Notes to the Company financial statements

Year ended 31 December 2010

• (a): Basis of accounting
• (b): Investments
• (c): Finance costs and debt
• (d): Financial liabilities and equity
• (e): Foreign currencies
• (f): Share issue expenses
• (g): Taxation
• (h): Share-based payments
• (i): Capital management
• Note 1: Investments
• Note 2: Dividends
• Note 3: Deferred tax
• Note 4: Debtors
• Note 5: Trade and other creditors
• Note 6: Bank loans
• Note 7: Loans from subsidiary undertakings
• Note 8: Called up equity share capital and share premium account
• Note 9: Shareholders’ funds
• Note 10: Other reserves
• Note 11: Share-based payments
• Note 12: Related party transactions
• Note 13: Subsequent events

(a) Basis of accounting

The financial statements have been prepared under the historical cost convention in accordance with the Companies Act 2006 and UK Generally Accepted Accounting Principles (UK GAAP). The following paragraphs describe the main accounting policies under UK GAAP which have been applied consistently.

In light of the ever-increasing operations of the Group being conducted in US dollars and the majority of the Group’s external funding being provided in US dollars the Directors have reviewed the functional currency of Tullow Oil plc (Company only) and have concluded that it is appropriate for the functional currency of the Company to be converted from sterling to US dollars (effective date of 1 January 2010).

In addition the Directors have deemed it appropriate to change the presentational currency of the Company from sterling to US dollars effective from 1 January 2010.

These are the first financial statements to be presented in US dollars and all comparative information has been restated in accordance with the requirements set out in FRS 23, The Effects of Changes in Foreign Exchange Rates with respect to translation of results to presentational currency:

1. assets and liabilities denominated in non-US dollar currencies were translated into US dollars at the closing rate prevailing at the balance sheet dates;
2. non-US dollar income and expenses were translated into US dollars at an exchange rate which approximates to the exchange rate ruling at the date of transactions; and
3. all resulting exchange rate differences have been recognised in other comprehensive income, within the foreign currency translation reserve.

In accordance with the provisions of Section 408 of the Companies Act, the profit and loss account of the Company is not presented separately. During the year the Company made a loss of $47.1 million. In accordance with the exemptions available under FRS 1 ‘Cash Flow Statements’, the Company has not presented a cash flow statement as the cash flow of the Company has been included in the cash flow statement of Tullow Oil plc Group.

In accordance with the exemptions available under FRS 8 ‘Related party transactions’, the Company has not separately presented related party transactions with other Group companies.

The Company closely monitors and manages its liquidity risk. Cash forecasts are regularly produced and sensitivities run for different scenarios including, but not limited to, changes in commodity prices, different production rates from the Group’s portfolio of producing fields and delays in development projects. The Company normally seeks to ensure that it has a minimum ongoing capacity of $500 million for a period of at least 12 months to safeguard the Company’s ability to continue as a going concern.

The major assumption in current cash flow forecasts is that the receipt of disposal proceeds from the Uganda farm-down, which has been delayed longer than expected, will now be received in Q2 2011. On this basis, the Company’s forecasts, taking into account reasonably possible changes as described above, show that the Company will be able to operate within its current debt facilities and have very significant financial headroom for the 12 months from the date of the approval of the 2010 Annual Report and Accounts. However, in the unlikely event that the Ugandan farm-down process is delayed beyond Q2 2011, the Directors are confident that the Company can manage its financial affairs, including the securing of additional funding, agreement with existing lenders, portfolio management and deferring of non-essential capital expenditure, so as to ensure that sufficient funding remains available for the next 12 months.

After taking account of the above, the Directors have a reasonable expectation that the Company has adequate resources to continue in operational existence for the foreseeable future. Accordingly, they continue to adopt the going concern basis in preparing the Annual Report and Accounts.

(b) Investments

Fixed asset investments, including investments in subsidiaries, are stated at cost and reviewed for impairment if there are indications that the carrying value may not be recoverable.

(c) Finance costs and debt

Finance costs of debt are allocated to periods over the term of the related debt at a constant rate on the carrying amount.

Interest-bearing bank loans are recorded at the proceeds received, net of direct issue costs. Finance charges, including premiums payable on settlement or redemption and direct issue costs, are accounted for on an accruals basis in the profit and loss account using the effective interest method and are added to the carrying amount of the instrument to the extent that they are not settled in the period in which they arise.

(d) Financial liabilities and equity

Financial liabilities and equity instruments are classified according to the substance of the contractual arrangements entered into. An equity instrument is any contract that evidences a residual interest in the assets of the Group after deducting all of its liabilities.

(e) Foreign currencies

The US dollar is the reporting currency of the Company. Transactions in foreign currencies are translated at the rates of exchange ruling at the transaction date. Monetary assets and liabilities denominated in foreign currencies are translated into US dollars at the rates of exchange ruling at the balance sheet date, with a corresponding charge or credit to the profit and loss account. However, exchange gains and losses arising on long-term foreign currency borrowings, which are a hedge against the Company’s overseas investments, are dealt with in reserves.

(f) Share issue expenses

Costs of share issues are written off against the premium arising on the issues of share capital.

(g) Taxation

Current and deferred tax, including UK corporation tax, is provided at amounts expected to be paid using the tax rates and laws that have been enacted or substantially enacted by the balance sheet date.

(h) Share-based payments

The Company has applied the requirements of FRS 20 Share-based Payments. In accordance with the transitional provisions of that standard, only those awards that were granted after 7 November 2002, and had not vested at 1 January 2005, are included.

All share-based awards of the Company are equity settled as defined by FRS 20. The fair value of these awards has been determined at the date of grant of the award allowing for the effect of any market-based performance conditions. This fair value, adjusted by the Company’s estimate of the number of awards that will eventually vest as a result of non-market conditions, is expensed uniformly over the vesting period.

The fair values were calculated using a binomial option pricing model with suitable modifications to allow for employee turnover after vesting and early exercise. Where necessary this model was supplemented with a Monte Carlo model. The inputs to the models include: the share price at date of grant; exercise price; expected volatility; expected dividends; risk free rate of interest; and patterns of exercise of the plan participants.

(i) Capital management

The Company defines capital as the total equity of the Company. Capital is managed in order to provide returns for shareholders and benefits to stakeholders and to safeguard the Company’s ability to continue as a going concern. Tullow is not subject to any externally-imposed capital requirements. To maintain or adjust the capital structure, the Company may adjust the dividend payment to shareholders, return capital, issue new shares for cash, repay debt, and put in place new debt facilities.

Note 1. Investments

The increase in the year is attributable to additional investments in the Company’s subsidiary companies.

Principal subsidiary undertakings

At 31 December 2010 the Company’s principal subsidiary undertakings were:

The Company is required to assess the carrying values of each of its investments in subsidiaries for impairment. The net assets of certain of the Company’s subsidiaries are predominantly intangible exploration and evaluation (E&E) assets. Where facts and circumstances indicate that the carrying amount of an E&E asset held by a subsidiary may exceed its recoverable amount, by reference to the specific indicators of impairment of E&E assets, an impairment test of the asset is performed by the subsidiary undertaking and the asset is impaired by any difference between its carrying value and its recoverable amount. The recognition of such an impairment by a subsidiary is used by the Company as the primary basis for determining whether or not there are indications that the investment in the related subsidiary may also be impaired, and thus whether an impairment test of the investment carrying value needs to be performed. The results of exploration activities are inherently uncertain, and the assessment for impairment of E&E assets by the subsidiary, and that of the related investment by the Company, is judgemental.

Note 2. Dividends

The proposed final dividend is subject to approval by shareholders at the Annual General Meeting and has not been included as a liability in these financial statements.

Note 3. Deferred tax

The Company has tax losses of $147.8 million (2009: $136.4 million) that are available indefinitely for offset against future non-ring-fence taxable profits in the Company. A deferred tax asset of $41.4million (2009: $38.9 million) has been recognised in respect of these losses on the basis that the Company anticipates making non-ring-fence profits in the foreseeable future.

Note 4. Debtors

Amounts falling due within one year

The amounts due from subsidiary undertakings include $2,118.5 million (2009: $292.1 million) that incurs interest at LIBOR plus 1.7%-2.7%. The remaining amounts due from subsidiaries accrue no interest. All amounts are repayable on demand.

Note 5. Trade and other creditors

Amounts falling due within one year

Note 6. Bank loans

Company bank loans are stated net of unamortised arrangement fees of $81.3 million (2009: $81.6 million).

Term loans and guarantees are secured by fixed and floating charges over the oil and gas assets (note 10) of the Group financial statements.

Interest rate risk

The interest rate profile of the Company’s financial assets and liabilities at 31 December 2010 was as follows:

The profile at 31 December 2009 for comparison purposes was as follows:

Cash at bank at floating interest rate consisted of deposits which earn interest at rates set in advance for periods ranging from overnight to one month by reference to market rates.

Floating rate debt comprises bank borrowings at interest rates fixed in advance from overnight to three months at rates determined by US dollar LIBOR and sterling LIBOR. Fixed rate debt comprises bank borrowings at interest rates fixed in advance for periods greater than three months or bank borrowings where the interest rate has been fixed through interest rate hedging.

The $2.5 billion Reserves Based Lending Facility incurs interest on outstanding debt at sterling or US dollar LIBOR plus an applicable margin. The outstanding debt is repayable in variable amounts (determined semi-annually) over the period to 31 December 2015, or such time as is determined by reference to the remaining reserves of the assets, whichever is earlier.

The $650 million Revolving Credit Facility is repayable in full on 31 December 2011. The facility incurs interest on outstanding debt at US dollar LIBOR plus an applicable margin.

At the end of December 2010, the headroom under the two facilities amounted to $685 million; $175 million under the $2.5 billion Reserves Based Lending Facility and $510 million under the Revolving Credit Facility. At the end of December 2009, the headroom under the two facilities was $620 million; $370 million under the $2 billion Reserves Based Lending Facility and $250 million under the Revolving Corporate Facility.

The Group is exposed to floating rate interest rate risk as entities in the Group borrow funds at floating interest rates. The Group hedges its floating rate interest rate exposure on an ongoing basis through the use of interest rate derivatives, namely interest rate swaps, interest rate collars and interest rate caps. The mark-to-market position of the Group’s interest rate portfolio as at 31 December 2010 was $13.6 million out of the money (2009: $8.9 million out of the money, 2008: $3.0 million out of the money). The interest rate hedges are included in the fixed rate debt in 2010, in the above table, and also included in the fixed rate debt in 2009 and 2008.

The carrying amounts of the Company’s foreign currency denominated monetary assets and monetary liabilities at the reporting date are net liabilities of $164.0 million (2009: net liabilities of $1,337 million).

Foreign currency sensitivity analysis

The Company is mainly exposed to fluctuations in the US dollar. The Company measures its market risk exposure by running various sensitivity analyses including 20% favourable and adverse changes in the key variables. The sensitivity analyses include only outstanding foreign currency denominated monetary items and adjust their translation at the period end for a 20% change in foreign currency rates.

As at 31 December 2010, a 20% increase in foreign exchange rates against the US dollar would have resulted in a decrease in foreign currency denominated liabilities of $27.3 million (2009: $226.7 million) and a 20% decrease in foreign exchange rates against the US dollar would have resulted in an increase in foreign currency denominated liabilities and equity of $32.8 million (2009: $339.9 million).

Note 7. Loans from subsidiary undertakings

Amounts falling due after more than one year

The amounts due from subsidiaries do not accrue interest. All loans from subsidiary companies are not due to be repaid within five years.

Note 8. Called up equity share capital and share premium account

Allotted equity share capital and share premium

Following the passing of a special resolution at the Company’s 2009 AGM, the Company no longer has an authorised share capital.

Note 9. Shareholders’ funds

During 2010 the Company issued 80,431,796 ordinary shares via an equity placing. In accordance with the provisions of Section 612 of the Companies Act 2006, the Company has transferred the premium on the shares issued of $1,464.8 million ($1,432.9 million net of expenses) (2009: $565.0 million, $549.3 million net of expenses), using the market value at the date of acquisition, to retained earnings as the premium is considered to be realised.

Note 10. Other reserves

The treasury shares reserve represents the cost of shares in Tullow Oil plc purchased in the market and held by the Tullow Oil Employee Trust to satisfy options held under the Group’s share incentive plans (see note 11).

Note 11. Share-based payments

2005 Performance Share Plan (PSP)

Under the PSP, senior executives can be granted nil exercise price options (normally exercisable three to ten years following grant) over shares worth up to 200% of salary p.a. (300% in exceptional circumstances). Awards made before 8 March 2010 were made as conditional awards to acquire free shares on vesting. To provide flexibility to participants, those awards have been converted into nil exercise price options. Awards granted in 2010 vest subject to a Total Shareholder Return (TSR) performance condition. Half of an award is tested against constituents of the FTSE 100 index (excluding investment trusts) and the other half against a comparator group of oil and gas companies. Performance is measured over a fixed three-year period starting on 1 January prior to grant, and an individual must normally remain in employment for three years from grant for the shares to vest. No dividends are paid over the vesting period. There are further details of PSP award measurement in the Directors’ remuneration report.

The shares outstanding under the PSP are as follows:

The expected life is the period from date of grant to vesting. Expected volatility was determined by calculating the historical volatility of the Company's share price over a period commensurate with the expected life of the awards. The weighted average fair value of the awards granted in 2010 was 700.8p per award (2009: 579.9p).

The Company recognised a total charge of $12.6million (2009: $9.4 million) in respect of the PSP.

2005 Deferred Share Bonus Plan (DSBP)

Under the DSBP, the portion of any annual bonus above 75% of the base salary (60% for bonuses paid for 2007 and earlier years) of a senior executive nominated by the Remuneration Committee is deferred into shares. Awards normally vest following the end of three financial years commencing with that in which they are granted. They are granted as nil exercise price options, normally exercisable from when they vest until 10 years from grant. Awards granted before 8 March 2010 as conditional awards to acquire free shares have been converted into nil exercise price options to provide flexibility to participants.

The shares outstanding under the DSBP are as follows:

The expected life is the period from the date of grant to the vesting date. The fair value of the awards granted in 2010 was 1,263.1p per award (2009: 760.2p).

The Company recognised a total charge of $1.3 million (2009: $0.8 million) in respect of the DSBP.

2000 Executive Share Option Scheme (ESOS)

The only share option scheme operated by the Company during the year was the 2000 ESOS. Options normally only become exercisable from the third anniversary of the date of the grant and if the performance condition has been met. The awards are tested against constituents of an index and 100% of awards will vest if the Company's TSR is above the median of the index over three years following grant. For awards from March 2008 the Index is the FTSE 100 index (excluding investment trusts); for awards before March 2008, the Index is the FTSE 250 index (excluding investment trusts).

Options granted under the previous 1998 ESOS had all been exercised at 31 December 2009. All awards under the 1998 ESOS were made prior to 7 November 2002 and therefore, under the FRS transitional provisions, they have not been accounted for in accordance with FRS 20 – Share-based Payments.

The following table illustrates the number and weighted average exercise prices (WAEP) of, and movements in, share options under the 2000 ESOS during the year.

The weighted average share price at exercise for options exercised in 2010 was 1,231.9p (2009: 1,000.5p).

Options outstanding at 31 December 2010 had exercise prices of 79p to 1,299.9p (2009: 63.0p to 1,179.0p) and remaining contractual lives of 1 to 10 years.

The fair values were calculated using a proprietary binomial valuation model. The principal inputs to the options valuation model were:

Expected volatility was determined by calculating the historical volatility of the Company's share price over a period commensurate with the expected lifetime of the awards.

The fair values and expected lives of the options valued in accordance with FRS 20 were:

The Company recognised a total charge of $11.5 million (2009: $7.6 million) in respect of the ESOS.

UK & Irish Share Incentive Plans (SIPs)

These are all-employee plans set up in the UK and Ireland, to enable employees to save out of salary up to prescribed monthly limits. Contributions are used by the Plan trustees to buy Tullow shares ('Partnership Shares') at the end of each three-month accumulation period. The Company makes a matching contribution to acquire Tullow shares ('Matching Shares') on a one-for-one basis. Matching Shares are subject to time-based forfeiture over three years on leaving employment in certain circumstances or if the related Partnership Shares are sold.

The fair value of a Matching Share is its market value at the start of the accumulation period.

For the UK plan, Partnership Shares are purchased at the lower of the market values at the start of the Accumulation Period and the purchase date (which is treated as a three-month share option for FRS 20 purposes). For the Irish plan, shares are bought at the market price at the purchase date which does not result in any FRS 20 accounting charge.

Matching Shares vest three years after grant and dividends are paid to the employee during this period.

The Company recognised a total charge of $0.2 million (2009: $0.2 million) for the UK SIP Plan and $0.2 million (2009: $0.2 million) for the Irish SIP plan.

Note 12. Related party transactions

The Directors of Tullow Oil plc are considered to be the only key management personnel as defined by FRS 8 – Related Party Disclosures.

Short-term employee benefits

These amounts comprise fees paid to the Directors in respect of salary and benefits earned during the relevant financial year, plus bonuses awarded for the year.

Post employment benefits

These amounts comprise amounts paid into the pension schemes of the Directors.

Amounts awarded under long-term incentive schemes

These amounts relate to the shares granted under the annual bonus scheme that is deferred for three years under the Deferred Share Bonus Plan (DSBP).

Share-based payments

This is the cost to the Group of Directors' participation in share-based payment plans, as measured by the fair value of options and shares granted accounted for in accordance with FRS 20, Share-based Payments.

There are no other related party transactions. Further details regarding transactions with the Directors of Tullow Oil plc are disclosed in the Remuneration Report.

Note 13. Subsequent events

Since the balance sheet date Tullow has continued to progress its exploration, development and business growth strategies.

In January 2011 the Group announced the Tweneboa-3 appraisal well in the Deepwater Tano licence offshore Ghana had successfully encountered gas condensate in excellent high quality sandstone reservoirs. The results of drilling, wireline logs and samples of reservoir fluids, together with the well's down-dip position, confirms the Greater Tweneboa Area resource base potential.

In March 2011 the Group announced the Enyenra-2A appraisal well in the Deepwater Tano licence offshore Ghana had successfully encountered oil in excellent quality sandstone reservoirs. Good evidence of communication with Owo-1 confirms that the Owo oil discovery, now renamed Enyenra, is a major light oil field.