Johnson and Johnson 2006 Annual Report Download - page 58

56 JOHNSON & JOHNSON 2006 ANNUAL REPORT
The Company uses forward exchange contracts to manage
its exposure to the variability of cash flows, primarily related to
the foreign exchange rate changes of future intercompany prod-
uct and third party purchases of raw materials denominated in
foreign currency. The Company also uses currency swaps to man-
age currency risk primarily related to borrowings. Both of these
types of derivatives are designated as cash flow hedges. Addition-
ally, the Company uses forward exchange contracts tooffset its
exposure to certain foreign currency assets and liabilities. These
forward exchange contracts are not designated as hedges and,
therefore, changes in the fair values of these derivatives are
recognized in earnings, thereby offsetting the current earnings
effect of the related foreign currency assets and liabilities.
The designation as a cash flow hedge is made at the entrance
date into the derivative contract. At inception, all derivatives are
expected to be highly effective. Changes in the fair value of a
derivative that is designated as a cash flow hedgeand is highly
effective are recorded in accumulated other comprehensive
income until the underlying transaction affects earnings, and are
then reclassified to earnings in the same account as the hedged
transaction. The fair value of a derivative instrument (i.e. forward
foreign exchange contract, currency swap) is the aggregation, by
currency, of all 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 dis-
continued. Hedge ineffectiveness, if any, is included in current
period earnings, and was insignificant in 2006, 2005 and 2004.
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 appropriate-
ness of financial instruments; and (4) manage the enterprise risk
associated with financial 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 recover-
ies related to product liability claims are recorded on an undis-
counted 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. Pay-
ments 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 administrative
expenses. Advertising expenses worldwide, which are comprised of
television, radio, print media and Internet advertising, were $1.9 bil-
lion in 2006, $2.1 billion in 2005 and $1.9 billion in 2004.
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 December
31, 2006 and January 1, 2006, the cumulative amount of undis-
tributed international earnings were approximately $17.9 billion
and $11.9 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 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
earnings per share reflects the potential dilution that could occur
if securities were exercised or converted into common stock
using the treasury stock method.
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, amortization,
employee benefits, contingencies and intangible asset and liabil-
ity 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 bene-
fits. Actual results may or may not differ from those estimates.
ANNUAL CLOSING DATE
The Company follows the concept of a fiscal year which ends on the
Sunday nearest to the end of the month of December. Normally
each fiscal year consists of 52 weeks, but every five or six years, the
fiscal year consists of 53 weeks, as was the case in 2004.
2. Inventories
At the end of 2006 and 2005, inventories were comprised of:
(Dollars in Millions) 2006 2005
Raw materials and supplies $980 931
Goods in process 1,253 1,073
Finished goods 2,656 1,955
$4,889 3,959