Estee Lauder 2005 Annual Report Download - page 40

THE EST{E LAUDER COMPANIES INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES
AND ESTIMATES
The discussion and analysis of our financial condition at
June 30, 2005 and our results of operations for the three
fiscal years ended June 30, 2005 are based upon our con-
solidated financial statements, which have been prepared
in conformity with U.S. generally accepted accounting prin-
ciples. The preparation of these financial statements
requires us to make estimates and assumptions that affect
the reported amounts of assets, liabilities, revenues and
expenses reported in those financial statements. These
judgments can be subjective and complex, and conse-
quently actual results could differ from those estimates.
Our most critical accounting policies relate to revenue
recognition; concentration of credit risk; inventory; pen-
sion and other postretirement benefit costs; goodwill and
other intangible assets; income taxes; and derivatives.
Management of the Company has discussed the selec-
tion of significant accounting policies and the effect of esti-
mates with the Audit Committee of the Company’s Board
of Directors.
REVENUE RECOGNITION
Revenues from merchandise sales are recognized upon
transfer of ownership, including passage of title to the cus-
tomer and transfer of the risk of loss related to those
goods. In the Americas region, sales are generally recog-
nized at the time the product is shipped to the customer
and, in the Europe, Middle East & Africa and Asia/Pacific
regions, sales are generally recognized based upon the
customer’s receipt. In certain circumstances, transfer of title
takes place at the point of sale (e.g., at our retail stores).
Sales are reported on a net sales basis, which is com-
puted by deducting from gross sales the amount of actual
product returns received, discounts, incentive arrange-
ments with retailers and an amount established for antici-
pated product returns. Our practice is to accept product
returns from retailers only if properly requested, author-
ized and approved. In accepting returns, we typically
provide a credit to the retailer against accounts receivable
from that retailer. As a percentage of gross sales, returns
were 4.7%, 4.6% and 5.1% in fiscal 2005, 2004 and 2003,
respectively.
Our sales return accrual is a subjective critical estimate
that has a direct impact on reported net sales. This accrual
is calculated based on a history of actual returns, estimated
future returns and information provided by authorized
retailers regarding their inventory levels. Consideration of
these factors results in an accrual for anticipated sales
returns that reflects increases or decreases related to
seasonal fluctuations. Experience has shown a relationship
between retailer inventory levels and sales returns in the
subsequent period, as well as a consistent pattern of
returns due to the seasonal nature of our business. In addi-
tion, as necessary, specific accruals may be established for
significant future known or anticipated events. The types of
known or anticipated events that we have considered, and
will continue to consider, include, but are not limited to, the
solvency of our customers, store closings by retailers,
changes in the retail environment and our decision to
continue or support new and existing products.
CONCENTRATION OF CREDIT RISK
An entity is vulnerable to concentration of credit risk if it is
exposed to risks of loss greater than it would have had it
mitigated its risks through diversification of customers. The
significance of such credit risk depends on the extent and
nature of the concentration.
We have three major customers that owned and oper-
ated retail stores that in the aggregate accounted for
$1,403.1 million, or 22%, of our consolidated net sales in
fiscal 2005 and $187.9 million, or 24%, of our accounts
receivable at June 30, 2005. These customers sell products
primarily within North America. Our two largest customers,
Federated Department Stores, Inc. and The May Depart-
ment Stores Company, merged on August 30, 2005.
Although management believes that our major customers
are sound and creditworthy, a severe adverse impact on
their business operations could have a corresponding
material adverse effect on our net sales, cash flows and/or
financial condition.
In the ordinary course of business, we have established an
allowance for doubtful accounts and customer deductions in
the amount of $28.9 million and $30.1 million as of June 30,
2005 and 2004, respectively. Our allowance for doubtful
accounts is a subjective critical estimate that has a direct
impact on reported net earnings. The allowance for doubt-
ful accounts was reduced by $12.6 million, $25.6 million
and $30.3 million for customer deductions and write-offs
in fiscal 2005, 2004 and 2003, respectively, and increased
by $11.4 million, $23.9 million and $31.5 million for addi-
tional provisions in fiscal 2005, 2004 and 2003, respectively.
This reserve is based upon the evaluation of accounts
receivable aging, specific exposures and historical trends.
INVENTORY
We state our inventory at the lower of cost or fair market
value, with cost being determined on the first-in, first-out
(FIFO) method. We believe FIFO most closely matches
the flow of our products from manufacture through sale.
The reported net value of our inventory includes saleable
products, promotional products, raw materials and com-
ponentry and work in process that will be sold or used in
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