June 2006 Half-year. Report on business activity and results Consolidated financial statements

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1 June 2006 Half-year report Report on business activity and results Consolidated financial statements

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3 Half-year report June 2006 TABLE OF CONTENTS Report on business activity and consolidated results for H p3 o Revenues p3 o Order intake p4 o Results.p4 o Cash flows..p6 o Recent events.p6 o Outlook for 2006 financial year..p6 Consolidated financial statements at 30 June 2006 &.p9 o Consolidated profit & loss account..p10 o Consolidated balance sheet...p11 o Consolidated statement of cash flows p12 o Consolidated statement of changes in stockholders equity and minority interests..p13 o Notes to the consolidated financial statements..p14 1

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5 Report on business activity and consolidated results for H Thales Board of Directors met on 27 July 2006, under the chairmanship of Denis Ranque, to review the first-half 2006 consolidated financial statements. These results confirm Thales s upward trend. The main evolutions were as follows: Continued increase in order intake (+ 12%) consolidating the record backlog level reached at end (over 20 bn representing 2 years in revenues), Further improvement in income from operations (+ 7%) and in operating margin, Increase in net income (+ 5%) after lower financial expenses, Reduction in net debt confirmed over the last twelve months. REVENUES In the first half of 2006, consolidated revenues grew slightly at a constant perimeter (+2.2%). Variations in the scope of consolidation resulted in a net reduction in revenues of 89 m. This was mainly due to the deconsolidation of High Tech Optics and Thales Broadcast & Multimedia, which were divested at the end of, and to the acquisition of the remaining 49% stake in Diehl Luftfahrt Elektronik previously owned by Thales s German partner Diehl Avionik, as well as the full consolidation of TDA Armements, previously 50%-owned. Consolidated revenues by division: H1 revenues in euros (millions) 2006 Total change Change at constant perimeter * Aerospace 1,027 1, % + 9% Air Systems % - 8% Land & Joint Systems 985 1, % +14% Naval % - 21% Security % + 9% Services % + 4% Others & disposals ns ns Consolidated revenues 4,757 4, % * After elimination of consolidation scope impacts and reordering of activities among divisions The relatively slow increase in consolidated revenues for H mainly results from the significant decrease in sales recorded by the Naval division, which were reduced by more than 20% at constant scope due to the completion of the Sawari 2 frigate programme for Saudi Arabia, for which significant revenues were still being recorded in H1. Revenues from the Aerospace division (+9%) still benefit from the vitality of its civil activities with more than 20% growth in avionics, in particular in In-Flight Entertainment and in the through-life support business, helped by growth of the Airbus fleet. In the military airborne systems business, some variations among domains were observed: higher billings in the Watchkeeper tactical surveillance programme for the United Kingdom, lower billings in France (Rafale) and completion of several major export programmes. 3

6 The decrease in billings, at a constant scope1, from the Air Systems division (- 8%) results from the decline in revenues from the surface radar business, mainly due to a temporary decline in the domain of naval radars. Sales in this business should pick up again in H2. Revenues have also momentarily declined in the support activity. The missile electronics activity continued to rise, in particular with the seekers for the Mica and Aster missiles and the proximity fuzes for the British Seawolf missiles. The air defence business, in particular the transatlantic joint venture ThalesRaytheonSystems and the air traffic management activity, remained stable in H1. The increase in sales from the Land & Joint Systems division (+ 14%) follows the growth in order intake observed last year. Revenues are boosted by sales from the American subsidiary of MBITR tactical radios and by billings on several programmes for France, such as Socrate or the Rafale s Forward Sector Optronics System (FSOS). Multidomestic markets are also particularly dynamic, most notably Australia and South Africa. Revenues from the Naval division stemmed not only from the continuation of the Franco-Italian Horizon frigate programme but also from several recently-booked programmes (such as P75 submarines for India), the provision of equipment of the S-Type frigates for Greece, Scorpene submarines for Malaysia and the second batch of the KDX programme for South Korea. The increase in sales from the Security division (+ 9%) reflects the first billings on the Etisalat contract in Saudi Arabia and the favourable trend in the cryptography business of the e-security department. Strength of the components and secure payments businesses was confirmed. Lastly, a 16% increase in revenues was generated by those Navigation businesses whose disposal has recently been announced.7/ In the Services division, revenues increased by 4% despite completion in of the Grant of Use contract for British Rail. This growth is attributable to almost all businesses of this division, especially simulation, IT systems and facilities management. ORDER INTAKE The rise in order intake observed in continued in H1. It reached 4,843 m, growing by 12% compared to H1 ( 4,313 m). The most significant improvements were recorded by the Naval division (combat management systems and radars for Navantia, demonstration phase in the CVF British aircraft carrier programme), the Land & Joint Systems division (MBITR tactical radio adapters for the US Marine Corps, tactical communications for the British MoD and naval communications for its T45 frigates) and the Security division (secure GSM network for Etisalat in Saudi Arabia). The Air Systems division, whose order intake grew slightly, booked a new logistic support contract for the Shahine systems in Saudi Arabia. The Services division, although slightly down, booked an important order in the United Kingdom for the maintenance of the railway communications system for Network Rail. Orders in the Aerospace division, also slightly down, include a significant retrofit order for the Mirage F1 in Morocco. At end-june 2006, the book-to-bill ratio stands above 1, compared to 0.9 at end- June. The order book at end-june 2006 remains as high as at end ( 20.1 bn) and still represents two years in revenues. RÉSULTS Further increase in income from operations, up 7% at 317 m compared with 297 m for the first half of, and improvement in the operating margin at 6.6% of revenues 1 The variations in scope observed in the Air Systems and Naval divisions result from the regrouping in 2006 within the Air Systems division of all surface radar activities, including those formerly covered by the Naval division. This is the result of the streamlining and modernisation policy run in the radar business. The difference between organic and total change in revenues for these two divisions is thus fully explained by this transfer of activity. 4

7 compared with 6.2% at 30 June. This improvement is particularly noteworthy since it includes a significant negative exchange effect related to export sales denominated in dollars by subsidiaries with operations in the euro zone: while the average dollar rate of the period has not significantly varied compared with the first half of, the progressive application of the dollar-hedging portfolio represented approximately twenty million euros weighting on these first half results, mainly those of the avionics business. Income from operations in euros (millions) H1 H variation Aerospace % in % of revenues 8.1% 8.0% Air Systems % in % of revenues 6.8% 7.8% Land & Joint Systems % in % of revenues 5.1% 7.1% Naval % in % of revenues 8.3% 8.8% Security % in % of revenues 4.0% 2.3% Services % in % of revenues 6.1% 6.1% Other & divested activities (6) (11) ns Income from operations % in % of revenues 6.2% 6.6% All divisions, with the exception of the Security division, have maintained or improved their operating margins. In the Security division, income from operations was affected by the loss of (17) m posted in H by the navigation business which Thales will divest, as recently announced. In spite of the aforementioned negative exchange effect, which mostly affects the avionics business, the Aerospace division increased its income from operations by 8%. The Air Systems division s income grew by more than 20% and its operating margin on revenues is back to nearly 8%, following the decline observed in due to higher than expected development costs on an important contract. Income from operations and related margin recorded by the Land & Joint Systems division, down in H1, have strongly increased, in particular with the satisfactory progression of the US-based activities and the recovery of the optronic business in France. The Naval division posted a decline in income from operations, due to the completion of the Sawari 2 programme, but improved its operating margin. Excluding the navigation business, the divestment of which has been announced, income from operations of the Security division has grown by 50% representing an operating margin superior to 6% of revenues. The Services division achieved higher income, in spite of a lower contribution from its Telecom Services subsidiary in the UK, thanks to a general improvement in most other segments. Income of operating activities decreased slightly to 273 m, compared with 290 m in H1 which included a 26 m net gain on disposals (net loss of 2 m in H1 2006). The increase in restructuring costs was minimal over this first half year ( 42 m compared with 33 m in H1 ). In the second half of 2006, these costs should be significantly higher, with total restructuring costs in FY2006 of around 200m (total costs of 212 m in FY). Significant decrease in the cost of net financial debt, from 45 m to 21 m, a downward trend which accompanies the reduction in net financial debt at end. 5

8 For the first half of fiscal year 2006, Thales recorded a net profit of 172 m, 5% higher than the 164 m profit of the previous first half. CASH FLOWS Operating cash flows before working capital changes were 402 m, compared to 389 m in H1, and almost covered the change in working capital requirements and restructuring expenses, payment of pension deficits and of income tax, and left a slightly negative balance of (30) m, compared with a negative balance of (10) m at 30 June. After funding (198) m of net capital expenditure, up from the (172) m figure for H1 in particular due to higher investment in R&D, operating activities provided a negative "operating free cash flow" of (228) m, compared with a negative balance of (182) m in H1. Net cash flows were negative at (263) for first half 2006, compared with negative net cash flows at (194) m for H1, after 105 m of net proceeds from disposals (net proceeds of 122 m in H1 ) and payment of (140) m in dividends. Net financial debt stood at 676 m at 30 June 2006, 278 m higher than at the end of fiscal year, but significantly reduced compared with net financial debt of 1,049 m at 30 June. Nota: The level of net indebtedness is traditionally higher at mid-year, compared with its level at year-end, reflecting the usual seasonality of sources and uses of cash flows. RÉCENT EVENTS In December, Thales and DCN signed a joint declaration of intent with a view to combining within DCN the Thales French naval activities, excluding equipment supply, and the acquisition by Thales of a 25% interest in DCN. Due diligence works have been going on during the first semester of This project is expected to be finalised in the second half of In April 2006, the Thales Board of Directors approved the project to contribute Alcatel's satellite activities and critical systems for security and transportation activities to Thales. This transaction should lead to issuance of million Thales shares to Alcatel and a cash payment of 673 million payable by Thales to Alcatel on closing. Additional purchase consideration could be payable by Thales at the beginning of 2009 on the basis of the value of the 67% share in Alcatel Alenia Space as determined by an expert. Alcatel's stake in Thales would increase from 9.5% to 21.6%. The closing of this transaction is scheduled for the second half of In March 2006, Thales announced plans to increase its stake in ADI from 50% to 100%. Transfield Holdings is the current joint venture partner. This transaction, which is subject to the approval of Australia's Foreign Investment Review Board (FIRB), is scheduled for the 3rd quarter of In July 2006, Thales has signed an agreement with an investor group to sell GPS navigation business for an amount of $170 million. In the first half of 2006, the contribution of these activities to the Group revenues amounts to 114 million, and the corresponding contribution to the consolidated income from operations is (17.8) million. At 30 June 2006, the corresponding assets and liabilities are presented on a specific caption of the balance sheet, in accordance with IFRS 5. OUTLOOK FOR 2006 FINANCIAL YEAR Based on these satisfactory interim results, Thales is in a position to confirm the outlook for the current financial year as indicated last March, in a context characterised by the completion of important export contracts, an unfavourable dollar rate impact and an increasingly competitive environment, while the full impact of the competitiveness measures launched in the second half of has yet to be achieved. Therefore, the group reiterates its targets for the current year: 6

9 A similar or slightly higher organic growth in revenues to that of (+ 3.8%), which implies a significant acceleration of growth in the second half, An increase in income from operations compared with that of the previous year. Furthermore, the Board has been informed of the satisfactory progress in the ongoing discussions with, on the one hand, DCN and, on the other hand, Alcatel. The implementation of these projects should represent a very positive development in the Group's profile for growth and strategic positioning. 7

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11 CONSOLIDATED FINANCIAL STATEMENTS AT 30 JUNE 2006 AND 9

12 Consolidated profit and loss account ( million) 2006 * Notes Full year Revenues note 4 4, , ,263.2 Cost of sales (3,627.0) (3,657.2) (7,851.1) Research and development expenses (156.7) (154.3) (366.0) Marketing and selling expenses (440.2) (428.0) (867.8) General and administrative expenses (228.5) (220.5) (456.5) INCOME FROM OPERATIONS note Restructuring costs (41.3) (32.5) (212.5) Other operating income (expense) (1.3) (0.4) (84.3) Impairment of non current operating assets note (34.2) Gain (loss) on disposal of assets note 5 (1.6) INCOME OF OPERATING ACTIVITIES Financial interest on gross debt (43.9) (57.8) (126.0) Financial income on cash at bank and equivalents Cost of net financial debt (20.6) (44.7) (82.8) Other financial income (expense) note 6 (0.5) 3.9 (10.2) Financial component of pension charge note 7 (14.6) (13.8) (33.6) Income tax note 8 (64.8) (75.0) (87.3) Equity in income of unconsolidated affiliates note NET INCOME (LOSS) Of which : Net income, Group share Minority interests Basic earnings per share (in euros) note Diluted earnings per share (in euros) note * Adjusted in comparison to the financial statements published at June, mainly to take account of the revised accounting treatment of a contract in the books of the British joint-venture Citylink (see annual report). 10

13 Consolidated balance sheet ( million) ASSETS Notes 30/06/06 31/12/05 Goodwill, net note 10 1, ,859.1 Other intangible assets, net Tangible assets, net ,027.9 Total non current operating assets 3, ,235.2 Equity in unconsolidated affiliates note Other investments Other financial assets Total non current financial assets Fair value of put and call options between Thales and Transfield / ADI note Pension and other employee benefits Deferred tax assets Non-current assets 4, ,255.9 Inventories and work in progress 1, ,619.5 Construction contracts: assets 2, ,042.8 Advances to suppliers 1, ,030.1 Accounts, notes and other current receivables 2, ,199.8 Fair value of derivatives: currency risk management Total current operating assets 7, ,925.7 Assets held for sale note Current tax receivables Fair value of derivatives: interest rate risk management note Current accounts with affiliated companies Marketable securities note Receivable on disposal of Broadcast & Multimedia to Thomson Cash at bank and equivalents note ,319.9 Total current financial assets ,640.9 Current assets 9, ,631.5 TOTAL ASSETS 13, ,887.4 LIABILITIES AND SHAREHOLDERS EQUITY Notes 30/06/06 31/12/05 Capital, paid-in surplus and other reserves 2, ,150.6 Cumulative translation adjustment Treasury shares (146.1) (142.3) Shareholders equity 2, ,061.8 Minority interests Total shareholders equity and minority interests note 12 2, ,102.8 Financial debt long term note ,449.4 Pension and other employee benefits 1, ,103.5 Deferred tax liabilities Non-current liabilities 2, ,583.0 Advances received from customers on contracts 2, ,755.8 Refundable grants Construction contracts: liabilities Reserves for contingencies note Accounts, notes and other current payables 4, ,601.4 Fair value of derivatives: currency risk management Total current operating liabilities 8, ,719.9 Liabilities related to disposal groups held for sale note Current tax payables Financial debt short term note Current accounts with affiliated companies note Total current financial liabilities Total current liabilities 9, ,201.6 TOTAL LIABILITIES AND SHAREHOLDERS EQUITY 13, ,

14 Consolidated statement of cash flows Notes 2006 ( million) Full year Net income (loss) Add (deduct) : Income tax expense (gain) Equity in income of unconsolidated affiliates (net of dividends received) (3.8) (6.1) 6.7 Depreciation of tangible and intangible assets Provisions for pensions and other employee benefits note Impairment of non current operating assets Loss (gain) on disposals of assets note (26.2) (158.3) Net allowances to restructuring provisions (29.0) (15.0) 94.9 Other items Operating cash flows before working capital changes Change in working capital requirements and in reserves for contingencies * (344.3) (338.7) (133.7) Payment of pension benefits (defined benefit plans) (73.7) (49.4) (110.9) Income tax (paid) received (13.5) (10.1) (46.5) Net cash flows from operating activities - I - (29.9) (9.8) Capital expenditure note 15-a (202.1) (181.3) (390.8) Proceeds from disposal of tangible and intangible assets Net operating investments (197.9) (171.6) (352.3) Acquisitions note 15-b (27.2) (8.3) (84.3) Disposals note 15-b Change in loans Change in current accounts with affiliated companies 57.3 (4.0) (23.0) Decrease (increase) in marketable securities (7.8) Net financial investment Net cash flows from investing activities - II - (28.2) (91.9) (187.9) Increase (decrease) in shareholders equity and minority interests note 15-c (141.8) (64.4) (15.1) Increase in debt Repayment of debt (298.3) (92.3) (584.5) Net cash flows from financing activities - III - (369.6) (56.5) (321.0) Effect of exchange rate variations - IV - (18.1) Total increase (decrease) in cash at banks and equivalents - I+II+III+IV - (445.8) (118.1) Cash at bank and equivalents at beginning of period 1, , ,181.6 Cash at bank and equivalents at end of period , ,319.9 * Including changes in proceeds from non-recourse sale of government receivables ( (189.5) million in first half 2006, (254.5) million in first half and (19.1) million in )). At 30 June 2006, receivables transferred without recourse, including notably amounts which have reached their due date for payment and which bear interest on arrears, amounted to million, million at 31 December and million at 30 June. 12

15 Consolidated statement of changes in shareholders equity and minority interests In first half 2006: ( million) Number Share Paid-in Retained Changes Cumulative Treasury Share- Minority Total of shares capital surplus earnings in translation Shares holders interests outstanding fair adjustment equity (thousands) values At 1 January , ,674.0 (1,098.2) (142.3) 2, ,102.8 Capital increase Dividends* (140.0) (140.0) -- (140.0) Change in treasury shares (134) (3.8) Total transactions with shareholders (94) (130.8) (3.8) (133.5) (133.5) Translation adjustment (44.7) -- (44.7) (2.7) (47.4) Financial instruments (note 12-d) Share-based payments (note 12-c) Other (0.4) (0.4) (0.2) (0.6) Total income and expense recognised directly through shareholders equity in the year (44.7) -- (7.6) (2.9) (10.5) Net income first half Changes in scope of consolidation At 30 June , ,675.0 (1,049.0) (146.1) 2, ,135.7 In first half **: Number Share Paid-in Retained Changes Cumulative Treasury Share- Minority Total of shares capital surplus earnings in translation shares holders interests outstanding fair adjustment equity (thousands) values At 1 January 165, ,673.1 (1,283.6) (26.0) (292.4) 1, ,740.5 Capital increase Dividends* (133.7) (133.7) (0.1) (133.8) Change in treasury shares 2, (23.1) Total transactions with shareholders 2, (156.8) (64.0) (0.1) (64.1) Translation adjustment Financial instruments (note 12-d) (54.2) (54.2) (0.3) (54.5) Share-based payments (note 12-c) Other (1.1) (1.1) (0.1) (1.2) Total income and expense recognised directly through shareholders equity in the year (54.2) Net income first half Changes in scope of consolidation At 30 June 167, ,673.4 (1,270.2) (199.9) 1, ,873.2 * Dividends per share amounted to 0.83 in 2006 and 0.80 in. * Adjusted in comparison to the financial statements published at June, mainly to take account of the revised accounting treatment of a contract in the books of the British joint-venture Citylink (see annual report). 13

16 Notes to the consolidated financial statements All amounts included in these notes are expressed in million except for per share data On July 27, 2006, the Board of Directors approved, and authorised for issue, Thales interim consolidated financial statements for the period ended June 30, Thales S.A. is a listed French société anonyme, registered with the Nanterre registrar of companies (Registre du Commerce et des Sociétés de Nanterre) under the number Accounting policies In application of European regulation N 1606/2002 pertaining to international standards, issued on 19 July 2002, the consolidated financial statements of the Thales Group are prepared, since January 1,, in accordance with IAS /IFRS standards (International Financial Reporting Standards) as approved by the European Union. The Group previously applied French accounting standards, as defined notably in regulation of the French accounting rules and regulations committee (Comité de Réglementation Comptable or C.R.C.). The interim accounts are prepared using accounting policies which are identical to those used to prepare the full-year financial statements, subject to the clarifications set out in note 1-w. Thales applied for its first IFRS financial statements specific rules defined in IFRS 1. Any specific options retained are set out in the following notes. Standards IAS 32 and IAS 39 pertaining to financial instruments have been applied as from 1 January. New accounting standards, amendments to existing accounting standards and interpretations effective as from 1 January 2006 have no significant impact on the consolidated financial statements for the period ended 30 June The interim accounts at 30 June 2006 have been prepared in conformity with IAS 34 Interim financial reporting. a) Consolidation The financial statements of significant subsidiaries directly or indirectly controlled by Thales have been fully consolidated. Companies in which Thales does not have a controlling interest but over which it exercises significant influence, directly or indirectly, are accounted for under the equity method. Companies under joint control are accounted for under the proportionate method. All transactions between fully consolidated or proportionately consolidated companies are eliminated, as are all internal gains and losses related to consolidated companies. Transactions between a fully consolidated company and a proportionately consolidated company, whether or not they affect consolidated profit and loss, are eliminated to the extent of the Group s ownership interest in the proportionately consolidated company. As an exception to this principle, transactions between a fully consolidated company and a proportionately consolidated company are fully eliminated when the jointly controlled company acts simply as an intermediary or performs profit-neutral services on behalf of, or as a direct extension of the activities of, its different shareholders. 14

17 b) Business combinations Business combinations are accounted using the purchase accounting method. Under this method, the acquired assets, liabilities and contingent liabilities are measured at their fair value at the date at which control is obtained. The difference between the cost of acquisition of the shares and the Group s share in the fair value of net assets constitutes goodwill. Goodwill can be adjusted in the twelve months following the acquisition date to take account of definitive estimates of the acquired assets and liabilities recognised. After this period, adjustments to fair value are recognised through profit and loss. By exception, in the case of tax loss carry forwards in respect of which deferred taxes were not recognised at the date of initial recognition of a business combination but which are subsequently used, the following accounting treatment is adopted: the tax income is cancelled and the carrying amount of goodwill is reduced by the amount that would have been recognised had the tax asset been recognised at the acquisition date. Negative goodwill is immediately recognised in other operating income (expense). Goodwill related to controlled enterprises is recognised in balance sheet assets under the intangible assets caption. Goodwill related to companies accounted for under the equity method is recognised under the equity in unconsolidated affiliates caption. Goodwill is not amortised but is subject, each year, to impairment tests in accordance with IAS 36. These tests consist of ensuring that the recoverable amount of each of the Group s cash generating units is at least equivalent to its corresponding net assets (including related goodwill). The recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use. Value in use is determined on the basis of discounted projections of future operating cash flows over a three-year period and a terminal value. The discount rate used was the Group s weighted average cost of capital (7.9% in ) adjusted if necessary for the specific risks attributable to each business sector. Assumptions used concerning growth in revenues and terminal values are based on a reasonable approach in line with specific data available for each business sector. Goodwill impairment is recognised as an expense in income of operating activities, except for impairment of goodwill related to equity in unconsolidated affiliates which is accounted for in equity in income of unconsolidated affiliates. Goodwill impairment cannot be reversed. Reminder of policy applied on first time adoption of IFRS The Group decided not to restate business combinations that occurred before 1 January c) Translation of the financial statements of foreign subsidiaries Balance sheet items are translated at the exchange rates prevailing at balance sheet dates. Profit and loss items and the statement of cash flows are translated at the average exchange rates for the year. Translation adjustments are directly recognised in shareholders equity. The main closing and average exchange rates used for translation purposes in recent years are summarised below: 30 June June 31 December EUROS Closing rate Average rate Closing rate Average rate Closing rate Average rate Australian Dollar Pound Sterling U.S. Dollar Reminder of policy applied on first time adoption of IFRS The Group took the option, provided by IFRS 1, of not retrospectively reconstituting cumulative translation adjustments in shareholders equity at 1 January Translation adjustments that predate the IFRS transition will therefore not be included when calculated gains or losses arising from the future disposals of consolidated subsidiaries or equity affiliates. 15

18 d) Accounting for foreign currency transactions Transactions in foreign currencies are translated at the rate of exchange prevailing at the transaction date. Foreign currency denominated assets and liabilities are translated into euros at closing exchange rates. Translation gains and losses are recorded in profit and loss. Foreign currency exposure is managed by the finance department of Thales which uses foreign currency derivatives to protect against changes in the value of future cash flows related to commercial flows in foreign currencies. In order for a derivative to be eligible for hedge accounting, it is necessary to define and document the hedging relationship and to demonstrate its effectiveness as from origination and throughout its duration. When a hedge is shown to be effective, hedge accounting is applied in the following manner: - the change in the fair value of the hedging instrument is recognised directly in shareholders equity for the effective portion of the hedge until such time as the hedged transaction occurs. The ineffective portion is recognised in profit and loss, - the amount of the foreign currency denominated transaction is subsequently translated at the exchange rate prevailing at the date of the hedge. Changes in the fair value of premiums or discounts related to forward foreign currency contracts, as well as the time value of foreign currency options, are recognised in other financial income (expense) as they are excluded from the hedging relationship. In addition, the Group puts in place hedges of its net investment in foreign subsidiaries. Foreign exchange gains or losses on foreign currency denominated financial instruments corresponding to such hedges are recognised through equity under the cumulative translation adjustment caption until the date of disposal of these investments. At this date, these foreign exchange gains or losses are recognised in profit and loss. e) Tangible and intangible fixed assets Property, plant and equipment are carried at their acquisition cost, as reduced by accumulated depreciation and impairment losses recognised. Depreciation of tangible fixed assets is generally calculated on the basis of the following typical useful lives: - 20 years for buildings, - 1 to 10 years for plant and equipment, - 5 to 10 years for other tangible fixed assets (vehicles, fixtures, etc.). The depreciable amount takes account of the residual value of the asset. The different components of tangible fixed assets are recognised separately when their estimated useful lives or patterns of use, and thus the period over which they are depreciated or the depreciation methods applicable to them, are materially different. When events or changes in the market environment indicate a risk of impairment of fixed assets, an impairment test is performed, in accordance with IAS 36. If the net book value is greater than the recoverable amount of the fixed asset (market value or value in use if the latter amount is greater), an impairment loss is recognised. Assets financed under finance leases that transfer substantially all the risks and rewards related to ownership of the asset are recognised in the balance sheet at their fair value or, if lower, at the present value of the minimum lease payments determined at the inception of the lease. Such assets are depreciated in accordance with the methodology described above. The corresponding debt is recognised in liabilities. The Group s intangible assets are principally comprised of goodwill (note 1-b) and capitalised development costs (note 1-j). 16

19 f) Investment securities / financial loans and receivables Investment securities (designated as available-for-sale assets in accordance with IAS 39) are measured at fair value. For listed securities, this value corresponds to their stock market price at the closing date. For unlisted securities, valuation models are used. If fair value cannot be reliably determined, such securities are recognised at cost. Changes in fair value are recognised directly in shareholders equity. If an impairment indicator of long-term loss of value is identified, a provision for impairment is recognised in other financial income (expense). Such provisions for impairment are only written back to profit and loss at the date of disposal of the security in question. Financial loans and receivables are recognised at amortised cost. They are subject to provisions for impairment if an impairment indicator of long-term loss of value is identified. Such provisions for impairment, recognised in the other financial income (expense) caption, can subsequently be reversed through profit and loss if the conditions which led to the impairment loss being recognised cease to exist. g) Inventories and work-in-progress Inventories and work-in-progress are carried at the lower of their production cost (determined using the FIFO or weighted-average cost method) or their net realisable value. Work-in-progress, semifinished and finished goods are stated at direct cost of raw materials, production labour and subcontract costs incurred during production, plus an appropriate portion of production overhead costs and of any other costs that can be directly allocated to contracts. In the consolidated balance sheet, work-in-progress related to construction contracts is included in the Construction contracts: assets caption or the Construction contracts: liabilities caption (note 1-i). h) Revenues from activities Revenues from activities relate to the sale of goods and services and to royalty and licence income. Revenue is recognised when it is probable that the future economic benefits associated with the transaction will flow to the Group and when the amount of revenue can be measured reliably. The following specific criteria must also be satisfied in order for revenue to be recognised: - revenues from the sale of goods are recognised when the enterprise has transferred the principal risks and rewards inherent to ownership of the goods to the purchaser, - revenues related to the rendering of services are recognised on the basis of the percentageof-completion of the transaction, - accounting policies relating to construction contracts are set out in note 1-i. Revenues are measured at the fair value of the consideration received or receivable. In the case where the deferral of payment has a material effect on the determination of such fair value, the amount at which revenues are recognised is adjusted to take discounting of future payments into account. i) Construction contracts A construction contract is a contract specifically negotiated for the construction of an asset or of a group of assets which are interrelated in terms of their design, technology, function, purpose or use. Income and expenses on construction contracts are recognised in accordance with the technical percentage of completion method. However, where there is no significant timing difference between technical percentage of completion and contractual dates of transfer of ownership, the percentage of completion is determined according to the contractual transfer of ownership. Penalties for late payment or relating to improper performance of a contract are recognised as a deduction from revenues. In the balance sheet, provisions for penalties are deducted from assets related to the contract. 17

20 Probable losses on contracts in progress or on the order book are fully recognised as soon as they are identified. Selling, administrative and interest expenses are directly charged to the financial year in which they are incurred. Estimates of work remaining to be completed on loss-making contracts do not include revenues from claims made by the Group, except when it is highly probable that such claims will be accepted by the customer. Progress payments received on construction contracts are deducted from contract assets as the contract is completed. Progress payments received before the corresponding work has been performed are presented in "Advances received from customers on contracts" in balance sheet liabilities. The cumulative amount of costs incurred and profit recognised, reduced by recognised losses and advance invoices issued, is determined on a contract-by-contract basis. If this amount is positive it is recognised in assets under the Construction contracts: assets caption in assets. If it is negative it is shown in Construction contracts: liabilities caption in liabilities. j) Research and development expenses A significant portion of research and development expenses is funded by customers and government agencies. Internally funded research and development expenses are charged to the profit and loss account as incurred as "Research and development expenses", except for project development costs that meet the following criteria: - the product or process is clearly defined, and costs are separately identified and measured reliably, - the product has been shown to be technically feasible, - the product or process will be sold or used in-house, - a potential market exists for the product, or its usefulness for in-house purposes has been demonstrated, - adequate resources are available to complete the project successfully. Development costs are capitalised once the above criteria are met. They are then amortised over the economic life of the product. The method of amortisation is determined by reference to expected future quantities or revenues over the period in which future economic benefits will be earned. The period of amortisation depends on the nature of the activity. If the asset becomes impaired, an impairment loss is recognised. The Group receives public financing, in the form of reimbursable advances, for the development of certain projects. Reimbursement of these advances is generally based on the expected future revenues to be generated by the development. The Group recognises such advances in liabilities taking account of the likelihood that they will be reimbursed. Costs incurred in respect of these projects are recognised in the work-in progress-caption. The Group benefits from tax credits related to research carried out by its subsidiaries. Such tax credits are deemed to be equivalent to operating grants and are thus included in income from operations. k) Deferred taxation Thales recognises deferred taxes when the tax value of an asset or liability differs from its book value. The effects of changes in the corporation tax rate are recorded in the profit and loss account for the financial year in which the change was decided, unless the underlying transactions were recognised directly through shareholders equity. Deferred tax assets and liabilities are not discounted. Deferred tax assets are not recognised in the balance sheet if the company concerned does not reasonably expect to recover the tax asset. To assess its ability to recover deferred tax assets, the Group takes into account forecasts of future taxable results of the tax entities concerned, nonrecurring past events and tax strategies specific to each country. 18

21 l) Restructuring Provisions for restructuring costs are made when restructuring programs have been finalised and approved by Group management and have been announced before the balance sheet date, resulting in an obligating event of the Group to the third parties in question, as long as the Group does not expect consideration for these costs. Such costs primarily relate to severance payments, costs for notice periods not worked and other costs linked to the closure of facilities such as write-offs of fixed assets. These costs and the costs directly linked to restructuring measures (removal costs, training costs of transferred employees, etc.), are recognised under the restructuring costs caption in the profit and loss account. m) Pension and other employee benefits In accordance with local legislation and practice in the countries in which it operates, the Group grants its employees post-employment benefits (pensions, retirement awards, medical care, etc.) and other long-term benefits (long-service benefits, long-service awards on departure, etc.). The Group calculates pension and similar benefits in accordance with the Projected Unit Credit method required under IAS 19. The following accounting policies are applied. - For defined contribution schemes and multi-employers schemes, contributions paid by the Group are expensed in the financial year. - For defined benefit schemes, the actuarial method used is the Projected Unit Credit method on the basis of estimated salaries at the date of retirement. For post-employment benefits, actuarial gains (losses) exceeding the greater of 10% of defined benefit obligations or of the market value of plan assets are amortised over the expected average remaining working life of employees (being the corridor method). The expense representing the change in net commitments is recognised in income from operations for the current service cost component and in the financial component of pension charge caption for other components. Reminder of policy applied on first time adoption of IFRS The Group decided to take the option, provided by IFRS 1, of recording its unamortised actuarial gains and losses at 1 January 2004 in shareholders equity at that date. As from 1 January 2004, the corridor method has been applied. The new option provided by IAS 19 of recognising actuarial gains and losses directly in shareholders equity has not been taken. n) Share based payments Share options granted by the Group to its employees are accounted for in accordance with the requirements of IFRS 2. The Group uses a binomial model to measure the amount of the benefit to employees receiving the option granted. The fair value of such options is determined at the grant date. The amounts thus obtained are taken to profit and loss over the vesting period of the rights. Recognition in profit and loss is not linear but, rather, is based on the specific conditions under which rights vest under each scheme. This expense is included in income from operations and a corresponding credit is recognised increasing retained earnings. It thus has no effect on the overall amount of shareholders equity. Reminder of policy applied on first time adoption of IFRS The Group took the option, provided by IFRS 1, of not restating share option plans whose grant date was prior to 7 November

22 o) Earnings per share Basic earnings per share is calculated by dividing profit attributable to shareholders by the weighted average number of shares outstanding during the financial year, excluding treasury shares. Diluted earnings per share (DEPS) take into account instruments that have a dilutive effect on earnings per share. No account is taken of anti-dilutive instruments. Diluted earnings per share is calculated on the basis of the weighted average number of shares and equity-equivalent bonds outstanding during the financial year, less treasury shares. Net income is adjusted for the after-tax interest expense of related convertible bonds. The dilutive effect of share options is calculated using the treasury stock method, taking into account the average market price for the share in the period in question. p) Financial debt Compound instruments Financial debt is initially recognised at the fair value of the amount received, less directly attributable transaction costs. Financial debt is subsequently measured at amortised cost, in accordance with the effective interest method. Certain financial instruments include both a financial debt component and a shareholders equity component. The OCEANE issued by the Group in 2001 falls into this category. In accordance with IAS 32 Financial instruments: disclosure and presentation these two components are separately recognised and have been determined as follows: - the debt component corresponds to the value of future contractual cash-flows (including both interest coupons and capital repayments) discounted at the market rate (taking account of credit risk at date of issue) for a similar instrument with the same conditions (maturity, cash flows) but without a conversion option. - the shareholders equity component represents the value of the option to convert the bonds into shares. Its value is equal to the difference between the amount of the proceeds of issue of the bond and the amount of the debt component calculated in the manner described above. q) Borrowing costs Borrowing costs incurred during the construction of a qualifying asset are treated as part of the cost of that asset. The interest rate used is that of the specific loan related to the asset or, if no specific financing exists, the Group s marginal financing rate. r) Cash at bank and equivalents Cash at bank and equivalents includes cash on hand, demand deposits and cash equivalents (short-term, liquid investments which can easily be converted into a known amount of cash and which are subject to an insignificant risk of change in value). It excludes bank overdrafts which are considered to be financing. s) Derivatives The Group uses financial instruments to manage and reduce its exposure to risks of changes in interest rates and foreign exchange rates. In accordance with the requirements of IAS 39 Financial instruments: recognition and measurement, derivatives are stated at their fair value in the balance sheet. In order to be eligible for hedge accounting, financial instruments must have the following characteristics: - at the date of origination of the financial instrument, the existence of a hedging relationship must be formal and documented; - and the hedge must be expected to be effective. Effectiveness must be capable of being measured in a reliable manner, and must be able to be demonstrated, over the entire period of the hedge relationship as initially determined. Accounting policies in respect of foreign exchange derivatives are presented above in note 1-d. 20

23 Financial instruments relating to interest rate hedges are hedge-accounted as either fair value hedges or cash flow hedges: - a fair value hedge is a hedge of the exposure to changes in the value of assets and liabilities; - a cash flow hedge is a hedge of the exposure to changes in the value of future cash flows (unknown future interest flows payable on existing variable rate borrowings or on highly probable future borrowing issues, for example). In the case of fair value hedge relationships, the financial liabilities hedged by the interest rate derivatives are remeasured by the amount of the change in the value of the loan resulting from the change in interest rates. Such changes in value are recognised in profit and loss of the period and are offset by symmetrical changes in the fair value of the interest rate derivatives, for the effective portion thereof. In the case of cash flow hedge relationships, changes in fair value of interest rate derivatives shown in the balance sheet are recognised directly through shareholders equity, for the effective portion thereof, until such time as the hedged flows affect profit and loss. t) Derecognition of trade receivables The Group transfers trade receivables from the French Direction Générale de l Armement (Directorate General of Armaments), notably overdue amounts which bear financial interest on arrears. As these transfers, which are without recourse in case of payment default by the debtor, are analysed as a transfer of substantially all risks and rewards of ownership, the corresponding receivables are derecognised in accordance with IAS 39. u) Assets held for sale A non current asset or a disposal group is considered as held for sale in accordance with IFRS 5 if it is available for immediate sale and the sale is highly probable. Such assets or disposal groups are measured at the lower of carrying amount and estimated sale price, less costs to sell. These items are presented on the face of the balance sheet in specific captions. v) Main sources of estimates Preparation of the Group s consolidated financial statements involves making estimates and assumptions which have an impact on the valuation of income, expenses, assets and liabilities. These estimates could need to be revised if the circumstances on which they were based were to change or if new information or additional experience were to be obtained. The main financial statement captions subject to material accounting estimates are as follows: Construction contracts Recognition of income and expenses relating to construction contracts is based on estimates of overall profit or loss on completion of such contracts (see note 1-i). These estimates are performed by project managers in accordance with Group procedures. Goodwill Goodwill, in accordance with IAS 36, is subject to impairment tests (see note 1-b). The recoverable amount of goodwill by cash generating unit is assessed on the basis of forecast data from the strategic plans prepared, in accordance with Group procedures, for each of the Group s businesses or divisions. Pension and other employee benefits Benefit obligations in respect of pensions and other employee benefits are estimated on statistical and actuarial bases in accordance with the policies outlined in note 1-m. Actuarial assumptions made by the Group (discount rates, expected return on plan assets, future compensation increases, rates of employee turnover, mortality tables, etc.) are reviewed each year with the Group s actuaries. 21