The significant policies which have been adopted in the preparation of this Financial Report are:

(a) Basis of preparation

The Financial Report is a general purpose financial report which has been prepared in accordance with Accounting Standards, Urgent Issues Group Consensus Views, other authoritative pronouncements of the Australian Accounting Standards Board and the Corporations Act 2001. It has been prepared on the basis of historical costs and except where stated, does not take into account changing money values, or fair values of non-current assets. These accounting policies have been consistently applied by each entity in the Consolidated Entity and, except where there is a change in accounting policy as disclosed in Note 2, are consistent with those of the previous financial year. Unless otherwise stated, these accounts have been prepared in Australian Dollars.

(b) Principles of consolidation

The consolidated financial statements of the Consolidated Entity include the financial statements of the Company, being the parent entity, and its controlled entities. Where an entity either began or ceased to be controlled during the financial year, the results are included only from the date control commenced or up to the date control ceased. The balances, and effects of transactions, between controlled entities included in the consolidated financial statements have been eliminated.

Outside interests in the equity and results of the entities that are controlled by the Company are shown as a separate item in the consolidated financial statements.

(c) Revenue recognition

Revenues are recognised at fair value of the consideration received net of the amount of goods and services tax (GST).

Sales revenue

Sales revenue comprises revenue earned (net of returns, discounts and allowances) from the provision of products or services to entities outside the Consolidated Entity. Revenue from the sale of goods is recognised when control of the goods passes to the customer. Revenue attributable to unfulfilled obligations is deferred and recognised when that obligation has been satisfied or the right to satisfy the obligation lapses.

Revenue from the sale of services is recognised when the service has been provided to the customer and where there are no continuing unfulfilled service obligations.

Interest income

Interest income is recognised as it accrues.

Other revenue

Other revenue, including government grants, is recognised when the entitlement is confirmed.

Sales of non-current assets

The gross proceeds of non-current asset sales are recognised as revenue at the date control of the asset passes to the buyer, usually when an unconditional contract of sale is signed.

The gain or loss on disposal is calculated as the difference between the carrying amount of the asset at the time of disposal and the net proceeds on disposal (including incidental costs).

Dividends

Revenue from distributions from controlled entities is recognised by the parent entity when they are declared by the controlled entities.

(d) Goods and services tax

Revenues, expenses and assets are recognised net of the amount of GST except where the amount of GST incurred is not recoverable from the Australian Taxation Office (ATO). In these circumstances, the GST is recognised as part of the cost of acquisition of the asset or as part of an item of the expense.

Receivables and payables are stated with the amount of GST included.

The net amount of GST recoverable from, or payable to, the ATO is included as a current asset or liability in the statement of financial position.

Cash flows are included in the statement of cash flows on a gross basis. The GST components of cash flows arising from investing and financing activities which are recoverable from, or payable to, the ATO are classified as operating cash flows.

(e) Foreign currency

Transactions

Foreign currency transactions are translated to Australian Dollars at the rates of exchange ruling at the dates of the transactions. Amounts receivable and payable in foreign currencies at reporting date are translated at the rates of exchange ruling on that date.

Exchange differences relating to amounts receivable and payable in foreign currencies are brought to account as exchange gains or losses in the statement of financial performance in the financial year in which the exchange rates change, except where:

• hedging specific anticipated transactions or net investments in self-sustaining operations; and
• relating to amounts receivable or payable in foreign currency forming part of a net investment in a self-sustaining foreign operation. In this case, the exchange difference, together with any related income tax expense/revenue, is transferred to the foreign currency translation reserve on consolidation.

Hedges

Transactions are designated as a hedge of the anticipated specific purchase or sale of goods or services, purchase of qualifying assets, or an anticipated interest transaction, only when they are expected to reduce exposure to the risks being hedged, are designated prospectively so that it is clear when an anticipated transaction has or has not occurred and it is probable the anticipated transaction will occur as designated. Gains or losses on the hedge arising up to the date of the anticipated transaction, together with any costs or gains arising at the time of entering into the hedge, are deferred and included in the measurement of the anticipated transaction when the transaction has occurred as designated. Any gains or losses on the hedge transaction after that date are included in the statement of financial performance.

The net amounts receivable or payable under forward foreign exchange contracts and the associated deferred gains or losses are recorded on the statement of financial position from the date of inception of the hedge transaction. When recognised, the net receivables or payables are revalued using the foreign currency exchange rate current at reporting date. Refer to Note 32.

When the anticipated transaction is no longer expected to occur as designated, the deferred gain or loss relating to the hedged transaction is recognised immediately in the statement of financial performance.

Where a hedge transaction is terminated early and the anticipated transaction is still expected to occur as designated, deferred gains and losses that arose on the foreign currency hedge prior to its termination continue to be deferred and are included in the measurement of the purchase or sale when it occurs. Where a hedge transaction is terminated early because the anticipated transaction is no longer expected to occur as designated, deferred gains and losses that arose on the foreign currency hedge prior to its termination are included in the statement of financial performance for the financial period.

Where a hedge is redesignated as a hedge of another transaction, gains or losses arising on the hedge prior to its redesignation are only deferred where the original anticipated transaction is still expected to occur as designated. When the original anticipated transaction is no longer expected to occur as designated, gains or losses relating to the hedge instrument are included in the statement of financial performance for the financial period.

Gains or losses that arise prior to and upon the maturity of transactions entered into under hedge rollover strategies are deferred and included in the measurement of the hedged anticipated transaction if the transaction is still expected to occur as designated. If the anticipated transaction is no longer expected to occur as designated, gains or losses are recognised immediately in the statement of financial performance.

Translation of controlled foreign entities

The assets and liabilities of controlled foreign entities that are self-sustaining are translated at the rates of exchange ruling at reporting date. Equity items are translated at historical rates. The statements of financial performance are translated at the average rate for the financial year. Exchange differences arising on translation are taken directly to the foreign currency translation reserve.

Translation of controlled foreign branches

The assets and liabilities of controlled foreign branches that are integrated foreign operations are translated using the temporal method. Monetary assets and liabilities are translated into Australian Dollars at rates of exchange current at reporting date, while non-monetary items and revenue and expense items are translated at exchange rates current when transactions are brought to account in the statements of financial performance and position. Exchange differences arising on translation are brought to account in the statement of financial performance.

(f) Borrowing costs

Borrowing costs include interest, finance charges in respect of finance leases and foreign exchange differences net of the effect of hedges on borrowings.

(g) Provisions

A provision is recognised when there is a legal, equitable or constructive obligation as a result of a past event and it is probable that a future sacrifice of economic benefits will be required to settle the obligation, the timing or amount of which is uncertain.

Warranties

Warranty periods on hardware products extend for three years to 10 years.

Provisions for warranty claims are made for claims received and claims expected to be received in relation to sales made prior to reporting date, based on historical claim rates and respective product populations. The provision is determined on a discounted cash flow basis.

Dividends

A provision for dividends payable is recognised in the financial period in which the dividends are declared, for the entire undistributed amount, regardless of the extent to which they will be paid in cash.

Restructuring, employee termination benefits and surplus lease space

Provisions for restructuring or termination benefits are only recognised when a detailed plan has been approved and the restructuring or termination has either commenced or been publicly announced, or firm contracts related to the restructuring or termination benefits have been entered into. Costs related to ongoing activities are not provided for. The liabilities for termination benefits that will be paid as a result of these restructurings have been included in the provision for employee benefits.

Provision is made for non-cancellable operating lease rentals payable on surplus leased premises when it is determined that no substantive future benefit will be obtained from its occupancy and sub-lease rentals are less than the lease rentals paid. The estimate is calculated based on discounted net future cash flows, using the interest rate implicit in the lease or an estimate thereof.

Self-insurance

The Company self-insures to manage risks associated with operating in its line of business. Outstanding claims are recognised when an incident occurs that may give rise to a claim and are measured at the cost that the Company expects to incur in settling the claims, discounted using a rate that reflects current market assessments of the time value of money and the risks specific to the liability.

(h) Classification of assets and liabilities

Assets and liabilities have been classified in the statement of financial position as either current or non-current. Current assets are cash assets and other assets that would in the ordinary course of business be consumed or converted to cash within 12 months. Current liabilities are liabilities that would in the ordinary course of business be due and payable within 12 months.

(i) Research and development expenditure

Research and development expenditure is expensed as incurred.

(j) Intangible assets

Goodwill

Goodwill represents the excess of the purchase consideration plus incidental costs over the fair value of the identifiable net assets acquired.

Acquired technology

The Consolidated Entity has acquired patented and unpatented technology as part of the purchase of Entific Medical Systems AB. This technology has been identified as an intangible asset with a finite useful life of four years. The asset is recorded at cost less accumulated amortisation.

Customer relationships

Customer related intangible assets acquired as part of the purchase of Entific Medical Systems AB have a finite useful life of four years and are recorded at cost less accumulated amortisation.

Intellectual property

The fair value of intellectual property contributed by an outside equity interest holder to Cochlear Acoustics Limited, a 75%-owned subsidiary, has been capitalised and recorded at fair value at the time of the contribution. The asset will be amortised on a straight line basis over a period of three years following the commercial release of the product to which the intellectual property relates.

(k) Recoverable amount of non-current assets valued on a cost basis

The carrying amounts of non-current assets valued on a cost basis are reviewed to determine whether they are in excess of their recoverable amount at reporting date. If the carrying amount of a non-current asset exceeds the recoverable amount, the asset is written down to the lower amount. The write-down is recognised as an expense in the financial period in which it occurs.

In assessing recoverable amounts of non-current assets, the relevant cash flows have not been discounted to their present value.

(l) Acquisition of assets

All assets acquired, including plant and equipment and intangibles other than goodwill, are initially recorded at their cost of acquisition, being fair value of the consideration provided plus incidental costs directly attributable to the acquisition and depreciated or amortised as outlined below.

The cost of plant and equipment constructed by the Consolidated Entity includes the cost of material and direct labour, an appropriate proportion of fixed and variable overheads and capitalised interest.

Enterprise Resource Planning system

The external expenditure incurred on hardware and software and the external costs necessary for the implementation of the Enterprise Resource Planning system are recognised as an asset to the extent that the entity controls future economic benefits as a result of the costs incurred. All internal development, licence and support costs attributable to feasibility, alternative approach assessment and implementation are expensed as incurred.

Carrying value

All items of plant and equipment are carried at the lower of cost less accumulated depreciation and amortisation, and their recoverable amount.

(m) Depreciation and amortisation

Items of plant and equipment, including leasehold assets, are depreciated or amortised using the straight line method over their estimated useful lives, taking into account estimated residual values. Assets are depreciated or amortised from the date of acquisition or, in respect of internally constructed assets, from the time an asset is completed and held ready for use.

Depreciation and amortisation rates and methods are reviewed annually for appropriateness. When changes are made, adjustments are reflected prospectively in current and future financial periods only.

The annual depreciation and amortisation rates used for each class of asset are as follows:

2005 2004             Leasehold improvements 12.0 - 20.0% 12.0 - 20.0% Plant and equipment 13.0 - 33.3% 13.0 - 33.3% Enterprise Resource Planning system 25.0 - 40.0% 25.0 - 40.0% Goodwill 5.0% - Acquired technology 25.0% - Customer relationships 25.0% - Intellectual property 33.0% 33.0%

(n) Leased assets

Leases under which the Consolidated Entity assumes substantially all the risks and benefits of ownership are classified as finance leases. Other leases are classified as operating leases.

Finance leases

Finance leases are capitalised. A lease asset and a liability equal to the present value of the minimum lease payments are recorded at the inception of the lease. Contingent rentals are expensed as incurred. Capitalised lease assets are amortised on a straight line basis over the term of the relevant lease, or where it is likely the Consolidated Entity will obtain ownership of the asset, the life of the asset. Lease liabilities are reduced by repayments of principal. The interest components of the lease payments are charged to the statement of financial performance.

Operating leases

Payments made under operating leases are expensed on a straight line basis over the term of the lease, except where an alternative basis is more representative of the pattern of benefits to be derived from the leased property.

(o) Inventories

Inventories are carried at the lower of cost and net realisable value.

Manufacturing activities

Cost is based on the first-in-first-out principle and includes expenditure incurred in acquiring the inventories and bringing them to their existing condition and location. In the case of manufactured inventories and work in progress, cost includes an appropriate share of both variable and fixed overhead costs. Fixed overhead costs are allocated on the basis of normal operating capacity.

Net realisable value

Net realisable value is determined on the basis of each entity’s normal selling pattern. Expenses of marketing, selling and distribution to customers are estimated and are deducted to establish net realisable value.

(p) Investments

Controlled entities

Investments in controlled entities are carried in the Company’s financial statements at the lower of cost and recoverable amount. Dividends and distributions are brought to account in the statement of financial performance of the parent entity when they are proposed by the controlled entities. All intra-group transactions are eliminated on consolidation.

(q) Employee benefits

Wages, salaries and annual leave

Liabilities for employee benefits for wages, salaries and annual leave expected to settle within 12 months of the year end represent present obligations resulting from employees’ services provided up to reporting date, calculated at undiscounted amounts based on remuneration wage and salary rates that the Consolidated Entity expects to pay as at reporting date including related on costs, such as workers’ compensation insurance and payroll tax.

Long service leave

The provision for employee benefits to long service leave represents the present value of the estimated future cash outflows to be made by the employer resulting from employees’ services provided up to reporting date.

The provision is calculated using expected future increases in remuneration rates, including related on costs, and expected settlement dates based on turnover history, and is discounted using the rates attaching to national government securities at reporting date, which most closely match the terms of maturity of the related liabilities. The unwinding of the discount is treated as a long service leave expense.

Share options

The Company has granted options to certain employees under an Executive Share Option Plan (ESOP) and the Cochlear Executive Long Term Incentive Plan (CELTIP). Further information is set out in the Remuneration Report. Other than the costs incurred in administering each plan which are expensed as incurred, each plan does not result in any expense to the Consolidated Entity.

No value is attributed to shares and options issued to employees as remuneration for future services in these financial statements. Shares issued to employees upon the exercise of options are recognised in equity at the fair value of consideration received.

Performance shares

The Company has granted performance shares to certain employees under the CELTIP. The cost of shares purchased on market are expensed over the vesting period.

Superannuation plans

The Consolidated Entity contributes to various employee superannuation plans. The liabilities of these plans are covered by the assets in the plans. The Consolidated Entity is obliged to contribute to the plans as a consequence of legislation or trust deeds. Legal enforceability is dependent on the terms of the legislation and the trust deeds. Contributions are charged against expense as they are made. A liability is recognised when the vested benefits of defined benefit members exceeds the market value of plan assets. Further information is set out in Note 30.

(r) Receivables

Trade debtors

Trade debtor terms vary from market to market depending on the economic factors relevant to the individual market. The Consolidated Entity has actual trading terms ranging up to 180 debtor days. The collectability of debts is assessed at reporting date and allowance made for any doubtful accounts.

The allowance for doubtful debts is calculated with reference to the profile of debtors in the Consolidated Entity’s sales and marketing regions. Where specific material doubtful debts are identified, an additional amount is allowed for.

Credit risk

The credit risk related to the trade debtors of the Consolidated Entity which have been recognised and the carrying amount on the statement of financial position is net of any allowance for doubtful debts. The Consolidated Entity trades in more than 80 countries and at the end of the financial year there was no adverse material exposure to any individual overseas country or individual customer other than as allowed for in the financial statements.

(s) Net fair values of financial assets and liabilities

The carrying values of the Consolidated Entity’s financial assets and liabilities approximate their net fair value.

(t) Taxation

The Consolidated Entity adopts the income statement liability method of tax effect accounting. Income tax expense is calculated on profit from ordinary activities adjusted for permanent differences between taxable and accounting income. The tax effect of timing differences which arise from items being brought to account in different years for income tax and accounting purposes, is carried forward in the statement of financial position as a future income tax benefit or a provision for deferred income tax.

Future income tax benefits are not brought to account unless realisation of the asset is assured beyond reasonable doubt, or if relating to tax losses when realisation is virtually certain.

Tax consolidation

The Company is the head entity in the tax consolidated group comprising all the Australian wholly-owned subsidiaries set out in Note 28. The implementation date for the tax consolidated group was 1 July 2003. The head entity recognises all the current and deferred tax assets and liabilities of the tax consolidated group (after elimination of intra-group transactions).

(u) Payables

Liabilities are recognised for amounts to be paid in the future for goods and services received, whether or not billed to the Company or Consolidated Entity. Trade accounts payable are normally settled within 60 days but are negotiated on an individual basis where appropriate.

(v) Interest bearing liabilities

Bank loans are carried in the statement of financial position at their principal amount. Interest expense is accrued at the contracted rate and included in trade creditors and other creditors.

Loan establishment fees are capitalised at the inception of the loan and are amortised on a straight line basis over the term of the loan. These are classified as other financial assets in the statement of financial position.

(w) Comparatives

Where necessary, comparative information has been reclassified to achieve consistency in disclosure with current financial year amounts and other disclosures.

(x) Earnings per share

Basic earnings per share (EPS) is calculated by dividing the net profit attributable to members of the parent entity for the financial period, after excluding any costs of servicing equity (other than ordinary shares) by the weighted average number of ordinary shares of the Company, adjusted for any bonus issue.

Diluted EPS is calculated by dividing the basic EPS earnings, adjusted by the after tax effect of financing costs associated with dilutive potential ordinary shares and the effect on revenues and expenses of conversion to ordinary shares associated with dilutive potential ordinary shares, by the weighted average number of ordinary shares and dilutive potential ordinary shares of the Company adjusted for any bonus issue.