Contents

Direction

Explanatory Memorandum

Summary

Chapter One – Introduction and background

Chapter Two – Initial proposals

Chapter Three – Responses to the draft Direction

Chapter Four – Oftel’s final decision

Annex A – Respondents to the draft Direction

Annex B – Side Letter Agreement between the Director and BT

Annex C – Glossary

DIRECTION UNDER CONDITION 78.14 OF THE PTO LICENCE GRANTED TO BRITISH TELECOMMUNICATIONS PLC

WHEREAS:

(i) The Secretary of State for Trade and Industry granted a licence (the "Licence") to British Telecommunications on 22 June 1984 under Section 7 of the Telecommunications Act 1984 (the "Act") for the running of telecommunications systems specified in Annex A to the Licence;

(ii) By virtue of Section 109 of, and paragraph 20 of Schedule 5 to, the Act, the Licence has effect as if granted to British Telecommunications plc ("BT");

(iii) BT, in accordance with condition 78 of the Licence, has an obligation to prepare and publish Financial Statements for each financial year in accordance with, amongst other things, the Accounting Documents;

(iv) Condition 78.14(a) of the Licence allows the Director General of Telecommunications ("the Director"), where he has reasonable grounds to believe that, amongst other things, any or all of the Accounting Documents or the Financial Statements are deficient, to investigate, assess, examine or review BT’s accounting records or accounting and reporting arrangements, systems or processes;

(v) Condition 78.14(b) of the Licence allows the Director, as a result of any such investigation, assessment, examination or review, and where he is satisfied that, amongst other things, any or all of the Accounting Documents or the Financial Statements are deficient, to direct BT to amend any or all of:

(vi) On publication of the Financial Statements prepared by BT pursuant to condition 78 of the Licence for the financial year 1998/1999, the Director had reasonable grounds to believe that those Financial Statements and the Accounting Documents were deficient. The Director therefore, in September 1999, commenced an investigation under condition 78.14(a) of the Licence into BT’s accounting records, accounting and reporting arrangements, systems and processes;

(vii) On publication of the Financial Statements prepared by BT pursuant to condition 78 of the Licence for the financial year 1999/2000, the Director had reasonable grounds to believe that those Financial Statements and the Accounting Documents were deficient. The Director therefore continued the investigation under condition 78.14(a) of the Licence commenced in September 1999 to include those Financial Statements;

(viii) On publication of the Financial Statements prepared by BT pursuant to condition 78 the Licence for the financial year 2000/2001, the Director had reasonable grounds to believe that those Financial Statements and the Accounting Documents were deficient. The Director therefore continued the investigation under condition 78.14(a) of the Licence commenced in September 1999 to include those Financial Statements;

(ix) As a result of the investigation under 78.14(a) of the Licence into the Financial Statements prepared and published by BT for the financial years 1998/1999, 1999/2000 and 2000/2001 and the Accounting Documents, the Director is satisfied that the Financial Statements and the Accounting Documents are deficient;

(x) The Director issued a draft of this direction and explanatory memorandum on 21 August 2002 and responses were invited by 18 September 2002;

(xi) Comments were received from BT and a number of operators as summarised in Chapter 3 of the explanatory memorandum published with this direction. The Director, in making this direction, has taken these comments into consideration;

THEREFORE

Pursuant to condition 78.14(b) of the Licence, the Director makes the following direction:

Composition of the Network and Access Businesses

1. BT shall within 14 days of the making of this Direction amend the composition of:

2. BT shall within 14 days of the making of this Direction amend the name of the Access Business to "Retail Narrowband Access Business", and, for the avoidance of doubt, from the date of the change of name, all references in the Licence, the Accounting Documents or this Direction to the "Access Business" shall be construed as a reference to the Retail Narrowband Access Business.

Amendments to form and content

3. BT shall within 14 days of the making of this Direction amend the form and content of the statement of costs on a current cost basis as part of the Financial Statement to the Network Business such that the Network Components currently disclosed within that statement of costs are replaced by the Network Components listed at Annex B.

Amendments to the Accounting Documents

4. BT shall, by 2 December 2002, amend each of the Accounting Documents as necessary to ensure that they provide a transparent description of the accounting and other methods used in the preparation of the Financial Statements and the Standard Service Statements such that a suitably informed reader can easily:

5. BT shall, by 2 December 2002, amend the Regulatory Accounting Principles as follows:

• gain a clear understanding of the overall structure of BT’s financial and information systems from which regulatory accounting data is derived and in particular the sequence of the processing and ‘cascade’ effect of the intermediate cost centres;
• gain a detailed understanding of all the material, methodologies and drivers (e.g. systems, processes and procedures) applied in the preparation of regulatory accounting data;
• make their own judgement as to the reasonableness of these methodologies and driver data and any changes to them."

6. BT shall, by 31 December 2002, amend the Attribution Methods such that a new paragraph 2.3.3.4 shall be inserted as follows:

7. BT shall, by 31 December 2002, amend all of the Accounting Documents such that they clearly indicate which parts of each Accounting Document, and which parts of each of the Detailed Attribution Methodology, the Detailed Valuation Methodology, and the Long Run Incremental Cost (Relationships and Parameters) constitute

8. For the purposes of this Direction, words and phrases shall have the meanings ascribed to them in the Licence or the Act as appropriate.

ANNEX A TO THE DIRECTION

[Pursuant to paragraph 1 of this Direction, BT shall amend the composition of the Network and Access Business in accordance with this Annex.]

"Network Business" means the Business which includes the revenues, costs and assets derived from or used in activities related to Interconnection taken together.

(b) The costs are:

(c) The assets are all of the facilities and equipment which cause the costs described in subparagraph (b) to be incurred plus the debtors of the Network Business less any creditors of the Network Business.

(d) For the purposes of this definition, the network components or parts (or groups of network components or parts) are:

1. Local exchange concentrator
2. Local exchange set up
3. Local exchange call set up
4. Main exchange set up
5. Main exchange call duration
6. Remote-local transmission link
7. Remote-local transmission length
8. Local-tandem transmission link
9. Local-tandem transmission length
10. Inter-tandem transmission link
11. Inter-tandem transmission length
12. Product management, policy & planning for PSTN/ISDN
13. National operator assistance
14. International operator assistance
15. Emergency operator assistance
16. Outpayments: geographic calls
17. Outpayments: non geographic calls
18. Outpayments: calls to mobile
19. Outpayments: CNS (formerly Concert)
20. Outpayments: other
21. Public payphones operation
22. Public payphones line
23. International network
24. Copper access lines
25. Fibre access lines
26. Fibre access paths over SDH
27. Network terminating equipment for PSTN/LLU
28. CWSS network terminating equipment & serving exchange equipment
29. DWSS network terminating equipment & serving exchange equipment
30. PDH multiplexors as customer premises equipment
31. SDH multiplexors as customer premises equipment
32. SDH (MSH) multiplexors as customer premises equipment
33. ATM network terminating equipment
34. PDH multiplexors
35. SDH mutliplexors
36. SDH cross connection/grooming equipment
37. Tributary card for SDH network by size
38. SDH (MSH) mutliplexors
39. SDH (MSH) cross connection/grooming equipment
40. Tributary card for SDH (MSH) network by size
41. Transmission links over fibre
42. Transmission links over radio
43. Inbuilding links
44. ATM switches
45. Customer facing ATM tributary cards by size
46. Network facing ATM tributary cards by size
47. Signalling links
48. Development switching
49. Guarantee schemes
50. Returns of infrastructure etc (eg drop/multiplexors) paid for upfront to BT
51. PSTN specific (line cards, pair gain equipment etc)
52. Passive optical network
53. ISDN 2 specific
54. ISDN 30 specific
55. Phonebooks etc
56. Number Portability Data Amendments
57. Number Portability Set-up Costs
58. Carrier Pre Selection System Set-Up
59. Carrier Pre Selection Operator Set-Up
60. Carrier Pre Selection Customer Set-Up
61. Carrier Pre Selection in life management
62. ASU switches (Featurenet)
63. DDSN switches
64. Universal card platform (for cashless services)
65. IN platform - basic services
66. IN platform - advanced services
67. Copper loop line information & testing
68. Copper cabling within exchange buildings
69. Copper cabling from within exchange buildings to outside
70. Comingling – electricity
71. Comingling - accomodation
72. Comingling - other
73. Colocation
74. Bespoke network build - copper
75. Bespoke network rearrangement - copper
76. Other LLU
77. Product management, policy & planning for LLU/ANFs
78. Private circuit specific: equipment (eg DPCN, test systems)
79. Product management, policy & planning for partial private circuits
80. Shorthaul data/LAN extension specific
81. Flexible bandwidth specific
82. Frame Relay specific (frame relay switches)
83. SMDS specific 84. xDSL specific (eg DSLAMS and CPE)
85. Product management, policy & planning for LLU/ANFs
86. Edge IP routers
87. Core IP routers
88. IP dial up
89. IP fixed access
90. IP broadband
91. IP virtual private networks
92. Voice over IP
93. IP international peering (outpayments)
94. Telex specific
95. Broadcast specific
96. Aeronautical & maritime specific 97. Satellite specific 98. DMS100 call centre

"[Retail Narrowband] Access Business" means the Business which includes the revenues, costs and assets as follows:

For the purposes of these definitions, "Switched Narrowband Lines" are lines used to provide switched telephony or ISDN calls providing for connections up to 128 kilobits per second.

ANNEX B TO THE DIRECTION

[Pursuant to paragraph 3 of this Direction, BT shall amend the form and content of the statement of costs on a current cost basis for the Network Business such that the following network components are set out within that statement.]

Local exchange concentrator
Local exchange processor set-up
Local exchange processor call duration
Total local exchange processor
Main and digital junction switching set-up
Main and digital junction switching call duration
Total main and digital junction switching
Local to remote transmission link
Local to remote transmission length (c)
Local to tandem transmission link
Local to tandem transmission length (c)
Tandem to tandem transmission link
Tandem to tandem transmission length (c)
Product management, policy & planning
Inbuilding links
Other
Total interconnect connections and rentals
Transmission links over radio
Product management, policy & planning for partial private circuits
Shorthaul data / LAN extension
Flexible Bandwidth Services
Other
Total inland private circuits
National operator assistance
International operator assistance
Emergency operator assistance (999)
Public payphone operations
Public payphone line
Number portability data amendments
Number portability set-up costs
ASU switches
Universal Card Platform
SMDS
Telex
DMS 100 Call Centre
Other
Total BT only other
ATM switches
Customer facin
ATM interface
Network Facing
ATM interface
Frame Relay
Core IP Router
IP Dial u
IP fixed acces
IP Broadban
IP VP
Other
Total data services
Core IN
IN Advanced Services
Other
Total Cambridge IN
Carrier Pre Selection System Set-Up
Carrier Pre Selection Operator Set-Up & in-life management
Carrier Pre Selection Customer Set-Up
Total Carrier Pre Select
DDSN Switches
Other
Total other multifunction
Broadcast
Other
Total international network costs
Outpayments: geographic calls
Outpayments: non-geographic calls
Outpayments: calls to mobile
Outpayments: Concert
Outpayments: other
Total outpayments
Access network

Explanatory Memorandum

Summary

S.1 The Director General of Telecommunications (‘the Director’) has issued a Direction following an investigation under licence condition 78.14 into the regulatory Financial Statements of British Telecommunications plc (‘BT’). This Direction was consulted upon by the issuing of a draft Direction on 21 August 2002. The Director has considered the representations received during the consultation period in issuing this Direction.

S.2 The results of the investigation were shared with BT and the proposals published in the draft Direction were the subject of detailed discussions at BT Group Finance Director level. These discussions with BT have continued following the consultation period. Oftel welcomes this positive commitment.

S.3 This Direction directs BT to make improvements to the regulatory Financial Statements and the Accounting Documents to address issues identified by the investigation. Additionally, certain issues are being dealt with in a side letter that formalises an agreement between Oftel and BT to carry out some improvements ‘off-licence’. The Direction, side letter and explanatory memorandum do not deal with BT’s statutory Consolidated Financial Statements and should not be read as any criticism of them.

S.4 The investigation under condition 78.14 identified a number of priority areas for improvement. These can be broadly categorised as follows:

• fuller disaggregation of regulatory financial information to a level of granularity required by the Director;
• greater transparency and disclosure of the policies, systems, procedures and processes that explain how the regulatory financial information has been prepared; and
• greater consistency in the treatment of some specific accounting matters and the presentation of comparative data.

S.5 The Director proposed in the draft Direction to address these issues by directing BT to:

• prepare regulatory financial information at a level of granularity more consistent with market analysis, typically at the level of product groups, or in specific cases at the level of geographic region or customer class;
• disclose all relevant methodologies (including those relating to the operational and financial policies, systems, procedures and processes) used to prepare the regulatory financial information in a clear and transparent manner; and
• amend some specific regulatory accounting treatments to those specified by the Director.

S.6 In its representations to the Director regarding the draft Direction, BT raised a number of practical concerns. These can be categorised as:

• the increased cost of providing financial statements on a greater number of disaggregated activities;
• the lack of a materiality threshold for product groups;
• the difficulty of producing financial statements disaggregated by customer class and geographic region.
• the difficulty of procuring ‘fairly presents in accordance’ (FPIA) audit opinions on the disaggregated activities and additional financial information; and
• the increased cost of implementing the ‘transparency test’.

S.7 Representations were also received by the Operators’ Group, Vodafone and Conduit. These representations were supportive of the Director’s proposals.

S.8 Following consideration of the representations and discussions with BT over their concerns, the Director has revised his proposals so that certain issues are dealt with ‘off-licence’ under the terms of a published side letter. The advantage of this approach is that it provides greater flexibility regarding the appropriate level of audit opinions than provided for by condition 78. The following information will be provided under the terms of the side letter:

• more detailed and transparent accounting documentation necessary to support the ‘transparency principle’;
• additional financial statements, with a ‘properly presented in accordance’ (PPIA) audit opinion, for each product group with revenues or costs greater than £50 million;
• an aggregation, with a PPIA audit opinion, within each regulatory business of those product groups with revenues or costs up to and including £50 million;
• the audit of any additional financial statements that the Director has reasonable grounds to believe that there is a regulatory need not covered above; and
• additional financial information, with a PPIA audit opinion on request.

S.9 The Director, therefore, is directing that BT:

• amend its regulatory Businesses;
• amend the form and content of the statement of costs to the Network Business to include more detailed network components;
• add a principle relating to transparency to the Accounting Documents;
• add a principle relating to the use of UK GAAP to the Accounting Documents; and
• exclude redundancy costs from its Network Business.

S.10 The Director decided that the purpose of the ‘transparency test’ could be met by a ‘transparency principle’ developed in the course of the discussion between BT and Oftel. Therefore, the Director is directing that BT implements and meets this ‘transparency principle’.

S.11 The Director believes that this course of action will aid Oftel in assessing accurate, relevant, up-to-date regulatory financial information, that is available in a timely manner and supported by an appropriate level of disclosure of its bases of preparation. The course of action is also consistent with Oftel’s goal to enable consumers to achieve the best deal in terms of quality, choice and value for money in telecommunications services.

S.12 Oftel will be issuing a separate consultation document setting out is medium-term proposals for the further development of regulatory accounting in the new European regulatory environment as part of the wider implementation programme.

Chapter One

Introduction and background

1.1 Condition 78.14 provides for the Director to investigate BT’s regulatory Financial Statements for a number of reasons, including that any of the Accounting Documents or the regulatory Financial Statements are ‘deficient’. It should be noted that ‘deficient’ is a term used in BT’s licence and refers only to the regulatory financial information provided to the Director under condition 78. If the Director is satisfied that the Accounting Documents or regulatory Financial Statements are ‘deficient’ he may direct BT to amend any or all of:

• the composition of any or all the Businesses;
• the manner in which any or all of the Businesses are disaggregated in terms of activities of the relevant Business;
• the form and content of any or all of the profit and loss account, the statement of mean capital employed, statements of cost and the additional information to be provided by way of notes comprised in the regulatory Financial Statements or the Restated regulatory Financial Statements or any or all of the Businesses; and
• any or all of the Accounting Documents.

1.2 On 21 August, Oftel published A draft Direction under the provisions of licence condition 78.14 – Regarding the regulatory Financial Statements of British Telecommunications plc. This draft Direction and explanatory memorandum presented the results of an investigation carried out in accordance with condition 78.14 of BT’s licence in relation to BT’s regulatory Financial Statements for the years ending 31 March 1999, 2000 and 2001. Based on the findings of this investigation, the Director concluded that the regulatory Financial Statements and the Accounting Documents that BT prepares under the terms of condition 78 are ‘deficient’. This was because:

• the regulatory Financial Statements currently provided by BT, on defined Businesses and disaggregated activities, are not sufficiently granular and multi-dimensional for the Director to continue to be able to carry out his duties effectively as possible; and
• the Accounting Documents, taken together with the supporting detailed methodology documents, do not disclose sufficient information for the Director to fully understand all the regulatory accounting methodologies (including descriptions of the policies, systems, procedures and processes used) used to prepare regulatory accounting information. Full transparency of the bases on which regulatory financial information is prepared is essential for the Director to be able to properly evaluate regulatory accounting information.

1.3 The Director also examined a number of technical accounting issues and proposes modifications to improve consistency and transparency of these matters in the regulatory Financial Statements.

1.4 This investigation also took account of Oftel’s experience in reviewing BT’s regulatory financial information which has, on a number of occasions, shown serious shortfalls such as:

• the limitations of BT’s systems and processes to provide the information that the Director needs in the discharge of his duties;
• the lack of transparency given to cost attribution methodologies; and
• the length of time taken to provide relevant detailed regulatory financial information.

1.5 The Director therefore proposed to direct BT to remedy the identified ‘deficiencies’ in the regulatory Financial Statements and in the Accounting Documents, within the framework of the existing condition 78, in the terms specified in the draft Direction published on 21 August.

1.6 Chapter Two summarises the proposals made in the draft Direction. Chapter Three summarises the responses made to the draft Direction and Oftel’s position on the issues raised by the responses. Chapter Four describes the Direction as it will be implemented.

Proposals in the draft Direction

2.1 On 21 August, Oftel published A draft Direction under the provisions of licence condition 78.14 – Regarding the regulatory Financial Statements of British Telecommunications plc. In this document the Director General proposed the generation of more granular, multi-dimensional regulatory Financial Statements. This chapter summarises the proposals. For more detail on the proposals please see the draft Direction and Explanatory Memorandum referred to above.

2.2 The Director proposed that BT be required to:

Chapter Three

Responses to the draft Direction

3.1 This section summarises the responses made to the draft Direction. It also presents Oftel’s views on the responses. The issues raised by the responses fell into two categories: those related to the detail of the proposals and those relating to the scope of the proposals and their context within issues such as EU legislation and competition law.

General issues relating to the draft Direction

Scope of condition 78.14

BT response

3.2 BT states that Oftel is attempting to extend the use of condition 78 to cover areas outside the "whole purpose" described in condition 78.1, ie to ensure that BT does not unfairly subsidise/cross-subsidise, or show undue preference/discrimination; to enable the Director General to investigate whether interconnection charges are reasonably and transparently derived from costs; and to ensure that the Director General is able to assess whether charges for Access Network Facilities are reasonably and transparently derived from costs.

3.3 The areas that BT claims Oftel is attempting to extend use of condition 78 to cover are:

• ensuring compliance with obligations set out in European Community Directives;
• assessing the effectiveness of competition under the Telecommunications Act 1984;
• carrying out competition investigations under the Competition Act 1998;
• calculating price/charge controls or determining the price of services;
• to ensure BT’s charges for leased lines and fixed telephony services meet the EU Directive obligations for cost orientation and transparency;
• to make price/charge determinations; and
• to ensure compliance with condition 78.

3.4 BT states that in its opinion this makes the draft Direction legally defective. BT also states that under condition 78.14 the Director General has the ability to amend the Accounting Documents, but not to direct changes to the DAM and other documents.

Oftel view

3.5 In the explanatory memorandum to the draft Direction published on 21 August, Oftel clearly indicated that the purpose of the proposals was to amend ‘deficiencies’ with the regulatory Financial Statements identified by the investigation, within the scope of condition 78.14. Oftel identified other issues and areas where the Director’s proposals might have a ‘knock-on’ effect, and commented on these issues for context. However, the rationale for all the proposals were within the scope of condition 78.14.

Cost benefit analysis

BT response

3.6 BT states in its response that Oftel has failed to carry out a Cost Benefit Analysis (CBA) for its proposed action. BT also states that Oftel has not made an attempt to quantify the benefits of its proposals, eg development of competition, speedier investigations, contributing to the setting of price determinations and charge controls. BT argues that the proposals would lead to the annual running costs of its regulatory accounting systems and processes would rise to at least £18 million.

Oftel view

3.7 Oftel carried out a regulatory option appraisal on the proposals in the explanatory memorandum in line with its published guidelines. Oftel is certain that the importance of ensuring the effectiveness of the accounting separation regime fully justifies the proposals made. It must be remembered that accounting separation is a key regulatory tool in a £41.4 billion sector, in large parts of which BT is identified as having significant market power (SMP).

Objective justification for proposals

BT response

3.8 In its response, BT argues that the examples given by Oftel to demonstrate the deficiencies of BT’s current regulatory Financial Statements do not relate to the main thrust of Oftel’s proposals and are not justified.

Oftel view

3.9 Oftel disagrees with BT’s argument and believes that both the volume and nature of the examples given were sufficient to demonstrate the deficiencies of BT’s current regulatory Financial Statements.

New directives

BT response

3.10 BT believes that Oftel’s proposals are not consistent with the new EU Directives which will come into force on 25 July 2003. BT’s interpretation of the new directives can be summarised as follows:

3.11 BT also states that it believes that given the relatively short time before the new directives are implemented it is not reasonable for Oftel to undertake such significant actions under a regime that has such a short lifespan.

Oftel view

3.12 The new EU Directives will not come into force until 25 July 2003. Until that time condition 78 of BT’s licence covers the accounting separation regime. It is also worth noting that the EC’s recommendation on relevant markets is still at draft stage.

3.13 Additionally, due to the time-lag in the production of the regulatory Financial Statements a significant proportion of the aspects of the proposed regime will cover two full financial years, ie the financial years ending 31 March 2002 and 31 March 2003, respectively. Therefore, given the importance of accounting separation to the regulatory regime, Oftel believes that it is fully justified in implementing changes that will cover a full two years of financial information.

3.14 Oftel has begun work on developing a regime to operate under the new EU Directives. A consultation document on accounting separation under the new EU Directives will be published in February 2003. Oftel’s position on BT’s interpretation of the new regime will be made clear in that document.

EU Consistency and harmonisation

BT response

3.15 BT argues that Oftel’s proposals in the draft Direction represent a far greater burden than those imposed on incumbent operators in other EU member states. It states that the UK complies more fully with the EU obligations on accounting separation than all the other member states, but argues that the proposals in the draft Direction will exacerbate this difference by making reporting in the UK even more onerous than in other member states.

Oftel view

3.16 Oftel does not consider an argument that other member states do not fully implement EU law for accounting separation relevant in ensuring its own compliance. Oftel is confident that its proposals are fully in accordance with the current EU regulatory framework. Oftel is also confident that it demonstrated in the explanatory memorandum to the draft Direction that these proposals were necessary to rectify deficiencies in the regulatory Financial Statements under the current regime.

Comparison with other UK sector regulators

BT response

3.17 BT states that the obligations proposed by Oftel are greater than those imposed by other UK sector regulators in terms of frequency and scope.

Oftel view

3.18 Oftel does not consider this to be a valid comparison. Indeed other UK sector specific regulators design their information requests for very different purposes and in some cases – eg Ofwat – these are far more detailed and onerous.

Comparison to competition law practices

BT response

3.19 BT argues in its response that the proposals in the draft Direction differ from competition law practices in four main ways:

• the level of information required by competition authorities is more tightly focused on particular issues of concern and is therefore less onerous;
• that competition authorities do not use a pre-defined set of economic markets as Oftel does;
• that there have been numerous competition law cases where the publication of detailed cost information has been judged to be anti-competitive; and
• that by causing material increases in BT’s cost of compliance and providing competitors with information, Oftel’s proposals risk distorting competition in the market.

Other responses

3.20 The Operators’ Group ("an informal alliance of major telecommunications operators in the UK excluding BT") stated in their response that as Oftel begins to draw as much on competition legislation as it does on general regulation, BT’s accounting obligations need to be updated to ensure that they are fit for purpose and more closely reflect the underlying principles of competition.

3.21 The Operators’ Group also stated that while it may be legitimate to suppress individual cost component numbers due to BT’s commercial confidentiality concerns, they were unaware of any instances where such a concern would be legitimate. They argued that the publication of accounts at product level should not infringe commercial confidentiality as many of BT’s interconnect charges are required to be cost oriented.

Oftel view

3.22 Oftel is a sectoral regulator and a competition authority. As a competition authority under the Competition Act of 1998 Oftel uses ex post regulation to address anti-competitive practices. However, as a sectoral regulator Oftel has been granted powers of ex ante regulation, ie the ability to impose regulations to prevent an operator with SMP from misusing its position in the market. Condition 78 is an example of ex ante regulation and therefore it is not appropriate to compare with examples of ex post regulation.

3.23 Oftel still does not believe that the level of disaggregated regulatory financial information published will increase significantly as a result of the proposals in the draft Direction (as explained in 5.34 of the explanatory memorandum to the draft Direction). Therefore, the issue BT raised regarding the potential anti-competitive effect of published information is not applicable.

Responses on the detail of the proposals

Transparency proposals

BT response

3.24 In its response, BT refers to the ‘reperformance test’. This is what Oftel referred to in the draft Direction and Explanatory Memorandum as the ‘transparency test’.

3.25 BT’s objections to the transparency test proposed by Oftel are:

• the concept of a ‘reasonably competent qualified accountant’ is not recognised by the accounting profession and that there are no professional audit guidelines for the test;
• it would lead to an expansion of the documentation to "tens of thousands of pages";
• as no one other than BT has the data necessary to carry out the test, it is impractical; and
• it would significantly increase BT’s costs.

3.26 BT suggests that it is Oftel’s intention that in order to meet this test BT and its auditors will have to actually carry out the test, ie build such a model.

3.27 As an alternative, BT proposed that it should improve the documentation so as to pass a ‘reasonable accountant’ test, ie that a reasonable accountant would be able to understand the regulatory Financial Statements if he devoted an appropriate period of time to his review. BT also stated that it was ready to accept Oftel’s proposal to include adherence to UK GAAP as a formal principle in the Accounting Documents. It also agreed to reflect any material ‘post balance sheet’ event, consistent with the GAAP assessment as to whether any such event was an adjusting event or simply required disclosure.

3.28 BT also states that it is unclear why Oftel is concerned about year-on-year comparatives. It states that its Financial Statements are restated where a cost attribution methodology is changed in a way that has a material year-on-year impact. However, it believes that it is impractical for it to re-process the prior year’s results to make it consistent with the current year.

Other responses

3.29 Vodafone supported Oftel’s proposals for transparency, including the documentation of supporting methodologies. In addition, Vodafone agreed that the ‘reasonably competent qualified accountant’ test would provide an effective degree of transparency and that the application of UK GAAP would provided a basis for comparability for regulatory accounts.

3.30 The Operators’ Group made a number of comments on transparency issues. The Operators’ Group welcomed the introduction of what they referred to as an ‘adequacy test’, ie the test referred to by Oftel as the ‘transparency test’. They also suggested that the test could benefit from the addition of a signed off commitment from the external auditors that the conditions of the test had been met.

3.31 The Operators’ Group also suggested that a document control process be established for the Accounting Documents and supporting methodological documents to increase transparency of any changes.

3.32 The Operators’ Group also welcomed Oftel’s proposal to link BT’s regulatory accounting treatment to UK GAAP as they believed that this would increase objectivity, consistency and comparability of the data and also increase transparency. They suggested that BT should publish a list of where the regulatory accounting treatment differed from UK GAAP.

Oftel view

3.33 Oftel regards increased transparency of BT’s accounting methodologies as the single most important proposal contained in the draft Direction. However, after detailed consideration, Oftel believes that this objective could be achieved by using a revised version developed in discussion with BT and external advisers. The acceptance of this proposal is obviously conditional on the quality of the improved documentation produced by BT. Therefore, Oftel has decided to replace the ‘transparency test’ in the draft Direction with the principle set out in the Direction, and to oblige BT to provide more detailed and transparent documentation of its accounting methodologies in order to meet this principle.

3.34 Additionally, Oftel stands by its concerns that there have been serious issues with year-on-year comparatives in the past. However, Oftel welcomes BT’s acceptance of the proposal to use UK GAAP and believes that this will resolve this and other comparability and consistency issues without the need for explicit additional provisions.

Impact of more granular financial statements

BT response

3.35 BT states that the additional disaggregation proposed by Oftel will significantly increase the amount of information that BT is obliged to produce, from 17 formally disaggregated activities to 344. BT repeats its assertion that the products and services listed as disaggregated activities do not correspond to the markets that Oftel will be required to analyse for the purposes of the new directives.

3.36 BT also states that it would be problematic to produce information on the basis of customer segmentation and geographic area. BT believes that Oftel has not supported the proposals by any rationale.

3.37 On the issue of geographic segmentation for leased lines, BT correctly interprets the draft Direction to reach the conclusion that Oftel’s proposal was for this to cover leased lines where both the ‘A’ and ‘B’ ends exist in that area, ie those leased lines for which BT has geographically deaveraged prices.

3.38 BT states that for the financial year 2000/2001, the smallest disaggregated activity was Public Payphones, with revenues of £220 million and the smallest value network component for which costings were published was International Operator Assistance with a total cost of £6 million. BT claims that under the proposals in the draft Direction it would have to report for products and components with revenues and costs below £1 million.

3.39 BT states that the draft Direction would require BT to obtain a ‘fairly presents in accordance with’ (FPIA) audit opinion for each of the 344 proposed disaggregated activities and regulatory businesses. BT states that it would be difficult to prepare information at this level of granularity so that it would gain an FPIA audit opinion required by condition 78, or would involve significant investment to upgrade its systems to achieve this. BT believes that the impact of this on the preparation and audit of the information would be impracticable, unreasonable and disproportionate.

3.40 BT proposed in its response that the product segmentation should follow the market definitions contained in the European Commission’s Recommendation on relevant product and service markets. BT accepts that for retail markets there may be detailed reporting requirements that may vary by market and that it would work with Oftel on implementation. Until that process was complete, BT proposes to disclose privately to Oftel each of the individual product groups for which it prepares results. In wholesale markets, BT proposes that it would disclose to Oftel all of the network components currently in the AS system and that components with a total cost above a certain level should be subject to the lower standard of a ‘properly prepared in accordance’ (PPIA) audit opinion. (See Annex C - Glossary for further descriptions of FPIA and PPIA.)

3.41 BT states that to include as part of the Financial Statements, as ‘additional information provided by way of notes’, information that it has previously provided on a voluntary basis will have consequences as such information would have to be audited and published. BT states that this would increase costs and that much of the information is commercially confidential.

Other responses

3.42 In its response to the draft Direction, Conduit plc – a provider of directory enquiry services – stated that its is essential that directory enquiries is treated as a separate business activity by BT in its regulatory Financial Statements due to BT’s dominant position in the market being likely to continue for a number of years.

3.43 The Operators’ Group supported Oftel’s decision to implement Option 3, ie targeted multi-dimensional regulatory Financial Statements. (For further details of Option 3, see Chapter Four of the Explanatory Memorandum of the draft Direction.) They stated that there is an ongoing need for the product list to be updated when new products become available or alterations are made and suggested an annual review of the product list would be beneficial.

3.44 In their response, the Operators’ Group requested clarification over what level of audit scrutiny was planned. They believed that the lack of external auditor involvement had contributed to be overall decline in the quality of BT’s regulatory accounts and would like to see a stronger audit obligation. They suggested a formal requirement for an external firm of accountants to sign off the regulatory accounts as fit for purpose.

Oftel view

3.45 Oftel would again make the point that the new EU Directives will not be implemented until 25 July 2003 and that a significant proportion of the proposals in the draft Direction will cover two full financial years’ worth of information. However, following discussions with BT regarding their concerns Oftel is willing to remove the proposed obligations to produce customer class and geographic area disaggregated activities. Oftel does wish to receive an explanation of the methodology on which the customer class information for the retail price control was prepared.

3.46 Oftel accepts that BT may have legitimate difficulties procuring audit opinions at an FPIA level for disaggregated activities. However, under condition 78.7 there is no flexibility for Oftel to accept any audit opinion other than FPIA in the regulatory Financial Statements. Therefore, Oftel proposes that the additional disaggregated are provided by BT ‘off-licence’ under the terms of a published side letter, on the understanding that these activities are audited to the level of PPIA.

3.47 Oftel is willing to accept a materiality threshold for the audit of product groups. Therefore, the side letter provides for BT to prepare financial statements for all product groups with revenues or costs in excess of £50 million. Oftel will also require financial statements for each Business aggregating those product groups that fall below the thresholds. The Director also reserves the ability to demand individual financial statements with a PPIA opinion for product groups with revenues or costs of £50 million or less, where a regulatory need can be demonstrated. However, Network components are still to be dealt with in the Direction under condition 78 although not as disaggregated activities (see 4.7 of Chapter Four).

3.48 Oftel also accepts BT’s concerns regarding audit levels for the additional information to be provided by way of notes (ie the ‘supplementary schedules’). Therefore, Oftel proposes that this information is also provided ‘off-licence’ and under the terms of the side letter, on the condition that this information can be audited at PPIA level on request.

3.49 To clarify the point made by the Operators’ Group, it should be noted that BT’s regulatory Financial Statements are already audited by an external auditor.

Timescales

BT response

3.50 In its response BT stated that – given the scope of the draft Direction – the timescales set by Oftel would be impracticable, ie requiring BT to undertake certain actions within 14 days of the publication of the Direction and others by 28 October 2002.

Oftel view

3.51 Oftel accepts that the deadlines expressed in the draft Direction no longer fit easily with the deadline for the 2001/2002 regulatory Financial Statements. Oftel has therefore revised some of the deadlines for implementation and the date for publication of the 2001/2002 regulatory Financial Statements to allow changes to be made where feasible. Certain other changes will only impact on the regulatory Financial Statements for 2002/2003 (see Chapter Four for details).

Cost exclusions

BT response

3.52 BT raised two issues in respect of cost exclusions, both in relation to redundancy costs:

• BT believes that, although UK GAAP requires immediate write-off of redundancy costs, the regulatory principle of cost causality would suggest BT's treatment of redundancy (by amortising over three years) is appropriate and;
• BT believes that the benefits of redundancy accrue to all customers and hence there is no justification for excluding them.

Oftel view

3.53 On the first point, Oftel is of the view that UK GAAP treatment of redundancy and related costs (ie as an expense) is appropriate for regulatory purposes and that the cost causality principle does not imply some amortisation of costs over an arbitrary period on the grounds that it might lead to future efficiency savings. Indeed, the key issue is rather the eligibility or otherwise of these costs for deriving relevant costs for regulatory purposes. This leads on to BT's second point where Oftel has decided to exclude redundancy costs from the calculation of interconnection costs. This investigation did not revisit past regulatory decisions but did identify an issue with the inconsistency between the Network Business profit and loss account (which includes redundancy costs) and the LRIC (long run incremental costs) data on Network components (which excludes redundancy costs.

Reporting timetables

BT response

3.54 In its response, BT proposed that it would operate its accounting separation system at the end of each Q2 and Q3, starting in the financial year 2003/04. However, BT states that these interim analyses would not be subject to audit, that not all the input data would be updated and that the information would not be published.

Operators’ Group response

3.55 In their response, the Operators’ Group stated that quarterly publication cycles would strike the appropriate balance between the need for timely information and BT’s reluctance to produce regulatory accounts on a continual basis.

Oftel view

3.56 Oftel welcomes BT’s proposal to operate its accounting separation systems at the end of Q2 and Q3 in addition to producing the annual regulatory Financial Statements. Oftel accepts that Q1 of each financial year is taken up by the production of BT’s annual statutory Consolidated Financial Statements and the regulatory Financial Statements.

Planning and system development

BT response

3.57 BT proposed in its response that in the fourth quarter of each year it would share with Oftel its plans for the forthcoming year, with particular emphasis on those activities that would have AS implications, eg new product structures. BT also proposed sharing its plans for systems development in the product reporting area with Oftel.

Oftel view

3.58 Oftel welcomes BT’s proposals on planning and system development.

Chapter Four

Oftel’s final decision

4.1 As a result of the responses to the draft Direction, Oftel has made a number of changes to its proposals. Oftel does not regard any of these as being a material change. The differences primarily regard process issues rather than matters of principle.

4.2 The largest difference is the introduction of the side letter to complement the Direction. As explained in Chapter Three, Oftel accepts that due to the inflexibility of condition 78 regarding auditing of disaggregated activities that additional disaggregated activities could be provided off-licence under the terms of a published side letter. The side letter is attached as Annex B of the Explanatory Memorandum.

4.3 This chapter therefore looks at the contents of the Direction and the side letter and identifies any changes to the original proposals. The table below summarises the proposals in the draft Direction and the Director’s decisions regarding implementation.

Final Direction

4.4 The following issues are being implemented via the Direction in the same way as proposed in the draft Direction:

• the redefinition of the Access and Network Businesses, within 14 days of the publication of the Direction (see paragraphs 1 and 2, and Annex A of the Direction);
• the insertion of a Regulatory Accounting Principle on the use of UK GAAP, by 2 December 2002 (see paragraph 5 of the Direction);
• the exclusion of redundancy from the regulatory Financial Statements for the Network Business and to treat such redundancy as a reconciling item between the regulatory Financial Statements and the statutory Consolidated Financial Statements, by 31 December 2002 (see paragraph 6 of the Direction); and
• the amendment of the Accounting Documents to clarify which parts are principles and which are procedures, by 31 December 2002 (see paragraph 7 of the Direction).

4.5 The Direction also covers the transparency issue. In the draft Direction the Director proposed that the Accounting Documents be amended to meet a ‘transparency test’ and that this test be inserted as a Regulatory Accounting Principle. (See paragraphs 6 and 7(d) of the draft Direction and 5.21 to 5.24 of the Explanatory Memorandum to the draft Direction for details of this test.)

4.6 However, following representations made on the draft Direction, Oftel agreed with BT that the aim of the transparency test could be accomplished using a transparency principle, based on a reasonably competent accountant being able to understand the regulatory Financial Statements. The Director believes that this principle will ensure that the bases of preparation for the regulatory Financial Statements will be made transparent. Therefore, the Director is directing BT to amend the Accounting Documents to insert the transparency principle by 2 December 2002 (see paragraph 4 of the Direction).

4.7 The Director decided that given the information required on network components, it was not necessary that they should be formally designated as disaggregated activities. Therefore, he is directing that the form and content of the regulatory Financial Statements is amended, within 14 days of the Direction, so that network components listed in Annex B of the Direction are included as statements of costs. This list of network components does not cover the areas of PPCs and LLU, which are the subject of other work in progress. (See paragraph 3 of the Direction.) Other issues which will need to be dealt with in the context of the 2002/2003 regulatory Financial Statements include:

• the definitions of components needs to be clear and easily understood by Oftel and other stake holders. The proper documentation of the transparency principle should assist with this point;
• the 2001/2002 list matched components with BT’s existing systems where possible but this left other components (such as the Access Network) where further disaggregation is necessary to demonstrate, for example, non-discrimination; and
• the audit opinion does not specifically cover each line in the Network Statement of Costs and combined with the limited set of components agreed for 2001/2002, this does not necessarily give Oftel sufficient validation of important cost elements.

Off-licence issues and the side letter

4.8 As explained in Chapter Three, after considering the concerns expressed by BT in its response, the Director decided that certain issues could be dealt with ‘off-licence’, ie under the terms of a published side letter formalising an agreement between BT and Oftel. In particular this was necessary due to the inflexibility of the licence regarding the FPIA audit opinion.

Preparation of additional accounting information

4.9 In order for the Transparency Principle to work it is necessary for there to be adequate accounting information available to Oftel, so that it can understand the bases of preparation for the regulatory Financial Statements. Therefore, by 30 June 2003, BT will have to prepare transparent description of the systems and processes for deriving or calculating the costs, revenues, assets and liabilities used by BT to prepare the regulatory Financial Statements. (See paragraphs 1 and 2 of the annex to the side letter.)

4.10 BT has told Oftel that a programme of work will be undertaken up to the completion date of June 2003 and this work will be shared with Oftel allowing comments to be made.

Additional financial statements

4.11 The Director accepted BT’s concerns regarding achieving adequate audit for disaggregated activities and supplementary information under the proposals in the draft Direction. The Director also accepted BT’s comments regarding a materiality threshold for the audit of disaggregated activities.

4.12 Under condition 78.7, the information provided as part of the regulatory Financial Statements require an FPIA audit opinion. BT was concerned that for the disaggregated activities and supplementary information it would be onerous to procure an FPIA opinion, which would lead to increased costs. However, as stated above, BT’s licence does not allow for a lower level of audit opinion for disaggregated activities.

4.13 The Director views it as essential that disaggregated activities and supplementary information is capable of being audited, but agreed that this did not necessarily require an FPIA opinion. Therefore, the Director is prepared for BT to provide this information off-licence under the terms of a published side letter.

4.14 Therefore, under paragraphs 3 to 6 of the annex to the side letter, BT will provide financial statements for all product groups listed in schedule 1 of the annex to the side letter and procure audit statements at PPIA level for:

• each product group with revenues or costs greater than £50 million;
• an aggregation within each regulatory business of those product groups with revenues or costs up to and including £50 million; and
• any additional financial statements that the Director believes are required by regulatory need.

Additional financial information

4.15 BT also expressed concerns about being able to provide an FPIA audit on the additional financial information (listed in Annex C of the draft Direction).

4.16 These provide information that is essential to Oftel’s understanding of the regulatory Financial Statements. However, the Director acknowledges that an FPIA audit opinion may present difficulties in this area, and therefore the Director has agreed for this information to also be provided under the side letter, on the condition that the Director can request a selection of this information to be subject to a PPIA audit opinion. (See paragraphs 7 to 11 and schedule 3 of the annex to the side letter.)

Other issues

4.17 The side letter also formalises – although ‘off-licence’ – the proposals made by BT to:

• operate its accounting separation systems at the end of each Q2 and Q3 and provide this to the Director on a non-audited basis on the understanding that it is not published (see paragraph 12 of the annex to the side letter);
• share, in the fourth quarter of each year, with Oftel its plans for the forthcoming year, with particular emphasis on activities that would impact on accounting separation (see paragraph 13 of the annex to the side letter); and
• share its plans for systems development in the product reporting area (see paragraph 13 of the annex to the side letter).

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