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Financial Review Highlights
Adjusted operating profit 455 874 490 941
Goodwill amortisation (224) (430) (264) (507)
Non operating items 9 17 6 12
Net interest payable (69) (133) (80) (154)
Profit before taxation 171 328 152 292
Taxation (62) (119) (75) (144)
Profit after taxation 109 209 77 148
Equity and minority interests (21) (40) (22) (42)
Profit for the financial year 88 169 55 106
Dividends (201) (386) (192) (369)
Loss retained (113) (217) (137) (263)

Adjusted operating profit, on an underlying basis, was up 5% (up 7% for continuing businesses).

Statutory profit before tax was 171m, up 19m, largely as a result of lower goodwill amortisation and a reduced interest charge. The 20 cent weakening in the average US dollar rate against the pound (1:$1.83 in 2004 against 1:$1.63 in 2003) reduced our reported operating profit.

Financial statements

Goodwill This is the final year of amortisation under UK GAAP, ahead of moving to International Financial Reporting Standards in 2005. The goodwill amortisation charge fell to 224m from 264m in 2003 as a result of the lower dollar exchange rate and the reduction in charges relating to fully amortised assets. There were no impairments in 2004.

Non operating items These reflected gains and losses on the sale or closure of businesses and on the disposal of fixed assets and investments. In 2004 we had profits on the sale of our stakes in Capella and, which were partially offset by small losses elsewhere.

Interest Net operating interest fell by 11m to 69m, as an increase in floating interest rates was offset by a combination of lower levels of average net debt and a one-off credit of 9m for interest on a repayment of tax in France. The average three month LIBOR (weighted for the Group's borrowings in US dollars, euros and sterling) rose by 0.4%. We were partially protected from these increases by our treasury policy, which put 736m of our year-end debt on a fixed rate basis. As a result, the Group's average net interest rate payable (excluding the 9m credit described above) rose by only 0.25%, to 5%.

Taxation The total tax charge for the year was 62m, representing a 36% rate on pre-tax profits of 171m. This was higher than the UK statutory rate of 30%; as in previous years, this was largely attributable to the fact that the goodwill amortisation charge in the profit and loss account was only partially eligible for tax relief. The total tax charge included credits of 48m relating to previous years; these reflected a combination of progress in settlements with the Revenue authorities and changes to deferred tax balances. The mix of profits between jurisdictions with different tax rates was also a relevant factor; the effect in 2004 was similar to that in 2003.

The tax rate on adjusted earnings reduced from 31.2% in 2003 to 30.3% in 2004, benefiting from prior year credits and the mix of profits.

Minority interests Minority interests were principally a 39% minority share in IDC and a 21% minority share in Recoletos.

Dividends The dividend payment of 201m which we are recommending in respect of 2004 represents 25.4p per share - a 5% increase on 2003. The dividend is covered 1.2 times by adjusted earnings and 1.4 times by free cash flow. We seek to maintain a balance between the requirements of our shareholders, including our many private shareholders, for a rising stream of dividend income and the reinvestment opportunities that we see across Pearson. This balance has been expressed in recent years as a commitment to increase our annual dividend faster than the prevailing rate of inflation while progressively reinvesting a higher proportion of our distributable earnings in our business.

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Other financial items

Pensions Pearson operates a variety of pension schemes. Our UK fund is by far the largest and we also have some smaller defined benefit funds in the US and Canada. Outside the UK, most of our people operate 401K (essentially defined contribution) plans. The pension funding level is kept under regular review by the company and the Fund trustees. The scheme was valued as at 1 January 2004 and the next valuation will be 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.

Accounting disclosures and policies During 2004 we adopted UITF Abstract 38 'Accounting for ESOP trusts' and the revision of UITF Abstract 17 'Employee share schemes' were issued on 15 December 2003 and these revisions have been applied for the first time in 2004. Under UITF 38 own shares held in treasury or through an ESOP trust are recorded at cost and shown as a deduction in arriving at shareholders' funds. Previously these shares were recorded at cost less provision for impairment and shown as a fixed asset investment with impairment charges being taken to the profit and loss account. Under the revised UITF 17, employee share scheme charges to the profit and loss account are now always calculated as the intrinsic value of the award and spread over the performance period. The intrinsic value is the difference between the fair value of shares at the date of grant and the amount paid by the employee to exercise the rights to those shares irrespective of the cost of shares purchased to fund the award. The amendment to UITF 17 in respect of the calculation of share scheme charges has had no material effect on the profit and loss account.

Adoption of International Financial Reporting Standards (IFRS)

From 2005 onwards Pearson will be adopting IFRS in its consolidated financial statements in compliance with European Union regulation. This will lead to a number of changes in reported financial data, which will also be reflected in Pearson's comparative financial information for prior periods. Pearson has decided to adopt IFRS as at 1 January 2003 which will have the advantage of providing two years of comparative IFRS data.

The Group started its IFRS transition project in 2003. The project is governed by a steering committee chaired by the chief financial officer and regular updates are provided to the audit committee. The project has entailed a detailed assessment of the impacts of IFRS on Pearson accounting policies and reported results; system changes to capture additional data; training of staff critical to the Group's reporting process and definition of our IFRS communication strategy.

The work related to all project activities remains on track to provide an analysis of the full impact of the adoption of IFRS on the Group's audited 2003 and 2004 results and respective balance sheets. We plan to communicate the adjustments from UK GAAP to IFRS in April 2005.

Other than the format of presentation, there is no cash flow impact from the adoption of IFRS.

In the meantime we set out below a summary of the main areas of impact on the Group's operating profit together with indicative estimates of the related amounts:

1. Goodwill and other intangibles: Under IFRS 3, goodwill is no longer amortised and, instead, is assessed annually for impairment. Goodwill arising on acquisitions before 1 January 2003 will not be restated; other intangible assets arising from acquisitions after 1 January 2003 will be separately identified and amortised over their estimated useful economic lives, often over shorter periods than goodwill has previously been amortised.

As a result of this change, Pearson's operating profit will be increased by the amount of goodwill amortisation recorded under UK GAAP (amounting to 224m for 2004 and 264m in 2003) but reduced by the amortisation of other purchased intangible assets (estimated to be up to 10m in each of 2004 and 2003).

2. Share based payments: Under IFRS 2, the imputed fair value at the date of grant of restricted shares, SAYE schemes and share options issued to employees will be charged to operating profit over the relevant vesting period. This will result in a reduction in Pearson's reported operating profit, as the cost will be higher than that currently charged under UK GAAP. The UK GAAP charge is based upon the intrinsic value of the award being the difference between exercise price and grant price.

The impact is estimated to be between 15m and 25m in 2003 and 2004.

3. Employee benefits: Under IAS 19 pensions are charged to the profit and loss account using a different basis of accounting from SSAP 24. IAS 19 uses a balance sheet approach (similar to FRS 17) rather than determinations based on long-term actuarial assumptions. The profit and loss 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. Any surplus or deficit on a deferred benefit scheme at the balance sheet date is recognised in the balance sheet. Where actual experience differs from the assumptions made, actuarial gains and losses will be recognised through the statement of recognised income and expense.

The adoption of IAS 19 is not anticipated to result in a significant change to operating profit compared to SSAP 24 for 2003 and 2004.

In addition to the above principal areas of impact, a number of other changes will arise upon transition to IFRS, for example, in relation to the treatment of software costs, deferred tax, dividends payable and certain balance sheet disclosures related to items such as pre-publication costs. We will report on these other adjustments including further details relating to the presentation and layout of the Group's IFRS income statement and balance sheet in our April announcement.

Going forward, Pearson has elected to adopt IAS 39 relating to financial instruments from 1 January 2005. Pearson uses derivative financial investments (as detailed below under our treasury policy) to hedge certain interest rates and currency exposures. Accounting for derivative financial instruments in accordance with IAS 39 may result in increased volatility of earnings. However, Pearson has been tracking its key derivatives during 2004 and has put in place the required documentation to qualify for hedge accounting: where hedge accounting cannot be applied under IAS 39's prescriptive rules, change in this market value of financial investment will be reported through the profit and loss account. Given the adoption date, there will be no impact from this area in the 2003 or 2004 accounts.

A number of new IFRS standards were published in final form by the International Accounting Standards Board in the period between November 2003 and March 2004 which will be mandatory for Pearson in preparing the Group's first IFRS financial statements. As a large number of countries, including the United Kingdom, are simultaneously adopting the standards for the first time there is limited established practice on which to draw when forming opinions regarding IFRS interpretation and application. Therefore at this stage, the full financial effect of reporting under IFRS cannot be definitively quantified due to the possible amendment of interpretative guidance by the IASB and developing industry practice.

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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, euros and sterling, at both floating and fixed rates of interest, using derivatives, where appropriate, to generate the desired effective currency profile and interest rate basis.

The derivatives used for this purpose are principally interest rate swaps, interest rate caps and collars, currency 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 board, which are summarised below. These policies have remained unchanged, except as disclosed, since the beginning of 2003. A treasury committee of the board receives reports on the Group's treasury activities, policies and procedures, which are reviewed periodically by a group of external professional advisers. The treasury department is not a profit centre and its activities are subject to internal audit.

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 interest rate swaps, interest rate caps and forward rate agreements. Since October 2002 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 within a 40% to 65% range. At the end of 2004 that ratio was 61%. A 1% change in the Group's variable rate US dollar, euro and sterling interest rates would have a 5m effect on profit before tax.

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 ten years. At the end of 2004 the average maturity of gross borrowings was six years and non-banks provided 1,650m (91%) of them (up from 4.9 years and 89% 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 2004 these amounted to 641m and their weighted average maturity was 4.5 years.

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 certain longer-dated, higher-value derivative contracts, specifically, a currency swap that transforms a major part of the 6.125% eurobonds due 2007 into a US dollar liability, the Group has entered into mark-to-market agreements whose effect is to reduce significantly the counterparty risk of the relevant transactions.

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, followed by the euro and sterling. 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 affected 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 transnational 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 borrowings in US dollars, euros and sterling with the split between those currencies of its forecast operating profit. This policy aims to dampen the impact of changes in foreign exchange rates on consolidated interest cover and earnings. Long-term core borrowing is limited to these three major currencies. However, the Group still borrows small amounts in other currencies, typically for seasonal working capital needs. At the year end the split of aggregate net borrowings in its three core currencies was US dollar 88%, euro 7% and sterling 5%.

Net borrowings fixed and floating rate
  2004   2003
  m $m   m $m
Fixed rate 736 1,413   829 1,592
Floating rate 470 902   532 1,021
Total 1,206 2,315   1,361 2,613

Gross borrowings
  2004   2003
  m $m   m $m
Bank debt 169 324   204 391
Bonds 1,650 3,168   1,718 3,299
Total 1,819 3,492   1,922 3,690

Gross borrowings by currency
  2004   2003
  m $m   m $m
US dollar 1,332 2,557   1,427 2,740
Sterling 201 386   201 386
Euro 284 545   292 560
Other 2 4   2 4
Total 1,819 3,492   1,922 3,690

Financial Review Highlights
  m $m
Cash inflow
Operating cash flow 422 810
Disposals 42 81
New equity 4 8
Cash outflow
Purchase of own shares (10) (19)
Integration costs (4) (8)
Interest, tax, dividends and other (328) (630)
Acquisitions (46) (88)
Opening net debt (1,361) (2,613)
Exchange differences on opening net debt 75 144
Closing net debt (1,206) (2,315)

Note Net debt excludes finance leases.

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