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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

Commission file number 1-1105

AT&T Corp.

One AT&T Way, Bedminster, New Jersey 07921

Telephone — Area Code 908-221-2000

      Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ          No o

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)     Yes þ          No o

      Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes o          No o

      At October 31, 2005, the following shares of stock were outstanding: AT&T common stock — 803,449,166

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PART I — FINANCIAL INFORMATION

AT&T CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

The notes are an integral part of the consolidated financial statements.

AT&T CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

The notes are an integral part of the consolidated financial statements.

AT&T CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREOWNERS’ EQUITY

(Unaudited)

AT&T accounts for treasury stock as retired stock. The amount attributable to treasury stock at September 30, 2005 and December 31, 2004, was $(17,011) million.

We have 100 million authorized shares of preferred stock at $1 par value.

The notes are an integral part of the consolidated financial statements.

AT&T CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

The notes are an integral part of the consolidated financial statements.

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

      The consolidated financial statements have been prepared by AT&T Corp. (AT&T) pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and, in the opinion of management, include all adjustments of a normal and recurring nature necessary for a fair statement of the consolidated results of operations, financial position and cash flows for each period presented. The consolidated results for interim periods are not necessarily indicative of results for the full year. These financial results should be read in conjunction with AT&T’s Forms 10-Q for the quarters ended March 31, 2005 and June 30, 2005, and Form 10-K/ A for the year ended December 31, 2004.

      On January 31, 2005, AT&T and SBC Communications Inc. (SBC) announced an agreement for SBC to acquire AT&T. Under the terms of the agreement, each AT&T share will be exchanged for 0.77942 of a share of SBC common stock. In addition, at the time of closing, we will pay our shareowners a special dividend of $1.30 per share. At the time of the announcement, this consideration was valued at $19.71 per share, or approximately $16.0 billion. The stock consideration in the transaction is expected to be tax-free to our shareowners. On June 30, 2005, AT&T shareowners voted to approve the proposed merger agreement with SBC. In October 2005, the Department of Justice and the Federal Communications Commission (FCC) approved the merger. The acquisition, which remains subject to approval by other regulatory authorities and customary closing conditions, is expected to close by the end of 2005. However, it is possible that factors outside of our control could require us to complete the merger at a later time or not to complete it at all. The terms of certain of our agreements, including contracts, employee benefit arrangements and debt instruments, have provisions which could result in changes to the terms or settlement amounts of these agreements upon a change in control of AT&T.

      We have a Long Term Incentive Program under which stock options, performance shares, restricted stock and other awards in common stock are granted, as well as an Employee Stock Purchase Plan (ESPP). Employee purchases of company stock under the ESPP were suspended in 2003. Effective January 1, 2003, we adopted the fair-value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” and we began to record stock-based compensation expense for all employee awards (including stock options) granted or modified after January 1, 2003. For awards issued prior to January 1, 2003, we apply Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for our plans. Under APB Opinion No. 25, no compensation expense has been recognized for stock options, other than for certain occasions when we have modified the terms of the stock option vesting schedule.

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      If we had elected to recognize compensation costs based on the fair value at the date of grant of all awards granted prior to January l, 2003, consistent with the provisions of SFAS No. 123, net income (loss) and earnings (loss) per share amounts would have been as follows:

      Pro forma stock-based compensation expense reflected above may not be indicative of future compensation expense that may be recorded. Future compensation expense may differ due to various factors, such as the number of awards granted and the market value of such awards at the time of grant, as well as the planned adoption of SFAS No. 123 (revised 2004), “Share-Based Payment,” beginning in the first quarter of 2006 (see note 12).

      For a detailed discussion of significant accounting policies, please refer to our Form 10-K/ A for the year ended December 31, 2004.

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      Amortization expense associated with purchased intangible assets for the three and nine months ended September 30, 2005, was $26 million and $79 million, respectively. Amortization expense for the three and nine months ended September 30, 2004, was $28 million and $89 million, respectively. Amortization expense for purchased intangible assets is estimated to be approximately $110 million for each of the years ending December 31, 2005 and 2006, and approximately $80 million for each of the years ending December 31, 2007 and 2008, at which time the purchased intangible assets will be fully amortized.

      During the third quarter of 2004, we recorded a $15 million impairment charge relating to other purchased intangible assets (customer lists and relationships) (see note 6).

      Recorded within other current assets as of December 31, 2004, was restricted cash of $546 million relating to debt that matured in February 2005 (see note 8).

      Recorded within other current liabilities were $574 million and $281 million of income taxes payable as of September 30, 2005 and December 31, 2004, respectively.

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      Basic earnings (losses) per common share (EPS) is computed by dividing net income (loss) by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution (considering the combined income and share impact) that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The potential issuance of common stock is assumed to occur at the beginning of the year (or at the time of issuance if later), and the incremental shares are included using the treasury stock method. The proceeds utilized in applying the treasury stock method consist of the amount, if any, to be paid upon exercise, the amount of compensation cost attributed to future service not yet recognized, and any tax benefits credited to paid-in-capital related to the exercise. These proceeds are then assumed to be used to purchase common stock at the average-market price during the period. The incremental shares (difference between the shares assumed to be issued and the shares assumed to be purchased), to the extent they would have been dilutive, are included in the denominator of the diluted EPS calculation. Potentially dilutive securities for all periods presented were stock options, restricted stock units and performance shares. No adjustments were made to income for the computation of diluted EPS. Since AT&T recorded a loss for the three and nine months ended September 30, 2004, diluted loss per share is the same as basic loss per share, as any potentially dilutive securities would be antidilutive.

      Asset impairment and net restructuring and other charges for the three months ended September 30, 2005, were a net credit of $1 million. During the third quarter of 2005, management reevaluated preexisting restructuring reserves and determined the actual or revised estimated obligations under these reserves differed

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

from the estimates initially made. As a result, a net $11 million of excess preexisting employee separation restructuring liabilities were reversed. These activities were partially offset by an additional $10 million net charge recorded to preexisting facilities closing and other reserves. These adjustments were recorded in the Corporate and Other group and did not result from changes to the actual or planned headcount separations or the number of vacated facilities.

      Asset impairment and net restructuring and other charges of $35 million for the nine months ended September 30, 2005, consisted of $55 million of net facility closing and other reserves and a related $5 million asset impairment charge. These activities were partially offset by the net reversal of $25 million of excess preexisting employee separation restructuring liabilities.

      The net facilities closing and other reserves of $55 million for the nine months ended September 30, 2005, primarily reflected a $45 million charge recorded in the second quarter of 2005 associated with the continued consolidation of our real estate portfolio and reflected the present value of contractual lease obligations, net of estimated sublease income, associated with vacant facilities primarily resulting from workforce reductions. In addition, we recorded a $10 million net charge in the third quarter of 2005 based on a reevaluation of preexisting facilities closing and other reserves as discussed above. Facilities closing and other charges of $53 million were recorded in the Corporate and Other group and $2 million in AT&T Business Services. Additionally, the Corporate and Other group and AT&T Business Services recorded $2 million and $3 million, respectively, of leasehold improvement impairment charges related to the second quarter 2005 facilities closing reserve.

      The net reversal of $25 million of excess preexisting employee separation restructuring liabilities for the nine months ended September 30, 2005, was the result of management’s reevaluation of employee separation restructuring reserves. Management determined the actual or revised estimates of separation and related benefit payments differed from the estimates initially made, resulting in a net reversal of $25 million. AT&T Business Services recorded $23 million of the reversal and the Corporate and Other group recorded $12 million. AT&T Consumer Services recorded an additional $10 million charge as a result of this review. The adjustment to these reserves did not result from changes to the actual or planned headcount separations.

      The following table displays the activity and balances of the restructuring reserve account:

      Net deductions primarily reflected total cash payments of $368 million. These cash payments include cash termination benefits of $310 million and $58 million of facility closing reserve payments, which were funded primarily through cash from operations.

      Asset impairment and net restructuring and other charges of $12,469 million for the three months ended September 30, 2004, were comprised of $11,389 million of asset impairment charges and $1,080 million of net business restructuring and other obligations.

      In July 2004, we announced a strategic change in our business focus away from traditional consumer services and towards business markets and emerging technologies. As a result of this strategic change, we performed an evaluation of our long-lived assets, including property, plant and equipment and internal-use software (the asset group) as of July 1, 2004, as this strategic change created a “triggering event”

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

necessitating such a review. In assessing impairments for long-lived assets we follow the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We operate an integrated telecommunications network; therefore, we performed our testing of the asset group at the entity level, as this is the lowest level for which identifiable cash flows are available.

      In performing the test, we determined that the total of the expected future undiscounted cash flows directly related to the existing service potential of the asset group was less than the carrying value of the asset group; therefore, an impairment charge was required. The impairment charges of $11,389 million represented the difference between the fair values of the asset group and its carrying values and were included within asset impairment and net restructuring and other charges in the consolidated statements of operations. The impairment charges resulted from sustained pricing pressure and the evolution of services toward newer technologies in the business market as well as changes in the regulatory environment, which led to a shift away from traditional consumer services.

      AT&T Business Services recorded impairment charges of $11,330 million resulting in reductions to property, plant and equipment of $11,023 million, internal-use software of $287 million, other purchased intangibles of $15 million and other long-lived assets of $5 million. AT&T Consumer Services recorded impairment charges of $59 million resulting in reductions to property, plant and equipment of $11 million and internal-use software of $48 million. As a result of the asset impairments, a new cost basis was established for those assets that were impaired. The new cost basis resulted in a reduction of gross property, plant and equipment and internal-use software and the write-off of accumulated depreciation and accumulated amortization.

      We calculated the fair value of our asset group using discounted cash flows. The discounted cash flows calculation was made utilizing various assumptions and estimates regarding future revenue, expenses and cash flows projections through 2012. The time horizon was determined based on the estimated remaining useful life of the primary assets in the asset group; the primary assets are those from which the most significant cash flows are generated, principally consisting of the transport central office equipment. Pursuant to SFAS No. 144, the forecasts were developed without contemplation of investments in new products. The 10% discount rate utilized was determined using a weighted-average cost of capital (debt and equity) and was more heavily weighted towards debt given that the asset group, which primarily consisted of tangible assets, can be financed with a larger proportion of debt. When allocating the impairment to the asset categories, market values were utilized, to the extent determinable, to ensure that no asset category was impaired below its fair value.

      The strategic change in business focus also created a “triggering event” for a review of our goodwill. We follow the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” for determining impairments. SFAS No. 142 indicates that if other types of assets (in addition to goodwill) of a reporting unit are being tested for impairment at the same time as goodwill, then those assets are to be tested for impairment prior to performing the goodwill impairment testing. Accordingly, the impairment charges noted above reduced the carrying value of the reporting units when performing the impairment test for goodwill.

      The goodwill impairment test requires us to estimate the fair value of our overall business enterprise down to the reporting unit level. Our reporting units are AT&T Business Services and AT&T Consumer Services. We estimated fair value using both a discounted cash flows model, as well as an approach using market comparables, both of which are weighted equally to determine fair value. Under the discounted cash flows method, we utilized estimated long-term revenue and cash flows forecasts, as well as assumptions of terminal value, together with an applicable discount rate, to determine fair value. Under the market approach, fair value was determined by comparing our reporting units to similar businesses (or guideline companies). We then compared the carrying value of our reporting units to their fair value. Since the fair value of our reporting units exceeded their carrying amounts, no goodwill impairment charge was recorded.

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      The net business restructuring activities of $1,080 million for the third quarter of 2004 consisted of $1,043 million for employee separations (of which $339 million related to benefit plan curtailment costs) and $37 million of facility closing obligations.

      This exit plan covered separation costs for approximately 11,200 employees (the majority of which were involuntary), approximately 60% of whom were managers. This activity resulted from the continued integration and automation of various functions within network operations, and our strategic change in focus away from traditional consumer services and towards business markets and emerging technologies.

      Facility closing reserves of $37 million for the three months ended September 30, 2004, were primarily associated with the continued consolidation of our real estate portfolio and reflect the present value of contractual lease obligations, net of estimated sublease income, associated with vacant facilities resulting from workforce reductions and network equipment space that will not be used.

      Asset impairment and net restructuring and other charges of $12,736 million for the nine months ended September 30, 2004, were comprised of $11,511 million of asset impairments and $1,225 million in net business restructuring and other obligations.

      The asset impairment charges of $11,511 million primarily reflect the third quarter asset impairments of $11,389 million as discussed above. In addition, we recorded real estate impairment charges of $122 million related to the decision made during the first quarter of 2004 to divest five owned properties in an effort to further reduce costs and consolidate our real estate portfolio. In accordance with SFAS No. 144, an impairment charge was recorded, within the Corporate and Other group, to reduce the book value of the five properties to fair-market value based on third-party assessments (including broker appraisals). The sales of these properties have been completed.

      The net restructuring obligations of $1,225 million for the nine months ended September 30, 2004, were primarily comprised of $1,147 million of net employee separations (of which $339 million related to benefit plan curtailment costs) and $78 million of facility closing obligations. These exit plans covered separation costs for approximately 12,600 employees (the majority of which were involuntary), nearly one-half of whom were managers. These activities resulted from the continued integration and automation of various functions within network operations, reorganizations throughout our non-U.S. operations, and our strategic change in focus away from traditional consumer services and towards business markets and emerging technologies.

      The facility closing reserves of $78 million for the nine months ended September 30, 2004, were primarily associated with the consolidation of our real estate portfolio and reflect the present value of contractual lease obligations, net of estimated sublease income, associated with vacant facilities resulting from workforce reductions and network equipment space that will not be used.

      Approximately 90% of headcount reductions associated with all of our 2004 exit plans were completed as of September 30, 2005. As of September 30, 2005, we had approximately 39,500 employees compared with approximately 47,600 employees at December 31, 2004.

      In May 2005, we repaid $125 million of short-term borrowings outstanding under the AT&T Consumer Services accounts receivable securitization facility and subsequently terminated the facility.

      In April 2005, we completed the early retirement of $1.25 billion of our outstanding 7.30% Notes maturing in November 2011, which carried an interest rate of 9.05% at the time of retirement. The notes were

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

repurchased with cash and resulted in a loss of approximately $0.2 billion recorded in other income (expense), net.

      In the normal course of business, we use various financial instruments, including derivative financial instruments, to manage our market risk associated with changes in interest rates and foreign exchange rates. We do not use financial instruments for trading or speculative purposes. The following information pertains to financial instruments with significant activity since December 31, 2004.

      Letters of credit are guarantees we purchase, which ensure our performance or payment to third parties in accordance with specified terms and conditions. Management has determined that our letters of credit do not create additional risk to us. The notional amounts outstanding at September 30, 2005 and December 31, 2004, were $0.3 billion and $1.2 billion, respectively. The decrease in the notional amount of the letters of credit was primarily related to the maturity of debt in February 2005. In addition, restricted cash of $546 million, recorded within other current assets as of December 31, 2004, which collateralized these letters of credit, was released upon maturity of this debt.

      We enter into interest rate swap agreements to manage the fixed/floating mix of our debt portfolio in order to reduce aggregate risk of interest rate movements. These agreements involve the exchange of floating-rate for fixed-rate payments or the exchange of fixed-rate for floating-rate payments without the exchange of the underlying notional amount. Floating-rate payments and receipts are primarily tied to the London Inter-Bank Offered Rate (LIBOR). During the first quarter of 2005, all of our floating-rate to fixed-rate swaps (notional amount of $108 million), designated as cash flow hedges, matured.

      In addition, we have combined interest-rate foreign-currency swap agreements for foreign-currency-denominated debt, which hedge our risk to both interest rate and currency movements. As of September 30, 2005, the notional amount and fair value of these contracts was $0.6 billion and $0.3 billion, respectively, compared with $1.4 billion and $0.7 billion, respectively, at December 31, 2004. The decreases in the notional amount and fair value of these agreements were primarily related to the February 2005 maturity of $0.7 billion notional amount of contracts relating to debt that also matured in February 2005.

      We enter into foreign currency contracts to manage our exposure to changes in currency exchange rates related to foreign-currency-denominated transactions. As of September 30, 2005, the notional amount outstanding on these contracts was $0.7 billion compared with $0.6 billion as of December 31, 2004. The increase in the notional amount was primarily attributable to changes in the forward contracts portfolio, the majority of which were not designated for accounting purposes, as well as an increase in our net investment hedges.

      We entered into equity options and equity swap contracts, which were undesignated, to manage our exposure to changes in equity prices associated with various equity awards tied to previously affiliated companies. During the first quarter of 2005, all of the previously outstanding equity awards and the related equity option and equity swap contracts expired (notional amount of $29 million).

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      We sponsor noncontributory defined benefit pension plans covering the majority of our U.S. employees. Our postretirement benefit plans for current and certain future retirees include health-care benefits, life insurance coverage and telephone concessions.

      The following table shows the components of net periodic benefit (credit) cost for our U.S. plans:

      In 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003 was signed into law. The Act introduced a prescription drug benefit under Medicare (Medicare Part D), as well as a federal subsidy to sponsors of retiree health-care benefits. In 2004, we determined that the prescription drug benefit provided to a specific portion of our postretirement benefit plan participants is actuarially equivalent to Medicare Part D.

      In the second quarter of 2005, we determined that the prescription drug benefit provided to the remaining plan participants is also actuarially equivalent to the Medicare Part D benefits and therefore, we expect to be entitled to the federal subsidy. The impact of such expected federal subsidy will not have a significant effect on our accumulated postretirement benefit obligation or net periodic postretirement benefit cost.

      We expect to contribute approximately $550 million to the postretirement benefit plans in 2005. As of September 30, 2005, approximately $400 million of such contributions have been made.

      Certain non-U.S. operations have varying types of pension programs providing benefits for substantially all of their employees.

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      The following table shows the components of net periodic benefit cost for non-U.S. plans:

      In the normal course of business we are subject to proceedings, lawsuits and other claims, including proceedings under laws and regulations related to disputes with other carriers, environmental and other matters. Such matters are subject to many uncertainties, and outcomes are not predictable with assurance. Consequently, we are unable to ascertain the ultimate aggregate amount of monetary liability or financial impact with respect to these matters at September 30, 2005. However, if these matters are adversely settled, such amounts could be material to our consolidated financial statements.

      During the second quarter of 2005, we reached a settlement for $29 million, subject to final approval by the Court, of the class action claims brought by participants in our Long Term Savings Plan for Management Employees (the Plan). The lawsuit alleged we breached our fiduciary duties to the Plan and Plan participants by making materially false and misleading statements and omitting to state material facts concerning our future business prospects. Final approval was received in September 2005. The settlement of this lawsuit did not have a material impact on our results of operations.

      In 2004, following an FCC ruling against a petition we filed in which we asked the FCC to decide the issue of whether certain phone-to-phone Internet protocol (“IP”) telephony services are exempt from paying access charges, SBC filed a lawsuit in federal district court in Missouri asserting claims that we avoided interstate and intrastate access charges. During the first quarter of 2005, AT&T and SBC settled a variety of claims and disputes between the parties, including this litigation. The settlement of all matters resulted in AT&T paying SBC approximately $60 million, which did not have a material impact on our results of operations. Other carriers, including BellSouth Telecommunications, Inc. (BellSouth) have filed similar lawsuits in various jurisdictions. These claims did not specify damages.

      During the second quarter of 2005, we settled and paid lawsuits brought by the trustee for the bondholders’ liquidating trust, as well as a preference claim brought by creditors of At Home Corporation (At Home). Under the terms of the settlement agreement, the bondholders were paid $340 million, in addition to AT&T and Comcast Corporation (Comcast) relinquishing claims held in reserve by the At Home estate. Under the terms of a separation agreement with our former broadband subsidiary, which was spun off to Comcast in 2002, the settlement was shared equally between the two parties. The settlement of this litigation did not have a material impact on our results of operations.

      Class action lawsuits filed in California on behalf of At Home shareholders, which alleged AT&T breached fiduciary obligations, have been dismissed and are on appeal.

      In February 2005, the FCC ruled against AT&T and our petition for a declaratory ruling that our enhanced prepaid card services is an interstate information service. Following this decision, Qwest Communications International, Inc. (Qwest) filed a lawsuit against us asserting claims for breach of federal and state tariffs, unjust enrichment, fraudulent misrepresentation and breach of contract. Qwest seeks unspecified

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

damages. Other carriers, including BellSouth, have filed similar lawsuits in various jurisdictions, all seeking unspecified damages.

      Our results are segmented according to the customers we service: AT&T Business Services and AT&T Consumer Services.

      AT&T Business Services provides a variety of communication services to various-sized businesses and government agencies including long distance, international, toll-free and local voice, including wholesale transport services, as well as data services and Internet protocol and enhanced (IP&E) services, which includes the management of network servers and applications. AT&T Business Services also provides outsourcing solutions and other professional services.

      AT&T Consumer Services provides a variety of communication services to residential customers. These services include traditional long distance voice services, such as domestic and international dial services (long distance or local toll calls where the number “1” is dialed before the call) and calling card services. Transaction services, such as prepaid card and operator-assisted calls, are also offered. Collectively, these services represent stand-alone long distance services and are not offered in conjunction with any other service. AT&T Consumer Services also provides dial-up Internet services, and all distance services, which generally bundle long distance, local and local toll.

      The balance of our operations is included in a “Corporate and Other” group. This group primarily reflects corporate staff functions and the elimination of transactions between segments.

      Total assets for each segment include all assets, except intercompany receivables. Nearly all prepaid pension assets, taxes and corporate-owned or leased real estate are held at the corporate level and, therefore, are included in the Corporate and Other group. Capital additions for each segment include capital expenditures for property, plant and equipment, additions to internal-use software (included in other assets) and additions to nonconsolidated investments. We evaluate performance based on several factors, of which the primary financial measure is operating income.

      AT&T Business Services sells services to AT&T Consumer Services at cost-based prices. These sales are recorded by AT&T Business Services as contra-expense.

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

     Reflecting the dynamics of our business, we continually review our management model and structure, which may result in adjustments to our operating segments in the future.

      In June 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position FSP FAS No. 143-1, “Accounting for Electronic Equipment Waste Obligations,” to address the accounting for obligations associated with the Directive on Waste Electrical and Electronic Equipment (the Directive) issued by the European Union (EU). The Directive was enacted on February 13, 2003, and directs EU-member countries to adopt legislation to regulate the collection, treatment, recovery, and environmentally sound disposal of electrical and electronic waste equipment. The Directive concludes that commercial users are obligated to retire, in an environmentally sound manner, specific assets that qualify as historical waste. FSP FAS No. 143-1 is effective for reporting periods ending after June 8, 2005, which is June 30, 2005 for us, or the date of adoption of the Directive by the applicable EU-member countries, if later. We have evaluated the impact to our operations in EU countries that have adopted legislation and have deemed these costs to be immaterial. We will continue to evaluate the impact as other EU-member countries enact legislation. However, if the remaining EU-member countries enact similar legislation, we do not expect a material impact to our results of operations.

      In March 2005, the FASB issued FASB Interpretation (FIN) 47, “Accounting for Conditional Asset Retirement Obligations,” an interpretation of SFAS No. 143, “Accounting for Asset Retirement Obligations.” FIN 47 clarifies that the term conditional asset retirement obligation, as used in SFAS No. 143, refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. FIN 47 requires an entity to recognize a liability for the fair value of the conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005, which is December 31, 2005 for us; however, earlier application is permitted. We are currently evaluating the impact of FIN 47 on our results of operations, financial position and cash flows.

      In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment,” which requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. Additional guidance to assist in the initial interpretation of this revised statement was subsequently issued by the SEC in Staff Accounting Bulletin No. 107. SFAS No. 123 (revised 2004) eliminates the alternative of using APB Opinion No. 25 intrinsic-value method of accounting that was provided for in SFAS No. 123 as originally issued. Effective January 1, 2003, we adopted the fair-value recognition provisions of original SFAS No. 123 on a prospective basis and we began to record stock-based compensation expense for all employee awards (including stock options) granted or modified after January 1, 2003, using the nominal-vesting approach. Had we used the non-substantive vesting method, which will be required upon adoption, our results of operations would not have been materially different from those reported for the nine months ended September 30, 2005 and 2004. Adoption of the revised standard will require that we begin to recognize expense for unvested awards issued prior to January 1, 2003. Additionally, this standard requires that estimated forfeitures be considered in determining compensation expense. For equity awards other than stock options, we have not previously included estimated forfeitures in determining compensation expense. Accordingly, the difference between the expense we have recognized to date and the compensation expense as calculated considering estimated forfeitures will be reflected as a cumulative effect of accounting change upon adoption. Further, SFAS No. 123 (revised 2004) requires that excess tax benefits be recognized as an addition to paid-in capital and amends SFAS No. 95, “Statement of Cash Flows,” to require that the excess tax benefits be reported as a financing cash inflow rather than as a reduction of taxes paid. SFAS No. 123 (revised 2004) is effective for

AT&T CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

annual periods beginning after June 15, 2005, which is January 1, 2006 for us. We intend to elect a modified prospective adoption beginning in the first quarter of 2006 and do not anticipate that the adoption of SFAS No. 123 (revised 2004) will have a material impact on our results of operations.

      In December 2004, the FASB issued FASB Staff Position FSP FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” which provides guidance on the accounting and disclosure requirements for the repatriation provision of the Act. The Act creates a one-time tax incentive for U.S. corporations to repatriate accumulated income earned abroad by providing a tax deduction of 85% of dividends received for certain foreign earnings that are repatriated. In an effort to assist taxpayers with the interpretation of the repatriation provision of the Act, in May 2005, the United States Department of Treasury issued detailed guidance on certain technical aspects that required clarification. Based upon this guidance, in the third quarter of 2005, we completed our evaluation of the impact of the repatriation provision and recorded an income tax benefit of $6 million related to deferred taxes previously provided on foreign earnings.

      On October 5, 2005, we entered into a $0.5 billion 364-day Revolving Credit Facility Agreement (the “Agreement”) with a group of financial institutions, including J.P. Morgan Securities Inc., Citigroup Global Markets Inc. and Banc of America Securities LLC. The Agreement replaces the $1.0 billion 364-day Revolving Credit Facility Agreement dated October 6, 2004.

AT&T CORP. AND SUBSIDIARIES

Forward-Looking Statements

      This document contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to financial condition, results of operations, cash flows, dividends, financing plans, business strategies, operating efficiencies, capital and other expenditures, competitive positions, availability of capital, growth opportunities for new and existing products, benefits from new technologies, availability and deployment of new technologies, plans and objectives of management, mergers and acquisitions, and other matters.

      Statements in this document that are not historical facts are hereby identified as “forward-looking statements” for the purpose of the safe harbor provided by Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The words “estimate,” “project,” “intend,” “expect,” “believe,” “plan,” and similar expressions are intended to identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this document. Any Form 10-K, Annual Report to Shareholders, Form 10-Q or Form 8-K of AT&T Corp. may include forward-looking statements. In addition, other written or oral statements which constitute forward-looking statements have been made and may in the future be made by or on behalf of AT&T, including with respect to the matters referred to above. These forward-looking statements are necessarily estimates, reflecting the best judgment of senior management that rely on a number of assumptions concerning future events, many of which are outside of our control, and involve a number of risks and uncertainties that could cause actual results to differ materially from those suggested by the forward-looking statements. These forward-looking statements should, therefore, be considered in light of various important factors, including those set forth in this document. Important factors that could cause actual results to differ materially from estimates or projections contained in the forward-looking statements include, without limitation:

      The discussion and analysis that follows provides information management believes is relevant to an assessment and understanding of AT&T’s consolidated results of operations for the three and nine months ended September 30, 2005 and 2004, and financial condition as of September 30, 2005 and December 31, 2004.

AT&T CORP. AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

Overview

      AT&T Corp. (AT&T) is among the world’s communications leaders, providing voice and data communications services to large and small businesses, consumers and government agencies. We provide domestic and international long distance, regional and local communications services, data and Internet services.

Critical Accounting Estimates and Judgments

      The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses as well as the disclosure of contingent assets and liabilities. Management bases its estimates and judgments on historical experience and other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

      For a discussion of the critical accounting estimates we identified that we believe require significant judgment in the preparation of our consolidated financial statements, please refer to AT&T’s Form 10-K/ A for the year ended December 31, 2004.

Consolidated Results of Operations

      Total revenue decreased $1.0 billion, or 13.3%, in the third quarter of 2005 and decreased $2.9 billion, or 12.3%, for the nine months ended September 30, 2005, compared with the same periods of 2004. These decreases were primarily driven by continued declines in stand-alone long distance voice revenue of $0.6 billion in the third quarter of 2005 and $2.2 billion for the nine months ended September 30, 2005, compared with the same periods of 2004. These declines were reflective of increased competition, which has led to lower prices in the business markets, and loss of market share in AT&T Consumer Services and small- and medium-sized business markets. In addition, stand-alone long distance voice revenue was negatively impacted by substitution. Total long distance voice volumes (including long distance volumes sold as part of a bundled product) increased approximately 3% in the third quarter of 2005 compared with the third quarter of 2004 primarily due to an increase in lower-priced wholesale volumes, partially offset by a decrease in higher-priced consumer and business retail volumes. Total long distance volumes decreased approximately 3% for the nine months ended September 30, 2005, compared with the respective period in 2004, primarily due to declines in consumer and business retail volumes, partially offset by an increase in business wholesale volumes. Also contributing to the overall revenue decline was lower data services revenue of $0.2 billion in the third quarter of 2005 and $0.5 billion for the nine months ended September 30, 2005, compared with the respective periods of 2004, primarily driven by competitive pricing pressure and lower volumes, including the impact of technology migration.

      Revenue by segment is discussed in greater detail in the Segment Results section.

AT&T CORP. AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS — (Continued)

     Operating Expenses

      Included within access and other connection expenses are costs we pay to connect calls using the facilities of other service providers, as well as the Universal Service Fund contributions and per-line charges mandated by the Federal Communications Commission (FCC). We pay domestic access charges to local exchange carriers to complete long distance calls carried across the AT&T network and originated or terminated on a local exchange carrier’s network. We also pay local connectivity charges for leasing components of local exchange carrier networks in order to provide local service to our customers. International connection charges paid to telephone companies to connect international calls are also included within access and other connection expenses. Universal Service Fund contributions are charged to all telecommunications carriers by the FCC based on a percentage of state-to-state and international services revenue to provide affordable services to eligible customers. In addition, the FCC assesses charges on a per-line basis. Since most of the Universal Service Fund contributions and per-line charges are passed through to the customer, a change in these rates generally results in a corresponding change in revenue.

      Access and other connection expenses decreased $0.1 billion, or 3.9%, in the third quarter of 2005 and $0.4 billion, or 5.6%, for the nine months ended September 30, 2005, compared with the same periods of 2004. The declines were due to lower average rates, as well as changes in product and country mix relating to domestic access and international connection charges, totaling $0.1 billion for the third quarter of 2005 and $0.4 billion for the year-to-date period. The decreased rates reflect a greater proportion of calls that have non-access incurring terminations (such as when a call terminates over our own network or over a leased line), as well as the impact of rate negotiations, settlements and more efficient network usage. In addition, these declines were attributable to lower volumes primarily relating to local service of $0.1 billion for the third quarter of 2005 and lower volumes relating to local and domestic long distance services of $0.3 billion for the nine months ended September 30, 2005. These declines were partially offset by an increase in Universal Service Fund expense of $0.1 billion for the third quarter of 2005 and $0.2 billion for the nine months ended September 30, 2005, primarily due to higher revenue subject to assessment.

      Costs of services and products include the costs of operating and maintaining our networks, the provision for uncollectible receivables and other service-related costs, including cost of equipment sold.

      Costs of services and products decreased $0.3 billion, or 16.0%, in the third quarter of 2005 and $0.7 billion, or 13.3%, for the nine months ended September 30, 2005, compared with the same periods of 2004. These declines were primarily driven by the overall impact of cost cutting initiatives, primarily

AT&T CORP. AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS — (Continued)

headcount reductions, as well as lower revenue. Also contributing to the declines was a lower provision for uncollectible receivables, resulting from improved collections and lower revenue.

      Selling, general and administrative expenses decreased $0.4 billion, or 25.7%, in the third quarter of 2005, and $1.3 billion, or 25.8%, for the nine months ended September 30, 2005, compared with the same periods of 2004. These declines were primarily attributable to cost control efforts throughout AT&T, as well as lower costs resulting from decreased customer levels, totaling $0.3 billion and $0.8 billion for the three and nine months ended September 30, 2005, respectively. Cost control efforts included headcount reductions, as well as continued process improvements. In addition, the declines reflect lower marketing and customer acquisition spending of $0.2 billion in the third quarter of 2005 and $0.7 billion for the nine months ended September 30, 2005, primarily as a result of our strategic decision in the third quarter of 2004 to shift our focus away from traditional consumer services. Also impacting the third quarter of 2005 decline compared with the same period in 2004 was a $50 million legal accrual recorded in the third quarter of 2004 associated with the settlement of an AT&T shareholder class action lawsuit. The decline for the nine months ended September 30, 2005, was partially offset by increased costs relating to the pending merger with SBC of $0.1 billion.

      Depreciation and amortization expenses decreased $24 million, or 3.7%, in the third quarter of 2005, and $1.2 billion, or 39.6%, for the nine months ended September 30, 2005, compared with the same periods of 2004. The decline in the third quarter of 2005 compared with the third quarter of 2004 was primarily due to a lower depreciable asset base. The year-to-date decrease was primarily attributable to asset impairment charges of $11.4 billion recorded in the third quarter of 2004, which decreased depreciation and amortization expense by approximately $1.1 billion in the nine months ended September 30, 2005, compared with the same period of 2004. Capital expenditures were $0.3 billion and $0.4 billion for the three months ended September 30, 2005 and 2004, respectively, and were $1.1 billion and $1.4 billion for the nine months ended September 30, 2005 and 2004, respectively. We continue to focus the majority of our capital spending on our advanced services offerings of Internet protocol and enhanced (IP&E) services and data services, both of which include managed services.

      Asset impairment and net restructuring and other charges for the three months ended September 30, 2005, were a net credit of $1 million. During the third quarter of 2005, management reevaluated preexisting restructuring reserves and determined the actual or revised estimated obligations under these reserves differed from the estimates initially made. As a result, a net $11 million of excess preexisting employee separation restructuring liabilities were reversed. These activities were partially offset by an additional $10 million net charge recorded to preexisting facilities closing and other reserves. These adjustments were recorded in the Corporate and Other group and did not result from changes to the actual or planned headcount separations or the number of vacated facilities.

      Asset impairment and net restructuring and other charges of $35 million for the nine months ended September 30, 2005, consisted primarily of net charge of $55 million for facility closing and other reserves and a related $5 million asset impairment charge. These activities were partially offset by the net reversal of $25 million of excess preexisting employee separation restructuring liabilities.

      The net facilities closing and other reserves of $55 million for the nine months ended September 30, 2005, primarily reflected a $45 million charge recorded in the second quarter of 2005 associated with the continued consolidation of our real estate portfolio and reflected the present value of contractual lease obligations, net of estimated sublease income associated with vacant facilities primarily resulting from workforce reductions. In addition, we recorded a $10 million net charge in the third quarter of 2005 based on a reevaluation of preexisting facilities closing and other reserves as discussed above. Net facilities closing and other charges of $53 million were recorded in the Corporate and Other group and $2 million in AT&T Business Services. Additionally, the Corporate and Other group and AT&T Business Services recorded $2 million and $3 million,

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS — (Continued)

respectively, of leasehold improvement impairment charges related to the second quarter 2005 facilities closing reserve.

      The net reversal of $25 million of excess preexisting employee separation restructuring liabilities for the nine months ended September 30, 2005, was the result of management’s reevaluation of preexisting employee separation restructuring reserves. Management determined the actual or revised estimates of separation and related benefit payments differed from the estimates initially made, resulting in a net reversal of $25 million. AT&T Business Services recorded $23 million of the reversal and the Corporate and Other group recorded $12 million. AT&T Consumer Services recorded an additional $10 million charge as a result of this review. The adjustment to these reserves did not result from changes to the actual or planned headcount separations.

      Asset impairment and net restructuring and other charges of $12,469 million for the three months ended September 30, 2004, were comprised of $11,389 million of asset impairment charges and $1,080 million of net business restructuring and other charges. Charges in the amount of $11,859 million were recorded in AT&T Business Services, $188 million in AT&T Consumer Services and $422 million in the Corporate and Other group.

      In July 2004, we announced a strategic change in our business focus away from traditional consumer services and towards business markets and emerging technologies. As a result of this strategic change, we performed an evaluation of our long-lived assets, including property, plant and equipment and internal-use software (the asset group) as of July 1, 2004, as this strategic change created a “triggering event” necessitating such a review. In assessing impairments of long-lived assets we follow the provisions of Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We operate an integrated telecommunications network; therefore, we performed our testing of the asset group at the entity level, as this is the lowest level for which identifiable cash flows are available.

      In performing the test, we determined that the total of the expected future undiscounted cash flows directly related to the existing service potential of the asset group was less than the carrying value of the asset group; therefore, an impairment charge was required. The impairment charges of $11,389 million represented the difference between the fair value of the asset group and its carrying value and were included within asset impairment and net restructuring and other charges in the consolidated statements of operations. The impairment charges resulted from sustained pricing pressure and the evolution of services toward newer technologies in the business market as well as changes in the regulatory environment, which led to a shift away from traditional consumer services.

      AT&T Business Services recorded impairment charges of $11,330 million resulting in reductions to property, plant and equipment of $11,023 million, internal-use software of $287 million, other purchased intangibles of $15 million and other long-lived assets of $5 million. AT&T Consumer Services recorded impairment charges of $59 million resulting in reductions to property, plant and equipment of $11 million and internal-use software of $48 million.

      We calculated the fair value of our asset group using discounted cash flows. The discounted cash flows calculation was made utilizing various assumptions and estimates regarding future revenue, expenses and cash flows projections through 2012. The time horizon was determined based on the estimated remaining useful life of the primary assets in the asset group; the primary assets are those from which the most significant cash flows are generated, principally consisting of the transport central office equipment. Pursuant to SFAS No. 144, the forecasts were developed without contemplation of investments in new products. The 10% discount rate utilized was determined using a weighted-average cost of capital (debt and equity) and was more heavily weighted towards debt given that the asset group, which primarily consists of tangible assets, can be financed with a larger proportion of debt. When allocating the impairment to the asset categories, market

AT&T CORP. AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS — (Continued)

values were utilized, to the extent determinable, to ensure that no asset category was impaired below its fair value.

      The use of different assumptions within our discounted cash flows model when determining fair value, including the selection of the discount rate, could result in different valuations for our long-lived assets. For every percentage point difference in the discount rate selected, the amount of the impairment would have increased or decreased by approximately $0.4 billion.

      The strategic change in business focus also created a “triggering event” for a review of our goodwill. We follow the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” for determining impairments. SFAS No. 142 indicates that if other types of assets (in addition to goodwill) of a reporting unit are being tested for impairment at the same time as goodwill, then those assets are to be tested for impairment prior to performing the goodwill impairment testing. Accordingly, the impairment charges noted above reduced the carrying value of the reporting units when performing the impairment test for goodwill.

      The goodwill impairment test requires us to estimate the fair value of our overall business enterprise down to the reporting unit level. Our reporting units are AT&T Business Services and AT&T Consumer Services. We estimated fair value using both a discounted cash flows model, as well as an approach using market comparables, both of which are weighted equally to determine fair value. Under the discounted cash flows method, we utilized estimated long-term revenue and cash flows forecasts, as well as assumptions of terminal value, together with an applicable discount rate, to determine fair value. Under the market approach, fair value was determined by comparing our reporting units to similar businesses (or guideline companies). We then compared the carrying value of our reporting units to their fair value. Since the fair value of our reporting units exceeded their carrying amounts, no goodwill impairment charge was recorded.

      The net business restructuring activities of $1,080 million for the third quarter of 2004 consisted of $1,043 million for employee separations (of which $339 million related to benefit plan curtailment costs) and $37 million of facility closing obligations.

      This exit plan covered separation costs for approximately 11,200 employees (the majority of which were involuntary), approximately 60% of whom were managers. This activity resulted from the continued integration and automation of various functions within network operations, and our strategic change in focus away from traditional consumer services and towards business markets and emerging technologies.

      Facility closing reserves of $37 million were primarily associated with the continued consolidation of our real estate portfolio and reflect the present value of contractual lease obligations, net of estimated sublease income, associated with vacant facilities resulting from workforce reductions and network equipment space that will not be used.

      Asset impairment and net restructuring and other charges of $12,736 million for the nine months ended September 30, 2004, were comprised of $11,511 million of asset impairments and $1,225 million in net business restructuring and other obligations. In this period, charges in the amount of $12,002 million were recorded in AT&T Business Services, $189 million in AT&T Consumer Services and $545 million in the Corporate and Other group.

      The asset impairment charges of $11,511 million primarily reflect the third quarter asset impairments of $11,389 million as discussed above. In addition, we recorded real estate impairment charges of $122 million related to the decision made during the first quarter of 2004 to divest five owned properties in an effort to further reduce costs and consolidate our real estate portfolio. In accordance with SFAS No. 144, an impairment charge was recorded, within the Corporate and Other group, to reduce the book value of the five properties to fair-market value based on third-party assessments (including broker appraisals). The sales of these properties have been completed.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS — (Continued)

      The net restructuring obligations of $1,225 million for the nine months ended September 30, 2004, were primarily comprised of $1,147 million of net employee separations (of which $339 million related to benefit plan curtailment costs) and $78 million of facility closing obligations. These exit plans covered separation costs for approximately 12,600 employees (the majority of which were involuntary), nearly one-half of whom were managers. These activities resulted from the continued integration and automation of various functions within network operations, reorganizations throughout our non-U.S. operations, and our strategic change in focus away from traditional consumer services and towards business markets and emerging technologies. Nearly one-half of the employees impacted by these exit plans are managers.

      The facility closing reserves of $78 million were primarily associated with the consolidation of our real estate portfolio and reflect the present value of contractual lease obligations, net of estimated sublease income, associated with vacant facilities resulting from workforce reductions and network equipment space that will not be used.

      Operating income (loss) improved to income of $1.0 billion in the third quarter of 2005 compared with a loss of $11.3 billion in the third quarter of 2004. For the nine months ended September 30, 2005, operating income was $2.8 billion compared with a loss of $10.7 billion for the same period of 2004. For the three and nine months ended September 30, 2004, the operating loss included $12.5 billion and $12.7 billion, respectively, of asset impairment and net restructuring and other charges. Also, as a result of the third quarter 2004 asset impairment charges, operating income for the nine months ended September 30, 2005, included $1.1 billion of benefits due to lower depreciation on the impaired assets. Operating margins improved 162.7 percentage points in the third quarter of 2005 and 59.9 percentage points in the nine months ended September 30, 2005, compared with the same periods of 2004. Asset impairment and net restructuring and other charges negatively impacted the margins for the three and nine months ended September 30, 2004, by 163.3 percentage points and 54.8 percentage points, respectively. The benefits due to lower depreciation positively impacted the margin for the nine months ended September 30, 2005, by 5.3 percentage points. Excluding these items, operating margins were essentially flat in the third quarter of 2005 and the nine months ended September 30, 2005, compared with the same periods of 2004, as operating margin improvements at AT&T Consumer Services were essentially offset by lower operating margins at AT&T Business Services. AT&T Consumer Services’ operating margin improvements resulted primarily from greater rates of decline in selling, general and administrative expenses in relation to revenue. AT&T Business Services’ lower operating margins were primarily reflective of the declining higher-margin long distance retail voice and data businesses coupled with a shift to lower-margin products, such as advanced and wholesale services.

      Other income (expense), net, in the third quarter of 2005 was income of $10 million compared with expense of $34 million in the third quarter of 2004. The favorable variance was primarily due to settlements of insurance claims and legal matters in 2005, losses in 2004 associated with the early repurchase of long-term debt, and increased investment-related income. These improvements were partially offset by an impairment of our investment in leveraged leases of certain aircraft as a result of the bankruptcy filings of Delta Air Lines, Inc. and Northwest Airlines Corp. Other income (expense), net, for the nine months ended September 30, 2005, compared with the same period of 2004, improved $59 million reflecting lower losses on early repurchases of long-term debt and increased investment-related income. Partially offsetting these favorable variances were higher impairment charges of our investment in leveraged leases of certain aircraft, and a settlement in 2004 associated with a business disposition.

AT&T CORP. AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS — (Continued)

      We continue to hold $0.4 billion of investments in leveraged leases, including leases of commercial aircraft. Should the financial difficulties in the U.S. airline industry lead to further bankruptcies or lease restructurings, we could record additional losses associated with our aircraft lease portfolio. In addition, in the event of bankruptcy or renegotiation of lease terms, if any portion of the non-recourse debt is canceled, such amounts would result in taxable income to AT&T and, accordingly, a cash tax expense.

      Interest (expense) decreased 13.7%, or $26 million, in the third quarter of 2005 compared with the third quarter of 2004, and decreased 12.0%, or $73 million, for the nine months ended September 30, 2005, compared with the nine months ended September 30, 2004. These declines were reflective of a lower debt balance due to early debt redemptions and scheduled debt maturities in 2004 and 2005, partially offset by the impact of interest rate step-ups on certain bonds as a result of long-term debt ratings downgrades in 2004.

      The effective tax rate is the (provision) benefit for income taxes as a percentage of income (loss) before income taxes. The effective tax rate for the third quarter of 2005 was positively impacted by tax benefits associated with the settlement of prior-year state income tax liabilities and tax benefits recognized in connection with the Foreign Earnings Repatriation Provision of the American Jobs Creation Act of 2004. The effective income tax benefit rate for the nine months ended September 30, 2004, was positively impacted by approximately 3.2 percentage points due to the reversal of a portion of the valuation allowance we recorded in 2002 attributable to the book and tax basis difference related to our investment in AT&T Latin America. During February 2004, the subsidiaries of AT&T Latin America were sold to Telefonos de Mexico S.A. de C.V., or Telmex, and the AT&T Latin America plan of liquidation became effective. As a result, we no longer needed a portion of the valuation allowance and recorded an income tax benefit of $0.4 billion in the first quarter of 2004.

Segment Results

      Our results are segmented according to the customers we service: AT&T Business Services and AT&T Consumer Services. The balance of our operations is included in a Corporate and Other group. This group primarily reflects corporate staff functions and the elimination of transactions between segments. The discussion of segment results includes revenue, operating income, capital additions and total assets.

      Operating income is the primary measure used by our chief operating decision makers to measure our operating results and to measure segment profitability and performance. See note 11 to our consolidated financial statements for a reconciliation of segment results to consolidated results.

      Total assets for each segment include all assets, except intercompany receivables. Nearly all prepaid pension assets, taxes and corporate-owned or leased real estate are held at the corporate level, and therefore are included in the Corporate and Other group. A substantial majority of our property, plant and equipment (including network assets) is included in the AT&T Business Services segment. Capital additions for each

AT&T CORP. AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS — (Continued)

segment include capital expenditures for property, plant and equipment, additions to internal-use software and additions to nonconsolidated investments.

      We continually review our management model and structure, which may result in additional adjustments to our operating segments in the future.

      AT&T Business Services provides a variety of global communications services to large domestic and multinational businesses, government agencies and small- and medium-sized businesses. These services include long distance, international, toll-free and local voice, including wholesale transport services (sales of services to service resellers, such as other long distance companies, local service providers, wireless carriers and cable companies), as well as data services and IP&E services. AT&T Business Services also provides outsourcing solutions and other professional services.