times by total free cash flow.

We seek to maintain a balance between the requirements of our shareholders for a rising stream of dividend income and the reinvestment opportunities which we identify around the Group. This balance has been expressed in recent years as a desire to increase our annual dividend by more than inflation, while also reinvesting a higher proportion of our distributable earnings in our businesses.

Other financial items

Pensions Pearson operates a variety of pension schemes. Our UK scheme is by far the largest and we also have some smaller defined benefit schemes in the US and Canada. Outside the UK, most of our companies operate defined contribution schemes. Pension funding levels are kept under regular review by the Company and the Fund trustees.

The UK scheme was valued as at 1 January 2004 and the next valuation will be as at 1 January 2006. As a result of the 2004 valuation, the Company agreed to increase contributions to 30m in respect of 2004; to 35m in 2005; and to 41m annually from 2006 to 2014.

Our total gross liability for retirement benefits was 389m at 31 December 2005 (2004: 408m) of which the UK scheme represented 271m, a reduction from 304m in 2004 as a result of good investment performance.

Accounting policies and disclosures As noted above, Pearson has adopted IFRS for its 2005 consolidated financial statements, in compliance with European Union regulation. This has resulted in changes to the format of presentation but has had no impact on the cash resources available to the Group. A full list of IFRS accounting policies can be found in note 1 to our financial statements.

In summary, the main changes to our reported 2005 statutory accounts from IFRS adoption are as follows:

Goodwill and other intangibles Under IFRS 3 'Business Combinations', goodwill is no longer amortised, but instead is assessed annually for impairment. Goodwill which arose on acquisitions prior to 1 January 2003 and which was capitalised under UK GAAP has not been restated; other intangible assets arising from acquisitions since 1 January 2003 have been separately identified, fair valued and capitalised. They are being amortised over their estimated useful economic life. The charge to the income statement for such amortisation was 11m in 2005 (2004: 5m).

Share-based payments Under IFRS 2 'Share-based payment', a proportion of the imputed fair value at the date of grant of restricted shares, SAYE schemes and share options issued to employees has been charged to operating profit. The proportion charged is determined with respect to the relevant vesting period. The amount charged in 2005 was 23m (2004: 25m).

Employee benefits Under IAS 19 'Employee Benefits', assets and liabilities relating to pension and other post-retirement benefits are valued and accounted for at the balance sheet date.

The income statement expense is determined using annually derived assumptions as to salary inflation, investment returns and discount rates, based on prevailing conditions at the start of the year. The assumptions for 2005 are disclosed in note 24 to our accounts, along with the year-end deficits in our defined benefit schemes. We recognise actuarial gains and losses arising when assumptions diverge from reality through the statement of recognised income and expense (SORIE).

Our charge to profit in respect of worldwide pensions under IAS 19 amounted to 64m in 2005 (2004: 57m) of which a charge of 60m was reported in operating profit and the net finance charge (4m) was reported against interest.

Pearson has adopted IAS 39, 'Financial Instruments: Recognition and Measurement' as at 1 January 2005, and the results of this are detailed below under our Treasury policy.

There are a number of other relatively minor statutory presentation and disclosure changes under IFRS which are treated consistently across our 2005 actual IFRS reported numbers and our 2004 and 2003 restated comparatives. The total impact of these changes on previously reported profits can be seen from our five-year summary.

Managing our financial risks

This section explains the Group's approach to the management of financial risk.

Treasury policy The Group holds financial instruments for two principal purposes: to finance its operations and to manage the interest rate and currency risks arising from its operations and its sources of finance. The Group finances its operations by a mixture of cash flows from operations, short-term borrowings from banks and commercial paper markets, and longer term loans from banks and capital markets. The Group borrows principally in US dollars, Euro and Sterling, at both floating and fixed rates of interest, using derivative financial instruments ('derivatives'), where appropriate, to generate the desired effective currency profile and interest rate basis. The derivatives used for this purpose are principally rate swaps, rate caps and collars, currency rate swaps and forward foreign exchange contracts. The main risks arising from the Group's financial instruments are interest rate risk, liquidity and refinancing risk, counterparty risk and foreign currency risk. These risks are managed by the chief financial officer under policies approved by the treasury committee of the board, which are summarised below. Apart from the change to interest rate policy and the modification to currency risk policy identified below, all other treasury policies have remained unchanged throughout 2005. The treasury committee of the board, and a group of external treasury advisers, receives reports on the Group's treasury activities, policies and procedures. The treasury department is not a profit centre and its activities are subject to regular internal audit.

Adoption of International Financial Reporting Standards From 1 January 2005 the Group adopted IAS 39 'Financial Instruments: Recognition and Measurement'. The market values of the Group's derivatives were taken onto the balance sheet at the adoption date. Subsequent changes in them will change the carrying values on the balance sheet and create movements in the finance costs section of the income statement, unless they have been designated (and passed the prescribed tests) for hedge accounting treatment. By contrast, under UK GAAP accounting, except for the impact of some currency rate derivatives, the values of derivatives were not carried in the balance sheet, nor were movements in those values taken to the income statement (although information on derivatives was disclosed in the notes). Thus both the balance sheet and the income statement have the potential to be more volatile under IAS 39 than they were before.

In addition, IAS 39 required us to value our derivatives at 1 January 2005 as if the standard had been in place at the start date of each individual contract. This has given rise to transition adjustments, which in some cases will have to be amortised over the remaining life of the relevant transaction. Also, where we have achieved hedge accounting on a derivative, the carrying value of the relevant bond is adjusted at each reporting date to reflect this (in addition to the requirement under IFRS that accrued interest should be included in the carrying value of the bond or derivative, in contrast to its treatment as a creditor under UK GAAP).

As the Company elected to adopt IAS 39 from 1 January 2005, the effects described above are not reflected in the 2004 and 2003 comparatives.

Interest rate risk The Group's exposure to interest rate fluctuations on its borrowings is managed by borrowing on a fixed rate basis and by entering into rate swaps, rate caps and forward rate agreements. Since September 2005 the Group's policy objective has been to set a target proportion of its forecast borrowings (taken at the year end, with cash netted against floating rate debt) to be hedged (i.e. fixed or capped) over the next four years, subject to a maximum of 65% and a minimum that starts at 40% and falls by 10% at each year end. Previously the minimum was 40% throughout. At the end of 2005 the hedging ratio was 55%. A simultaneous 1% change on 1 January in the Group's variable interest rates in each of US dollar, Euro and Sterling, taking into account forecast seasonal debt would have a 7m effect on profit before tax.

Use of interest rate derivatives The policy in the section above creates a group of derivatives, under which the Group is a payer of fixed rates and a receiver of floating rates. The Group also strives to avoid undue exposure to a single interest rate setting. Reflecting this, it swaps its fixed rate bond issues to floating rate at their launch. These create a second group of derivatives, under which the Group is a receiver of fixed rates and a payer of floating rates.

The Group's accounting objective in its use of interest rate derivatives is to minimise the impact on the income statement of changes in the mark-to-market value of its derivative portfolio as a whole. It uses duration calculations to estimate the sensitivity of the derivatives to movements in market rates. The Group also identifies which derivatives are eligible for fair value hedge accounting (which reduces sharply the income statement impact of changes in the market value of a derivative). The Group then divides the total portfolio between hedge-accounted and pooled segments, so that the expected movement on the pooled segment is minimal.

Liquidity and refinancing risk The Group's objective is to procure continuity of funding at a reasonable cost. To do this it seeks to arrange committed funding for a variety of maturities from a diversity of sources. The Group's policy objective has been that the weighted average maturity of its core gross borrowings (treating short-term advances as having the final maturity of the facilities available to refinance them) should be between three and 10 years. At the end of 2005 the average maturity of gross borrowings was five years and non-banks provided 1,855m (95%) of them (down from six years and up from 91% respectively at the beginning of the year). The Group believes that ready access to different funding markets also helps to reduce its liquidity risk, and that published credit ratings and published financial policies improve such access. All of the Group's credit ratings remained unchanged during the year. The long-term ratings are Baa1 from Moody's and BBB+ from Standard & Poor's, and the short-term ratings are P2 and A2 respectively. The Group strives to maintain a rating of at least BBB+/Baa1 over the long term. The Group will also continue to use internally a range of ratios to monitor and manage its finances. These include interest cover, net debt to operating profit, net debt to enterprise value and cash flow to debt measures. The Group also maintains undrawn committed borrowing facilities. At the end of 2005 these amounted to 786m and their weighted average maturity was 3.5 years.

Net borrowings fixed and floating rate
Fixed Rate 549 740
Floating Rate 447 481
Total 996 1,221
Gross Borrowings
Bank debt 105 173
Bonds 1,854 1,650
Total 1,959 1,823
Gross borrowings by currency
  As reported
US dollar 1,165 290 1,455 1,335
Sterling 357 (150) 207 202
Euro 437 (140) 297 284
Other - - - 2
Total 1,959 - 1,959 1,823

Counterparty risk The Group's risk of loss on deposits or derivative contracts with individual banks is managed in part through the use of counterparty limits. These limits, which take published credit limits (among other things) into account, are approved by the Chief financial officer. In addition, for a currency rate swap that transforms a major part of the 6.125% Euro Bonds due 2007 into a US dollar liability, the Group has entered into a mark-to-market agreement which significantly reduces the counterparty risk of that transaction.

Currency risk Although the Group is based in the UK, it has its most significant investment in overseas operations. The most significant currency for the Group is the US dollar. The Group's policy on routine transactional conversions between currencies (for example, the collection of receivables, and the settlement of payables or interest) remains that these should be completed at the relevant spot exchange rate. No unremitted profits are hedged with foreign exchange contracts, as the Company judges it inappropriate to hedge non-cash flow translational exposure with cash flow instruments. However, the Group does seek to create a 'natural hedge' through its policy of aligning approximately the currency composition of its core net borrowings with its forecast operating profit. This policy aims to dampen the impact of changes in foreign exchange rates on consolidated interest cover and earnings. In September 2005 this policy was modified to apply only to currencies that accounted for more than 15% of group operating profit, which currently is only the US dollar.

Previously, the policy applied specifically to US dollars, Euro and Sterling. However, the Group still borrows small amounts in other currencies, typically for seasonal working capital needs. In addition, the Group currently expect to hold the legacy borrowings in Euro and Sterling to their maturity dates: our policy does not require existing currency debt to be terminated to match declines in that currency's share of group operating profit. Included within year end net debt, the net borrowings/(cash) in the three principal currencies above (taking into account the effect of cross currency swaps) were: US dollar 1,114m, Euro 78m and Sterling (93)m.

Use of currency debt and derivatives The Group uses both currency denominated debt and derivative instruments to implement the above policy. Its intention is that gains/losses on the derivatives and debt offset the losses/gains on the foreign currency assets and income. Each quarter the value of hedging instruments is monitored against the assets in the relevant currency and, where practical, a decision is made whether to treat the debt or derivative as a net investment hedge (permitting foreign exchange movements on it to be taken to reserves) for the purposes of IAS 39.

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