Johnson and Johnson 2005 Annual Report Download - page 47

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PAGE 45
future cash flows discounted to its present value at prevailing
market interest rates and subsequently converted to the U.S.
dollar at the current spot foreign exchange rate.
On an ongoing basis, the Company assesses whether each
derivative continues to be highly effective in offsetting changes
in the cash flows of hedged items. If and when a derivative
is no longer expected to be highly effective, hedge accounting
is discontinued. Hedge ineffectiveness, if any, is included in
current period earnings, and was insignificant in 2005, 2004
and 2003.
The Company documents all relationships between hedged
items and derivatives. The overall risk management strategy
includes reasons for undertaking hedge transactions and
entering into derivatives. The objectives of this strategy are:
(1) minimize foreign currency exposure’s impact on the
Company’s financial performance; (2) protect the Company’s
cash flow from adverse movements in foreign exchange
rates; (3) ensure the appropriateness of financial instruments;
and (4) manage the enterprise risk associated with finan-
cial institutions.
Product Liability
Accruals for product liability claims are recorded, on an undis-
counted basis, when it is probable that a liability has been
incurred and the amount of the liability can be reasonably
estimated based on existing information. The accruals are
adjusted periodically as additional information becomes
available. As a result of cost and availability factors, effective
November 1, 2005, the Company ceased purchasing third party
product liability insurance. Based on the availability of prior
coverage, receivables for insurance recoveries related to
product liability claims are recorded on an undiscounted basis,
when it is probable that a recovery will be realized.
Research and Development
Research and development expenses are expensed as incurred.
Upfront and milestone payments made to third parties in con-
nection with research and development collaborations are
expensed as incurred up to the point of regulatory approval.
Payments made to third parties subsequent to regulatory
approval are capitalized and amortized over the remaining
useful life of the related product. Amounts capitalized for
such payments are included in other intangibles, net of
accumulated amortization.
Advertising
Costs associated with advertising are expensed in the year
incurred and are included in the selling, marketing and admin-
istrative expenses. Advertising expenses worldwide, which
are comprised of television, radio, print media and Internet
advertising, were $2.1 billion in 2005, $1.9 billion in 2004 and
$1.7 billion in 2003.
Income Taxes
The Company intends to continue to reinvest its undistributed
international earnings to expand its international operations;
therefore, no U.S. tax expense has been recorded to cover the
undistributed portion not intended for repatriation. At January
1, 2006 and January 2, 2005, the cumulative amount of undis-
tributed international earnings were approximately $12.0 bil-
lion and $18.6 billion, respectively.
Deferred income taxes are recognized for tax consequences
of temporary differences by applying enacted statutory
tax rates, applicable to future years, to differences between
the financial reporting and the tax basis of existing assets
and liabilities.
Net Earnings Per Share
Basic net earnings per share is computed by dividing net
earnings available to common shareholders by the weighted
average number of common shares outstanding for the period.
Diluted net earnings per share reflects the potential dilution
that could occur if securities were exercised or converted into
common stock using the treasury stock method.
Stock Options
At January 1, 2006, the Company had 17 stock-based employee
compensation plans that are described in Note 10. The Com-
pany accounts for those plans under the recognition and mea-
surement principles of Accounting Principle Board Opinion No.
25, Accounting for Stock Issued to Employees (APB 25), and its
related Interpretations. Compensation costs are not recorded in
net earnings for stock options as all options granted under
those plans had an exercise price equal to the market value of
the underlying common stock on the date of grant.
As required by SFAS No. 148, Accounting for Stock-Based
Compensation — Transition and Disclosure —an amendment
of FASB Statement No. 123, the following table shows the esti-
mated effect on net income and earnings per share if the Com-
pany had applied the fair value recognition provision of SFAS
No. 123, Accounting for Stock-Based Compensation, to stock-
based employee compensation.
(Dollars in Millions
Except Per Share Data) 2005 2004 2003
Net earnings, as reported $10,411 8,509 7,197
Less:
Compensation expense(1) 351 329 349
Net earnings, pro forma 10,060 8,180 6,848
Net earnings per share:
Basic — as reported $ 3.50 2.87 2.42
— pro forma 3.38 2.76 2.31
Diluted — as reported 3.46 2.84 2.40
— pro forma 3.35 2.74 2.29
(1) Determined under fair value based method for all awards, net of tax.
Use of Estimates
The preparation of consolidated financial statements in
conformity with accounting principles generally accepted in the
U.S. requires management to make estimates and assumptions
that affect the amounts reported. Estimates are used when
accounting for sales discounts, rebates, allowances and incen-
tives, product liabilities, income taxes, depreciation, amortiza-
tion, employee benefits, contingencies and asset and liability
valuations. For instance, in determining annual pension and
post-employment benefit costs, the Company estimates the rate
of return on plan assets, and the cost of future health care ben-
efits. Actual results may or may not differ from those estimates.