The significant differences between IFRS and UK GAAP have been drawn to shareholders' attention in a number of publications including the Operating and Financial Review in the Annual Report and Accounts 2005 and in a press release dated 21 November 2005 published on the Smiths website (www.smiths.com/press_2005.htm). Further information about the transition to IFRS and the key accounting policies can be found elsewhere in this report.

The accounting policies adopted include those necessary to comply with the requirements of IAS 32 and IAS 39 accounting standards that deal with the measurement and disclosure of financial instruments. These standards were adopted prospectively from 1 August 2005 and, as permitted, the comparative figures exclude the impact of the new standards. The 2006 financial year ended on 5 August. The 2005 financial year ended on 31 July.

Significant judgements, key assumptions and estimates
Applying accounting policies requires the use of certain judgements, assumptions and estimates. The most important of these are set out below. Further judgements, assumptions and estimates are set out in the accounts.

Revenue recognition
The timing of revenue recognition in complex contractual arrangements is important and is usually measured by reference to the stage of completion of contract activity at the balance sheet date. This assessment necessarily requires a high degree of judgement. For other aspects of revenue recognition, Smiths accounting policies allow revenue to be recognised only when the risks and rewards of ownership have passed to the customer.

Impairment
IFRS requires companies to carry out impairment testing on any assets that show indications of impairment, and annually on goodwill and intangibles that are not subject to amortisation. This testing involves exercising management judgement about future cash-flows and other events which are, by their nature, uncertain. The measurement of the impairment charge recorded this year against TI Automotive is an example of this judgement.

Retirement benefits
The assumptions underlying the calculation of retirement benefits are important and are based on independent advice. Changes in these assumptions could have a material impact on the measurement of our retirement benefit liabilities.

Taxation
The tax charge for the year represented an effective rate of 26% on the headline profit before taxation, the same as for 2005. This has been maintained through taking advantage of global tax incentives, the tax-efficient use of capital and active tax compliance management. Tax payments normally lag the tax charge and therefore boost free cash-flow. Current and deferred tax liabilities are recognised on the balance sheet in accordance with generally accepted accounting practice.

The fundamental tenets of the Smiths approach to taxation are to enhance the Company's competitive position on a global basis, while engaging with tax authorities around the world on a basis of full disclosure, full co-operation and full legal compliance. The Board considers and approves the management of the Company's tax affairs in the context of the Company's commercial objectives.

Smiths seeks to build open relationships with tax authorities to bring about timely agreement of tax affairs and to remove uncertainty on business transactions.

The Company's taxation strategy is to mitigate the burden of taxation in a responsible manner for competitive advantage, and, in this way, to enhance long-term shareholder value.

Cost of capital and return on investment
Smiths uses its weighted average cost of capital as one measure to appraise both internally-generated investment opportunities and acquisitions. During 2006, the Company's weighted average cost of capital (WACC) was 8%.

The after-tax headline return on average shareholder investment, including goodwill set-off against reserves (ROI), was 14% (2005: 11%).

Retirement benefits
The Company applies the full accounting requirements of International Accounting Standard (IAS) 19. These requirements are broadly similar to those previously adopted under UK GAAP.

Under IAS 19, the balance sheet reflects the net surplus/deficit in retirement benefit plans, taking assets at their market values at 5 August 2006 and evaluating liabilities at year-end AA corporate bond interest rates.

The table below gives an analysis of the year end retirement benefit liabilities.

Mortality assumptions are reviewed at each actuarial valuation, and were updated in the current year in the UK. The present assumptions are illustrated by the life expectancy of a 65-year-old retiring in 2013. Men are assumed to have a life expectancy of 21 years and women 24 years. The change in mortality assumptions has increased UK pension liabilities by 4%. In the US, mortality assumptions were updated in 2005.

Full details of the retirement benefits accounted for under IAS are shown in note 9.

Exchange rates
The results of overseas operations are translated into sterling at average exchange rates. The net assets are translated at year-end rates. The exchange rates, expressed in terms of the value of sterling, are shown in the following table.

Goodwill and intangibles
Goodwill on all acquisitions since 1998 is capitalised and, under UK GAAP, was amortised over a maximum 20-year period. Under IFRS, goodwill is no longer amortised but instead is subject to annual reviews to test impairment.

On transition to IFRS, the amortised balance was tested for impairment, and subsequent tests have been performed in 2005 and 2006. Impairment of £11m was charged in 2005 in respect of the acquisition of Fairchild Defense Systems; no impairment charges have been made in the current year.

Treasury
The aim of Treasury in Smiths is to ensure a robust and prudent financial profile while driving value throughout the Company to attain the business's full potential. With this goal in mind, Treasury aims to reduce the cost of capital by optimising financial liabilities with the support of world class banks.

Smiths continues to apply centralised treasury management over its financial risks, operating within a strong control environment. The Company uses financial instruments to raise money for its operations and to manage the related financial risks. Smiths neither speculates nor trades in derivative financial instruments and all financial instruments are properly recognised on the balance sheet. The Board has approved a Treasury Policy, which governs the financial risk profile, and a treasury compliance report is presented annually to the Audit Committee.

The objectives of the treasury function remain the same as in previous years and are explained in further detail below.

1. To deliver the liquidity requirements of the businesses cost-effectively. The Company aims to minimise the level of surplus cash but, where surpluses arise, tight controls apply to ensure that they are securely placed with highly-rated counterparties and are available for redeployment at short notice. The Company is required under IFRS to show gross borrowings and cash under its cash pooling arrangements, despite these balances being netted for interest purposes, which exaggerates the Company's surplus cash balance. Local working capital needs and capital expenditure requirements are typically funded by local bank facilities. In addition, Smiths has extensive local and cross-border cash pooling arrangements, and arm's length inter-company lending through financial centres, to optimise the global deployment of funds across its businesses in a tax-efficient manner.

2. To manage the central funding demands and provide a low cost of debt. The Company's funding requirements are largely driven by acquisition activity and met by centrally arranged debt finance. Smiths has net debt of £923m with average maturity of five years and at an average effective interest rate after interest and currency swaps of 5.6%. Through the use of interest rate swaps, Smiths maintains a broadly even mix of fixed and floating rate debt.

Credit ratings remain at A-/A3 with Standard & Poor's and Moody's respectively, reflecting the Company's strong financial profile and business outlook. The key financial measures that the ratings agencies consider are interest cover, currently standing at 9.6 times headline operating profit and the proportion of operating cash-flow to total debt, which under IFRS stands at 40%.

3. To develop and maintain strong and stable banking relationships and services. Smiths has a core and stable group of eleven leading global banks and financial institutions that competitively tender for treasury business. Credit exposures to any one bank are carefully controlled. All business transacted with the banks is on consistent terms and is fairly allocated.

4. To provide reasonable protection from the effect of foreign currency volatility. Material cross-border sales or purchase contracts in foreign currencies are hedged at their inception by appropriate derivative financial instruments, principally forward foreign exchange contracts and swaps, with the Company's core banks as counterparties. Whilst the trends of foreign currency movements cannot be eliminated, this hedging programme reduces volatility, protecting cash-flow and margins.

Smiths has adopted hedge accounting for the majority of the Company's business at its larger sites, thereby mitigating the impact of transactional exposures in the profit and loss account.

Smiths protects its reserves from foreign currency fluctuations by ensuring that at least 75% of the total net overseas operational assets are offset either by borrowings in the respective currency or by currency swaps. This excludes goodwill which is only partly hedged.

Overseas earnings are translated at average currency rates for the year, which smoothes the effect of currency volatility.

The Company's strategy is to continue to take a risk-averse approach to managing and controlling financial risks, be it hedging currency and interest rate risk, liquidity or management of refinancing risk.

Financial controls
While the Company's decentralised organisation delegates day-to-day control to local management, Smiths has comprehensive control systems in place with regular reporting to the Board. The Company has continuous formalised business risk management processes operating at each business unit.

The internal audit department reviews all units over a rolling three-year cycle, and its findings are reported to the Audit Committee. All acquisitions are reviewed within 12 months of acquisition, to verify compliance with Company procedures.

Further information regarding the Company's procedures to maintain strict controls over all aspects of risk, including financial risk, are set out in the Corporate governance report.