Notes to the Financial Statements (11 – 20)

Tax on items taken directly to equity is disclosed in notes 31 and 32.

The Group earns its profits primarily in the UK, therefore the tax rate used for tax on profit from ordinary activities is the standard rate for UK corporation tax, which was 28% for 2009 (2008: 28.5%), with the exception of upstream profits, which were taxed at a UK corporation tax rate of 30% (2008: 30%) plus a supplementary charge at 20% (2008: 20%). Certain upstream assets also bear petroleum revenue tax at 50% (2008: 50%). Taxation for other jurisdictions is calculated at the rates prevailing in those respective jurisdictions.

(b) Factors affecting the tax charge for the year

The differences between the total tax shown above and the amount calculated by applying the standard rate of UK corporation tax to the profit before tax is as follows:

(c) Factors that may affect future tax charges

Production of gas and oil within the UK continental shelf is subject to several taxes: corporation tax at 30% (2008: 30%) on profits of gas and oil production; supplementary charge at 20% (2008: 20%) on profits of gas and oil production (adjusted for financing costs); petroleum revenue tax (PRT) at 50% (2008: 50%) on income generated from certain gas and oil production (net of certain costs).

PRT is a deductible expense for the purposes of corporation tax and the supplementary charge. The effective rate of tax suffered on profits of UK gas production therefore falls between 50% and 75%. To the extent that the Group’s profits are earned from UK oil and gas production, its effective tax rate will remain above the current UK statutory rate of 28% (2008: 28%).

Income earned in North America and other territories outside the UK is generally subject to higher effective rates of tax than the current UK statutory rate. In the medium term, the Group’s effective tax rate is expected to remain above the UK statutory rate.

12. Dividends

The prior year final dividend was paid on 10 June 2009 (2008: 11 June). The interim dividend was paid on 11 November 2009 (2008: 12 November).

The Directors propose a final dividend of 9.14 pence per ordinary share (totalling £470 million) for the year ended 31 December 2009. The dividend will be submitted for formal approval at the Annual General Meeting to be held on 10 May 2010 and, subject to approval, will be paid on 16 June 2010 to those shareholders registered on 30 April 2010.

13. Auditors’ remuneration

It is the Group’s policy to seek competitive tenders for all major consultancy and advisory projects. Appointments are made taking into account factors including expertise, experience and cost. In addition, the Board has approved a detailed policy defining the types of work for which the auditors can tender and the approvals required. In the past, the auditors have been engaged on assignments in addition to their statutory audit duties where their expertise and experience with the Group are particularly important, including tax advice, due diligence reporting and reporting accountant services on acquisitions.

14. Earnings per ordinary share

Basic earnings per ordinary share has been calculated by dividing the earnings attributable to equity holders of the Company for the year of £844 million (2008: loss of £137 million) by the weighted average number of ordinary shares in issue during the year of 5,121 million (2008: 4,198 million). The Directors believe that the presentation of adjusted basic earnings per ordinary share, being the basic earnings per ordinary share adjusted for certain re-measurements, exceptional items and the impact of Strategic Investments, assists with understanding the underlying performance of the Group, as explained in note 2. The reconciliation of basic to adjusted basic earnings per ordinary share is as follows:

Venture

The Group obtained a controlling interest in the Venture Group on 27 August 2009. The fair values attributable to the acquired assets, liabilities and contingent liabilities arising on acquisition are set out in note 37. Fair value adjustments amounting to £651 million have been made to interests acquired in oil and gas fields to report these at their acquisition-date fair values amounting to £1,748 million (included within property, plant and equipment). The fair value adjustments are provisional as the Directors have not yet reached final determination on all aspects of the fair value exercise. The Directors will finalise the fair values within 12 months of the acquisition date. The acquired oil and gas field interests are depreciated over their remaining useful economic lives on a unit of production basis in accordance with the Group’s accounting policies as set out in note 2. As explained in note 2, the depreciation relating to fair value uplifts relating to the acquired property, plant and equipment and related taxation is excluded in arriving at adjusted earnings for the year, which amounted to £20 million depreciation and a taxation credit of £10 million in the period.

British Energy

The Group acquired a 20% interest in British Energy on 26 November 2009 and accounts for its interest as an investment in associate as set out in note 19. As explained in note 3, the Group has undertaken a provisional notional fair value exercise at the date of acquisition to allocate the cost of the investment to the individual assets, liabilities and contingent liabilities at their acquisition-date fair values. The fair values attributed are provisional as the Directors have not yet reached final determination on all aspects of the fair value exercise. The Directors will finalise the fair values within 12 months of the acquisition date. The Group’s share of provisional fair value adjustments made to the existing nuclear power stations amounts to £1,275 million resulting in an acquisition-date fair value attributable to these stations of £1,549 million. The nuclear power stations are depreciated over their useful economic lives in accordance with the Group’s accounting policies as set out in note 2. As explained in note 2, the impact of depreciation arising on fair value uplifts attributed to the nuclear power stations and related taxation included within the Group’s share of the post-taxation results of the associate is excluded in arriving at adjusted earnings for the period, which amounted to £7 million net of taxation.

Certain re-measurements (notes 2 and 8) included within operating profit and discontinued operations comprise re-measurements arising on energy procurement activities and re-measurements of proprietary trades in relation to cross-border transportation or capacity contracts. All other re-measurements are included within results before exceptional items and certain re-measurements.

In addition to basic and adjusted basic earnings per ordinary share, information is presented for diluted and adjusted diluted earnings per ordinary share. Under this presentation, no adjustments are made to the reported earnings for either 2009 or 2008, however the weighted average number of shares used as the denominator is adjusted for potentially dilutive ordinary shares. In 2008, no outstanding awards or options were considered to be potentially dilutive for diluted earnings per ordinary share, because doing so would have decreased the loss per ordinary share. However, potentially dilutive ordinary shares were taken into account when calculating adjusted diluted earnings per ordinary share.

15. Goodwill

16. Other intangible assets

17. Impairment testing of goodwill and intangibles with indefinite useful lives

(a) Carrying amount of goodwill and intangible assets with indefinite useful lives allocated to cash-generating units

Goodwill acquired through business combinations and indefinite-lived intangible assets have been allocated for impairment testing purposes to individual cash-generating units each representing the lowest level within the Group at which the goodwill or indefinite-lived intangible asset is monitored for internal management purposes as follows:

(b) Basis on which recoverable amount has been determined

Value in use calculations have been used to determine recoverable amounts for all of the goodwill and indefinite-lived intangible asset balances noted above, with the exception of the impairment test for the Upstream UK – Gas production and development cash-generating unit, where fair value less costs to sell has been used as the basis for determining recoverable amount.

(i) Value in use

The value in use calculations use pre-tax cash flow projections based on the Group’s internal Board-approved three-year business plans. The Group’s business plans are based on past experience, and adjusted to reflect market trends, economic conditions, key risks, the implementation of strategic objectives and changes in commodity prices, as appropriate. Commodity prices used in the planning process are based in part on observable market data and in part on internal estimates. The extent to which the commodity prices used in the business plans are based on observable market data is determined by the extent to which the market for the underlying commodity is judged to be active. Note 29 provides additional detail on the active period of each of the commodity markets in which the Group operates.

Cash flows beyond the three-year plan period have been extrapolated using growth rates in line with historic long-term growth rates in the market where the cash-generating unit operates.

Cash flows are discounted using a discount rate specific to each cash-generating unit to determine the cash-generating unit’s value in use, which is then deemed to be its recoverable amount. The recoverable amount is compared to the carrying value of each cash-generating unit’s net assets to determine whether the carrying values of any of the Group’s goodwill or indefinite-lived intangible asset balances are greater than their corresponding recoverable amounts.

(ii) Fair value less costs to sell

Fair value less costs to sell is used as the basis for determining the recoverable amount of goodwill allocated to Upstream UK – Upstream gas and oil. This methodology is deemed to be more appropriate as it is based on the post-tax cash flows arising from each field within Upstream UK – Upstream gas and oil. This is consistent with the approach taken by management to evaluate the economic value of the underlying assets.

Fair value less costs to sell is determined by discounting the post-tax cash flows expected to be generated by the gas production and development assets within Upstream UK – Upstream gas and oil, net of associated selling costs, taking into account those assumptions that market participants would use in estimating fair value. Post-tax cash flows are derived from projected production profiles of each field within Upstream UK – Upstream gas and oil, taking into account forward prices for gas and liquids over the relevant period.

Where forward market prices are not available, prices are determined based on internal model inputs. Note 29 provides additional detail on the active period of each of the commodity markets in which the Group operates.

The date of cessation of production depends on the interaction of a number of variables, such as the recoverable quantities of hydrocarbons, production costs, the contractual duration of the licence area and the selling price of the gas and liquids produced. As each field has specific reservoir characteristics and economic circumstances, the post-tax cash flows for each field are computed using individual economic models and key assumptions as determined by management. Post-tax cash flows used in the fair value less costs to sell calculation for the first three years are based on the Group’s internal Board-approved three-year business plans and, thereafter, are based on long-term production and cash flow forecasts. Where necessary, the business plan and long-term forecasts are updated in the economic models to reflect the latest view of each field as at the balance sheet date. The future post-tax cash flows are discounted using a post-tax nominal discount rate of 7% to determine the fair value less costs to sell of Upstream UK – Upstream gas and oil. Fair value less costs to sell is compared to the carrying value of the Upstream UK – Upstream gas and oil cash-generating unit to determine whether goodwill is impaired. The discount rate used in the fair value less costs to sell calculation is determined in the same manner as the discount rates used in the value in use calculations described below, with the exception of the adjustment required to determine an equivalent pre-tax discount rate that is not required for the fair value less costs to sell calculation.

(c) Key rates used in value in use calculations

(i) Growth rate to perpetuity

Long-term growth rates are determined using a blend of publicly available historical data and long-term growth rate forecasts published by external analysts.

(ii) Discount rates

Discount rates reflect the current market assessments of the time value of money and are derived from the Group’s weighted average cost of capital. Risks specific to cash-generating units are reflected within cash flow forecasts. Each cash-generating unit’s weighted average cost of capital is then adjusted to reflect the impact of tax in order to calculate an equivalent pre-tax discount rate.

Long-term growth rates used in the value in use calculations for each of the Group’s cash-generating units are provided in the table below together with pre-tax discount rates.

(iii) Inflation rates

Inflation rates used in the three-year business plan were based on a blend of a number of publicly available inflation forecasts available in the UK, Canada and the US. Inflation rates used for the value in use calculations were as follows: UK – 1.7% in 2010–2012, Canada – 1.8% in 2010–2012 and the US – 2.0% in 2010–2012.

(d) Key assumptions used and summary of results

(i) Downstream UK – Business energy supply and services

Key assumptions

• Gross margin percentage: based on the contractual terms for customers on existing contracts and gross margin percentages achieved in the period leading up to approval of the business plan for new and renewal customers, adjusted to reflect current market conditions and higher expected transportation costs.
• Revenues: based on the average market share achieved immediately prior to the approval of the business plan, adjusted for growth forecasts based on sales and marketing activity and recent customer acquisitions, with prices based on forward market curves for both gas and electricity.
• Operating costs: based on a projection of headcount in line with expected activity and salary increases based on inflation expectations, with a slight increase in the provision for credit losses experienced historically to reflect the current economic environment in the UK.

Summary of results

The recoverable amount of the Downstream UK – Business energy supply and services cash-generating unit exceeded its carrying value at the impairment test date. Reasonably possible changes in the key assumptions listed above would not cause the recoverable amount of the goodwill to be equal to or less than the carrying amount.

(ii) Downstream UK – Residential services – Dyno-Rod

Key assumptions

• Gross margin percentage: based on gross margins achieved in the period leading up to the approval of the business plan.
• Revenues: based on revenue levels achieved in the period leading up to the approval of the business plan adjusted for the impact of increased marketing spend and the targeting of key accounts with individual sales staff, with a slight reduction in growth rates to reflect the current economic environment in the UK.
• Operating costs: based on a projection of headcount in line with expected activity and salary increases based on inflation expectations.

Summary of results

The recoverable amount of the Downstream UK – Residential services – Dyno-Rod cash-generating unit exceeded its carrying value at the impairment test date. Reasonably possible changes in the key assumptions listed above would not cause the recoverable amount of the goodwill or indefinite-lived intangible asset to be equal to or less than their carrying amounts.

(iii) Upstream UK – Upstream gas and oil

Key assumptions

• Cash inflows: based on forward market prices for gas and oil for the active period of the market and internal model inputs thereafter, with reserve volumes and production profiles based on internal management or operator estimates.
• Cash outflows: based on forecast capital and operating expenditure and the estimated future costs of abandonment.
• Taxation: based on tax rates expected to be in effect at the point of the forecast cash flow.

Summary of results

The recoverable amount of the Upstream UK – Gas production and development cash-generating unit exceeded its carrying value at the impairment test date. Reasonably possible changes in the key assumptions listed above would not cause the recoverable amount of the goodwill to be equal to or less than the carrying amount.

(iv) North America – Residential energy supply

Key assumptions

• Gross margin percentage: based on contractual terms for customers on existing contracts and gross margin percentages achieved in the period leading up to the approval of the business plan for new and renewal customers, adjusted to reflect competitor data, where available. Where applicable, regulated gross margin percentages are based on the gross margin percentages included in regulatory applications submitted to the Alberta Utilities Commission in Canada.
• Revenues: based on average market share by individual market sector achieved in the period immediately prior to the approval of the business plan, adjusted for expectations of growth or decline based on individual jurisdictions to reflect regulatory or competitive differences, including customer propensity to switch, and contractual prices, with non-contractual prices based on forward market gas and power curves in Canada and the US.
• Operating costs: based on a projection of headcount in line with expected activity and salary increases based on inflation expectations, with a slight decrease in costs to reflect planned business process efficiencies.

Summary of results

The recoverable amount of the North America – Residential energy supply cash-generating unit exceeded its carrying value at the impairment test date. Reasonably possible changes in the key assumptions listed above would not cause the recoverable amount of the goodwill to be equal to or less than the carrying amount.

(v) North America – Business energy supply

Key assumptions

• Gross margin percentage: based on contractual terms for gross margin under contract and historical experience for planned renewals and new sales. Unit margins were planned to achieve an acceptable return on risk adjusted capital.
• Revenues: based on historical growth trends and planned sales activities by individual market sector. Prices are based on forward market curves for gas and electricity in Canada and the US.
• Operating costs: based on historical trends adjusted to reflect expected cost optimisations, as well as improved bad debt performance as a result of assumed economic and credit market recovery.

Summary of results

The recoverable amount of the North America – Business energy supply cash-generating unit exceeded its carrying value at the impairment test date. Reasonably possible changes in the key assumptions listed above would not cause the recoverable amount of the goodwill to be equal to or less than the carrying amount.

(vi) North America – Residential and business services

Key assumptions

• Gross margin percentage: based on gross margin percentages achieved in the period leading up to the approval of the business plan, adjusted to reflect the current economic conditions and housing decline in North America.
• Revenues: based on historical growth trends by individual market sector, adjusted for new product offerings and continued penetration into new markets.
• Operating costs: based on projected headcount and inflationary increases.

Summary of results

An amount of £3 million of goodwill attributable to the North America – Residential and business services cash-generating unit was written off as a result of the Appliances division being classified as held for sale (in accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued Operations, the assets should be written down to the lower of their cost and recoverable amount). The recoverable amount of the North America – Residential and business services cash-generating unit exceeded its carrying value at the impairment test date. Reasonably possible changes in the key assumptions listed above would not cause the recoverable amount of the goodwill to be equal to or less than the carrying amount.

18. Property, plant and equipment

During 2009, declining commodity prices have given rise to impairment charges within Upstream UK – Power generation (£35 million), Upstream UK – Upstream gas and oil (£22 million) and North America – Upstream and wholesale energy (£30 million). The impairment charges arise as a result of the assets being written down to the higher of their value in use (Upstream UK – Power generation) or fair value less costs to sell (Upstream UK – Upstream gas and oil, and North America – Upstream and wholesale energy). Note 17 provides more detail on the general approach to impairment calculations and provides the assumptions used to assess Upstream UK – Upstream gas and oil for impairment. For North America – Upstream and wholesale energy, fair value less cost to sell is determined based on evidence from recent acquisition transactions for similar assets in the local oil and gas market, net of estimated selling costs.

For Upstream UK – Power generation assets, the future cash flows were discounted using a pre-tax discount rate of 7.6%. The key assumptions are:

• Cash inflows: based on forward market prices for power for the active period of the market and internal models thereafter, with production profiles based on best economic running decision;
• Cash outflows: based on planned operating and capital expenditure; and
• Taxation: based on tax rates expected to be in effect at the point of the forecast cash flow.

The net book value of assets to which title was restricted at 31 December 2009 was £374 million (2008: £351 million), of which £324 million (2008: £351 million) relates to the Spalding power station finance lease asset. The net book value of assets pledged as security for liabilities as at 31 December 2009 was £157 million (2008: £nil).

19. Interests in joint ventures and associates

British Energy

The Group acquired a 20% interest in British Energy for £2,255 million and NNB Holding Company Limited for £32 million on 26 November 2009, including transaction costs of £15 million which were unpaid at 31 December 2009. As explained in note 2, the Group has undertaken a provisional notional fair value exercise at the date of acquisition to allocate the cost of the investment to the individual assets, liabilities and contingent liabilities at their acquisition-date fair values. The fair values attributed at acquisition date are provisional as the Directors have not yet reached final determination on all aspects of the fair value exercise. The Directors will finalise the fair values within 12 months of the acquisition date. The Group’s share of loss arising from its investment in British Energy for the period 26 November 2009 to 31 December 2009 as set out in the table above includes the effect of unwinding the fair value adjustments. As explained in note 2 the depreciation, net of taxation, arising on fair value uplifts attributed to the nuclear power stations is reversed in arriving at adjusted profit for the period as shown in the reconciliation table below and as set out in notes 6 and 14.

20. Inventories

The Group consumed £786 million of inventories (2008: £515 million) during the year. Write-downs of inventory of £3 million (2008: £23 million) were recognised in gross profit during the year to reflect the impact of a reduction in the forward market price of gas on the net realisable value of gas in storage and transportation, with £1 million recognised in Direct Energy and £2 million recognised in Centrica Energy.