The Gap 2006 Annual Report Download - page 61

Cost of Goods Sold and Occupancy Expenses
Cost of goods sold and occupancy expenses include the cost of merchandise, inventory shortage and
valuation adjustments, freight charges, costs associated with our sourcing operations, production costs, insurance
costs related to merchandise and occupancy, rent, common area maintenance, real estate taxes, utilities, and
depreciation for our stores and distribution centers.
Operating Expenses
Operating expenses include payroll and related benefits (for our store operations, field management,
distribution centers, and corporate functions), advertising, general and administrative expenses, and other income
(expense). Also included are costs to design and develop our products, merchandise handling and receiving in
distribution centers and stores, distribution center general and administrative expenses, and rent, occupancy and
depreciation for headquarter facilities.
Advertising
Costs associated with the production of advertising, such as writing, copy, printing and other costs, are
expensed as incurred. Costs associated with communicating advertising that has been produced, such as
television and magazine, are expensed when the advertising event takes place. Advertising costs were
$581 million, $513 million, and $528 million in fiscal 2006, 2005, and 2004, respectively, and are included in
operating expenses in the Consolidated Statements of Income.
Income Taxes
Income taxes are accounted for using the asset and liability method in accordance with SFAS 109,
“Accounting for Income Taxes.” Under this method, deferred income taxes arise from temporary differences
between the tax basis of assets and liabilities and their reported amounts in the Consolidated Financial
Statements. A valuation allowance is established against deferred tax assets when it is more likely than not that
some portion or all of the deferred tax assets will not be realized.
We record reserves for estimates of probable settlements of foreign and domestic tax audits. At any point in
time, many tax years are subject to or in the process of audit by various taxing authorities. To the extent that our
estimates of probable settlements change or the final tax outcome of these matters is different than the amounts
recorded, such differences will impact the income tax provision in the period in which such determinations are
made.
Share-Based Compensation
On January 29, 2006, we adopted the provisions of SFAS 123(R) using the modified prospective transition
method. We account for share-based compensation in accordance with the fair value recognition provisions of
SFAS 123(R). We use the Black-Scholes-Merton option-pricing model which requires assumptions requiring a
high degree of judgment. These assumptions include estimating the length of time employees will retain their
vested stock options before exercising them, the estimated volatility of our common stock price over the
expected term and the number of options that will ultimately not complete their vesting requirements. Changes in
the subjective assumptions can materially affect the estimate of fair value of share-based compensation and,
consequently, the related amount recognized in the Consolidated Statements of Income.
Prior to fiscal 2006, we accounted for share-based awards to employees and directors using the intrinsic
value method of accounting in accordance with Accounting Principles Board Opinion No. (“APB”) 25,
“Accounting for Stock Issued to Employees.” Under the intrinsic value method, when the exercise price of the
employee stock options equals the market price of the underlying stock on the date of grant, no compensation
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