AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON May 5, 2006April 30, 2007
 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 20-F
   
(Mark One)  
o
 REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
 
or
 
þ
 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
  for the fiscal year ended December 31, 20052006
or
 
o
 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
  for the transition period from           to
o
 SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
  Date of event requiring this shell company report
 
  If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12-b2 of the Exchange Act).  Yes o     No o
Commission file number 1-16055
PEARSON PLC
(Exact name of Registrant as specified in its charter)
England and Wales
(Jurisdiction of incorporation or organization)
80 Strand
London, England WC2R 0RL
(Address of principal executive offices)
Securities registered or to be registered pursuant to Section 12(b) of the Act:
   
Title of Class Name of Each Exchange on Which Registered
   
*Ordinary Shares, 25p par value New York Stock Exchange
American Depositary Shares, each Representing One Ordinary Share, 25p per Ordinary Share New York Stock Exchange
 
Not for trading, but only in connection with the registration of American Depositary Shares, pursuant to the requirements of the SEC.
 
Securities registered or to be registered pursuant to Section 12(g) of the Act:
None
 
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
None
 
     Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock at the close of the period covered by the annual report:
     
Ordinary Shares, 25p par value  804,020,000806,108,760 
     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes þ         No o
     Indicate by check mark which financial statement item the Registrant has elected to follow:
Item 17 þ                   Item 18 o
     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes þ         No o
     If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.    Yes o         No þ
     Note — Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations under those Sections.
     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ         No o
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer”, in Rule 12b-2 of the Exchange Act. (Check one):
       
þLarge accelerated filer oAccelerated filer oNon-accelerated filer
     Indicate by check mark which financial statement item the Registrant has elected to follow:
Item 17þItem 18o
     If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):
Yes o                           No þ
 
 


TABLE OF CONTENTS
       
    Page
     
   Introduction  4 
   Forward-Looking Statements  4 
 PART I
  Identity of Directors, Senior Management and Advisers  6 
  Offer Statistics and Expected Timetable  6 
  Key Information  6 
   Selected Consolidated Financial Data  6 
   Dividend Information  8 
   Exchange Rate Information  89 
   Risk Factors  9 
  Information on the Company  1213 
   Pearson  1213 
   Overview of Operating Divisions  1214 
   Our Strategy  1214 
   Operating Divisions  1315 
     Pearson Education  1315 
     The FT Group  1416 
     The Penguin Group  1617
Operating Cycles18 
   Competition  1618 
   Intellectual Property  1719 
   Raw Materials  1719 
   Government Regulation  1719 
   Licenses, Patents and Contracts  1719 
   Recent Developments  1719 
   Organizational Structure  1720 
   Property, Plant and Equipment  1820 
  Unresolved Staff Comments  1921 
  Operating and Financial Review and Prospects  1921 
   General Overview  1921 
   Results of Operations  2427 
   Liquidity and Capital Resources  3740 
   Accounting Principles  3943 
  Directors, Senior Management and Employees  4243 
   Directors and Senior Management  4243 
   Compensation of Senior Management  4445 
   Share Options of Senior Management  4951 
   Share Ownership of Senior Management  5152 
   Employee Share Ownership Plans  5153 
   Board Practices  5153 
   Employees  5254 
  Major Shareholders and Related Party Transactions  5355 
  Financial Information  5355 
   Legal Proceedings  5355 
  The Offer and Listing  5356 
  Additional Information  5457
Memorandum and Articles of Association57
Material Contracts61
Exchange Controls62
Tax Considerations62
Documents on Display64 
  Quantitative and Qualitative Disclosures About Market Risk  6264 
   Introduction  62
Interest Rates62
Currency Exchange Rates63
Forward Foreign Exchange Contracts63
Description of Securities Other Than Equity Securities64 

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    Page
     
Interest Rates65
Currency Exchange Rates65
Forward Foreign Exchange Contracts66
Derivatives66
Description of Securities Other Than Equity Securities67
 PART II
  Defaults, Dividend Arrearages and Delinquencies  6467 
  Material Modifications to the Rights of Security Holders and Use of Proceeds  6467 
  Controls and Procedures  6467
Disclosure Controls and Procedures67
Management’s Annual Report on Internal Control Over Financial Reporting67
Change in Internal Control Over Financial Reporting68 
  Audit Committee Financial Expert  6568 
  Code of Ethics  6568 
  Principal Accountant Fees and Services  6568 
  Exemptions from the Listing Standards for Audit Committees  6669 
  Purchases of Equity Securities by the Issuer and Affiliated Purchases  6669 
 PART III
  Financial Statements  6669 
  Financial Statements  6669 
  Exhibits  6669 
Exhibit 8.1
Exhibit 12.1
Exhibit 12.2
Exhibit 13.1
Exhibit 13.2
Exhibit 15

3


INTRODUCTION
      In this Annual Report on Form 20-F (the “Annual Report”) references to “Pearson”, the “Company” or the “Group” are references to Pearson plc, its predecessors and its consolidated subsidiaries, except as the context otherwise requires. “Ordinary Shares” refer to the ordinary share capital of Pearson of par value 25p each. “ADSs” refer to American Depositary Shares which are Ordinary Shares deposited pursuant to the Deposit Agreement dated March 21, 1995, amended and restated as of August 8, 2000 among Pearson, The Bank of New York as depositary (the “Depositary”) and owners and holders of ADSs (the “Deposit Agreement”). ADSs are represented by American Depositary Receipts (“ADRs”) delivered by the Depositary under the terms of the Deposit Agreement.
      We have prepared the financial information contained in this Annual Report in accordance with European Union(“EU”)-adopted International Financial Reporting Standards (“IFRS”), which differ in certain significant respects from generally accepted accounting principles in the United States, or US GAAP. We describe these differences in “Item 5. Operating and Financial Review and Prospects — Accounting Principles”, and in note 3536 to our consolidated financial statements included in “Item 17. Financial Statements” of this Annual Report. Unless we indicate otherwise, any reference in this Annual Report to our consolidated financial statements is to the consolidated financial statements and the related notes, included elsewhere in this Annual Report.
      We publish our consolidated financial statements in sterling. We have included, however, references to other currencies. In this Annual Report:
 • references to “sterling”, “pounds”, “pence” or “£” are to the lawful currency of the United Kingdom,
 
 • references to “euro” or “” are to the euro, the lawful currency of the participating Member States in the Third Stage of the European Economic and Monetary Union of the Treaty Establishing the European Commission, and
 
 • references to “US dollars”, “dollars”, “cents” or “$” are to the lawful currency of the United States.
      For convenience and except where we specify otherwise, we have translated some Sterlingsterling figures into US dollars at the rate of £1.00 = $1.72,$1.96, the noon buying rate in The City of New York for cable transfers and foreign currencies as certified by the Federal Reserve Bank of New York for customs purposes on December 30, 2005,29, 2006, the last business day of 2005.2006. We do not make any representation that the amounts of sterling have been, could have been or could be converted into dollars at the rates indicated. On April 28, 2006March 30, 2007 the noon buying rate for sterling was £1.00 = $1.82.$1.97.
FORWARD-LOOKING STATEMENTS
      You should not rely unduly on forward-looking statements in this Annual Report. This Annual Report, including the sections entitled “Item 3. Key Information — Risk Factors”, “Item 4. Information on the Company” and “Item 5. Operating and Financial Review and Prospects”, contains forward-looking statements that relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terms such as “may”, “will”, “should”, “expect”, “intend”, “plan”, “anticipate”, “believe”, “estimate”, “predict”, “potential”, “continue” or the negative of these terms or other comparable terminology. Examples of these forward-looking statements include, but are not limited to, statements regarding the following:
 • operations and prospects,
 
 • growth strategy,
 
 • funding needs and financing resources,
 
 • expected financial position,
 
 • market risk,

4


 • currency risk,
 
 • US federal and state spending patterns,
 
 • debt levels, and
 
 • general market and economic conditions.

4


      These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. In evaluating them, you should consider various factors, including the risks outlined under “Item 3. Key Information — Risk Factors”, which may cause actual events or our industry’s results to differ materially from those expressed or implied by any forward-looking statement. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.

5


PART I
ITEM 1.IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS
      Not applicable.
ITEM 2.OFFER STATISTICS AND EXPECTED TIMETABLE
      Not applicable.
ITEM 3.KEY INFORMATION
Selected Consolidated Financial Dataconsolidated financial data
      The tabletables below showsshow selected consolidated financial data under IFRS and US GAAP. Under US GAAP, the consolidated financial data has been presented for each of the years in the five-year period ended December 31, 2005.2006. The Company adopted IFRS on January 1, 2003. As a result, in accordance with the instructions of Form 20-F, selected consolidated financial data under IFRS is only presented for each of the years in the four-year period ended December 31, 2006. The selected consolidated profit and loss account data for the years ended December 31, 2006, 2005 2004 and 20032004 and the selected consolidated balance sheet data as at December 31, 2005, 20042006 and 20032005 have been derived from our audited consolidated financial statements included in “Item 17. Financial Statements” in this Annual Report and have been prepared in accordance with IFRS.Report.
      Our consolidated financial statements for the year ended December 31, 2005 have been prepared in accordance with IFRS, which differs from US GAAP in certain significant respects. See “Item 5. Operating and Financial Review and Prospects — Accounting Principles” and note 3536 to the consolidated financial statements. The consolidated financial statements contain a reconciliation to US GAAP of profit/lossprofit for the financial year, shareholders’ funds and certain other financial data.
      The selected consolidated financial information should be read in conjunction with “Item 5. Operating and Financial Review and Prospects” and our consolidated financial statements and the related notes appearing elsewhere in this Annual Report. The information provided below is not necessarily indicative of the results that may be expected from future operations.
      For convenience, we have translated the 20052006 amounts into US dollars at the rate of £1.00 = $1.72,$1.96, the noon buying rate in The City of New York on December 30, 2005.
Restatement
      In accordance with EU regulations, the Company has prepared the financial statements as at December 31, 2005 in accordance with EU-adopted International Financial Reporting Standards (IFRS) and International Financial Reporting Interpretations Committee interpretations (IFRIC). Consolidated financial statements of Pearson until December 31, 2004 had been prepared in accordance with UK GAAP. UK GAAP differs in certain respects from IFRS. When preparing the Group’s 2005 consolidated financial statements, management has amended certain accounting, valuation and consolidation methods applied in the UK GAAP financial statements to comply with IFRS. The comparative figures in respect of 2004 and 2003 were restated to reflect these adjustments. See note 34 to our consolidated financial statements for an explanation of the effects of transition to IFRS.29, 2006.

6


                 
  Year Ended December 31
   
  2005 2005 2004 2003
         
    IFRS IFRS IFRS
  IFRS £ £ £
  $
  (In millions, except for per share amounts)
IFRS Information:
                
Consolidated Profit and Loss Account Data
                
Statutory Measures
                
Total sales  7,045   4,096   3,696   3,850 
Total operating profit/(loss)  922   536   404   406 
Profit/(loss) after taxation from continuing operations  588   342   262   252 
Profit/(loss) for the financial year  1,108   644   284   275 
Basic earnings/(loss) per equity share(4) $1.35   78.2p  32.9p  31.7p
Diluted earnings/(loss) per equity share(5) $1.34   78.1p  32.9p  31.7p
Dividends per ordinary share $0.46   27.0p  25.4p  24.2p
Consolidated Balance Sheet Data
                
Total assets (Fixed assets plus Current assets)  13,072   7,600   6,578   6,736 
Shareholders funds  6,130   3,564   2,800   2,969 
Long-term obligations(6)  (4,300)  (2,500)  (2,403)  (1,982)
Capital stock(1)  346   201   201   201 
Number of equity shares outstanding
(millions of ordinary shares)
  804   804   803   802 
                     
  Year ended December 31
   
  2006 2006 2005 2004 2003
           
    IFRS IFRS IFRS IFRS
  IFRS £ £ £ £
  $
  (In millions, except for per share amounts)
IFRS information:
                    
Consolidated Income Statement data
                    
Total sales  8,109   4,137   3,808   3,479   3,651 
Total operating profit  1,058   540   516   382   401 
Profit after taxation from continuing operations  892   455   330   248   249 
Profit for the financial year  919   469   644   284   275 
Basic earnings per equity share(4)  $1.10   55.9p  78.2p  32.9p  31.7p
Diluted earnings per equity share(5)  $1.09   55.8p  78.1p  32.9p  31.7p
Dividends per ordinary share  $0.57   29.3p  27.0p  25.4p  24.2p
Consolidated Balance Sheet data at period end
                    
Total assets (Fixed assets plus Current assets)  14,137   7,213   7,600   6,578   6,736 
Shareholders funds  6,813   3,476   3,564   2,800   2,969 
Long-term obligations(6)  (3,632)  (1,853)  (2,500)  (2,403)  (1,982)
Capital stock(1)  396   202   201   201   201 
Number of equity shares outstanding
(millions of ordinary shares)
  806   806   804   803   802 
                         
  Year Ended December 31
   
  2005 2005 2004 2003 2002 2001
             
    £ £ £ £ £
  $  
  (In m illions, except for per share amounts)
US GAAP Information(7):
                        
Consolidated Profit and Loss Account Data
                        
Statutory Measures
                        
Total sales  7,045   4,096   3,696   3,879   4,320   4,225 
Total operating profit/(loss)(2)  746   434   260   364   453   (389)
Profit/(loss) after taxation from continuing operations  330   192   203   198   219   (1,483)
Profit/(loss) for the financial year(8)  707   411   182   173   189   (1,500)
Profit/(loss) from continuing operations for the financial year(3)  299   174   166   160   221   (424)
(Loss)/profit from discontinued operations(3)  (3)  (2)  16   16   (10)  (91)
Profit/(loss) on disposal of discontinued operations(3)  411   239      (3)  (1)  (985)
Basic earnings/(loss) per equity share(4) $0.89   51.5p  22.9p  21.8p  23.7p  (188.6)p
Diluted earnings/(loss) per equity share(5) $0.88   51.4p  22.8p  21.8p  23.7p  (188.6)p
Basic earnings/(loss) from continuing operations per equity share(1)(4) $0.37   21.8p  20.9p  20.1p  27.8p  (53.3)p
Diluted earnings/(loss) from continuing operations per equity shares(3)(5) $0.37   21.7p  20.8p  20.1p  27.8p  (53.3)p
Basic (loss)/earnings per share from discontinued operations(3)(4) $0.51   29.7p  2.0p  1.7p  (4.1)p  (135.3)p
Diluted (loss)/earnings per share from discontinued operations(3)(5) $0.51   29.7p  2.0p  1.7p  (4.1)p  (135.3)p
Dividends per ordinary share $0.46   27.0p  25.4p  24.2p  22.7p  21.9p
Consolidated Balance Sheet Data
                        
Total assets  13,416   7,800   7,040   7,101   6,767   8,280 
Shareholders’ funds  6,601   3,838   3,218   3,333   4,155   4,155 
Long-term obligations(6)  (4,123)  (2,397)  (2,392)  (1,951)  (2,026)  (2,829)
                          
  Year ended December 31
   
  2006 2006 2005 2004 2003 2002
             
    £ £ £ £ £
  $  
  (I n millions, except for per share amounts)
US GAAP information(7):
                        
Consolidated Income Statement data
                        
Total sales(8)  8,292   4,231   3,892   3,562   3,774   3,896 
Total operating profit(2)  902   460   364   269   361   408 
Profit after taxation from continuing operations  823   420   182   170   197   185 
Net income for the year  668   341   411   182   173   189 
Profit from continuing operations for the year(3)  780   398   164   153   159   187 
(Loss)/profit from discontinued operations(3)  (112)  (57)  8   29   17   24 
Profit/(loss) on disposal of discontinued operations(3)        239      (3)  (1)
Basic earnings per equity share(4) $0.84   42.7p  51.5p  22.8p  21.8p  23.7p
Diluted earnings per equity share(5) $0.83   42.6p  51.4p  22.8p  21.8p  23.7p
Basic earnings from continuing operations per equity                        
 Share(1)(4) $0.98   49.9p  20.5p  19.2p  20.0p  23.5p
Diluted earnings from continuing operations per equity Shares(3)(5) $0.97   49.8p  20.5p  19.2p  20.0p  23.5p
Basic (loss)/earnings per share from discontinued operations(3)(4) $(0.14)  (7.2)p  31.0p  3.6p  1.8p  2.9p
Diluted (loss)/earnings per share from discontinued operations(3)(5) $(0.14)  (7.2)p  30.9p  3.6p  1.8p  2.9p
Dividends per ordinary share $0.57   29.3p  27.0p  25.4p  24.2p  22.7p

7


                         
  Year ended December 31
   
  2006 2006 2005 2004 2003 2002
             
    £ £ £ £ £
  $  
  (I n millions, except for per share amounts)
Consolidated Balance Sheet data at period end
                        
Total assets  14,351   7,322   7,800   7,040   7,101   6,767 
Shareholders’ funds  7,019   3,581   3,838   3,218   3,333   4,155 
Long-term obligations(6)  (3,622)  (1,848)  (2,397)  (2,392)  (1,951)  (2,026)
 
(1) Capital stock and the number of equity shares outstanding are the same under both IFRS and US GAAP.
 
(2) Total operating profit under US GAAP includes a loss of £2m in 2006 (2005: £nil; 2004: profit of £nil in 2005 (a profit of £14 million in 2004 and a loss of £7 million in 2003)£14m) on the sale of fixed assets and investments. Additionally, the US GAAP operating profit includes the operating profit impact of the GAAP adjustments discussed in note 3536 in “Item 17. Financial Statements”.
 
(3) Discontinued operations under both IFRS and US GAAP comprise the results of Pearson Government Solutions for all years presented, Recoletos Grupo de Comunicacion SA for all years presented2005, 2004, 2003 and 2002 and the results of RTL Group for 2002 and 2001.2002. Discontinued operations under US GAAP also include the results of the Forum Corporation for 2003 2002 and 2001.2002.
 
(4) Basic earnings/lossearnings per equity share is based on profit/loss for the financial period and the weighted average number of ordinary shares in issue during the period.
 
(5) Diluted earnings/lossearnings per equity share is based on diluted earnings/lossearnings for the financial period and the diluted weighted average number of ordinary shares in issue during the period. Diluted earnings/lossearnings comprise earnings/lossearnings adjusted for the tax benefit on the conversion of share options by employees and the weighted average number of ordinary shares adjusted for the dilutive effect of share options.
 
(6) Long-term obligations comprise any liabilities with a maturity of more than one year, including medium and long-term borrowings, derivative financial instruments, pension obligations and deferred income tax liabilities.
 
(7) See note 3536 to the consolidated financial statements included in this Annual Report entitled “Summary of principal differences between International Financial Reporting Standards and United States of America generally accepted accounting principles”.
 
(8) The loss of £1,500 millionCommencing in 2001 is after charging goodwill amortization of £527 million. Since 2002, goodwill2006, the Company has no longerincluded within Sales, shipping and handling fees and costs, distribution income and subrights income, which were previously reflected on a net basis within operating expenses. Sales figures for all prior years presented have been subject to amortization under US GAAP. See note 35 in “Item 17. Financial Statements”revised for comparative purposes (2006: £94m; 2005: £84m; 2004: £83m; 2003: £94m; and 2002: £109m).
Dividend Informationinformation
      We payThe Group pays dividends to holders of ordinary shares on dates that are fixed in accordance with the guidelines of the London Stock Exchange. OurThe board of directors normally declares an interim dividend in July or August of each year to be paid in September or October. OurThe board of directors normally recommends a final dividend following the end of the fiscal year to which it relates, to be paid in the following May or June, subject to shareholders’ approval at our annual general meeting. At ourthe annual general meeting on April 21, 200627, 2007 our shareholders approved a final dividend of 17.0p18.8p per ordinary share for the year ended December 31, 2005.2006.

8


      The table below sets forth the amounts of interim, final and total dividends paid in respect of each fiscal year indicated, and is translated into cents per ordinary share at the noon buying rate in the city of New York on each of the respective payment dates for interim and final dividends. The final dividend for the 20052006 fiscal year will be paid on May 2006.11, 2007.
                                                
Fiscal Year Interim Final Total Interim Final Total
Fiscal year Interim Final Total Interim Final Total
                        
 (Pence per ordinary share) (Cents per ordinary share) (Pence per ordinary share) (Cents per ordinary share)
2006
  10.5  18.8  29.3  20.6  36.8  57.4 
2005
  10.0  17.0  27.0  17.2  29.2  46.4   10.0  17.0  27.0  17.2  29.2  46.4 
2004  9.7  15.7  25.4  18.6  30.2  48.8   9.7  15.7  25.4  18.6  30.2  48.8 
2003  9.4  14.8  24.2  16.7  26.4  43.1   9.4  14.8  24.2  16.7  26.4  43.1 
2002  9.1  14.3  23.4  14.7  23.0  37.7   9.1  14.3  23.4  14.7  23.0  37.7 
2001  8.7  13.6  22.3  12.6  19.7  32.3 
      Future dividends will be dependent on our future earnings, financial condition and cash flow, as well as other factors affecting the Group.
Exchange Rate Informationrate information
      The following table sets forth, for the periods indicated, information concerning the noon buying rate for sterling, expressed in dollars per pound sterling. The average rate is calculated by using the average of the noon buying rates in the city of New York on each day during a monthly period and on the last day of each month

8


during an annual period. On December 30, 2005, the noon buying rate for sterling was £1.00 = $1.72. On April 28,29, 2006, the noon buying rate for sterling was £1.00 = $1.82.$1.96. On March 30, 2007 the noon buying rate for sterling was £1.00 = $1.97.
         
Month High Low
     
April 2006 $1.82  $1.74 
March 2006 $1.76  $1.73 
February 2006 $1.78  $1.73 
January 2006 $1.79  $1.74 
December 2005 $1.77  $1.72 
November 2005 $1.78  $1.71 
         
Month High Low
     
March 2007 $1.97  $1.92 
February 2007 $1.97  $1.94 
January 2007 $1.98  $1.93 
December 2006 $1.98  $1.95 
November 2006 $1.97  $1.89 
October 2006 $1.91  $1.85 
        
Year Ended December 31 Average Rate
Year ended December 31 Average rate
    
2006 $1.84 
2005 $1.81  $1.81 
2004 $1.84  $1.83 
2003 $1.63  $1.63 
2002 $1.51  $1.51 
2001 $1.45 
Risk Factorsfactors
     You should carefully consider the risk factors described below, as well as the other information included in this Annual Report. Our business, financial condition or results from operations could be materially adversely affected by any or all of these risks, or by other risks that we presently cannot identify.
Our US educational textbook and testing businesses may be adversely affected by changes in state educational funding resulting from either general economic conditions, changes in government educational funding, programmes and legislation (both at the federal and state level), and/or changes in the state procurement process.
      The results of our US educational textbook and testing business depends on the level of US and state educational funding and this funding is a significant influence on our ability to grow.
      With the improvement in the US economy state educational expenditure has increased as state tax receipts have increased, reducing or eliminating state budget deficits, thereby minimizing the risk that state educational expenditure is cut or deferred. Federal legislative changes can also affect the funding available for educational expenditure, e.g. the No Child Left Behind Act. These might also include changes in the procurement process for textbooks, learning material and student tests, particularly in the adoptions market. For example, changes in curricula, delays in the timing of the adoptions and changes in the student testing process can all affect these programs and therefore the size of our market in any given year.
      There are multiple competing demands for educational funds and there is no guarantee that states will fund new textbooks or testing programs, or that we will win this business.
Our newspaper businesses may be adversely affected by reductions in advertising revenues and/or circulation either due to weak general economic conditions or competing news information distribution channels, particularly online and digital formats.
      Our newspaper businesses are highly geared and remain dependent on advertising revenue; relatively small changes in revenue, positive or negative, have a disproportionate affect on profitability. We are beginning to see an increase in advertising revenues compared to prior years, however any downturn in corporate and financial advertising spend would negatively impact our results.
      Changes in consumer purchasing habits, as readers look to alternative sources and/or providers of information, such as the internet and other digital formats, may change the way we distribute our content. We might see a decline in print circulation in our more mature markets as readership habits change and readers migrate online, although we see further opportunities for growth in our less mature markets outside Europe. If the migration of readers to new digital formats occurs more quickly than we expect, this is likely to affect print advertising spend by our customers, adversely affecting our profitability.

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Our intellectual property and proprietary rights may not be adequately protected under current laws in some jurisdictions and that may adversely affect our results and our ability to grow.
      Our products largely comprise intellectual property delivered through a variety of media, including newspapers, books and the internet. We rely on trademark, copyright and other intellectual property laws to establish and protect our proprietary rights in these products.
      We cannot be sure that our proprietary rights will not be challenged, invalidated or circumvented. Our intellectual property rights in countries such as the United StatesUS and the United Kingdom, which are theUK, jurisdictions withcovering the largest proportionsproportion of

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our operations, are well established. However, we also conduct business in other countries where the extent of effective legal protection for intellectual property rights is uncertain, and this uncertainty could affect our future growth. Moreover, despite trademark and copyright protection, third parties may copy, infringe or otherwise profit from our proprietary rights without our authorization.
      These unauthorized activities may be more easily facilitated by the internet. The lack of internet-specific legislation relating to trademark and copyright protection creates an additional challenge for us in protecting our proprietary rights relating to our online business processes and other digital technology rights. The loss or diminution in value of these proprietary rights or our intellectual property could have a material adverse effect on our business and financial performance. In that regard, Penguin Group (USA) Inc. and Pearson Education have joined three other major US publishers in a suit brought under the auspices of the Association of American Publishers to challenge Google’s plans to copy the full text of all books ever published without permission from the publishers or the authors. This lawsuit seeks to demarcate the extent to which search engines, and other internet operators and libraries may rely on the fair-use doctrine to copy content without authorization from the copyright proprietors, and may give publishers and authors more control overon-line online users of their intellectual property. If the lawsuit is unsuccessful, publishers and authors may not be ableunable to control copying of their content for purposes of on-lineonline searching, which could have an adverse impact on our business and financial performance.
The contracting risks associated with our Professional division within Pearson Education are complexOur US educational textbook and couldtesting businesses may be adversely affect our financial resultsaffected by changes in state educational funding resulting from either general economic conditions, changes in government educational funding, programs and growth prospects.legislation (both at the federal and state level), and/or changes in the state procurement process.
      Our Professional division provides services ranging from call center operationsThe results and growth of our US educational textbook and testing business is dependent on the level of US and state educational funding, which in turn is dependent on the robustness of state finances and the level of funding allocated to complete outsourcing of administrative functions. Customers are government agencies and professional organizations, mainlyeducational programs. Federal and/or state legislative changes can also affect the funding available for educational expenditure, e.g. the No Child Left Behind Act.
      Similarly changes in the USAstate procurement process for textbooks, learning material and student tests, particularly in the UK, and commercial businesses. These services are provided under contracts with values that vary significantly, from a few million to several hundred million pounds overadoptions market can also affect our markets. For example, changes in curricula, delays in the termtiming of the contract, whichadoptions and changes in the student testing process can run from one to ten years in length. The resultsall affect these programs and therefore the size of our Professional division can be significantlymarket in any given year.
      There are multiple competing demands for educational funds and there is no guarantee that states will fund new textbooks or testing programs, or that we will win this business.
Our newspaper businesses may be adversely affected by reductions in advertising revenues and/or circulation either because of competing news information distribution channels, particularly online and digital formats, or due to weak general economic conditions.
      Changes in consumer purchasing habits, as readers look to alternative sources and/or providers of information, such as the internet and other digital formats, may change the way we distribute our content. We might see a decline in print circulation in our more mature markets as readership habits change and readers migrate online, although we see further opportunities for growth in our less mature markets outside Europe. If the migration of readers to new digital formats occurs more quickly than we expect, this is likely to affect print advertising spend by our customers, adversely affecting our profitability.
      Our newspaper businesses are highly geared and remain dependent on advertising revenue; relatively small changes in revenue, positive or negative, have a small number of large contracts.
      Asdisproportionate effect on profitability. We are beginning to see an increase in advertising revenues compared to prior years, however any long-term contracting business, there are inherent risks associated with the bidding process, operational performance, contract compliance (including penalty clauses), indemnification (if available)downturn in corporate and contract re-bidding, which could adversely affectfinancial advertising spend would negatively impact our financial performance and/or reputation. In addition, US government contracts are subject to audit and investigation by the applicable contracting government entity and may otherwise be investigated by the government, and this can result in payment delays and, in certain circumstances, reductions in the amounts received, penalties or other sanctions.results.

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A control breakdown in our school testing businesses could result in financial loss and reputational damage.
      There are inherent risks associated with our school testing businesses, both in the USA and the UK. A breakdown in our testing and assessment products and processes could lead to a mis-grading of student tests and/or late delivery of test results to students and their schools. In either event we may be subject to legal claims, penalty charges under our contracts, non-renewal of contracts andand/or in the case of our UK testing business, the suspension or withdrawal of our accreditation.accreditation to conduct tests. It is also possible that such events would result in adverse publicity, which may affect our ability to retain existing contracts and/or obtain new customers.
      We have recently experienced adverse publicity as a result of the rescoring of the October 2005 Scholastic Aptitude Test, or SAT, in the USA. We provide answer sheet scanning services for the College Board, which administers the SAT. We rescanned approximately 1.5 million tests taken in October 2005 through January 2006 and, as a result, the College Board reissued higher scores for about 4,400 out of

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approximately 495,000 tests taken in October. We have also been named along with the College Board as a defendant in a class action lawsuit filed as a result of the revised scores.
Changes inOur professional services and school testing businesses involve complex contractual relationships with both government agencies and commercial customers for the Penguin businessprovision of various testing services. Our financial results, growth prospects and/or reputation may restrict our ability to growbe adversely affected if these contracts and our profitability.relationships are not managed.
      New distribution channels, e.g. digital format, the internet, used books, combinedThese businesses are characterized by multi-million pound contracts spread over several years. As in any contracting business, there are inherent risks associated with the concentration of retailer power pose multiple threats tobidding process, start-up, operational performance and contract compliance (including penalty clauses) which could adversely affect our traditional consumer publishing models. Penguin’s financial performance can also be negatively affected if book return rates increase.and/or reputation.
      Several of these businesses are dependent on either single or a small number of large contracts. Failure to retain these contracts at the end of the contract term would adversely impact our future revenue growth. At Edexcel, our UK Examination board and testing business, any change in UK Government policy to exam marking and student testing could have a significant impact on our present business model.
We operate in a highly competitive environment that is subject to rapid change and we must continue to invest and adapt to remain competitive.
      Our education, business information and book publishing businesses operate in highly competitive markets. These markets constantly change in response to competition, technological innovations and other factors. To remain competitive we continue to invest in our authors, products, services and services.people. There is no guarantee that these investments will generate the anticipated returns or protect us from being placed at a competitive disadvantage with respect to scale, resources and our ability to develop and exploit opportunities.
      Specific competitive threats we face at present include:
 • Students seeking cheaper sources of content, e.g. on-line, used books or importedre-imported textbooks. To counter this trend we introduced our own on-line format (called SafariX) and are providing students with a greater choice and customization of our products.
 
 • Competition from major publishers and other educational material and service providers in our US educational textbook and testing businesses.
 
 • Penguin — Authors’ advances in consumer publishing. We compete with other publishing businesses forto purchase the rights to author manuscripts. In certain instances author advances can beOur competitors may bid up to a level at which we cannotcould not generate a sufficient return on our investment.investment, and so, typically, we would not purchase these rights.
• People — the investments we make in our employees, combined with our employment policies and practices, we believe are critical factors enabling us to recruit and retain the very best people in our business sectors. However, some of our markets are presently undergoing radical restructuring with several of our competitors up for sale, particularly in the Education sector. New owners, particularly private equity, may try to recruit our key talent as part of this industry restructuring.
At Penguin, changes in product distribution channels, increased book returns and/or customer bankruptcy may restrict our ability to grow and affect our profitability.
      New distribution channels, e.g. digital format, the internet, used books, combined with the concentration of retailer power pose multiple threats (and opportunities) to our traditional consumer publishing models, potentially impacting both sales volumes and pricing.

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      Penguin’s financial performance can also be negatively affected if book return rates increase above historical average levels. Similarly, the bankruptcy of a major retail customer would disrupt short-term product supply to the market as well as result in a large debt write off.
We operate in markets which are dependent on Information Technology systems and technological change.
      All our businesses, to a greater or lesser extent, are dependent on technology. We either provide software and/or internet services to our customers or we use complex information technology systems and products to support our business activities, particularly in business information publishing, back-office processing and infrastructure.
      We face several technological risks associated with software product development and service delivery in our educational businesses, information technology security (including virus and hacker attacks), e-commerce, enterprise resource planning system implementations and upgradesupgrades. The failure to recruit and retain staff with relevant skills may constrain our ability to grow as we combine traditional publishing products with online and service offerings.
Operational disruption to our business caused by a major disaster and/or external threat such as Avian Flu, restricting our ability to supply products and services to our customers.
      Across all our businesses we manage complex operational and logistical arrangements including distribution centers, third-party print sites, data centers and large office facilities. Failure to recover from a major disaster, e.g. fire, flood etc, at a key facility or the disruption of supply from a key third-party vendor could restrict our ability to service our customers. Similarly external threats, such as Avian Flu, terrorist attacks, strikes etc, could all affect our business and employees, disrupting our daily business activities.
      We have developed business continuity arrangements, including IT disaster recovery plans, to minimize any business disruption in the event of a major disaster. However, despite regular updates and testing of these plans there is no guarantee that our financial performance will not be adversely affected in the event of a major disaster at a key data center.and/or external threat to our business. Insurance coverage may minimize any losses in certain circumstances.
Investment returns outside our traditional core US and UK markets may be lower than anticipated.
      To minimize dependence on our core markets, particularly the US, we are seeking growth opportunities outside these markets, building on our existing substantial international presence. Certain markets we may target for growth are inherently more risky than our traditional markets. Political, economic, currency and corporate governance risks (including fraud) as well as unmanaged expansion are all factors which could limit our returns on investments made in these non-traditional markets.
Our reported earnings and cash flows may be adversely affected by changes in our pension costs and funding requirements due to poor investment returns and/or changes in pension regulations.requirements.
      We operate a number of pension schemesplans throughout the world, the principal ones being in the UK and US. The major schemesplans are self-administered with the schemes’plans’ assets held independently of the Group. Regular valuations, conducted by independent qualified actuaries, are used to determine pension costs and funding requirements.
      It is our policy to ensure that each pension schemeplan is adequately funded, over time, to meet its ongoing and future liabilities. Our earnings and cash flows may be adversely affected by lowerthe need to provide additional funding to eliminate pension fund deficits in our defined benefit plans. Our greatest exposure relates to our UK defined benefit pension plan. Pension fund deficits have/may arise because of inadequate investment returns, due to a general deteriorationincreased member life expectancy, changes in equity or bond markets, requiring increased company funding of these schemes to eliminate any deficits over time. Similarly,actuarial assumptions and changes in pension regulations, including accounting rules may affectand minimum funding requirements.
      The latest valuation of our UK defined benefit pension costsplan has been completed and future funding status.arrangements have been agreed between the Company and the pension fund Trustee. Additional payments

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amounting to £100m will be made by the Company in 2007. We review these arrangements every three years and are confident that the pension funding plans are sufficient to meet future liabilities without unduly affecting the development of the Company.
Social, environmental and ethical risk
      We consider social, environmental and ethical (SEE) risks no differently to the way we manage any other business risk. Our 2006 risk assessments did not identify any significant under-managed SEE risks, nor have any of our most important SEE risks, many concerned with reputational risk, changed year on year. These are:
• Journalistic/author integrity;
• Ethical business behavior;
• Compliance with UN Global Compact principles on labor standards, human rights, environment and anti-corruption;
• Environmental impact;
• People;
• Data privacy.
Sarbanes-Oxley (SOX) 404 Compliance costChanges in our tax position can significantly affect our reported earnings and cash flows.
      Beginning withThere are several factors which may affect our 2006 fiscal year, we will be required to comply with section 404reported tax rate and/or level of SOX relating to internal control over financial reporting. Our SOX 404 implementation project commencedtax payments in 2003 and we believe wethe future. The most important are on track to be compliant. However, the cost of complying with SOX 404 may reduce our earnings.as follows:

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We generate• Changes in corporate tax rates and/or other relevant tax laws in the UK and/or the US could have a substantial proportionmaterial impact on our future reported tax rate and/or our future tax payments.
• A material shortfall in profits of our revenueUS businesses below the level projected in foreign currencies, particularlyour strategic plans would require us to reconsider the amount of the deferred tax asset relating to US dollar, and foreign exchange rate fluctuationsnew operating losses in our balance sheet (£126m at December 31, 2006). This could adversely affect our earnings.lead to a material increase in the reported tax rate.
We generate a substantial proportion of our revenue in foreign currencies, particularly the US dollar, and foreign exchange rate fluctuations could adversely affect our earnings and the strength of our balance sheet.
      As with any international business, our earnings can be materially affected by exchange rate movements. We are particularly exposed to movements in the US dollar to sterling exchange rate as approximately 65% of our revenue is generated in US dollars. We estimate that if 20042005 average rates had prevailed in 2005,2006, sales for 20052006 would have been £46 million£44m or 1% lower.higher. This is predominantly a currency translation risk (i.e., non-cash flow item), and not a trading risk (i.e., cash flow item), as our currency trading flows are relatively limited. Pearson generates about two-thirds of its sales in the US and each five cent change in the average £:$ exchange rate for the full year (which in 2006 was £1:$1.84 and in 2005 was £1:$1.81) would have an impact of 1p on earnings per share. We estimate that a five cent change in the averageclosing exchange rate between the US dollar and sterling in any year could affect our reported earnings per shareshareholders’ funds by approximately 1 pence.£85m.
ITEM 4.INFORMATION ON THE COMPANY
Pearson
      Pearson is a global publishing company with its principal operations in the education, business information and consumer publishing markets. We have significant operations in the United States, where we generate over 65% of our revenues, and in the United Kingdom and continental Europe. We create and manage intellectual property, which we promote and sell to our customers under well-known brand names, to inform, educate and entertain. We deliver our content in a variety of forms and through a variety of channels,

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including books, newspapers and internet services. We increasingly offer services as well as content, from test processing to training.
      Pearson was incorporated and registered in 1897 under the laws of England and Wales as a limited company and re-registered under the UK Companies Act as a public limited company in 1981. We conduct our operations primarily through our subsidiaries and other affiliates. Our principal executive offices are located at 80 Strand, London WC2R 0RL, United Kingdom (telephone: +44 (0) 20 7010 2000).
Overview of Operating Divisionsoperating divisions
      Although our businesses increasingly share markets, brands, processes and facilities, they consist of three core operations:
     Pearson Educationis a global leader in educational publishing and services.the world’s leading education company. We are a leading international publisher of textbooks, supplementary materials and electronic education programs for elementaryteachers and secondary school, higher educationstudents of all ages, and business and professional markets worldwide. We alsowe play a major role in the testing and certification of school students and professionals, mainly in the US but increasingly in the UK.professionals. Pearson Education consists of the following three operating segments:
 • School — publisher, provider of testing and software services for primary and secondary schoolsschools;
 
 • Higher Education — publishespublisher of textbooks and related course materials for colleges and universitiesuniversities;
 
 • Professional — publishespublisher of texts, reference and interactive products for industry professionals. ProvidesProvider of various testing and service arrangements for government departments and professional bodies.
     The FT Group consistsis a leading provider of our international newspaper,business and financial news, data, comment and analysis, in print and online financial information, business magazine and professional publishing interests. Our flagship product is theFinancial Times, published internationally and known for its premium editorial content and international scope both in newspaper and internet formats.online. The FT Group comprises the following operating segments:
 • FT Publishing — publishespublisher of theFinancial Times, other business newspapers, magazines and specialistfinancial information and intelligence;
 
 • Interactive Data (“IDC”) — providesprovider of financial and business information to financial institutions and retail investors.
     The Penguin Groupis one of the premierworld’s foremost English language publishers in the world, with brand imprints such as Penguin, Putnam, Berkley, Viking and Dorling Kindersley (“DK”).publishers. We publish the works of many authors in an extensive portfolio of fiction, non-fiction, reference and illustrated works.works under imprints including Penguin, Hamish Hamilton, Putnam, Berkley, Viking and Dorling Kindersley.
Our Strategystrategy
      Since 1997,Over the past decade we have reshapedtransformed Pearson by divestingfocusing on companies which provide ‘education’ in the broadest sense of the word; companies that educate, inform and entertain. Through a rangecombination of non-core interestsorganic investment and investing over $7 billion in education, consumer publishing and business information companies. Eachacquisitions, we have built each one of our businesses into a leader in its market, and we have integrated our operations where appropriate so that our businesses can share assets, brands, processes, facilities, technology and central services.

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aims      Our goal is to benefit from educating, informingproduce sustainable growth on our three key financial measures — adjusted earnings per share, cash flow and entertaining peoplereturn on invested capital — which we believe are, together, good indicators that we are building the long-term value of Pearson.
      We do this by investing consistently in an increasingly knowledge-based economy. Our strategy is:four areas, which are common to all our businesses:
 • to focus on businesses which provide “education,”Content: We invest steadily in unique, valuable publishing content and keep replenishing it. Over the broadest sense of the word, through intellectual property;past five years, for example, we have invested $1.6bn in new content in our education business alone.
 
 • to provide a combination of publishing, bothTechnology and services: We invested early and consistently in print and online, and related servicestechnology, believing that, make our publishing more valuable and take us into new, faster-growing markets;
• to continue to invest in the growthdigital world, content alone would not be enough. In 2006, we generated more than $1bn in sales from technology products and services, and our testing and assessment businesses, serving school students and professionals, made more than $1bn of our businesses, including:sales, up from around $200m seven years ago.

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 • extendingInternational markets: Though we currently generate two-thirds of our lead in education publishing, investing in new programs for students in School and Higher Education and in testing and software services that help educators to personalize the learning process, bothsales in the US, our brands, content and technology-plus-services models work around the world;world. All parts of Pearson are investing in selected emerging markets, where the demand for information and education is growing particularly fast.
 
 • developingEfficiency: We have invested to become a leaner, more efficient company, through savings in our fast-growing contractingindividual businesses which provide testing and other servicesthrough a strong centralized operations structure. Over the past five years, we have increased our profit margins from 9.9% to corporations13.4% and government agencies;
• building the international reachreduced average working capital as a percentage of theFinancial Times  — bothsales in print through its four editions worldwidePearson Education and online through FT.com — and enhancing the market positions of our network of national business newspapers around the world; and
• growing our position in consumer publishing, balancing our investment across our stable of best-selling authors, new talent and our own home-grown content;Penguin from 30.7% to 26.3%, freeing up cash for further investment.
      We believe this strategy can create a virtuous circle — efficiency, investment, market share gains and scale — which in turn can produce sustainable growth on our financial goals and the value of the Company.
• to foster a collaborative culture which facilitates greater productivity and innovation by sharing processes, costs, technology, talent and assets across our business;
• to capitalize on the growth prospects in our markets and on our leaner operations to improve profits, cash flows and returns on invested capital.
Operating Divisionsdivisions
Pearson Education
      Pearson Education is one of the world’s largest publishers of textbooks and online teaching materials based on published sales figures and independent estimates of sales. Pearson Educationmaterials. It serves the growing demands of teachers, students, parents and professionals throughout the world for stimulating and effective education programs. With federalprograms in print and state governments increasingly required to measure academic progress against clear objective standards, the market for educational testing services in the United States has grown significantly, as have markets around the world. Our integrated approach to education has helped us grow faster because of our breadth.online.
      We report Pearson Education’s performance by the three market segments it serves: School, Higher Education and Professional. In 2005,2006, Pearson Education had sales of £2,663 million£2,591m or 65%63% of Pearson’s total sales (63% in 2004).(2005: 62%) and contributed 68% (2005: 63%) to Pearson’s total operating profit.
School
      In the United States, ourOur School business includescontains a unique mix of publishing, testing and software operations.technology products, which are increasingly integrated. It generates around two-thirds of its sales in the US.
      In the US, we publish high quality curriculum programs for school students covering subjects such as reading, literature, maths, science and social studies. We publish under a range of well-known imprints that include Scott Foresman in the elementary school market and Prentice Hall in secondary. Our school testing business is the leading provider of test development, processing and scoring services to US states and the federal government, processing some 40 million tests each year. We are also the leading provider of electronic learning programs for schools, and of ‘Student Information Systems’ technology which enables schools and districts to record and manage information about student attendance and performance.
      In the US, more than 90% of government funds for schools comes from state or local government, with the remainder coming from federal sources. Our School company’s major customers are state education boards and local school districts.
      Outside of the United States,US, we have a growing English Language Teaching business and we also publish school and college materials in local languages in a number of countries. In the United States, we publish for pre-kindergarten through 12th grade, with a comprehensive range of textbooks, supplementary materials and electronic education programs. Pearson Education’s elementary school imprint, Pearson Scott Foresman, and secondary school imprint, Pearson Prentice Hall School, publish high quality programs covering subjects such as reading, literature, math, science and social studies. We also publish supplementary teaching aids for both elementary and secondary schools and teacher-written activity books. We are a leading publisher in online assessment and digital courseware through Pearson Digital Learning, whose offerings include SuccessMaker, NovaNet and the Waterford Early Reading Program. Through Pearson Achievement Solutions, we provide professional development for teachers in kindergarten through 12th grade with the use of the latest technologies and software tools to improve classroom teaching.
      In the US, Pearson’s assessments & testing operations are leading service providers in the markets for test development, processing and scoring and the provision of enterprise software solutions to schools. We score and process some 40 million student tests across the United States each year.

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      Pearson School Systems provides district-wide solutions that combine the power of assessment, student information, financial systems and actionable reporting to improve student performance. We are the market leader in student information with our solutions used by over 20% of schools nationwide and we are theworld’s leading provider of English Language Teaching materials for children and adults, published under the newest technologies for benchmarkwell-known Longman imprint. We are also a leading provider of testing, assessment and student progress analysis.
      Over 90% of education spending for kindergarten through 12th grade inqualification services. Our key markets outside the United States is financed atUS include Canada, the state or local level, withUK, Australia, Italy, Spain, South Africa, Hong Kong and the remainder coming from federal funds. The School division’s major customers are state education boards and local school districts. In the United States, 21 states, which account for over 50% of the total kindergarten through 12th grade US school population of some 53 million students, buy educational programs by means of periodic statewide “adoptions”. These adoptions cover programs in the core subject areas. Typically, a state committee selects a short-list of education programs from which the school districts then make individual choices. We actively seek to keep as many of our offerings as possible on the approved list in each state, and we sell directly to the school districts. In the states without adoptions, called “open territories”, local school districts choose education programs from the entire range available. We actively sell to school districts in open territories as well.
      In 2004, Edexcel won a five year contract for the administration and marking of “Key Stage” testing for 11 and 14 year old students in the UK. Edexcel also began electronic scanning and marking of GCSE and A-level exams in 2004. 4 million scripts were marked electronically in 2005.Middle East.
Higher Education
      Pearson Education is the United States’ largest publisher, by sales, of textbooks and related course materials for colleges and universities. We publish across all of the main fields of study with imprints such as Pearson Prentice Hall, Pearson Addison Wesley, Pearson Allyn & Bacon and Pearson Benjamin Cummings. Our sales forces call on college educators, who chooseTypically, professors or other instructors select or ‘adopt’ the textbooks and online resources to be purchasedthey recommend for their students, which students then purchase either in a bookstore or online. Today the majority of our textbooks are accompanied by their students. In 2005, 1.8 million college students registered for our online offerings,services which include homework and assessment products, onlinetools, study guides and textbook companion websites. Many of our online offerings are integrated with course management systems that provide easy-to-use tools that enable professors to create online courses. We have also introduced new

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formats such as downloadable audio study guides and electronic textbooks which are sold on subscription. In addition, ourwe have a fast-growing custom publishing business Pearson Custom,which works with professors to produce textbooks and online resources specifically adapted for their particular course. In 2006, our Higher Education business generated approximately 80% of its sales in the US. Outside the US, we adapt our textbooks and technology services for individual markets, and we have a growing local publishing program. Our key markets outside the US include Canada, the UK, Benelux, Mexico, Germany, Hong Kong, Taiwan and Malaysia.
Professional
      WeOur Professional education businesses publish text, reference,educational materials and interactive productsprovide testing and qualifications services for IT industry professionals, graphics and design users of all types, and consumers interested in software applications and certification, professional business books, and strategy guides for those who use PC and console games. Publishingadults. Our publishing imprints in this area include Addison Wesley Professional, Prentice Hall PTR, and Cisco Press (IT professional imprints)(for IT professionals), Peachpit Press and New Riders Press (graphics and design imprints)professionals), Que/Sams (consumer and professional imprint) and Prentice Hall Financial Times (business imprint)(for the business education market). We also generate revenues through our own website — InformIT, and through Safari Books Online (a joint venture with O’Reilly Media). We also provide services to professional markets, managing several commercialhave a fast-growing Professional Testing business, Pearson VUE, which manages major long-term contracts to implement and executeprovide qualification and assessment systems for individual professions, including IT professionalsservices through its network of test centers around the world. Key customers include major technology companies, the Graduate Management Admissions Council, the National Association of Securities Dealers and nurses.
      Our Government Solutions group manages and processes student loan applications on behalf of the US Department of Education. It also provides a number ofnon-education and other testing and service-related contracts with various government agencies both within and outside the US.
UK’s Driving Standards Agency. We also provide a range of data collection and management services, including scanners, to a wide range of customers. We also provide corporate training coursesIn December 2006, the Group announced that it had agreed to professionals.
      Contracts includesell Pearson Government Solutions to Veritas Capital, a seven year contractprivate equity firm. This operation is disclosed as discontinued in the years ended December 31, 2006, 2005 and 2004. The assets and liabilities of Pearson Government Solutions have been reclassified to develop and delivernon-current assets held for sale in the Graduate Management Admissions Test (GMAT) worldwide, beginning in January 2006 and a nine year,non-exclusive contract to deliver the National Association of Security Dealers exams.Group’s Consolidated Balance Sheet as at December 31, 2006.
The FT Group
      The FT Group one of the world’s leading business information sources, aims to provideprovides a broad range of data, analysis and services to an audience of internationally-minded business people.people and financial institutions. In 2005,2006, the FT Group had sales of £629 million,£698m, or 15%17% of Pearson’s total sales (16% in 2004)(2005: 17%), and contributed 21% of Pearson’s operating profit (2005: 25%). The
      It has two major parts: FT Group’sPublishing, our network of international and national business is global,

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producing a combination of news, data, comment, analysisnewspapers and context. In addition to professionalonline services; and business consumers, individuals worldwide are demanding such strategic business information.Interactive Data Corporation, our 62%-owned financial information company.
FT Publishing
      TheFinancial Timesis athe world’s leading international daily business newspaper. Its average daily circulation of 439,563430,469 copies in December 2005,2006, as reported by the Audit Bureau of Circulation, gives theFinancial Times the second largest circulation of any English language business daily in the world. TheFinancial Times derived approximately 67% of its revenue in 2005 from advertising and approximately 33% from print and online content sales. The geographic distribution of theFinancial Times average daily circulation in 2005 was:is split as follows:
     
United Kingdom/ Republic of Ireland  3231%
Continental Europe Africa and Middle East27%
Americas  31%
Americas29%
Asia  89%
Rest of the World2%
      TheFinancial Times is printed on contract in 23 cities around the world and our sales mix is increasingly international. The newspaper draws upon an extensive local network of correspondents to produce unique, informative and timely business information. For production and distribution, theFinancial Times uses computer-driven communications and printing technology for timely deliveryIn 2006, approximately 70% of the various editions of the newspaper to the appropriate geographic markets. TheFinancial Times is distributedFT’s revenues were generated through independent newsagents and direct delivery to homes and institutions.
advertising. The FT seeks to make itsalso sells content available both in print and advertising online through FT.com, its internet service, and sales of electronic content to third parties.FT.com. FT.com charges subscribers for detailed industry news, comment and analysis, while providing general news and market data to a wider audience. The business earns revenues by selling content directly, selling advertising and selling subscriptions. At the end of December 2005, FT.com had 84,000 paying subscribers and an average of 3.2 million unique monthly users.
      Our other business publishing interests include France’s leading business newspaper,Les Echos with an average daily 2005 circulation of 119,000 and lesechos.fr, its internet service.
      FT Publishing also includes: FT Business, produceswhich publishes specialist information on the retail, personal and institutional finance industries and publishes the UK’s premier personal finance magazine,through titles includingInvestors Chronicle together with,Money Management,Financial AdvisorAdviserandThe Banker for professional advisers; Les Echos, France’s leading business newspaper, and a number of joint ventures and associates in business publishing.

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      In August 2006, the Financial Times acquired Mergermarket, an online financial sector professionals.data and intelligence provider. The acquisition strengthens the FT Group, adding proprietary content, a premium customer base, reliable growth from new revenue sources and attractive financial characteristics to the organization.
Interactive Data Corporation
      Through our 62% interest in Interactive Data Corporation (“Interactive Data”), we are one of the world’sis a leading global providersprovider of financial market data, analytics and related services to financial institutions, active traders and individual investors. Interactive Data suppliesThe company’s businesses supply time-sensitive pricing, dividend, corporate action,evaluations and descriptive informationreference data for more than 3.5 million securities traded around the world, including hard-to-value instruments. Customers subscribe toinstruments such as illiquid bonds. We own 62% of Interactive Data’s services and useData Corporation; the company’s analytical tools in support of their trading, analysis, portfolio management, and valuation activities.remaining 38% is publicly traded.
Recoletos
      On December 14, 2004,April 8, 2005, the Group announced that we had accepted an offer fromcompleted the sale to Retos Catera S.A. to sellof our 79% stake in Recoletos, a publicly quoted Spanish media group that we built with its Spanish founding shareholders over a number of years,Group, for gross proceeds of743 million. The consortium of investors behind Retos Cartera included members of the Recoletos management team, individual Spanish investors and the Banesto banking group. We decided to accept the offer as Recoletos’ strategy in sport, lifestyle and general publications had taken it further away from Pearson’s core focus on financial and business news and information. The sale became unconditional in February, 2005 and net743m. Net cash proceeds of £371 million£371m were received on April 8, 2005 resulting in a profit on disposal of £306 million.£306m.
Joint Ventures and Associates
      As at 2005 year end,2006 year-end, the FT Group also had a number of other associates and joint ventures, including:
      A 50% interest inFT Deutschland, launched in February 2000, in partnership with Gruner + Jahr.FT Deutschland is a German language newspaper with a fully integrated online business news, analysis and data service. Its circulation grew by 6% in 2005 to 102,000 copies.

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      A 50% interest in The Economist Group, which publishes the world’s leading weekly business and current affairs magazine. Its circulation increased by 10% to 1,038,519 for the January to June 2005 period.
      A 50% interest in FTSE International, a joint venture with the London Stock Exchange, which publishes a wide range of global indices, including the important FTSE index.
      A 33% interest inVedomosti, a leading Russian business newspaper and a partnership venture with Dow Jones and IMH Media Ltd.
      A 50% interest inBusiness Day andFinancial Mail, publishers of South Africa’s leading financial newspaper and magazine.
      A 14% interest inBusiness Standard, India’s third largest daily financial newspaper.
• 50% interest in The Economist Group, publisher of the world’s leading weekly business and current affairs magazine.
• 50% interest inFT Deutschland, a German language business newspaper with a fully integrated online business news, analysis and data service.
• 50% interest in FTSE International, a joint venture with the London Stock Exchange, which publishes a wide range of global indices, including the important FTSE index.
• 33% interest inVedomosti, a leading Russian business newspaper.
• 50% interest inBusiness DayandFinancial Mail, publishers of South Africa’s leading financial newspaper and magazine.
• 14% interest inBusiness Standard, one of India’s leading business newspapers.
The Penguin Group
      Penguin is one of the world’s premier English language book publishers in the world.publishers. We publish an extensive backlist and frontlist of titles, including some of the very best new fiction and non-fiction, literary prize winners, commercial bestsellers, classics and commercial bestsellers. Our titles range from history and science to essential reference. We are also one of the pre-eminent classics publishers and publish some of the most highly prized and enduring brands in children’s publishing, featuring popular characters such as Spot, Peter Rabbit and Madeline, as well as the books of Roald Dahl.titles. We rank in the top three consumer publishers, based upon sales, in all major English speaking and related markets — the United States,US, the United Kingdom,UK, Australia, New Zealand, Canada, India and South Africa.
      Penguin publishes under many imprints including, in the adult market, Allen Lane, Avery, Berkley Books, Dorling Kindersley, Dutton, Hamish Hamilton, Michael Joseph, Plume, Putnam, Riverhead and Viking. Our leading children’s imprints include Puffin, Ladybird, Warne and Grosset & Dunlap. In 2005, Penguin’s US imprints placed 129 titles onThe New York Times bestseller list. In the United Kingdom, 54 Penguin titles featured on the Nielsen Bookscan top ten bestseller list. Our illustrated reference business, Dorling Kindersley, or DK, is the leading global publisher of high quality illustrated reference books. DK has built a unique graphic style that is now recognized around the world. It produces books for children and adults covering a huge variety of subjects including childcare, health, gardening, food and wine, travel, business and sports. Not only does DK’s “lexigraphic” design approach make its books easily translatable across cultures, but it has also formed the basis of a library of 2.5 million wholly-owned images which have many applications — in print and online.
      In 2005,2006, Penguin had sales of £804 million,£848m, representing 20% of Pearson’s total sales (21%(2005: 21%) and contributed 11% of Pearson’s operating profit (2005: 12%). Its largest market is the US, which generated around 60% of Penguin’s sales in 2004). Revenues are balanced between frontlist and backlist titles.2006. The Penguin Group earns over 95%around 99% of its revenues from the sale of hard cover and paperback books. The balance comes from audio books and from the sale and licensing of intellectual property rights, such as the Beatrix Potter series of fictional characters, and acting as a book distributor for a number of smaller publishing houses.
      We sell directly to bookshops and through wholesalers. Retail bookshops normally maintain relationships with both publishers and wholesalers and use the channel that best serves the specific requirements of an order. We also sell online through third parties such as Amazon.com.

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Operating cycles
      Pearson determines a normal operating cycle separately for each entity/cash generating unit within the Group with distinct economic characteristics. The “normal operating cycle” for each of the Group’s education businesses is primarily based on the expected period over which the educational programs and titles will generate cash flows, and also takes account of the time it takes to produce the educational programs.
      Particularly for the US School and Higher Education businesses, which represent more than 50% (by sales) of our education publishing businesses, there are well established cycles operating in the market:
• The School market is primarily driven by an adoption cycle in which major state education boards ‘adopt’ programs and provide funding to schools for the purchase of these programs. There is an established and published adoption cycle with new adoptions taking place on average every 5 years for a particular subject. Once adopted, a program will typically sell over the course of the subsequent 5 years. The Company renews its pre-publication assets to meet the market adoption cycles. Therefore the operating cycle naturally follows the market cycle.
• The Higher Education market has a similar pattern, with colleges and professors typically refreshing their courses and selecting revised programs on a regular basis, often in line with the release of new editions or new technology offerings. The Company renews its pre-publication assets to meet the typical demand for new editions of, or revisions to, educational programs. Analysis of historical data shows that the average life cycle of Higher Education content is 5 years. Again the operating cycle mirrors the market cycle.
      A development phase of typically 12 to 18 months for Higher Education and up to 24 months for School precedes the period during which the Company receives and delivers against orders for the products it has developed for the program.Non-US markets operate in a similar way although often with less formal ‘adoption’ processes.
      The operating cycles in respect of the Professional and Penguin Group’s gateway internet site, Penguin.com, provides accesssegments are more specialized in nature as they relate to its focused websiteseducational or heavy reference products released into smaller markets (e.g. the financial training, IT and travel sectors). Nevertheless, in these markets, there is still a regular cycle of product renewal, in line with demand which management monitor. Typically the United States, Canada, United Kingdomlife cycle is 5 years for Professional content and Australia. Websites have also been developed to target certain niche audiences. For example, Penguinclassics.com has an entire online service4 years for the classics, with anthologies, original essays, interviews and discussions and links to other classics sites.Penguin content.
Competition
      All of Pearson’s businesses operate in highly competitive environments.
      Pearson Education competes with other publishers and creators of educational materials and services. These companies include some small niche players and some large international companies, such asMcGraw-Hill, Reed Elsevier, Houghton Mifflin Riverdeep Group and Thomson.Thomson alongside smaller niche players that specialize in a particular academic discipline or focus on a learning technology. Competition is based on the ability to deliver quality products and services that address the specified curriculum needs and appeal to the school boards, educators and government officials making purchasing decisions.
      The FT Group’s newspapers, magazines and magazineswebsites compete with newspapers and other information sources, such asThe Wall Street Journal, by offering timely and expert journalism.analysis and insight. It competes for advertisers with

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other forms of media based on the ability to offer an effective means for advertisers to reach their target audience. The efficiencyIDC competes with Reuters, Bloomberg and Thomson Financial on a global basis for the provision of its cost basefinancial data to the back office. In Europe Telekurs is also a competitive factor.direct competitor for these services.
      The Penguin Group competes with other publishers of fiction and non-fiction books. Principal competitors include Random House, HarperCollins, and Hachette Livre. Publishers compete by developing a portfolio of books by established authors and by seeking out and promoting talented new writers.

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Intellectual Propertyproperty
      Our principal intellectual property assets consist of our trademarks and other rights in our brand names, particularly theFinancial Timesand the various imprints of Penguin and Pearson Education, as well as all copyrights in our content and our patents held in the testing business in the name of Pearson NCS. We believe we have taken all appropriate available legal steps to protect our intellectual property in all relevant jurisdictions.
Raw Materialsmaterials
      Paper is the principal raw material used by each of Pearson Education, the FT Group and the Penguin Group. We purchase most of our paper through our central purchasing department located in the United States. We have not experienced and do not anticipate difficulty in obtaining adequate supplies of paper for our operations, with sourcing available from numerous suppliers. While local prices fluctuate depending upon local market conditions, we have not experienced extensive volatility in fulfilling paper requirements. In the event of a sharp increase in paper prices, we have a number of alternatives to minimize the impact on our operating margins, including modifying the grades of paper used in production.
Government Regulationregulation
      The manufacture of certain of our products in various markets is subject to governmental regulation relating to the discharge of materials into the environment. Our operations are also subject to the risks and uncertainties attendant to doing business in numerous countries. Some of the countries in which we conduct these operations maintain controls on the repatriation of earnings and capital and restrict the means available to us for hedging potential currency fluctuation risks. The operations that are affected by these controls, however, are not material to us. Accordingly, these controls have not significantly affected our international operations. Regulatory authorities may have enforcement powers that could have an impact on us. We believe, however, that we have taken and continue to take measures to comply with all applicable laws and governmental regulations in the jurisdictions where we operate so that the risk of these sanctions does not represent a material threat to us.
Licenses, Patentspatents and Contractscontracts
      We are not dependent upon any particular licenses, patents or new manufacturing processes that are material to our business or profitability. Likewise, we are not materially dependent upon any contracts with suppliers or customers, including contracts of an industrial, commercial or financial nature.
Recent Developmentsdevelopments
      On January 9, 2006February 15, 2007 the Group completed the disposal of Pearson announcedGovernment Solutions, its Government services business, to Veritas Capital. Sale proceeds consist of $560m in cash, $40m in preferred stock and 10% of the purchaseequity of 1,130,739 shares in Interactive Data from an individual shareholderthe business. The Group expects to report a post tax loss on the disposal, as the capital gain for $21.67 per share in cash. This purchase brings Pearson’s total holding in Interactive Data to almost 62%.tax purposes will exceed any book gain.
      On January 23,September 30, 2006, Pearson announced the acquisitionGroup acquired 100% of the voting rights of Mergermarket, a financial information company providing information to financial institutions, corporations and their advisers. In addition, several other businesses were acquired in 2006 including Promissor, a leading professional testing business from Houghton Mifflin Company for $42m in cash.
      On April 25, 2006 Pearson announced the acquisition ofParavia Bruno Mondadori (PBM), National Evaluation Systems Inc, a leading teacher certification testing company(NES), PowerSchool and Chancery in the US.Education business and Quote.com in IDC.
      On May 5, 2006July 22, 2005, Pearson announcedacquired 100% of the acquisitionvoting rights of AGS Publishing, an 80% stakeeducational assessments and curriculum materials publisher.
      In addition, several other businesses were acquired in Paravia Bruno Mondadori, onethe current and prior years, none of Italy’s leading educational publishing companies.which were individually material to the Group.

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Organizational Structurestructure
      Pearson plc is a holding company which conducts its business primarily through subsidiaries and other affiliates throughout the world. Below is a list of our significant subsidiaries as at December 31, 2005,2006, including name, country of incorporation or residence, proportion of ownership interest and, if different, proportion of voting power held.

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    Percentage
    Interest/ Votinginterest/voting
Name Country of Incorporation/ Residenceincorporation/residence Powerpower
     
Pearson Education
      
Pearson Education Inc United States (Delaware)  100% 
Pearson Education Ltd England and Wales  100% 
NCS Pearson Inc United States (Minnesota)  100% 
FT Group
      
The Financial Times Limited England and Wales  100% 
Financial Times Business Ltd England and Wales  100% 
Mergermarket LtdEngland and Wales100%
Interactive Data Corporation United States (Delaware)  61%62% 
Les Echos SA France  100% 
The Penguin Group
      
Penguin Group (USA) Inc United States (Delaware)  100% 
The Penguin Publishing Co Ltd England and Wales  100% 
Dorling Kindersley Holdings Ltd England and Wales  100% 
Property, Plantplant and Equipmentequipment
      Our headquarters isare located at leasehold premises in London, England. We own or lease approximately 650 properties in more than 50 countries worldwide, the majority of which are located in the United Kingdom and the United States.
      All of the properties owned and leased by us are suitable for their respective purposes and are in good operating condition. These properties consist mainly of offices, distribution centers and computer centers.
      The vast majority of our printing is carried out by third party suppliers. We operate two small digital print operations as part of our Pearson Assessment and Testing businesses. These operations provide short-run and print-on-demand products, typically custom client applications.
      We own the following principal properties:
       
General Useuse of Propertyproperty Location Area in Square Feetsquare feet
     
Warehouse Pittstown, Pennsylvania, USA  510,000 
Warehouse Kirkwood, New York, USA  409,000 
Offices Iowa City, Iowa, USA  310,000 
Offices Old Tappan, New Jersey, USA  210,100210,112 
Warehouse/ officeOffices Cedar Rapids, Iowa, USA  205,000 
Warehouse/ Offices Reading, Massachusetts, USA  177,800177,822 
Offices London, UK  155,000 
Printing/ Processing Owatonna, Minnesota, USA  128,000 
Printing/ Processing Columbia, Pennsylvania, USA  121,400121,370 
Offices Eagan, Minnesota, USA  109,500 
Offices Mesa, Arizona, USA  96,000 

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      We lease the following principal properties:
       
General Useuse of Propertyproperty Location Area in Square Feetsquare feet
     
Warehouses/Offices Lebanon, Indiana, USA  1,091,4001,091,435 
Warehouse/ Offices Cranbury, New Jersey, USA  886,700886,747 
WarehouseWarehouse/Offices Indianapolis, Indiana, USA  737,850 
Warehouse/Offices Newmarket, Ontario, Canada  518,128 
Offices Upper Saddle River, New Jersey, USA  474,801 
Warehouse/Offices Rugby, UK  446,000
OfficesLondon, UK375,000446,077 
Offices Hudson St., New York, USA  302,000431,278
OfficesLondon, UK282,917 
Warehouse/Offices Austin, Texas, USA  226,100226,076 
Offices Boston, Massachusetts, USA  225,299 
Warehouse Scoresby, Victoria, Australia  215,820 
Offices Boston, Massachusetts, USA  191,360 
Offices Glenview, Illinois, USA  187,500 
Offices Bloomington, Minnesota, USA  151,056153,240 
Offices Parsippany, New Jersey, USA  143,800143,777 
Offices Harlow, UK  137,900 
Offices Chester, Virginia, USA  123,200
Warehouse/OfficesQuarry Bay, Hong Kong121,748 
Warehouse San Antonio Zomeyucan, Mexico  113,638 
Offices London, UK  112,000 
Offices New York, New York, USA  107,939 
OfficesLawrence Kansas, Kansas, USA105,000
Capital Expenditures
      See Item 5. “Operating and Financial Review and Prospects — Liquidity and Capital Resources” for description of the Company’s capital expenditures.
ITEM 4A.     UNRESOLVED STAFF COMMENTS
ITEM 4A.     UNRESOLVED STAFF COMMENTS
      There are no unresolved staff comments.
ITEM 5.     OPERATING AND FINANCIAL REVIEW AND PROSPECTS
ITEM 5.     OPERATING AND FINANCIAL REVIEW AND PROSPECTS
      The following discussion and analysis is based on and should be read in conjunction with the consolidated financial statements, including the related notes, appearing elsewhere in this Annual Report. The financial statements have been prepared in accordance with IFRS, which differs in certain significant respects from US GAAP. Note 3536 to our consolidated financial statements, included in “Item 17. Financial Statements”, provides a description of the significant differences between IFRS and US GAAP as they relate to our business and provides a reconciliation to US GAAP. These consolidated financial statements are the Group’s first financial statements to be prepared in accordance with IFRS, as adopted by the EU. Consolidated financial statements of Pearson up to and including December 31, 2004 had been prepared in accordance with UK GAAP. UK GAAP differs in certain respects from IFRS. When preparing the Group’s 2005 consolidated financial statements, management has amended certain accounting, valuation and consolidation methods applied in the UK GAAP financial statements to comply with IFRS. The comparative figures in respect of 2004 and 2003 were restated to reflect these adjustments. Note 34 included in “Item 17. Financial Statements”, describes how, in preparing the consolidated financial statements, the Group has applied accounting standards as adopted for use in the EU under the first-time adoption provisions as set out in IFRS 1.
General Overviewoverview
Introduction
      Sales from continuing operations increased from £3,696 million£3,808m in 20042005 to £4,096 million£4,137m in 2005,2006, an increase of 11%9%. The increase reflected growth across all the businesses together with a particularly strong performance at Pearson Education.additional contributions from acquisitions made in both 2005 and 2006. The year on year growth was impacted by exchange rates, but less so than in previous years.particular the US dollar. The average US dollar exchange rate strengthened slightlyweakened in 2005,2006, which had the effect of increasingreducing reported sales

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in 20052006 by £46 million£44m when compared to the equivalent figure at constant 20042005 rates. Reported operating profit increased by 33%5% from £404 million£516m in 20042005 to £536 million£540m in 2005. Pearson Education benefited from strong2006. All parts of the Group contributed to the operating profit increase through good sales growth and improved margins in the School and Higher Education businesses. FT Group benefited from improved profits largely as a result of increases in advertising revenues at FT Publishing and IDC’s continued strong organic growth and synergies from the integration of recent acquisitions. Penguin profits benefited from

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the effect of exchange rates but still improved from the prior year, with margins increasing despite only a small increase in sales.which more than offset an increased charge for intangible amortization. Included within operating profit in 2005 was the profit on the sale of MarketWatch of £40 million. Equivalent sales of businesses and investments£40m. There were no equivalent disposals in 2004 saw a profit of £9 million.2006. Reported operating profit in 20052006 was £12m higher£7m lower than the equivalent figure reported at constant 20042005 exchange rates.
      Profit before taxation in 20052006 of £466 million£466m compares to a profit before taxation of £325 million£446m in 2004.2005. The increase of £141 million£20m reflects the improved operating performance andoffset by a reductionsmall increase in net finance costs. Net finance costs reducedincreased from £79 million£70m in 20042005 to £70 million£74m in 2005. Net2006. The Group’s net interest payable benefited from the reductionincreased by £17m in average net debt following receipt of the proceeds from the sale of Recoletos and MarketWatch and good cash generation from the businesses. Partially offsetting this effect was an increase in the group’s average net interest rate payable driven principally by2006 due to the strong rise in US dollar floating interest rates and an increase in the year. As at January 1, 2005 we adoptedGroup’s average net debt largely reflecting the cost of acquisitions made in 2006. Partially offsetting this effect was finance income relating to post retirement plans of £4m in 2006 compared to a cost of £7m in 2005. The adoption of IAS 39‘Financial Instruments: Recognition and Measurement’in our financial statements. Thisstatements as at January 1, 2005 has had the effect of introducingpotential to introduce increased volatility into the net finance cost andalthough the effect in 2005 the adoption of2006 was not significantly different from that in 2005. IAS 39 related items and foreign exchange gains and losses together reduced net finance costs by £14 million. There was no equivalent benefit£16m in 20052006 compared to the one-off credita reduction of £9 million for interest on a repayment of tax that occurred£14m in 2004.2005.
      In AprilDecember 2006 the Group announced the sale of its Government contracting business, Pearson Government Solutions. The sale was completed in February 2007 and the results of this business have been shown in discontinued operations in the consolidated income statement for 2006, 2005 Pearsonand 2004. In 2005 the Group sold its 79% interest in Recoletos Grupo de Comunicacion S.A. to Retos Cartera, a consortium of investors, as part of a tender offer for all of Recoletos. The transaction became unconditional on approval from the Spanish regulatory authorities in February 2005. The results of Recoletos have been consolidated for the period to February 28, 2005 and have been shown as discontinued operations in the consolidated income statement for 2005 2004 and 2003.2004.
      Net cash generated from operating activities increaseddecreased to £709 million£456m in 2006 from £487m in 2005. Cash generation in 2006 would have shown an improvement on 2005 from £562 million in 2004 with very strong cash generation across allbut for the businesses. Cash flow in 2004 benefited from collection of the $151 million receivable in respect of the Transportation Security Administration (“TSA”) contract, a contract to create a qualification, assessment, staffing and placement system for security screeners at airports in the US. The relative strengthweakness of the US dollar also increasedwhich reduced the value of our cash flows in Sterling. Capital expenditure was down from 2004 following the up-front expenditure on professional testing contracts in that year but investment in pre-publication increased.sterling. On an average basis, the use of working capital continued to improve. Capital expenditure in 2006 was in line with 2005 levels at constant exchange rates. The net cash inflowoutflow in respect of businesses acquired increased from £246m in 2005 to £363m in 2006. There were no significant disposals in 2006 to match the proceeds received from the sale of Recoletos and Marketwatch in 2005 resulting in a decrease in cash proceeds from disposals net of acquisitions was £175 million in 2005 compared£420m. Dividends from joint ventures and associates increased by £31m largely due to a net cash outflow of £4 million in 2004.special dividends received from the Economist. Dividends paid of £222 million£235m in 20052006 (including £17 million£15m paid to minority interests) compares to £197 million£222m in 2004 and, after an adverse2005. After a favorable currency movement of £121 million,£126m, overall net borrowings fell 18%increased by 6% from £1,221 million£996m at the end of 20042005 to £996 million£1,059m at the end of 2005.2006.
Outlook
      Pearson reported record results in 2006 and our strong trading has continued in the early part of 2007. We have made a good start in the major school textbook adoptions; continued to roll out our groundbreaking online learning and assessment platforms in Higher Education; published a string of bestsellers in Penguin; and achieved steady growth in both advertising and circulation at FT Publishing.
      We are trading in line with expectations for 2007 and expect 2006 to be anotherachieve good year for Pearson as we anticipate increasing margins andunderlying earnings growth, cash conversion ahead of our markets. We expect to achieve strong earnings growth, good cash generation80% threshold, and a further significant improvementincrease in return on invested capital. As always, our sales and profits will be concentrated in the second half of the year.
      Our expectations for the full year remain:
Pearson Education
      We expect Pearson EducationSchool to achieve underlying sales growth in the 3-5%4-6% range with similar rates of growth in each of its three worldwide businesses (School,margins improving; Higher Education and Professional). We expect margins to improve in School and Professional and remain stable in the Higher Education business. School testing is strengthened by 2005 contract wins with a lifetime value of $700 million (including Texas, Virginia, Michigan and Minnesota) and the US School new adoption market is expectedsales to grow strongly overin the period 2007 to 2009.
      We expect our US Higher Education business to continue to benefit from its scale, the strength of its publishing and its lead in technology. 2006 is expected3-5% range with stable margins; Professional revenues to be a strong year for first editions,broadly level with major new titles in statistics, algebra, psychology, economics, health and writing. We plan to launch online homework and assessment programs in new curriculum areas including economics, psychology and development writing and to extend our highly successful customized print publishing model to online curriculum and course management programs.
      We expect our Professional business to deliver sustained growth on the basis of long-term contracts in Government Solutions and Professional Testing and to improve margins after the successful start-up of major new contracts in 2004 and 2005. We also expect to maintain our leading market share in professionalimproving;

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publishing with a stronger schedule of releases in the professional and consumer technology market in 2006 and a strong list within the business publishing imprints.
FT Group
      We expect furtherFinancial Times Group profit improvementto grow strongly with our cost measures, integration actions and revenue diversification pushing margins into double digits at the FT Group. TheFinancial Times continuesPublishing. IDC revenues to show good momentumgrow in the6-9% range with circulation up 4% and advertising revenues continue to show double digitnet income growth in the early part of 2006. IDC expects another good year, benefiting from similar business conditionshigh single-digits to 2005, strong organiclow double-digits (headline growth and the contribution of recent acquisitions.under US GAAP);
The Penguin Group
      Penguin is expected to grow at a similar rate in 2006 to 2005 with continued investment in new markets and international talent and with a strong list of new titles from best selling authors. Margins are expectedmargins to improve steadilyfurther, as we benefit fromits publishing investment and efficiency gains.
Exchange rates
      We generate around two-thirds of total sales in the US and a five cent change in the average exchange rate for the full year (which in 2005 was £1: $1.81) will have an impact of approximately 1p on earnings per share.programs continue to bear fruit.
Sales Informationinformation by Operating Divisionoperating division
      The following table shows sales information for each of the past three years by operating division:
                          
 Year Ended December 31  Year ended December 31
     
 2005 2004 2003  2006 2005 2004
             
 £m £m £m  £m £m £m
Education:Education:    ��     Education:          
School  1,295  1,087  1,149 School  1,455  1,295  1,087 
Higher Education  779  729  770 Higher Education  795  779  729 
Professional  589  507  503 Professional  341  301  290 
FT Group:FT Group:          FT Group:          
FT Publishing  332  318  315 FT Publishing  366  332  318 
IDC  297  269  273 IDC  332  297  269 
PenguinPenguin  804  786  840 Penguin  848  804  786 
               
TotalTotal  4,096  3,696  3,850 Total  4,137  3,808  3,479 
               
Sales Informationinformation by Geographic Marketgeographic market supplied
      The following table shows sales information for each of the past three years by geographic region:
             
  Year Ended December 31
   
  2005 2004 2003
       
  £m £m £m
European countries  963   835   768 
North America  2,717   2,504   2,742 
Asia Pacific  300   263   255 
Other countries  116   94   85 
          
Pearson Group  4,096   3,696   3,850 
          
              
  Year ended December 31
   
  2006 2005 2004
       
  £m £m £m
 European countries  1,089   951   820 
 North America  2,642   2,451   2,309 
 Asia Pacific  298   300   263 
 Other countries  108   106   87 
          
Total  4,137   3,808   3,479 
          
Exchange Rate Fluctuationsrate fluctuations
      We earn a significant proportion of our sales and profits in overseas currencies, principally the US dollar. Sales and profits are translated into sterling in the consolidated financial statements using average rates. The average rate used for the US dollar was $1.84 in 2006, $1.81 in 2005, and $1.83 in 2004 and $1.63 in 2003.2004. Fluctuations in exchange rates can have a significant impact on our reported sales and profits. The GroupPearson generates approximately 65% of its sales in US dollars andthe US. We estimate that a five cent change in the averageclosing exchange rate forbetween the fullUS dollar and sterling in any year has an impact of approximately 1 pence oncould affect our reported earnings per share.share by 1p and shareholders’ funds by approximately £85m. See “Item 11. Quantitative and Qualitative Disclosures About Market Risk” for more information. Theyear-end US dollar rate for 2006 was £1:$1.96 compared to £1:$1.72 for 2005. The weakening in the US dollar reduced our shareholders’ funds by £417m (see note 27 of “Item 17. Financial

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Statements”) in 2006. Theyear-end rate for 2005 was £1:$1.72 compared to £1:$1.92 for 2004 resulting in an increase in shareholders’ funds of £327m in 2005.
Critical Accounting Policiesaccounting policies
      Our consolidated financial statements, included in Item“Item 17. “FinancialFinancial Statements”, are prepared based on the accounting policies described in note 1 to the consolidated financial statements. These financial statements which are prepared in accordance with IFRS, which differs in certain significant respects from US GAAP.
      The preparation of our consolidated financial statements in accordance with IFRS, and the reconciliation of these financial statements to US GAAP as described in note 35,36, requires management to make estimates and assumptions that affect the carrying value of assets and liabilities at the date of the consolidated financial statements and the reported amount of sales and expenses during the periods reported in these financial statements. Certain of our accounting policies require the application of management judgment in selecting assumptions when making significant estimates about matters that are inherently uncertain. Management bases its estimates on historical experience and other assumptions that it believes are reasonable.
      We believe that the following are the more critical accounting policies used in the preparation of our consolidated financial statements that could have a significant impact on our future consolidated results of operations, financial position and cash flows. Actual results could differ from estimates.
Revenue Recognitionrecognition
      Revenue comprises the fair value of the consideration received or receivable for the sale of goods and services net ofvalue-added tax and other sales taxes, rebates and discounts, and after eliminating sales within the Group. Revenue is recognized as follows:
      Revenue from the sale of books is recognized when title passes. A provision for anticipated returns is made based primarily on historical return rates. If these estimates do not reflect actual returns in future periods then revenues could be understated or overstated for a particular period.
      Circulation and advertising revenue is recognized when the newspaper or other publication is published. Subscription revenue is recognized on astraight-line basis over the life of the subscription.
      Where a contractual arrangement consists of two or more separate elements that can be provided to customers either on astand-alone basis or as an optional extra and fair value exists for each separate element, such as the provision of supplementary materials with textbooks, revenue in such multiple element arrangements is recognized forwhen each element as if it were an individual contractual arrangement.product has been delivered and all other relevant revenue recognition criteria are achieved.
      Revenue from multi-year contractual arrangements, such as contracts to process qualifying tests for individual professions and government departments, is recognized as performance occurs. The assumptions, risks, and uncertainties inherent inlong-term contract accounting can affect the amounts and timing of revenue and related expenses reported. Certain of these arrangements, either as a result of a single service spanning more than one reporting period or where the contract requires the provision of a number of services that together constitute a single project, are treated aslong-term contracts with revenues recognized on a percentage of completion basis. Losses on contracts are recognized in the period in which the loss first becomes foreseeable. Contract losses are determined to be the amount by which estimated direct and indirect costs of the contract exceed the estimated total revenues that will be generated by the contract. The assumptions, risks and uncertainties inherent in long-term contract accounting can affect the amounts and timing of revenue and related expenses reported.
      On certain contracts, where the Group acts as agent, only commissions and fees receivable for services rendered are recognized as revenue. Any third party costs incurred on behalf of the principal that are rechargeable under the contractual arrangement are not included in revenue.

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Pre-publication Costsassets
      Pre-publication costs represent direct costs incurred in the development of educational programs and titles prior to their publication. These costs are carried forward inrecognized as current intangible assets where the title will generate probable future economic benefits within their normal operating cycle and costs can be measured reliably. These costsPre-publication assets are amortized upon publication of the title over estimated economic lives of five years or less, being an estimate of the estimated expected operating life cycle of the title, usually with a higher proportion of the amortization taken in the earlier years. The investment inpre-publication has been disclosed as part of the investingcash generated from operating activities in the cash flow statement. The assessment of useful lifethe recoverability ofpre-publication assets and the calculationdetermination of the amortization profile involve a significant amountdegree of estimation and management judgment based on historical trends and management estimation of their future potential sales. The overstatement of useful livesAn incorrect amortization profile could result in excess amounts being carried forward in

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as intangible assets that would otherwise have been written off to the profit and loss accountincome statement in an earlier period. Reviews are performed regularly to estimate recoverability ofpre-publication costs.
Royalty Advancesadvances
      Advances of royalties to authors are included within trade and other receivables when the advance is paid less any provision required to bring the amount down to its net realizable value. The royalty advance is expensed at the contracted royalty rate as the related revenues are earned. Royalty advances which will be consumed within one year are held in current assets. This represents the operating cycle of consumer publishing titles. Royalty advances which will be consumed after one year are held in non-current assets. The realizable value of royalty advances relies on a degree of management judgementjudgment in determining the profitability of individual author contracts. If the estimated realizable value of author contracts is overstated then this will have an adverse effect on operating profits as these excess amounts will be written off. The recoverability of royalty advances is based upon an annual detailed management review of the age of the advance, the future sales projections for new authors and prior sales history of repeat authors. The royalty advance is expensed at the contracted or effective royalty rate as the related revenues are earned. Royalty advances which will be consumed within one year are held in current assets. Royalty advances which will be consumed after one year are held innon-current assets.
Defined Benefit Pension Obligationsbenefit pension obligations
      The liability in respect of defined benefit pension plans is the present value of the defined benefit obligation at the balance sheet date minus the fair value of plan assets. The defined benefit obligation is calculated annually by independent actuaries using the projected unit credit method. The present value of the defined benefit obligation is determined by discounting estimated future cash flows using yields on high quality corporate bonds which have terms to maturity approximating the terms of the related liability.
      The determination of the pension cost and defined benefit obligation of the Group’s defined benefit pension schemes depends on the selection of certain assumptions (see note 24 in “Item 17 — Financial Statements”) which include the discount rate, inflation rate, salary growth, longevity and expected return on scheme assets. Differences arising from actual experience or future changes in assumptions will be reflected in subsequent periods (actuarial gains and losses).
      Actuarial gains and losses arising from differences between actual and expected returns on plan assets, experience adjustments on liabilities and changes in actuarial assumptions are recognized immediately in the statement of recognized income and expense.
      The service cost, representing benefits accruing over the year, is included as an operating cost and the unwinding of the discount rate on the scheme liabilities and the expected return on scheme assets as a financing charge or financing income.
      Obligations for contributions to defined contribution pension plans are recognized as an expense in the income statement as incurred.
      The determination of the pension cost and defined benefit obligation of the Group’s defined benefit pension schemes depends on the selection of certain assumptions (see note 24 in “Item 17 — Financial Statements”) which include the discount rate, inflation rate, salary growth, longevity and expected return on scheme assets. Differences arising from actual experience or future changes in assumptions will be reflected in subsequent periods.
Income Taxestaxes
      The Group is subject to income taxes in numerous jurisdictions. Significant judgement is required in determining the estimates in relation to the worldwide provision for income taxes. There are many transactions and calculations for which the ultimate tax determination is uncertain during the ordinary course of business. The Group recognises liabilities for anticipated tax audit issues based on estimates of whether additional taxes will be due. Where the final tax outcome of these matters is different from the amounts that were initially recorded, such differences will impact the income tax and deferred tax provisions in the period in which such determination is made.
      Deferred income tax is provided, using the liability method on temporary differences arising between the tax bases of assets and liabilities and their carrying amounts in the consolidated financial statements. Deferred

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income tax is determined using tax rates (and laws)and laws that have been enacted or substantively enacted by the balance sheet date and are expected to apply when the related deferred tax asset is realized or the deferred income tax liability is settled.
      Deferred tax assets are recognized to the extent that it is probable that future taxable profitprofits will be available against which the temporary differences can be utilized.
      Deferred income tax is provided in respect of the undistributed earnings of subsidiaries, other than where it is intended that those undistributed earnings will not be remitted in the foreseeable future.
      Deferred tax is recognized in the income statement, except when the tax relates to items charged or credited directly to equity, in which case the tax is also recognized in equity.

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      The Group is subject to income taxes in numerous jurisdictions. Significant judgment is required in determining the estimates in relation to the worldwide provision for income taxes. There are many transactions and calculations for which the ultimate tax determination is uncertain during the ordinary course of business. The Group recognizes liabilities for anticipated tax audit issues based on estimates of whether additional taxes will be due. Where the final tax outcome of these matters is different from the amounts that were initially recorded, such differences will impact the income tax and deferred tax provisions in the period in which such determination is made.
      Deferred tax assets and liabilities require management judgment in determining the amounts to be recognized. In particular, significant judgment is used when assessing the extent to which deferred tax assets should be recognized with consideration given to the timing and level of future taxable income together with any future tax planning strategies.
Goodwill
      Goodwill represents the excess of the cost of an acquisition over the fair value of the Group’s share of the net identifiable assets of the acquired subsidiary or associate at the date of acquisition. Goodwill on acquisitions of subsidiaries is included in intangible assets. Goodwill on acquisitions of associates is included in investments in associates. Goodwill is tested annually for impairment and carried at cost less accumulated impairment losses. The recoverable amounts of cash generating units have been determined based on value in use calculations. These calculations require the use of estimates. Goodwill is allocated to cash generating units for the purpose of impairment testing. The allocation is made to those cash generating units that are expected to benefit from the business combination in which the goodwill arose. Gains and losses on the disposal of an entity include the carrying amount of goodwill relating to the entity sold.
IFRS and US GAAP
      We prepare our financial statements in accordance with IFRS, which differs in certain significant respects from US GAAP. Profit attributable to equity holders of the Company and equity shareholders’ funds under IFRS and US GAAP were as follows for the respective period:
                          
 December 31, 2005 December 31, 2004 December 31, 2003  Year ended December 31
         
 £m £m £m  2006 2005 2004
Profit for the financial year
          
      
 £m £m £m
Profit for the year
Profit for the year
          
IFRS  624  262  252 IFRS  446  624  262 
US GAAP  411  182  173 US GAAP  341  411  182 
Equity shareholders’ funds
Equity shareholders’ funds
          
Equity shareholders’ funds
          
IFRS  3,564  2,800    IFRS  3,476  3,564    
US GAAP  3,838  3,218    US GAAP  3,581  3,838    
      The main differences between IFRS and US GAAP relate to goodwill and intangible assets, acquisition and disposal adjustments, derivatives, pensions, stock based compensation and taxation. These differences are

26


discussed in further detail under “—“ — Accounting Principles” and in note 3536 to the consolidated financial statements.
Results of Operationsoperations
Year ended December 31, 2006 compared to year ended December 31, 2005
Consolidated results of operations
Sales
      Our total sales from continuing operations increased by £329m, or 9%, to £4,137m in 2006, from £3,808m in 2005. The increase reflected growth across all the businesses together with additional contributions from acquisitions made in both 2005 and 2006. The year on year growth was impacted by movements in exchange rates, particularly in the US dollar. We estimate that had the 2005 average rates prevailed in 2006, sales would have been approximately £4,181m.
      Pearson Education had another strong year with an increase in sales of 9%. The School business was the biggest contributor to this growth with an increase of 12%. Some of the School increase was due to the contribution from acquisitions made in 2006 and 2005 but we estimate that after excluding these acquisitions and restating at constant exchange rates that the growth would have been 6%. US School publishing sales were up 3% compared to an industry decline of 6% (source: Association of American Publishers) and the business took a leading share of the new US adoption market. School testing sales continued to improve even after growth in US school testing revenues of more than 20% in 2005. Higher Education growth was more modest at 2% in total but was up 4% in the US. Pearson’s US Higher Education business has grown faster than the industry for eight straight years. In the Professional business, sales increased 13%, with testing sales ahead by more than 30% in 2006 following the successful start up of new contracts and a contribution from the newly acquired Promissor business. Professional publishing sales declined again in 2006 due to the continuedindustry-wide weakness intechnology-related publishing.
      The FT Group sales were 11% ahead of last year. FT Publishing sales were up by 10% driven by higher advertising revenues at theFinancial Times particularly in the online, luxury goods and corporate finance categories. IDC sales were up by 12% with consistent organic growth and aided by contributions from the acquisition of IS.Teledata(re-branded Interactive Data Managed Solutions) and Quote.com.
      Penguin’s sales grew by 5% with a record number of best sellers in the US and UK, an increase in market share in the UK and continued success with the premium paperback format in the US.
      Pearson Education, our largest business sector, accounted for 63% of our continuing business sales in 2006, compared to 62% in 2005. North America continued to be the most significant source of our sales and as a proportion of total continuing sales contributed 64% in both 2006 and 2005.
Cost of goods sold and operating expenses
      The following table summarizes our cost of sales and net operating expenses:
          
  Year ended
  December 31
   
  2006 2005
     
  £m £m
Cost of goods sold  1,917   1,787 
       
 Distribution costs  299   292 
 Administration and other expenses  1,504   1,351 
 Other operating income  (99)  (84)
       
Total  1,704   1,559 
       

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Cost of goods sold. Cost of sales consists of costs for raw materials, primarily paper, printing and binding costs, amortization ofpre-publication costs and royalty charges. Our cost of sales increased by £130m, or 7%, to £1,917m in 2006, from £1,787m in 2005. The increase mainly reflected the increase in sales over the period although the overall gross margin also increased slightly from 53% in 2005 to 54% in 2006.
Distribution costs. Distribution costs consist primarily of shipping costs, postage and packing and are typically a fairly constant percentage of sales.
Administration and other expenses. Our administration and other expenses increased by £153m, or 11%, to £1,504m in 2006, from £1,351m in 2005. As a percentage of sales they increased to 36% in 2006, from 35% in 2005. The increase in administration and other costs comes principally from additional employee benefit expense, additional property costs and increased intangible amortization.
Other operating income. Other operating income mainly consists of freight recharges,sub-rights and licensing income and distribution commissions. Other operating income increased 18% to £99m in 2006 from £84m in 2005, with the increase mainly due to profits made on the disposal of a building. See “Item 17. Financial Statements” note 36 (ix) for the treatment under US GAAP.
Other net gains and losses
      Profits or losses on the sale of businesses, associates and investments that are included in our continuing operations are reported as “other net gains and losses”. In 2005 the only item in this category was the £40m profit on the sale of our associate interest in MarketWatch. In 2006, there were no similar gains or losses.
Share of results of joint ventures and associates
      The contribution from our joint ventures and associates increased from £14m in 2005 to £24m in 2006. The increase was mainly due to an increase in circulation and revenue at The Economist Group, who also recorded a gain on sale of its investment in Commonwealth Business Media Inc. There was also further reduction in losses at FT Deutschland.
Operating profit
      The total operating profit increased by £24m, or 5%, to £540m in 2006 from £516m in 2005. This increase was due to increases across all the businesses, after taking account of theone-off gain from the sale of MarketWatch at FT Publishing of £40m in 2005 and a charge of £7m in 2006 at Penguin relating to an adjustment to goodwill following recognition ofpre-acquisition tax losses. We estimate that had the 2005 average rates prevailed in 2006, operating profit would have been £7m higher.
      Operating profit attributable to Pearson Education increased by £42m, or 13%, to £365m in 2006, from £323m in 2005. The increase was due to continued improvement in School margins, the profit impact of strong sales and cost reductions in technology publishing in Professional testing. Operating profit attributable to the FT Group decreased by £16m, or 12%, to £117m in 2006, from £133m in 2005. This decrease was attributable to the absence in 2006 of the £40m profit from the sale of MarketWatch that was recorded in 2005. After excluding this item profits increased by £24m, £7m at IDC and £17m at FT Publishing. The FT Publishing increase reflected thepick-up in advertising revenues. Operating profit attributable to the Penguin Group decreased by £2m, or 3%, to £58m in 2006, from £60m in 2005. The decrease was attributable to an adjustment to goodwill of £7m caused by the recognition of previously unrecognized tax losses relating to the acquisition of Dorling Kindersley in 2000.
Net finance costs
      Net finance costs increased from £70m in 2005 to £74m in 2006. Net interest payable in 2006 was £94m, up from £77m in 2005. Although we were partly protected by our fixed rate policy, the strong rise in average 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, euros and sterling at the year end) rose by 1.5% to 4.9%. Combining the rate rise with an increase in the Group’s average net debt of £40m, the Group’s average net interest rate

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payable rose by 1.1% to 7.0%. In 2006 the net finance income relating topost-retirement plans was an income of £4m compared to a cost of £7m in the previous year. Other net finance income relating to foreign exchange andshort-term fluctuations in the market value of financial instruments remained fairly constant year on year with a £16m gain in 2006 compared to a £14m gain in 2005. For a more detailed discussion of our borrowings and interest expenses see “ — Liquidity and Capital Resources — Capital Resources” and “ — Borrowings” below and “Item 11. Quantitative and Qualitative Disclosures About Market Risk”.
Taxation
      The total tax charge in 2006 of £11m represents just over 2% ofpre-tax profits compared to a charge of £116m or 26% ofpre-tax profits in 2005. The low tax rate in 2006 was mainly accounted for by two factors. First, in the light of the announcement of the disposal of Government Solutions, we were able to recognize a deferred tax asset in relation to capital losses in the US where previously we were not confident that the benefit of the losses would be realized prior to their expiry. Second, in light of our trading performance in 2006 and our strategic plans, together with the expected utilization of US net operating losses in the Government Solutions sale, we havere-evaluated the likely utilization of operating losses both in the US and the UK; this has enabled us to increase the amount of the deferred tax asset carried forward in respect of such losses. The combined effect of these two factors was to create anon-recurring credit of £127m.
Minority interests
      Following the disposal of our 79% holding in Recoletos and the purchase of the remaining 25% minority stake in Edexcel in 2005, our minority interests now comprise mainly the minority share in IDC. In January 2006 we increased our stake in IDC reducing the minority interest from 39% to 38%.
Discontinued operations
      In December 2006 the Group announced the sale of its Government contracting business, Pearson Government Solutions. The sale was completed in February 2007 and the results of this business have been shown in discontinued operations in the consolidated income statement in both 2006 and 2005. Operating profit for Government solutions in 2006 was £22m compared to £20m in 2005. Following the disposal of Recoletos in 2005 its results were consolidated for the period up to February 28, 2005 and included in discontinued operations in 2005. The results for 2005 include an operating loss for the two months to February 28, 2005 of £3m. Thepre-tax profit on disposal of Recoletos reported in 2005 was £306m.
Profit for the year
      The total profit for the year in 2006 was £469m compared to a profit in 2005 of £644m. The overall decrease of £175m was to the absence of the profits on disposal of Recoletos and MarketWatch reported in 2005. After taking account of these disposals there was an increase in profit in 2006 due to improvement in operating profits and the sharp reduction in tax due to the recognition of losses in 2006.
Earnings per ordinary share
      The basic earnings per ordinary share, which is defined as the profit for the financial year divided by the weighted average number of shares in issue, was 55.9p in 2006 compared to 78.2p in 2005 based on a weighted average number of shares in issue of 798.4m in 2006 and 797.9m in 2005. The decrease in earnings per share was due to the additional profit for 2005 described above and was not significantly affected by the movement in the weighted average number of shares.
      The diluted earnings per ordinary share of 55.8p in 2006 and 78.1p in 2005 was not significantly different from the basic earnings per share in those years as the effect of dilutive share options was again not significant.

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Exchange rate fluctuations
      The weakening of the US dollar against sterling on an average basis had a negative impact on reported sales and profits in 2006 compared to 2005. We estimate that if 2005 average rates had prevailed in 2006, sales would have been higher by £44m and operating profit would have been higher by £7m. See “Item 11. Quantitative and Qualitative Disclosures About Market Risk” for a discussion regarding our management of exchange rate risks.
Sales and operating profit by division
      The following tables summarize our sales and operating profit for each of Pearson’s divisions. Adjusted operating profit is anon-GAAP measure and is included as it is a key financial measure used by management to evaluate performance and allocate resources to business segments, as reported under FAS 131. See also note 2 of “Item 17. Financial Statements”.
      In our adjusted operating profit we have excluded amortization and adjustment of acquired intangibles, other gains and losses and other net finance costs of associates. The amortization and adjustment of acquired intangibles is the amortization or subsequent impairment of intangible assets acquired through business combinations. The charge is not considered to be fully reflective of the underlying performance of the Group. Other gains and losses represent profits and losses on the sale of subsidiaries, joint ventures, associates and investments that are included within continuing operations but which distort the performance for the year.
      Adjusted operating profit enables management to more easily track the underlying operational performance of the Group. A reconciliation of operating profit to adjusted operating profit for continuing operations is included in the tables below:
                             
  Year Ended December 31, 2006
   
    Higher   FT  
£m School Education Professional Publishing IDC Penguin Total
               
Sales  1,455   795   341   366   332   848   4,137 
   36%   19%   8%   9%   8%   20%   100% 
Total operating profit  167   161   37   35   82   58   540 
   31%   30%   7%   6%   15%   11%   100% 
Add back:                            
Amortization and adjustment of acquired intangibles  17      1   2   7   8   35 
Other net gains and losses including associates           (4)        (4)
Other net finance costs of associates           (1)        (1)
                      
Adjusted operating profit:
continuing operations
  184   161   38   32   89   66   570 
Adjusted operating profit:
discontinued operations
        22            22 
                      
Total adjusted operating profit  184   161   60   32   89   66   592 
                      
   31%   27%   10%   6%   15%   11%   100% 

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  Year Ended December 31, 2005
   
    Higher   FT  
£m School Education Professional Publishing IDC Penguin Total
               
Sales  1,295   779   301   332   297   804   3,808 
   34%   20%   8%   9%   8%   21%   100% 
Total operating profit  142   156   25   58   75   60   516 
   28%   30%   5%   11%   14%   12%   100% 
Add back:                            
Amortization and adjustment of acquired intangibles  5         1   5      11 
Other net gains and losses including associates           (40)        (40)
Other net finance costs of associates           2         2 
                      
Adjusted operating profit:
continuing operations
  147   156   25   21   80   60   489 
Adjusted operating profit:
discontinued operations
        20   (3)        17 
                      
Total adjusted operating profit  147   156   45   18   80   60   506 
                      
   29%   31%   9%   3%   16%   12%   100% 
School
      School business sales increased by £160m, or 12%, to £1,455m in 2006, from £1,295m in 2005 and adjusted operating profit increased by £37m, or 25%, to £184m in 2006 from £147m in 2005. In addition to strong underlying growth in sales and profits, the School results in 2006 benefit from the inclusion of National Evaluation Systems (NES), Paravia Bruno Mondadori (PBM), Chancery and PowerSchool together with a number of smaller acquisitions all made in the first half of 2006 and from a full year contribution from AGS Publishing, acquired in July 2005. Offsetting these factors was the effect of the weakening of the US dollar, which we estimate reduced sales by £17m when compared to the equivalent figures at constant 2005 exchange rates.
      In the US school market, Pearson’s school publishing business grew 3% against the Association of American Publishers’ estimate of a decline in the industry of 6%. New adoption market share was 33% in the adoptions where Pearson competed (and 30% of the total new adoption market). The School business now has the number one or number two market share in reading, math, science and social studies. US School testing sales were up in the high single digits even after growth in excess of 20% in 2005. School testing benefited from further contract wins, market share gains and leadership in onscreen marking, online testing and embedded (formative) assessment. The acquisition of NES providing customized assessments for teacher certification in the US has allowed us to expand in an attractive adjacent market. The School technology business grew both through the acquisitions of Chancery and PowerSchool and through organic growth in the digital curriculum business which continued to grow while investing in a new generation of digital products to meet the demands of school districts for personalized classroom learning.
      The international School business, outside the US, continued to grow. The international testing business was again able to benefit from technology leadership. In the UK, we have marked over 9 million GCSE, AS and A-Level scripts on screen. In School publishing, the launch in the UK of ActiveTeach technology providing multimedia teaching resources has brought increased market share in math and science. The acquisition of PBM, one of Italy’s leading education publishers, has allowed us to expand our existing Italian business and integrate publishing, sales and marketing, distribution and back office operations. Our market leading school companies in Hong Kong and South Africa both outperformed their respective markets in 2006 and our worldwide English Language Training program for elementary schools,English Adventure(with Disney), was successfully launched in Asia and Latin America.
      School margins improved again in 2006 and were up by 1.2% points to 12.6% with continued efficiency gains in central costs, production, distribution and software development.

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Higher Education
      Sales in Higher Education increased by £16m, or 2%, to £795m in 2006, from £779m in 2005. Adjusted operating profit increased by £5m, or 3%, to £161m in 2006 from £156m in 2005. Both sales and adjusted operating profit were affected by the weakening of the US dollar which we estimate reduced sales by £8m when compared to the equivalent figures at constant 2005 exchange rates.
      In the US, the Higher Education sales were up by 4% (in US dollars) ahead of the Association of American Publishers’ estimate of industry growth once again. Over the past eight years, Pearson’s US Higher Education business has grown at an average annual rate of 7% compared to the industry’s average growth rate of 4%. In the US there was rapid growth in the online learning businesses with approximately 4.5 million US college students using one of our online programs. Of these approximately 2.3 million register for an online course on one of our ‘MyLab’ online homework and assessment programs, an increase of almost 30% on 2005. In psychology and economics, two of the three largest markets in US higher education, Pearson published successful first edition bestsellers: Cicarrelli’sPsychologytogether with MyPsychLab and Hubbard’sEconomicstogether with MyEconLab. Cicarrelli’sPsychologyincreased Pearson’s market share in the subject by 3% to 25% and is the bestselling launch of a first edition in the discipline in the past decade. Also in the US the custom publishing business, which builds customized textbooks and online services around the courses of individual faculties or professors, continued its strong progress with another year of double-digit growth.
      International Higher Education publishing sales grew by 3%, benefiting from good growth in local language publishing programs and an increasing focus on custom publishing and technology based assessment services with the MyLab suite of products.
      Higher Education margins remained constant year on year with only a small increase of 0.3% points to 20.3% in 2006.
Professional
      After excluding sales and adjusted operating profit from Government Solutions which were reported as discontinued in 2006, Professional sales increased by £40m, or 13%, to £341m in 2006 from £301m in 2005. Adjusted operating profit increased by £13m, or 52%, to £38m in 2006, from £25m in 2005. Sales were only slightly affected by the weakening US dollar, which we estimate reduced sales by £2m when compared to the equivalent figures at constant 2005 exchange rates.
      Professional testing sales were up more than 30% in 2006 benefiting in particular from the acquisition of Promissor and the successful start-up of the Graduate Management Admissions Test with 220,000 examinations delivered in 400 test centers in 96 countries during the first year of the new contract. Professional Testing has moved into profitability in 2006 compared to a break-even position in 2005. Technology publishing profits were up in 2006 as cost actions offset sales weakness in a market that continues to decline. There was a strong performance in other professional publishing with particular successes in the Wharton School Publishing and FT Press imprints.
      Overall margins in the Professional business were significantly higher at 11.1% in 2006 compared to 8.3% in 2005 as the testing business moved into profitability and the technology publishing business took specific cost actions.
FT Publishing
      Sales at FT Publishing increased by £34m or 10%, from £332m in 2005 to £366m in 2006. Adjusted operating profit increased by £11m, from £21m in 2005 to £32m in 2006. Much of the sales and profit increase was again at the FT newspaper and FT.com where sales were up 8% and profit increased by £9m to £11m.
      The FT newspaper advertising revenues were up 9% for the year with rapid growth in online, luxury goods and corporate finance categories, all up more than 30% on 2005. FT worldwide circulation was up 1% to 430,469 copies per day (Source: ABC, average for six months to December 2006). FT.com’s paying subscribers were up 7% to 90,000 while the December audience was up 29% to 4.2 million. The FT continued

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to benefit from international expansion with approximately three-quarters of the FT’s advertising booked in two or more international editions and almost half booked for all four editions worldwide. The FT’s ‘new newsroom’ has created an integrated multi-media newsroom that improves commissioning, reporting, editing and production efficiency and provided further cost savings in 2006.
      In September 2006, the FT Publishing business acquired Mergermarket, an online financial data and intelligence provider that contributed additional sales and profit in the last three months of 2006. FT Business showed good growth and improved margins driven by strong performances in events, UK retail financial titles (Investment AdviserandFinancial Adviser) and internationally withThe Banker. Les Echosachieved modest circulation and advertising growth in a weak market ahead of the French presidential elections in 2007.FT Deutschlandoutperformed the German newspaper market once again increasing circulation by 2% and reducing losses.The Economist, in which Pearson owns a 50% stake, increased its contribution to FT Publishing’s adjusted operating profit with another good year that saw circulation increase by 9% to 1.2 million (for the July-December ABC period).
      Overall margins at FT Publishing continued to increase as the newspaper becomes more profitable and are now 8.7% compared to 6.3% in 2005.
Interactive Data
      Interactive Data, grew its sales by 12% from £297m in 2005 to £332m in 2006. Adjusted operating profit grew by 11% from £80m in 2005 to £89m in 2006. Both sales and adjusted operating profit were affected by the weakening US dollar, which we estimate reduced sales by £4m and adjusted operating profit by £1m when compared to the equivalent figures at constant 2005 exchange rates.
      Interactive Data Pricing and Reference Data (formerly FT Interactive Data), IDC’s largest business (approximately two-thirds of IDC revenues) generated strong growth in North America and Europe. Growth was driven by sustained demand for fixed income evaluated pricing services and related reference data. Interactive Data Pricing and Reference Data continued to expand its market coverage, adding independent valuations of credit default swaps and other derivative securities. There was improved momentum at Interactive Data Real-Time Services (formerly Comstock) with new sales to institutional clients and lower cancellation rates and also at eSignal with continued growth in its base of direct subscription terminals. The acquisition of Quote.com in March 2006 has expanded eSignal’s suite of real-time market data platforms and analytics and added two financial websites which enabled eSignal to generate strong growth through online advertising in 2006. IS.Teledata, acquired at the end of 2005 and rebranded Interactive Data Managed Solutions, contributed a full year of sales and profit for the first time in 2006.
      IDC margins remained roughly constant year on year at 26.8% in 2006 compared to 26.9% in 2005.
The Penguin Group
      Penguin Group sales were up 5% to £848m in 2006 from £804m in 2005 and adjusted operating profit up 10% to £66m in 2006 from £60m in 2005. Both sales and adjusted operating profit were affected by the weakening US dollar which we estimate reduced sales by £13m and adjusted operating profit by £7m when compared to the equivalent figures at constant 2005 exchange rates.
      2006 was a record year for Penguin in terms of literary success and bestseller performance. In the US, Penguin placed 139 books on theNew York Timesbestseller list, 10 more than in 2005, and kept them there for 809 weeks overall, up 119 weeks from 2005. Penguin UK placed 59 titles in the BookScan Top Ten bestseller list, up by 5 from 2005, and kept them there for 361 weeks, up 42 weeks from 2005.
      Penguin authors won a large number of prestigious awards during 2006: a Pulitzer Prize for Fiction (Marchby Geraldine Brooks); a National Book Critics Circle Award (THEM: A Memoir of Parentsby Francine du Plessix Gray); the Michael L. Printz award (Looking for Alaskaby John Green); the Orange Prize for Fiction (On Beautyby Zadie Smith); and the Man Booker Prize (The Inheritance of Lossby Kiran Desai).

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      Penguin UK’s focus on fiction in 2006 was rewarded with a substantial increase in market share, led by Marina Lewycka’sA Short History of Tractors in Ukrainian.In the US, the premium paperback format accelerated revenue growth and increased profitability in the important mass-market category. In India, Penguin continued its rapid growth and extended its market leadership and there was also strong growth and increased market share for Penguin in South Africa. 2006 also saw strong growth in online revenues and unique visitors to the Penguin and DK websites.
      Penguin continued to focus on efficiency and improvement in operating margins and has benefited from the Pearson-wide renegotiation of major global paper, print and binding contracts, the integration of warehouse and back office operations in Australia and New Zealand and is investing in India as a pre-production and design center for reference titles.
Results of operations
Year ended December 31, 2005 compared to year ended December 31, 2004
Consolidated Resultsresults of Operationsoperations
Sales
      Our total sales increased by £400 million,£329m, or 11%9%, to £4,096 million£3,808m in 2005, from £3,696 million£3,479m in 2004. Sales growth was due to strong performance in our markets, helped in part by a favourablefavorable exchange rate impact. We estimate that had the 2004 average rates prevailed in 2005, sales would have been approximately £4,050 million.£3,765m.
      Pearson Education had a strong year with an increase in sales of 15%13%. The School and Professional businesses were the biggest contributors to this growth with increasesan increase of 19% and 16% respectively.. Higher Education growth was 5%7% in total and 6% in the US. Pearson’s US Higher Education business has grown faster than the industry for seven straight years. The School publishing business benefited from a large share of the new adoption market in the US and testing sales were up more than 20% as the business made significant market share gains and benefited from mandatory state testing in the US under No Child Left Behind. In the Professional business Professionalsales increased 4%, with testing and Government Solutions sales were both up by more than a third onahead of last year withfollowing the successful start-up of major new contracts. Worldwide sales of technology-related books were again lower than the previous year although weakness in the professional markets was partly offset by growth in consumer technology publishing.
      The FT Group sales were 7% in 2005 ahead of last year.2004. FT Publishing sales were up by 4% driven by higher advertising revenues at theFinancial Timesand IDC sales were up by 10% with organic growth at all its businesses aided by a full year contribution from FutureSource, acquired in September 2004, and the strength of the US dollar. Penguin’s sales grew by 2% with successful format innovation helping to offset the weakness in the mass marketmass-market category in the US, down a further 4% for the industry in 2005.
      Pearson Education, our largest business sector, accounted for 65%62% of our sales in 2005, compared to 63%61% in 2004. North America continued to be the most significant source of our sales although sales there decreased, as a proportion of total sales, to 66%64% in 2005, compared to 68%66% in 2004.

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Cost of Salesgoods sold and Operating Expensesnet operating expenses
      The following table summarizes our cost of sales and net operating expenses:
         
  Year Ended
  December 31
   
  2005 2004
     
  £m £m
Cost of goods sold  2,022   1,789 
       
Distribution costs  249   201 
Administrative and other expenses  1,384   1,365 
Other operating income  (41)  (46)
       
Total operating expenses  1,592   1,520 
       
          
  Year ended
  December 31
   
  2005 2004
     
  £m £m
Cost of goods sold  1,787   1,631 
       
 Distribution costs  292   226 
 Administration and other expenses  1,351   1,340 
 Other operating income  (84)  (83)
       
Total  1,559   1,483 
       

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     Cost of Sales.goods sold.Cost of sales consists of costs for raw materials, primarily paper, printing costs, amortization of pre-publication costs and royalty charges. Our cost of sales increased by £233 million,£156m, or 13%10%, to £2,022 million£1,787m in 2005, from £1,789 million£1,631m in 2004. The increase mainly reflected the increase in sales over the period althoughso the overall gross margin declined slightly from 52% in 2004 to 51% in 2005.stayed constant at 53%.
     Distribution Costs.Distribution costs consist primarily of shipping costs, postage and packing and are typically a fairly constant percentage of sales.
     Administration and Other Expenses.other expenses.Our administration and other expenses increased by £19 million,£11m, or 1%, to £1,384 million£1,351m in 2005, from £1,365 million£1,340m in 2004, although as a percentage of sales they decreased to 34%35% in 2005, from 37%39% in 2004. The increase in administration and other costs comes principally from additional employee benefit expense, but cost savings and more modest increases in other administration expenses hashave enabled overall operating margins to improve.
     Other operating Income.income.Other operating income mainly consists of freight recharges, sub-rights and licensing income and distribution commissions. Other operating income decreased 11% to £41 million in 2005 from £46 million in 2004, with the decrease mainly representing the continued decline in commissions received for distribution of third party books.
Other Net Gainsnet gains and Losseslosses
      Profits or losses on the sale of businesses, associates and investments that are included in our continuing operations are reported as “other net gains and losses”. In 2005 the only item in this category was the £40 million£40m profit on the sale of our associate interest in MarketWatch. In 2004, other gains and losses amounted to £9 million,£9m, with the principal items being profits on the sale of stakes in Capella and Business.com.
Share of results of joint ventures and associates
      The contribution from our joint ventures and associates increased from £8 million£8m in 2004 to £14 million£14m in 2005. The increase was due to profit improvement at The Economist Group and a reduction in losses at FT Deutschland.
Operating Profitprofit
      The total operating profit increased by £132 million,£134m, or 32.7%35%, to £536 million£516m in 2005 from £404��million£382m in 2004. This £132 million£134m or 33%35% increase was due to increases across all the businesses, the one-off gain from the sale of MarketWatch of £40 million£40m and a beneficial impact of exchange. We estimate that had the 2004 average rates prevailed in 2005, operating profit would have been £12 million£12m lower.
      Operating profit attributable to Pearson Education increased by £56 million,£58m, or 20%22%, to £343 million£323m in 2005, from £287 million£265m in 2004. The increase was due to strong sales and improved margins in both the School and Higher Education businesses. Operating profit attributable to the FT Group increased by £63 million,£63m, or 90%, to £133 million£133m in 2005, from £70 million£70m in 2004. £40 million£40m of the increase was due to the profit from the sale of MarketWatch but there were also increases at IDC of £13 million£13m and FT Publishing of £10 million.£10m. Operating profit attributable to the Penguin Group increased by £13 million,£13m, or 28%, to £60 million£60m in 2005, from £47 million£47m in 2004. The increase at Penguin was due in part to increased efficiencies and improved margins and also due to exchange gains and one-off items in 2004. Penguin’s

25


operating profit in 2004 was reduced by costs associated with disruption in UK distribution following the move to a new warehouse and closure costs associated with Penguin TV.
Net Finance Costsfinance costs
      Net finance costs reduced from £79 million£79m in 2004 to £70 million£70m in 2005. Net interest payable in 2005 was £77 million,£77m, up from £74 million£74m in 2004. The group’sGroup’s net interest rate payable rose by 0.9% to 5.9%. Although we were partly protected by our fixed rate policy, 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%. This was largely offset by the £260m fall in average net debt, reflecting in particular the proceeds from the disposal of Recoletos and good cash generation. 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. As at January 1, 2005 we adopted IAS 39‘Financial Instruments: Recognition and Measurement’in our financial statements. This has had the effect of introducing increased volatility into the net finance cost and in 2005 the

35


adoption of IAS 39 reduced net finance costs by £14 million.£14m. For a more detailed discussion of our borrowings and interest expenses see “— Liquidity and Capital Resources — Capital Resources” and “— Borrowing” below and “Item 11. Quantitative and Qualitative Disclosures About Market Risk”.
Taxation
      The total tax charge for the year was £124 million,£116m, representing a 27%26% rate on pre-tax profits of £466 million.£446m. This compares with a 2004 rate of 19%18% (or £63m£55m on a pre-tax profit of £325m)£303m). 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 Marketwatch.com was free of tax.
Minority Interestsinterests
      Following the disposal of our 79% holding in Recoletos in April 2005 and the purchase of the 25% minority stake in Edexcel in February 2005, our minority interests now mainly comprise the 39% minority share in IDC.
Discontinued Operationsoperations
      Following the announcement of the disposal of Government Solutions in December 2006, the results of the Pearson Government Solution business have been reclassified as discontinued in 2005 and 2004. The results for the year ended December 31, 2005 included an operating profit of £20m with a corresponding operating profit of £22m in 2004. The results of Recoletos have been consolidated for the period up to February 28, 2005 and included in discontinued operations in 2005 and 2004. The results for 2005 include an operating loss for the two months to February 28, 2005 of £3 million£3m compared to an operating profit in the full year to December 31, 2004 of £26 million.£26m. The pre-tax profit on disposal of Recoletos reported in 2005 was £306 million.£306m.
Profit for the Financial Yearyear
      The total profit for the financial year in 2005 was £644 million£644m compared to a profit in 2004 of £284 million.£284m. The overall increase of £360 million£360m was mainly due to the profit on disposal of Recoletos and MarketWatch together with significant improvement in operating profits reported across all the Pearson businesses. These increases were only partially offset by the increase in the tax charge in 2005.
Earnings per Ordinary Shareordinary share
      The basic earnings per ordinary share, which is defined as the profit for the financial year divided by the weighted average number of shares in issue, was 78.2 pence78.2p in 2005 compared to 32.9 pence32.9p in 2004 based on a weighted average number of shares in issue of 797.9 million in 2005 and 795.6 million in 2004. This increase in earnings per share was due to the additional profit for the financial year described above and was not significantly affected by the movement in the weighted average number of shares.
      The diluted earnings per ordinary share of 78.1 pence78.1p in 2005 and 32.9 pence32.9p in 2004 was not significantly different from the basic earnings per share in those years as the effect of dilutive share options was again not significant.
Exchange Rate Fluctuationsrate fluctuations
      The strengthening of the US dollar against sterling on an average basis had a positive impact on reported sales and profits in 2005 compared to 2004. We estimate that if the 2004 average rates had prevailed in 2005, sales would have been lower by £46 million£43m and operating profit would have been lower by £12 million.£12m. See

26


“Item “Item 11. Quantitative and Qualitative Disclosures About Market Risk” for a discussion regarding our management of exchange rate risks.

36


Sales and Operating Profitoperating profit by Divisiondivision
      The following table summarizestables summarize our sales and operating profit and results from operations for each of Pearson’s divisions. Adjusted operating profit is a non-GAAP measure and is included as it is a key financial measure used by management to evaluate performance and allocate resources to business segments, as reported under SFASFAS 131. Since 1998 we have reshaped the Pearson portfolio by divestingSee also note 2 of non-core interests and investing in educational publishing and testing, consumer publishing and business information companies. During this period of transformation management has used adjusted operating profit to track underlying core business performance.“Item 17. Financial Statements”.
      In our adjusted operating profit we have excluded amortization and adjustment of acquired intangibles, other gains and losses and other net finance costs of associates. The amortization and adjustment of acquired intangibles is the amortization or subsequent impairment of intangible assets acquired through business combinations. The charge is not considered to be fully reflective of the underlying performance of the group.Group. Other gains and losses represent profits and losses on the sale of subsidiaries, joint ventures, associates and investments that are included within continuing operations but which distort the performance for the year. Other net finance costs of associates are foreign exchange and other gains and losses that represent short-term fluctuations in market value and are subject to significant volatility. These gains and losses may not be realized in due course as it is normally the intention to hold these instruments to maturity. Increased volatility has been introduced as a result of adopting IAS 39 ’Financial Instruments: Recognition and Measurement’ as at January 1, 2005. Finance costs and income of joint ventures and associates are reported within the share of results of joint ventures and associates that is included within operating profit. Group finance costs and income are reported separately in the income statement below the operating profit line.

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      Adjusted operating profit enables management to more easily track the underlying operational performance of the group.Group. A reconciliation of operating profit to adjusted operating profit is included in the tabletables below:
                   
  Year Ended December 31
   
  2005 2004
     
  £m % £m %
         
Total operating profit
                
Pearson Education:                
 School  142   27   112   27 
 Higher Education  156   29   133   33 
 Professional  45   8   42   10 
FT Group:                
 FT Publishing  58   11   8   2 
 IDC  75   14   62   16 
Penguin  60   11   47   12 
             
Total  536   100   404   100 
             
  
Add back:
                
  
Amortization of acquired intangibles
                
  School  5            
  Higher Education              
  Professional              
  Penguin              
  FT Publishing  1            
  IDC  5       5     
             
  Total  11       5     
             
  
Other net gains and losses
                
  School         (4)    
  Higher Education         (4)    
  Professional         (2)    
  Penguin         5     
  FT Publishing  (40)      (4)    
  IDC              
             
  Total  (40)      (9)    
             
  
Other net finance costs of associates
                
  School              
  Higher Education              
  Professional              
  Penguin              
  FT Publishing  2            
  IDC              
             
  Total  2            
             
Adjusted operating profit
                
Pearson Education:                
 School  147   29   108   27 
 Higher Education  156   31   129   32 
 Professional  45   9   40   10 
FT Group:                
 FT Publishing  21   4   4   1 
 IDC  80   15   67   17 
Penguin  60   12   52   13 
             
Total  509   100   400   100 
             
                             
  Year ended December 31, 2005
   
    Higher   FT  
£m School Education Professional Publishing IDC Penguin Total
               
Sales  1,295   779   301   332   297   804   3,808 
   34%   20%   8%   9%   8%   21%   100% 
Total operating profit  142   156   25   58   75   60   516 
   28%   30%   5%   11%   14%   12%   100% 
Add back:                            
Amortization and adjustment of acquired intangibles  5         1   5      11 
Other net gains and losses including associates           (40)        (40)
Other net finance costs of associates           2         2 
                      
Adjusted operating profit:                            
continuing operations  147   156   25   21   80   60   489 
Adjusted operating profit:                            
discontinued operations        20   (3)        17 
                      
Total adjusted operating profit  147   156   45   18   80   60   506 
                      
   29%   31%   9%   3%   16%   12%   100% 

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  Year ended December 31, 2004
   
    Higher   FT  
£m School Education Professional Publishing IDC Penguin Total
               
Sales  1,087   729   290   318   269   786   3,479 
   31%   21%   8%   9%   8%   23%   100% 
Total operating profit  112   133   20   8   62   47   382 
   29%   35%   5%   2%   16%   13%   100% 
Add back:                            
Amortization and adjustment of acquired intangibles              5      5 
Other net gains and losses including associates  (4)  (4)  (2)  (4)     5   (9)
Other net finance costs of associates                     
                      
Adjusted operating profit:                            
continuing operations  108   129   18   4   67   52   378 
Adjusted operating profit:                            
discontinued operations        22   26         48 
                      
Total adjusted operating profit  108   129   40   30   67   52   426 
                      
   25%   30%   9%   7%   16%   13%   100% 
School
      School business sales increased by £208 million,£208m, or 19%, to £1,295 million£1,295m in 2005, from £1,087 million£1,087m in 2004 and adjusted operating profit increased by £39 million,£39m, or 36%, to £147 million£147m in 2005 from £108 million£108m in 2004. The School results in 2005 benefit from the inclusion of AGS Publishing, acquired in July 2005 and the strengthening of the US dollar, which we estimate added £34 million£12m to sales and £2 million£2m to adjusted operating profit when compared to the equivalent figures at constant 2004 exchange rates.
      In the US school market, Pearson’s school publishing business grew 12% ahead of the Association of American Publishers’ estimate of industry growth of 10.5%. New adoption market share was 33% in the adoptions where Pearson competed (and 24% of the total new adoption market). The School business now has leading positions in math, science, literature and foreign languages. School testing sales were up more than 20%, benefiting from significant market share gains and mandatory state testing under No Child Left Behind. School software also had a strong year with good sales and profit growth on curriculum and school administration services.
      Outside the US, the School publishing sales increased in high single digits. The worldwide English Language Teaching business benefited from strong demand for English language learning and investments in new products, includingEnglish Adventure (with(with Disney) for the primary school market,Skyfor secondary schools,Total Englishfor adult learners andIntelligent Business (withThe Economist) for the business markets. There was also strong growth in the international school testing markets. Four million UK GCSE, AS andA-Level scripts were marked onscreen and 2005 saw the first year of running the UK National Curriculum tests and a new contract for a national school testing pilot in Australia.
      School margins were up by 1.5% points to 11.4% with efficiency gains in central costs, production, distribution and software development.
Higher Education
      Sales in Higher Education increased by £50 million,£50m, or 7%, to £779 million£779m in 2005, from £729 million£729m in 2004. Adjusted operating profit increased by £27 million,£27m, or 21%, to £156 million£156m in 2005 from £129 million£129m in 2004. Both sales and adjusted operating profit benefited from the strengthening US dollar which we estimate added £14 million£14m to sales and £3 million£3m to adjusted operating profit when compared to the equivalent figures at constant 2004 exchange rates.

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      In the US, the Higher Education sales were up by 6% ahead of the Association of American Publishers’ estimate of industry growth of 5%. 2005 is the seventh consecutive year that Pearson’s US Higher Education business has grown faster than the industry. The US business benefited from continued growth from market-leading authors in key academic disciplines including biology (Campbell & Reece), chemistry (Brown & LeMay), sociology (Macionis), marketing (Kotler & Keller), math (Tobey & Slater), developmental math (Martin-Gay) and English composition (Faigley’sPenguin Handbook). There was also expansion in the career and workforce education sector, with major publishing initiatives gaining market share in allied health, criminal justice, paralegal, homeland security and hospitality. The online learning and custom publishing businesses saw rapid growth. Approximately 3.6 million US college students are studying through one of our online programs, an increase of 20% on 2004; and custom publishing, which builds customized textbooks and online services around the courses of individual faculties or professors, had double digit sales growth.
      International Higher Education publishing sales grew by 4%, benefiting from the local adaptation of global authors, including Campbell and Kotler, and the introduction of custom publishing and online learning capabilities into new markets in Asia and the Middle East.
      Higher Education margins were up by 2.3% points to 20%. Good margin improvement in the US and in international publishing was helped by shared services and savings in central costs, technology, production and manufacturing.
Professional
      Professional sales (excluding discontinued businesses) increased by £82 million,£11m, or 16%4%, to £589 million£301m in 2005 from £507 million£290m in 2004. Adjusted operating profit increased by £5 million,£7m, or 13%39%, to £45 million£25m in 2005, from £40 million£18m in 2004. Sales benefited from the strengthening US dollar, which we estimate added £8 million£5m to sales when compared to the equivalent figures at constant 2004 exchange rates.

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      Professional testing sales were up more than 40% in 2005 benefiting from the successful start-up of major new contracts including the Driving Standards Agency, National Association of Securities Dealers and the Graduate Management Admissions Council. Government Solutions grew sales by 38%, helped by new contracts with the US Department of Education and the Social Security Administration worth over $800 million, together with strong growth from add-ons to existing programs, including those with the US Department of Health and Human Services.
      Overall margins in the Professional business were a little lower in 2005 compared to 2004 mainly due to new contract start-up costs at Government Solutions.costs. Margins in the Professional publishing businesses were maintained despite falling sales.
FT Publishing
      Sales at FT Publishing (excluding discontinued businesses) increased by £14 million£14m or 4%, from £318 million£318m in 2004 to £332 million£332m in 2005. Adjusted operating profit increased by £17 million,£17m, from £4 million£4m in 2004 to £21 million£21m in 2005. Much of the sales and profit increase was at the FT newspaper; sales at the other business newspapers were broadly level with 2004 with a small increase in adjusted operating profit compared to 2004.
      FT newspaper sales were up 6% while adjusted operating profit increased £14 million£14m to register a profit of £2 million£2m in 2005 compared to a loss of £12 million£12m in 2004. FT advertising revenues were up 9% for the year with sustained growth in luxury goods and worldwide display advertising. FT.com advertising sales were up 27% as some of the FT’s biggest advertisers shifted to integrated print and online advertising. The FT’s worldwide circulation was 2% lower for the year at 426,453 average copies per day although the second half of the year showed improvement to 430,635 average copies per day. FT.com’s paying subscribers increased by 12% to 84,000 and the average unique monthly users was up 7% to 3.2 million.3.2m.
      Les Echos advertising and circulation revenues for 2005 were level with 2004 despite tough trading conditions. FT Business improved margins with growth in its international finance titles. Our share of the results of the FT’s joint ventures and associates improved asFT Deutschlandreduced its losses and increased its average circulation despite a weak advertising market in Germany andThe Economistincreased profits helped by an increase in circulation (10% to an average weekly circulation of 1,038,519 for the January-June ABC period).

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Interactive Data
      Interactive Data, grew its sales by 10% from £269 million£269m in 2004 to £297 million£297m in 2005. Adjusted operating profit grew by 19% from £67 million£67m in 2004 to £80 million£80m in 2005. Both sales and adjusted operating profit benefited from the strengthening US dollar, which we estimate added £2 million£2m to sales and £1 million£1m to adjusted operating profit when compared to the equivalent figures at constant 2004 exchange rates.
      FT Interactive Data, IDC’s largest business (approximately two-thirds of IDC revenues) generated strong growth in North America and returned to growth in Europe. There was more modest growth at Comstock, IDC’s business providing real-time data for global financial institutions, and at CMS BondEdge, its fixed income analytics business. Renewal rates for IDC’s institutional businesses remain at around 95%. eSignal, IDC’s active trader services business, increased sales by 27% with continued growth in the subscriber base and a full year contribution from FutureSource, acquired in September 2004.
The Penguin Group
      The Penguin Group sales were up 2% to £804 million£804m in 2005 from £786 million£786m in 2004 and adjusted operating profit up 15% to £60 million£60m in 2005 from £52 million£52m in 2004. Both sales and adjusted operating profit benefited from the strengthening US dollar which we estimate added £9 million£9m to sales and £6 million£6m to adjusted operating profit when compared to the equivalent figures at constant 2004 exchange rates. 2005 adjusted operating profit also benefited from reduced operating costs at our UK distribution center.
      In the US, successful format innovation helped to address weakness in the mass marketmass-market category that saw a further decline of 4% for the industry in 2005. The first seven Penguin Premium paperbacks were published in 2005, priced at $9.99, and all became bestsellers, with authors including Nora Roberts, Clive Cussler and Catherine Coulter.

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      Penguin authors received a number of awards during the year: A Pulitzer Prize (for Steve Coll’sGhost Wars), a National Book Award (William T. Vollman’sEurope Central), the Whitbread Book of the Year (Hilary Spurling’sMatisse the Master), the Whitbread Novel of the Year (Ali Smith’sThe Accidental) and the FT & Goldman Sachs Business Book of the Year Award (Thomas Friedman’sThe World is Flat). In 2005, there were 129 New York Times bestsellers and 54 top 10 bestsellers in the UK. Major bestselling authors include Patricia Cornwell, John Berendt, Sue Grafton, Jared Diamond, Jamie Oliver, Gillian McKeith, Jeremy Clarkson and Gloria Hunniford.
      In 2005, there was also a strong contribution from new imprints and first-time authors. The new imprint strategy continued to gather pace and Penguin published more than 150 new authors in the US and approximately 250 worldwide — its largest ever investment in new talent. Sue Monk Kidd’s first novel,The Secret Life of Bees, has been a New York Times bestseller for almost two years; her second,The Mermaid Chair, reached number one in 2005.The Kite Runner, Khaled Hosseini’s first book, stayed on the New York Times bestseller list for all of 2005, selling an additional two million copies (three million in total). In the UK, there was also strong performance from new fiction authors including Jilliane Hoffman, PJ Tracy, Karen Joy Fowler and Marina Lewycka.
Results of Operations
Year ended December 31, 2004 compared to year ended December 31, 2003
Consolidated Results of Operations
Sales
      Our total sales decreased by £154 million to £3,696 million in 2004, from £3,850 million in 2003. This decrease of 4% was attributable to the effect of foreign currency exchange. The strength of sterling compared to the US dollar had a significant negative effect on sales, and we estimate that had the 2003 average rates prevailed in 2004, sales would have been higher by £301 million. In constant exchange rate terms Pearson Education had a strong year with an increase in sales of 5%. The Higher Education and Professional businesses were the main contributors to this growth with the Higher Education business growing faster than its market for the sixth straight year and Professional benefiting from new contracts and add-ons to existing contracts at Pearson Government Solutions. The School business was helped by a full year contribution from Edexcel, the UK testing business, but otherwise sales were flat as new adoption spending in the US fell by approximately $200 million. The FT Group sales were ahead of last year after another good year at Interactive Data and a return to sales growth for the Financial Times newspaper in a more stable business advertising environment. Penguin’s results were disappointing with sales down 6% as reported, but flat on a constant currency basis after disruption to UK distribution and a weakness in the US consumer publishing market.
      Pearson Education, our largest business sector, accounted for 63% of our sales in 2004 and in 2003. North America continued to be the most significant source of our sales although sales in the region decreased, as a proportion of total sales, to 68% in 2004, compared to 71% in 2003. This decrease in 2004, however, reflects the comparative strength of sterling and the euro compared to the US dollar.
Cost of Sales and Net Operating Expenses
      The following table summarizes our cost of sales and net operating expenses:
         
  Year Ended
  December 31
   
  2004 2003
     
  £m £m
Cost of goods sold  1,789   1,846 
       
Distribution costs  201   206 
Administrative and other expenses  1,365   1,439 
Other income  (46)  (51)
       
Total operating expenses  1,520   1,594 
       
Cost of Sales.Cost of sales consists of costs for raw materials, primarily paper, printing costs, amortization of pre-publication costs and royalty charges. Our cost of sales decreased by £57 million, or 3%, to

31


£1,789 million in 2004, from £1,846 million in 2003. The decrease mainly reflected the decrease in sales over the period with overall gross margin remaining constant.
Distribution Costs.Distribution costs consist primarily of shipping costs, postage and packing.
Administration and Other Expenses.Our administration and other expenses decreased by £74 million, or 5%, to £1,365 million in 2004, from £1,439 million in 2003. Administration and other expenses as a percentage of sales remained constant at 37%. The decrease in administration and other expenses comes from both the effect of exchange and increased efficiencies, in particular from the cost actions taken at the Financial Times in recent years.
Other Operating Income.Other operating income mainly consists of sub-rights and licensing income and distribution commissions. Other operating income decreased 10% to £46 million in 2004 from £51 million in 2003 with the decrease mainly representing the continued decline in distribution commissions received for distribution of third party books.
Other Net Gains and Losses
      Profits or losses on the sale of businesses, associates and investments that are included in our continuing operations are reported as other net gains and losses. In 2004, other gains and losses amounted to £9 million with the principal items being profits on the sale of stakes in Capella and Business.com. In 2003 there were small losses on a number of items totaling £6 million.
Share of results of joint ventures and associates
      The contribution from our joint ventures and associates increased from £2 million in 2003 to £8 million in 2004. The increase was largely due to a reduction in losses at FT Deutschland together with some improvement in profit at the Economist.
Operating Profit/Loss
      The total operating profit in 2004 of £404 million compares to a profit of £406 million in 2003. This marginal decrease was due to the impact of exchange rates. We estimate that had the 2003 average rates prevailed in 2004, operating profit would have been £51 million greater. Operating profit attributable to Pearson Education remained constant at £287 million in both 2004 and 2003. There was an estimated reduction in profit of £29 million from exchange. After accounting for exchange rates, operating profit was ahead in each of the School, Higher Education and Professional businesses. Operating profit attributable to the FT Group increased by £33 million, or 89%, to £70 million in 2004, from £37 million in 2003. The increase was largely due to another strong performance from Interactive Data and significant cost savings at the Financial Times newspaper. Operating profit attributable to the Penguin Group decreased by £35 million, or 43%, to £47 million in 2004, from £82 million in 2003. The biggest single factor in the profit decline was exchange rates, which are estimated to have accounted for £14 million of the difference. There were also a number of other factors, including disruption in UK distribution following the move to a new warehouse and the weakness of the US consumer publishing market.
Net Finance Costs
      Net finance costs decreased by £14 million to £79 million in 2004 from £93 million in 2003. Net interest payable decreased by £10 million, or 12%, to £74 million in 2004, from £84 million in 2003. The reduction is due to lower average net debt levels in 2004, which more than offset the effect of a general increase in floating interest rates, and a one-off credit of £9 million for interest on a repayment of tax in France which reduced the net interest cost in 2004. Year end indebtedness decreased to £1,221 million in 2004 compared to £1,376 million in 2003 due to funds generated from operations and foreign exchange movements. The weighted average three month London Interbank Offered (“LIBOR”) rate, reflecting our borrowings in US dollars, euros and sterling, rose by 40 basis points, or 0.4%. The company is partially protected from these increases by our treasury policy, which put £736 million of the year end debt on a fixed rate basis. As a result the net interest rate payable (excluding the £9 million credit referred to above) rose by only 25 basis points or 0.25% to 5% in 2004. For a more detailed discussion of our borrowings and interest expenses see “— Liquidity and Capital Resources — Capital Resources” and “— Borrowing” and “Item 11. Quantitative and Qualitative Disclosures About Market Risk”.

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Taxation
      The overall taxation charge for 2004 was £63 million, compared to a charge of £61 million in 2003. In 2004 the Group recorded a total pre-tax profit of £325 million giving a tax rate of 19% compared to a similar rate of 19% on total pre-tax profits of £313 million in 2003. These low rates of tax were mainly a result credits of £56 million and £48 million respectively relating to prior year items; these reflect a combination of settlements with the Inland Revenue authorities and changes to deferred tax balances.
Minority Interests
      Minority interests principally consist of the public’s 39% interest in Interactive Data.
Discontinued Operations
      Following the disposal of Recoletos in 2005, the results of Recoletos have been included in discontinued operations in 2004 and 2003. The results for 2004 include an operating profit of £26 million compared to an operating profit in 2003 of £43 million. The profit in 2003 includes a profit of £12 million on the sale of the Recoletos interest in El Mundo.
Profit for the Financial Year
      The total profit for the financial year in 2004 was £284 million compared to a profit in 2003 of £275 million. The overall increase of £9 million was mainly due to the decrease in net finance costs in 2004 after adverse movements in exchange had eroded the underlying increase in operating profit.
Earnings per Ordinary Share
      The basic earnings per ordinary share, which is defined as the profit for the financial year divided by the weighted average number of shares in issue, was 32.9 pence in 2004 compared to 31.7 pence in 2003 based on a weighted average number of shares in issue of 795.6 million in 2004 and 794.4 million in 2003. This increase in earnings per share was due to the additional profit for the financial year described above and was not significantly affected by the movement in the weighted average number of shares.
      The diluted earnings per ordinary share of 32.9 pence in 2004 and 31.7 pence in 2003 was not significantly different from the basic earnings per share in those years as the effect of dilutive share options was again not significant.
Exchange Rate Fluctuations
      The weakening of the US dollar against sterling on an average basis had a negative impact on reported sales and profits in 2004 compared to 2003. We estimate that if the 2003 average rates had prevailed in 2004, sales would have been higher by £301 million and operating profit would have been higher by £51 million. See “Item 11. Quantitative and Qualitative Disclosures About Market Risk” for a discussion regarding our management of exchange rate risks.
Sales and Operating Profit by Division
      The following table summarizes our operating profit and results from operations for each of Pearson’s divisions. Adjusted operating profit is included as it is a key financial measure used by management to evaluate performance and allocate resources to business segments, as reported under SFAS 131. Since 1998 we have reshaped the Pearson portfolio by divesting of non-core interests and investing in educational publishing and testing, consumer publishing and business information companies. During this period of transformation management has used adjusted operating profit to track underlying core business performance.
      In our adjusted operating profit we have excluded amortization of acquired intangibles, other gains and losses and other net finance costs of associates. The amortization of acquired intangibles is not considered to be fully reflective of the underlying performance of the group. Other gains and losses represent profits and losses on the sale of subsidiaries, joint ventures, associates and investments that are included within continuing operations but which distort the performance for the year.

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      Adjusted operating profit enables management to more easily track the underlying operational performance of the group. A reconciliation of operating profit to adjusted operating profit is included in the table below:
                   
  Year Ended December 31
   
  2004 2003
     
  £m % £m %
         
Total operating profit
                
Pearson Education:                
 School  112   27   114   28 
 Higher Education  133   33   140   35 
 Professional  42   10   33   8 
FT Group:                
 FT Publishing  8   2   (29)  (7)
 IDC  62   16   66   16 
Penguin  47   12   82   20 
             
Total  404   100   406   100 
             
  
Add back:
                
  
Amortization of acquired intangibles
                
  School              
  Higher Education              
  Professional              
  Penguin              
  FT Publishing              
  IDC  5       4     
             
  Total  5       4     
             
  
Other net gains and losses
                
  School  (4)      2     
  Higher Education  (4)      2     
  Professional  (2)      1     
  Penguin  5       1     
  FT Publishing  (4)           
  IDC              
             
  Total  (9)      6     
             
  
Other net finance costs of associates
                
  School              
  Higher Education              
  Professional              
  Penguin              
  FT Publishing              
  IDC              
             
Total              
             
Adjusted operating profit
                
Pearson Education:                
 School  108   27   116   28 
 Higher Education  129   32   142   34 
 Professional  40   10   34   8 
FT Group:                
 FT Publishing  4   1   (29)  (7)
 IDC  67   17   70   17 
Penguin  52   13   83   20 
             
Total  400   100   416   100 
             

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School
      The School business sales decreased by £62 million, or 5%, to £1,087 million in 2004, from £1,149 million in 2003 and adjusted operating profit decreased by £8 million, or 7%, to £108 million in 2004 from £116 million in 2003. Both sales and adjusted operating profit were adversely affected by the weakening US dollar and we estimate that had 2003 average rates prevailed in 2004 then sales would have been approximately £93 million higher than reported and results from operations £8 million higher. The School results include a full year contribution from Edexcel, 75% of which was acquired in 2003. The extra Edexcel contribution increased sales growth in 2004 but reduced profit growth as the business is loss making in the first half.
      In the US school market, adoption spending in 2004 fell by some $200 million to approximately $500 million. Our school businesses took the largest share (27%) of the new adoption opportunities. We benefited from strength across a wide range of subjects and grade levels, with a decline in elementary sales (after particularly strong market share growth in 2003) mitigated by a strong performance in the secondary market. We returned to growth in the open territories and in supplementary publishing, helped by restructuring actions taken in 2003 and by the sharp recovery in US state budgets. Our US school testing business benefited from growth in new and existing state contracts, including Texas, Ohio, Virginia and Washington. We continued to win new multi-year contracts including Tennessee, New Jersey and California ahead of implementation of the No Child Left Behind Act testing requirements, which become mandatory in the school year starting in September 2005. Our digital learning business showed a further profit improvement on slightly lower sales as we continued to integrate our content, testing and technology in a more focused way.
      Outside the US, the School business sales increased with continued growth in English Language Teaching (ELT) helped by a very significant investment in ELT and in school testing we won $200 million of multi-year contracts.
Higher Education
      Higher Education sales decreased by £41 million, to £729 million in 2004, from £770 million in 2003. Adjusted operating profit decreased by £13 million, or 9%, to £129 million in 2004 from £142 million in 2003. Both sales and adjusted operating profit were adversely affected by the weakening US dollar, and we estimate that had 2003 average rates prevailed in 2004 then sales would have been approximately £69 million higher than reported and results from operations £16 million higher than reported. In the US we grew faster than the market for the sixth consecutive year in US dollar terms, up 4% while the industry without Pearson was up 2% according to the Association of American Publishers.
      In the US, our Higher Education business benefited from strength in two-year career colleges, a fast growing segment, with vocational programs in allied health, technology and graphic arts, and elsewhere in math and modern languages. Margins reduced a little as we achieved good growth outside the US and continued to invest to make our technology central to the teaching and learning process. Our custom publishing business, which creates specific programs built around the curricula of individual faculties or professors, grew strongly. Pearson Custom has now increased its sales in dollar terms eight-fold over the past six years and we have introduced our first customized online resources for individual college courses.
Professional
      Sales and profit from operations in our Professional business improved in spite of the weakening dollar. Sales increased by £4 million, or 1%, to £507 million in 2004 from £503 million in 2003. Adjusted operating profit increased by £6 million, or 18%, to £40 million in 2004, from £34 million in 2003. We estimate that had 2003 average rates prevailed in 2004 then sales would have been approximately £60 million higher than reported and results from operations £5 million higher than reported.
      After taking out the effect of exchange rates, Pearson Government Solutions grew sales by 25%, with strong growth from add-ons to existing programs. We also won some important new contracts, including multi-year contracts worth $500 million from customers such as the US Department of Health and Human Services and the London Borough of Southwark. Our professional testing business grew sales (before exchange impacts) by 31% as we benefited from the start-up of major new contracts, although we continued to operate at a small loss as we invested in building up the infrastructure for our 150-strong UK test center

35


network. Markets remained tough for our technology publishing titles, where although sales were lower, profits were broadly level as a result of further cost actions.
FT Publishing
      Sales at the FT Publishing (excluding discontinued businesses) increased by £3 million, from £315 million in 2003 to £318 million in 2004 and adjusted operating profit increased by £33 million from a loss of £29 million in 2003 to a profit of £4 million in 2004. Sales were boosted by a return to growth at theFinancial Times newspaper (“FT”) for the first year since 2000. The FT returned to profit in the seasonally strong fourth quarter of 2004 with both advertising and circulation revenues ahead for the full year.
      Advertising performance across all categories and regions at the FT were mixed throughout the year. While the recruitment and luxury goods categories increased by more than 20%, the business-to-business and technology sectors showed few signs of recovery. In terms of geography, good growth in Europe and Asia offset a very weak US corporate advertising market. Average circulation for 2004 was 3% lower than in 2003, whilst FT.com now has 76,000 paying subscribers and 3.0 million average unique monthly users. Adjusted operating profit at the FT improved by £24 million over 2003 as we continued to reduce the FT’s cost base, which is now £110 million lower than it was in 2000.
      Les Echos achieved euro sales growth of 4% and profits grew strongly despite a volatile advertising market. Average circulation grew 3% to 119,800, while competitors saw falling sales. FT Business posted significant sales growth of 8%, with progress in all its main markets. Profits improved 25% following a continued emphasis on cost management. Adjusted operating profit at the FT’s associates and joint ventures showed a profit of £6 million compared to £2 million in 2003. Losses narrowed at FT Deutschland as circulation and advertising revenue grew strongly. FT Deutschland reached the 100,000 copy sales mark in December and circulation averaged 96,600, up 6% on the previous year. The Economist Group again increased adjusted operating profit with The Economist’s circulation passing the 1 million mark with an average weekly circulation of 1,009,759(January-June Audit Bureau of Circulations period).
Interactive Data
      Interactive Data, our 61%-owned financial information business saw a decrease in sales of £4 million, from £273 million in 2003 to £269 million in 2004 and adjusted operating profit decreased by £3 million from £70 million in 2003 to £67 million in 2004. We estimate that had 2003 average rates prevailed in 2004 then sales would have been approximately £22 million higher than reported and results from operations £7 million higher than reported.
      FT Interactive Data and e-Signal (Interactive Data’s real-time financial market information and decision support tool business) performed well particularly in the US in 2004 where there were some signs of improvement in market conditions. Worldwide renewal rates among institutional clients remained at or above 95%. Demand for Interactive Data’s value-added services remained strong, with the signing of our 100th customer for our Fair Value Information Service product in December 2004. IDC had a first full year contribution from acquisitions made in 2003, ComStock and Hyperfeed Technologies, and acquired FutureSource in September 2004 to expand and compliment e-Signal.
The Penguin Group
      The Penguin Group had a difficult 2004 with sales down 6% to £786 million from £840 million in 2003 and adjusted operating profit down 37% to £52 million in 2004 from £83 million in 2003. Both sales and adjusted operating profit were adversely affected by the weakening US dollar, and we estimate that had 2003 average rates prevailed in 2004 then sales would have been approximately £57 million higher than reported and results from operations £14 million higher than reported. In addition to exchange, the decline in results from operations was caused by a number of factors including disruption at the new UK warehouse and a weakening in the US consumer publishing market.
      In the UK, our move to a new warehouse, to be shared with Pearson Education, disrupted supply of our books and had a particular impact on backlist titles. Although we traded well in the second half of 2004, and shipped more books to our UK customers than in the previous year, we incurred some £9 million of additional costs as we took special measures to deliver books, including the costs of running two warehouses, shipping

36


books direct and additional marketing support. By the end of the year we had eliminated the order backlog in the warehouse and the new management team has continued to make good progress in the early part of 2005.
      After a good start to the year, the US consumer publishing market deteriorated sharply in the second half and full year industry sales were 1% lower than in 2003, according to the Association of American Publishers. The adult mass market segment, which accounts for approximately one-third of Penguin’s US sales, was down 9% for the industry for the full year, and 13% in the second half.
      Despite the problems outlined above, Penguin had another great publishing year in 2004. We benefited from our new imprint strategy, with a further four imprints published for the first time. Non-fiction performed particularly well, with a 40% increase in our titles on the New York Times bestseller list, including Lynne Truss’sEats, Shoots & Leaves (now with over one million copies in print), Ron Chernow’sAlexander Hamilton and Maureen Dowd’sBushworld. Best selling UK titles included Jamie Oliver’sJamie’s Dinners, Sue Townsend’sAdrian Mole and the Weapons of Mass Destruction and Gillian McKeith’sYou Are What You Eat.
Liquidity and Capital Resourcescapital resources
Cash Flowsflows and Financingfinancing
      Net cash inflow from operating activities decreased by £32m, or 5%, to £621m in 2006, from £653m in 2005. This reduction was entirely due to the weakening of the US dollar compared to sterling. The majority of the Group’s cash flows arise in US dollars, so any weakening of the US dollar reduces the Group’s cash flows in sterling terms. The closing rate for translation of dollar cash flows was $1.96 in 2006 ($1.72 in 2005). Underlying working capital efficiency continued to improve. On an average basis, the working capital to sales ratio for our book publishing businesses improved from 27.4% in 2005 to 26.3% in 2006. The net cash inflow from operating activities in 2005 increased by £170 million,£129m, or 24%25%, to £875 million in 2005,£653m from £705 million£524m in 2004, even though the 2004 cash inflow included collectionreceipt of the $151 milliona $151m receivable in respect of the TSA contract. Cash flows withinPart of this increase was due to the education businesses and IDC in particular continued to grow strongly andstrengthening of the US dollar during that period. The closing rate for translation of dollar cash flows at Penguin recovered significantlywas

40


$1.72 in 2005, compared to $1.92 in 2004. The improvement in cash flow from their lower levels in 2004 and 2003. Underlyingoperating activities also reflected more efficient use of working capital efficiency improved considerably.capital. On an average basis, (excluding the impact of the TSA receivable), the working capital to sales ratio for our book publishing businesses improved from 29.4% to 27.4%. Compared to 2003, the net cash inflow from operating activities in 2004 increased by £174 million, or 33%, to £705 million from £531 million. Although the 2004 performance was helped by the receipt of the $151 million receivable27.4% in respect of the TSA contract, growth within the education businesses and IDC underpinned the underlying improvement.2005.
      Net interest paid was £72 million£82m in 2006 compared to £72m in 2005 compared to £85 millionand £85m in 20042004. The 14% increase in 2006 over 2005 reflected the higher average debt resulting from the acquisitions made in the year and £76 millionhigher interest rates (particularly in 2003.the US). The 7% decrease15% reduction in 2005 over 2004 reflectedwas primarily due to the reduction inreduced debt following receipt of the proceeds from the disposalssale of Recoletos and MarketWatch (offset in part by the impact of the year on year increases in interest rates), while the 2004 increase compared to 2003 was entirely due to the year on year increases in interest rates.MarketWatch.
      Capital expenditure on property, plant and equipment was £76 million£68m in 2005 compared to £101 million£76m in 20042005 and £79 million£101m in 2003.2004. The reduction in 2006 compared to 2005 is due to the movement in US dollar exchange rates. The higher spendingexpenditure in 2004 compared to both 2005 and 2003, reflected up-front expenditure on our Professional testing contracts.
      The acquisition of subsidiaries, joint ventures and associates accounted for a cash outflow of £253 million£367m in 2006 against £253m in 2005 against £51 millionand £51m in 20042004. In 2006, the principal acquisition was of Mergermarket for £109m. The balance relates to various smaller bolt-on acquisitions (primarily in the school segment) including those of National Evaluation Systems and £65 million in 2003.Paravia Bruno Mondadori. The principal acquisitions in 2005 were of AGS for £161 million£161m within the School business and IS. Teledata for £29 million£29m by Interactive Data. The principal acquisitions in 2004 were of KAT and Dominie Press for £10 million£10m within our education businesses and FutureSource by Interactive Data for £9 million. The principal acquisition in 2003 was of ComStock by Interactive Data for net cash of £68 million.£9m. The sale of subsidiaries and associates produced a cash inflow of £430 million£10m in 2006 against £430m in 2005 against £31 millionand £31m in 2004 and £56 million2004. The disposal in 2002.2006 relates entirely to the proceeds from the take-up of share options issued to minority shareholders. The principal disposals in 2005 were of Recoletos for net cash proceeds of £371 million£371m and MarketWatch for net cash proceeds of £54 million.£54m. The proceeds in 2004 relate primarily to the sale of Argentaria Cartera by Recoletos. The principal disposal in 2003 was the sale of Unedisa by Recoletos.
      The cash outflow from financing of £321 million£348m in 2006 primarily reflects the payment of the Group dividend (at a higher dividend per share than 2005) and the repayment of a $250m bond at its maturity date. The cash outflow from financing of £321m in 2005 reflects the improved groupGroup dividend (compared to 2004) and the repayment of bank borrowings following the sale of Recoletos. The cash outflow from financing of £261 million£261m in 2004 reflects the payment of the groupGroup dividend and the repayment of one550 million550m bond offset by the proceeds from the issue of new $350 million$350m and $400 million$400m bonds. The cash outflow from financing of £142 million in 2003 again reflects the group dividend and the issue in the year of a $300 million bond as we took advantage of favorable market conditions, offset by the repayment of a250 million bond. Bonds are issued as part of our overall financing program to support general corporate expenditure.

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Capital Resourcesresources
      Our borrowings fluctuate by season due to the effect of the school year on the working capital requirements in the educational materials business. Assuming no acquisitions or disposals, our maximum level of net debt normally occurs in July, and our minimum level of net debt normally occurs in December. Based on a review of historical trends in working capital requirements and of forecast monthly balance sheets for the next 12 months, we believe that we have sufficient funds available for the group’sGroup’s present requirements, with an appropriate level of headroom given our portfolio of businesses and current plans. Our ability to expand and grow our business in accordance with current plans and to meet long-term capital requirements beyond this 12-month period will depend on many factors, including the rate, if any, at which our cash flow increases and the availability of public and private debt and equity financing, including our ability to secure bank lines of credit. We cannot be certain that additional financing, if required, will be available on terms favorable to us, if at all.
      At December 31, 2005,2006, our net debt was £996 million£1,059m compared to net debt of £1,221 million£996m at December 31, 2004.2005. Net debt is defined as all short-term, medium-term and long-term borrowing (including finance leases), less all cash and liquid resources. Liquid resources comprise short-term deposits of 90 days and investments that are readily realizable and held on a short-term basis. Short-term, medium-term and long-term borrowing amounted to £1,959 million£1,743m at December 31, 2005,2006, compared to £1,823 million£1,959m at December 31, 2004.2005. At December 31, 2005,2006, cash and liquid resources were £902 million,£592m, compared to £461 million£902m at December 31, 2004.2005. Some of the cash at December 31, 2006 was being held to fund a591m bond repayment due on February 1, 2007.

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Contractual Obligationsobligations
      The following table summarizes the maturity of our borrowings and our obligations under non-cancelable operating leases.
                      
 At December 31, 2005  At December 31, 2006
     
   Less Than One to Two to After Five    Less than One to Two to After five
 Total One Year Two Years Five Years Years  Total one year two years five years years
                     
 £m £m £m £m £m  £m £m £m £m £m
Gross borrowings:Gross borrowings:                Gross borrowings:                
Bank loans, overdrafts and commercial paper  102  102       Bank loans, overdrafts and commercial paper  173  173       
Variable rate loan notes           Variable rate loan notes           
Bonds  1,854  152  436  310  956 Bonds  1,566  421  105  444  596 
Lease obligationsLease obligations  1,395  129  115  288  863 Lease obligations  1,369  123  113  276  857 
                       
Total
Total
  3,351  383  551  598  1,819 
Total
  3,108  717  218  720  1,453 
                       
      The groupAt December 31, 2006 the Group had capital commitments for fixed assets, including finance leases already under contract, of £1 million.£nil (2005: £1m). There are contingent liabilities in respect of indemnities, warranties and guarantees in relation to former subsidiaries and in respect of guarantees in relation to subsidiaries and associates. In addition there are contingent liabilities in respect of legal claims. None of these claims or guarantees is expected to result in a material gain or loss.
      The groupGroup is committed to a quarterly fee of 0.125%0.0675% per annum, payable quarterly in arrears on the unused amount of the group’sGroup’s bank facility.
Off-Balance Sheetsheet arrangements
      The Group does not have any off-balance sheet arrangements, as defined by the SEC Final Rule 67(FR-67),“Disclosure “Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations”, that have or are reasonably likely to have a material current or future effect on the Group’s financial position or results of operations.
Borrowings
      We have in place a $1.35 billion term$1.75bn revolving credit facility, which matures in July 2009.May 2011. At December 31, 2005,2006, approximately $1.35 billion$1.75bn was available under this facility. This included allocations to

38


refinance short-term borrowings not directly drawn under the facility. The credit facility contains two key covenants measured for each 12 month period ending June 30 and December 31:
      We must maintain the ratio of our profit before interest and tax to our net interest payable at no less than 3:1; and
      We must maintain the ratio of our net debt to our EBITDA, which we explain below, at no more than 4:1.
      “EBITDA” refers to earnings before interest, taxes, depreciation and amortization. We are currently in compliance with these covenants.
Treasury Policypolicy
      We hold financial instruments for two principal purposes: to finance our operations and to manage the interest rate and currency risks arising from our operations and from our sources of financing.
      We finance our 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. We borrow principally in US dollars, sterling and euro at both floating and fixed rates of interest, using derivatives, where

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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. For a more detailed discussion of our borrowing and use of derivatives, see “Item 11. Quantitative and Qualitative Disclosures About Market Risk”.
Related Partiesparties
      There were no significant or unusual related party transactions in 2006, 2005 2004 or 2003.2004. Refer to note 3234 in “Item 17. Financial Statements”.
Accounting Principlesprinciples
      The following summarizesFor a summary of the principal differences between IFRS and US GAAP in respect of our financial statements. For further detailsstatements and recent US GAAP and IFRS pronouncements refer to note 3536 in “Item 17. Financial Statements”.
      Before the adoption of IFRS 3 on 1 January 2003 and before the adoption of FAS 142 on 1 January 2002, goodwill was recognized as an asset and amortization expense was recorded over useful lives ranging between 3 and 20 years. Under IFRS 3 and FAS 142 goodwill is no longer amortized but tested annually for impairment. Before the adoption of IFRS, the Group’s intangible assets were not recognized as they did not meet the requirements under UK GAAP. Under IFRS and US GAAP, intangible assets are recognized separately from goodwill when they arise from separate contractual or legal rights or can be separately identified and be sold, transferred, licensed, rented or exchanged regardless of intent. Therefore, intangible assets such as publishing rights, non-compete agreements, software, databases, patents and non-contractual customer relationships such as advertising relationships have been recognized and are being amortized over a range of useful lives between 2 and 25 years. A difference between US GAAP and IFRS arises in goodwill and intangible assets due to the different adoption dates of IFRS 3 and FAS 142 as well as the impact of foreign exchange on the translation of those underlying assets that are denominated in a foreign currency. This difference also creates a difference in the gain or loss recognized on the disposal of a business.
      Under IFRS, the Group reviews the recoverability of goodwill annually. These reviews are based on comparing the fair value of the Group’s cash-generating units determined by discounting future cash flows to their carrying value. Under US GAAP, a two stage impairment test is required at least annually under FAS 142. The Group performed the transitional impairment test under FAS 142 by comparing the carrying value of each reporting unit with its fair value as determined by discounted future cash flows. The Group also completed the annual impairment tests required by FAS 142 in 2005, 2004 and 2003. The Group has determined that its reporting units under FAS 142 are consistent with its cash-generating units under IAS.
      IAS 12“Income Taxes” requires a full provision to be made for deferred taxes. Deferred taxes are to be accounted for on all temporary differences, with deferred tax assets recognized to the extent that they are more likely than not recoverable against future taxable profits. Under US GAAP, deferred tax assets not considered recoverable are adjusted through a separate valuation allowance in the balance sheet. There are no separate valuation allowances under IFRS. Under US GAAP, deferred taxes are accounted for in accordance with FAS 109,“Accounting for Income Taxes,” with a full provision also made for deferred taxes on all temporary

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differences and a valuation allowance is established when it is more likely than not that they will not be realised. This is similar to the treatment required under IAS 12.
      Using the transitional exceptions of IAS 39, derivatives were accounted for in accordance with UK GAAP for the years ended 31 December 2003 and 2004. Under UK GAAP, there are no specific criteria, which must be fulfilled in order to record derivative contracts such as interest rate swaps, currency swaps and forward currency contracts as a hedging instrument. Accordingly, based upon our intention and stated policy with respect to entering into derivative transactions, they have been recorded as hedging instruments for UK GAAP. This means that unrealized gains and losses on these instruments are typically deferred and recognized when realized. From 1 January 2005, the Group has adopted IAS 39“Financial Instruments: Recognition and Measurement” and IAS 32“Financial Instruments: Disclosure and Presentation”. Under US GAAP, we have adopted FAS 133,“Accounting for Derivative Instruments and Hedging Activities” and its related guidance. In 2003, our derivative contracts did not meet the prescribed criteria for hedge accounting, and have been recorded at market value at each period end, with changes in their fair value being recorded in the profit and loss account. In 2004 the Group met the prescribed designation requirements and hedge effectiveness tests under US GAAP for certain of its derivative contracts. As a result, the movements in the fair value of the effective portion of fair value hedges and net investment hedges have been offset in earnings and other comprehensive income respectively by the corresponding movement in the fair value of the underlying bond or asset.
      Finance lease rentals are capitalized at the net present value of the total amount of rentals payable under the leasing agreement (excluding finance charges) and depreciated over the period of the lease (if in respect of property) or the useful economic life of the asset (if in respect of plant and equipment). Finance charges are written off over the period of the lease in reducing amounts in relation to the written down carrying cost. Operating lease rentals are charged to the profit and loss on a straight-line basis over the duration of each lease term.
      Under IFRS and US GAAP, the annual pension is determined in accordance with IAS 19 “Employee Benefits” and FAS 87 “Employers Accounting for Pensions”. Actuarial assumptions are adjusted annually to reflect current market and economic conditions. Under IFRS the difference between the fair value of the assets and the defined benefit obligation is recognized as a prepayment/ liability. Actuarial gains and losses are recognized in the statement of recognized income and expenses. Under US GAAP, if the fair value of a pension plan’s assets is below the plan’s accumulated benefit obligation, a minimum pension liability is required to be recognized in the balance sheet. Unrecognized gains or losses outside the 10% corridor are spread over the employees’ remaining service lifetimes.
      Under IFRS and US GAAP, we account for options and restricted shares granted to employees using their fair value. Compensation expense is determined based upon the fair value at the grant date, and has been estimated using the Black Scholes, Binomial or Monte Carlo model as appropriate. Compensation cost is recognized over the service life of the awards, which is normally equal to the vesting period. Differences between the US GAAP and IFRS charges are mainly due to the different treatment of options with graded vesting features. Under IFRS, the charge is recognized as the options gradually vest. Under US GAAP, the charge is recognized on a straight line basis over the vesting period. Other noteable differences include the treatment of forfeitures.
      For a further explanation of the differences between IFRS and US GAAP see note 35 to the consolidated financial statements.
Recent U.S. Accounting Pronouncements
      In November 2004, the FASB issued FASB Statement No. 151“Inventory Costs  — An Amendment of ARB No. 43, Chapter 4” (“FAS 151”). FAS 151 amends the guidance in ARB No. 43, Chapter 4 “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. Additionally, FAS 151 requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. FAS 151 is effective for fiscal years beginning after June 15, 2005.

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The Group will adopt FAS 151 in 2006 but does not expect the adoption of the new standard to have a material impact.
      In December 2004, the FASB issued FASB Statement No. 153“Exchanges of Nonmonetary Assets — An Amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions” (“FAS 153”). FAS 153 eliminates the exception from fair value measurement for non monetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” and replaces it with an exception for exchanges that do not have commercial substance. FAS 153 specifies that a non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. FAS 153 is effective for the fiscal periods beginning after June 15, 2005. The Group will adopt FAS 153 in 2006 but does not expect the adoption of the new standard to have a material impact.
      In December 2004, the FASB issued FASB Statement No. 123 (revised 2004)“Share-Based Payment” (“FAS 123(R)”), which replaces FAS No. 123“Accounting for Stock-Based Compensation” (“FAS 123”) and supersedes APB Opinion No. 25“Accounting for Stock Issued to Employees.” FAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim or annual period after June 15, 2005, with early adoption encouraged. The pro forma disclosures previously permitted under FAS 123 no longer will be an alternative to financial statement recognition. The Group will adopt FAS 123(R) in 2006 but does not expect the adoption of the new standard to have a material impact as it already recognizes share-based payment cost in its income statement in accordance with FAS 123.
      In March 2005, the FASB issued FASB Interpretation No. 47“Accounting for Conditional Asset Retirement Obligations — an interpretation of FASB Statement No. 143” (“FIN 47”). FIN 47 clarifies the timing of liability recognition for legal obligations associated with the retirement of a tangible long-lived asset when the timing and/or settlement are conditional on a future event. FIN 47 is effective for the fiscal periods ending after December 15, 2005. The adoption of FIN 47 did not have a material impact on the Group.
      In May 2005, the FASB issued Statement No. 154,“Accounting Changes and Error Corrections — A replacement of APB Opinion No. 20 and FASB Statement No. 3” (“FAS 154”). This statement requires retrospective application to prior periods’ financial statements of changes in accounting principles unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement applies to all voluntary changes in accounting principles and changes required by an accounting pronouncement that does not include specific transition provisions. FAS 154 is required to be adopted in fiscal years beginning after December 15, 2005. FAS 154 would not have had a material effect on the financial position, results of operations or cash flows of the Group under US GAAP as at December 31, 2005.
      In October 2005, the FASB issued FASB Staff Position (FSP) 13-1“Accounting for Rental Costs Incurred during a Construction Period” (“FSP 13-1”). FSP 13-1 requires rental costs associated with ground or building operating leases that are incurred during a construction period to be recognized as rental expense and included in income from continuing operations. FSP 13-1 is effective for the fiscal periods beginning after December 15, 2005. The Group will adopt FSP 13-1 in 2006 but does not expect the adoption of the new standard to have a material impact.
      In January 2006 the FASB issued FASB Statement No. 155“Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140” (“FAS 155”). FAS 155 provides entities with relief from having to separately determine the fair value of an embedded derivative that would otherwise be required to be bifurcated from its host contract. FAS 155 is effective for all financial instruments acquired, issued or subject to a remeasurement event occurring after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Group is currently evaluating the impact the adoption of FAS 155 will have, but does not expect it to have a material impact.
Recent International Accounting Pronouncements
IFRS 7 “Financial Instruments: Disclosures”. IFRS 7 introduces new disclosures of qualitative and quantitative information about exposure to risks arising from financial instruments, including specified minimum disclosures about credit risk, liquidity risk and market risk. IFRS 7 is effective for accounting

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periods beginning on or after 1 January 2007. The Group is currently assessing the impact of IFRS 7 on the Group’s financial statements, but does not expect it to be significant.
      A complementary amendment of IAS 1“Presentation of Financial Statements — Capital Disclosures”. The amendment to IAS 1 introduces disclosures about the level of an entity’s capital and how it manages capital. The amendment to IAS 1 is effective for accounting periods beginning on or after 1 January 2007. The Group is currently assessing the impact of the amendment to IAS 1, but does not expect it to be significant.
      IFRIC 4“Determining whether an Arrangement contains a Lease”. IFRIC 4 requires the determination if whether an arrangement is or contains a lease to be based on the substance of the arrangement. IFRIC 4 is effective for accounting periods beginning on or after 1 January 2006. The Group will implement IFRIC 4 from 1 January 2006 but does not expect it to have a significant impact on the Group’s operations.
      IAS 21 (Amendment)“Net investment in a foreign operation”. This amendment deals with the requirement for a monetary item that forms part of a reporting entity’s net investment in a foreign operation to be denominated in the functional currency of either the reporting entity or the foreign operation. The amendment also clarifies the accounting treatment of exchange differences arising on a loan made between two “sister companies” within a group. The exchange differences would be taken to equity in the parent’s consolidated financial statements, irrespective of the currency in which the loan is made, provided that the nature of the loan is similar to an equity investment, that is, settlement of the loan is neither planned nor expected to occur in the foreseeable future.
      IFRIC 8“Scope of IFRS 2”. IFRIC 8 clarifies that transactions within the scope of IFRS 2“Share-based payment”, include those in which the entity cannot specifically identify some or all of the goods or services received. If the identifiable consideration given appears to be less than the fair value of the equity instruments granted or liability incurred, this situation generally indicates that other consideration has been or will be received.
ITEM 6.     DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES
Directors and Senior Managementsenior management
      We are managed by a board of directors and a chief executive who reports to the board and manages through a management committee. We refer to the board of directors and the chairman of the board of directors as our “senior management”.
      The following table sets forth information concerning senior management, as of April 2006.2007.
       
Name Age Position
     
Glen Moreno  6263  Chairman
Marjorie Scardino  5960  Chief Executive
David Arculus60Non-executive Director
David Bell  5960  Director for People and Chairman of theThe FT Group
Terry Burns  6263  Non-executive Director
Patrick Cescau  5758  Non-executive Director
Rona Fairhead  4445Chief Executive of The FT Group
Robin Freestone48  Chief Financial Officer
Susan Fuhrman63Non-executive Director
Ken Hydon  62  Non-executive Director
John Makinson  5152  Chairman and Chief Executive Officer, Penguin Group
Reuben Mark67Non-executive Director
Vernon Sankey56Non-executive Director
Rana Talwar58Non-executive Director
David Arculus  59  Non-executive Director
Ken Hydon61Non-executive Director
     Glen Morenowas appointed chairman on October 1, October 2005. He is the senior independent non-executive director of Man Group plc and also a director of Fidelity International Limited and a trustee of The Prince of Liechtenstein Foundation and of The Liechtenstein Global Trust.Foundation.
     Marjorie Scardinojoined the board and became chief executive in January 1997. She is a member of Pearson’s nomination committee. She trained and practiced as a lawyer and was chief executive of The Economist Group from 1993 until joining Pearson. She is also a non-executive director of Nokia Corporation.
David Arculusbecame a non-executive director in February 2006 and currently serves on the audit and nomination committees and as chairman of the personnel committee. He is a non-executive director of Telefonica SA, and was previously chairman of O2 plc from 2004 until it was acquired by Telefonica in early 2006. His previous roles include chairman of Severn Trent plc, chairman of IPC Group, chief operating officer

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of United Business Media plc, group managing director of EMAP plc and non-executive director of Barclays Bank plc.
David Bellbecame a director in March 1996. He is chairman of the FT Group, having previously been chief executive of theFinancial Timesfrom 1993 to 1998. In July 1998, he was appointed Pearson’s director for people with responsibility for the recruitment, motivation, development and reward of employees across the Pearson Group. He is also a non-executive director of VITEC Group plc and chairman of Sadlers Wells and Crisis, a charity for the International Youth Foundation.homeless.
     Terry Burnsbecame a non-executive director in May 1999 and the senior independent director in February 2004. He currently serves on the nomination and personnel committees. He was the UK government’s chief economic advisor from 1980 until 1991 and Permanent Secretary of HM Treasury from 1991 until 1998. He is non-executive chairman of Abbey National plc and Glas Cymru Limited and a non-executive director of Banco Santander Central Hispano. On 1 October 2005, he was appointed deputyHe has been chairman of Marks and Spencer Group plc.plc since July 2006, having previously been deputy chairman from October 1, 2005.
     Patrick Cescaubecame a non-executive director in April 2002. He joined the audit committee in January 2005, and is also a member of the nomination committee. He joined Unilever in 1973, latterly serving as Finance Director until January 2001, at which time he was appointed Director of Unilever’s Foods Division. He is currently group chief executive of Unilever.
     Rona Fairheadbecame a director andin June 2002. She was appointed chief executive of the FT Group on June 12, 2006 having previously been chief financial officer inof Pearson from June 2002.2002 and was appointed to the Interactive Data Corporation board on 15 February 2007. She had served as deputy finance director of Pearson from October 2001. From 1996 until 2001, she worked at ICI plc, where she served as executive vice president, group control and strategy, and as a member of the executive committee from 1998. Prior to that, she worked for Bombardier Inc. in finance, strategy and operational roles. She is also a non-executive director of HSBC Holdings plc.
     Robin Freestonebecame a director of Pearson on June 12, 2006 and was appointed chief financial officer, having previously served as deputy chief financial officer since 2004. He was previously group financial controller of Amersham plc (now part of GE), having joined Amersham as chief financial officer of their health business in 2000. Prior to that he held a number of senior financial positions with ICI, Zeneca and Henkel. He is also a non-executive director of eChem Limited.
Susan Fuhrmanbecame a non-executive director in July 2004. She is a member of the audit and nomination committees. She is president of Teachers College at Columbia University, America’s oldest and largest graduate school of education having previously been dean of the Graduate school of Education at the University of Pennsylvania. She is a member of the Board of Trustees of the Carnegie Foundation for the Advancement of Teaching and a memberan officer of the Council for CorporateNational Academy of Education.
Ken Hydonbecame a non-executive director in February 2006 and School Partnershipscurrently serves on the nomination committee and as chairman of the Coca-Cola Foundation.audit committee. He is a non-executive director of Tesco plc, Reckitt Benckiser plc and Royal Berks NHS Foundation Trust. He was previously finance director of Vodafone Group plc and of subsidiaries of Racal Electronics.
     John Makinsonbecame chairman of the Penguin Group in May 2001 and its chief executive officer in June 2002. He was appointed chairman of Interactive Data Corporation in December 2002. He served as PearsonPearson’s Finance Director from March 1996 until June 2002. From 1994 to 1996 he was managing director of theFinancial Times, and prior to that he founded and managed the investor relations firm Makinson Cowell. He is also a non-executive director of George Weston Limited in Canada.
     Reuben Mark became a non-executive director in 1988 and served on the audit and nomination committees and as chairman of the personnel committee. He became chief executive of the Colgate Palmolive Company in 1984, and chairman in 1986. He has held these positions since then. He is also a director of Time Warner Inc. He retired from the board at the 2006 AGM.
Vernon Sankey became a non-executive director in 1993 and served as chairman of the audit committee and as a member of the treasury and nomination committees. He was previously chief executive of Reckitt & Colman plc and is chairman of Photo-Me International plc. He is also a non-executive director of Taylor Woodrow plc and Zurich Financial Services AG. He retired from the board at the 2006 AGM.
Rana Talwarbecame a non-executive director in March 2000 and currently serves on the personnel nomination and treasurynomination committees. He is currently chairman of Sabre Capital Worldwide and Centurion Bank and a non-executive director of Schlumberger Limited and Fortis Bank. He served as group chief executive of Standard Chartered plc from 1998 until 2001, and was at Citicorp from 1969 to 1997, where he held a number of senior international management roles.
David Arculus became a non-executive director in February 2006 and currently serves on He retired from the audit and nomination committees and as chairman ofboard at the personnel committee. He is a non-executive director of Telefonica SA, and was chairman of O2 plc from 2004 until it was acquired by Telefonica in early 2006. His previous roles include chairman of Severn Trent plc, chairman of IPC Group, chief operating officer of United Business Media plc, group managing director of EMAP plc andnon-executive director of Barclays Bank plc.
Ken Hydon became a non-executive director in February 2006 and currently serves on the nomination committee and as chairman of the audit committee. He is a non-executive director of Tesco plc and Reckitt Benckiser plc. He was previously finance director of Vodafone Group plc and of subsidiaries of Racal Electronics.2007 AGM.

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Compensation of Senior Managementsenior management
      It is the role of the personnel committee to approve the remuneration and benefits packages of the executive directors, the chief executives of the principal operating companies and other members of the Pearson Management Committee, as well as to ensure senior management receives the development they need and that succession plans are being made.Committee. The committee also takes note of the remuneration for those executives with base pay over a certain level, representing approximately the top 50 executives of the company.
Remuneration Policypolicy
      Pearson seeks to generate a performance culture by operating incentive programmesprograms that support its business goals and reward their achievement. It is the company’s policy that total remuneration (base compensation plus short- andshort-and long-term incentives) should reward both short- and long-term results, delivering competitive rewards for target performance, but outstanding rewards for exceptional company performance.
      The company’s policy is that base compensation should provide the appropriate rate of remuneration for the job, taking into account relevant recruitment markets and business sectors and geographic regions. Benefit programmesprograms should ensure that Pearson retains a competitive recruiting advantage.
      Share ownership is encouraged throughout the company. Equity-based reward programmesprograms align the interests of directors, and employees in general, with those of shareholders by linking rewards directly to Pearson’s financial performance.
      Total remuneration is made up of fixed and performance-linked elements, with each element supporting different objectives. Base salary and other fixed remuneration (such as benefits and pension) reflectreflects competitive market level, role and individual contribution. Annual incentives motivate the achievement of annual strategic goals. Bonus share matching encourages executive directors and operational goals.other senior executives to acquire and hold Pearson shares and aligns executives and shareholders’ interests. Long-term incentives focus ondrive long-term earnings and share price growth improvement in returns and value creation and align withexecutives’ and shareholders’ interests through ownership and retention of shares.interests.
      Consistent with its policy, the committee places considerable emphasis on the performance-linked elements i.e. annual incentive, bonus share matching and long-term incentives.
      The committee will continue to review the mix of fixed and performance-linked remuneration on an annual basis, consistent with its overall philosophy.
      Our policy is that the remuneration of the executive directors should be competitive with those of directors and executives in similar positions in comparable companies. We use a range of UK and US companies in different sectors including the media sector. Some are of a similar size to Pearson, some smaller,while others are larger, but the method which the committee’s independent advisers use to make comparisons on remuneration takes this into account. In addition, allAll have very substantial overseas operations. We also use selected media companies in North America as well as the UKAmerica. We use these companies because they represent the wider executive talent pool from which we might expect to recruit externally and the pay market to which we might be vulnerable if our remuneration was not competitive.
Base Salarysalary
      Our normal policy is to review salaries annually, consideringtaking into account the remuneration of directors and executives in similar positions in comparable companies, individual performance and levels of pay and pay increases throughout the company.
Other EmolumentsAllowances and benefits
      Other emoluments may include benefits such as company car, healthcare, and, where relevant, amounts paid in respect of housing or other costs.
      It is the company’s policy that its benefit programmesprograms should be competitive in the context of the local labourlabor market, but as an international company we require executives to operate worldwide and recognize that recruitment also operates worldwide.

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Annual Bonusincentives
      The committee establishes the annual incentive plans for the executive directors and the chief executives of the company’s principal operating companies, including performance measures and targets. The committee also establishes the target and maximum levels of individual incentive opportunity based on an assessment by the committee’s independent advisers of market practice for comparable companies and jobs.
      The perform-

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anceperformance measures relate to the company’s main drivers of business performance at both the corporate and operating company level. Performance is measured separately for each item. For each performance measure, the committee establishes thresholds, targets and maxima for different levels of payout. With the exception of the CEO, 10% of the total annual incentive opportunity for the executive directors and other members of the Pearson Management Committee is based on performance against personal objectives. Forobjectives as agreed with the CEO, all measures are financial.CEO.
      For 2006,2007, the financial performance measures for Pearson plc are sales, growth in underlying adjusted earnings per share for continuing operations at constant exchange rates, average working capital as a ratio to sales and operating cash flow. For subsequent years, the measures will be set at the time.
      There have beenFor 2007, there are no changes to the executive directors’ individual incentive opportunities. For the CEO, the target annual incentive opportunity is 100% of base salary and the maximum is 150%. For the other executive directors and other members of the Pearson Management Committee, the target is up to a maximum of 75% of salary and the maximum is twice target.
      The incentive plans are discretionary and the committee may award individual discretionary paymentsreserves the right to make adjustments up or exercise discretion in the payment of bonuses under the plan.down taking into account exceptional factors.
      The committee will continue to review the annual incentive plans each year and to revise the performance measures, targets and individual incentive opportunities in light of current conditions.
      Annual incentive payments do not form part of pensionable earnings.
      For 2006, annual incentives for Marjorie Scardino, David Bell, Rona Fairhead and Robin Freestone were based on the financial performance of Pearson plc. In the case of John Makinson, 70% of his annual incentive was based on the performance of Penguin Group and 20% on the financial performance of Pearson plc. In the case of David Bell, Rona Fairhead, Robin Freestone and John Makinson, 10% of their annual incentives was based on performance against personal objectives.
      For Pearson plc, the performance measures were earnings per share growth, operating cash flow, sales and average working capital as a ratio to sales. Underlying growth in adjusted earnings per share at constant exchange rates consistent with reported adjusted earnings per share of 40.2p was better than target but below the level of performance required for maximum payout. Average working capital as a ratio to sales and operating cash flow of £575m were at and above maximum respectively. Sales at £4,423m were below target but above threshold.
      For Penguin Group, the performance measures were sales, operating profit, operating cash flow and average working capital as a ratio to sales. For working capital as a ratio to sales and operating cash flow, performance was better than that required for maximum payout. Sales and operating profit were both above target but below maximum.
      None of the executive directors was directly covered by the plans for the other operating companies where the same performance measures applied.
Bonus Share Matchingshare matching
      The company encourages executive directors and other senior executives to acquire and hold Pearson shares.
      The annual bonus share matching plan permits executive directors and senior executives around the company to invest up to 50% of any after-tax annual bonus in Pearson shares. For awards to be made insince 2006, and thereafter, if these shares are held and the company’s adjusted earnings per share increase in real terms by at least 3% per annum compound over a five-year period, the company will match them on a gross basis of one share for every two held after

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one held. Half the matching shares will vest if the company’s adjusted earnings per share increase in real terms by at least 3% per annum compound over the first three years, and another one for two held (i.e. a total of one-for-one) after five years.
      Real growth is measured against the UK Government’s Index of Retail Prices (All Items). We choose to test our earnings per share growth against UK inflation over three and five years to measure the company’s financial progress over the period to which the entitlement to matching shares relates.
The Long-Term Incentive Planlong-term incentive plan
      Shareholders atAt the AGMannual general meeting in April 2006, shareholders approved the renewal of the long-term incentive plan first introduced in 2001. The committee has reviewed the operation of this plan in the light of the company’s strategic goals and concluded that it is operating satisfactorily and achieving its objectives. We have therefore sought and received approval of its renewal on broadly its original terms.
      Executive directors, senior executives and other managers will beare eligible to participate in the plan which can deliver restricted stock and/or stock options. The aim as before is to give the committee a range of tools with which to link corporate performance to management’s long-term reward in a flexible way. It is not the committee’s intention to grant stock options in 2007.
      Restricted stock granted to executive directors will vestvests only when stretching corporate performance targets over a specified period have been met. Awards will vest on a sliding scale based on performance over the period. There will beis no retesting. The committee will determinedetermines the performance measures and targets governing an award of restricted stock prior to grant.
      It is notThe performance measures that applied for 2006 and that will apply for the committee’s intention to grant stock options in 2006. Should2007 awards and subsequently for the committee decide to grant them in future, options granted to executive directors would come withare focused on delivering and improving returns to shareholders. These are relative total shareholder return, return on invested capital and earnings per share growth.
      Pearson wishes to encourage executives and managers to build up a minimumlong-term holding of shares so as to demonstrate their commitment to the company. To achieve this, for awards of restricted stock that are subject to performance conditions over a three-year vesting period, and would vest on a sliding scale based on stretching performance over75% of the award vests at the end of the three-year period with no retesting.period. The remaining 25% of the award only vests if the participant retains the after-tax number of shares that vest at year three for a further two years.
      The committee’s independent advisers calculatecommittee establishes each year the expected value of both restricted stock and stock options i.e. their net present value afterindividual awards taking into account allassessments by the conditions and, in particular, the probability that any performance conditions will be met. Taking into account thecommittee’s independent advisors’ values and assessmentsadvisers of market practice for comparable companies, directors’ total remuneration relative to the committee establishes guidelines each year formarket and the maximumpotential value of awards should the performance target be met in full.
      Restricted stock may be granted without performance conditions to satisfy recruitment and retention objectives. Restricted stock awards that are not subject to performance conditions will not be granted to any of the current executive directors.
      Where shares vest, participants receive additional shares representing the gross value of dividends that would have been paid on these shares during the performance period and reinvested. The expected value of individual awards.awards made on this basis take this into account.
      In any rolling 10-year period, no more than 10% of Pearson equity will be issued, or available for issue,be capable of being issued, under all Pearson’s share plans, and no more than 5% of Pearson equity will be issued, or available for issue,be capable of being issued, under executive or discretionary plans.

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Shareholding Policypolicy
      As previously noted, in line with the policy of encouraging widespread employee ownership, the company encourages executive directors to build up a substantial shareholding in the company.
      Given the share retention features of the annual bonus share matching and long-term incentive plans and the volatility of the stock market, we do not think it is necessaryappropriate to specify a particular relationship of shareholding to salary.

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Service Agreementsagreements
      In accordance with long established policy, all continuing executive directors have rolling service agreements under which, other than by termination in accordance with the terms of these agreements, employment continues until retirement.
These service agreements provide that the company may terminate these agreements by giving 12 months’ notice, and in some instances they specify the compensation payable by way of liquidated damages in circumstances where the company terminates the agreements without notice or cause. We feel that these notice periods and provisions for liquidated damages are adequate compensation for loss of office and in line with the market. The compensation payable in these circumstances is typically 100% of annual salary, 100% of other benefits and a proportion of potential bonus.
      Peter Jovanovich stood down as a director of the company for health reasons on 31 January 2005, but remained entitled to contractual short- and long-term disability and other benefits. These arrangements are set out in an agreement dated 28 January 2005. Dennis Stevenson retired as chairman and director on 1 October 2005. Glen Moreno was appointed chairman and director on 1 October 2005.
Retirement Benefitsbenefits
      Following are the retirement benefits for each of the executive directors.
      Executive directors participate in the approved pension arrangements set up for Pearson employees. Marjorie Scardino, John Makinson, Rona Fairhead and Peter JovanovichRobin Freestone will also receive benefits under unapproved arrangements because of the cap on the amount of benefits that can be provided from the approved arrangements in the US and the UK.
      The pension arrangements for all the executive directors include life insurance cover while in employment, and entitlement to a pension in the event of ill-health or disability. A pension for their spouse and/or dependants is also available on death.
      In the US, the approved defined benefit arrangement is the Pearson Inc. Pension Plan. This plan provides a lump sum convertible to a pension on retirement. The lump sum accrued at 6% of capped compensation until December 31, December 2001 when further benefit accruals ceased. Normal retirement is age 65 although early retirement is possible subject to a reduction for early payment. No increases are guaranteed for pensions in payment. There is a spouse’s pension on death in service and the option to provide a death in retirement pension by reducing the member’s pension.
      The approved defined contribution arrangement in the US is a 401(k) plan. At retirement, the account balances will be used to provide benefits. In the event of death before retirement, the account balances will be used to provide benefits for dependants.
      In the UK, the approved plan is the Pearson Group Pension Plan and some executive directors participate in either the Final Pay or the Money Purchase 2003 section. Normal retirement age is 62 but, subject to company consent, retirement is possible after age 50. The accrued pension is reduced on retirement prior to age 60. Pensions in payment are guaranteed to increase each year at 5% or the increase in the Index of Retail Prices, if lower. Pensions for a member’s spouse, dependentdependant children and/or nominated financial dependant are payable in the event of death.
      Members of the Pearson Group Pension Plan who joined after May 1989 are subject to an upper limit of earnings that can be used for pension purposes, known as the earnings cap. This limit, £108,600 as at April 5, 2006, was abolished by the Finance Act 2004. However the Pearson Group Pension Plan has retained its own ‘cap’, which will increase annually in line with the UK Government’s Index of Retail Prices (All Items).
In response to the UK Government’s plans for pensions simplification and so-called ’A-Day’‘A-Day’ effective from April 2006, UK executive directors and other members of the Pearson Group Pension Plan who are, or become, affected by the lifetime allowance will bewere offered a cash supplement as an alternative to further accrual of pension benefits on a basis that is broadly cost neutral to the company. Further details will be set out in the report on directors’ remuneration for 2006.
Marjorie Scardino
      Marjorie Scardino participates in the Pearson Inc. Pension Plan and the approved 401(k) plan.
      Additional pension benefits will be provided through an unfunded unapproved defined contribution plan and a

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funded defined contribution plan approved by HM Revenue and Customs as a corresponding plan to

48


replace part of the unfunded plan. The account balance of the unfunded unapproved defined contribution plan is determined by reference to the value of a notional cash account that increases annually by a specified notional interest rate. This plan provides the opportunity to convert a proportion of this notional cash account into a notional share account reflecting the value of a number of Pearson ordinary shares. The number of shares in the notional share account is determined by reference to the market value of Pearson shares at the date of conversion.
David Bell
      David Bell is a member of the Pearson Group Pension Plan. He is eligible for a pension of two-thirds of his final base salary at age 62 due to his long service. Earlyservice but early retirement with a reduced pension before that date is possible, subject to company consent.
Rona Fairhead
      Rona Fairhead is a member of the Pearson Group Pension Plan. Her pension accrual rate is 1/30th of pensionable salary per annum, restricted to the plan earnings cap introduced bycap.
      Until April 2006, the Finance Act 1989. The company also contributescontributed to a Funded Unapproved Retirement Benefits Scheme (FURBS) on her behalf. In the event of death before retirement, the proceeds of the FURBS account will be used to provide benefits for her dependants. Since April 2006, she has received a taxable and non-pensionable cash supplement in replacement of the FURBS.
Peter JovanovichRobin Freestone
      Peter JovanovichRobin Freestone is a member of the Pearson Inc. Pension Plan and the approved 401(k) plan. He also participates in an unfunded, unapproved Supplemental Executive Retirement Plan (SERP) that provides an annual accrualMoney Purchase 2003 section of 2% of final average earnings, less benefits accrued in the Pearson Inc.Group Pension Plan and US Social Security. He ceasedPlan. Company contributions are 16% of pensionable salary per annum, restricted to build up further benefits in the SERP at 31 December 2002. Additional defined contribution benefits are provided throughplan earnings cap.
      Until April 2006, the company also contributed to a funded, unapproved 401(k) excess plan and an unfunded, unapproved arrangement.Funded Unapproved Retirement Benefits Scheme (FURBS) on his behalf. In the event of death while in receiptbefore retirement, the proceeds of disability benefits, the FURBS account balances in the defined contribution arrangements will be used to provide benefits for his dependants. The SERP arrangement providesSince April 2006, he has received a spouse’s pension on death whiletaxable and non-pensionable cash supplement in receiptreplacement of disability benefits and the option of a death in retirement pension by reducing the member’s pension.FURBS.
John Makinson
      John Makinson is a member of the Pearson Group Pension Plan under which his pensionable salary is restricted to the plan earnings cap. The company ceased contributions on December 31, December 2001 to his FURBS arrangement. During 2002 it set up an Unfunded Unapproved Retirement Benefits Scheme (UURBS) for him. The UURBS tops up the pensionspension payable from the Pearson Group Pension Plan and the closed FURBS to target a pension of two-thirds of a revalued base salary on retirement at age 62. The revalued base salary is defined as £450,000 effective at June 1, June 2002, increased at January 1, January each year by reference to the increase in the UK Government’s Index of Retail Prices.Prices (All Items). In the event of his death a pension from the Pearson Group Pension Plan, the FURBS and the UURBS will be paid to his spouse or nominated financial dependant. Early retirement is possible from age 50, with company consent. The pension is reduced to reflect the shorter service, and before age 60, further reduced for early payment.
Chairman’s Remuneration
Executive directors’ non-executive directorships
      Our policy is that executive directors may, by agreement with the board, serve as non-executives of other companies and retain any fees payable for their services.
      The following executive directors served as non-executive directors elsewhere for the period covered by this report as follows: Marjorie Scardino (Nokia Corporation and MacArthur Foundation); David Bell (VITEC Group plc); Rona Fairhead (HSBC Holdings plc); Robin Freestone (eChem) and John Makinson (George Weston Limited).

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Chairman’s remuneration
      Our policy is that the chairman’s pay should be set at a level that is competitive with those of chairmen in similar positions in comparable companies. He is not entitled to any annual or long-term incentive, retirement or other benefits.
      The committee’s viewIn accordance with the terms of his appointment, the committee intends to review the chairman’s remuneration in 2007. Any change to current remuneration is that, taking into accountsubject to the approval of the full board and will be set out in the report on directors’ remuneration of chairmen in comparable positions, the appropriate total pay level is £425,000 per year.for 2007.
Non-executive Directors
Non-Executive directors
      Fees for non-executive directors are determined by the full board having regard to market practice and within the restrictions contained in the company’s articles of association. Non-executive directors receive no other pay or benefits (other than reimbursement for expenses incurred in connection with their directorship of the company) and do not participate in the company’s equity-based incentive plans.

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      For 2005, the chairman and the executive directors of the board reviewed the The level and structure of non-executive directors’ fees which had not been changed sinceeffective from January 2000. After reviewing external benchmarks, they agreed an increase in the basic fee to £45,000, an increase in the fee for the audit and personnel committee chairmen to £10,000, the introduction of separate fees of £5,000 for audit and personnel committee membership and of £10,000 for the senior independent director and the replacement of the fee for non-UK based directors with a fee of £2,500 for overseas meetings.2005 is as follows:
Fees payable from
January 1, 2005
(£)
Basic non-executive director fee45,000
Chairmanship of audit and personnel committees10,000
Membership of audit and personnel committees5,000
Senior independent director’s fee10,000
Overseas meetings (per meeting)2,500
      One-third of the basic fee, or the entire fee in the case of Rana Talwar, is paid in Pearson shares that the non-executive directors have committed to retain for the period of their directorships.
      In the case of Patrick Cescau, hisCescau’s fee wasis paid over to his employer.
      The board intends to review the level and structure of non-executive directors’ fees in 2007. Any changes to existing arrangements will be set out in the report on directors’ remuneration for 2007.
      Non-executive directors serve Pearson under letters of appointment and do not have service contracts. There is no entitlement to compensation on the termination of their directorships.
Remuneration of Senior Management
Remuneration of senior management
      Excluding contributions to pension funds and related benefits, senior management remuneration for 20052006 was as follows:
                    
             Salaries/ Annual      
 Salaries/Fees Bonus(1) Other(2) Total Fees incentive(1) Allowances(2) Benefits Total
                  
 £’000 £’000 £’000 £’000 £000 £000 £000 £000 £000
Chairman
                             
Dennis Stevenson (retired 1 October 2005)  281      281 
Glen Moreno (appointed 1 October 2005)  106      106 
Glen Moreno  425        425 
Executive directors
                             
Marjorie Scardino  710  1,038  62  1,810   830  1,067  50  15  1,962 
David Bell  395  560  17  972   425  512    17  954 
Rona Fairhead  420  608  16  1,044   470  573    19  1,062 
Peter Jovanovich  41    373  414 
Robin Freestone (appointed June 12, 2006)  209  243    8  460 
John Makinson  475  564  211  1,250   490  627  183  26  1,326 
                    
Senior management as a group
  2,428  2,770  679  5,877   2,849  3,022  233  85  6,189 
                    

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(1) For Marjorie Scardino, David Bell and Rona Fairhead, annual incentives were based on the financial performance of Pearson plc. In the case of John Makinson, 70% of hisfull year, Robin Freestone’s remuneration was: salary/fees — £315,170; annual incentive was based on the performance of Penguin Group and 20% on the financial performance of Pearson plc. In the case of David Bell, Rona Fairhead and John Makinson, 10% of their annual incentives was based on performance against personal objectives.— £329,438; benefits — £13,980; total — £658,588.
      For Pearson plc, the performance measures were earnings per share growth, operating cash flow, sales and average working capital as a ratio to sales. Actual underlying growth in adjusted earnings per share at constant exchange rates consistent with the reported adjusted earnings per share (pre-intangibles) of 34.1p, operating cash flow of £570m and average working capital as a ratio to sales were each better than the level of performance required for maximum payout. Actual sales at £4,096m were above target but below maximum.
      For Penguin Group, the performance measures were operating profit, operating cash flow and average working capital as a ratio to sales. For operating cash flow and working capital as a ratio to sales actual performance was better than that required for maximum payout and for operating profit was above target but below maximum.
(2) Other emoluments include company car and healthcare benefits. In the case ofAllowances for Marjorie Scardino these include £39,245£40,190 in respect of housing costs and a cash US payroll supplement of £8,372.£9,646. John Makinson is entitled to a location and market premium in relation to the management of the business of the Penguin Group in the US. HeUS and received £186,279 in cash£183,125 for 2005.2006.
(3) Benefits include company car, car allowance and health care. Marjorie Scardino, Rona Fairhead, David Bell and John Makinson have the use of a chauffeur. In accordance with
(4) No amounts as compensation for loss of office and no expense allowances chargeable to UK income tax were paid during the agreement dated 28 January 2005 referred to on page 26 of this report, Peter Jovanovich received short-and long-term disability payments in cash for the period 1 February 2005 to 31 December 2005.year.

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Share Optionsoptions of Senior Managementsenior management
      This table sets forth for each director the number of share options held as of December 31, 20052006 as well as the exercise price, rounded to the nearest whole penny/cent, and the range of expiration dates of these options.
                     
  Number of   Exercise Earliest  
Director Options (1) Price Exercise Date Expiry Date
           
Dennis Stevenson3,556b494.8p01/08/1101/02/12
Total
3,556
Marjorie ScardinoScardino(2)  176,556   a*  973.3p   09/14/09/01   09/14/09/08 
   5,660   a*  1090.0p   09/14/09/01   09/14/09/08
2,224b424.8p01/08/0601/02/07 
   37,583   c*  1372.4p   06/08/06/02   06/08/06/09 
   37,583   c*  1647.5p   06/08/06/02   06/08/06/09
37,583c1921.6p08/06/0208/06/09 
   36,983   c   3224.3p   05/03/05/03   05/03/05/10 
   41,550   d*  1421.0p   05/09/05/02   05/09/05/11 
   41,550   d*  1421.0p   05/09/05/03   05/09/05/11 
   41,550   d*  1421.0p   05/09/05/04   05/09/05/11 
   41,550   d*  1421.0p   05/09/05/05   05/09/05/11 
                
Total
  500,372460,565                
                
David Bell  20,496   a*  973.3p   09/14/09/01   09/14/09/08
272b696.0p01/08/0501/02/06
444b424.8p01/08/0601/02/07 
   1,142   b   494.8p   08/01/08/07   02/01/02/08 
   373   b   507.6p   08/01/08/08   02/01/09
297b629.6p08/01/0902/0901/10 
   18,705   c*  1372.4p   06/08/06/02   06/08/06/09 
   18,705   c*  1647.5p   06/08/06/02   06/08/06/09
18,705c1921.6p08/06/0208/06/09 
   18,686   c   3224.3p   05/03/05/03   05/03/05/10 
   16,350   d*  1421.0p   05/09/05/02   05/09/05/11 
   16,350   d*  1421.0p   05/09/05/03   05/09/05/11 
   16,350   d*  1421.0p   05/09/05/04   05/09/05/11 
   16,350   d*  1421.0p   05/09/05/05   05/09/05/11 
                
Total
  162,928143,804                
                
Rona Fairhead  1,904   b   494.8p   08/01/08/07   02/01/02/08 
   20,000   d*  822.0p   11/01/11/02   11/01/11/11 
   20,000   d*  822.0p   11/01/11/03   11/01/11/11 
   20,000   d*  822.0p   11/01/11/04   11/01/11/11 
                
Total
  61,904                
                

4951


                     
  Number of   Exercise Earliest  
Director Options (1) Price Exercise Date Expiry Date
           
Peter Jovanovich  8,250   a*  757.5p   12/09/00   12/09/07 
   102,520   a*  676.4p   12/09/00   12/09/07 
   32,406   c*  1372.4p   08/06/02   08/06/09 
   32,406   c*  1647.5p   08/06/02   08/06/09 
   32,406   c   1921.6p   08/06/02   08/06/09 
   33,528   c   3224.3p   03/05/03   03/05/10 
   31,170   d* $21.00   09/05/02   09/05/11 
   31,170   d* $21.00   09/05/03   09/05/11 
   31,170   d* $21.00   09/05/04   09/05/11 
   31,170   d* $21.00   09/05/05   09/05/11 
   20,000   d* $11.97   01/11/02   01/11/11 
   20,000   d* $11.97   01/11/03   01/11/11 
   20,000   d* $11.97   01/11/04   01/11/11 
                
Total
  426,196                
                
John Makinson  36,736   a*  584.0p   08/08/99   08/08/06 
   73,920   a*  676.4p   12/09/00   12/09/07 
   30,576   a*  973.3p   14/09/01   14/09/08 
   4,178   b   424.8p   01/08/10   01/02/11 
   21,477   c*  1372.4p   08/06/02   08/06/09 
   21,477   c*  1647.5p   08/06/02   08/06/09 
   21,477   c   1921.6p   08/06/02   08/06/09 
   21,356   c   3224.3p   03/05/03   03/05/10 
   19,785   d*  1421.0p   09/05/02   09/05/11 
   19,785   d*  1421.0p   09/05/03   09/05/11 
   19,785   d*  1421.0p   09/05/04   09/05/11 
   19,785   d*  1421.0p   09/05/05   09/05/11 
                
Total
  310,337                
                
Number ofExerciseEarliest
DirectorOptions(1)PriceExercise DateExpiry Date
Robin Freestone1,866b507.6p08/01/0802/01/09
Total
1,866
John Makinson73,920a*676.4p09/12/0009/12/07
30,576a*973.3p09/14/0109/14/08
4,178b424.8p08/01/1002/01/11
21,477c*1372.4p06/08/0206/08/09
21,477c*1647.5p06/08/0206/08/09
21,356c3224.3p05/03/0305/03/10
19,785d*1421.0p05/09/0205/09/11
19,785d*1421.0p05/09/0305/09/11
19,785d*1421.0p05/09/0405/09/11
19,785d*1421.0p05/09/0505/09/11
Total
252,124
 
(1) Shares under option are designated as:aexecutive;bworldwide save for shares;cpremium priced; anddlong-term incentive; and*where options are exercisable.
aExecutive
 Subject to any performance condition being met,The plans under which these options were granted were replaced with the introduction of the long-term incentive plan in 2001. No executive options becomehave been granted to the directors since 1998. All options that remain outstanding are exercisable on the third anniversary of the date of grant(all performance conditions having already been met prior to 2005) and lapse if they remain unexercised at the tenth.
Options granted prior to 1996 are not subject to performance conditions representing market best practice at that time.
The exercisetenth anniversary of options granted since 1996 is subject to a real increase in the company’s adjusted earnings per share over any three-year period prior to exercise.date of grant.
bWorldwide save for shares
 The acquisition of shares under the worldwide save for shares plan is not subject to the satisfaction of a performance target.
cPremium priced
 Subject toThe plan under which these options were granted was replaced with the performance conditions being met,introduction of the long-term incentive plan in 2001. No Premium Priced Options (PPOs) have been granted to the directors since 1999. The share price targets for the three-year and five-year tranches of PPOs granted in 1999 have already been met prior to 2006. The share price target for the seven-year tranche of PPOs granted in 1999 was not met in 2006 and the options lapsed. The share price target for the outstanding PPOs granted in 2000 has yet to be met. The secondary real growth in earnings per share target for any PPOs to become exercisable on the third anniversary of the date of grant andhas already been met prior to 2006.
All PPOs that remain outstanding lapse if they remain unexercised at the tenth.
PPOs were granted in three tranches. For these to become exercisable,tenth anniversary of the Pearson share price has to stay above the option price for 20 consecutive days within three, five and seven years respectively. In addition, for options to be exercisable, the company’s adjusted earnings per share have to increase in real terms by at least 3% per annum over the three-year period prior to exercise.date of grant.
dLong-term incentive

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 Options granted in 2001 were based on pre-grant earnings per share growth of 75% against a target of 16.6% over the period 1997 to 2000 andAll options that remain outstanding are not subject to further performance conditions on exercise.
Long-term incentive options granted on May 9, 2001 become exercisable in tranches on the first, second, third and fourth anniversary of the date of grant and lapse if they remain unexercised at the tenth. The fourth tranche lapses if any of the options in the first, second or third tranche are exercised prior to the fourthtenth anniversary of the date of grant.
Long-term incentive options granted on November 1, 2001 become exercisable in tranches on the first, second and third anniversary of the date of grant and lapse if they remain unexercised at the tenth.
(2) In addition, Marjorie Scardino contributes US$1,000 per month (the maximum allowed) to the above listed optionsUS employee stock purchase plan. The terms of this plan allow participants to make monthly contributions for one year and to acquire shares at the end of that period at a price that is the lower of the market price at the beginning or the end of the period, both Marjorie Scardino and Peter Jovanovich participate in the Pearson US Employee Stock Purchase Plan saving the maximum amount of US$12,000 per annum.less 15%.
Share Ownershipownership of Senior Managementsenior management
      The table below sets forth the number of ordinary shares and restricted shares held by each of our directors as at March 31, 2006.2007. Additional information with respect to share options held by, and bonus

52


awards for, these persons is set out above in “Remuneration of Senior Management” and “Share Options for Senior Management”. The total number of ordinary shares held by senior management as of March 31, 20062007 was 626,152734,913 representing less than 1% of the issued share capital on March 31, 2006.2007.
                
As at March 31, 2006 Ordinary Shares(1) Restricted Shares(2)
 Ordinary Restricted
As at March 31, 2007 shares(1) shares(2)
        
Glen Moreno  100,000     110,000   
Marjorie Scardino  184,889  1,336,015   216,777  1,668,675 
David Arculus (appointed February 28, 2006)  1,317   
David Bell  103,158  587,829   109,578  658,625 
Terry Burns  5,717     7,349   
Patrick Cescau       2,758   
Rona Fairhead  43,209  637,936   62,593  750,046 
Robin Freestone (appointed June 12, 2006)  2,089  153,435 
Susan Fuhrman  2,681     4,163   
Ken Hydon (appointed February 28, 2006)  6,317   
John Makinson  149,466  642,756   172,872  724,562 
Reuben Mark  16,908   
Vernon Sankey  5,563   
Rana Talwar  14,561   
Reuben Mark (resigned April 21, 2006)  16,908   
Vernon Sankey (resigned April 21, 2006)  5,563   
Rana Talwar (resigned April 27, 2007)  18,683   
 
(1) Amounts include shares acquired by individuals under the annual bonus share matching plan and amounts purchased in the market by individuals.
 
(2) Restricted shares comprise awards made under the reward, annual bonus share matching andlong-term incentive plans. The number of shares shown represents the maximum number of shares which may vest, subject to the performance conditions being fulfilled.
Employee Share Ownership Plansshare ownership plans
Worldwide Savesave for Sharesshares & US Employee Share Purchase Plansemployee share purchase plans
      In 1998, we introduced a worldwide save for shares plan. Under this plan, our employees around the world have the option to save a portion of their monthly salary over periods of three, five or seven years. At the end of this period, the employee has the option to purchase ordinary shares with the accumulated funds at a purchase price equal to 80% of the market price prevailing at the commencement of the employee’s participation in the plan.
      In the United States, this plan operates as a stock purchase plan under Section 423 of the US Internal Revenue Code of 1986. This plan was introduced in 2000 following Pearson’s listing on the New York Stock Exchange. Under it, participants save a portion of their monthly salary over six month periods, at the end of which they have the option to purchase ADRs with their accumulated funds at a purchase price equal to 85% of the lower of the market price prevailing at the beginning or end of the period.
Board Practices
      Our board currently comprises the chairman, who is a part-timenon-executive,part-timenon-executive, fourfive executive directors and six (this will be 5 following the resignation of Rana Talwar after April 27, 2007)non-executive directors. Our articles of association provide that at every annual general meeting,one-third of the board of directors, or the number nearest toone-third, shall retire from office. The directors to

51


retire each year are the directors who have been longest in office since their last election or appointment. A retiring director is eligible forre-election. If at any annual general meeting, the place of a retiring director is not filled, the retiring director, if willing, is deemed to have beenre-elected, unless at or prior to such meeting it is expressly resolved not to fill the vacated office, or unless a resolution for there-election of that director has been put to the meeting and

53


lost. Our articles of association also provide that every director be subject tore-appointment by shareholders at the next annual general meeting following their appointment.
      Details of our approach to corporate governance and an account of how we comply with NYSE requirements can be found on our website (www.pearson.com/investor/corpgov.htm).
      The board of directors has established the following committees, all of which have written terms of reference setting out their authority and duties:
Audit Committeecommittee
      This committee provides the board with a vehicle to appraise our financial management and reporting and to assess the integrity of our accounting procedures and financial controls. Until April 21, 2006, Vernon Sankey chairedKen Hydon chairs this committee and Terry Burns,its other members are David Arculus, Patrick Cescau and Reuben Mark were members. Vernon Sankey wasSusan Fuhrman. Ken Hydon is also the designated audit committee financial expert within the meaning of the applicable rules and regulations of the US Securities and Exchange Commission. Vernon Sankey and Reuben Mark retired from the committee on April 21, 2006 and Terry Burns stepped down from the committee on April 27, 2006. Ken Hydon, David Arculus and Susan Fuhrman have now joined the committee, with Ken Hydon as both the chairman and designated audit committee financial expert. Our internal and external auditors have direct access to the committee to raise any matter of concern and to report the results of work directed by the committee. The committee reports to the full board of directors.
Personnel Committeecommittee
      This committee meets regularly to decide the remuneration and benefits of the executive directors and the chief executives of our three operating divisions. The committee also recommends the chairman’s remuneration to the board of directors for its decision and reviews management development and succession plans. Until April 21, 2006, Reuben Mark chairedDavid Arculus chairs this committee and its other members are Terry Burns, and Rana Talwar were members. Reuben Mark retired from the committee on April 21, 2006. David Arculus has now joined the committee as chairman. All the three members are non-executive directors.and, since 1 January 2007, Glen Moreno.
Nomination Committeecommittee
      This committee meets from time to time as necessary to consider the appointment of new directors. The committee is chaired by Glen Moreno and comprises Marjorie Scardino and all of thenon-executive directors.
Treasury Committeecommittee
      This committee sets the policies for our treasury department and reviews its procedures onFollowing a regular basis. Dennis Stevenson was chairmanreview of the board committees by the new chairman during 2006, it was decided to disband the treasury committee, until his retirement on October 1, 2005dividing its responsibilities between the board (with regard to approval of treasury policies) and Rona Fairhead, Vernon Sankey and Rana Talwar were members. Vernon Sankey retired from the audit committee on April 21, 2006. The constitution of the committee will be reviewed later in the year.(to monitor compliance with these policies).
Employees
      The average numbers of persons employed by us during each of the three fiscal years ended 20052006 were as follows:
 • 34,341 in fiscal 2006
• 32,203 in fiscal 2005, and
 
 • 33,086 in fiscal 2004, and
• 30,584 in fiscal 2003.2004.
      We, through our subsidiaries, have entered into collective bargaining agreements with employees in various locations. Our management has no reason to believe that we would not be able to renegotiate any such agreements on satisfactory terms. We encourage employees to contribute actively to the business in the context of their particular job roles and believe that the relations with our employees are generally good.

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      The table set forth below shows for 2006, 2005 2004 and 20032004 the average number of persons employed in each of our operating divisions.
                        
Average number employed 2005 2004 2003 2006 2005 2004
            
School  10,133  10,403  9,348   11,064  10,133  10,403 
Higher Education  4,196  4,087  3,912   4,368  4,196  4,087 
Professional  8,342  7,491  6,434   3,754  3,809  3,368 
Penguin  4,051  4,085  4,318   3,943  4,051  4,085 
FT Publishing  1,952  1,989  2,283   2,285  1,952  1,989 
IDC  1,956  1,826  1,628   2,200  1,956  1,826 
Other  1,573  1,365  928   1,669  1,573  1,365 
Continuing operations  32,203  31,246  28,851   29,283  27,670  27,123 
              
Discontinued operations    1,840  1,733   5,058  4,533  5,963 
              
Total  32,203  33,086  30,584   34,341  32,203  33,086 
              
ITEM 7.     MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
ITEM 7.     MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
      To our knowledge, as of February 26, 2006,28, 2007, the only beneficial owners of 3% or more of our issued and outstanding ordinary share capital were Franklin Resources Inc. which owned 104,485,808103,908,285 ordinary shares representing 13.0%12.9% of our outstanding ordinary shares, FMR Corp. and Fidelity International Limited which owned 49,800,888 ordinary shares representing 6.2% of our outstanding ordinary shares and The CapitalLegal and General Group Companies Inc.plc which owned 55,653,20928,868,364 ordinary shares representing 6.9%3.6% of our outstanding ordinary shares. On February 26, 2006,28, 2007, record holders with registered addresses in the United States held 34,992,60336,623,444 ADRs, which represented 4.4%4.5% of our outstanding ordinary shares. Because some of these ADRs are held by nominees, these numbers may not accurately represent the number of beneficial owners in the United States.
      Loans and equity advanced to joint ventures and associates during the year and as at December 31, 20052006 are shown in note 13 in “Item 17. Financial Statements.” Amounts due from joint ventures and associates are set out in note 1719 and dividends receivable from joint ventures and associates are set out in note 13 in “Item 17. Financial Statements”. There were no other related party transactions in 2005.2006.
ITEM 8.     FINANCIAL INFORMATION
ITEM 8.     FINANCIAL INFORMATION
      The financial statements filed as part of this Annual Report are included on pages F-1 throughF-1F-70 throughF-80 hereof.
      Other than those events described in note 3335 in “Item 17. Financial Statements” of this Form 20-F and seasonal fluctuations in borrowings, there has been no significant change to our financial condition or results of operations since December 31, 2005.2006. Our borrowings fluctuate by season due to the effect of the school year on the working capital requirements of the educational book business. Assuming no acquisitions or disposals, our maximum level of net debt normally occurs in July, and our minimum level of net debt normally occurs in December.
      Our policy with respect to dividend distributions is described in response to “Item 3. Key Information” above.
Legal Proceedings
      We and our subsidiaries are defendants in a number of legal proceedings including, from time to time, government and arbitration proceedings, which are incidental to our and their operations. We do not expect that the outcome of pending proceedings, either individually or in the aggregate, will have a significant effect on our financial position or profitability nor have any such proceedings had any such effect in the recent past. To our knowledge, there are no material proceedings in which any member of senior management or any of

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our affiliates is a party adverse to us or any of our subsidiaries or in respect of which any of those persons has a material interest adverse to us or any of our subsidiaries.
ITEM 9.     THE OFFER AND LISTING
      The principal trading market for our ordinary shares is the London Stock Exchange. Our ordinary shares also trade in the United States in the form of ADSs evidenced by ADRs under a sponsored ADR facility with The Bank of New York as depositary. We established this facility in March 1995 and amended it in August 2000 in connection with our New York Stock Exchange listing. Each ADS represents one ordinary share.

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      The ADSs trade on the New York Stock Exchange under the symbol “PSO”.
      The following table sets forth the highest and lowest middle market quotations, which represent the average of closing bid and asked prices, for the ordinary shares, as derived from the Daily Official List of the London Stock Exchange and the average daily trading volume on the London Stock Exchange:
 • on an annual basis for our five most recent fiscal years,
 
 • on a quarterly basis for our most recent quarter and two most recent fiscal years, and
 
 • on a monthly basis for the six most recent months.
              
  Ordinary Shares  
    Average Daily
Reference Period High Low Trading Volume
       
    (Ordinary
  (In pence) shares)
Five Most Recent Fiscal Years
            
 2005  695   608   5,296,700 
 2004  682   579   6,219,200 
 2003  680   430   6,631,800 
 2002  922   505   6,164,500 
 2001  1,726   645   5,245,000 
Most Recent Quarter and Two Most Recent Fiscal Years
            
2006 First quarter  811   671   6,395,400 
2005 Fourth quarter  692   616   4,947,900 
Third quarter  695   652   4,860,700 
Second quarter  668   628   5,823,300 
First quarter  662   608   5,626,100 
2004 Fourth quarter  640   590   5,020,800 
Third quarter  657   579   5,864,300 
Second quarter  682   623   6,993,900 
First quarter  657   584   7,039,600 
Most Recent Six Months
            
April 2006  798   756   7,614,100 
March 2006  811   720   7,055,300 
February 2006  737   706   4,336,400 
January 2006  734   671   7,577,400 
December 2005  692   674   3,912,900 
November 2005  673   636   6,524,000 
              
  Ordinary  
  shares  
    Average daily
Reference period High Low trading volume
       
    (Ordinary shares)
  (In pence)  
Five most recent fiscal years
            
 2006  811   671   5,004,500 
 2005  695   608   5,296,700 
 2004  682   579   6,219,200 
 2003  680   430   6,631,800 
 2002  922   505   6,164,500 
Most recent quarter and two most recent fiscal years
            
 2007 First quarter  842   762   5,864,200 
 2006 Fourth quarter  796   742   3,979,500 
 Third quarter  767   689   3,900,700 
 Second quarter  798   688   5,728,800 
 First quarter  812   671   6,395,400 
 2005 Fourth quarter  692   616   4,947,900 
 Third quarter  695   652   4,860,700 
 Second quarter  668   628   5,823,300 
 First quarter  662   608   5,626,100 
Most recent six months
            
 March 2007  872   783   8,538,000 
 February 2007  834   790   4,812,500 
 January 2007  842   762   6,380,300 
 December 2006  781   742   4,378,900 
 November 2006  789   751   3,509,000 
 October 2006  796   761   4,099,600 

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ITEM 10.     ADDITIONAL INFORMATION
ITEM 10.     ADDITIONAL INFORMATION
Memorandum and Articlesarticles of Associationassociation
      We summarize below the material provisions of our memorandum and articles of association, as amended, which have been filed as an exhibit to our annual report on Form 20-F for the year ended December 31, 2003. The summary below is qualified entirely by reference to the Memorandum and Articles of Association. We have multiple business objectives and purposes and are authorized to do such things as the board may consider to further our interests or incidental or conducive to the attainment of our objectives and purposes.
Directors’ Powers
Directors’ powers
      Our business shall be managed by the board of directors and the board may exercise all such of our powers as are not required by law or by the Articles of Association to be exercised by resolution of the shareholders in general meeting.
Interested Directors
Interested directors
      A director shall not be disqualified from contracting with us by virtue of his or her office or from having any other interest, whether direct or indirect, in any contract or arrangement entered into by or on behalf of us. An interested director must declare the nature of his or her interest in any contract or arrangement entered into by or on behalf of us in accordance with the Companies Act 1985. Provided that the director has declared

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his interest and acted in accordance with law, no such contract or arrangement shall be avoided and no director so contracting or being interested shall be liable to account to us for any profit realized by him from the contract or arrangement by reason of the director holding his office or the fiduciary relationship thereby established. A director may not vote on any contract or arrangement or any other proposal in which he or she has, together with any interest of any person connected with him or her, an interest which is, to his or her knowledge, a material interest, otherwise than by virtue of his or her interests in shares, debentures or other securities of or otherwise in or through us. If a question arises as to the materiality of a director’s interest or his or her entitlement to vote and the director does not voluntarily agree to abstain from voting, that question will be referred to the chairman of the board or, if the chairman also is interested, to a person appointed by the other directors who is not interested. The ruling of the chairman or that other person, as the case may be, will be final and conclusive. A director will not be counted in the quorum at a meeting in relation to any resolution on which he or she is prohibited from voting.
      Notwithstanding the foregoing, a director will be entitled to vote, and be counted in the quorum, on any resolution concerning any of the following matters:
 • the giving of any guarantee, security or indemnity in respect of money lent or obligations incurred by him or her or by any other person at the request of or for the benefit of us or any of our subsidiaries;
 
 • the giving of any guarantee, security or indemnity to a third party in respect of a debt or obligation of ours or any of our subsidiaries for which he or she has assumed responsibility in whole or in part and whether alone or jointly with others under a guarantee or indemnity or by the giving of security;
 
 • any proposal relating to us or any of our subsidiaries where we are offering securities in which a director is or may be entitled to participate as a holder of securities or in the underwriting orsub-underwriting of which a director is to participate;
 
 • any proposal relating to an arrangement for the benefit of our employees or any of our subsidiaries that does not award him or her any privilege or benefit not generally awarded to the employees to whom such arrangement relates; and
 
 • any proposal concerning insurance that we propose to maintain or purchase for the benefit of directors or for the benefit of persons, including directors.

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      Where proposals are under consideration concerning the appointment of two or more directors to offices or employment with us or any company in which we are interested, these proposals may be divided and considered separately and each of these directors, if not prohibited from voting under the proviso of the fourth clause above, will be entitled to vote and be counted in the quorum with respect to each resolution except that concerning his or her own appointment.
Borrowing Powers
Borrowing powers
      The board of directors may exercise all powers to borrow money and to mortgage or charge our undertaking, property and uncalled capital and to issue debentures and other securities, whether outright or as collateral security for any of our or any third party’s debts, liabilities or obligations. The board of directors must restrict the borrowings in order to secure that the aggregate amount of undischarged monies borrowed by us (and any of our subsidiaries), but excluding anyintra-group debts, shall not at any time exceed a sum equal to twice the aggregate of the adjusted capital and reserves, unless the shareholders in general meeting sanction an excession of this limitation.
Other Provisions Relating to Directors
Other provisions relating to directors
      Under the articles of association, directors are paid out of our funds for their services as we may from time to time determine by ordinary resolution and, in the case ofnon-executive directors, up to an aggregate of £500,000 or such other amounts as resolved by the shareholders at a general meeting. Directors currently are not required to be qualified by owning our shares. WhileChanges to the Companies Act, 1985 states that nowhich came into force on April 7, 2007, now permit the appointment of a director may be appointed after he reaches the age of 70 our articles of association provide for the reappointment, after retirement, of directors attaining the age of 70. This is permissible under the Companies Act 1985.or over.

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Annual General Meetings and Extraordinary General Meetings
Annual general meetings and extraordinary general meetings
      Shareholders’ meetings may be either annual general meetings or extraordinary general meetings. However, the following matters are ordinarily transacted at an annual general meeting:
 • sanctioning or declaring dividends;
 
 • consideration of the accounts and balance sheet;
 
 • ordinary reports of the board of directors and auditors and any other documents required to be annexed to the balance sheet;
 
 • as holders of ordinary shares vote for the election ofone-third of the members of the board of directors at every annual general meeting, the appointment or election of directors in the place of those retiring by rotation or otherwise;
 
 • appointment or reappointment of, and determination of the remuneration of, the auditors; and
 
 • the renewal, limitation, extension, variation or grant of any authority of or to the board, pursuant to the Companies Act 1985, to allot securities.
      Business transacted at an extraordinary general meeting may also be transacted at an annual general meeting.
      We hold a general meeting as our annual general meeting within fifteen months after the date of the preceding annual general meeting, at a place and time determined by the board. The board may call an extraordinary general meeting at any time and for any reason. The board must convene an extraordinary general meeting if requested to do so by shareholders holding not less thanone-tenth of our issued share capital.
      Three shareholders present in person and entitled to vote will constitute a quorum for any general meeting. If a quorum for a meeting convened at the request of shareholders is not present within fifteen minutes of the appointed time, the meeting will be dissolved. In any other case, the general meeting will be adjourned to the same day in the next week, at the same time and place, or to a time and place that the chairman fixes. If at that rescheduled meeting a quorum is not present within fifteen minutes from the time

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appointed for holding the meeting, the shareholders present in person or by proxy will be a quorum. The chairman or, in his absence, the deputy chairman or any other director nominated by the board, will preside as chairman at every general meeting. If no director is present at the general meeting or no director consents to act as chairman, the shareholders present shall elect one of their number to be chairman of the meeting.
Ordinary Shares
Ordinary shares
      Certificates representing ordinary shares are issued in registered form and, subject to the terms of issue of those shares, are issued following allotment or receipt of the form of transfer bearing the appropriate stamp duty by our registrar, Lloyds Bank Registrars, theThe Causeway, Worthing, West Sussex BN99 6DA, United Kingdom, telephone number +44-1903-502-541.+44-1903-502-541.
Share Capital
Share capital
      Any share may be issued with such preferred, deferred or other special rights or other restrictions as we may determine by way of a shareholders’ vote in general meeting. Subject to the Companies Act 1985, any shares may be issued on terms that they are, or at our or the shareholders’ option are, liable to be redeemed on such terms and in such manner as we, before the issue of the shares, may by special resolution of the shareholders, determine.
      There are no provisions in the Articles of Association which discriminate against any existing or prospective shareholder as a result of such shareholder owning a substantial number of shares.
      Subject to the terms of the shares which have been issued, the directors may from time to time make calls upon the shareholders in respect of any moneys unpaid on their shares, provided that (subject to the terms of the shares so issued) no call on any share shall be payable at less than fourteen clear days from the last call. The directors may, if they see fit, receive from any shareholder willing to advance the same, all and any part of the moneys uncalled and unpaid upon any shares held by him.

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Changes in Capital
Changes in capital
      We may from time to time, by ordinary resolution:
 • consolidate and divide our share capital into shares of a larger amount than its existing shares; or
 
 • sub-divide all of or any of our existing shares into shares of smaller amounts than is fixed by the Memorandum of Association, subject to the Companies Act 1985; or
 
 • cancel any shares which, at the date of passing of the resolution, have not been taken, or agreed to be taken, by any person and diminish the amount of our share capital by the amount of the shares so cancelled.
      We may, from time to time, by ordinary resolution increase our share capital and, by special resolution, decrease our share capital, capital redemption reserve fund and any share premium account in any way.
Voting Rights
Voting rights
      Every holder of ordinary shares present in person at a meeting of shareholders has one vote on a vote taken by a show of hands. On a poll, every holder of ordinary shares who is present in person or by proxy has one vote for every ordinary share of which he or she is the holder. Voting at any meeting of shareholders is by a show of hands unless a poll is properly demanded before the declaration of the results of a show of hands. A poll may be demanded by:
 • the chairman of the meeting;
 
 • at least three shareholders present in person or by proxy and entitled to vote;
 
 • any shareholder or shareholders present in person or by proxy representing not less thanone-tenth of the total voting rights of all shareholders having the right to vote at the meeting; or

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 • any shareholder or shareholders present in person or by proxy holding shares conferring a right to vote at the meeting being shares on which the aggregate sum paid up is equal to not less thanone-tenth of the total sum paid up on all shares conferring that right.
Dividends
Dividends
      Holders of ordinary shares are entitled to receive dividends out of our profits that are available by law for distribution, as we may declare by ordinary resolution, subject to the terms of issue thereof. However, no dividends may be declared in excess of an amount recommended by the board of directors. The board may pay interim dividends to the shareholders as it deems fit. We may invest or otherwise use all dividends left unclaimed for six months after having been declared for our benefit, until claimed. All dividends unclaimed for a period of twelve years after having been declared will be forfeited and revert to us.
      The directors may, with the sanction of a resolution of the shareholders, offer any holders of ordinary shares the right to elect to receive ordinary shares credited as fully paid, in whole or in part, instead of cash in respect of such dividend.
      The directors may deduct from any dividend payable to any shareholder all sums of money (if any) presently payable by that shareholder to us on account of calls or otherwise in relation to our shares.
Liquidation Rights
Liquidation rights
      In the event of our liquidation, after payment of all liabilities, our remaining assets would be used to repay the holders of ordinary shares the amount they paid for their ordinary shares. Any balance would be divided among the holders of ordinary shares in proportion to the nominal amount of the ordinary shares held by them.
Other Provisions of the Articles of Association
Other provisions of the articles of association
      Whenever our capital is divided into different classes of shares, the special rights attached to any class may, unless otherwise provided by the terms of the issue of the shares of that class, be varied or abrogated, either with the written consent of the holders ofthree-fourths of the issued shares of the class or with the sanction of an extraordinary resolution passed at a separate meeting of these holders.
      In the event that a shareholder or other person appearing to the board of directors to be interested in ordinary shares fails to comply with a notice requiring him or her to provide information with respect to their interest in voting shares pursuant to section 212 of the Companies Act 1985, we may serve that shareholder with a notice of default. After service of a default notice, that shareholder shall not be entitled to attend or vote

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at any general meeting or at a separate meeting of holders of a class of shares or on a poll until he or she has complied in full with our information request.
      If the shares described in the default notice represent at leastone-fourth of 1% in nominal value of the issued ordinary shares, then the default notice may additionally direct that in respect of those shares:
 • we will not pay dividends (or issue shares in lieu of dividends); and
 
 • we will not register transfers of shares unless the shareholder is not himself in default as regards supplying the information requested and the transfer, when presented for registration, is in such form as the board of directors may require to the effect that after due and careful inquiry, the shareholder is satisfied that no person in default is interested in any of the ordinary shares which are being transferred or the transfer is an approved transfer, as defined in our articles of association.
      No provision of our articles of association expressly governs the ordinary share ownership threshold above which shareholder ownership must be disclosed. Under the Companies Act 1985, any person who acquires, either alone or, in specified circumstances, with others:
 • a material interest in our voting share capital equal to or in excess of 3%; or
 
 • a non-material interest equal to or in excess of 10%,

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comes under an obligation to disclose prescribed particulars to us in respect of those ordinary shares. A disclosure obligation also arises where a person’s notifiable interests fall below the notifiable percentage, or where, above that level, the percentage of our voting share capital in which a person has a notifiable interest increases or decreases.
Limitations Affecting Holders of Ordinary Shares or ADSs
Limitations affecting holders of ordinary shares or ADSs
      Under English law and our memorandum and articles of association, persons who are neither UK residents nor UK nationals may freely hold, vote and transfer ordinary shares in the same manner as UK residents or nationals.
      With respect to the items discussed above, applicable UK law is not materially different from applicable US law.
Material Contractscontracts
      The following summaries are not intended to be complete and reference is made to the contracts themselves, which are included, or incorporated by reference, as exhibits to this annual report. We have entered into the following contracts outside the ordinary course of business during the two year period immediately preceding the date of this annual report:
Issuance of $350,000,000 4.70% Guaranteed Senior Notes due 2009 and $400,000,000 5.70% Guaranteed Senior Notes due 2014
Issuance of $350,000,000 4.70% Guaranteed Senior Notes due 2009 and $400,000,000 5.70% Guaranteed Senior Notes due 2014
      Our wholly-owned subsidiary, Pearson Dollar Finance plc, issued $350 million$350m principal amount of 4.70% senior notes due 2009 and $400 million$400m principal amount of 5.70% senior notes due 2014, in each case fully and unconditionally guaranteed by Pearson plc, under an indenture dated May 25, 2004 between Pearson Dollar Finance plc, Pearson plc and The Bank of New York, as trustee. The firstsemi-annual interest payment was made on December 1, 2004. Pearson Dollar Finance may redeem the notes at any time, in whole or in part, at its option.
      The indenture describes the circumstances that would be considered events of default. If an event of default occurs, other than an insolvency or bankruptcy of Pearson Dollar Finance plc, Pearson plc or a principal subsidiary of Pearson plc (as defined in the indenture), the holders of at least 25% of the principal amount of the then outstanding notes may declare the notes, along with accrued but unpaid interest and other amounts described in the indenture, as immediately due and payable. In the event of an insolvency or bankruptcy of Pearson Dollar Finance plc, Pearson plc or a principal subsidiary of Pearson plc (as defined in the indenture), the principal of all outstanding notes shall become due and payable immediately.
      The indenture limits our ability to create liens to secure certain types of debt intended to be listed or traded on an exchange.

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Issuance of $300,000,000 4.625% Senior Notes due 2018
Issuance of $300,000,000 4.625% Senior Notes due 2018
      We issued $300 million$300m principal amount of 4.625% senior notes due 2018 under an indenture dated June 23, 2003 between us and The Bank of New York, as trustee. The firstsemi-annual interest payment was made on December 15, 2003. We may redeem the notes at any time, in whole or in part, at our option.
      The indenture describes the circumstances that would be considered events of default. If an event of default occurs, other than the insolvency or bankruptcy of us or a principal subsidiary (as defined in the indenture), the holders of at least 25% of the principal amount of the then outstanding notes may declare the notes, along with accrued, but unpaid, interest and other amounts described in the indenture, as immediately due and payable.
      The indenture limits our ability to create liens to secure certain types of debt intended to be listed or traded on an exchange.

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Executive Employment Contracts
Executive employment contracts
      We have entered into agreements with each of our executive directors pursuant to which such executive director is employed by us. These agreements describe the duties of such executive director and the compensation to be paid by us. See “Item 6. Directors, Senior Management & Employees — Compensation of Senior Management”. Each agreement may be terminated by us on 12 months’ notice or by the executive director on six months’ notice. In the event we terminate any executive director without giving the full 12 months’ advance notice, the executive director is entitled to receive liquidated damages equal to 12 months base salary and benefits together with a proportion of potential bonus.
Agreement with Peter Jovanovich
      On January 28, 2005, we entered into a letter agreement with Peter Jovanovich with respect to his employment with Pearson Education and its affiliates. Due to poor health, Mr. Jovanovich terminated his employment with us. The letter agreement sets forth the terms of his disability leave and confirms his existing disability benefits, including benefits under our short term disability plan, long-term disability plan, and supplemental long-term disability plan. Under the terms of the agreement, Mr. Jovanovich will receive standard benefits (except awards under Pearson plc stock plans), and thereafter, will receive coverage under our medical, dental and vision plans and our life insurance plan, plus a payment for unused vacation days. We have agreed to continue to credit Mr. Jovanovich’s individual defined contribution arrangement. We also agreed to pay him his 2004 annual bonus. The value of Mr. Jovanovich’s disability package, and his total remuneration for our 2004 financial year, is included in “Item 6. Directors and Senior Management”.
Exchange Controlscontrols
      There are no UK government laws, decrees, regulations or other legislation which restrict or which may affect the import or export of capital, including the availability of cash and cash equivalents for use by us or the remittance of dividends, interest or other payments to nonresident holders of our securities, except as otherwise described under “—“ — Tax Considerations” below.
Tax Considerationsconsiderations
      The following is a discussion of the material US federal income tax considerations and UK tax considerations arising from the acquisition, ownership and disposition of ordinary shares and ADSs by a US holder. A US holder is:
 • an individual citizen or resident of the US,
 
 • a corporation created or organized in or under the laws of the United States or any of its political subdivisions, or
 
 • an estate or trust the income of which is subject to US federal income taxation regardless of its source.
      This discussion deals only with ordinary shares and ADSs that are held as capital assets by a US holder, and does not address tax considerations applicable to US holders that may be subject to special tax rules, such as:
 • dealers or traders in securities or currencies,
 
 • financial institutions or other US holders that treat income in respect of the ordinary shares or ADSs as financial services income,

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 • insurance companies,
 
 • tax-exempt entities,
 
 • US holders that hold the ordinary shares or ADSs as a part of a straddle or conversion transaction or other arrangement involving more than one position,
 
 • US holders that own, or are deemed for US tax purposes to own, 10% or more of the total combined voting power of all classes of our voting stock,
 
 • US holders that have a principal place of business or “tax home” outside the United States, or
 
 • US holders whose “functional currency” is not the US dollar.
      For US federal income tax purposes, holders of ADSs will be treated as the owners of the ordinary shares represented by those ADSs.
      The discussion below is based upon current UK law and the provisions of the US Internal Revenue Code of 1986, or the Code, and regulations, rulings and judicial decisions as of the date of this Annual Report; any such authority may be repealed, revoked or modified, perhaps with retroactive effect, so as to result in tax consequences different from those discussed below. This discussion is also based on the Income Tax Treaty between the United Kingdom and the United States, which came into force in March 2003 (the “ Income Tax Treaty”). The discussions below regarding US residents are based on the articles of the New Income Tax Treaty.
In addition, the following discussion assumes that The Bank of New York will perform its obligations as depositary in accordance with the terms of the depositary agreement and any related agreements.
     Because US and UK tax consequences may differ from one holder to the next, the discussion set out below does not purport to describe all of the tax considerations that may be relevant to you and your particular situation. Accordingly, you are advised to consult your own tax advisor as to the US federal, state

62


and local, UK and other, including foreign, tax consequences of investing in the ordinary shares or ADSs. The statements of US and UK tax law set out below are based on the laws and interpretations in force as of the date of this Annual Report, and are subject to any changes occurring after that date.
UK Income Taxation of Distributions
UK income taxation of distributions
      The United Kingdom does not impose dividend withholding tax on dividends paid to US holders.
US Income Taxation of Distributions
US income taxation of distributions
      Distributions that we make with respect to the ordinary shares or ADSs, other than distributions in liquidation and distributions in redemption of stock that are treated as exchanges, will be taxed to US holders as ordinary dividend income to the extent that the distributions do not exceed our current and accumulated earnings and profits. The amount of any distribution will equal the amount of the cash distribution. Distributions, if any, in excess of our current and accumulated earnings and profits will constitute anon-taxable return of capital to a US holder and will be applied against and reduce the US holder’s tax basis in its ordinary shares or ADSs. To the extent that these distributions exceed the tax basis of the US holder in its ordinary shares or ADSs, the excess generally will be treated as capital gain.
      Dividends that we pay will not be eligible for the dividends received deduction generally allowed to US corporations under Section 243 of the Code.
      In the case of distributions in pounds, the amount of the distributions generally will equal the US dollar value of the pounds distributed, determined by reference to the spot currency exchange rate on the date of receipt of the distribution by the US holder in the case of shares or by The Bank of New York in the case of ADSs, regardless of whether the US holder reports income on a cash basis or an accrual basis. The US holder will realize separate foreign currency gain or loss only to the extent that this gain or loss arises on the actual disposition of pounds received. For US holders claiming tax credits on a cash basis, taxes withheld from the distribution are translated into US dollars at the spot rate on the date of the distribution; for US holders claiming tax credits on an accrual basis, taxes withheld from the distribution are translated into US dollars at the average rate for the taxable year.
      A distribution by the Company to noncorporate shareholders before 20092011 will be taxed as net capital gain at a maximum rate of 15%, provided certain holding periods are met, to the extent such distribution is treated as a dividend under U.S. federal income tax principles.

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UK Income Taxation of Capital Gains
UK income taxation of capital gains
      Under the Income Tax Treaty, each country generally may tax capital gains in accordance with the provisions of its domestic law. Under present UK law, a US holder that is not a resident, and, in the case of an individual, not ordinarily resident, in the United Kingdom for UK tax purposes and who does not carry on a trade, profession or vocation in the United Kingdom through a branch or agency to which ordinary shares or ADSs are attributable will not be liable for UK taxation on capital gains or eligible for relief for allowable losses, realized on the sale or other disposal (including redemption) of these ordinary shares or ADSs.
US Income Taxation of Capital Gains
US income taxation of capital gains
      Upon a sale or exchange of ordinary shares or ADSs to a person other than Pearson, a US holder will recognize gain or loss in an amount equal to the difference between the amount realized on the sale or exchange and the US holder’s adjusted tax basis in the ordinary shares or ADSs. Any gain or loss recognized will be capital gain or loss and will belong-term capital gain or loss if the US holder has held the ordinary shares or ADSs for more than one year.Long-term capital gain of a noncorporate US holder is generally taxed at a maximum rate of 15%. Thislong-term capital gain rate is scheduled to expire in 2009.2011.
      Gain or loss realized by a US holder on the sale or exchange of ordinary shares or ADSs generally will be treated asUS-source gain or loss for US foreign tax credit purposes.

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Estate and Gift Tax
Estate and gift tax
      The current Estate and Gift Tax Convention, or the Convention, between the United States and the United Kingdom generally relieves from UK Inheritance Tax (the equivalent of US Estate and Gift Tax) the transfer of ordinary shares or of ADSs where the transferor is domiciled in the United States, for the purposes of the Convention. This relief will not apply if the ordinary shares or ADSs are part of the business property of an individual’s permanent establishment in the United Kingdom or pertain to the fixed base in the United Kingdom of a person providing independent personal services. If no relief is given under the Convention, inheritance tax may be charged on the amount by which the value of the transferor’s estate is reduced as a result of any transfer made by way of gift or other gratuitous transfer by an individual, in general within seven years of death, or on the death of an individual. In the unusual case where ordinary shares or ADSs are subject to both UK Inheritance Tax and US Estate or Gift Tax, the Convention generally provides for tax paid in the United Kingdom to be credited against tax payable in the United States or for tax paid in the United States to be credited against tax payable in the United Kingdom based on priority rules set forth in the Convention.
Stamp Duty
Stamp duty
      No stamp duty or stamp duty reserve tax (SDRT) will be payable in the United Kingdom on the purchase or transfer of an ADS, provided that the ADS, and any separate instrument or written agreement of transfer, remain at all times outside the United Kingdom and that the instrument or written agreement of transfer is not executed in the United Kingdom. Stamp duty or SDRT is, however, generally payable at the rate of 1.5% of the amount or value of the consideration or, in some circumstances, the value of the ordinary shares, where ordinary shares are issued or transferred to a person whose business is or includes issuing depositary receipts, or to a nominee or agent for such a person.
      A transfer for value of the underlying ordinary shares will generally be subject to either stamp duty or SDRT, normally at the rate of 0.5% of the amount or value of the consideration. A transfer of ordinary shares from a nominee to its beneficial owner, including the transfer of underlying ordinary shares from the Depositary to an ADS holder, under which no beneficial interest passes is subject to stamp duty at the fixed rate of £5.00 per instrument of transfer.
Close Company Status
Close company status
      We believe that the close company provisions of the UK Income and Corporation Taxes Act 1988 do not apply to us.
Documents on Displaydisplay
      Copies of our Memorandum and Articles of Association, the material contracts described above and filed as exhibits to this Annual Report and certain other documents referred to in this Annual Report are available for inspection at our registered office at 80 Strand, London WC2R 0RL (c/o the Company Secretary), or, in

61


the United States, at the registered office of Pearson Inc. at 1330 Avenue of the Americas, 7th Floor, New York, New York, during usual business hours upon reasonable prior request.
ITEM 11.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Introduction
      Our principal market risks are changes in interest rates and currency exchange rates. Following an evaluation of these positions, we selectively enter into derivative financial instruments to manage our risk exposure. For this purpose, we primarily use interest rate swaps, interest rate caps and collars, forward rate agreements, currency swaps and forward foreign exchange contracts. Managing market risks is the responsibility of the Chief Financial Officer, who acts pursuant to policies approved by a Treasury Committee of ourthe board of directors. ThisThe Audit Committee receives regular reports on our treasury activities, which outsideand we periodically meet with external advisers alsoto review periodically.our activities.

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      We have a policy of not undertaking any speculative transactions, and we do not hold theour derivative and other financial instruments for purposes other than trading.trading purposes.
      We have formulated our policies for hedging exposures to interest rate and foreign exchange risk, and have used derivatives to ensure compliance with these policies. Although the majority of our derivative contracts were transacted without regard to existing US GAAP requirements on hedge accounting, during 20052006 and 2004 (but not 2003)2005 we qualified for hedge accounting under US GAAP on a limited number of our key derivative contracts.
      The following discussion addresses market risk only and does not present other risks that we face in the normal course of business, including country risk, credit risk and legal risk.
Adoption of International Financial Reporting Standards
      From 1 January 2005 the Group adopted IAS 39 “Financial Instruments: Recognition and Measurement” and IAS 32 “Financial Instruments: Disclosure and Presentation”. The market values of the Group’s derivatives were recognized in the balance sheet at the date of adoption. Subsequent changes in their market value will change the carrying values on the balance sheet and create movements in the finance cost section of the income statement, unless they have been designated (and passed the prescribed tests) for hedge accounting treatment. In addition, IAS 39 requires to value the Group’s 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 are being amortised over the remaining life of the relevant transaction. Also, where the Group qualifies for hedge accounting on a derivative, the carrying value of the relevant bond is adjusted 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).
      As the Group elected to adopt IAS 39 from 1 January 2005 as permitted by the transitional provisions in IFRS 1, the effects described above are not reflected in the 2004 and 2003 comparatives. A detailed description on the effects of the adoption of IAS 39 is included in note 1 and note 34 in “Item 17. Financial Statements”.
Interest Ratesrates
      The Group’s financial exposure to interest rates arises primarily from its borrowings, particularly those in US dollars.borrowings. The Group manages its exposure by borrowing at fixed and variable rates of interest, and by entering into derivative instruments.transactions. Objectives approved by the Treasury Committee of the board concerning the proportion of debt outstanding at fixed rates govern the use of these financial instruments.
      The Group’s objectives are applied to core net debt, which is measured at the year-end and comprises borrowings net of year-end cash and other liquid funds. Since September 2005 theOur objective has beenis to maintain a proportion of forecast core net debt in fixed or capped form for the next four years, subject to a maximum of 65% and a minimum that starts at 40% and falls by 10% each year. Within this target range the proportion that is hedged is triggered by a formula based on historical interest rate frequencies. Previously the minimum was 40%.
      The principal method to hedgeof hedging interest rate risk is to enter into an agreement with a bank counterparty to pay a fixed-rate and receive a variable rate, known as a swap. Under interest rate swaps, the Group agrees with other parties to exchange, at specified intervals, the difference between fixed-rate and variable-rate amounts calculated by reference to an agreed notional principal amount. The majority of thesethe company’s swap contracts are US dollar denominated,

62


and some of them have deferred start dates, in order to maintain the desired risk profile as other contracts mature. The variable rates received are normally based on three-month andor six-month LIBOR, and the dates on which these rates are set do not necessarily exactly match those of the hedged borrowings. Management believes that our portfolio of these types of swaps is an efficient hedge of our portfolio of variable rate borrowings.
      In addition, from time to time, the Group issues bonds or other capital market instruments to refinance existing debt. To avoid the fixed rate on a single transaction unduly influencing our overall net interest expense, itour practice is practice to enter into a related derivative contract effectively converting the interest rate profile of the bond transaction to that of the debt which it is refinancing. Most often this is a variable interest rate denominated in US dollars.rate. In severalsome cases, the bond issue was denominated in a different currency thanto the debt being refinancedGroup’s desired borrowing risk profile and the Group has entered into a related cross currency interest rate and currency swap in order to maintain an unchanged borrowingthis risk profile.profile, which is predominantly borrowings denominated in US dollars.
      The Group’s accounting objective in its use of interest rate derivatives is to minimize 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 sharplysignificantly the income statement impact of changes in the market value of a derivative). The Group then divides the total portfolio betweenhedge-accounted and pooled segments, so that the expected movement on the pooled segment is minimal.minimized.
Currency Exchange Ratesexchange rates
      Although the Group is based in the United Kingdom, it has significant investments in overseas operations. The most significant currency in which the Group trades is the US dollar.
      The Group’s policy is to align approximately the currency composition of its core net borrowings with its forecast operating profit.profit (from February 2007, the policy is amended slightly to align core net borrowings with forecast operating profit before depreciation and amortization). This policy aims to dampen the impact of

65


changes in foreign exchange rates on consolidated interest cover and earnings. In September 2005 thisThis policy was modified to applyapplies only to currencies that accountedaccount for more than 15% of group operating profit, which currently is currently 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 expects to hold its legacy borrowings in Euroseuros and Sterlingsterling to their maturity dates: the Group’s policy does not require existing currency debt to be terminated to match declines in that currency’s share of group operating profit. At December 31, 20052006 the Group’s net borrowings/(cash) in the threeour main currencies above (taking into account the effect of cross currency rate swaps) were: US dollar £1114 million,£979m, euro £78 million£158m and sterling £(93) million£30m.
      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 reporting under IFRS and US GAAP.
      Investments in overseas operations are consolidated for accounting purposes by translating values in one currency to another currency, in particular from US dollars to Sterling.sterling. Fluctuations in currency exchange rates affect the currency values recorded in our accounts, although they do not give rise to any realized gain or loss, nor to any currency cash flows.
      The Group is also exposed to currency exchange rates in its cash transactions and its investments in overseas operations. Cash transactions — typically for purchases, sales, interest or dividends — require cash conversions between currencies. Fluctuations in currency exchange rates affect the cash amounts that the Group pays or receives.
Forward Foreign Exchange Contractsforeign exchange contracts
      The Group uses forward foreign exchange contracts where a specific major project or forecasted cash flow, including acquisitions and disposals, arises from a business decision that has used a specific foreign

63


exchange rate. The Group’s policy is to effect routine transactional conversions between currencies, for example to collect receivables or settle payables, at the relevant spot exchange rate.
      The Group seeks to offset purchases and sales in the same currency, even if they do not occur simultaneously. In addition, its debt and cash portfolios management gives rise to temporary currency shortfalls and surpluses. Both of these activities require usingshort-dated foreign exchange swaps between currencies.
      Although the Group prepares its consolidated financial statements in Sterling,sterling, significant sums have been invested in overseas assets, particularly in the United States. Therefore, fluctuations in currency exchange rates, particularly between the US dollar and Sterling,sterling, and alsoto a lesser extent between the Euroeuro and Sterling,sterling, are likely to affect shareholders’ funds and other accounting values.
Derivatives
      Under both IFRS and US GAAP, the Group is required to record all derivative instruments on the balance sheet at fair value. Derivatives not classified as hedges are adjusted to fair value through earnings. Changes in fair value of the derivatives that the Group has designated and that qualify as effective hedges are recorded in either other comprehensive income or earnings. Any ineffective portion of derivatives that are classified as hedges is immediately recognized in earnings.
      Using the transitional exceptions of IAS 39, derivatives were accounted for in accordance with UK GAAP for the years ended December 31, 2003In 2006 and 2004. Under UK GAAP, there are no specific criteria, which must be fulfilled in order to record derivative contracts such as interest rate swaps, currency swaps and forward currency contracts as a hedging instrument. Accordingly, based upon our intention and stated policy with respect to entering into derivative transactions, they have been recorded as hedging instruments for UK GAAP. This means that unrealized gains and losses on these instruments are typically deferred and recognized when realized. From January 1, 2005 the Group has adopted IAS 39“Financial Instruments: Recognition and Measurement” and IAS 32“Financial Instruments: Disclosure and Presentation”, which resulted in a transitional adjustment in reserves of £12 million.
      Under US GAAP, in 2003 our derivative contracts did not meet the prescribed criteria for hedge accounting, and have been recorded at market value at each period end, with changes in their fair value being recorded in the profit and loss account. In 2005 and 2004 the Group met the prescribed designation requirements and hedge effectiveness tests under US GAAP for certainsome of its derivative contracts. As a result, the movements in the fair value of the effective portion of fair value hedges and net investment hedges have been offset in earnings and other comprehensive income respectively by the corresponding movement in the fair value of the underlying bond or asset.hedged item.

66


      In line with the Group’s treasury policy, none of these instruments were considered trading instruments and each instrument was transacted solely to match an underlying financial exposure.
Quantitative information about market risk
      The sensitivity of the Group’s derivative portfolio to changes in interest rates is found in note 16 to the financial statements.
ITEM 12.DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
      Not applicable.
PART II
ITEM 13.     DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
ITEM 13.DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
      None.
ITEM 14.MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS
      Not applicable.None.
ITEM 15.CONTROLS AND PROCEDURES
Disclosure controls and procedures
      An evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 20052006 was carried out by us under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer. Based on that evaluation the Chief Executive Officer and Chief Financial Officer concluded that Pearson’s disclosure controls and procedures have been designed to provide, and are effective in providing, reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and

64


Exchange Commission’s rules and forms.forms and that such information is accumulated and communicated to management, including the principal executive and financial officers, as appropriate to allow such timely decision regarding required disclosures. A controls system, no matter how well designed and operated cannot provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.detected, and that such information is accumulated and communicated to management, including the principal executive and principal financial officers, as appropriate, to allow such timely decisions regarding required disclosure.
Management’s annual report on internal control over financial reporting
      The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with IFRS, including the reconciliations required under US GAAP.
      Management conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
      Management has assessed the effectiveness of internal control over financial reporting, as at December 31, 2006, and has concluded that such internal control over financial reporting was effective.

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      PricewaterhouseCoopers LLP, which has audited the consolidated financial statements of the Company for the year ended December 31, 2006, has also audited management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of the Company’s internal control over financial reporting under Auditing Standard No. 2 of the Public Company Accounting Oversight Board (United States). Their audit report is included under “Item 17. Financial Statements” page F-2.
Change in internal control over financial reporting
      During the period covered by this Annual Report on Form 20-F, Pearson has made no changes to its internal control over financial reporting that have materially affected or are reasonably likely to materially affect Pearson’s internal control over financial reporting.
ITEM 16A.AUDIT COMMITTEE FINANCIAL EXPERT
      The members of the Board of Directors of Pearson plc have determined that Vernon Sankey was an audit committee financial expert within the meaning of the applicable rules and regulations of the US Securities and Exchange Commission for the period until April 21, 2006. The members of the Board of Directors of Pearson plc have determined that Ken Hydon is an audit committee financial expert, for subsequent periods.
ITEM 16B.CODE OF ETHICS
      Pearson has adopted a code of ethics (the Pearson code of business conduct) which applies to all employees including the Chief Executive Officer and Chief Financial Officer and other senior financial management. This code of ethics is available on our website (www.pearson.com/investor/corpgov.htm). The information on our website is not incorporated by reference into this report.
ITEM 16C.PRINCIPAL ACCOUNTANT FEES AND SERVICES
      In 2003, the audit committee adopted a revised policy for external auditor services. The policy requires all audit engagements undertaken by our external auditors, PricewaterhouseCoopers LLP, to be approved by the audit committee. The policy permits the auditors to be engaged for other services provided the engagement is specifically approved in advance by the committee or alternatively meets the detailed criteria of specific pre-approved services and is notified to the committee.
      The Group Chief Financial Officer or Deputy Chief Financial Officer can procure pre-approved services, as defined in the audit committee’s policy for auditor services, of up to an amount of £100,000 per engagement, subject to a cumulative limit of £500,000 per year. The limit of £100,000 will be subject to annual review by the audit committee. Where pre-approval has not been granted for a service or where the amount is above these limits, specific case by case approval must be obtained from the audit committee prior to the engagement of our auditor.
             
Auditors’ Remuneration 2005 2004 2003
       
  £m £m £m
Statutory audit  4   3   3 
Audit-related regulatory reporting services  1   1    
Non-audit services  2   2   2 
Non-audit services are analysed as follows:            
Tax compliance services  1   1   1 
Tax advisory services     1   1 
Other non-audit services  1       
         
Auditors’ Remuneration 2006 2005
     
  £m £m
Audit fees  5   4 
Audit-related fees  4    
Tax fees  1   1 
All other fees  1   2 
NoteIncluded in statutory audit fees are amounts relating to the parent company of £30,000 (2004: £20,000; 2003: £20,000). Audit-related regulatory reporting fees are £225,000 (2004: £225,000; 2003: £200,000). Non-audit fees in the UK in 2005 are £1,000,000 (2004: £1,000,000; 2003: £341,000) and are in respect of tax advisory and tax compliance services and other advisory services. The remainder of the non-audit fees relate to overseas subsidiaries.

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ITEM 16D.     EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES
ITEM 16D.EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES
      Not applicable.
ITEM 16E.PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASES
                 
        Maximum
number
      Total number of of shares that
      units purchased may yet be
      as part of publicly purchased under
  Total number of Average price announced plans the plans or
Period shares purchased paid per share or programs programs
         
SeptemberMarch 1, 20052006 - September 30, 2005March 31, 2006  625,000900,000   £6.63 7.40N/AN/A
May 1, 2006 - May 31, 2006900,000£ 7.67N/AN/A
August 1, 2006 - August 31, 2006900,000£ 7.43N/AN/A
December 1, 2006 - December 31, 20062,000,000£ 7.73   N/A   N/A 
      Purchases of shares were made to satisfy obligations under Pearson employee share award programs. All purchases were made in open-market transactions. None of the foregoing share purchases was made as part of a publicly announced plan or program.
PART III
ITEM 17.FINANCIAL STATEMENTS
      The financial statements filed as part of this Annual Report are included on pages F-1 throughF-79 hereof.
ITEM 18.FINANCIAL STATEMENTS
      We have elected to respond to Item 17.
ITEM 19.EXHIBITS
   
1.1 Memorandum and Articles of Association of Pearson plc.†
2.1 Indenture dated June 23, 2003 between Pearson plc and The Bank of New York, as trustee.†
2.2 Indenture dated May 25, 2004 among Pearson Dollar Finance plc, as Issuer, Pearson plc, Guarantor, and the Bank of New York, as Trustee, Paying Agent and Calculation Agent.#
4.1 Letter Agreement dated January 28, 2005 between Pearson plc and Peter Jovanovich.#
4.2Irrevocable undertakings in respect of an offer by Retos Cartera, for the shares of Recoletos Grupo de Communicación, dated December 14, 2004 between Pearson plc and Retos Cartera.#
8.1 List of Significant Subsidiaries.
12.1 Certification of Chief Executive Officer.
12.2 Certification of Chief Financial Officer.
13.1 Certification of Chief Executive Officer.
13.2 Certification of Chief Financial Officer.
15 Consent of PricewaterhouseCoopers LLP.
 
†  Incorporated by reference from the Form 20-F of Pearson plc for the year ended December 31, 2003 and filed May 7, 2004.
Incorporated by reference from the Form 20-F of Pearson plc for the year ended December 31, 2004 and filed June 27, 2005.

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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
   
  Page
Report of Independent Registered Public Accounting Firm F-2
Consolidated Income Statement for the year ended December 31, 2006, 2005 and 2004 F-3F-4
Statement of Recognized Income and Expense for the Year Endedyear ended December 31, 2006, 2005 and 2004 F-4F-5
Consolidated Balance Sheet as at December 31, 2006 and 2005 F-5
Consolidated Cash Flow Statement for the Year Endedyear ended December 31, 2006, 2005 and 2004 F-7
Notes to the AccountsConsolidated Financial Staetments F-8

F-1


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Pearson plc:plc
      We have completed an integrated audit of Pearson plc’s December 31, 2006 consolidated financial statements and of its internal control over financial reporting as of December 31, 2006 and an audit of its December 31, 2005 and December 31, 2004 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements
      In our opinion, the accompanying consolidated balance sheetsincome statements and the related consolidated incomebalance sheets, consolidated statements of cash flows and, consolidated statements of recognised income and expense and consolidated cash flow statements present fairly, in all material respects, the financial position of Pearson plc and its subsidiaries (the “Group”) at December 31, December2006 and 2005 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, December 2005,2006, in conformity withEU-adopted International Financial Reporting Standards.Standards (IFRSs) as adopted by the European Union. These financial statements are the responsibility of the Company’s management; ourGroup’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statementstatements presentation. We believe that our audits provide a reasonable basis for our opinion.
      As discussed in Note 1, the CompanyGroup adopted International Accounting StandardsStandard (IAS) 32 “Financial Instruments: Disclosure and Presentation”, and IAS 39 “Financial Instruments: Recognition and Measurement”, prospectively from 1 January 2005. As discussed in accordance with International Financial Reporting StandardsNote 31 to the consolidated financial statements, during the year ended December 31, 2006, the Group reclassified investment in pre-publication assets from cash used in investing activities to cash generated from operations.
      IFRSs as adopted by the European Union. The change has been accounted for prospectively from 1 January 2005.
EU-adopted International Financial Reporting StandardsUnion vary in certain significant respects from accounting principles generally accepted in the United States of America. Information relating to the nature and effect of such differences is presented in Note 3536 to the consolidated financial statements.
Internal control over financial reporting
      Also, in our opinion, management’s assessment, included in Managements’ annual report on internal control over financial reporting as set out in “Item 15. Controls and Procedures”, that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Group maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the COSO. The Group’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Group’s internal control over financial reporting based on our audit.
      We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment,

F-2


testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
      A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting standards and principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting standards and principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
      Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
PricewaterhouseCoopers LLP
London England
May 5, 2006United Kingdom
April 30, 2007

F-2F-3


CONSOLIDATED INCOME STATEMENT
YEAR ENDED 31 DECEMBER 20052006
(All figures in £ millions)
                                
 Notes 2005 2004 2003 Notes 2006 2005 2004
                
Continuing operations
                          
Sales
  2  4,096  3,696  3,850   2  4,137  3,808  3,479 
Cost of goods sold     (2,022)  (1,789)  (1,846)  5  (1,917)  (1,787)  (1,631)
                  
Gross profit     2,074  1,907  2,004      2,220  2,021  1,848 
Operating expenses  5  (1,592)  (1,520)  (1,594)  5  (1,704)  (1,559)  (1,483)
Other net gains and losses  4  40  9  (6)  4    40  9 
Share of results of joint ventures and associates     14  8  2   13  24  14  8 
                  
Operating profit
  2  536  404  406   2  540  516  382 
Finance costs  7  (132)  (96)  (100)  7  (133)  (132)  (96)
Finance income  7  62  17  7   7  59  62  17 
                  
Profit before tax
     466  325  313      466  446  303 
Income tax  8  (124)  (63)  (61)  8  (11)  (116)  (55)
                  
Profit for the year from continuing operations
     342  262  252      455  330  248 
Profit for the year from discontinued operations  3  302  22  23   3  14  314  36 
                  
Profit for the year
     644  284  275      469  644  284 
                  
Attributable to:
                          
Equity holders of the Company     624  262  252      446  624  262 
Minority interest     20  22  23      23  20  22 
                  
Earnings per share for profit from continuing and discontinued operations attributable to the equity holders of the Company during the year (expressed in pence per share)
                          
— basic  9  78.2p  32.9p  31.7p  9  55.9p  78.2p  32.9p 
— diluted  9  78.1p  32.9p  31.7p  9  55.8p  78.1p  32.9p 
         
Earnings per share for profit from continuing operations attributable to the equity holders of the Company during the year (expressed in pence per share)
                          
— basic  9  40.4p  30.8p  29.4p  9  54.1p  38.9p  29.0p 
— diluted  9  40.3p  30.8p  29.4p  9  54.0p  38.8p  29.0p 
                  

F-3F-4


CONSOLIDATED STATEMENT OF RECOGNISED INCOME AND EXPENSE
YEAR ENDED 331 DECEMBER 20052006
(All figures in £ millions)
                                
 Notes 2005 2004 2003 Notes 2006 2005 2004
                
Net exchange differences on translation of foreign operations  26  327  (203)  (288)  27  (417)  327  (203)
Actuarial gains/(losses)on defined benefit pension and post-retirement medical schemes  24  26  (61)  (28)
Taxation on items taken directly to equity  8  12  9   
Actuarial gains/(losses) on defined benefit pension and post-retirement medical plans  24  107  26  (61)
Taxation on items charged to equity  8  12  12  9 
                  
Net income/(expense) recognised directly in equity
     365  (255)  (316)
Net (expense)/income recognised directly in equity
     (298)  365  (255)
Profit for the year     644  284  275      469  644  284 
                  
Total recognised income and expense for the year
     1,009  29  (41)     171  1,009  29 
                  
Attributable to:
                          
Equity holders of the Company     989  7  (64)     148  989  7 
Minority interest     20  22  23      23  20  22 
                  
Effect of transition adjustment on adoption of IAS 39
                          
Attributable to:
                          
Equity holders of the Company  34  (12)              (12)   
                  

F-4


CONSOLIDATED BALANCE SHEET
AS AT 31 DECEMBER 20052006
(All figures in £ millions)
                            
 Notes 2005 2004 2003 Notes 2006 2005
              
Assets
                       
Non-current assets
                       
Property, plant and equipment  11  384  355  402   11  348  384 
Intangible assets  12  3,854  3,278  3,550   12  3,581  3,854 
Investments in joint ventures and associates  13  36  47  64   13  20  36 
Deferred income tax assets  14  385  359  342   14  417  385 
Financial assets — Derivative financial instruments  16  79       16  36  79 
Other financial assets  15  18  15  21   15  17  18 
Other receivables  19  108  102  100   19  124  108 
                
     4,864  4,156  4,479      4,543  4,864 
Current assets
                       
Intangible assets — pre-publication  17  426  356  362 
Intangible assets — Pre-publication  17  402  426 
Inventories  18  373  314  319   18  354  373 
Trade and other receivables  19  1,031  933  1,025   19  953  1,031 
Financial assets — Derivative financial instruments  16  4       16  50  4 
Financial assets — Marketable securities     25   
Cash and cash equivalents (excluding overdrafts)  20  902  461  551   20  592  902 
                
     2,736  2,064  2,257      2,376  2,736 
Non-current assets classified as held for sale       358     29  294   
                
     2,736  2,422  2,257      2,670  2,736 
                
Total assets
     7,600  6,578  6,736      7,213  7,600 
                

F-5


CONSOLIDATED BALANCE SHEET (CONTINUED)
AS AT 31 DECEMBER 20052006
(All figures in £ millions)
                            
 Notes 2005 2004 2003 Notes 2006 2005
              
Liabilities
                       
Non-current liabilities
                       
Financial liabilities—Borrowings  21  (1,703)  (1,714)  (1,349)  21  (1,148)  (1,703)
Financial liabilities—Derivative financial instruments  16  (22)       16  (19)  (22)
Deferred income tax liabilities  14  (204)  (139)  (140)  14  (245)  (204)
Retirement benefit obligations  24  (389)  (408)  (364)  24  (250)  (389)
Provisions for other liabilities and charges  22  (31)  (43)  (59)  22  (29)  (31)
Other liabilities  23  (151)  (99)  (70)  23  (162)  (151)
                
     (2,500)  (2,403)  (1,982)     (1,853)  (2,500)
Current liabilities
                       
Trade and other liabilities  23  (974)  (868)  (943)  23  (998)  (974)
Financial liabilities — Borrowings  21  (256)  (109)  (578)
Financial liabilities—Borrowings  21  (595)  (256)
Current income tax liabilities     (104)  (89)  (54)     (74)  (104)
Provisions for other liabilities and charges  22  (33)  (14)  (18)  22  (23)  (33)
                
     (1,367)  (1,080)  (1,593)     (1,690)  (1,367)
Liabilities directly associated with non-current assets classified as held for sale       (81)     29  (26)   
                
Total liabilities
     (3,867)  (3,564)  (3,575)     (3,569)  (3,867)
                
Net assets
     3,733  3,014  3,161      3,644  3,733 
                
Equity
                       
Share capital  25  201  201  201   25  202  201 
Share premium  25  2,477  2,473  2,469   25  2,487  2,477 
Treasury shares  26  (189)  (153)
Other reserves  26  (328)  (623)  (410)  27  (592)  (175)
Retained earnings  26  1,214  749  709   27  1,568  1,214 
                
Total equity attributable to equity holders of the Company
     3,564  2,800  2,969      3,476  3,564 
Minority interest     169  214  192      168  169 
         
Total equity
     3,733  3,014  3,161      3,644  3,733 
                
These financial statements have been approved for issue by the board of directors on 26 February 20069 March 2007 and signed on its behalf by
Rona Fairhead,Robin Freestone, Chief financial officer

F-6


CONSOLIDATED CASH FLOW STATEMENT
YEAR ENDED 31 DECEMBER 20052006
(All figures in £ millions)
                                
 Notes 2005 2004 2003 Notes 2006 2005 2004
                
Cash flows from operating activities
                          
Cash generated from operations  29  875  705  531   31  621  653  524 
Interest paid     (101)  (98)  (87)     (106)  (101)  (98)
Tax paid     (65)  (45)  (44)     (59)  (65)  (45)
                  
Net cash generated from operating activities
     709  562  400      456  487  381 
                  
Cash flows from investing activities
                          
Acquisition of subsidiaries, net of cash acquired  27  (246)  (41)  (60)  28  (363)  (246)  (41)
Acquisition of joint ventures and associates     (7)  (10)  (5)     (4)  (7)  (10)
Purchase of property, plant and equipment (PPE)     (76)  (101)  (79)     (68)  (76)  (101)
Proceeds from sale of PPE  29  3  4  8      8  3  4 
Purchase of intangible assets     (24)  (24)  (26)     (29)  (24)  (24)
Investment in pre-publication     (222)  (181)  (173)
Purchase of other financial assets     (2)  (1)  (3)       (2)  (1)
Disposal of subsidiaries, net of cash disposed  28  376  7  (3)  30  10  376  7 
Disposal of joint ventures and associates     54  24  57        54  24 
Disposal of other financial assets       17            17 
Interest received     29  13  11      24  29  13 
Dividends received from joint ventures and associates     14  12  10      45  14  12 
                  
Net cash used in investing activities
     (101)  (281)  (263)
Net cash (used in)/generated from investing activities
     (377)  121  (100)
                  
Cash flows from financing activities
                          
Proceeds from issue of ordinary shares  25  4  4  5   25  11  4  4 
Purchase of treasury shares     (21)  (10)  (1)  26  (36)  (21)  (10)
Proceeds from borrowings       414  235      84    473 
Short-term investments (acquired)/repaid       (5)  1 
Other borrowings       59  (13)
Short-term investments required         (5)
Liquid resources acquired     (24)     
Repayments of borrowings     (79)  (524)  (159)     (145)  (79)  (524)
Finance lease principal payments     (3)  (2)  (3)     (3)  (3)  (2)
Dividends paid to Company’s shareholders  10  (205)  (195)  (188)  10  (220)  (205)  (195)
Dividends paid to minority interests     (17)  (2)  (19)     (15)  (17)  (2)
                  
Net cash used in financing activities
     (321)  (261)  (142)     (348)  (321)  (261)
Effects of exchange rate changes on cash and cash equivalents     13  (4)  45      (44)  13  (4)
                  
Net increase in cash and cash equivalents
     300  16  40 
Net (decrease)/increase in cash and cash equivalents
     (313)  300  16 
                  
Cash and cash equivalents at beginning of year     544  528  488      844  544  528 
                  
Cash and cash equivalents at end of year
  20  844  544  528   20  531  844  544 
                  

F-7


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
General information
      Pearson plc (the Company) and its subsidiaries (together the Group)are involved in the provision of information for the educational sector, consumer publishing and business information.
      The Company is a limited liability company incorporated and domiciled in England. The address of its registered office is 80 Strand, London WC2R 0RL.
      The Company has its primary listing on the London Stock Exchange but is also listed on the New York Stock Exchange.
      These consolidated financial statements were approved for issue by the Boardboard of Directorsdirectors on 26 February 2006.9 March 2007.
1Accounting policies
      The principal accounting policies applied in the preparation of these consolidated financial statements are set out below.
a.     Basis of preparation
a.Basis of preparation
      These consolidated financial statements have been prepared in accordance with EU-adopted International Financial Reporting Standards (IFRS) and International Financial Reporting Interpretations Committee (IFRIC) interpretations and with those parts of the Companies Act 1985 applicable to companies reporting under IFRS.
The Group transitioned from UK GAAP to IFRS 1 ‘First-time Adoption of International Financial Reporting Standards’ has been applied in preparing these financial statements. These consolidated financial statements are the Group’s first financial statements to be prepared in accordance with IFRS as adopted by the EU.
      The policies set out below have been consistently applied to all the years presented, with the exception of IAS 32 ‘Financial Instruments: Disclosure and Presentation’ and IAS 39 ‘Financial Instruments: Recognition and Measurement’ which have been applied with effect fromon 1 January 2005.
      Consolidated financial statements of Pearson plc until 31 December 2004 had been prepared in accordance with UK GAAP. UK GAAP differs in certain respects from IFRS.
      When preparing the Group’s 2005 consolidated financial statements, management has amended certain accounting, valuation and consolidation methods applied in the UK GAAP financial statements to comply with IFRS. The comparative figures in respect of 2004 and 2003 were restated to reflect these adjustments.
      Note 34 describes how, in preparing these consolidated financial statements, the Directors have applied accounting standards as adopted for use in the EU under the first-time adoption provisions as set out in IFRS 1.2003.
      These consolidated financial statements have been prepared under the historical cost convention.
      The preparationconvention as modified by the revaluation of financial statements in conformity with IFRS requires the use of certain critical accounting estimates. It also requires management to exercise its judgement in the process of applying the Group’s accounting policies. The areas involving a higher degree of judgement or complexity, or areas where assumptionsassets and estimates are significant to the consolidated financial statements, are disclosed below in ‘Critical accounting assumptions and judgements’.

F-8


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)liabilities (including derivative instruments) at fair value.
(1) Interpretations and amendments to published standards effective in 20052006 — 
The following amendments and interpretations to standards are mandatory for the Group’s accounting periods beginning on or after 1 January 2005:2006:
 • IFRIC 2 ‘Members’ SharesIAS 21 ‘The Effects of Changes in Co-operative Entities and Similar Instruments’Foreign Currency’;
• SIC 12 (Amendment) ‘Consolidation — Special Purpose Entities’; and
 
 • IAS 39 (Amendment) ‘Transition‘Cash Flow Hedge Accounting of Forecast Intragroup Transactions’;
• IAS 39 (Amendment) ‘The Fair Value Option’;
• IAS 39 and RecognitionIFRS 4 (Amendment) ‘Financial Guarantee Contracts’;
• IFRS 6 ‘Exploration for and Evaluation of Financial AssetsMineral Resources’;
• IFRIC 4 ‘Determining whether an Arrangement contains a Lease’;
• IFRIC 5 ‘Rights to Interests arising from Decommissioning, Restoration and Financial Liabilities’Environmental Rehabilitation Funds’;
• IFRIC 6 ‘Liabilities arising from Participating in a Specific Market — Waste Electrical and Electronic Equipment’.
      Management assessed the relevance of these amendments and interpretations with respect to the Group’s operations and concluded that they are not relevant or material to the Group.
(2) Standards, interpretations and amendments to published standards that are not yet effective —
Certain new standards, amendments and interpretations to existing standards have been published that are

F-8


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
mandatory for the Group’s accounting periods beginning on or after 1 January 20062007 or later periods but which theperiods. The Group has not early adopted. Theseadopted any of the new pronouncements which are as follows:
 • IFRS 7 ‘Financial Instruments: Disclosures’ (effective from 1 January 2007). IFRS 7 introduces new disclosures of qualitative and quantitative information about exposure to risks arising from financial instruments, including specifiedspecific minimum disclosures about credit risk, liquidity risk and market risk.
 
 • A complementary amendment to IAS 1 ‘Presentation of Financial Statements — Capital Disclosures’(effective from 1 January 2007). The amendment to IAS 1 introduces disclosures about the level and the management of the capital of an entity’s capitalentity.
• IFRS 8 ‘Operating Segments’ (effective 1 January 2009). IFRS 8 requires an entity to adopt the ‘management approach’ to reporting on the financial performance of its operating segments, revise explanations of the basis on which the segment information is prepared and how it manages capital. provide reconciliations to the amounts recognised in the income statement and balance sheet.
• Management is currently assessing the impact of IFRS 7, IFRS 8 and the complementary amendment to IAS 1 on the Group’s financial statements; and
• IFRIC 4 ‘Determining whether an Arrangement contains a Lease’ (effective from 1 January 2006). IFRIC 4 requires the determination whether an arrangement is or contains a lease to be based on the substance of the arrangement. Management is currently assessing the impact of IFRIC 4 on the Group’s operations, but does not expect it to be significant.statements.
      In addition, management has assessed the relevance of the following amendments and interpretations with respect to the Group’s operations and concluded that they are not relevant to the Group:operations:
 • IAS 39 (Amendment) ‘Cash Flow Hedge AccountingIFRIC 8 ‘Scope of Forecast Intragroup Transactions’IFRS 2’ (effective for annual periods beginning on or after 1 May 2006). IFRIC 8 requires consideration of transactions involving the issuance of equity instruments — where the identifiable consideration received is less than the fair value of the equity instruments issued — to establish whether or not they fall within the scope of IFRS 2. The Group will apply IFRIC 8 from 1 January 2006);
• IAS 39 (Amendment) ‘The Fair Value Option’ (effective from 1 January 2006);
• IAS 39 (Amendment) and IFRS 4 (Amendment) ‘Financial Guarantee Contracts’ (effective from 1 January 2006);
• IFRS 1 (Amendment) ‘First-time Adoption of International Financial Reporting Standards’ (effective from 1 January 2006);
• IFRS 6 ‘Exploration for and Evaluation of Mineral Resources’ (effective from 1 January 2006);2007, but it is not expected to have any impact on the Group’s accounts;
 
 • IFRIC 5 ‘Rights of Interests arising from Decommissioning, Restoration10 ‘Interim Financial Reporting and Environmental Rehabilitation Funds’Impairment’ (effective for annual periods beginning on or after 1 November 2006). IFRIC 10 prohibits impairment losses recognised in an interim period on goodwill, investments in equity instruments and investments in financial assets carried at cost to be reversed at a subsequent balance sheet date. The Group will apply IFRIC 10 from 1 January 2007;
• IFRIC 7 ‘Applying the Restatement Approach under IAS 29 Financial Reporting in Hyperinflationary Economies’(effective for annual reporting periods beginning on or after 1 March 2006);. IFRIC 7 provides guidance on how to apply the requirements of IAS 29 in a reporting period in which an entity identifies the existence of hyperinflation in the economy of its functional currency, when the economy was not hyperinflationary in the prior period. As none of the Group entities have a currency of a hyperinflationary economy as their functional currency, IFRIC 7 is not relevant to the Group’s operations; and
 
 • IFRIC 6 ‘Liabilities arising9 ‘Reassessment of Embedded Derivatives’ (effective for annual periods beginning on or after 1 June 2006). IFRIC 9 requires an entity to assess whether an embedded derivative is required to be separated from Participatingthe host contract and accounted for as a derivative when the entity first becomes a party to the contract. Subsequent reassessment is prohibited unless there is a change in the terms of the contract that significantly modifies the cash flows that otherwise would be required under the contract, in which case reassessment is required. The Group does not expect IFRIC 9 to have a Specific Market — Waste Electrical and Electronic Equipment’ (effective from 1 December 2005).material impact.
(3) Critical accounting assumptions and judgements —The preparation of financial statements in conformity with IFRS requires the use of certain critical accounting assumptions. It also requires management to exercise its judgement in the process of applying the Group’s accounting policies. The areas requiring a higher degree of judgement or complexity, or areas where assumptions and estimates are significant to the

F-9


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
consolidated financial statements, are discussed in the relevant accounting policies under the following headings:
• Intangible assets:Goodwill
• Intangible assets:Pre-publication assets
• Royalty advances
• Taxation
• Employee benefits:Retirement benefit obligations
• Revenue recognition.
b.Consolidation
     (1) SubsidiariesBusiness combinations — — Subsidiaries are entities over which the Group has the power to govern the financial and operating policies generally accompanying a shareholding of more than one half of the voting rights.

F-9


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Subsidiaries are fully consolidated from the date on which control is transferred to the Group and are de-consolidated from the date that control ceases.
The purchase method of accounting is used to account for the acquisition of subsidiaries by the Group. Acquisitions made prior to the date of transition to IFRS were accounted for in accordance with UK GAAP (see note 34). The cost of an acquisition is measured as the fair value of the assets given, equity instruments issued and liabilities incurred or assumed at the date of exchange, plus costs directly attributable to the acquisition. Identifiable assets and contingent assets acquired and identifiable liabilities and contingent liabilities assumed in a business combination are measured initially at their fair values at the acquisition date. For material acquisitions, the fair value of the acquired intangible assets is determined by an external, independent valuer. The excess of the cost of acquisition over the fair value of the Group’s share of the identifiable net assets acquired, after the identification of purchased intangible assets, is recorded as goodwill. See note 1e(1)for the accounting policy on goodwill.
     (2) Subsidiaries —Subsidiaries are entities over which the Group has the power to govern the financial and operating policies generally accompanying a shareholding of more than one half of the voting rights. Subsidiaries are fully consolidated from the date on which control is transferred to the Group and are de-consolidated from the date that control ceases.
(3) Joint ventures and associates — — Joint ventures are entities in which the Group holds an interest on a long-term basis and which are jointly controlled, with one or more other ventures,venturers, under a contractual arrangement. Associates are entities over which the Group has significant influence but not the power to control the financial and operating policies, generally accompanying a shareholding of between 20% and 50% of the voting rights. Investments in joint ventures and associates are accounted for by the equity method of accounting and are initially recognised at cost. The Group’s investment in associates includes related goodwill.
      The Group’s share of its joint ventures’ and associates’ post-acquisition profits or losses is recognised in the income statement, and its share of post-acquisition movements in reserves is recognised in reserves. The Group’s share of its joint ventures’ and associates’ results is recognised as a component of operating profit as these operations form part of the core publishing business of the Group and an integral part of existing wholly owned businesses. The cumulative post-acquisition movements are adjusted against the carrying amount of the investment. When the Group’s share of losses in a joint venture or associate equals or exceeds its interest in the joint venture or associate, the Group does not recognise further losses, unless the Group has incurred obligations or made payments on behalf of the joint venture or associate.
c.Foreign currency translation
     (1) Functional and presentation currency — Items included in the financial statements of each of the Group’s entities are measured using the currency of the primary economic environment in which the entity operates (the ‘functional currency’). The consolidated financial statements are presented in Sterling,sterling, which is the Company’s functional and presentation currency.
     (2) Transactions and balances — Foreign currency transactions are translated into the functional currency using the exchange rates prevailing at the dates of the transactions. Foreign exchange gains and losses resulting from the settlement of such transactions and from the translation at year end exchange rates of

F-10


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
monetary assets and liabilities denominated in foreign currencies, are recognised in the income statement, except when deferred in equity as qualifying net investment hedges.
      Translation differences on other non-monetary items such as equities held at fair value are reported as part of the fair value gain or loss through the income statement. Fair value adjustments on non-monetary items such as equities classified as available for sale financial assets, are included in the fair value reserve in equity as from 1 January 2005.equity.
     (3) Group companies — The results and financial position of all Group entitiescompanies that have a functional currency different from the presentation currency are translated into the presentation currency as follows:
       i) assets and liabilities are translated at the closing rate at the date of the balance sheet;
 
       ii) income and expenses are translated at average exchange rates;
 
       iii) all resulting exchange differences are recognised as a separate component of equity.

F-10


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      On consolidation, exchange differences arising from the translation of the net investment in foreign entities, and of borrowings and other currency instruments designated as hedges of such investments, are taken to shareholders’ equity. The Group treats specific intercompanyinter-company loan balances, which are not intended to be repaid forin the foreseeable future, as part of its net investment. When a foreign entity is sold, such exchange differences are recognised in the income statement as part of the gain or loss on sale.
      At the date of transition to IFRS the cumulative translation differences for foreign operations have been deemed to be zero. Any gains and losses on disposals of foreign operations will exclude translation differences arising prior to the transition date.
      The principal overseas currency for the Group is the US Dollar.dollar. The average rate for the year against Sterlingsterling was $1.81 (2004: $1.83; 2003: $1.63)$1.84 (2005: $1.81) and the year end rate was $1.72 (2004: $1.92; 2003: $1.79)$1.96 (2005: $1.72).
d.     Property, plant and equipment
d.Property, plant and equipment
      Property, plant and equipment is stated at historical cost less depreciation. Land is not depreciated. Depreciation on other assets is calculated using the straight-line method to allocate their cost to their residual values over their estimated useful lives as follows:
       Buildings (freehold) 20–50: 20-50 years
 
       Buildings (leasehold): 50 years (or over the period of the lease if shorter)
 
       Plant and equipment 3–20equipment: 3-20 years
      The asset’s residual values and useful lives are reviewed, and adjusted if appropriate, at each balance sheet date.
      The asset’s residual values and useful lives are reviewed, and adjusted if appropriate, at each balance sheet date.
e.Intangible assets
      The carrying value of an asset is written down to its recoverable amount if the carrying value of the asset is greater than its estimated recoverable amount.
e.     Intangible assets
     (1) Goodwill — Goodwill represents the excess of the cost of an acquisition over the fair value of the Group’s share of the net identifiable assets of the acquired subsidiary or associate at the date of acquisition. Goodwill on acquisitions of subsidiaries is included in intangible assets. Goodwill on acquisitions of associates is included in investments in associates. Goodwill is tested annually for impairment and carried at cost less accumulated impairment losses. The recoverable amounts of cash generating units have been determined based on value in use calculations. These calculations require the use of estimates (see note 12). Goodwill is allocated to cash generating units for the purpose of impairment testing. The allocation is made to those cash

F-11


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
generating units that are expected to benefit from the business combination in which the goodwill arose. Gains and losses on the disposal of an entity include the carrying amount of goodwill relating to the entity sold. IFRS 3 ‘Business Combinations’ has not been applied retrospectively to business combinations before the date of transition to IFRS. Subject to the transition adjustments to IFRS required by IFRS 1, the accounting for business combinations before the date of transition has been grandfathered.
     (2) Software development costsAcquired software — Costs directly associated with the production of identifiable and uniqueSoftware separately acquired for internal use is capitalised at cost. Software acquired in material business combinations is capitalised at its fair value as determined by an independent valuer. Acquired software products, where it is probable that they will generate economic benefits exceeding costs, are recognised as intangible assets and are amortised on a straight line basis over theirits estimated useful lives not exceeding ten years from when the software is available for use.life of between three and five years.
     (3) Internally developed software — Internal and external costs incurred during the preliminary stage of developing computer software for internal use are expensed as incurred. Internal and external costs incurred to develop computer software for internal use during the application development stage are capitalised if the Group expects economic benefits from the development. Capitalisation in the application development stage begins once the Group can reliably measure the expenditure attributable to the software development and has demonstrated its intention to complete and use the software. Internally developed software is amortised on a straight-line basis over its estimated useful life of between three and five years.
(4) Acquired intangible assets — Acquired intangible assets comprise publishing rights, customer lists and relationships, technology, trade names and trademarks. These assets are capitalised on acquisition at cost and included in intangible assets. Intangible assets andacquired in material business combinations are capitalised at their fair value as determined by an independent valuer. Intangible assets are amortised over their estimated useful lives of between two and 30 years.20 years, using a depreciation method that reflects the pattern of their consumption.
     (4)(5) Pre-publication costsassets — Pre-publication costs represent direct costs incurred in the development of educational programmes and titles prior to their publication. These costs are carried forward inrecognised as current intangible assets where the title will generate probable future economic benefits within their normal operating cycle and costs can be measured reliably. These costsPre-publication assets are amortizedamortised upon publication of the title over estimated economic lives of five years or less, being an estimate of the estimated expected operating life cycle of the title, with a higher proportion of the amortizationamortisation taken in the earlier years. The investment in pre-publication assets has been disclosed as part of the investing activitiescash generated from operations in the cash flow statement.statement(see note 31).

F-11


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)      The assessment of the recoverability of pre-publication asset and the determination of the amortisation profile involve a significant degree of judgement based on historical trends and management estimation of future potential sales. An incorrect amortisation profile could result in excess amounts being carried forward as intangible assets that would otherwise have been written off to the income statement in an earlier period. Reviews are performed regularly to estimate recoverability of pre-publication assets. The carrying amount of pre-publication assets is set out in note 17.
f.f.     Other financial assets
Up to 31 December 2004 — Other financial assets include investments in companies other than subsidiaries and associates and other securities. Financial fixed assets are recorded at historical cost less provisions for diminution in value.
From 1 January 2005 —      Other financial assets, designated as available for sale investments, are non-derivative financial assets measured at estimated fair value. Changes in the fair value are recorded in equity in the fair value reserve. On the subsequent disposal of the asset, the net fair value gains or losses are taken through the income statement.
g.g.     Inventories
      Inventories are stated at the lower of cost and net realisable value. Cost is determined using the first in first out (FIFO) method. The cost of finished goods and work in progress comprises raw materials, direct labour, and other direct costs and related production overheads. Net realisable value is the estimated selling price

F-12


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
in the ordinary course of business, less estimated costs necessary to make the sale. Provision isProvisions are made for slow moving and obsolete stock.
h.     Royalty advances
h.Royalty advances
      Advances of royalties to authors are included within trade and other receivables when the advance is paid less any provision required to bringadjust the amount downadvance to its net realisable value. The realisable value of royalty advances relies on a degree of management judgement in determining the profitability of individual author contracts. If the estimated realisable value of author contracts is overstated then this will have an adverse effect on operating profits as these excess amounts will be written off. The recoverability of royalty advances is based upon an annual detailed management review of the age of the advance, the future sales projections for new authors and prior sales history of repeat authors. The royalty advance is expensed at the contracted or effective royalty rate as the related revenues are earned. Royalty advances which will be consumed within one year are held in current assets. This represents the operating cycle of consumer publishing titles. Royalty advances which will be consumed after one year are held in non-current assets.
i.     Newspaper development costs
i.Newspaper development costs
      Investment in the development of newspaper titles consists of measures to increase the volume and geographical spread of circulation. The measures include additional and enhanced editorial content, extended distribution and remote printing. These extra costs arisingcost are expensed as incurred as they do not meet the criteria under IAS 38 to be capitalised as intangible assets.
j.     Cash and cash equivalents
j.Cash and cash equivalents
      Cash and cash equivalents in the statement of cash flowsflow statement include cash in hand, deposits held at call with banks, other short termshort-term highly liquid investments with original maturities of three months or less, and bank overdrafts. Bank overdrafts are shown withinincluded in borrowings in current liabilities in the balance sheet.
k.     Share capital
k.Share capital
      Ordinary shares are classified as equity.
      Incremental costs directly attributable to the issue of new shares or options are shown in equity as a deduction, net of tax, from the proceeds.
      Where any Group company purchases the Company’s equity share capital (Treasury shares) the consideration paid, including any directly attributable incremental costs (net of income taxes) is deducted from equity attributable to the Company’s equity holders until the shares are cancelled, reissued or disposed of. Where such shares are subsequently sold or reissued, any consideration received, net of any directly attributable incremental transaction costs and the related income tax effects, is included in equity attributable to the Company’s equity holders.

F-12


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)l.     Borrowings
l.Borrowings
      Borrowings are recognised initially at fair value, which is proceeds received net of transaction costs incurred. Borrowings are subsequently stated at amortised cost with any difference between the proceeds (net of transaction costs) and the redemption value being recognised in the income statement over the period of the borrowings using the effective interest method. From 1 January 2005, accruedAccrued interest is also included as part of the borrowing.borrowings. Where a debt instrument is in a fair value hedging relationship, an adjustment is made to the bondits carrying value to reflect the hedged risk. Interest on borrowings is expensed as incurred.

F-13


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
m.Derivative financial instruments
Upto 31 December 2004m.     Derivative financial instruments — Amounts payable or receivable in respect of interest rate derivatives are accrued within net interest payable over the period of the contract. Where the derivative instrument is terminated early, the gain or loss is spread over the remaining maturity of the original instrument. Where the underlying exposure ceases to exist, any termination gain or loss is taken to the income statement. Foreign currency borrowings together with their related cross currency derivatives are carried in the balance sheet at the relevant exchange rates at the balance sheet date. Gains or losses in respect of the hedging of overseas subsidiaries are taken to reserves. Gains or losses arising from foreign exchange contracts are taken to the income statement in line with the transactions which they are hedging.
From 1 January 2005 —      Derivatives are initially recognised at fair value at the date of transition to IAS 39 39(1 January 2005)or, if later, on the date a derivative is entered into. Derivatives are subsequently remeasured at their fair value. The fair value of derivatives has been determined by using market data and the use of established estimation techniques such as discounted cashflowcash flow and option valuation models. The Group designates certain of the derivative instruments within its portfolio to be hedges of the fair value of its bonds (fairbonds(fair value hedges) or hedges of net investments in foreign operations (net investment hedges).
      Changes in the fair value of derivatives that are designated and qualify as fair value hedges are recorded in the income statement, together with any changes in the fair value of the hedged asset or liability that are attributable to the hedged risk.
      The effective portion of changes in the fair value of derivatives that are designated and qualify as net investment hedges are recognised in equity. Gains and losses accumulated in equity are included in the income statement when the corresponding foreign operation is disposed of. Gains or losses relating to the ineffective portion are recognised immediately in finance income or finance costs in the income statement.
      Certain derivatives do not qualify or are not designated as hedging instruments. Such derivatives are classified at fair value and any movement in their fair value is recognised in finance income or finance costs in the income statement immediately.
n.     Taxation
n.Taxation
      Current tax is recognizedrecognised on the amounts expected to be paid or recovered under the tax rates and laws that have been enacted or substantively enacted at the balance sheet date.
      Deferred income tax is provided, using the liability method, on temporary differences arising between the tax bases of assets and liabilities and their carrying amounts in the consolidated financial statements.amounts. Deferred income tax is determined using tax rates (and laws)and laws that have been enacted or substantively enacted by the balance sheet date and are expected to apply when the related deferred tax asset is realised or the deferred income tax liability is settled.
      Deferred tax assets are recognised to the extent that it is probable that future taxable profit will be available against which the temporary differences can be utilised.
      Deferred income tax is provided in respect of the undistributed earnings of subsidiaries other than where it is intended that those undistributed earnings will not be remitted in the foreseeable future.

F-13


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      Current and deferred tax are recognised in the income statement, except when the tax relates to items charged or credited directly to equity, in which case the tax is also recognizedrecognised in equity.
      The Group is subject to income taxes in numerous jurisdictions. Significant judgement is required in determining the estimates in relation to the worldwide provision for income taxes. There are many transactions and calculations for which the ultimate tax determination is uncertain during the ordinary course of business. The Group recognises liabilities for anticipated tax audit issues based on estimates of whether additional taxes will be due. Where the final tax outcome of these matters is different from the amounts that were initially recorded, such differences will impact the income tax and deferred tax provisions in the period in which such determination is made.
o.Employee benefits
      Deferred tax assets and liabilities require management judgement in determining the amounts to be recognised. In particular, significant judgement is used when assessing the extent to which deferred tax assets should be recognised with consideration given to the timing and level of future taxable income together with any future tax planning strategies.

F-14


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
o.     Employee benefits
     (1) Retirement benefit obligations — The Group has elected to early adopt the amendment to IAS 19 “Employee Benefits’ with effect from the date of transition to IFRS. The liability in respect of defined benefit pension plans is the present value of the defined benefit obligations at the balance sheet date minusless the fair value of plan assets. The defined benefit obligation is calculated annually by independent actuaries using the projected unit credit method. The present value of the defined benefit obligation is determined by discounting estimated future cash flows using yields on high quality corporate bonds which have terms to maturity approximating the terms of the related liability.
      The determination of the pension cost and defined benefit obligation of the Group’s defined benefit pension schemes depends on the selection of certain assumptions, which include the discount rate, inflation rate, salary growth, longevity and expected return on scheme assets. Differences arising from actual experience or future changes in assumptions will be reflected in subsequent periods (actuarial gains and losses).
Actuarial gains and losses arising from differences between actual and expected returns on plan assets, experience adjustments on liabilities and changes in actuarial assumptions are recognised immediately in the statement of recognised income and expense.
      The service cost, representing benefits accruing over the year, is included in the income statement as an operating cost and thecost. The unwinding of the discount rate on the scheme liabilities and the expected return on scheme assetsasset are presented as a financing chargefinance costs or financingfinance income.
      Obligations for contributions to defined contribution pension plans are recognised as an operating expense in the income statement as incurred.
     (2) Other post-retirement obligations — The Group provides certain healthcare and life assurance benefits. The principal plans are unfunded. The expected costs of these benefits are accrued over the period of employment, using an accounting methodology which is the same as that for defined benefit pension plans. The liabilities and costs relating to other post-retirement obligations are assessed annually by independent qualified actuaries.
     (3) Share-based compensationpayments — The Group has a number of employee option and performance share schemes.plans. The fair value of options or shares granted is recognised as an employee expense after taking into account the Company’sGroup’s best estimate of the number of awards expected to vest. Fair value is measured at the date of grant and is spread over the vesting period of the instrument.option or share. The fair value of the options granted is measured using whichever of the Black-Scholes, Binomial and Monte Carlo model is most appropriate to the award. The fair value of shares awarded is measured using the share price at the date of grant unless another method is more appropriate. Any proceeds received are credited to share capital and share premium when the options are exercised. The Group has applied IFRS 2 ‘Share-based Payment’ retrospectively to all options granted but not fully vested at the date of transition to IFRS.
p.     Provisions
p.Provisions
      Provisions are recognizedrecognised when the Group has a present legal or constructive obligation as a result of past events, it is more likely than not that an outflow of resources will be required to settle the obligation and the amount can be reliably estimated. Provisions are discounted to present value where the effect is material.
      The Group recognises a provision for deferred consideration in the period that an acquisition is made and the Group becomes legally committed to making the payment.
      The Group recognises a provision forfore integration and reorganisation costs in the period in which the Group becomes legally or constructively committed to making the payment.
      The Group recognises a provision for onerous lease contracts when the expected benefits to be derived from a contract are less than the unavoidable costs of meeting the obligations under the contract. The

F-15


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
provision is based on the present value of future payments for surplus leased properties under non-cancellable operating leases, net of estimated sub-leasing revenue.

F-14


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)q.     Revenue recognition
q.Revenue recognition
      Revenue comprises the fair value of the consideration received or receivable for the sale of goods and services net of value-added tax and other sales taxes, rebates and discounts, and after eliminating sales within the Group. Revenue is recognizedrecognised as follows:
      Revenue from the sale of books is recognizedrecognised when title passes. AnticipatedA provision for anticipated returns are estimatedis made based primarily on historical return rates. If these estimates do not reflect actual returns in future periods then revenues could be understated or overstated for a particular period.
      Circulation and advertising revenue is recognised when the newspaper or other publication is published. Subscription revenue is recognised on a straight-line basis over the life of the subscription.
      Where a contractual arrangement consists of two or more separate elements that can be provided to customers either on a stand-alone basis or as an optional extra and fair value exists for each separate element, such as the provision of supplementary materials with textbooks, revenue in such multiple element arrangements is recognised forwhen each element as if it were an individual contractual arrangement.product has been delivered and all other relevant revenue recognition criteria are achieved.
      Revenue from multi-year contractual arrangements, such as contracts to process qualifying tests for individual professions and government departments, is recognised as performance occurs. The assumptions, risks, and uncertainties inherent in long-term contract accounting can affect the amounts and timing of revenue and related expenses reported. Certain of these arrangements, either as a result of a single service spanning more than one reporting period or where the contract requires the provision of a number of services that together constitute a single project, are treated as long-term contracts with revenue recognised on a percentage of completion basis. Losses on contracts are recognised in the period in which the loss first becomes foreseeable. Contract losses are determined to be the amount by which estimated total costs of the contract exceed the estimated total revenues that will be generated by the contract.
      On certain contracts, where the Group acts as agent, only commissions and fees receivable for services rendered are recognised as revenue. Any third party costs incurred on behalf of the principal that are rechargeable under the contractual arrangement are not included in revenue.
      Income from recharges of freight and other activities which are incidental to the normal revenue generating activities is included in other income.
r.Leases
r.     Leases
      Leases of property, plant and equipment where the Group has substantially all the risks and rewards of ownership are classified as finance leases. Finance leases are capitalised at the commencement of the lease at the lower of the fair value of the leased property and the present value of the minimum lease payments. Each lease payment is allocated between the liability and finance charges so as to achieve a constant rate on the finance balance outstanding. The corresponding rental obligations, net of finance charges, are included in other long-term payables.financial liabilities — borrowings. The interest element of the finance cost is charged to the income statement over the lease period so as to produce a constant periodic rate of interest on the remaining balance of the liability for each period. The property, plant and equipment acquired under finance leases is depreciated over the shorter of the useful life of the asset or the lease term.
      Leases where a significant portion of the risks and rewards of ownership are retained by the lessor are classified as operating leases by the lessee. Payments made under operating leases (net of any incentives received from the lessor) are charged to the income statement on a straight-line basis over the period of the lease.

F-16


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
s.Dividends
s.     Dividends
      Dividends are recorded in the Group’s financial statements in the period in which they are approved by the Company’s shareholders. Interim dividends are recorded in the period in which they are approved and paid.

F-15


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)t.     Non-current assets held for sale and discontinued operations
t.Non-current assets held for sale and discontinued operations
      Non-current assets are classified as assets held for sale and stated at the lower of carrying amount and fair value less costs to sell if it is intended to recover their carrying amount principally through a sale transaction rather than through continuing use. No depreciation is charged in respect of non-current assets classified as held for sale. Amounts relating to non-current assets held for sale are classified as discontinued operations in the income statement.
u.     Trade receivables
u.Trade receivables
      Trade receivables are recognisedstated at fair value less provision for bad and doubtful debts and anticipated future sales returns (see also note 1q).
Critical accounting assumptions and judgements
      The preparation of financial statements in conformity with IFRS requires the use of certain critical accounting assumptions. It also requires management to exercise its judgement in the process of applying the Group’s accounting policies. The areas requiring a higher degree of judgement or complexity, or areas where assumptions and estimates are significant to the consolidated financial statements, are discussed below.
Critical accounting estimates and assumptions
(1) Revenue recognition — Revenue from the sale of books is recognized when title passes. A provision for anticipated returns is made based primarily on historical return rates. If these estimates do not reflect actual returns in future periods then revenues could be understated or overstated for a particular period. The provision for sales returns is set out in note 19.
(2) Pre-publication costs — The assessment of the useful life of pre-publication costs and the calculation of amortisation involve a significant amount of judgement based on historical trends and management estimation of their future potential sales, in accordance with the accounting policy stated in note 1e(4). The overstatement of useful lives could result in excess amounts being carried forward as intangible assets that would otherwise have been written off to the income statement in an earlier period. Reviews are performed regularly to estimate recoverability of pre-publication costs. The carrying amount of pre-publication costs is set out in note 17.
(3) Royalty advances — The realisable value of royalty advances relies on a degree of management judgement in determining the profitability of individual author contracts, in accordance with the accounting policy stated in note 1h. If the estimated realisable value of author contracts is overstated then this will have an adverse effect on operating profits as these excess amounts will be written off. The carrying amount of royalty advances is set out in note 19.
(4) Income taxes — The Group is subject to income taxes in numerous jurisdictions. Significant judgement is required in determining the estimates in relation to the worldwide provision for income taxes. There are many transactions and calculations for which the ultimate tax determination is uncertain during the ordinary course of business. The Group recognises liabilities for anticipated tax audit issues based on estimates of whether additional taxes will be due. Where the final tax outcome of these matters is different from the amounts that were initially recorded, such differences will impact the income tax and deferred tax provisions in the period in which such determination is made.
(5) Goodwill — The Group tests annually whether goodwill has suffered any impairment, in accordance with the accounting policy stated in note 1e(1). The recoverable amounts of cash generating units have been determined based on value in use calculations. These calculations require the use of estimates (see note 12).

F-16


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Critical judgements in applying the Group’s accounting policies
(1) Revenue recognition — Revenue from multi-year contractual arrangements is recognised as performance occurs. The assumptions, risks, and uncertainties inherent in long-term contract accounting can affect the amounts and timing of revenue and related expenses reported.
(2) Retirement benefit obligations — The determination of the pension cost and defined benefit obligation of the Group’s defined benefit pension schemes depends on the selection of certain assumptions, which include the discount rate, inflation rate, salary growth, longevity and expected return on scheme assets. Differences arising from actual experience or future changes in assumptions will be reflected in subsequent periods.
(3) Deferred income tax — Deferred tax assets and liabilities require management judgement in determining the amounts to be recognised. In particular, significant judgement is used when assessing the extent to which deferred tax assets should be recognised with consideration given to the timing and level of future taxable income together with any future tax planning strategies.
Financial risk management
      The Group’s treasury policy governs the management of financial risks within the Group. The policy, which is approved by the treasury committee, covers interest rate risk, liquidity and refinancing risk, counterparty risk and foreign currency risk. In accordance with the treasury policy, the Group actively monitors and manages its financial risk exposures. The policy permits the use of financial instruments such as derivatives, where appropriate. The policy only permits transactions related to underlying positions and speculative transactions are not permitted.
Interest rate risk — A change in market interest rates can cause fluctuations in the Group’s net income or financial position. The Group is predominantly funded through bonds issued at fixed rates and nearly all of these bonds have been swapped to a floating rate for the term of the debt. The Group’s policy (as updated in September 2005) requires that interest rates on its net debt position are fixed for the next four years such that the fixed rate portion is within a range of 65% to 40% in the first year, with the lower end of the range declining by 10% each year such that the fixed rate portion falls within a range of 65% to 10% in year four. The Group also uses derivatives to change the currency profile of its debt and to alter the timing of floating interest rate resets in order to comply with its policy. The Group manages the derivatives and debt to achieve policy objectives on a portfolio basis. The Group designates derivatives as hedges under IAS 39 where hedge accounting is possible, so long as a designation will not have an adverse effect on the balancing of the portfolio.
Liquidity and refinancing risk — The Group’s funding objective is to ensure that committed funding is available to the Group at a reasonable cost, with an extended maturity profile and that funding is available from diverse sources. To assist with the diversity of funding objective, the Group has ratings with Moody’s and Standard & Poor’s, which provides greater access to international capital markets.
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 reflecting published credit ratings. Exposures to individual counterparties are monitored on a regular basis. Where appropriate, ISDA Master Agreements permitting the netting of transactions in the event of counterparty failure are entered into with derivative counterparties.
Foreign currency risk — The Group has operations overseas and is therefore exposed to movements in foreign currencies, particularly the US dollar. For transactional foreign exchange exposure, the policy allows the use of derivatives where appropriate. The Group mainly converts foreign currencies at spot rate and had no cash flow hedges in place at the balance sheet date. Translational foreign exchange exposure is of more significance to the Group. It seeks to offset this exposure through its policy of aligning approximately the currency composition of its core net borrowings with its forecast operating profit. This policy only applies where a currency accounts for more than 15% of Group operating profit and currently is only applicable to the

F-17


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
US dollar. The Group uses its dollar denominated debt and the foreign exchange portion of certain cross currency rate derivatives as net investment hedges of foreign operations. Unremitted profits are not hedged with foreign exchange contracts, as the Company judges it inappropriate to hedge non-cash flow translational exposure with cash flow instruments.
2     Segment information
      Due to the differing risks and rewards associated with each business segment and the different customer focus of each segment, business is the Group’s primary segment reporting segment. At 31 December 2005 theformat is by business. The Group is organised into the following five business segments:
School — publisher, provider of testing and software services for primary business segments, School, and secondary schools;
Higher Education — publisher of textbooks and related course materials for colleges and universities;
Penguin — publisher with brand imprints such as Penguin, Putnam, Berkley, Viking, Dorling Kindersley;
FT Publishing — publisher of theFinancial Times, other business newspapers, magazines and specialist information;
Interactive Data Corporation (IDC).The — provider of financial and business information to financial institutions and retail investors.
      The remaining business group, Professional, brings together a number of education publishing, testing and services businesses that publish texts, reference and interactive products for industry professionals and does not meet the criteria for classification as a “segment”‘segment’ under IFRS. For more detail on the services and products included in each business segment refer to the Business Review.

F-17


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Primary reporting format — business segments
Primary reporting format — business segments
                                                                
   Higher     FT     2005     Higher     FT     2006
 School Education Professional Penguin Publishing IDC Corporate Group Notes School Education Professional Penguin Publishing IDC Corporate Group
                                  
 (All figures in £ millions) (All figures in £ millions)
Continuing operations
                                                     
Sales (external)  1,295  779  589  804  332  297    4,096      1,455  795  341  848  366  332    4,137 
Sales (inter-segment)        16        16      1      18        19 
                                    
Operating profit before joint ventures and associates  138  156  44  60  49  75    522      161  161  36  58  18  82    516 
Share of results of joint ventures and associates  4    1    9      14      6    1    17      24 
                                    
Operating profit
  142  156  45  60  58  75    536      167  161  37  58  35  82    540 
                                    
Finance costs                       (132)  7                       (133)
Finance income  7                       59 
                                    
Finance income         ��              62 
Profit before tax
                       466                           466 
                                    
Income tax                       (124)  8                       (11)
                                    
Profit for the year from continuing operations
                       342                           455 
                                    
Reconciliation to adjusted operating profit
                                                     
Operating profit  142  156  45  60  58  75    536      167  161  37  58  35  82    540 
Adjustment to goodwill on recognition of pre-acquisition deferred tax           7        7 
Amortisation of acquired intangibles  5        1  5    11      17    1  1  2  7    28 
Other net gains and losses          (40)      (40)
Other net gains and losses of associates             (4)      (4)
Other net finance costs of associates          2      2              (1)      (1)
                   
Adjusted operating profit — continuing operations  147  156  45  60  21  80    509      184  161  38  66  32  89    570 
                                    
Segment assets  2,067  1,402  1,705  960  154  291  985  7,564      2,684  1,347  580  954  317  314  703  6,899 
Joint ventures  6      2  4      12   13  5      3  4      12 
Associates  6        18      24   13  4        4      8 
                                    
Assets — continuing operations     2,693  1,347  580  957  325  314  703  6,919 
Assets — discontinued operations         294          294 
                   
Total assets
  2,079  1,402  1,705  962  176  291  985  7,600      2,693  1,347  874  957  325  314  703  7,213 
                                    
Total liabilities
  (557)  (341)  (263)  (280)  (336)  (109)  (1,981)  (3,867)     (662)  (268)  (177)  (269)  (300)  (131)  (1,762)  (3,569)
                                    
Other segment items
                                                     
Capital expenditure (notes 11, 12 and 17)  114  96  43  34  14  19    320 
Depreciation (note 11)  26  8  17  7  11  11    80 
Amortisation (notes 12 and 17)  91  78  20  24  3  5    221 
Capital expenditure 11, 12, 17  124  88  30  38  19  20    319 
Depreciation  11  21  8  19  7  9  13    77 
Amortisation 12, 17  117  78  21  34  4  7    261 
                                    

F-18


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                                                                
   Higher     FT     2004     Higher     FT     2005
 School Education Professional Penguin Publishing IDC Corporate Group Notes School Education Professional Penguin Publishing IDC Corporate Group
                                  
 (All figures in £ millions) (All figures in £ millions)
Continuing operations
                                                     
Sales (external)  1,087  729  507  786  318  269    3,696      1,295  779  301  804  332  297    3,808 
Sales (inter-segment)        15        15            16        16 
                                    
Operating profit before joint ventures and associates  109  133  42  46  4  62    396      138  156  24  60  49  75    502 
Share of results of joint ventures and associates  3      1  4      8      4    1    9      14 
                                    
Operating profit
  112  133  42  47  8  62    404      142  156  25  60  58  75    516 
                                    
Finance costs                       (96)  7                       (132)
Finance income                       17   7                       62 
                                    
Profit before tax
                       325                           446 
                                    
Income tax                       (63)  8                       (116)
                                    
Profit for the year from continuing operations
                       262                           330 
                                    
Reconciliation to adjusted operating profit
                                                     
Operating profit  112  133  42  47  8  62    404      142  156  25  60  58  75    516 
Amortisation of acquired intangibles            5    5      5        1  5    11 
Other net gains and losses  (4)  (4)  (2)  5  (4)      (9)             (40)      (40)
Other net finance costs of associates             2      2 
                                    
Adjusted operating profit — continuing operations  108  129  40  52  4  67    400      147  156  25  60  21  80    489 
                                    
Segment assets  1,860  1,224  1,345  892  502  247  461  6,531      2,347  1,648  1,179  960  154  291  985  7,564 
Joint ventures  7      5  2      14   13  6      2  4      12 
Associates  5        28      33   13  6        18      24 
                                    
Total assets
  1,872  1,224  1,345  897  532  247  461  6,578      2,359  1,648  1,179  962  176  291  985  7,600 
                                    
Total liabilities
  (439)  (286)  (212)  (259)  (435)  (110)  (1,823)  (3,564)     (557)  (341)  (263)  (280)  (336)  (109)  (1,981)  (3,867)
                                    
Other segment items
                                                     
Capital expenditure (notes 11,12 and 17)  104  79  62  36  15  12    308 
Depreciation (note 11)  25  9  16  9  16  9    84 
Amortisation (notes 12 and 17)  74  65  18  29  2  5    193 
Capital expenditure 11, 12, 17  114  96  43  34  14  19    320 
Depreciation  11  26  8  17  7  11  11    80 
Amortisation 12, 17  91  78  20  24  3  5    221 
                                    

F-19


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                                                                
   Higher     FT     2003     Higher     FT     2004
 School Education Professional Penguin Publishing IDC Corporate Group Notes School Education Professional Penguin Publishing IDC Corporate Group
                                  
 (All figures in £ millions) (All figures in £ millions)
Continuing operations
                                                     
Sales (external)  1,149  770  503  840  315  273    3,850      1,087  729  290  786  318  269    3,479 
Sales (inter-segment)      1  15        16            15        15 
                                    
Operating profit before joint ventures and associates  112  140  33  81  (28)  66    404      109  133  20  46  4  62    374 
Share of results of joint ventures and associates  2      1  (1)      2      3      1  4      8 
                                    
Operating profit
  114  140  33  82  (29)  66    406      112  133  20  47  8  62    382 
                                    
Finance costs                       (100)  7                       (96)
Finance income                       7   7                       17 
                                    
Profit before tax
                       313                           303 
                                    
Income tax                       (61)  8                       (55)
                                    
Profit for the year from continuing operations
                       252                           248 
                                    
Reconciliation to adjusted operating profit
                                                     
Operating profit  114  140  33  82  (29)  66    406      112  133  20  47  8  62    382 
Amortisation of acquired intangibles            4    4                 5    5 
Other net gains and losses  2  2  1  1        6      (4)  (4)  (2)  5  (4)      (9)
                                    
Other net finance costs of associates                      
Adjusted operating profit — continuing operations  116  142  34  83  (29)  70    416      108  129  18  52  4  67    378 
                                    
Segment assets  2,072  1,157  1,387  907  358  240  551  6,672      1,860  1,224  1,345  892  502  247  461  6,531 
Joint ventures  6      4  2      12   13  7      5  2      14 
Associates  5        47      52   13  5        28      33 
                                    
Total assets
  2,083  1,157  1,387  911  407  240  551  6,736      1,872  1,224  1,345  897  532  247  461  6,578 
                                    
Total liabilities
  (458)  (318)  (158)  (398)  (203)  (113)  (1,927)  (3,575)     (439)  (286)  (212)  (259)  (435)  (110)  (1,823)  (3,564)
                                    
Other segment items
                                                     
Capital expenditure (notes 11, 12 and 17)  101  65  21  47  26  17    277 
Depreciation (note 11)  26  9  13  6  19  12    85 
Amortisation (notes 12 and 17)  68  58  18  39  2  5    190 
Capital expenditure 11, 12, 17  104  79  62  36  15  12    308 
Depreciation  11  25  9  16  9  16  9    84 
Amortisation 12, 17  74  65  18  29  2  5    193 
                                    
      In 2006, sales from the provision of goods were £3,117m (2005: £2,956m; 2004: 2,787m) and sales from the provision of services were £1,020m (2005: £852m; 2004: 692m). Sales from the Group’s educational publishing, consumer publishing and newspaper business are classified as being from the provision of goods and sales from its assessment and testing, marketpricing, corporate training and management service businesses are classified as being from the provision of services.
      Corporate costs are allocated to business segments on an appropriate basis depending on the nature of the cost and therefore the segment result is equal to the Group result.operating profit. Inter-segment pricing is determined on an arm’s length basis. Segment assets consist primarily of property, plant and equipment, intangible assets, inventories, receivables and deferred taxation and exclude cash and cash equivalents and derivative assets. Segment liabilities comprise operating liabilities and exclude borrowings and derivative liabilities. Corporate assets and liabilities comprise cash and cash equivalents, marketable securities, borrowings and derivative financial instruments. Capital expenditure comprises additions to property, plant and equipment and intangible assets, including pre-publication but excluding goodwill (see notes 11, 12 and 17).

F-20


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      Property, plant and equipment and intangible assets acquired through business combinations were £111m (2004: £16m; 2003: £54m)(see£173m (2005: £111m; 2004: £16m) (see notes 11, 12 and 17). Capital expenditure, depreciation and amortisation

F-20


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
includes include amounts relating to discontinued operations. In April 2005, Pearson sold its 79% interest in Recoletos Grupo de Communicación S.A.S.A.. This operation is now disclosed as a ‘discontinued’ operation. The relateddiscontinued operation in 2005 (see note 3). In December 2006 Pearson announced its intention to sell Pearson Government Solutions. This operation is disclosed as a discontinued operation (see note 3) and the assets and liabilities are disclosed within the FT Publishing segment in 2004 and 2003.classified as held for sale (see note 29).
Secondary reporting format — geographic segments
Secondary reporting format — geographical segments
      Although theThe Group’s business segments are managed on a worldwide basis they alland operate in the following main geographicalgeographic areas:
                                                            
 Sales Total assets Capital expenditure Sales Total assets Capital expenditure
            
 2005 2004 2003 2005 2004 2003 2005 2004 2003 2006 2005 2004 2006 2005 2004 2006 2005 2004
                                    
 (All figures in £ millions) (All figures in £ millions)
Continuing operations
                                                        
European countries  963  835  768  1,711  1,112  1,003  60  79  63   1,089  951  820  1,608  1,711  1,112  70  63  79 
North America  2,717  2,504  2,742  5,476  4,716  5,015  242  208  188   2,642  2,451  2,309  4,908  5,476  4,716  231  242  208 
Asia Pacific  300  263  255  325  302  301  13  10  11   298  300  263  327  325  302  12  13  10 
Other countries  116  94  85  52  43  37  2  3  4   108  106  87  56  52  43  2  2  3 
                                      
Total
  4,096  3,696  3,850  7,564  6,173  6,356  317  300  266   4,137  3,808  3,479  6,899  7,564  6,173  315  320  300 
                                      
Discontinued operations (European countries)  27  190  169    358  316  3  8  11 
Discontinued operations
                            
European countries  17  39  205  9    358  1    8 
North America  257  266  195  281      2     
Other countries  12  10  7  4      1     
                   
Total
  286  315  407  294    358  4    8 
Joint ventures and associates        36  47  64               20  36  47       
                                      
Total
  4,123  3,886  4,019  7,600  6,578  6,736  320  308  277   4,423  4,123  3,886  7,213  7,600  6,578  319  320  308 
                                      
      Sales are allocated based on the country in which the customer is located. This does not differ materially from the location where the order is received. Total assets and capital expenditure are allocated to where the assets are located.

F-21


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
3Discontinued operations
      In AprilOn 11 December 2006, Pearson announced that it had agreed to sell Pearson Government Solutions to Veritas Capital, a private equity firm. This operation is disclosed as discontinued and the assets and liabilities of Pearson Government Solutions have been reclassified to non-current assets held for sale (see notes 29 and 35).
      Discontinued operations in 2005 Pearson sold itsalso relate to the sale of Pearson’s 79% interest in Recoletos Grupo de Communicación S.A. to Retos Cartera, a consortium of investors. This operation is disclosed as a ‘discontinued’ operation (see note 28).S.A..
      An analysis of the resultresults and cash flows of discontinued operations isare as follows:
                        
 2006 2005     2004    
 Pearson Pearson     Pearson    
     Government Government 2005 2005 Government 2004 2004
 2005 2004 2003 Solutions Solutions Recoletos Total Solutions Recoletos Total
                    
 (All figures in £ millions) (All figures in £ millions)
Sales  27  190  169   286  288  27  315  217  190  407 
       ��              
Operating (loss)/profit  (3)  26  43 
Operating profit/(loss)  22  20  (3)  17  22  26  48 
Net finance income    3  3             3  3 
                      
(Loss)/profit before tax
  (3)  29  46 
Profit/(loss) before tax
  22  20  (3)  17  22  29  51 
                      
Attributable tax benefit/(expense)  1  (7)  (23)
Attributable tax (expense)/benefit  (8)  (8)  1  (7)  (8)  (7)  (15)
                      
(Loss)/profit after tax
  (2)  22  23 
Profit on disposal of discontinued operations (note 28)  306     
Profit/(loss) after tax
  14  12  (2)  10  14  22  36 
Profit on disposal of discontinued operations before tax      306  306       
Attributable tax expense  (2)           (2)  (2)       
                      
Profit for the year from discontinued operations
  302  22  23   14  12  302  314  14  22  36 
                      
Operating cash flows  (6)  12  11   20  22  (6)  16  112  12  124 
Investing cash flows    17  47   (8)  (13)    (13)  (5)  17  12 
Financing cash flows      (92)  (1)  (1)    (1)       
                      
Total cash flows
  (6)  29  (34)  11  8  (6)  2  107  29  136 
                      
4Other net gains and losses
            
 2005 2004 2003    
       2006 2005 2004
 (All figures in £      
 millions) (All figures in £ millions)
Profit on sale of interest in MarketWatch  40         40   
Other items    9  (6)      9 
              
Total other net gains and losses
  40  9  (6)    40  9 
              
      Other net gains and losses represent profits and losses on the sale of subsidiaries, joint ventures, associates and other financial assets that are included within continuing operations.

F-22


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
5Operating expenses
             
  2005 2004 2003
       
  (All figures in £ millions)
By function:
            
Cost of goods sold  2,022   1,789   1,846 
          
Operating expenses
            
Distribution costs  249   201   206 
Administrative and other expenses  1,384   1,365   1,439 
Other income  (41)  (46)  (51)
          
Total operating expenses
  1,592   1,520   1,594 
          
Total
  3,614   3,309   3,440 
          
By nature:
            
Utilisation of inventory  768   700   710 
Depreciation of property, plant and equipment (note 11)  80   78   79 
Amortisation of intangible assets — pre-publication (note 17)  192   168   158 
Amortisation of intangible assets — other (note 12)  29   25   32 
Employee benefit expense (note 6)  1,273   1,154   1,156 
Operating lease rentals  119   126   148 
Other property costs  88   73   61 
Royalties expensed  363   331   354 
Advertising, promotion and marketing  202   181   193 
Information technology costs  84   76   85 
Other costs  457   443   515 
Other income  (41)  (46)  (51)
          
Total
  3,614   3,309   3,440 
          
             
  2006 2005 2004
       
  (All figures in £ millions)
By function:
            
Cost of goods sold  1,917   1,787   1,631 
          
Operating expenses
            
Distribution costs  299   292   226 
Administrative and other expenses  1,504   1,351   1,340 
Other income  (99)  (84)  (83)
          
Total operating expenses
  1,704   1,559   1,483 
          
Total
  3,621   3,346   3,114 
          
                 
  Notes 2006 2005 2004
         
    (All figures in £ millions)
By nature:
                
Utilisation of inventory  18   820   767   699 
Depreciation of property, plant and equipment  11   71   76   74 
Amortisation of intangible assets — pre-publication  17   210   192   168 
Amortisation of intangible assets — other  12   48   26   24 
Employee benefit expense  6   1,280   1,177   1,074 
Operating lease rentals      125   111   126 
Other property costs      121   84   69 
Royalties expensed      360   363   331 
Advertising, promotion and marketing      212   198   171 
Information technology costs      90   81   73 
Other costs      383   355   351 
Other income      (99)  (84)  (46)
             
Total
      3,621   3,346   3,114 
             
      During the year the Group obtained the following services from the Group’s auditor:
             
  2005 2004 2003
       
  (All figures in £ millions)
Statutory audit  4   3   3 
Audit-related regulatory reporting services  1   1    
Non-audit services:            
Tax compliance  1   1   1 
Tax advisory     1   1 
Other non-audit services  1       
          
             
  2006 2005 2004
       
  (All figures in £ millions)
Audit services
            
Fees payable to the Company’s auditor for the audit of parent company and consolidated accounts  1   1   1 
Non-audit services
            
Fees payable to the Company’s auditor and its associates for other services:            
 — The audit of the Company’s subsidiaries pursuant to legislation  4   3   3 
 — Other services pursuant to legislation  4       
 — Tax services  1   1   2 
 — Services relating to corporate finance transactions  1   1    
 — All other services     1    
          
   11   7   6 
          
      Audit-related regulatory reporting services were £700,000 (2004: £600,000; 2003: £nil). This relates to services in respect of the transition to IFRS and Sarbanes-Oxley section 404 compliance services. Other non-audit services were £700,000 (2004: £100,000; 2003: £400,000) and mainly relate to due diligence work performed at IDC.
      Non-audit fees in the UK were £1.0m (2004: £1.0m; 2003: £300,000) and were in respect of tax advisory, tax compliance and other advisory services. The remainder of the non-audit fees related to overseas subsidiaries.

F-23


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      ‘Other services pursuant to legislation’ represents fees payable for services in relation to other statutory filings or engagements that are required to be carried out by the appointed auditor. In particular, this includes fees for reports under section 404 (S-404) of the US Public Company Accounting Reform and Investor Protection Act of 2002 (Sarbanes-Oxley) which are required for the first time in 2006.
      ‘Services relating to corporate finance transactions’ relate to a carve-out audit of Pearson Government Solutions in 2006. In 2005 this largely related to due diligence work at IDC.
      ‘All other services’ in 2005 relate to IFRS transition work and Sarbanes-Oxley section 404 compliance services.
      Audit fees in relation to the IDC SEC filings have been entirely included in ‘The audit of the Company’s subsidiaries pursuant to legislation’. The audit fee relates to an integrated S-404 review and audit in which the audit work takes leverage from the results of S-404 testing. The fees for the S-404 review and the audit are not separate, therefore no IDC fees have been included in ‘Other services pursuant to legislation’.
6Employee information
             
  2005 2004 2003
       
  (All figures in £ millions)
Employee benefit expense
            
Wages and salaries (including termination benefits and restructuring costs)  1,088   983   988 
Social security costs  101   89   87 
Share-based payment costs (note 24)  23   25   29 
Pension costs — defined contribution plans (note 24)  35   32   28 
Pension costs — defined benefit plans (note 24)  25   24   23 
Other post-retirement benefits (note 24)  1   1   1 
          
   1,273   1,154   1,156 
          
                 
  Notes 2006 2005 2004
         
    (All figures in £ millions)
Employee benefit expense
                
Wages and salaries (including termination benefits and restructuring costs)      1,080   993   903 
Social security costs      111   100   89 
Share-based payment costs  24   25   23   25 
Pension costs — defined contribution plans  24   36   35   32 
Pension costs — defined benefit plans  24   29   25   24 
Other post-retirement benefits  24   (1)  1   1 
             
       1,280   1,177   1,074 
             
      The details of the emoluments of the directors of Pearson plc are shown on pages 21 to 37.in Item 6 of this Form 20-F.
                        
 2005 2004 2003 2006 2005 2004
            
 (Average number employed) (Average number employed)
School  10,133  10,403  9,348   11,064  10,133  10,403 
Higher Education  4,196  4,087  3,912   4,368  4,196  4,087 
Professional  8,342  7,491  6,434   3,754  3,809  3,368 
Penguin  4,051  4,085  4,318   3,943  4,051  4,085 
FT Publishing  1,952  1,989  2,283   2,285  1,952  1,989 
IDC  1,956  1,826  1,628   2,200  1,956  1,826 
Other  1,573  1,365  928   1,669  1,573  1,365 
              
Continuing operations
  32,203  31,246  28,851   29,283  27,670  27,123 
              
Discontinued operations
    1,840  1,733   5,058  4,533  5,963 
              
  32,203  33,086  30,584   34,341  32,203  33,086 
              

F-24


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
7Net finance costs
                            
 2005 2004 2003 Notes 2006 2005 2004
              
 (All figures in £ millions)   (All figures in £ millions)
Interest payable  (98)  (91)  (91)     (117)  (98)  (91)
Finance costs re employee benefits  (7)  (5)  (9)  24    (7)  (5)
Net foreign exchange losses  (9)          (2)  (9)   
Other losses on financial instruments in a hedging relationship:                       
— fair value hedges  (1)            (1)   
— net investment hedges            (2)     
Other losses on financial instruments not in a hedging relationship:                       
— derivatives  (17)          (12)  (17)   
                
Finance costs
  (132)  (96)  (100)     (133)  (132)  (96)
                
Interest receivable  21  17  7      23  21  17 
Finance income re employee benefits  24  4     
Net foreign exchange gains  21          21  21   
Other gains on financial instruments in a hedging relationship:                       
— fair value hedges  1            1   
— net investment hedges  3            3   
Other gains on financial instruments not in a hedging relationship:                       
— amortisation of transitional adjustment on bonds  7          8  7   
— derivatives  9          3  9   
                
Finance income
  62  17  7      59  62  17 
                
Net finance costs
  (70)  (79)  (93)     (74)  (70)  (79)
                
Analysed as:
                       
Net interest payable  (77)  (74)  (84)     (94)  (77)  (74)
Finance costs re employee benefits  (7)  (5)  (9)
Finance income/(costs) re employee benefits  24  4  (7)  (5)
                
Net finance costs reflected in adjusted earnings  (84)  (79)  (93)     (90)  (84)  (79)
Other net finance income  14          16  14   
                
Total net finance costs
  (70)  (79)  (93)     (74)  (70)  (79)
                

F-25


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
8Income tax
                            
 2005 2004 2003 Notes 2006 2005 2004
              
 (All figures in £ millions)   (All figures in £ millions)
Current tax
                       
Charge in respect of current year  (76)  (65)  (45)     (88)  (68)  (57)
Adjustments in respect of prior years  (1)  25  13 
Recognition of previously unrecognised trading losses     23     
Other adjustments in respect of prior years     35  (1)  25 
                
Total current tax charge
  (77)  (40)  (32)     (30)  (69)  (32)
                
Deferred tax
                       
In respect of timing differences  (66)  (46)  (72)     (73)  (66)  (46)
Adjustments in respect of prior years  19  23  43 
Recognition of previously unrecognised capital losses     76     
Recognition of previously unrecognised trading losses     37     
Other adjustments in respect of prior years     (21)  19  23 
                
Total deferred tax charge (note 14)
  (47)  (23)  (29)
Total deferred tax benefit/(charge)
  14  19  (47)  (23)
                
Total tax charge
  (124)  (63)  (61)     (11)  (116)  (55)
                

F-25


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)      In 2006, the Group has recognised a deferred tax asset in relation to capital losses in the US which will be utilised on the sale of Pearson Government Solutions. Previously it had not been possible to foresee the utilisation of these losses prior to their expiry. In addition, due to improved trading performance and revised strategic plans together with the expected utilisation of US net operating losses in the Pearson Government Solutions sale, the Group has re-evaluated the likely utilisation of operating losses both in the US and UK and as a consequence has increased the amount of the deferred tax asset carried forward in respect of such losses. The combined effect of these two factors was to create a non-recurring tax benefit of £127m.
      The tax on the Group’s profit before tax differs from the theoretical amount that would arise using the UK tax rate as follows:
                        
 2005 2004 2003 2006 2005 2004
            
 (All figures in £ millions) (All figures in £ millions)
Profit before tax  466  325  313   466  446  303 
Tax calculated at UK rate  (140)  (97)  (94)  (140)  (134)  (91)
Effect of overseas tax rates  (22)  (8)  (6)  (19)  (20)  (6)
Joint venture and associate income reported net of tax  5  2     7  5  2 
Income not subject to tax  16  6  11   5  16  6 
Expenses not deductible for tax purposes  (9)  (5)  (7)  (18)  (9)  (5)
Utilisation of previously unrecognised tax losses  11  5  15   7  11  5 
Recognition of previously unrecognised tax losses  136     
Unutilised tax losses  (3)  (14)  (36)  (3)  (3)  (14)
Prior year adjustments  18  48  56   14  18  48 
              
Total tax charge
  (124)  (63)  (61)  (11)  (116)  (55)
              
UK  (26)  5  (13)  (15)  (26)  5 
Overseas  (98)  (68)  (48)  4  (90)  (60)
              
Total tax charge
  (124)  (63)  (61)  (11)  (116)  (55)
              
Add back: tax benefit on other gains and losses  (4)  (36)  (35)
Add back: tax benefit on amortisation of acquired intangibles  (4)  (2)  (1)
Add back: tax charge on other finance income  3     — 
       
Adjusted income tax charge — continuing operations  (129)  (101)  (97)
Adjusted income tax charge — discontinued operations  1  (7)  (19)
       
Total adjusted income tax charge
  (128)  (108)  (116)
       
Tax rate reflected in adjusted earnings
  30.3%  30.9%  32.5%
       

F-26


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The tax benefitbenefit/(charge) on items charged to equity is as follows:
            
 2005 2004 2003 2006 2005 2004
            
 (All figures in £ millions) (All figures in £ millions)
Deferred tax on stock options  3  4   
Deferred tax on share based payments  2  3  4 
Deferred tax on net investment hedges  3     
Deferred tax on actuarial gains and losses  9     
Current tax on foreign exchange gains and losses  9  5     (2)  9  5 
              
  12  9     12  12  9 
              
9Earnings per share
Basic
Basic
      Basic earnings per share is calculated by dividing the profit attributable to equity shareholders of the Company by the weighted average number of ordinary shares in issue during the year, excluding ordinary shares purchased by the Company and held as treasury shares.
Diluted
Diluted
      Diluted earnings per share is calculated by adjusting the weighted average number of ordinary shares to take account of all dilutive potential ordinary shares and adjusting the profit attributable, if applicable, to account for any tax consequences that might arise from conversion of those shares.

F-26


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
             
  2005 2004 2003
       
  (All figures in £ millions)
Earnings  624   262   252 
Adjustments to exclude profit for the year from discontinued operations:            
Profit for the year from discontinued operations  (302)  (22)  (23)
Minority interest share of above     5   5 
          
Earnings — continuing operations
  322   245   234 
          
Earnings  624   262   252 
          
Weighted average number of shares (millions)  797.9   795.6   794.4 
Effect of dilutive share options (millions)  1.1   1.1   0.9 
          
Weighted average number of shares (millions) for diluted earnings  799.0   796.7   795.3 
          
Earnings per share from continuing and discontinued operations
            
Basic  78.2p  32.9p  31.7p
Diluted  78.1p  32.9p  31.7p
          
Earnings per share from continuing operations
            
Basic  40.4p  30.8p  29.4p
Diluted  40.3p  30.8p  29.4p
          
Earnings per share from discontinued operations
            
Basic  37.8p  2.1p  2.3p
Diluted  37.8p  2.1p  2.3p
          
                 
  Notes 2006 2005 2004
         
    (All figures in £ millions)
Earnings      446   624   262 
Adjustments to exclude profit for the year from discontinued operations:                
Profit for the year from discontinued operations  3   (14)  (314)  (36)
Majority interest share of above            5 
             
Earnings — continuing operations
      432   310   231 
             
Earnings      446   624   262 
             
Weighted average number of shares (millions)      798.4   797.9   795.6 
Effect of dilutive share options (millions)      1.5   1.1   1.1 
Weighted average number of shares (millions) for diluted earnings      799.9   799.0   796.7 
             
10Dividends
             
  2005 2004 2003
       
  (All figures in £ millions)
Final paid in respect of prior year 15.7p (2004: 14.8p; 2003: 14.3p)  125   119   115 
Interim paid in respect of current year 10p (2004: 9.7p; 2003: 9.4p)  80   76   73 
          
   205   195   188 
          
             
  2006 2005 2004
       
Earnings per share from continuing and discontinued operations
            
Basic  55.9p  78.2p  32.9p
Diluted  55.8p  78.1p  32.9p
          
Earnings per share from continuing operations
            
Basic  54.1p  38.9p  29.0p
Diluted  54.0p  38.8p  29.0p
          
Earnings per share from discontinued operations
            
Basic  1.8p  39.3p  3.9p
Diluted  1.8p  39.3p  3.9p
          
      The directors are proposing a final dividend in respect of the financial year ending 31 December 2005 of 17.0p per share which will absorb an estimated £136m of shareholders’ funds. It will be paid on 5 May 2006 to shareholders who are on the register of members on 7 April 2006. These financial statements do not reflect this dividend payable (see note 34k).

F-27


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
10Dividends
             
  2006 2005 2004
       
  (All figures in £ millions)
Final paid in respect of prior year 17p (2005: 15.7p; 2004: 14.8p)  136   125   119 
Interim paid in respect of current year 10.5p (2005: 10p; 2004: 9.7p)  84   80   76 
          
   220   205   195 
          
      A final dividend in respect of the financial year ending 31 December 2006 of 18.8p per share has been approved and will absorb an estimated £151m of shareholders’ funds. It will be paid on 11 May 2007 to shareholders who are on the register of members on 10 April 2007. These financial statements do not reflect this dividend.
11Property, plant and equipment
                                
     Assets in       Assets in  
 Land and Plant and course of   Land and Plant and course of  
 buildings equipment construction Total buildings equipment construction Total
                
 (All figures in £ millions) (All figures in £ millions)
Cost
                          
At 1 January 2003
  319  619  20  958 
Exchange differences  (19)  (28)  (3)  (50)
Additions  12  52  14  78 
Disposals  (15)  (55)    (70)
Acquisition through business combination  5  19    24 
Disposal through business disposal  (2)  (6)    (8)
Reclassifications  1  9  (10)   
         
At 31 December 2003
  301  610  21  932 
         
Exchange differences  (9)  (10)  (1)  (20)
Additions  14  81  8  103 
Disposals  (13)  (39)    (52)
Acquisition through business combination  1  4    5 
Disposal through business disposal  (4)      (4)
Reclassifications    13  (13)   
Transfer to non-current assets held for sale  (14)  (81)  (2)  (97)
         
At 31 December 2004
  276  578  13  867 
         
At 1 January 2005
  280  604  13  897 
Exchange differences  18  40    58   18  40    58 
Transfers    13    13     13    13 
Additions  32  41  1  74   32  41  1  74 
Disposals  (5)  (28)    (33)  (5)  (28)    (33)
Acquisition through business combination  3  6    9   3  6    9 
Reclassifications    7  (7)       7  (7)   
                  
At 31 December 2005
  324  657  7  988   328  683  7  1,018 
                  
Exchange differences  (20)  (54)    (74)
Transfers    (11)  (1)  (12)
Additions  12  52  13  77 
Disposals  (9)  (32)    (41)
Acquisition through business combination  9  12    21 
Reclassifications    8  (8)   
Transfer to non-current assets held for sale  (7)  (27)    (34)
         
At 31 December 2006
  313  631  11  955 
         

F-28


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                            
     Assets in       Assets in  
 Land and Plant and course of   Land and Plant and course of  
 buildings equipment construction Total buildings equipment construction Total
                
 (All figures in £ millions) (All figures in £ millions)
Depreciation
                          
At 1 January 2003  (104)  (419)    (523)
Exchange differences  10  17    27 
Charge for the year  (16)  (69)    (85)
Disposals  7  53    60 
Acquisition through business combination    (14)    (14)
Disposal through business disposal  1  4    5 
         
At 31 December 2003
  (102)  (428)    (530)
         
Exchange differences  4  5    9 
Charge for the year  (16)  (68)    (84)
Disposals  6  38    44 
Acquisition through business combination    (4)    (4)
Disposal through business disposal  4      4 
Transfer to non-current assets held for sale  2  47    49 
         
At 31 December 2004
  (102)  (410)    (512)
         
At 1 January 2005  (106)  (436)    (542)
Exchange differences  (7)  (33)    (40)  (7)  (33)    (40)
Charge for the year  (17)  (63)    (80)  (17)  (63)    (80)
Disposals    30    30     30    30 
Acquisition through business combination    (2)    (2)    (2)    (2)
                  
At 31 December 2005
  (126)  (478)    (604)  (130)  (504)    (634)
                  
Exchange differences  10  41    51 
Transfers    5    5 
Charge for the year  (17)  (60)    (77)
Disposals  4  27    31 
Acquisition through business combination    (8)    (8)
Transfer to non-current assets held for sale  5  20    25 
         
At 31 December 2006
  (128)  (479)    (607)
         
Carrying amounts
                          
At 1 January 2003  215  200  20  435 
At 31 December 2003  199  182  21  402 
At 31 December 2004  174  168  13  355 
At 1 January 2005  174  168  13  355 
At 31 December 2005
  198  179  7  384   198  179  7  384 
At 31 December 2006
  185  152  11  348 
                  
      Depreciation expense of £19m (2004: £17m; 2003: £15m)£18m (2005: £19m) has been included in the income statement in cost of goods sold, £7m (2004: £6m; 2003: £6m)£6m (2005: £7m) in distribution expenses and £54m (2004: £55m; 2003: £58m)£53m (2005: £54m) in administrative and other expenses. In 20042006 £6m (2003: £6m)(2005: £4m) relates to discontinued operations.
      The Group leases certain equipment under a number of finance lease agreements. The net carrying amount of leased plant and equipment included within property, plant and equipment was £3m (2004: £3m; 2003: £5m)£4m (2005: £3m).

F-29


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
12Intangible assets
                                
     Acquired Other Total       Acquired Other Total  
     publishing intangibles intangibles       publishing intangibles intangibles  
 Goodwill Software rights acquired acquired Total Goodwill Software rights acquired acquired Total
                        
 (All figures in £ millions) (All figures in £ millions)
Cost
                                      
At 1 January 2003  3,610  146        3,756 
Exchange differences  (275)  (10)        (285)
Additions  113  26        139 
Disposals  (4)  (2)        (6)
Acquisition through business combination        44  44  44 
             
At 31 December 2003
  3,444  160    44  44  3,648 
             
Exchange differences  (201)  (8)    (3)  (3)  (212)
Additions  22  24        46 
Disposals  (4)  (11)        (15)
Acquisition through business combination      10  5  15  15 
Transfer to non-current assets held for sale  (101)          (101)
             
At 31 December 2004
  3,160  165  10  46  56  3,381 
             
At 1 January 2005  3,160  181  10  46  56  3,397 
Exchange differences  345  15  2  4  6  366   345  15  2  4  6  366 
Transfers    (13)        (13)    (13)        (13)
Additions  155  24        179     24        24 
Disposals  (6)  (10)        (16)  (6)  (10)        (16)
Acquisition through business combination      56  33  89  89   155    56  33  89  244 
                          
At 31 December 2005
  3,654  181  68  83  151  3,986   3,654  197  68  83  151  4,002 
                          
Exchange differences  (396)  (17)  (8)  (8)  (16)  (429)
Transfers    6        6 
Additions    29        29 
Disposals  (5)  (2)        (7)
Acquisition through business combination  246  4  36  117  153  403 
Adjustment on recognition of pre-acquisition deferred tax  (7)          (7)
Transfer to non-current assets held for sale  (221)  (16)        (237)
             
At 31 December 2006
  3,271  201  96  192  288  3,760 
             
                         
      Acquired Other Total  
      publishing intangibles intangibles  
  Goodwill Software rights acquired acquired Total
             
  (All figures in £ millions)
Amortisation
                        
At 1 January 2005     (111)     (8)  (8)  (119)
Exchange differences     (10)           (10)
Charge for the year     (18)  (5)  (6)  (11)  (29)
Disposals     10            10 
                   
At 31 December 2005
     (129)  (5)  (14)  (19)  (148)
                   
Exchange differences     13   1   2   3   16 
Transfers     (5)           (5)
Charge for the year     (23)  (11)  (17)  (28)  (51)
Disposals     1            1 
Acquisition through business combination     (1)           (1)
Transfer to non-current assets held for sale     9            9 
                   
At 31 December 2006
     (135)  (15)  (29)  (44)  (179)
                   
Carrying amounts
                        
At 1 January 2005  3,160   70   10   38   48   3,278 
At 31 December 2005  3,654   68   63   69   132   3,854 
At 31 December 2006
  3,271   66   81   163   244   3,581 
                   

F-30


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                         
      Acquired Other Total  
      publishing intangibles intangibles  
  Goodwill Software rights acquired acquired Total
             
  (All figures in £ millions)
Amortisation
                        
At 1 January 2003     (75)           (75)
Exchange differences     7            7 
Charge for the year     (28)     (4)  (4)  (32)
Disposals     2            2 
Acquisition through business combination                  
                   
At 31 December 2003
     (94)     (4)  (4)  (98)
                   
Exchange differences     8      1   1   9 
Charge for the year     (20)     (5)  (5)  (25)
Disposals     11            11 
Acquisition through business combination                  
                   
At 31 December 2004
     (95)     (8)  (8)  (103)
                   
Exchange differences     (10)           (10)
Charge for the year     (18)  (5)  (6)  (11)  (29)
Disposals     10            10 
Acquisition through business combination                  
                   
At 31 December 2005
     (113)  (5)  (14)  (19)  (132)
                   
Carrying amounts
                        
At 1 January 2003  3,610   71            3,681 
At 31 December 2003  3,444   66      40   40   3,550 
At 31 December 2004  3,160   70   10   38   48   3,278 
                   
At 31 December 2005
  3,654   68   63   69   132   3,854 
                   
      Other intangibles acquired include customer lists and relationships, software rights, technology, trade names and trademarks. Amortisation of £4m (2004: £3m; 2003: £5m)(2005: £4m) is included in the income statement in cost of salesgoods sold and £25m (2004: £22m; 2003: £27m)£47m (2005: £25m) in administrative and other expenses. In 2006 £3m of software amortisation (2005: £3m) relates to discontinued operations.
Impairment tests for cash-generating units containing goodwill
      Impairment tests have been carried out where appropriate as described below. The recoverable amount for each unit tested exceeds its carrying value.
      Goodwill is allocated to the Group’s cash-generating units identified according to the business segment.

F-31


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Goodwill has been allocated as follows:
          
 Notes    
      
   2006 2005
                  
 2005 2004 2003   )
         (All figures
 (All figures in £ millions)   in £ millions
Higher Education  1,106  950  1,007      780  903 
School Book  861  739  783      683  714 
School Assessment and Testing  271  232  246      342  310 
School Technology  385  330  350      356  408 
Other Assessment and Testing  245  211  223      490  531 
Other Government Solutions  234  201  213        249 
Other Book  70  60  63      56  57 
              
Pearson Education total
  3,172  2,723  2,885      2,707  3,172 
              
Penguin US  149  122  138      156  179 
Penguin UK  146  146  146      114  114 
Pearson Australia  45  42  44      44  47 
              
Penguin total
  340  310  328      314  340 
              
IDC
  138  123  127      149  138 
              
FT Publishing
  4  4  4 
Mergermarket  28  97   
Other FT Publishing     4  4 
FT Publishing total
     101  4 
              
Recoletos
      100 
Total goodwill — continuing operations
     3,271  3,654 
       
Goodwill held for sale  29  221   
              
Total goodwill
  3,654  3,160  3,444      3,492  3,654 
              
      The Group has adopted IFRS 3 ‘Business Combinations’ with effect from the date of transition to IFRS. In accordance with IFRS 3, goodwill is no longer amortised but rather tested for impairment on an annual basis.      Goodwill has been allocated for impairment purposes to twelve cash generating13 cash-generating units. The recoverable amount of each cash generatingcash-generating unit is based on value in use calculations, with the exception of IDC which is assessed on a market value basis. Goodwill is tested for impairment annually. Following a review in 2006, the allocation of corporate items has been revised. The 2005 comparative has been revised accordingly.
      The value in use calculations use cash flow projections based on financial budgets approved by management covering a five year period. The key assumptions used by management in the value in use calculations were:
      Discount rate — The discount rate is based on the risk-free rate for government bonds, adjusted for a risk premium to reflect the increased risk in investing in equities. The risk premium adjustment is assessed for each specific cash generatingcash-generating unit. The average pre-tax discount rates used are in the range

F-31


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
of 8.5%10.3% to 11.5%11.9% for the Pearson Education businesses, 8%7.8% to 13%10.3% for the Penguin businesses and 8.5%10.5% to 11.5%11.0% for the FT Publishing businesses.
 
      Perpetuity growth rates — The cash flows subsequent to the approvalapproved budget period are based upon the long-term historic growth rates of the underlying territories in which the cash generatingcash-generating unit operates and reflect the long-term growth prospects of the sectors in which the cash generatingcash-generating unit operates. The perpetuity growth rates used vary between 3.0% to 4.0%2.5% and 3.5%. The perpetuity growth rates are consistent with appropriate external sources for the relevant markets.
 
      Cash flow growth rates — The cash flow growth rates are derived from forecast sales growth taking into consideration past experience of operating margins achieved in the cash generatingcash-generating unit. Historically, such forecasts have been reasonably accurate.
      The valuation of IDC is determined using an observable market price for each share. Other than goodwill there are no intangible assets with indefinite lives.

F-32


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
13Investments in joint ventures and associates
Joint ventures
    
         2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
At beginning of year  14  12  12   12  14 
Exchange differences  (3)  1  4   (3)  (3)
Share of loss after tax  (1)  (5)  (9)
Share of profit/(loss) after tax  3  (1)
Dividends  (4)  (3)  (2)  (4)  (4)
Additions or further investment  6  9  7 
Additions and further investment  4  6 
            
At end of year
  12  14  12   12  12 
            
      Investments in joint ventures are accounted for byusing the equity method of accounting and are initially recognised at cost.
      The aggregate of the Group’s share in its joint ventures, none of which are individually significant, are as follows:
        
             2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Assets
                 
Non-current assets  3  3     3  3 
Current assets  26  19  18   24  26 
       
     
Liabilities
                 
Current liabilities  (17)  (8)  (6)  (15)  (17)
            
Net assets
  12  14  12   12  12 
            
Income  46  37  33   52  46 
Expenses  (47)  (42)  (42)  (49)  (47)
            
Loss after income tax
  (1)  (5)  (9)
Profit/(loss)after income tax
  3  (1)
            
Associates
             
  2005 2004 2003
       
  (All figures in £ millions)
At beginning of year  33   52   94 
Share of profit after tax  15   15   13 
Dividends  (10)  (9)  (8)
Loan repayment        (2)
Additions     1    
Disposals  (14)  (24)  (45)
Transfer to non-current assets held for sale     (2)   
          
At end of year
  24   33   52 
          
      Investments in associates at 31 December 2005 include goodwill of £nil (2004: £6m; 2003: £7m). The share of profit after tax includes £nil (2004: £2m; 2003: £2m) in respect of discontinued operations.

F-33F-32


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Associates
         
  2006 2005
     
  (All figures in
  £ millions)
At beginning of year  24   33 
Exchange differences  (1)   
Share of profit after tax  21   15 
Dividends  (41)  (10)
Disposals     (14)
Distribution from associate in excess of carrying value  5    
       
At end of year
  8   24 
       
      There is no acquisition goodwill relating to the Group’s investments in associates.
      The Group’s interests in its principal associates, all of which are unlisted, were as follows:
                                          
   %           %        
2005 Country of incorporation Interest held Assets Liabilities Revenues Profit
2006 Country of incorporation Interest held Assets Liabilities Revenues Profit
                        
 (All figures in £ millions)   (All figures in £ millions )    
The Economist Newspaper Ltd  England  50  79  (67)  105  12   England  50  64  (64)  122  18 
Other        42  (30)  49  3         28  (20)  48  3 
                          
Total
        121  (97)  154  15         92  (84)  170  21 
                          
                                          
   %           %        
2004 Country of incorporation Interest held Assets Liabilities Revenues Profit
2005 Country of incorporation Interest held Assets Liabilities Revenues Profit
                        
 (All figures in £ millions)   (All figures in £ millions )    
The Economist Newspaper Ltd  England  50  71  (62)  98  11   England  50  79  (67)  105  12 
Other        42  (18)  192  4         42  (30)  49  3 
                          
Total
        113  (80)  290  15         121  (97)  154  15 
                          
                         
    %        
2003 Country of incorporation Interest held Assets Liabilities Revenues Profit
             
  (All figures in £ millions)
The Economist Newspaper Ltd  England   50   103   (101)  95   9 
Other          81   (31)  139   4 
                   
Total
          184   (132)  234   13 
                   
      The interest held in associates is equivalent to voting rights.
14Deferred income tax
             
  2005 2004 2003
       
  (All figures in £ millions)
Deferred tax assets
            
Deferred tax asset to be recovered after more than 12 months  343   318   313 
Deferred tax asset to be recovered within 12 months  42   41   29 
          
   385   359   342 
          
Deferred tax liabilities
            
Deferred tax liability to be settled after more than 12 months  (204)  (139)  (140)
Deferred tax liability to be settled within 12 months         — 
          
   (204)  (139)  (140)
          
Net deferred tax
  181   220   202 
          
         
  2006 2005
     
  (All figures in £
  millions)
Deferred tax assets
        
Deferred tax assets to be recovered after more than 12 months  288   343 
Deferred tax assets to be recovered within 12 months  129   42 
       
   417   385 
       
Deferred tax liabilities
        
Deferred tax liabilities to be settled after more than 12 months  (245)  (204)
Deferred tax liabilities to be settled within 12 months      
       
   (245)  (204)
       
Net deferred tax
  172   181 
       

F-33


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      Deferred tax assets to be recovered within 12 months relate to the utilisation of losses in the US. Included within the losses to be utilised in 2007 are capital and operating losses of £93m which it is anticipated will be utilised on the sale of Pearson Government Solutions.
      Deferred income tax assets and liabilities may be offset when there is a legally enforceable right to offset current tax assets against current tax liabilities and when the deferred income taxes relate to the same fiscal authority. The Group has unprovidedunrecognised deferred tax assets at 31 December 20052006 in respect of UK losses (£32m) and US losses (£37m)of £35m and has not recognised a deferred tax asset amounting to £47m on the net pension deficit on UK plans on the basis that it is not sufficiently certain that suitable future profits will arise against which to offset the liability. The related unprovidedNone of these unrecognised deferred tax asset is £96m.assets have expiry dates associated with them.
      The recognition of the deferred tax assets is supported by management’s forecasts of the future profitability of the relevant business units.

F-34


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The gross movement on the net deferred income tax account is as follows:
                      
 2005 2004 2003 Notes 2006 2005
            
 (All figures in £   (All figures in
 millions)   £ millions)
At beginning of year  220  202  255      181  220 
Transition adjustment on adoption of IAS 39  5     —        5 
Exchange differences  21  (13)  (34)     (16)  21 
Acquisition through business combination  (21)    (15)  28  (26)  (21)
Transfer between current and deferred taxation    41  25 
Income statement charge (note 8)  (47)  (23)  (29)
Tax benefit to equity (note 8)  3  4   
Transfer to non-current assets held for sale    9   
Income statement release/(charge)  8  19  (47)
Tax benefit to equity     14  3 
              
At end of year
  181  220  202      172  181 
              
      The movement in deferred income tax assets and liabilities during the year is as follows:
                                
   Goodwill         Goodwill    
 Tax and     Capital Trading and    
 losses intangibles Other Total losses losses intangibles Other Total
                  
 (All figures in £ millions) (All figures in £ millions)
Deferred income tax assets
                             
At 1 January 2003  131  57  186  374 
Exchange differences  (16)  (4)  (22)  (42)
Transfer between current and deferred taxation  25    (17)  8 
Income statement (charge)/release  (27)  (7)  36  2 
         
At 31 December 2003
  113  46  183  342 
         
Exchange differences  (10)  (3)  (11)  (24)
Transfer between current and deferred taxation  41    (11)  30 
Income statement release/(charge)  6  (6)  7  7 
Tax benefit to equity      4  4 
         
At 31 December 2004
  150  37  172  359 
         
At 1 January 2005    150  37  172  359 
Transition adjustment on adoption of IAS 39      5  5         5  5 
Exchange differences  16  4  18  38     16  4  18  38 
Acquisition through business combination      1  1         1  1 
Transfer between current and deferred taxation      23  23         23  23 
Income statement charge  (32)  (6)  (6)  (44)    (32)  (6)  (6)  (44)
Tax benefit to equity      3  3         3  3 
                    
At 31 December 2005
  134  35  216  385     134  35  216  385 
                    
Exchange differences    (17)  (4)  (21)  (42)
Income statement release/(charge)  76  12  (6)  (19)  63 
Tax benefit to equity        11  11 
           
At 31 December 2006
  76  129  25  187  417 
           

F-34


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      Other deferred tax assets include temporary differences on inventory, sales returns and other provisions.

F-35


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                        
 Goodwill and     Goodwill and    
 intangibles Other Total intangibles Other Total
            
 (All figures in £ millions) (All figures in £ millions)
Deferred income tax liabilities
                    
At 1 January 2003  (25)  (94)  (119)
Exchange differences    8  8 
Acquisition through business combination  (15)    (15)
Transfer between current and deferred taxation    17  17 
Income statement charge  (19)  (12)  (31)
       
At 31 December 2003
  (59)  (81)  (140)
       
Exchange differences  8  3  11 
Transfer between current and deferred taxation    11  11 
Income statement charge  (8)  (22)  (30)
Transfer to non-current assets held for sale    9  9 
       
At 31 December 2004
  (59)  (80)  (139)
       
At 1 January 2005  (59)  (80)  (139)
Exchange differences  (8)  (9)  (17)  (8)  (9)  (17)
Acquisition through business combination  (24)  2  (22)  (24)  2  (22)
Transfer between current and deferred taxation    (23)  (23)    (23)  (23)
Income statement (charge)/release  (26)  23  (3)  (26)  23  (3)
              
At 31 December 2005
  (117)  (87)  (204)  (117)  (87)  (204)
              
Exchange differences  15  11  26 
Acquisition through business combination  (20)  (6)  (26)
Income statement charge  (27)  (17)  (44)
Tax benefit to equity    3  3 
       
At 31 December 2006
  (149)  (96)  (245)
       
      Other deferred tax liabilities include temporary differences on capital allowancesin respect of depreciation and royalty advances.
15Other financial assets
                  
 2005 2004 2003 2006 2005
          
 (All figures in £ (All figures in
 millions) £ millions)
At beginning of year  15  21  22   18  15 
Exchange differences  1  (1)  (3)  (1)  1 
Additions  4  5  3     4 
Disposals  (2)  (8)  (1)    (2)
Transfer to non-current assets held for sale    (2)   
            
At end of year
  18  15  21   17  18 
            
      Other financial assets arecomprise non-current unlisted securities.

F-36F-35


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
16Derivative financial instruments
      The Group’s approach to the management of financial risks is set out in Item 11 of this Form 20-F. The Group’s outstanding derivative financial instruments are as follows:
         
  2005 2005
  Assets Liabilities
     
  (All figures in £
  millions)
Interest rate derivatives — in a fair value hedging relationship  31   (16)
Interest rate derivatives — not in a hedging relationship  18   (6)
Cross currency rate derivatives — in a net investment hedging relationship  13    
Cross currency rate derivatives — not in a hedging relationship  21    
       
   83   (22)
       
Analysed as:
        
Non-current  79   (22)
Current (expiring in less than 1 year)  4    
       
   83   (22)
       
             
  2006
   
  Gross  
  notional  
  amounts Assets Liabilities
       
  (All figures in £ millions)
Interest rate derivatives — in a fair value hedge relationship  953   20   (17)
Interest rate derivatives — not in a hedge relationship  1,026   9   (2)
Cross currency rate derivatives — in a net investment hedge relationship  230   40    
Cross currency rate derivatives — not in a hedge relationship  180   17    
          
Total
  2,389   86   (19)
          
Analysed as expiring:
            
In less than one year  976   50    
Later than one year and not later than five years  1,005   26   (4)
Later than five years  408   10   (15)
          
Total
  2,389   86   (19)
          
             
  2005
   
  Gross  
  notional  
  amounts Assets Liabilities
       
  (All figures in £ millions)
Interest rate derivatives — in a fair value hedge relationship  1,109   31   (16)
Interest rate derivatives — not in a hedge relationship  1,330   18   (6)
Cross currency rate derivatives — in a net investment hedge relationship  230   13    
Cross currency rate derivatives — not in a hedge relationship  180   21    
          
Total
  2,849   83   (22)
          
Analysed as expiring:
            
In less than one year  250   4    
Later than one year and not later than five years  1,823   57   (8)
Later than five years  776   22   (14)
          
Total
  2,849   83   (22)
          
      The faircarrying value of the above derivative financial instruments isequals their fair value. Fair values are determined by using market data and the sameuse of established estimation techniques such as discounted cash flow and option valuation models.
      At the carrying value.end of 2006, the currency split of themark-to-market values of rate derivatives, including the exchange of principal on cross currency rate derivatives, was US dollar £(247)m, euro £157m and sterling £157m (2005: US dollar £(269)m, euro £166m and sterling £164m).
      The fixed interest rates on outstanding rate derivative contracts at the end of 2006 range from 3.02% to 7.00% (2005: 3.02% to 7.23%) and the floating rates are based on LIBOR in US dollar, sterling and euro(EURIBOR).

F-36


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The Group’s portfolio of rate derivatives is diversified by maturity, counterparty and type. Natural offsets between transactions within the portfolio and the designation of certain derivatives as hedges significantly reducesreduce the risk of income statement volatility.
      The following sensitivity analysis of derivative financial instruments to interest rate movements is based on the assumption of a 1% change in interest rates for all currencies and maturities, with all other variables held constant.
             
  2006
   
  Net carrying 1% rate 1% rate
  amount increase decrease
       
  (All figures in £ millions)
Interest rate derivatives — in a fair value hedge relationship  3   (28)  31 
Interest rate derivatives — not in a hedge relationship  7   1   (1)
Cross currency rate derivatives — in a net investment hedge relationship  40       
Cross currency rate derivatives — not in a hedge relationship  17   (1)  1 
          
Total
  67   (28)  31 
          
Effect of fair value hedge accounting     28   (31)
Sensitivity after the application of hedge accounting  67       
          
Counterparty exposure from all derivatives is managed, together with that from deposits and bank account balances, within credit limits that reflect published credit ratings to ensure that there is no significant risk to any one counterparty. No single derivative transaction had a market value (positive or negative) at the balance sheet date that exceeded 3% of the Group’s consolidated total equity.
      At the year end the Group had receivedheld an amount of £43m£29m equivalent as collateral under amark-to-market agreement. This reflected the amount, at market rates prevailing at the end of October 2005,2006, owed to the Group by thea counterparty for a set of three related rate derivatives. Under these derivatives the Group is due to exchange $209m for204m inat the beginning of February 2007.2007,with the repayment of the591m bond. There are no restrictions on the Group’s use of these funds, which have been recorded in borrowings as a current bank loan.
      In accordance with IAS 39 ‘Financial Instruments: Recognition and Measurement’, the Group has reviewed all of its material contracts for embedded derivatives that are required to be separately accounted for if they do not meet certain requirements, and has concluded that there are no material embedded derivatives.

F-37


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
17Intangible assets — pre-publication
        
             2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Cost
                 
At beginning of year  1,109  1,104  1,189   1,357  1,109 
Exchange differences  112  (63)  (90)  (148)  112 
Acquisition through business combination  27     — 
Transfers  6   
Additions  222  181  173   213  222 
Disposals  (113)  (113)  (168)  (280)  (113)
Acquisition through business combination  4  27 
            
At end of year
  1,357  1,109  1,104   1,152  1,357 
            
Amortisation
                 
At beginning of year  (753)  (742)  (809)  (931)  (753)
Exchange differences  (87)  44  57   111  (87)
Acquisition through business combination  (12)     — 
Charge for the year  (192)  (168)  (158)  (210)  (192)
Disposals  113  113  168   280  113 
Acquisition through business combination    (12)
            
At end of year
  (931)  (753)  (742)  (750)  (931)
            
Carrying amounts
                 
At end of year
  426  356  362   402  426 
            
      Included in the above are pre-publication assets amounting to £243m (2005: £261m)which will be realised in more than 12 months.
      Amortisation is included in the income statement in cost of goods sold. There was no amortisation relating to discontinued operations in 2006 and 2005.
18Inventories
      
         2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Raw materials  23  23  19   26  23 
Work in progress  43  35  30   28  43 
Finished goods  307  256  270   300  307 
            
  373  314  319   354  373 
            
      The cost of inventories, recognisedall relating to continuing operations, recognized as an expense and included in the income statement in cost of goods sold amounted to £768m (2004: £700m; 2003: £710m)£820m (2005: £767m). In 2005 £42m (2004: £41m; 2003: £37m)2006 £46m (2005: £42m) of inventory provisions were charged in the income statement. None of the inventory is pledged as security.

F-38


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
19Trade and other receivables
    
           2006 2005
 2005 2004 2003    
       (All figures in £
 (All figures in £ millions) millions)
Current
                 
Trade receivables  825  725  814   768  825 
Royalty advances  124  114  110   91  124 
Prepayments and accrued income  38  41  38   34  38 
Other receivables  42  51  62   58  42 
Receivables from related parties  2  2  1   2  2 
            
  1,031  933  1,025   953  1,031 
            
Non-current
                 
Royalty advances  67  70  83   80  67 
Prepayments and accrued income  4  1  1   4  4 
Other receivables  37  31  16   40  37 
            
  108  102  100   124  108 
            
      Trade receivables are stated net of provisions for bad and doubtful debts and anticipated future sales returns of £313m (2004: £354m; 2003: £339m)£284m (2005: £313m). The carrying amounts are stated at their fair value. Concentrations of credit risk with respect to trade receivables are limited due to the Group’s large number of customers, who are internationally dispersed.
20Cash and cash equivalents (excluding overdrafts)
      
         2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Cash at bank and in hand  393  338  302   421  393 
Short-term bank deposits  509  123  249   171  509 
            
  902  461  551   592  902 
            
      Short-term bank deposits are invested with banks and earn interest at the prevailing short-term deposit rates.
      TheAt the end of 2006 the currency split of cash and cash equivalents in 2005 is 31% US dollars (2004:31% (2005: 31%), sterling 35% (2005: 38%), 38% Sterling (2004: 31%),euros 21% (2005: 24% Euro (2004: 12%) and other 13% (2005: 7% (2004: 19%).
      The fair value of cashCash and cash equivalents is the same as thehave fair values that approximate to their carrying value.amounts due to their short-term nature.
      Cash and cash equivalents include the following for the purpose of the cash flow statement:
        
             2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Cash and cash equivalents  902  461  551   592  902 
Cash and cash equivalents included in assets classified as held for sale    141   
Bank overdrafts  (58)  (58)  (23)  (61)  (58)
            
  844  544  528   531  844 
            

F-39


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
21Financial liabilities — Borrowings
      The Group’s current and non-current borrowings are as follows:
        
             2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Non-current
                 
Bank borrowings    62  85 
7.375% US Dollar notes 2006 (nominal amount $250m)    130  139 
6.125% Euro Bonds 2007 (nominal amount591m)
  436  390  343     436 
10.5% Sterling Bonds 2008 (nominal amount £100m)  107  100  100   105  107 
4.7% US Dollar Bonds 2009 (nominal amount $350m)  203  181     178  203 
7% Global Dollar Bonds 2011 (nominal amount $500m)  307  260  278   266  307 
7% Sterling Bonds 2014 (nominal amount £250m)  250  226  235   251  250 
5.7% US Dollar Bonds 2014 (nominal amount $400m)  238  207     206  238 
4.625% US Dollar notes 2018 (nominal amount $300m)  161  156  167   139  161 
Finance lease liabilities  1  2  2   3  1 
            
  1,703  1,714  1,349   1,148  1,703 
            
Current
       
Due within one year or on demand:
       
Bank loans and overdrafts  173  102 
7.375% US Dollar notes 2006    152 
6.125% Euro Bonds 2007 (nominal amount591m)
  421   
Finance lease liabilities  1  2 
     
  595  256 
     
Total borrowings
  1,743  1,959 
     
Included in the non-current borrowings above is £35m£12m of accrued interest in 2005.(2005: £35m).
             
Current
            
Due within one year or on demand:
            
Bank loans and overdrafts  102   107   119 
7.375% US Dollar notes 2006  152       — 
9.5% Sterling Bonds 2004        108 
4.625% Euro Bonds 2004        348 
Finance lease liabilities  2   2   3 
          
   256   109   578 
          
Total borrowings
  1,959   1,823   1,927 
          
Included in the current borrowings above is £3m£22m of accrued interest in 2005.(2005: £3m).
      The Group has elected to apply the provisions of IAS 32 and IAS 39 with effect from 1 January 2005. The comparative financial information is prepared in accordance with UKGAAP. The nature of the main adjustments that would make the information comply with IAS 32 and IAS 39 are set out in note 34.
      The 2004 and 2003 figures for the 2007 Euro Bonds and 2014 Sterling Bonds (together with the 2004 Sterling and Euro Bonds which have now been redeemed) include the effect of accounting for the foreign exchange element of the related derivatives.
All of the Group’s borrowings are unsecured. In respect of finance lease obligations (£3m in 2005; £4m in 2004 and £5m in 2003)(2006: £4m; 2005: £3m) the rights to the leased asset revert to the lessor in the event of default.
The maturity of the Group’s non-current borrowing is as follows:
         
  2006 2005
     
  (All figures in
  £ millions)
Between one and two years  107   437 
Between two and five years  445   310 
Over five years  596   956 
       
   1,148   1,703 
       

F-40


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The maturity of the Group’s non-current borrowing is as follows:
             
  2005 2004 2003
       
  (All figures in £ millions)
Between one and two years  437   131   86 
Between two and five years  310   734   583 
Over five years  956   849   680 
          
   1,703   1,714   1,349 
          
As at 31 December 20052006 the exposure of the borrowings of the Group to interest rate changes when the borrowings re-price is as follows:
                                
     One to More than     One to More than
 Total One year five years five years Total One year five years five years
                
 (All figures in £ millions) (All figures in £ millions)
Carrying value of borrowings  1,959  256  747  956   1,743  595  552  596 
Effect of interest rate swaps    1,161  (473)  (688)
Effect of rate derivatives    629  (221)  (408)
                  
  1,959  1,417  274  268   1,743  1,224  331  188 
                  
      The carrying amounts and fairmarket values of non-current borrowings are as follows:
                                                
   Carrying   Carrying   Carrying     Carrying Market Carrying Market
 Effective amount Fair value amount Fair value amount Fair value Effective amount value amount value
 interest Rate 2005 2005 2004 2004 2003 2003 interest Rate 2006 2006 2005 2005
                        
 (All figures in £ millions)   (All figures in £ millions)
Bank borrowings  n/a      62  62  85  85 
7.375% US Dollar notes 2006  7.75%      130  138  139  157 
6.125% Euro Bonds 2007  6.18%  436  419  390  409  343  448   6.18%      436  419 
10.5% Sterling Bonds 2008  10.53%  107  113  100  116  100  120   10.53%  105  106  107  113 
4.7% US Dollar Bonds 2009  4.86%  203  200  181  185       4.86%  178  176  203  200 
7% Global Dollar Bonds 2011  7.16%  307  310  260  293  278  317   7.16%  266  269  307  310 
7% Sterling Bonds 2014  7.20%  250  282  226  255  235  275   7.20%  251  265  250  282 
5.7% US Dollar Bonds 2014  5.88%  238  234  207  217       5.88%  206  203  238  234 
4.625% US Dollar notes 2018  4.69%  161  155  156  142  167  151   4.69%  139  135  161  155 
Finance lease liabilities  n/a  1  1  2  2  2  2   n/a  3  3  1  1 
                          
     1,703  1,714  1,714  1,819  1,349  1,555      1,148  1,157  1,703  1,714 
                          
      The fairmarket values are based on clean market prices at the year end or, where these are not available, on the quoted market prices of comparable debt issued by other companies. The effective interest rates above relate to the underlying debt instruments. The carrying amounts of current borrowings approximate their fair value.
      The carrying amounts of the Group’s borrowings are denominated in the following currencies:
        
             2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
US dollar  1,165  1,335  1,432   966  1,165 
Sterling  357  202  201   356  357 
Euro  437  284  292   421  437 
Other currencies    2  2 
            
  1,959  1,823  1,927   1,743  1,959 
            

F-41


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The maturity of the Group’s finance lease obligations is as follows:
      
     2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Finance lease liabilities — minimum lease payments
                 
Not later than one year  2  2  3   1  2 
Later than one year and not later than five years  1  2  3   3  1 
Later than five years       —      
Future finance charges on finance leases      (1)     
Present value of finance lease liabilities  3  4  5   4  3 
     

F-41


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The present value of finance lease liabilities is as follows:
      
     2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Not later than one year  2  2  3   1  2 
Later than one year and not later than five years  1  2  2   3  1 
Later than five years            
            
  3  4  5   4  3 
            
      The carrying amount of the Group’s lease obligations approximates their fair value.
      The Group has the following undrawn committed borrowing facilities as at 31 December:
    
     2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Floating rate
                 
— expiring within one year            
— expiring beyond one year  786  641  950   894  786 
            
  786  641  950   894  786 
            
      During the year, the Group renegotiated its revolving credit facility which increased the amount and extended the maturity date.
      In addition to the above facilities, there are a number of short-term facilities that are utilised in the normal course of business.
22Provisions for other liabilities and charges
                                
 Deferred   Re-       Deferred   Re-      
 consideration Integration organisations Leases Other Total consideration Integration organizations Leases Other Total
                        
 (All figures in £ millions) (All figures in £ millions)
At 1 January 2005  20  5  11  14  7  57 
At 1 January 2006  26  3  5  12  18  64 
Exchange differences  2    1  1    4         (2)  (2)  (4)
Charged to consolidated income statement
                                      
— Additional provisions        1  13  14       1  4  7  12 
— Unused amounts reversed      (1)  (3)  (1)  (5)  (9)    (2)    (4)  (15)
On acquisition/disposal  5          5 
On acquisition  17        3  20 
Utilised during year  (1)  (2)  (6)  (1)  (1)  (11)  (9)  (1)  (3)  (2)  (10)  (25)
                          
At 31 December 2005
  26  3  5  12  18  64 
At 31 December 2006
  25  2  1  12  12  52 
                          
         
  2006 2005
     
  (All figures in
  £ millions)
Analysis of provisions
        
Non-current  29   31 
Current  23   33 
       
   52   64 
       

F-42


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
             
  2005 2004 2003
       
  (All figures in £ millions)
Analysis of provisions
            
Non-current  31   43   59 
Current  33   14   18 
          
   64   57   77 
          
     Deferred consideration — During the year, additionalAdditional deferred consideration of £5m£17m was incurred mainlyduring the year relating to the acquisition of Index books.
Integration — During the year, £2m of this balance has been utilised, primarily in relation to properties, severance and IT systems. The remaining provision should be utilised in the next two years.
Reorganisations — There were no additional provisions in 2005 and £5m has been utilised, mainly in respect of redundancies.Mergermarket.
     Lease commitments — These relate primarily to onerous lease contracts, acquired through business combinations, which have various expiry dates up to 2010. The provision is based on current occupancy estimates.
23Trade and other liabilities
        
           2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Trade payables  348  316  405   343  348 
Social security and other taxes  21  14  4   18  21 
Accruals and deferred income  600  509  465 
Accruals  345  363 
Deferred income  276  237 
Other liabilities  156  128  139   178  156 
            
  1,125  967  1,013   1,160  1,125 
            
Less: non-current portion
                 
Accruals and deferred income  66  21  9 
Accruals  24  15 
Deferred income  47  51 
Other liabilities  85  78  61   91  85 
            
  151  99  70   162  151 
            
Current portion
  974  868  943   998  974 
            
      The carrying value of the Group’s trade and other liabilities approximates their fair value.
      The deferred income balances comprise:
      • multi-year obligations to deliver workbooks to adoption customers in school businesses;
      • advance payments in contracting businesses;
      • subscription income in school, newspaper and market pricing businesses; and
      • advertising income relating to future publishing days in newspaper businesses.
24Employee benefits
Retirement benefit obligations
      The Group operates a number of retirement benefit plans throughout the world, the principal ones being in the UK and US. The major schemesplans are self-administered with the schemes’plans’ assets being held independently of the Group. Retirement benefit costs are assessed in accordance with the advice of independent qualified actuaries. The UK Group schemeplan is a hybrid schemeplan with both defined benefit and defined contribution sections but, predominantly, consisting of defined benefit liabilities. There are a number of defined contribution schemes,plans, principally overseas.
      The most recent actuarial valuation of the UK Group schemeplan was completed onas at 1 January 2004.2006.

F-43


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The principal assumptions used for the UK Group schemeplan are shown below. Weighted average assumptions have been shown for the other schemes.plans.
                                                
 2005 2005 2004 2004 2003 2003 2006 2006 2005 2005 2004 2004
 UK Group Other UK Group Other UK Group Other UK Group Other UK Group Other UK Group Other
% scheme schemes scheme schemes scheme schemes plan plans plan plans plan plans
                        
Inflation  2.80  2.95  2.80  2.98  2.75  2.98   3.00  2.91  2.80  2.95  2.80  2.98 
Expected rate of increase in salaries  4.50  4.43  4.80  4.44  4.75  4.45   4.70  4.37  4.50  4.43  4.80  4.44 
Expected rate of increase for pensions in payment and deferred pensions 2.50 to 4.00   2.80 to 4.00   2.75 to 4.00    2.10 to 4.60   2.50 to 4.00   2.80 to 4.00   
Rate used to discount scheme liabilities  4.85  5.54  5.40  5.84  5.50  6.11 
Rate used to discount plan liabilities  5.20  5.70  4.85  5.54  5.40  5.84 
Expected return on assets  6.40  7.31  6.60  7.23  6.81  7.75   6.40  7.18  6.40  7.31  6.60  7.23 
                          
      Assumptions regarding future mortality experience are set based on advice, published statistics and experience in each territory. In 2006, the Group used the PMFA92 (medium-cohort) series mortality tables for the UK Group plan modified for age-rating adjustments to recalibrate the tables against observed experience of the plan, and allowing for the future improvement effect from the medium cohort approach.
      The remaining average life expectancy in years of a pensioner retiring at age 65 on the balance sheet date is as follows for the UK Group plan:
         
  2006 2005
     
Male  20.9   19.5 
Female  21.3   21.5 
       
      The remaining average life expectancy in years of a pensioner retiring at age 65, 20 years after the balance sheet date, is as follows for the UK Group plan:
         
  2006 2005
     
Male  22.2   20.2 
Female  22.5   22.1 
       
      The amounts recognised in the income statement are as follows:
                     
    Defined      
  UK Group benefit   Defined 2005
  scheme other Sub Total contribution Total
           
  (All figures in £ millions)
Current service cost  (25)  (2)  (27)  (35)  (62)
Past service cost               
Curtailments     2   2      2 
                
Total operating charge
  (25)     (25)  (35)  (60)
                
Expected return on plan assets  75   6   81      81 
Interest on pension scheme liabilities  (79)  (6)  (85)     (85)
                
Net finance charge
  (4)     (4)     (4)
                
Net income statement charge
  (29)     (29)  (35)  (64)
                
Actual return on plan assets
  214   7   221      221 
                
                                      
   Defined         Defined      
 UK Group benefit   Defined 2004 UK Group benefit   Defined 2006
 scheme other Sub Total contribution Total plan other Sub Total contribution Total
                    
 (All figures in £ millions) (All figures in £ millions)
Current service cost  (22)  (2)  (24)  (32)  (56)  27  2  29  36  65 
Past service cost           
                      
Total operating charge
  (22)  (2)  (24)  (32)  (56)
Total operating costs
  27  2  29  36  65 
                      
Expected return on plan assets  71  6  77    77   (85)  (7)  (92)    (92)
Interest on pension scheme liabilities  (72)  (6)  (78)    (78)  78  7  85    85 
                      
Net finance charge
  (1)    (1)    (1)
Net finance income
  (7)    (7)    (7)
                      
Net income statement charge
  (23)  (2)  (25)  (32)  (57)  20  2  22  36  58 
                      
Actual return on plan assets
  135  9  144    144   153  13  166    166 
                      

F-44


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                                        
   Defined         Defined      
 UK Group benefit Sub Defined 2003 UK Group benefit Sub Defined 2005
 scheme other Total contribution Total plan other Total contribution Total
                    
 (All figures in £ millions) (All figures in £ millions)
Current service cost  (21)  (2)  (23)  (28)  (51)  25  2  27  35  62 
Past service cost           
Curtailments    (2)  (2)    (2)
                      
Total operating charge
  (21)  (2)  (23)  (28)  (51)
Total operating costs
  25    25  35  60 
                      
Expected return on plan assets  65  4  69    69   (75)  (6)  (81)    (81)
Interest on pension scheme liabilities  (67)  (7)  (74)    (74)  79  6  85    85 
                      
Net finance charge
  (2)  (3)  (5)    (5)
Net finance costs
  4    4    4 
                      
Net income statement charge
  (23)  (5)  (28)  (28)  (56)  29    29  35  64 
                      
Actual return on plan assets
  145  12  157    157   214  7  221    221 
                      
                     
    Defined      
  UK Group benefit Sub Defined 2004
  plan other Total contribution Total
           
  (All figures in £ millions)
Current service cost  22   2   24   32   56 
                
Total operating costs
  22   2   24   32   56 
                
Expected return on plan assets  (71)  (6)  (77)     (77)
Interest on pension scheme liabilities  72   6   78      78 
                
Net finance costs
  1      1      1 
                
Net income statement charge
  23   2   25   32   57 
                
Actual return on plan assets
  135   9   144      144 
                
The total operating charge is included in administrative and other expenses.
The amounts recognised in the balance sheet are as follows:
                                                                
 2005 2005 2005   2004 2004 2004   2003 2003 2003   2006 2006 2006   2005 2005 2005  
 UK Other Other   UK Other Other   UK Other Other   UK Other Other   UK Other Other  
 Group funded unfunded 2005 Group funded unfunded 2004 Group funded unfunded 2003 Group funded unfunded 2006 Group funded unfunded 2005
 scheme plans plans Total scheme plans plans Total scheme plans plans Total plan plans plans Total plan plans plans Total
                                        
 (All figures in £ millions) (All figures in £ millions)
Fair value of plan assets  1,390  110    1,500  1,198  82    1,280  1,089  75    1,164   1,528  105    1,633  1,390  110    1,500 
Present value of plan liabilities  (1,661)  (131)  (11)  (1,803)  (1,502)  (104)  (9)  (1,615)  (1,340)  (105)  (9)  (1,454)
Present value of defined benefit obligation  (1,683)  (115)  (12)  (1,810)  (1,661)  (131)  (11)  (1,803)
                                          
Net pension liability
  (271)  (21)  (11)  (303)  (304)  (22)  (9)  (335)  (251)  (30)  (9)  (290)  (155)  (10)  (12)  (177)  (271)  (21)  (11)  (303)
                                          
Other post-retirement medical benefit obligation           (60)           (58)           (61)           (48)           (60)
Other pension accruals           (26)           (15)           (13)           (25)           (26)
                                          
Total retirement benefit obligations
           (389)           (408)           (364)           (250)           (389)
                                          

F-45


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The following amountsgains/(losses) have been recognised in the statement of recognised income and expense:
                    
 2005 2004 2003 2006 2005 2004
            
 (All figures in (All figures in £ millions)
 £ millions)
Amounts recognised for defined benefit schemes  21  (60)  (25)
Amounts recognised on post-retirement medical benefit schemes  5  (1)  (3)
Amounts recognised for defined benefit plans  102  21  (60)
Amounts recognised for post-retirement medical benefit plans  5  5  (1)
              
Total recognised in year
  26  (61)  (28)  107  26  (61)
              
Cumulative amounts recognised
  (63)  (89)  (28)  44  (63)  (89)
              
      The fair value of plan assets comprises the following:
                                                            
 2005 2005   2004 2004   2003 2003   2006 2006   2005 2005  
 UK Other   UK Other   UK Other   UK Other   UK Other  
 group funded 2005 Group funded 2004 Group funded 2003 Group funded 2006 Group funded 2005
% scheme plans Total scheme plans Total scheme plans Total plan plans Total plan plans Total
                              
Equities  47.4  4.3  51.7  49.7  4.2  53.9  50.5  4.2  54.7   46.6  3.9  50.5  47.4  4.3  51.7 
Bonds  24.7  2.0  26.7  21.5  2.1  23.6  22.5  2.1  24.6   23.8  2.1  25.9  24.7  2.0  26.7 
Properties  8.9    8.9  8.9    8.9  9.2    9.2   9.2    9.2  8.9    8.9 
Other  11.7  1.0  12.7  13.5  0.1  13.6  11.4  0.1  11.5   14.0  0.4  14.4  11.7  1.0  12.7 

F-45


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The plan assets do not include any of the Group’s own financial instruments, nor any property occupied by the Group.

F-46


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      Changes in the values of plan assets and liabilities are as follows:
                                                      
 2005     2004     2003     2006 UK     2005 UK    
 UK Group 2005 2005 UK Group 2004 2004 UK Group 2003 2003 Group 2006 2006 Group 2005 2005
 scheme Other Total scheme Other Total scheme Other Total plan Other Total plan Other Total
                              
 (All figures in £ millions) (All figures in £ millions)
Fair value of assets
                            
Fair value of plan assets
                   
Opening fair value of plan assets  1,198  82  1,280  1,089  75  1,164  974  57  1,031   1,390  110  1,500  1,198  82  1,280 
Exchange differences    9  9    (5)  (5)    (5)  (5)    (12)  (12)    9  9 
Expected return on plan assets  75  6  81  71  6  77  65  4  69   85  7  92  75  6  81 
Actuarial gains and losses  139  1  140  64  3  67  80  8  88   68  6  74  139  1  140 
Contributions by employer  35  10  45  30  9  39  24  9  33   43  2  45  35  10  45 
Contributions by employee  6    6  6    6  6    6   7    7  6    6 
Benefits paid  (63)  (6)  (69)  (62)  (6)  (68)  (60)  (6)  (66)  (65)  (8)  (73)  (63)  (6)  (69)
Acquisition through business combination    8  8          8  8           8  8 
                                
Closing fair value of plan assets
  1,390  110  1,500  1,198  82  1,280  1,089  75  1,164   1,528  105  1,633  1,390  110  1,500 
                                
Present value of defined benefit obligation
                                               
Opening defined benefit obligation  (1,502)  (113)  (1,615)  (1,340)  (114)  (1,454)  (1,207)  (96)  (1,303)  (1,661)  (142)  (1,803)  (1,502)  (113)  (1,615)
Exchange differences    (12)  (12)    6  6    9  9     15  15    (12)  (12)
Current service cost  (25)  (2)  (27)  (22)  (2)  (24)  (21)  (2)  (23)  (27)  (2)  (29)  (25)  (2)  (27)
Curtailment    2  2             —           2  2 
Interest cost  (79)  (6)  (85)  (72)  (6)  (78)  (67)  (7)  (74)  (78)  (7)  (85)  (79)  (6)  (85)
Actuarial gains and losses  25  3  28  (112)  (7)  (119)
Contributions by employee  (6)    (6)  (6)    (6)  (6)    (6)  (7)    (7)  (6)    (6)
Benefits paid  65  8  73  63  6  69 
Acquisition through business combination    (10)  (10)          (10)  (10)    (2)  (2)    (10)  (10)
Benefits paid  63  6  69  62  6  68  60  6  66 
Actuarial gains and losses  (112)  (7)  (119)  (124)  (3)  (127)  (99)  (14)  (113)
                                
Closing defined benefit obligation
  (1,661)  (142)  (1,803)  (1,502)  (113)  (1,615)  (1,340)  (114)  (1,454)  (1,683)  (127)  (1,810)  (1,661)  (142)  (1,803)
                                
      The history of the defined benefit plans is as follows:
                            
 2005 2004 2003 2006 2005 2004 2003
              
 (All figures in £ millions) (All figures in £ millions)
Fair value of plan assets  1,633  1,500  1,280  1,164 
Present value of defined benefit obligation  (1,803)  (1,615)  (1,454)  (1,810)  (1,803)  (1,615)  (1,454)
Fair value of plan assets  1,500  1,280  1,164 
                
Net pension liability
  (303)  (335)  (290)  (177)  (303)  (335)  (290)
                
Experience adjustments on plan assets  74  140  67  88 
Experience adjustments on plan liabilities  (119)  (127)  (113)  28  (119)  (127)  (113)
Experience adjustments on plan assets  140  67  88 
                

F-46


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The expected rates of return on categories of plan assets are determined by reference to relevant indices. The overall expected rate of return is calculated by weighting the individual rates in accordance with the anticipated balance in the plan’s investment portfolio.
      The Group expects to contribute approximately £41m£150m to its defined benefit plans in 2006.2007, which includes an additional contribution of £100m to the UK Group plan.

F-47


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The effect of a one percentage point increase and decrease in the discount rate is as follows:
         
  2006 2006
  1% increase 1% decrease
     
  (All figures in £ millions)
Effect on:
        
(Decrease)/increase in defined benefit obligation  (242)  297 
Other post-retirement obligations
      The Group operates a number of post-retirement medical benefit schemes,plans, principally in the USA.US. These plans are unfunded. The method of accounting and the frequency of valuations are similar to those used for defined benefit pension schemes.plans.
      The principal assumptions used are shown below:
                        
% 2005 2004 2003 2006 2005 2004
            
Inflation  3.0  3.0  3.0   3.00  3.00  3.00 
Initial rate of increase in healthcare rates  10.0  12.0  12.0   10.00  10.00  12.00 
Ultimate rate of increase in healthcare rates  5.0  5.0  5.0   5.00  5.00  5.00 
Rate used to discount scheme liabilities  5.6  6.1  6.1   5.85  5.60  5.60 
      The amounts recognised in the income statement are as follows:
        
 2005 2004 2003 2006 2005 2004
            
 (All figures in £ millions) (All figures in £ millions)
Current service cost  (1)  (1)  (1)  1  1  1 
       
Past service cost  (2)     
       
Total operating (income)/costs
  (1)  1  1 
       
Interest cost  (3)  (4)  (4)  3  3  4 
              
Net income statement charge
  (4)  (5)  (5)  2  4  5 
              
      The current and past service cost hascosts have been included in administrative and other expenses.
                    
 2005 2004 2003 2006 2005
          
 (All figures in £ millions) (All figures in
Opening obligation  (58)  (61)  (63)
 £ millions)
Opening defined benefit obligation  (60)  (58)
Exchange differences  (7)  6  6   8  (7)
Reclassifications  (3)   
Current service cost  (1)  (1)  (1)  (1)  (1)
Past service cost  2   
Interest cost  (3)  (4)  (4)  (3)  (3)
Benefits paid  4  3  4   4  4 
Actuarial gains and losses  5  (1)  (3)  5  5 
            
Closing obligation
  (60)  (58)  (61)
Closing defined benefit obligation
  (48)  (60)
            

F-48


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The effect of a one percentage point increase (and decrease)and decrease in the assumed medical cost trend rates is as follows:
                         
  2005 2005 2004 2004 2003 2003
  1% increase 1% decrease 1% increase 1% decrease 1% increase 1% decrease
             
  (All figures in £ millions)
Effect on:
                        
Aggregate of service cost and interest cost  0.2   (0.2)  0.2   (0.2)  0.3   (0.3)
Defined benefit obligation  4.7   4.1   4.1   (3.7)  4.8   (4.2)
                         
  2006 2006 2005 2005 2004 2004
  1% increase 1% decrease 1% increase 1% decrease 1% increase 1% decrease
             
  (All figures in £ millions)
Effect on:
                        
Increase/(decrease) of aggregate of service cost and interest cost  0.1   (0.1)  0.2   (0.2)  0.2   (0.2)
(Decrease)/increase in defined benefit obligation  (4.7)  5.1   (4.7)  4.1   (4.1)  3.7 

F-47


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Share-based compensationpayments
      The Group recognised the following charges in the income statement in respect of its equity-settled share-based payment plans:
        
 2005 2004 2003 2006 2005 2004
            
 (All figures in £ millions) (All figures in £ millions)
Pearson plans  13  15  20   18  13  15 
IDC plans  10  10  9   7  10  10 
              
Total share-based payment costs
  23  25  29   25  23  25 
              
      The Group operates the following equity-settled employee option and performanceshare plans:
      Profit Sharing Plan — The Group operates a profit sharing plan for all employees, the payment of which is at the discretion of the Pearson board and may be made in cash or Pearson shares.
Worldwide Save for Shares PlansPlan — Since 1994, the Group has operated a Save-As-You-Earn plan for UK employees. In 1998, the Group introduced a Worldwide Save for Shares Plan. Under these plans, employees can save a portion of their monthly salary over periods of three, five or seven years. At the end of this period, the employee has the option to purchase ordinary shares with the accumulated funds at a purchase price equal to 80% of the market price prevailing at the time of the commencement of the employee’s participation in the plan. Options that are not exercised within six months of the third, fifth or seventh anniversary after grant lapse unconditionally.
 
      Employee Stock Purchase Plan — In 2000, the Group established an Employee Stock Purchase Plan which allows all employees in the United StatesUS to save a portion of their monthly salary over six month periods. At the end of the period, the employee has the option to purchase ADRs with their accumulated funds at a purchase price equal to 85% of the lower of the market price prevailing at the beginning or end of the period.
 
      Executive Share Option Plan — Under this plan, options were granted to senior management at an exercise price equal to the market price of the shares on the date of grant. Options granted prior to 1996 are not subject to performance conditions. The exercise of options granted since 1996 is subject to growth in the Group’s adjusted earnings per share over a three year period prior to exercise. Options become exercisable on the third anniversary of the date of grant and lapse if they remain unexercised at the tenth. No new awards will be made under this plan.
Reward Plan — Awards of premium priced options were made under this plan in 1999 and 2000 with an exercise price above the market value of the shares at the grant date. The exercise of options is subject to Pearson’s share price remaining above certain thresholds for specified periods of time and to growth in the Group’s adjusted earnings per share over the three year period prior to exercise. Options became exercisable on the third anniversary of the date of grant and lapse if they remain unexercised at the tenth. No new awards will be made under this plan.
Special Share Option Plan — In 2000, the Group made a special one-off award of share options with an exercise price equal to the market price of the shares on the grant date. They vested in tranches of 50% on the first anniversary of the date of grant and 25% on the second and third anniversaries of the grant date. Options lapse if they remain unexercised at the tenth anniversary of the grant date. No new awards will be made under this plan.

F-48


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Long-Term Incentive Plan — This plan was introduced in 2001 and renewed in 2006 and consists of two parts: share options and/or restricted shares.
 
       Options were granted under this plan in 2001 based on a pre-grant earnings per share growth test and are not subject to further performance conditions on exercise. The options became exercisable in tranches and lapse if they remain unexercised at the tenth anniversary of the date of grant.
 
       The vesting of restricted shares is normally dependent on continuing service and/or upon the satisfaction of corporate performance targets over a three yearthree-year period. These targets may be based on market and/or non-market performance criteria. Restricted shares grantedawarded to senior management in 2001 vested based on Pearson’s three-year cumulative free cash flow per share performance. Awards made in December 2002 and September 2003 vest in tranches. One sixth of the award vests after three years with no performance conditions. The vesting of the balance depends on Pearson’s share price performance over the seven year period following the grants. Restricted shares awarded in December 2004 and September 2005October 2006 vest dependent on the following market and non-market performance criteria: relative shareholder return, return on invested capital and a combination of earnings per share and sales growth. The award iswas split equally across all three measures. Other restricted shares awarded in 2006 vest depending on continuing service over a three-year period.

F-49


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      Annual Bonus Share Matching Plan — This plan permits executive directors and senior executives around the Group to invest up to 50% of any after tax annual bonus in Pearson shares. If these shares are held more than three years and the Group meets an earnings per share growth target, the Company will match them on a gross basis of up to one share for everyone held after three years and anotherevery one for two originally held after five years.
      In addition to the above, share options remain outstanding under Executive Share Option, Reward and Special Share Option Plans. These are legacy plans which were replaced with the introduction of the Long-Term Incentive Plan in 2001.
      The number and weighted average exercise prices of share options granted under the Group’s schemesplans are as follows:
                                        
 2005 2005 2004 2004 2003 2003 2006 2006 2005 2005
 Number of Weighted Number of Weighted Number of Weighted Number of Weighted Number of Weighted
 share average share average share average share average share average
 options exercise options exercise options exercise options exercise options exercise
 000s price £ 000s price £ 000s price £ 000s price £ 000s price £
                    
Outstanding at beginning of year  26,179  5.93  32,284  6.93  35,608  8.84   21,677  13.15  26,179  13.62 
Granted during the year  606  5.06  886  4.56  2,309  5.16   837  6.30  606  4.92 
Exercised during the year  (324)  6.78  (254)  10.10  (89)  10.60   (1,396)  5.36  (324)  6.01 
Forfeited during the year  (4,352)  10.42  (6,301)  7.49  (5,053)  16.25   (1,828)  15.39  (4,352)  15.75 
Expired during the year  (432)    (436)    (491)     (429)  6.72  (432)  9.17 
                      
Outstanding at end of year
  21,677  5.05  26,179  5.93  32,284  6.93   18,861  13.36  21,677  13.15 
                      
Options exercisable at the end of year
  7,634  7.80  9,071  9.23  9,882  9.44 
Options exercisable at end of year
  15,595  14.14  17,420  13.90 
                      
      Options were exercised regularly throughout the year. The weighted average share price during the year was £6.52 (2004: £6.25; 2003: £5.72)£7.45 (2005: £6.52). Early exercises arising from redundancy, retirement or death are treated as an acceleration of vesting and the remaining charge isGroup therefore recognises in the income statement the amount that otherwise would have been recognised atfor services received over the dateremainder of exercise.

F-49


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)the original vesting period.
      The options outstanding at the end of the year have weighted average remaining contractual lives and exercise prices as follows:
                                        
 2005 2005 2004 2004 2003 2003 2006 2006 2005 2005
 Number of Weighted Number of Weighted Number of Weighted Number of Weighted Number of Weighted
 share average share average share average share average share average
Range of exercise prices options contractual options contractual options contractual options contractual options contractual
£ 000s life years 000s life years 000s life years 000s life years 000s life years
                    
0 — 5  2,773  2.08  3,251  2.97  2,740  3.66   1,649  1.94  2,773  2.32 
5 — 10  5,555  4.48  6,538  5.44  7,797  6.02   5,254  3.85  5,555  4.57 
10 — 15  8,237  4.63  9,604  5.57  11,758  6.63   7,638  3.63  8,237  4.64 
15 — 20  1,168  3.80  1,469  4.81  2,210  5.78   1,050  2.88  1,168  3.81 
20 — 25  930  3.80  1,346  4.92  2,210  6.02   424  3.19  930  3.80 
>25  3,014  4.22  3,971  4.65  5,569  5.79   2,846  3.22  3,014  4.22 
                      
  21,677  4.13  26,179  5.00  32,284  5.99   18,861  3.42  21,677  4.19 
                      
      In 2005, 20042006 and 20032005 options were granted under the Worldwide Save for Shares Plan. The weighted average estimated fair value for the options granted was calculated using a Black-Scholes option pricing model.

F-50


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The weighted average estimated fair values and the inputs in tointo the Black-Scholes model are as follows:
                    
 2005 2004 2003 2006 2005
 Weighted Weighted Weighted Weighted Weighted
 average average average average average
          
Fair value  £2.34  £2.70  £1.82   £1.92  £2.41 
       
Weighted average share price  £6.54  £6.58  £5.15   £7.66  £6.54 
Weighted average exercise price  £5.08  £4.96  £4.25   £6.30  £5.08 
Expected volatility  33.69%  41.95%  48.74%  23.12%  35.47%
Expected life 3.6 years 3.8 years 4.0 years  4.0 years 4.1 years 
Risk free rate  4.48%  4.77%  3.84%  4.42%  4.48%
Expected dividend yield  2.40%  2.72%  4.55%  3.52%  3.93%
Forfeiture rate  20.0%  21.1%  18.7%  5.0%  6.3%
            
      The expected volatility is based on the historic volatility of the Company’s share price over the previous 3 — 7three to seven years depending on the vesting term of the options.
      During the year theThe following shares were granted under restricted share arrangements:
                                        
 2005 2005   2004   2003 2006 2006   2005
 Number Weighted 2004 Weighted 2003 Weighted Number Weighted 2005 Weighted
 of shares average Number average Number average of shares average Number average
 000s fair value of shares fair value of shares fair value 000s fair value of shares fair value
   £ 000s £ 000s £   £ 000s £
                    
Annual Bonus Share Matching Plan  71  5.57  53  5.42  108  4.36   90  6.27  71  5.57 
Long-term Incentive Plan  3,987  5.05  2,413  4.54  1,711  5.21 
Long-Term Incentive Plan  3,585  6.96  3,987  5.05 

F-50


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      TheIn 2005, the fair value of restricted shares awarded under the Annual Bonus Share Matching Plan and the Long-Term Incentive Plan was determined using a Black-Scholes model. Shares awardedmodel to reflect dividends foregone using a dividend yield of 3.85%. From 2006 onwards, participants of the Long-Term Incentive Plan are entitled to dividends during the vesting period. Following a review of the accounting policies for share-based payments in 2006, the restricted shares granted in 2006 under the Annual Bonus Share Matching Plan are valued using the share price at the date of grant discounted by the dividend yield (3.66%) to take into account any dividends foregone. The fair value of shares granted under the Long-Term Incentive Plan were also valued using a Black-Scholes model provided the shares vest unconditionally. The weighted average estimated fair values and the inputs into the Black-Scholes model are as follows:
         
  2005 2004
  Weighted Weighted
  Average Average
     
Fair value  £6.19   £4.54 
       
Weighted average share price  £6.69   £6.13 
Weighted average exercise price      
Expected volatility  32.79%  38.39%
Expected life  3.3 years   3.0 years 
Risk free rate  4.19%  4.59%
Expected dividend yield  2.35%  4.00%
Forfeiture rate  9.9%  4.5%
       
      In 2003, no restricted shares granted were valued using a Black-Scholes model. The fair value of restricted shares that vest conditionally uponunconditionally was determined using the fulfilmentshare price at the date of grant. The number of shares to vest was adjusted based on historical experience to account for any potential forfeitures. Restricted shares with a market performance condition were valued by an independent actuary using a Monte Carlo model. SharesRestricted shares with a non-market vestingperformance condition were fair valued based on the share price at the date of grant taking into account any future dividend payments. Thegrant. Non-market performance conditions were considered by adjusting the number of shares expected to vest based on the most likely outcome of the relevant performance criteria.
Subsidiary share option plans
      IDC, a 61%62% subsidiary of the Group, operates the following share-based payment plans:
      2001 Employee Stock Purchase PlanIn 2001, IDC adopted the 2001 Employee Stock Purchase Plan for all eligible employees worldwide. The 2001 Employee Stock Purchase Plan allows employees to purchase stock at a discounted price at specific times.
 
      2000 Long-Term Incentive PlanUnder this plan, the Compensation Committee of the Board of Directors can grant share-based awards representing up to 20% of the total number of shares of common stock outstanding at the date of grant. The plan provides for the discretionary issuance of share-baseshare-based awards to directors, officers and employees of IDC, as well as persons who provide consulting or other services to IDC. The exercise price for all options granted to date has been equal to the market price of

F-51


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
the underlying shares at the date of grant. Options expire ten years from the date of grant and generally vest over a three to four year period without any performance criteria attached.
      In addition, grants of restricted stock can be made to certain executives and members of the Board of Directors of IDC. The awarded shares are available for distribution, at no cost, at the end of a three-year vesting period. No performance criteria are attached to shares granted under this plan.

F-51


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The number and weighted average exercise prices of share options granted under the 2000 Long-Term Incentive Plan isare as follows:
                                                            
   2005     2004     2003     2006     2005  
 2005 Weighted 2005 2004 Weighted 2004 2003 Weighted 2003 2006 Weighted 2006 2005 Weighted 2005
 Number average Weighted Number average Weighted Number average Weighted Number average Weighted Number average Weighted
 of share exercise average of share exercise average of share exercise average of share exercise average of share exercise average
 options price exercise options price exercise options price exercise options price exercise options price exercise
 000s $ price £ 000s $ price £ 000s $ price £ 000s $ price £ 000s $ price £
                              
Outstanding at beginning of year  9,832  13.46  7.36  9,358  12.15  7.44  8,619  10.43  6.38   10,068  15.16  8.37  9,832  13.46  7.36 
Granted during the year  1,940  21.38  11.80  1,937  17.48  9.56  2,107  16.40  10.04   1,835  20.58  10.52  1,940  21.38  11.80 
Exercised during the year  (1,412)  11.57  6.39  (1,157)  9.59  5.24  (1,195)  7.20  4.41   (1,252)  12.88  6.58  (1,412)  11.57  6.39 
Forfeited during the year  (292)  16.86  9.31  (306)  13.32  7.28  (173)  12.36  7.57   (139)  19.02  9.72  (292)  16.86  9.31 
Expired during the year  (6)  11.46  5.86       
                                
Outstanding at end of year
  10,068  15.16  8.37  9,832  13.46  7.36  9,358  12.15  7.44   10,506  16.33  8.34  10,068  15.16  8.37 
                                
Options exercisable at end of year
  6,052  12.58  6.94  5,321  11.41  6.24  4,259  9.93  6.08   6,547  14.11  7.21  6,052  12.58  6.94 
                                
      The options outstanding at the end of the year have a weighted average remaining contractual life and exercise price as follows:
                        
 2005 2005 2004 2004 2003 2003 2006 2006 2005 2005
 Number Weighted Number Weighted Number Weighted Number Weighted Number Weighted
 of share average of share average of share average of share average of share average
Range of exercise prices options contractual options contractual options contractual options contractual options contractual
$ 000s life years 000s life years 000s life years 000s life years 000s life years
                    
0 — 4.4  33  4.2  64  4.3  143  6.1   30  3.1  33  4.2 
4.4 — 7.5  206  3.6  287  4.5  499  5.0   157  2.3  206  3.6 
7.5 — 12  2,685  5.3  3,398  6.3  4,117  7.3   2,164  4.4  2,685  5.3 
12 — 20  5,243  7.4  6,083  8.4  4,599  8.8   4,640  6.4  5,243  7.4 
>20  1,901  9.5         —   3,515  9.0  1,901  9.5 
                      
  10,068  5.4  9,832  7.5  9,358  7.9   10,506  6.8  10,068  5.4 
                      
      During the year IDC granted the following shares under restricted share arrangements:
                                                            
   2005                 2006        
 2005 Weighted 2005   2004 2004   2003 2003 2006 Weighted 2006   2005 2005
 Number average Weighted 2004 Weighted Weighted 2003 Weighted Weighted Number average Weighted 2005 Weighted Weighted
 of shares fair value average Number average average Number average average of shares fair value average Number average average
 000s $ fair value of shares fair value fair value of shares fair value fair value 000s $ fair value of shares fair value fair value
     £ 000s $ £ 000s $ £     £ 000s $ £
                              
2000 Long-Term Incentive Plan  148  20.57  11.35  69  17.57  9.61  76  16.97  10.39   196  20.82  10.64  148  20.57  11.35 
2001 Employee Stock Purchase Plan  178  3.68  2.03  124  3.24  1.77  118  2.64  1.62   206  3.98  2.03  178  3.68  2.03 
      Shares awarded under the 2000 Long-Term Incentive Plan were valued based on the share price prevailing at the date of grant. The fair value of the options granted under the Long-Term Incentive Plan and

F-52


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
of the shares awarded under the 2001 Employee Stock Purchase Plan was estimated using a Black-Scholes model.

F-52


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The weighted average estimated fair values and the inputs into the Black-Scholes model are as follows:
                                        
 Long-Term Incentive Plan Employee Stock Purchase Plan Long-Term Incentive Plan Employee Stock Purchase Plan
        
 2005 2004 2003 2005 2004 2003 2006 2005 2006 2005
 Weighted Weighted Weighted Weighted Weighted Weighted Weighted Weighted Weighted Weighted
 average average average average average average average average average average
                    
Fair value  $ 5.56  $ 7.50  $ 8.09  $ 3.68  $ 3.24  $ 2.64   $ 6.57  $ 5.56  $ 3.98  $ 3.68 
             
Weighted average share price  $21.38  $17.48  $16.40  $15.46  $14.48  $11.24   $20.58  $21.38  $15.58  $15.46 
Weighted average exercise price  $21.38  $17.48  $16.40  $15.46  $14.48  $11.24   $20.58  $21.38  $15.58  $15.46 
Expected volatility  24.50%  32.20%  61.10%  20.00%  20.00%  25.00%  25.90%  24.50%  18.32%  20.00%
Expected life 4.0  years 4.0  years 4.0  years 0.5  years 0.5  years 0.5  years  4.7 years 4.0 years 0.5 years 0.5 years 
Risk free rate  3.86%  3.45%  2.00%  2.33%  1.03%  1.20%  4.56% to 5.11%  3.86%  3.66% to 5.22%  2.33%
Expected dividend yield  0.0%  0.0%  0.0%  0.0%  0.0%  0.0%  0.0%  0.0%  0.0%  0.0%
Forfeiture rate  0.0%  0.0%  0.0%  0.0%  0.0%  0.0%  0.0%  0.0%  0.0%  0.0%
                      
      The expected volatility is based on the historic volatility of IDC’s share price over the vesting term of the options.
25Share capital and share premium
             
  Number of Ordinary Share
  shares shares premium
  (thousands) £m £m
       
At 1 January 2003  801,662   200   2,465 
Issue of shares — share option schemes  726   1   4 
          
At 31 December 2003
  802,388   201   2,469 
Issue of shares — share option schemes  862      4 
          
At 31 December 2004
  803,250   201   2,473 
Issue of shares — share option schemes  770      4 
          
At 31 December 2005
  804,020   201   2,477 
          
             
  Number Ordinary Share
  of shares shares premium
  000s £m £m
       
At 1 January 2005  803,250   201   2,473 
Issue of ordinary shares — share option schemes  770      4 
          
At 31 December 2005
  804,020   201   2,477 
          
Issue of ordinary shares — share option schemes  2,089   1   10 
          
At 31 December 2006
  806,109   202   2,487 
          
      The total authorised number of ordinary shares is 1,186 million1,190m shares (2004: 1,182 million shares; 2003: 1,178 million(2005: 1,186m shares) with a par value of 25 pence25p per share (2004: 25p per share;2003:(2005: 25p per share). All issued shares are fully paid. All shares have the same rights.
26Treasury shares
                     
  Pearson plc IDC Total
       
  Number   Number    
  of shares   of shares    
  000s £m 000s £m £m
           
At 1 January 2005  4,623   105   3,145   27   132 
Purchase of treasury shares  626   5   1,407   16   21 
                
At 31 December 2005
  5,249   110   4,552   43   153 
                
Purchase of treasury shares  4,700   36   1,500   16   52 
Release of treasury shares  (1,188)  (16)        (16)
                
At 31 December 2006
  8,761   130   6,052   59   189 
                
      The Group holds its own shares in trust to satisfy its obligations under its restricted share plans (see note 24). These shares are held as treasury shares and have a par value of 25p per share.
      IDC hold their own shares in respect of share buy-back programmes. These shares are held as treasury shares and have a par value of $0.01.

F-53


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The nominal value of Pearson plc treasury shares amounts to £2.2m (2005: £2.1m). The nominal value of IDC treasury shares amounts to £0.3m (2005: £0.3m).
      At 31 December 2006 the market value of Pearson plc treasury shares was £67.6m (2005: £36.2m) and the market value of IDC treasury shares was £74.3m (2005: £60.2m).
2627Other reserves and retained earnings
                     
        Total  
  Treasury Translation Fair value other Retained
  shares reserve reserve reserves earnings
           
  (All figures in £ millions)
At 1 January 2003  (121)        (121)  644 
Net exchange differences on translation of foreign operations     (288)     (288)   
Purchase of treasury shares  (1)        (1)   
Profit for the year attributable to equity holders of the parent              252 
Dividends paid              (188)
Equity settled transactions              29 
Actuarial gains and losses on defined benefit schemes              (28)
Taxation on items taken directly to equity               
                
At 31 December 2003
  (122)  (288)     (410)  709 
                
Net exchange differences on translation of foreign operations     (203)     (203)   
Purchase of treasury shares  (10)        (10)   
Profit for the year attributable to equity holders of the parent              262 
Dividends paid              (195)
Equity settled transactions              25 
Actuarial gains and losses on defined benefit schemes              (61)
Taxation on items taken directly to equity              9 
                
At 31 December 2004
  (132)  (491)     (623)  749 
                
Net exchange differences on translation of foreign operations     327      327    
Cumulative translation adjustment disposed     (14)     (14)   
Purchase of treasury shares  (21)        (21)   
Profit for the year attributable to equity holders of the parent              624 
Dividends paid              (205)
Equity settled transactions              23 
Actuarial gains and losses on defined benefit schemes              26 
Taxation on items taken directly to equity              12 
Transition adjustment on adoption of IAS 39 (note 34)     3      3   (15)
                
At 31 December 2005
  (153)  (175)     (328)  1,214 
                
                     
        Total  
    Translation Fair value other Retained
  Notes reserve reserve reserves earnings
           
  (All figures in £ millions)
At 1 January 2005      (491)     (491)  749 
Net exchange differences on translation of foreign operations      327      327    
Cumulative translation adjustment disposed      (14)     (14)   
Profit for the year attributable to equity holders of the Company               624 
Dividends paid to equity holders of the Company  10            (205)
Equity settled transactions  24            23 
Actuarial gains on post-retirement plans  24            26 
Taxation on items charged to equity  8            12 
Transition adjustment on adoption of IAS 39      3      3   (15)
                
At 31 December 2005
      (175)     (175)  1,214 
                
Net exchange differences on translation of foreign operations      (417)     (417)   
Profit for the year attributable to equity holders of the Company               446 
Dividends paid to equity holders of the Company  10            (220)
Equity settled transactions  24            25 
Actuarial gains on post-retirement plans  24            107 
Treasury shares released under employee share plans  26            (16)
Taxation on items charged to equity  8            12 
                
At 31 December 2006
      (592)     (592)  1,568 
                
      The translation reserve includes exchange differences arising from the translation of the net investment in foreign entities,operations and of borrowings and other currency instruments designated as hedges of such investments.

F-54


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
2728Business combinations
      On 22 July 200530 September 2006, the Group acquired 100% of the voting rights of AGS Publishing, an educational assessmentsMergermarket, a financial information company providing information to financial institutions, corporations and curriculum materials publisher.their advisers. In addition, several other businesses were acquired in the current year including Promissor, Paravia Bruno Mondadori (PBM), National Evaluation Systems (NES), PowerSchool and prior years, noneChancery in the Education business and Quote.com in IDC. None of whichthese other acquisitions were individually material to the Group.
      The assets and liabilities arising from acquisitions in each of In 2005, the years are as follows:
                             
  2005    
    2004 2003
  AGS AGS AGS Other Total Total Total
  carrying fair value fair fair fair fair fair
  amount adjs value value value value value
               
  (All figures in £ millions)
Tangible fixed assets  1      1   6   7   1   10 
Intangible assets     58   58   31   89   15   44 
Intangible assets — pre-publication  15      15      15       — 
Inventory  3      3   7   10   2    
Receivables  7      7   25   32   3   32 
Payables  (5)  (1)  (6)  (36)  (42)  (4)  (95)
Provisions  (2)     (2)  (1)  (3)  1   (4)
Deferred taxation     (20)  (20)  (1)  (21)     (15)
Cash and cash equivalents  (1)     (1)  4   3      34 
Equity minority interests           8   8   (3)  (8)
                      
Net assets/(liabilities) acquired at fair value
  18   37   55   43   98   15   (2)
                      
Goodwill
  105      105   50   155   22   113 
                      
Total
          160   93   253   37   111 
                      
Satisfied by:
                            
Cash          (160)  (89)  (249)  (39)  (87)
Deferred cash consideration             (5)  (5)     (24)
Costs provided for             1   1   (1)   
Net prior year adjustments                   3    
                      
Total consideration
          (160)  (93)  (253)  (37)  (111)
                      
Book value of net assets/(liabilities acquired)          18   40   58   4   (32)
Fair value adjustments          37   3   40   1   30 
                      
Fair value to the Group
          55   43   98   5   (2)
                      
      The fair value adjustments relatingamounts shown below mainly relate to the acquisition of AGS are provisional and will be finalised during 2006. They include the valuation of intangible assets, the related deferred tax effect and recognition of provisions. Adjustments to 2004 provisional fair values largely relate to the acquisition of Dominie Press.Publishing.
      Net cash outflow on acquisition:
             
  2005 2004 2003
       
  (All figures in £ millions)
Cash — current year acquisitions  (249)  (39)  (87)
Deferred payments for prior year acquisitions and other items     (2)  (7)
Cash and cash equivalents acquired  3      34 
          
Cash outflow on acquisition
  (246)  (41)  (60)
          

F-55F-54


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The assets and liabilities arising from acquisitions are as follows:
                             
    2006 2005
       
    Mergermarket Mergermarket   Other Total Total
    Carrying Fair value Mergermarket Fair Fair Fair
  Notes amount adjs Fair value value value value
               
  (All figures in £ millions)
Property, plant and equipment  11   1      1   12   13   7 
Intangible assets  12      34   34   122   156   89 
Intangible assets — Pre-publication  17            4   4   15 
Inventories               14   14   10 
Trade and other receivables      11      11   13   24   32 
Cash and cash equivalents      14      14   14   28   3 
Trade and other liabilities      (21)     (21)  (31)  (52)  (42)
Financial liabilities — Borrowings               (3)  (3)   
Deferred income tax liabilities  14      (10)  (10)  (16)  (26)  (21)
Retirement benefit obligations  24            (2)  (2)  (2)
Provisions for other liabilities and charges  22            (3)  (3)  (1)
Equity minority interest               (9)  (9)  8 
                      
Net assets acquired at fair value
      5   24   29   115   144   98 
                      
Goodwill
              97   149   246   155 
                      
Total
              126   264   390   253 
                      
Satisfied by:
                            
Cash              (109)  (273)  (382)  (249)
Deferred consideration              (17)     (17)  (5)
Net prior year adjustments                 9   9   1 
Total consideration
              (126)  (264)  (390)  (253)
                      
Book value of net assets acquired              5   43   48   58 
Fair value adjustments              24   72   96   40 
                      
Fair value to the Group
              29   115   144   98 
                      
      The fair value adjustments relating to the acquisition of Mergermarket are provisional and will be finalised during 2007. They include the valuation of intangible assets and the related deferred tax effect. Adjustments to 2005 provisional fair values largely relate to the acquisition of AGS Publishing.
      Net cash outflow on acquisition:
             
  2006 2005 2004
       
  (All figures in £ millions)
Cash — Current year acquisitions  (382)  (249)  (39)
Deferred payments for prior year acquisitions and other items  (9)     (2)
Cash and cash equivalents acquired  28   3    
          
Cash outflow on acquisition
  (363)  (246)  (41)
          
      The goodwill arising on the acquisition of AGSMergermarket is attributable to the profitability of the acquired business and the significant synergies expected to arise.
      AGSMergermarket contributed £21m£9m of sales and £6m£2m to the Group’s profit before tax between the date of acquisition and the balance sheet date. Other businesses acquired contributed £1m£15m to the Group’s profit before tax between the date of acquisition and the balance sheet date.

F-55


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      If the acquisitions had been completed on 1 January 2005, total2006, Group sales for the period would have been £4,168m,£4,199m and profit before tax would have been £474m.£478m.
29  Non-current assets classified as held for sale
      As described in note 3, on 11 December 2006 the Group announced the disposal of Pearson Government Solutions. This disposal was completed on 15 February 2007 (see note 35). The major classes of assets and liabilities comprising the operations classified as held for sale at the balance sheet date are as follows:
         
  Notes 2006
     
    (All figures in
    £ millions)
Property, plant and equipment  11   9 
Intangible assets — Goodwill  12   221 
Intangible assets — Other  12   7 
Inventories      1��
Trade and other receivables      56 
       
Non-current assets classified as held for sale
      294 
       
Other liabilities      (26)
       
Liabilities directly associated with non-current assets classified as held for sale
      (26)
       
Net assets classified as held for sale
      268 
       
2830Disposals
      In April 2005 the Group disposed of its 79% interest in Recoletos Grupo de Communicación S.A.
                     
  2005    
    2004 2003
  Recoletos Other Total Total Total
           
  (All figures in £ millions)
Disposal of subsidiaries
                    
Property, plant and equipment  (48)     (48)     (3)
Other financial assets  (2)     (2)      — 
Associates  (3)     (3)      — 
Inventory  (4)     (4)     (2)
Receivables  (59)     (59)  (4)  (9)
Payables  68   3   71   2   10 
Provisions  2   1   3       — 
Deferred taxation  8      8       — 
Net (cash and cash equivalents)/borrowings  (132)  (2)  (134)  1   1 
Equity minority interests  60   (6)  54   (4)   
Attributable goodwill  (98)  (6)  (104)  (4)  (4)
Currency translation adjustment  14      14       — 
                
Net assets disposed of
  (194)  (10)  (204)  (9)  (7)
                
Proceeds received  503   10   513   8   1 
Costs  (3)     (3)  (2)  (1)
Deferred consideration              2 
Net prior year adjustments              1 
                
Profit/(loss) on sale
  306      306   (3)  (4)
                
             
  2005 2004 2003
       
Cash flow from disposals
            
Cash — current year disposals  513   8   1 
Costs paid  (3)  (2)  (2)
Deferred receipts and payments from prior year disposals and other amounts        (3)
Cash and cash equivalents/net debt disposed of  (134)  1   1 
          
Net cash outflow
  376   7   (3)
          
             
  2006 2005 2004
       
  (All figures in £ millions)
Disposal of subsidiaries
            
Property, plant and equipment     (48)   
Investments in associates     (3)   
Deferred income tax assets     8    
Other financial assets     (2)   
Inventories     (4)   
Trade and other receivables     (59)  (4)
Trade and other liabilities  (1)  71   2 
Provisions for other liabilities and charges     3    
Cash and cash equivalents     (134)  1 
Equity minority interests  (4)  54   (4)
Attributable goodwill  (5)  (104)  (4)
Currency translation adjustment     14     
          
Net assets disposed of
  (10)  (204)  (9)
          
Proceeds received  10   513   8 
Costs     (3)  (2)
          
Profit on sale
     306   (3)
          

F-56


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
             
  2006 2005 2004
       
Cash flow from disposals
            
Cash — Current year disposals  10   513   8 
Costs paid     (3)  (2)
Cash and cash equivalents/net debt disposed of     (134)  1 
          
Net cash inflow
  10   376   7 
          
      The 2006 disposal relates to share options exercised in IDC.
29Cash generated from operations
      2005 disposals relate mainly to the disposal of the Group’s 79% interest in Recoletos Grupo de Communicación S.A..
31  Cash generated from operations
                            
 2005 2004 2003 Notes 2006 2005 2004
              
 (All figures in £ millions)   (All figures in £ millions)
Net profit  644  284  275      469  644  284 
Adjustments for:
                       
Tax  125  70  84      19  125  70 
Depreciation  80  84  85   11  77  80  84 
Amortisation of purchased intangible assets  11  5  4   12  28  11  5 
Adjustment on recognition of pre-acquisition deferred tax  12  7   —   
Amortisation of other intangible assets  18  20  28   12  23  18  20 
Amortisation of pre-publication investment  192  168  158 
Investment in pre-publication assets  17  (213)  (222)  (181)
Amortisation of pre-publication assets  17  210  192  168 
Loss on sale of property, plant and equipment    4  2      2   —  4 
(Profit)/loss on sale of other financial assets    (16)  1 
Profit on sale of investments         (16)
Net finance costs  70  76  90      74  70  76 
Share of results of joint ventures and associates  (14)  (10)  (4)  13  (24)  (14)  (10)
(Profit)/loss on sale of subsidiaries and associates  (346)  3  (8)       (346)  3 
Net foreign exchange losses/(gains) from transactions  39  (15)  (51)
Share-based payments  23  25  29 
Net foreign exchange(losses)/gains from transactions     (37)  39  (15)
Share-based payment costs  24  25  23  25 
Inventories  (17)  (12)  10      (16)  (17)  (12)
Trade and other receivables  (4)  (18)  (92)     (60)  (4)  (18)
Trade and other payables  71  61  (50)
Trade and other liabilities     54  71  61 
Provisions  (17)  (24)  (30)     (17)  (17)  (24)
               
Cash generated from operations
  875  705  531      621  653  524 
               
      Following a review of accounting presentation in 2006, the Group has chosen to reclassify investment in pre-publication assets as cash generated from operations. This aligns the classification in the cash flow with the treatment of comparable items in other industries and provides more relevant information on the Group cash flow. The impact of this change is to reduce cash generated from operations by £222m in 2005 (£181m in 2004) and increase net cash (used in)/generated from investing activities by £222m in 2005 (£181m in 2004).

F-57


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      In the cash flow statement, proceeds from sale of property, plant and equipment comprise:
                
 2005 2004 2003 2006 2005
          
 (All figures in (All figures in
 £ millions) £ millions)
Net book amount  3  8  10   10  3 
Loss on sale of property, plant and equipment    (4)  (2)  (2)   
            
Proceeds from sale of property, plant and equipment
  3  4  8   8  3 
            
Non-cash transactions
          
The principal non-cash transactions are movements in finance lease obligations    (1)  (1)
       
      The principal non-cash transactions are movements in finance lease obligations of £4m (2005: £nil).
30Contingencies
32  Contingencies
      There are contingent Group liabilities that arise in the normal course of business in respect of indemnities, warranties and guarantees in relation to former subsidiaries and in respect of guarantees in relation to subsidiaries and associates. In addition there are contingent liabilities of the Group in respect of legal claims. None of these claims is expected to result in a material gain or loss to the Group.

F-57


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
3133  Commitments
Capital commitments
      Capital expenditure contracted for at the balance sheet date but not yet incurred is as follows:
             
  2005 2004 2003
       
  (All figures in
  £ millions)
Property, plant and equipment  1   6   1 
          
         
  2006 2005
     
  (All figures in
  £ millions)
Property, plant and equipment     1 
       
      The Group leases various offices and warehouses under non-cancellable operating lease agreements. The leases have varying terms and renewal rights. The Group also leases various plant and equipment under operating lease agreements, also with varying terms. The lease expenditure charged to the income statement during the year is disclosed in note 5.
      The future aggregate minimum lease payments in respect of operating leases are as follows:
        
             2006 2005
 2005 2004 2003    
       (All figures in
 (All figures in £ millions) £ millions)
Not later than one year  129  117  123   123  132 
Later than one year and not later than five years  397  353  375 
Later than one year and not later than two years  113  117 
Later than two years and not later than three years  103  108 
Later than three years and not later than four years  90  97 
Later than four years and not later than five years  83  81 
Later than five years  869  584  529   857  915 
            
  1,395  1,054  1,027   1,369  1,450 
            

F-58


32NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
34  Related party transactions
     Joint ventures and associates — Amounts advanced to joint ventures and associates during the year and at the balance sheet date are set out in note 13. Amounts falling due from joint ventures and associates are set out in note 19.
     Key management personnelare deemed to be the members of the board of directors of Pearson plc. It is this board which has responsibility for planning, directing and controlling the activities of the Group. Key management personnel compensation is disclosed in the directors’ remuneration report.
      There were no other material related party transactions.
      No guarantees have been provided to related parties.
3335  Events after the balance sheet date
      On 9 January 200615 February 2007 the Group completed the disposal of Pearson announcedGovernment Solutions, its Government services business, to Veritas Capital. Sale proceeds consist of $560m in cash, $40m in preferred stock and 10% of the purchaseequity of 1,130,739 shares in Interactive Data Corporation (IDC)the business. The Group expects to make a post-tax loss on the disposal as the capital gain for $21.67 per share in cash. This purchase brings Pearson’s total holding in IDC to almost 62%. On 23 January 2006 Pearson announced the acquisition of Promissor, a leading professional testing business from Houghton Mifflin Company for $42m in cash. On April 25, 2006 Pearson announced the acquisition of National Evaluation Systems, Inc, a leading teacher certification testing company in the US. On May 5, 2006 Pearson announced the acquisition of an 80% stake in Paravia Bruno Mondadori, one of Italy’s leading educational publishing companies.
34     Explanation of transition to IFRS
      These are the Group’s first consolidated financial statements prepared in accordance with IFRS as adopted by the EU.
      The accounting policies set out in note 1 have been applied in preparing the financial statements for the year ended 31 December 2005, the comparative information presented in these financial statements for thetax purposes will exceed any book gain.

F-58F-59


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
years ended 31 December 2004 and 31 December 2003 and the preparation of an opening IFRS balance sheet at 1 January 2003 (the Group’s date of transition). IAS 39 ‘Financial Instruments: Recognition and Measurement’ and IAS 32 ‘Financial Instruments: Disclosure and Presentation’ have not been applied to the comparative periods because the Group has taken a transitional exemption and adopted those standards prospectively from 1 January 2005. The effect of the transitional adjustment on the balance sheet as at 1 January 2005 is set out in the tables below.
      In preparing its opening IFRS balance sheet, the Group has made adjustments to amounts previously reported in its financial statements under UK GAAP. An explanation of how the transition from previous UK GAAP to IFRS has affected the Group’s financial position and cash flows is set out in the tables and notes below. These adjustments include some reclassifications of items within the income statement and within the balance sheet in accordance with IFRS disclosure requirements.

F-59


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Balance sheet as at 1 January 2003 (date of transition)
             
  UK GAAP Adjs IFRS
       
  (All figures in £ millions)
Assets
Non-current assets
            
Property, plant and equipment  503   (68)  435 
Intangible assets  3,610   71   3,681 
Investments in joint ventures and associates  113   (7)  106 
Deferred income tax assets     374   374 
Other financial assets  22      22 
Other receivables     74   74 
          
   4,248   444   4,692 
          
Current assets
            
Intangible assets — pre-publication     380   380 
Inventories  734   (380)  354 
Trade and other receivables  1,059   (79)  980 
Deferred income tax assets  174   (174)   
Cash and cash equivalents  575   (10)  565 
          
   2,542   (263)  2,279 
          
Total assets
  6,790   181   6,971 
          
 
Liabilities
Non-current liabilities
            
Financial liabilities — Borrowings  (1,734)  (2)  (1,736)
Deferred income tax liabilities     (119)  (119)
Retirement benefit obligations     (351)  (351)
Provisions for other liabilities and charges  (165)  120   (45)
Other liabilities  (60)  (10)  (70)
          
   (1,959)  (362)  (2,321)
          
Current liabilities
            
Trade and other liabilities  (1,114)  178   (936)
Financial liabilities — Borrowings  (249)  (3)  (252)
Current income tax liabilities     (52)  (52)
Provisions for other liabilities and charges     (34)  (34)
          
   (1,363)  89   (1,274)
Total liabilities
  (3,322)  (273)  (3,595)
          
Net assets
  3,468   (92)  3,376 
          
Equity
            
Share capital  200      200 
Share premium  2,465      2,465 
Other reserves  (121)     (121)
Retained earnings  732   (88)  644 
          
Total equity attributable to equity holders of the Company
  3,276   (88)  3,188 
Minority interest  192   (4)  188 
          
Total equity
  3,468   (92)  3,376 
          

F-60


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Balance sheet as at 31 December 2003
             
  UK GAAP Adjs IFRS
       
  (All figures in £ millions)
Assets
Non-current assets
            
Property, plant and equipment  468   (66)  402 
Intangible assets  3,260   290   3,550 
Investments in joint ventures and associates  64      64 
Deferred income tax assets     342   342 
Other financial assets  21      21 
Other receivables     100   100 
          
   3,813   666   4,479 
          
Current assets
            
Intangible assets — pre-publication     362   362 
Inventories  683   (364)  319 
Trade and other receivables  1,134   (109)  1,025 
Deferred income tax assets  145   (145)   
Cash and cash equivalents  561   (10)  551 
          
   2,523   (266)  2,257 
          
Total assets
  6,336   400   6,736 
          
 
Liabilities
Non-current liabilities
            
Financial liabilities — Borrowings  (1,347)  (2)  (1,349)
Deferred income tax liabilities     (140)  (140)
Retirement benefit obligations     (364)  (364)
Provisions for other liabilities and charges  (152)  93   (59)
Other liabilities  (45)  (25)  (70)
          
   (1,544)  (438)  (1,982)
          
Current liabilities
            
Trade and other liabilities  (1,129)  186   (943)
Financial liabilities — Borrowings  (575)  (3)  (578)
Current income tax liabilities     (54)  (54)
Provisions for other liabilities and charges     (18)  (18)
          
   (1,704)  111   (1,593)
Total liabilities
  (3,248)  (327)  (3,575)
          
Net assets
  3,088   73   3,161 
          
Equity
            
Share capital  201      201 
Share premium  2,469      2,469 
Other reserves  (122)  (288)  (410)
Retained earnings  345   364   709 
          
Total equity attributable to equity holders of the Company
  2,893   76   2,969 
Minority interest  195   (3)  192 
          
Total equity
  3,088   73   3,161 
          

F-61


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Balance sheet as at 31 December 2004
             
  UK GAAP Adjs IFRS
       
  (All figures in £ millions)
Assets
Non-current assets
            
Property, plant and equipment  473   (118)  355 
Intangible assets  2,890   388   3,278 
Investments in joint ventures and associates  48   (1)  47 
Deferred income tax assets     359   359 
Other financial assets  17   (2)  15 
Other receivables     102   102 
          
   3,428   728   4,156 
          
Current assets
            
Intangible assets — pre-publication     356   356 
Inventories  676   (362)  314 
Trade and other receivables  1,104   (171)  933 
Deferred income tax assets  165   (165)   
Cash and cash equivalents  613   (152)  461 
          
   2,558   (494)  2,064 
Non-current assets classified as held for sale     358   358 
          
   2,558   (136)  2,422 
          
Total assets
  5,986   592   6,578 
          
 
Liabilities
Non-current liabilities
            
Financial liabilities — Borrowings  (1,712)  (2)  (1,714)
Deferred income tax liabilities     (139)  (139)
Retirement benefit obligations     (408)  (408)
Provisions for other liabilities and charges  (123)  80   (43)
Other liabilities  (60)  (39)  (99)
          
   (1,895)  (508)  (2,403)
          
Current liabilities
            
Trade and other liabilities  (1,168)  300   (868)
Financial liabilities — Borrowings  (107)  (2)  (109)
Current income tax liabilities     (89)  (89)
Provisions for other liabilities and charges     (14)  (14)
          
   (1,275)  195   (1,080)
Liabilities directly associated with non-current assets classified as held for sale     (81)  (81)
          
Total liabilities
  (3,170)  (394)  (3,564)
          
Net assets
  2,816   198   3,014 
          
Equity
            
Share capital  201      201 
Share premium  2,473      2,473 
Other reserves  (132)  (491)  (623)
Retained earnings  61   688   749 
          
Total equity attributable to equity holders of the Company
  2,603   197   2,800 
Minority interest  213   1   214 
          
Total equity
  2,816   198   3,014 
          

F-62


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Adjustments to equity
                 
  Notes 1 Jan 2003 31 Dec 2003 31 Dec 2004
         
    (All figures in £ millions)
Total equity UK GAAP
      3,468   3,088   2,816 
Goodwill amortisation  a   66   228   394 
Intangible assets acquired  b      40   48 
Intangible assets — capitalised software costs  c   3       
Intangible assets — pre-publication expenditure  d          
Share-based payments  e   13   15   22 
Employee benefits  f   (259)  (284)  (338)
Leases  g   (12)  (22)  (33)
Joint ventures  h   (3)  (5)  (6)
Associates  i   (10)  (10)  (8)
Income taxes  j   (3)  (5)  (7)
Dividends  k   115   119   125 
Other      (2)  (3)  1 
Discontinued operations  l          
             
Total adjustments to equity
      (92)  73   198 
             
Total equity IFRS
      3,376   3,161   3,014 
             
Income statement for the year to 31 December 2003
             
  UK GAAP Adjs IFRS
       
  (All figures in £ millions)
Continuing operations
            
Sales  4,048   (198)  3,850 
Cost of goods sold  (1,910)  64   (1,846)
          
Gross profit
  2,138   (134)  2,004 
Operating expenses  (1,912)  318   (1,594)
Other net gains and losses  6   (12)  (6)
Share of results of joint ventures and associates     2   2 
          
Operating profit
  232   174   406 
Net finance costs  (80)  (13)  (93)
          
Profit before tax
  152   161   313 
Income tax  (75)  14   (61)
          
Profit for the year from continuing operations
  77   175   252 
Profit for the year from discontinued operations     23   23 
          
Profit for the year
  77   198   275 
          

F-63


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Income statement for the year to 31 December 2004
             
  UK GAAP Adjs IFRS
       
  (All figures in £ millions)
Continuing operations
            
Sales  3,919   (223)  3,696 
Cost of goods sold  (1,866)  77   (1,789)
          
Gross profit
  2,053   (146)  1,907 
Operating expenses  (1,832)  312   (1,520)
Other net gains and losses  9      9 
Share of results of joint ventures and associates  10   (2)  8 
          
Operating profit
  240   164   404 
Net finance costs  (69)  (10)  (79)
          
Profit before tax
  171   154   325 
Income tax  (62)  (1)  (63)
          
Profit for the year from continuing operations
  109   153   262 
Profit for the year from discontinued operations     22   22 
          
Profit for the year
  109   175   284 
          
Adjustments to profit
             
  Notes 2003 2004
       
    (All figures in £
    millions)
Profit for the year UK GAAP
      77   109 
          
Goodwill amortisation  a   242   204 
Intangible assets acquired  b   (4)  (5)
Intangible assets — capitalised software costs  c   (1)  (1)
Intangible assets — pre-publication expenditure  d       
Share-based payments  e   (23)  (16)
Employee benefits  f   1   6 
Leases  g   (10)  (12)
Joint ventures  h   (2)  (2)
Associates  i   (2)  (2)
Income taxes  j   (2)  (2)
Other      (1)  5 
Discontinued operations  l       
          
Total adjustments to profit for the year
      198   175 
          
Profit for the year IFRS
      275   284 
          

F-64


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Cash flow for the year to 31 December 2003
             
  UK GAAP Adjs IFRS
       
  (All figures in £ millions)
Cash flows from operating activities  228   172   400 
Cash flows from investing activities  (91)  (172)  (263)
Cash flows from financing activities  (228)  86   (142)
Effects of exchange rate changes on cash and cash equivalents  37   8   45 
          
Net (decrease)/increase in cash and cash equivalents
  (54)  94   40 
          
Cash and cash equivalents at beginning of year  340   148   488 
Cash and cash equivalents at end of year
  286   242   528 
          
Cash flow for the year to 31 December 2004
             
  UK GAAP Adjs IFRS
       
  (All figures in £ millions)
Cash flows from operating activities  387   175   562 
Cash flows from investing activities  (102)  (179)  (281)
Cash flows from financing activities  (255)  (6)  (261)
Effects of exchange rate changes on cash and cash equivalents  (3)  (1)  (4)
          
Net increase/(decrease) in cash and cash equivalents
  27   (11)  16 
          
Cash and cash equivalents at beginning of year  286   242   528 
Cash and cash equivalents at end of year
  313   231   544 
          
Effect of IAS 32 and IAS 39 transitional adjustment (note 1m)
             
  31 Dec 2004 Adj 1 Jan 2005
       
  (All figures in £ millions)
Non-current assets
            
Deferred income tax assets  359   5   364 
Financial assets — Derivative financial instruments     145   145 
          
Current assets
            
Financial assets — Derivative financial instruments     1   1 
          
Non-current liabilities
            
Financial liabilities — Borrowings  (1,714)  (134)  (1,848)
Financial liabilities — Derivative financial instruments     (40)  (40)
          
Current liabilities
            
Trade and other liabilities  (868)  14   (854)
Financial liabilities — Borrowings  (109)     (109)
Financial liabilities — Derivative financial instruments     (3)  (3)
          
Reserves
  (126)  12   (114)
          
First-time adoption exemptions applied
      IFRS 1 ‘First-time Adoption of International Financial Reporting Standards’ sets out the transition rules which must be applied when IFRS is adopted for the first time in reporting IFRS financial information. In

F-65


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
general the Group is required to select accounting policies in accordance with IFRS valid at its first IFRS reporting date and apply those polices retrospectively. The standard sets out certain mandatory exceptions to retrospective application and certain optional exemptions. The most significant optional exemptions adopted by the Group are set out below:
136Business combinations
      The Group has elected not to apply IFRS 3 ‘Business Combinations’ retrospectively to business combinations that occurred before the date of transition. Subject to the transition adjustments to IFRS required by IFRS 1, the accounting for business combinations before the date of transition is grandfathered at the date of transition from the UK GAAP financial statements.
2Employee benefits
      All cumulative actuarial gains and losses have been recognised in full in the period in which they occur in the statement of recognised income and expense in accordance with IAS 19 ‘Employee Benefits’ (as amended on 16 December 2004).
3Share-based payments
      The Group has elected to apply IFRS 2 ‘Share-based Payment’ retrospectively to all options granted but not fully vested at the date of transition. Consequently the share-based payment charge from 2003 represents the charge for all options granted and not fully vested at 31 December 2002.
4Summary of principal differences between International Financial instruments
      The Group has elected to apply IAS 39 ‘Financial Instruments: Recognition and Measurement’ and IAS 32 ‘Financial Instruments: Disclosure and Presentation’ from 1 January 2005. After this date, where hedge accounting cannot be applied under IAS 39, changes in the market value of financial instruments will be taken to the income statement. No adjustment to the 2003 or 2004 UK GAAP financial statements was required due to the chosen adoption date of IAS 32 and IAS 39.
5Cumulative translation differences
      The Group has deemed the cumulative translation differences for foreign operations to be zero at the date of transition. Any gains and losses on disposals of foreign operations will exclude translation differences arising prior to the transition date.
Significant adjustments
a. Goodwill amortisation — IFRS 3 ‘Business Combinations’ requires that goodwill is not amortised but instead is subject to an impairment review annually or when there are indications that the carrying value may not be recoverable. The Group has elected not to apply IFRS 3 retrospectively to business combinations before the date of transition.
b. Intangible assets acquired — Business combinations since the date of transition have been accounted for in accordance with IFRS 3 ‘Business Combinations’, with intangible assets recognised and amortised over their useful economic lives where they are separable or arise from a contractual or legal right. As part of the acquisition of Comstock Inc in February 2003, certain intangible assets were acquired, mainly relating to customer lists and acquired technology, which are being amortised over periods between two and 30 years. In addition, other less significant intangible assets, mainly relating to publishing rights, have been recognised for some of the smaller acquisitions made during 2004 and amortised over periods of up to 15 years.
c. Capitalised software costs — Under IAS 38 ‘Intangible Assets’ computer software which is not integral to a related item of hardware should be classified as an intangible asset. As such, certain computer

F-66


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
software costs have been re-classified from property, plant and equipment to intangible assets. In addition, certain costs relating to software development, previously expensed under UK GAAP, have been capitalised under IAS 38 and are being amortised over their estimated useful lives.
d. Pre-publication expenditure — Under IAS 38 ‘Intangible Assets’, intangible assets are required to be recognized if they meet the criteria of identifiability, control over a resource and existence or probability of inflow of future economic benefits. As such pre-publication costs (the direct costs incurred in the development of educational programmes and titles prior to their publication) have been re-classified from inventory to intangible assets. They continue to be amortised upon publication of the title over estimated economic lives of five years or less, being an estimate of the expected operating life cycle of the title, with a higher proportion of the amortisation taken in the earlier years.
e. Share-based payments — IFRS 2 ‘Share-based Payment’ requires that the expense incurred for equity instruments granted is recognised in the financial statements at their fair value measured at the date of grant and that the expense is recognised over the vesting period of the instrument. The Group has a number of employee option and performance share schemes. The Group has elected to apply IFRS 2 ‘Share-based Payment’ retrospectively to all options granted but not fully vested at the transition date. Consequently the share-based payment charge from 2003 represents the charge for all options granted and not fully vested at 31 December 2002.
f. Employee benefits — IAS 19 ‘Employee Benefits’ was amended on 16 December 2004. The Group has elected to adopt the December 2004 amendments to the standard early and differences between the actual and expected return on assets, changes in the retirement benefit obligation due to experience and changes in actuarial assumptions are included in full in equity in the statement of recognised income and expense. Therefore the amount recognised on the balance sheet in respect of liabilities for defined benefit pension and other post-retirement benefit plans represents the present value of the obligations for past service offset by the fair value of scheme assets.
      The service cost of benefits accruing is accounted for as an operating cost and the unwinding of the discount rate on the scheme liabilities and the expected return on scheme assets as a financing charge or financing income. The Group has adopted the same assumptions under IAS 19 as were used for FRS 17 purposes under UK GAAP in 2003 and 2004.
      The restated opening IFRS balance sheet reflects the fair value of the plan assets and the present value of the defined benefit obligation of the Group’s defined benefit schemes.
g. Leases — IAS 17 ‘Leases’ sets out additional criteria to be considered in ascertaining whether a lease is a finance or operating lease. Following a review of all lease agreements no properties have been re-classified.
      In addition, IAS 17 requires that the expense is recognised on a straight line basis over the lease term, including any rent-free periods given at the inception of a lease. Contracted future lease increments must also be amortised evenly over the full period of the lease rather than the period to which the lease is estimated to revert to market rates. The profit and loss account has been adjusted to take into account the amortisation of lease incentives over longer periods than under UK GAAP and to accelerate the charge in respect of fixed contractual increments in lease payments.
h. Joint ventures — Following a review, the Group has concluded that its 50% holding in Maskew Miller Longman should be accounted for as a joint venture under IFRS rather than its classification as a subsidiary under UK GAAP.
i. Joint ventures and associates — The results of all joint ventures and associates have been adjusted to take into account IFRS adjustments within their own financial statements.
j. Income taxes — IAS 12 ‘Income Taxes’, requires that deferred taxation also be provided on all temporary differences, not just timing differences as required under UK GAAP. Deferred tax is provided, using the liability method, on temporary differences arising between the tax bases of assets and liabilities and

F-67


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
their carrying amounts in the financial statements unless the initial recognition exemption applies. Deferred tax is not recognised for temporary differences arising on initial recognition of an asset or liability in a transaction other than a business combination if at the time of transaction neither accounting nor taxable profit is affected. Deferred taxation has been provided on the post-acquisition difference between the book and tax bases of intangible assets and goodwill if its amortisation is tax deductible. A deferred tax liability has also been recognised in respect of the undistributed earnings of subsidiaries other than where it is intended that those undistributed earnings will not be remitted in the foreseeable future.
      Deferred taxation has been recognised on the IFRS adjustments at the tax rates that have been enacted or substantively enacted by the balance sheet date and are expected to apply when the asset is realised or the liability is settled. Deferred tax assets are recognised to the extent that it is probable that future taxable profit will be available against which the temporary differences can be utilised.
k. Dividends — IAS 10 ‘Events after the Balance Sheet Date’ requires that dividends declared after the balance sheet date should not be recognised as a liability at the balance sheet date as they do not represent a present obligation at that date as defined by IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’.
      The final dividends relating to the years to 31 December 2002, 2003 and 2004 have been reversed and recognised as a liability in the years 2003, 2004 and 2005 respectively.
l. Discontinued operations — Consistent with the UK GAAP treatment, Recoletos has been treated as discontinued as at 31 December 2004 and met the criteria as ‘held for sale’ at that date. Accordingly the results are disclosed in one line in the income statement, ‘Profit for the year from discontinued operations’ for both 2003 and 2004 and, at 31 December 2004, it is disclosed in the balance sheet in two lines — ‘Non-current assets classified as held for sale’ and ‘Liabilities associated with non-current assets classified as held for sale’.
      When an asset’s carrying value will be recovered principally through a sale transaction rather than through continuing use and certain criteria regarding probability and proximity of the sale are satisfied, it is classified as held for sale and stated at the lower of carrying value and fair value less costs to sell. No depreciation is charged in respect of non-current assets classified as held for sale.
35.SUMMARY OF PRINCIPAL DIFFERENCES BETWEEN INTERNATIONAL ACCOUNTING STANDARDS AND UNITED STATES OF AMERICA GENERALLY ACCEPTED ACCOUNTING PRINCIPLESReporting Standards and United States of America generally accepted accounting principles
      The accompanying consolidated financial statements have been prepared in accordance withEU-adopted International Financial AccountingReporting Standards (“IFRS”), which differ in certain significant respects from generally accepted accounting principles in the United States of America (“US GAAP”). Such differences involve methods for measuring the amounts shown in the financial statements.
      The following is a summary of the adjustments to consolidated profit for the financial year and consolidated shareholders’ funds that would have been required in applying the significant differences between IFRS and US GAAP.

F-68


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Reconciliation of consolidated profit for the financial year
                  
    Year ended December 31
     
  Note 2005 2004 2003
         
    £m £m £m
Profit for the financial year under IFRS
      624   262   252 
US GAAP adjustments:                
 Intangible amortization  (i)  (60)  (75)  (97)
 Discontinued operations  (ii)     (1)  (3)
 Disposal adjustments  (iii)  (119)  3   (6)
 Pensions and other post-retirement benefits  (iv)  (26)  (23)  (4)
 Deferred taxation  (v)  1      (27)
 Share based payments  (vi)  (4)  (13)  (4)
 Derivative financial instruments  (vii)  (12)  (23)  35 
 Acquisition adjustments  (x)  1       
 Partnerships and associates  (viii)  (2)     (3)
 Minority interests  (ix)  2      (1)
 Other      (9)  (1)  4 
 Taxation effect of US GAAP adjustments  (v)  15   53   27 
             
Total US GAAP adjustments      (213)  (80)  (79)
             
Profit for the financial year under US GAAP
      411   182   173 
             
Profit from continuing operations (less charge for applicable taxes 2005: £107m, 2004: £11m, 2003: £71m)      174   166   160 
(Loss)/profit from discontinued operations (less charge for/(benefit from) applicable taxes 2005: £(1)m; 2004: £6m, 2003: £22m)      (2)  16   16 
Profit/(loss) on disposal of discontinued operations (less charge for applicable taxes 2005: £1m; 2004: £nil, 2003: £2m)      239      (3)
             
Profit for the financial year under US GAAP
      411   182   173 
             
                  
    Year ended December 31
     
  Note 2006 2005 2004
         
    £m £m £m
Profit for the financial year under IFRS
      446   624   262 
US GAAP adjustments:                
 Intangible amortization  (i)   (50)  (60)  (74)
 Discontinued operations  (iii)   (71)     (2)
 Leases  (v)   (5)     3 
 Disposal adjustments  (iv)      (119)   
 Pensions and other post-retirement benefits  (vi)   (19)  (26)  (23)
 Share-based payments  (vii)      (4)  (13)
 Derivative financial instruments  (viii)   (11)  (12)  (23)
 Acquisition adjustments  (xii)   (3)  1    
 Partnerships and associates  (x)   (1)  (2)   
 Minority interests  (xi)   1   2    
 Other      (2)  (9)  (1)
 Taxation effect of US GAAP adjustments  (xiv)   56   16   53 
             
Total US GAAP adjustments      (105)  (213)  (80)
             
Net income under US GAAP
      341   411   182 
             
Profit from continuing operations (less (benefit from)/charge for applicable taxes 2006: £(45)m, 2005: £100m, 2004: £2m)      398   164   153 
(Loss)/profit from discontinued operations (less charge for applicable taxes 2006: £8m; 2005: £8m, 2004: £15m)      (57)  8   29 
Profit on disposal of discontinued operations (less charge for applicable taxes 2006: £nil; 2005: £1m, 2004: £nil)         239    
             
Net income under US GAAP
      341   411   182 
             

F-69F-60


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
                                
   Year ended December 31   Year ended December 31
        
 Note 2005 2004 2003 Note 2006 2005 2004
                
Presentation of earnings per equity share under US GAAP
  (xi)            (xiii)          
Earnings per equity share     (p)  (p)  (p)
Earnings/(loss) per equity share     (p)  (p)  (p)
Basic:                          
Continuing operations     21.8  20.9  20.1      49.9  20.5  19.2 
Discontinued operations     29.7  2.0  1.7      (7.2)  31.0  3.6 
                  
Total     51.5  22.9  21.8      42.7  51.5  22.8 
                  
Diluted:                          
Continuing operations     21.7  20.8  20.1      49.8  20.5  19.2 
Discontinued operations     29.7  2.0  1.7      (7.2)  30.9  3.6 
                  
Total     51.4  22.8  21.8      42.6  51.4  22.8 
                  
Average shares outstanding (millions)     797.9  795.6  794.4      798.4  797.9  795.6 
Dilutive effect of stock options (millions)     1.1  1.1  0.9      1.5  1.1  1.1 
                  
Average number of shares outstanding assuming dilution (millions)     799.0  796.7  795.3      799.9  799.0  796.7 
                  
Reconciliation of consolidated shareholders’ funds
                          
   Year ended    Year ended
   December 31    December 31
         
 Note 2005 2004  Note 2006 2005
             
   £m £m    £m £m
Shareholders’ funds under IFRS
Shareholders’ funds under IFRS
     3,564  2,800 
Shareholders’ funds under IFRS
     3,476  3,564 
US GAAP adjustments:US GAAP adjustments:          US GAAP adjustments:          
Goodwill  (i)  88  136 Goodwill  (i)  76  81 
Intangibles  (i)  231  267 Intangibles  (i),(ii)  158  231 
Discontinued operations  (ii)    49 Discontinued operations  (iii)  (64)  7 
Pensions and other post-retirement benefits  (iv)  61  62 Leases  (v)  (5)   
Derivative financial instruments  (vii)  15  11 Pensions and other post-retirement benefits  (vi)    61 
Acquisition adjustments  (x)  26  20 Derivative financial instruments  (viii)  5  15 
Partnerships and associates  (viii)  15  9 Share-based payments  (vii)  (3)   
Minority interests  (ix)  (30)  (15)Acquisition adjustments  (xii)  24  26 
Other     (6)  3 Partnerships and associates  (x)  9  15 
Taxation effect of US GAAP adjustments  (v)  (126)  (124)Minority interests  (xi)  (26)  (30)
       Other     (8)  (6)
Taxation effect of US GAAP adjustments  (xiv)  (61)  (126)
       
Total US GAAP adjustmentsTotal US GAAP adjustments     274  418 Total US GAAP adjustments     105  274 
               
Shareholders’ funds under US GAAP
Shareholders’ funds under US GAAP
     3,838  3,218 
Shareholders’ funds under US GAAP
     3,581  3,838 
               
Restatements
      The consolidated financial statements on pages F-3 toF-68 are the Group’s first financial statements to be prepared in accordance withEU-adopted IFRS. Consolidated financial statements of Pearson until December 31, 2004 had been prepared in accordance with UK GAAP. UK GAAP differs in certain respects from IFRS. When preparing the Group’s 2005 consolidated financial statements, management has amended certain accounting, valuation and consolidation methods applied in the UK GAAP financial statements to

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
comply with IFRS. The comparative figures in respect of 2004 and 2003 were restated to reflect these adjustments. Note 34 included in “Item 17. Financial Statements”, describes how, in preparing the consolidated financial statements, the Group has applied IFRS as adopted for use in the EU under the first-time adoption provisions as set out in IFRS 1. The reconciliations between IFRS and US GAAP for the years ended December 31, 2004 and 2003 have been restated accordingly.
      A summary of the principal differences and additional disclosures applicable to the Group are set out below:
     (i) (i) Goodwill and other intangibles
      Both IFRS and US GAAP require purchase consideration to be allocated to the net assets acquired at their fair value on the date of acquisition, with the difference between the consideration and the fair value of the identifiable net assets recorded as goodwill.
      Under UK GAAP, before the transition to IFRS on January 1, 2003, goodwill arising on acquisitions prior to January 1, 1998 was written off directly to reserves in the year of acquisition and goodwill arising from January 1, 1998 to December 31, 2002 was capitalized and amortized over its estimated useful life. Following the adoption of IFRS on January 1, 2003, goodwill is no longer required to be amortized butGoodwill is tested for impairment on an annual basis in accordance with IFRS 3‘Business Combinations’. Goodwill arising on business combinations before January 1, 2003 has been grandfathered under the first time adoption provisions of IFRS 1.
      For the purposes of US GAAP, all goodwill written off against reserves before the transition to IFRS has been reinstated as an asset on the balance sheet. Prior to July 1, 2001, goodwill was amortized over its estimated useful life. In July 2001, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard (“FAS”) 142,“Goodwill and Other Intangible Assets”which required that goodwill no longer be amortized. SFAS 142 was effective for the Group on January 1, 2002. As a result, goodwill is no longer subject to amortization subsequent to the date of adoption, but is subject to the annual impairment testing provisions of FAS 142. Impairment reviews were performed and, consistent with IFRS, no cash-generatingreporting units were impaired.
      Under UK GAAP, before the transition to IFRS on January 1, 2003, intangible assets (other than goodwill) could only be recognized where they could be disposed of separately from the businesses to which they related. Consequently the Group did not recognize any acquired intangible assets other than goodwill prior to January 1, 2003. In accordance with IFRS 3, acquired intangible assets (such as publishing rights, customer relationships, technology and trademarks) in respect of acquisitions after January 1, 2003 have been capitalized and amortized over a range of estimated useful lives between 2 and 30 years. Under US GAAP, acquired intangible assets on all acquisitions have been capitalized and amortized. The identified intangibles have been valued based on independent appraisals and management evaluation and analysis. Under both IFRS and US GAAP pre-publication costs and software development costs (both of which are internally generated) are also recognized as intangible assets. Under US GAAP, all intangible assets would be classified asnon-current.
      GAAP differences between IFRS and US GAAP arise from the following factors. In respect of acquisitions prior to January 1, 1998, goodwill has remained as a deduction to reserves under IFRS in accordance with the transition rules of IFRS 1 but has been capitalized under US GAAP. In respect of acquisitions between January 1, 1998 and December 31, 2002, no acquired intangible assets other than goodwill have been recognized under IFRS while they have been fully recognized under US GAAP. Amortization of goodwill ceased on December 31, 2001 under US GAAP but ceased a year later under IFRS. Also, contingent consideration is recognized as a cost of acquisition under IFRS, if it is probable that the contingent consideration will be paid and can be measured reliably. Under US GAAP, contingent consideration is only recognisedrecognized when paid (see acquisition adjustments (x)(xii) below).

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The movement of the US GAAP adjustments to goodwill and intangibles in the years ended December 31, 2006 and 2005 is as follows:
         
  Goodwill Intangible assets
     
  £m £m
Year ended December 31, 2004  129   267 
Foreign exchange differences  (9)  28 
Amortization     (60)
Net movement in deferred consideration  (39)   
Acquisitions     (4)
       
Year ended December 31, 2005  81   231 
       
Foreign exchange differences  1   (25)
Amortization     (50)
Net movement in deferred consideration  (4)   
Acquisitions  (2)  2 
       
Year ended December 31, 2006  76   158 
       
     (ii) (ii) Pre-publication assets
      In accordance with IAS 1 ‘Presentation of Financial Statements’ the Group classifies its pre-publication assets as current intangibles under IFRS, as they are expected to be consumed within their normal identifiable operating cycle. Under IFRS an asset shall be disclosed as current when it is expected to be realized in, or is intended for sale or consumption in, the entity’s normal operating cycle, provided that the operating cycle is clearly identifiable. Where the operating cycle is not clearly identifiable its duration is assumed to be twelve months. Under US GAAP, these assets are classified as long-term assets, as the benefit will accrue to several future annual periods, in accordance with ARB 43 ‘Restatement & Revision of Accounting Research Bulletin (Working Capital)’. As a result of this difference in classification, non-current intangible assets are £402m higher under US GAAP in 2006 than under IFRS (2005: £426m higher) and current intangible assets under US GAAP are £nil for all periods presented.
      The Company determines a normal operating cycle under IFRS separately for each entity/ cash generating unit within the group with distinct economic characteristics. Each of its education businesses has an operating cycle which is clearly identifiable. The duration of the cycle is primarily based on the expected period over which the educational programs and titles will generate cash flows, and also takes account of the time it takes to produce the educational programs. The pre-publication assets are amortized from the date of first delivery of the program. The normal operating cycle commences when pre-publication activity starts and typically ends 5 years after the date of first delivery for the School, Higher Education and Professional segments, and 4 years after the date of first delivery for the Penguin segment.
      Under US GAAP, the Company’s investment in pre-publication assets has been classified as an investing activity, whereas under IFRS, investment in pre-publication assets has been classified as an operating activity. Consequently under US GAAP, net cash generated from operations, in respect of this item, is £213m higher in 2006 than under IFRS (£222m higher in 2005 and £181m higher in 2004) while the cash flow from investing activities in 2006 is £213m lower than under IFRS (£222m lower in 2005 and £181m lower in 2004).
(iii) Discontinued operations
      Discontinued operations comprise the differences between IFRS and US GAAP in respect of Pearson Government solutions for 2006, 2005 and 2004 and Recoletos for 2005 2004 and 2003.2004.

F-63


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The operating profits,(loss)/profit before tax, assets and liabilities in respect of discontinued operations under US GAAP are as follows:
                        
 2005 2004 2003 2006 2005 2004
            
 £m £m £m £m £m £m
Total operating profit/(loss) in respect of discontinued operations  (3)  21  27 
Total (loss)/profit before tax in respect of discontinued operations  (49)  17  49 
Assets in respect of discontinued operations    413      240  388  729 
Liabilities in respect of discontinued operations    (148)      (27)  (51)  (183)
      Under US GAAP, the Company has included the Cumulative Translation Adjustment (CTA) relating to the assets held for sale in relation to Government Solutions in its impairment analysis as required by EITF 01-05. As the resulting carrying value exceeds the fair value less cost to sell, the Group has recognized an impairment loss of £70m in its US GAAP income statement for the year ended December 31, 2006. The CTA will be released to net income upon the completion of the disposal of Government Solutions in 2007.
      Under IFRS, the Group has measured its assets and liabilities that have been classified as held for sale at the lower of its carrying amount and fair value less costs to sell. IFRS does not require the CTA to be included in the carrying value when assessing an asset held for disposal for impairment. As a result, there is no impairment loss recognized in the Group’s financial statements under IFRS in 2006.
     (iii) (iv) Disposal adjustments
      In 2005 2004 and 20032004 gains and losses were recognized under IFRS on the disposal of a number of the Group’s businesses and assets. Adjustments made to reconcile US GAAP and IFRS have an effect on the net assets of these businesses and, accordingly, a corresponding impact on the gain or loss on disposal. There were no corresponding disposal adjustments in 2006.
      Under IFRS, goodwill previously written off to reserves, which has been grandfathered under the first time adoption provisions of IFRS 1, is not treated as part of the calculation of profit or loss on disposal when the business to which it relates is sold. This usually results in higher profits on disposal than under US GAAP, where the goodwill was capitalized and forms part of the calculation of profit or loss on disposal.
      Under both IFRS and US GAAP, it is necessary to factor into the disposal calculation any cumulative translation adjustment associated with the business. However, a GAAP difference arises on disposals of entities acquired before the adoption of IFRS as the translation reserve was reset to zero at the date of the adoption of IFRS in accordance with the transitional provisions in IFRS 1. Under US GAAP, the translation reserve runs from the date of acquisition.
      Differences can arise on the treatment of property disposals and sale and leaseback transactions. The timing of recognition of profits or losses on these transactions can differ between IFRS and US GAAP.
The reconciling items between IFRS and US GAAP in respect of disposals are summarisedsummarized as follows:
                        
 2005 2004 2003 2006 2005 2004
            
 £m £m £m £m £m £m
Difference in carrying value on disposal  (86)         (86)   
Cumulative translation adjustment  (33)         (33)   
Timing on property disposals    3  (6)
              
Total US GAAP differences in respect of disposals
  (119)  3  (6)    (119)   
              
(v) Leases
      During the year, the Group disposed of one of its properties in a sale and lease back transaction. The resulting lease qualifies under both IFRS and US GAAP as an operating lease. A GAAP difference arises as under US GAAP any gain that arises on the sale is deferred and spread over the remaining life of the lease. In accordance with IAS 17, the gain on disposal was recognized immediately in the income statement as the transaction was established at fair value.

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
     (iv)(vi) Pensions and other post-retirement benefits
      The Group operates defined benefit pension plans for its employees and former employees throughout the world. The largest defined benefit schemeplan is a funded schemeplan operated in the UK.
      In 2006, the Group adopted FAS 158 ‘Employers’ accounting for defined benefit pension and other post retirement plans’, this applies in conjunction with FAS 87 ‘Employers’ Accounting for Pensions’. FAS 87 has been applied during 2004 and 2005.
      Under IFRS, the expense of defined benefit pension schemesplan and other post-retirement benefits is charged to the income statement as an operating expense over the periods benefiting from the employee’s services. The charge is based on actuarial assumptions reflecting market conditions at the beginning of the financial year.
      Under US GAAP, the annual pension cost comprises the estimated cost of benefits accruing in the period as determined in accordance with SFAS 87“Employers Accounting for Pensions”. The methodology required is broadly similar to IFRS, however, different assumptions on the expected asset return are used in the

F-72


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
SFAS 87 pension calculation. Additionally, under US GAAP, where an accumulated benefit obligation exists in excess of the fair value plan assets and is not covered by a liability recognized on the balance sheet, an additional minimum pension liability has been booked with the offset as a reduction to equity through other comprehensive income. Under IFRS, there is no requirement to recognize a minimum pension liability in respect of the unfunded accumulated benefit obligation.
      Under IAS 19, the Group has recognized a pension obligation representing the excess of the defined benefit obligation over the fair value of assets as at December 31, 2005 and December 2005.31, 2006. Actuarial gains and losses, i.e. the difference between the expected development of the assets and liabilities and the actual development, are recognized immediately through the statement of recognized income and expenses.
      Under SFASboth FAS 158 and FAS 87, in addition to the Group haspension expense items recognized prepaid pension cost amounting to £57 millionunder IFRS, actuarial gains and a minimum pension liability of £298 millionlosses in respect of pensions. In respect of post-retirement benefit plans the accrued pension cost amounts to £49 million as at December 31, 2005. The difference between the net balance sheet position and the plans’ funded status (the difference between the fair valueexcess of the plan assets and liabilities) is held as an unrecognized off-balance sheet item and spreadcorridor are recognized over the employees’average remaining service lifetimes.life of employees. However, the unrecognized amount attributable to actuarial gains and losses falling within a 10% corridor (i.e. 10% of the greater of the market value of the plan assets or plan liabilities) is deferred and not spread. Under US GAAP this results in an £19m increase in the pension charge in 2006 (2005: £26m; 2004: £23m).
      Under FAS 87, the accrual or prepayment recognized in the balance sheet in respect of pensions represents the cumulative income statement charges net of contributions to the scheme since transition to the standard. In addition to this amount, FAS 87 requires that an additional minimum liability is recorded for any plan where the accumulated benefit obligation exceeds the fair value of the plan assets by an amount greater than the liability recognized in the balance sheet.
      Under FAS 158, the provision or surplus recognized on the balance sheet represents the difference between the fair value of plan assets and the projected benefit obligation.
      The adoption of FAS 158 resulted in the recognition of a pension obligation representing the excess of the defined benefit obligation over the fair value of assets. The effect was an increase in the pension liability under US GAAP of £44m. At December 31, 2006 there is no difference between the pension liabilities under IFRS and US GAAP. For the year ended December 31, 2005 the Group had recognized prepaid pension costs amounting to £57m and a minimum pension liability of £298m in respect of pensions and accrued pension costs amounting to £49m in respect of post-retirement benefit plans in line with FAS 87.
     (v)(vii) Deferred taxation
      IAS 12“Income Taxes” requires a full provision to be made for deferred taxes. Deferred taxes are to be accounted for on all temporary differences with deferred tax assets recognized to the extent that they are more likely than not recoverable against future taxable profits. Under US GAAP deferred tax assets not considered recoverable are adjusted for through a separate valuation allowance in the balance sheet. There are no separate valuation allowances under IFRS. Under US GAAP, deferred taxes are accounted for in accordance with SFAS 109,“Accounting for Income Taxes” with a full provision also made for deferred taxes on all temporary differences and a valuation allowance established for the amount of the deferred tax assets not considered recoverable. This is similar to the treatment required under IAS 12.
      The reconciling items in 2005 and 2004 reflect the impact of recording the full provision and deferred tax assets, net of valuation allowance, and are summarized below:
                     
  Income Equity Income Equity Income
  2005 2005 2004 2004 2003
           
  £m £m £m £m £m
Tax effect of GAAP adjustments on:
                    
Goodwill and intangible amortization  18   (121)  17   (129)  20 
Derivative financial instruments  3   (5)  38   (3)  (21)
Options, pensions, disposals and other adjustments  (6)     (2)  8   28 
                
Total taxation effect of US GAAP adjustments
  15   (126)  53   (124)  27 
                
      Income tax adjustments on the GAAP differences on goodwill and intangible amortization are calculated by reference to each specific acquisition. These adjustments arise on tax deductible goodwill and intangibles primarily on acquisitions prior to January 1, 2003 where intangibles have been recognized under US GAAP which have not been recognized under IFRS. The net effect of the adjustments is to recognize a smaller deferred tax liability under US GAAP.
      Adjustments to the deferred tax on derivatives are provided on the gross adjustment to the value of the derivatives at the balance sheet date with the movement on the tax adjustment shown as a reconciling item in the profit and loss account.

F-73


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The recognized deferred tax asset is based upon the expected future utilization of tax loss carryforwards and the reversal of other temporary differences. For financial reporting purposes, the Group has recognized a valuation allowance for those benefits for which realization does not meet the more likely than not criteria.
      The valuation allowance has been recognized in respect of the tax loss carryforwards. The Group regularly reviews the adequacy of the valuation allowance and is recognizing these benefits only as reassessment indicates that it is more likely than not that the benefits will be realized.
      The deferred tax item in 2003 also incorporates the effect of a change in estimate in respect of deferred tax assets relating to a purchase business combination in prior years, which was recorded through the profit and loss account under IFRS, but which was required to be adjusted against goodwill under US GAAP.
     (vi) Share basedShare-based payments
      Under both IFRS and US GAAP, the share-based payment charge is determined based on the fair value of the award at the grant date and is spread over the vesting period.
      Under both IFRS and US GAAP, the fair value of awards is determined at the date of grant using whichever of the Black-Scholes, Binomial and Monte Carlo model is most appropriate to the award. These models require assumptions to be made regarding share price volatility, dividend yield, risk freerisk-free rate of return and expected option lives. Differences
      The Group adopted FAS 123(R) as at January 1, 2006 using the ‘Modified Prospective Application’ transition method. In 2006, differences between US GAAP and IFRS relate to the treatment of dual-indexed awards which are considered equity-settled under IFRS. Under US GAAP these awards are classified as liabilities and revalued to their fair value at each balance sheet date. On adoption the Group reclassified £1.2m relating to dual-indexed awards from equity to liabilities and revalued them. The revaluation of these awards

F-65


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
on adoption and at year-end resulted in an increase of the share-based payment charge by £1m. This increase was offset by differences in the IFRS and US GAAP charge due to the different treatment of forfeitures in prior years.
      In 2005, differences between the US GAAP and IFRS charge arewere mainly due to the different treatment of options with graded vesting features. Under IFRS the charge is recognized as the options gradually vest, whereas under US GAAP the charge is recognized on a straight linestraight-line basis over the vesting period resulting in an additional cost of £5.4 million.£5m (2004: £13m). The remainder of the adjustment in 2005 relates to the treatment of forfeitures.
      Differences also arise between US GAAP and IFRS on the calculation of deferred tax on share-based payments. Whereas under IFRS the deferred tax benefit is calculated based on the intrinsic value of the option/share at the balance sheet date, FAS 123(R) requires the tax benefit to be calculated based on the compensation expense recognized during the year.
     (vii)(viii) Derivative financial instruments
      Prior to the adoption of IAS 39‘Financial Instruments: Recognition and Measurement’ on January 1, 2005, the Group’s derivatives were recorded as hedging instruments. Amounts payable or receivable in respect of interest rate swaps were accrued with net interest payable over the period of the contract. Unrealized gains and losses on currency swaps and forward currency contracts were deferred and recognized when paid.
Following the adoption of IAS 39, derivatives are required to be recognized at fair value using market prices or established estimation techniques such as discounted cash flow or option valuation models. The transitional effect of recording all the Group’s derivative financial instruments at fair value on January 1, 2005 is shown in note 34 to these financial statements.
      For both IFRS and US GAAP, the Group designates certain of the derivative financial instruments in its portfolio to be hedges of the fair value of its bonds (fair value hedges) or hedges of net investment in foreign operations (net investment hedges). Changes in the fair value of derivatives that are designated and qualify as fair value hedges are recorded in the income statement, together with the change in fair value of the hedged assets or liability attributable to the hedgehedged risk. The effective portion of changes in the fair value of derivatives that are designated and qualify as net investment hedges are recognized in equity. Gains and losses accumulated in equity are included in the income statement when the corresponding foreign operation is disposed of. Gains or losses relating to the ineffective portion are recognized immediately in the income statement. Changes in the fair value of derivatives not in hedging relationships are recognized in the income statement.
      In 2003, underUnder US GAAP, certain of the Group did not meet the prescribed designation requirements and hedge effectiveness tests to obtain hedge accounting. Consequently, for that year, the Group has recorded the changes in the fair values of its derivative contracts through earnings under US GAAP. Certain derivativeGroup’s financial instruments met the designation and testing requirements for hedge accounting for 2004from January 1, 2004. Under IFRS, hedge accounting has only been available from the date of adoption of IAS 39, on January 1, 2005. This additional year of hedge accounting under US GAAP gives rise to a difference between IFRS and 2005.

F-74


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)US GAAP in respect of shareholders’ funds.
      On adoption of IAS 39 on January 1, 2005, certain of the Group’s derivative financial instruments were deemed to be in fair value hedging relationships for the purposes of calculating the transition adjustment. The Group has elected not to designate all of these derivatives as hedges on an ongoing basis. In this circumstance, the transitional adjustment to the carrying value of those bonds deemed to be in fair value hedging relationships is being amortized over the life of the corresponding derivative financial instrument. This gives rise to a difference between IFRS and US GAAP, as this amortization is included in the income statement under IFRS with no corresponding entry under US GAAP.
     (viii)(ix) Revenue recognition
      The Group recharges some of its freight revenue to its customers. As this income is incidental to the Group’s main revenue generating business, this income is classified as other income under IFRS as disclosed in note 5 to these financial statements. Under US GAAP freight recharges should be recognized as revenue in accordance with EITF 00-10 ‘Accounting for Shipping and Handling Fees and Costs’. The Group has also

F-66


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
reclassified distribution and subrights income to revenue for all years presented. This resulted in an increase in sales under US GAAP of £94m in 2006 (2005: £84m; 2004: £83m).
     (x) Partnerships and associates
      There is no difference between IFRS and US GAAP in the accounting for partnerships and associates. However, the accounts of partnerships and associates must be adjusted from IFRS to US GAAP, which has an impact on the results of the partnerships and associates, as well as the carrying value of the investment in these entities. Principal differences identified with respect to the Group’s investments in partnerships and associates include: historic goodwill, pensions and derivatives.
      Under US GAAP, in accordance with Accounting Principles Board Opinion (“APB”) No. 18,“The Equity Method of Accounting for Investments in Common Stock”, the Group periodically reviews its equity method investments for impairment. These reviews are performed to determine whether declines in market values of investments below their carrying values are deemed to be other than temporary.
     (ix) (xi) Minority interests
      Under IFRS, when less than 100% of a subsidiary has been acquired, minority interest in a business combination is stated at the minority’s proportion of the net fair value of acquired assets, liabilities and contingent liabilities assumed. Under US GAAP, the minority interest is valued at historical book value. In the years ended December 31, 2006, 2005 2004 and 2003,2004, there was no difference between IFRS and US GAAP in the recognition of minority interest. In all years, minority interests represent the minority share of US GAAP adjustments.
      Under IFRS, minority interest is classified as a component of shareholders’ equity. Under US GAAP, minority interest is classified outside of equity.
     (x) (xii) Acquisition adjustments
      Under US GAAP, consideration related to the acquisition of businesses contingent on a future event such as achieving specific earnings levels in future periods, that is treated as additional purchase price is recorded only when the specified conditions are met and the consideration determinable, in accordance withSFAS 141 “Business Combinations.”Consideration related to the acquisition of a business contingent on a future event that is treated as compensation expense is recorded over the period in which the compensation is earned. Under IFRS, contingent consideration is treated as part of the purchase price on the date of acquisition, if it is probable that the contingent consideration will be paid and can be measured reliably. Additionally, certain post-acquisition restructuring costs are capitalized under US GAAP in accordance with Emerging Issues Task Force No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination”, but are charged to the income statement under IFRS.
     (xi) (xiii) Presentation of earnings per equity share
      Under US GAAP an entity that reports a discontinued operation or cumulative effect of an accounting change must present basic and diluted EPS for those line items.discontinued operations or the cumulative effect of an accounting change. Accordingly, the Group has presented EPS for income from continuing operations, discontinued operations and net income.
     (xii) (xiv) Deferred taxation
      Under IFRS, IAS 12“Income Taxes”, deferred tax is recognized if it is probable that sufficient taxable profit is available against which the temporary difference can be utilized. Under US GAAP, deferred tax is recognized in full but then reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax asset will not be realized.

F-67


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
      The reconciling items in 2006, 2005 and 2004 reflect the impact of recording the full provision and deferred tax assets, net of valuation allowance, and are summarized below:
                     
  Income Equity Income Equity Income
  2006 2006 2005 2005 2004
           
  £m £m £m £m £m
Tax effect of GAAP adjustments on:
                    
Goodwill and intangible amortization  20   (94)  18   (121)  17 
Derivative financial instruments  3   (1)  3   (5)  38 
Options, pensions, disposals and other adjustments  33   34   (6)     (2)
                
Total taxation effect of US GAAP adjustments
  56   (61)  15   (126)  53 
                
      Income tax adjustments on the GAAP differences on goodwill and intangible amortization are calculated by reference to each specific acquisition. These adjustments arise on tax deductible goodwill and intangibles primarily on acquisitions prior to January 1, 2003 where intangibles have been recognized under US GAAP which have not been recognized under IFRS. The net effect of the adjustments is to recognize a smaller deferred tax liability under US GAAP.
      Adjustments to the deferred tax on derivatives are provided on the gross adjustment to the value of the derivatives at the balance sheet date with the movement on the tax adjustment shown as a reconciling item in the profit and loss account.
      Valuation allowances have previously been recognized in respect of the tax losses carried forward. Following a review of the tax position in the US and the likely utilization of operating losses, the Group has released its valuation allowance in respect of the deferred tax asset relating to its US share-based payment plans amounting to £38m in 2006. These plans are not in the money and, consequently, a deferred tax asset has not been recognized in line with IAS 12. FAS 123(R) only permits a valuation allowance where there are insufficient future taxable profits to utilize the reversal of the temporary difference.
Other disclosures required by US GAAP
     Consolidation
Consolidation
      The consolidated financial statements include the accounts of the Group and majority-owned and controlled subsidiaries. Under IFRS, the investments in companies in which the Group is unable to exercise

F-75


NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
control but has the ability to exercise significant influence over operating and financial policies are accounted for by the equity method, which is consistent with the equity method under US GAAP. Accordingly, the Group’s share of the net earnings of these companies is included in the consolidated profit and loss. The investments in other companies are carried at cost. Inter-company accounts and transactions are eliminated upon consolidation.
      The Group consolidates variable interest entities where we are deemed to be the primary beneficiary of the entity. Operating results for variable interest entities in which we are deemed the primary beneficiary are included in the profit and loss account from the date such determination is made.
     Use of estimates
Use of estimates
      Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Accounting estimates have been used in these financial statements to determine reported amounts, including realizability, useful lives of tangible and intangible assets, income taxes and other items. Actual results could differ from those estimates.
Companies Act 1985
      The consolidated financial statements do not constitute “statutory accounts” within the meaning of the Companies Act 1985 of Great Britain for any of the periods presented. Statutory accounts for the years ended December 31, 2005, 2004 and 2003 have been filed with the United Kingdom’s Registrar of Companies. The auditors have reported on these accounts. Their reports were unqualified and did not contain statements under Section 237 (2) or (3) of that Act.
      These consolidated financial statements include all material disclosures required by generally accepted accounting principles in the United Kingdom including those Companies Act 1985 disclosures relating to the profit and loss account and balance sheet items.
Recent U.S. Accounting Pronouncements
      In November 2004, the FASB issued FASB Statement No. 151“Inventory Costs — An Amendment of ARB No. 43, Chapter 4” (“FAS 151”). FAS 151 amends the guidance in ARB No. 43, Chapter 4 “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. Additionally, FAS 151 requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. FAS 151 is effective for fiscal years beginning after June 15, 2005. The Group will adopt FAS 151 in 2006 but does not expect the adoption of the new standard to have a material impact.
      In December 2004, the FASB issued FASB Statement No. 153“Exchanges of Nonmonetary Assets — An Amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions” (“FAS 153”). FAS 153 eliminates the exception from fair value measurement for non monetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” and replaces it with an exception for exchanges that do not have commercial substance. FAS 153 specifies that a non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. FAS 153 is effective for the fiscal periods beginning after June 15, 2005. The Group will adopt FAS 153 in 2006 but does not expect the adoption of the new standard to have a material impact.

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
     U.S. Accounting Pronouncements
      In December 2004,July 2006, the FASB issued FASB Statement No. 123 (revised 2004)“Share-Based Payment” (“FAS 123(R)”), which replaces FAS No. 123“Accounting for Stock-Based Compensation” (“FAS 123”) and supersedes APB Opinion No. 25“Accounting for Stock Issued to Employees.” FAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim or annual period after June 15, 2005, with early adoption encouraged. The pro forma disclosures previously permitted under FAS 123 no longer will be an alternative to financial statement recognition. The Group will adopt FAS 123(R) in 2006 but does not expect the adoption of the new standard to have a material impact as it already recognizes share-based payment cost in its income statement in accordance with FAS 123.
      In March 2005, the FASB issued FASB Interpretation No. 47“Accounting48, “Accounting for Conditional Asset Retirement Obligations —Uncertainty in Income Taxes” (“FIN 48”), an interpretationInterpretation of FASB Statement No. 143” (“109. The provisions of FIN 47”). FIN 47 clarifies the timing of liability recognition for legal obligations associated with the retirement of a tangible long-lived asset when the timing and/or settlement48 are conditional on a future event. FIN 47 is effective for the fiscal periods ending after December 15, 2005. The adoption of FIN 47 did not have a material impact on the Group.
      In May 2005, the FASB issued Statement No. 154,“Accounting Changes and Error Corrections — A replacement of APB Opinion No. 20 and FASB Statement No. 3” (“FAS 154”). This statement requires retrospective application to prior periods’ financial statements of changes in accounting principles unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement applies to all voluntary changes in accounting principles and changes required by an accounting pronouncement that does not include specific transition provisions. FAS 154 is required to be adopted in fiscal years beginning after December 15, 2005. FAS 154 would2006 with the cumulative effect of a change in accounting principle recorded as an adjustment to opening retained earnings. The provisions of FIN 48 are to be applied to all tax positions upon initial adoption of this standard. FIN 48 requires that the Group recognizes in the financial statements the impact of a tax position, if that position is more likely than not have had a material effectof being sustained on audit, based on the financial position, results of operations or cash flowstechnical merits of the Group under US GAAP as at December 31, 2005.
      In October 2005,position. FIN 48 also provides guidance on derecognizing, classification, interest and penalties, accounting in interim periods, disclosure, and transition attributable to the FASB issued FASB Staff Position (FSP) 13-1“Accounting for Rental Costs Incurred during a Construction Period” (“FSP 13-1”). FSP 13-1 requires rental costs associated with ground or building operating leases that are incurred during a construction period to be recognized as rental expense and included in income from continuing operations. FSP 13-1 is effective for the fiscal periods beginning after December 15, 2005. The Group will adopt FSP 13-1 in 2006 but does not expect the adoption of the new standard to have a material impact.
      In January 2006 the FASB issued FASB Statement No. 155“Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140” (“FAS 155”). FAS 155 provides entities with relief from having to separately determine the fair value of an embedded derivative that would otherwise be required to be bifurcated from its host contract. FAS 155 is effective for all financial instruments acquired, issued or subject to a remeasurement event occurring after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Grouptax position. Management is currently evaluatingassessing the impact of FIN 48 on the adoption of FAS 155 will have, but does not expect it to have a material impact.Group.
Recent International Accounting Pronouncements
      IFRS 7“Financial ‘Financial Instruments: Disclosures”Disclosures’ (effective from January 1, 2007). IFRS 7 introduces new disclosures of qualitative and quantitative information about exposure to risks arising from financial instruments, including specifiedspecific minimum disclosures about credit risk, liquidity risk and market risk. IFRS 7 is effective for accounting periods beginning on or after 1 January 2007. The GroupManagement is currently assessing the impact of IFRS 7 on the Group’s financial statements, but does not expect it to be significant.statements.
      A complementary amendment ofto IAS 1“Presentation ‘Presentation of Financial Statements — Capital Disclosures”Disclosures’ (effective from 1 January 2007). The amendment to IAS 1 introduces disclosures about the level and the management of the capital of an entity’s capital and how it manages capital. The amendment to IAS 1 is effective for accounting periods beginning on or after 1 January 2007. The Groupentity. Management is currently assessing the impact of the complementary amendment to IAS 1 but does not expect iton the Group’s financial statements
      IFRS 8 ‘Operating Segments’ (effective January 1, 2009). IFRS 8 requires an entity to be significant.

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)adopt the ‘management approach’ to reporting on the financial performance of its operating segments, revise explanations of the basis on which the segment information is prepared and provide reconciliations to the amounts recognized in the income statement and balance sheet. Management is currently assessing the impact of IFRS 8 on the Group’s financial statements.
      IFRIC 4“Determining whether an Arrangement contains a Lease”. IFRIC 4 requires the determination8 ‘Scope of whether an arrangement is or contains a lease to be based on the substance of the arrangement. IFRIC 4 is effectiveIFRS 2’ (effective for accountingannual periods beginning on or after May 1, January 2006. The Group will implement IFRIC 4 from 1 January 2006 but does not expect it to have a significant impact on the Group’s operations.
      IAS 21 (Amendment)“Net investment in a foreign operation”. This amendment deals with the requirement for a monetary item that forms part of a reporting entity’s net investment in a foreign operation to be denominated in the functional currency of either the reporting entity or the foreign operation. The amendment also clarifies the accounting treatment of exchange differences arising on a loan made between two “sister companies” within a group. The exchange differences would be taken to equity in the parent’s consolidated financial statements, irrespective of the currency in which the loan is made, provided that the nature of the loan is similar to an equity investment, that is, settlement of the loan is neither planned nor expected to occur in the foreseeable future.
      IFRIC 8“Scope of IFRS 2”2006). IFRIC 8 clarifies thatrequires consideration of transactions withininvolving the scopeissuance of IFRS 2 “Share-based payment”, include those in which the entity cannot specifically identify some or all of the goods or services received. Ifequity instruments — where the identifiable consideration given appears to bereceived is less than the fair value of the equity instruments grantedissued — to establish whether or liability incurred, this situation generally indicatesnot they fall within the scope of IFRS 2. The Group will apply IFRIC 8 from January 1, 2007, but it is not expected to have any impact on the Group’s accounts.
      IFRIC 10 ‘Interim Financial Reporting and Impairment’ (effective for annual periods beginning on or after November 1, 2006). IFRIC 10 prohibits impairment losses recognized in an interim period on goodwill, investments in equity instruments and investments in financial assets carried at cost to be reversed at a subsequent balance sheet date. The Group will apply IFRIC 10 from January 1, 2007 but it is not expected to have a significant impact on the Group’s accounts.
      IFRIC 7 ‘Applying the Restatement Approach under IAS 29 Financial Reporting in Hyperinflationary Economies’ (effective for annual reporting periods beginning on or after March 1, 2006). IFRIC 7 provides guidance on how to apply the requirements of IAS 29 in a reporting period in which an entity identifies the existence of hyperinflation in the economy of its functional currency, when the economy was not hyperinflationary in the prior period. As none of the Group entities have a currency of a hyperinflationary economy as their functional currency, IFRIC 7 is not relevant to the Group’s operations.
      IFRIC 9 ‘Reassessment of Embedded Derivatives’ (effective for annual periods beginning on or after June 1, 2006). IFRIC 9 requires an entity to assess whether an embedded derivative is required to be separated from the host contract and accounted for as a derivative when the entity first becomes a party to the contract. Subsequent reassessment is prohibited unless there is a change in the terms of the contract that other consideration has been or willsignificantly modifies the cash flows that otherwise would be received.required under the contract, in which case reassessment is required. The Group does not expect IFRIC 9 to have a material impact.

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SIGNATURES
      The registrant hereby certifies that it meets the requirements for filing on Form 20-F and that it has caused and authorized the undersigned to sign this annual report on its behalf.
 Pearson plc
 
 /s/ Rona FairheadRobin Freestone
  
 Rona FairheadRobin Freestone
 Chief Financial Officer
Date: May 5, 2006April 30, 2007

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