NESTLÉ HOLDINGS, INC. (A Wholly Owned Subsidiary of Nestlé S.A.) AND SUBSIDIARIES A N N U A L F I N A N C I A L R E P O R T. Management Report ***

Transcription

1 A N N U A L F I N A N C I A L R E P O R T Management Report *** Responsibility Statement *** Consolidated Financial Statements (With Independent Auditors Report Thereon)

2 Management Report Nestlé Holdings, Inc. ( NHI ) (hereinafter, together with its subsidiaries, referred to as the Company ) is the holding company for Nestlé S.A. s principal operating subsidiaries in the United States, other than Nestlé Waters North America, Inc. and Alcon Laboratories, Inc. The Company manufactures food and beverages, with a strategic focus on the areas of nutrition, health and wellness. Its products are distributed primarily in the United States of America. Key Figures (US Dollars in millions) change % Net sales $21,719.1 $21, % Growth excluding acquisitions and divestitures 3.0% 6.8% Growth excl. acquisitions, divestitures and pricing 1.5% 1.5% Earnings before interest, taxes, and other expenses ("EBIT") $2,520.0 $2, % as a % of net sales 11.6% 10.8% Net financing costs ($688.3) ($764.3) (9.9%) Income tax expense ($698.2) ($1,194.2) (41.5%) Net Income $1,025.7 $ % as a % of net sales 4.7% 1.5% Operating cash flows $2,835.6 $ % as a % of net sales 13.1% 3.4% Capital expenditures $704.4 $801.9 (12.2%) Overview The after-shocks of the financial crisis were still reverberating as 2009 began, with projections of a sharp decline in economic growth, and of rising unemployment leading to dramatic falls in consumer confidence. Looking forward in January it was therefore difficult to imagine how the year would unfold, both from a macro-context and for the Company. We did, however, have some certainties: our commitment to our strategy was unwavering, even if our execution was adaptable; we had a clear set of priorities and a roadmap for where we wanted to get to; we had instilled in the organization a need for acceleration with discipline in all that we were doing and we had achieved the alignment of our people behind our roadmap. It was also clear that in an environment that was less conducive to growth than the previous few years we 1

3 would need to step up our efficiency programs and target our investment to capture growth wherever there was an opportunity to do so. This two-pronged approach was an example of our acceleration, and was particularly important because we were facing continued input cost pressure in an economic environment that was making consumers even more price- and value-conscious. Looking back at the performance a year later, it is clear that the Company rose to these challenges and delivered good results despite these uncertainties. Sales growth and lower raw material input prices were a significant factor in the ability to improve EBIT margins. Sales For the year ended December 31, 2009, consolidated net sales totaled $21.7 billion, representing an increase of 3.0% compared to the same period last year. Nestlé USA Brands sales growth was mainly attributable to volume growth and product mix when compared to 2008, and to a lesser degree, due to price increases. Notable product lines driving 2009 growth were coffee enhancers, frozen small dishes, soluble coffee, ready-to-drink beverages and baking chocolate. Offsetting this growth, a few product lines experienced declines in sales compared to 2008 such as powdered beverages and ambient culinary products. Sales of refrigerated cookie dough recovered well after the voluntary recall of cookie dough which started in late June A few prominent brands in this segment include Coffee-Mate, Juicy Juice, Nesquik, Stouffers, Lean Cuisine, Nestlé Crunch, and Nestlé Toll House. PetCare sales growth in comparison to 2008 was achieved through improved sales volume, product mix, and product pricing with particularly good results in all pet food categories, including dry and wet dog food, dry and wet cat food, dog snacks and the cat treat product lines. A few notable brands in this segment include Beneful, Alpo, Purina One, Purina Dog Chow, Mighty Dog, Friskies, Pro Plan, Fancy Feast and Purina Cat Chow. Nutrition sales declined by 5.3%, due to the combination of the tough economic environment, which particularly affected weight management and infant nutrition products, and the divestiture of the Baby care business in Dec 2008 (which represented 2.8% of the 5.3% decline). Notable brands in this segment are Gerber, Jenny Craig and PowerBar. Other businesses sales remained consistent with the 2008 levels, with growth in Nespresso offsetting the effect on Nestlé Professional of lower out-of-home dining due to the difficult economy. Profitability EBIT for the year ended December 31, 2009 grew 10.2% to $2.5 billion, with EBIT margins increasing by 0.8% of net sales (80 basis points) compared to last year. Growth, along with lower commodity input prices and internal cost saving and efficiency initiatives, improved EBIT margin; although these efforts were partially offset by higher selling and administrative costs. Taken together, the declines in commodity and other raw material input costs drove cost of goods sold down from 48.2% to 46.4% of net sales, a decline of 182 basis points, when compared to In the same period, non-production costs, as a percentage of net sales, increased by 106 basis points primarily driven by higher marketing and promotional activities, partially offset by savings in distribution costs from 2

4 the integration of Healthcare Nutrition and Gerber into the Company s ambient distribution network over the last two years and other efficiency programs. Net Profit Margin other items of interest Net financing costs decreased 9.9% or $76.1 million in comparison to the prior fiscal year, due to lower interest rates on financial liabilities, mostly bonds and commercial paper. Net other expenses increased by $88.3 million, primarily due to the costs associated with the recall of Nestlé Toll House Refrigerated Cookie Dough, the restructuring of the Company s nutrition business unit and the closure of the ice cream manufacturing facility in Houston, Texas. The Company's tax charge for 2009 decreased primarily as a result of decreased activity related to acquisitions. Cash flow Operating cash flow increased by $2,113.6 million, or 292.7%, in 2009 when compared to 2008, primarily due to improved accounts receivable collections and growth in the Company s net income, which were partially offset by lower trade payables and accruals. Capital expenditures decreased 12.2% in comparison to the prior year. Principal risks and uncertainties Risk Management At the Nestlé S.A. level, the Nestlé Group Enterprise Risk Management Framework (ERM) is designed to identify, communicate, and mitigate risks in order to minimize their potential impact on the Nestlé group of companies, including NHI. A Top-Down assessment occurs annually and focuses on the global risk portfolio. It is intended to allow management to make sound decisions on the future operations of the Company. Risk assessments are the responsibility of line management; this applies equally to a segment or a corporate function, and any mitigating actions identified in the assessments are the responsibility of the individual line management. If Nestlé S.A. intervention is required, responsibility for mitigating actions will generally be determined by the Executive Board of Nestlé S.A. The results of the ERM are presented to the Executive Board and Audit Committee of Nestlé S.A. annually. Factors Affecting Results The Company s reputation is based on consumers trust. Any major event triggered by a serious food safety or other compliance issue could potentially impact the Company s reputation or brand image. The Company has all required policies, processes and controls in place to mitigate against such an event. The Company is dependent on sustainable supplies of a number of raw materials, packaging materials and services/utilities. Any major event triggered by natural hazards (drought, flood, etc.), change in macroeconomic environment (shift in production patterns, biofuels, excessive trading) resulting in input price volatilities and/or capacity constraints could potentially impact the Company s financial results. The Company has all required policies, processes and controls in place to mitigate against such an event. The Company s liquidities/liabilities (currency, interest rate, derivatives, and/or hedging, pension funding obligations, commercial credit) could potentially be impacted by any major event in the financial markets. 3

5 NHI, along with its parent company Nestlé S.A., has necessary policies, processes and controls in place to mitigate against such an event. The Company is dependent on sustainable supplies of finished goods for all product categories. A major event in one of the Company s key plants, at a key supplier, contract manufacturers, co-packers, and/or key warehouse facility could potentially lead to a supply disruption and impact the Company s financial results. Necessary business continuity plans are established and regularly maintained in order to mitigate such an event. Security, political stability, legal and regulatory, macro-economic, foreign trade, labor, and/or infrastructure risks could potentially also impact the Company s ability to do business. Events such as a human pandemic could potentially also impact the Company s ability to operate. Any of these events could potentially lead to a supply disruption and impact the Company s financial results. Regular monitoring and ad hoc business continuity plans are established in order to mitigate against such an event. Outlook The US economy was severely impacted in the last year and a half by the ongoing financial crisis. The purchasing power and decision-making of the typical US consumer was directly affected as a result of continued layoffs and loss of wealth. While the Company is not immune to these developments, it is well positioned with strong, high quality brands, which are valued by the consumer. It is committed to achieving continued growth in 2010 in line with the Nestlé model by addressing the short term concerns of the consumer through continuous product innovation and the high quality price-value portfolio of product offerings. 4

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7 Auditors Report 7 Consolidated Financial Statements

8 KPMG LLP Suite South Grand Avenue Los Angeles, CA Independent Auditors Report The Board of Directors Nestlé Holdings, Inc.: We have audited the accompanying consolidated balance sheet of Nestlé Holdings, Inc. (a wholly owned subsidiary of Nestlé S.A.) and subsidiaries (the Company) as of, and the related consolidated income statement and statements of comprehensive income (loss), cash flows and changes in equity for the years then ended. These consolidated financial statements are the responsibility of the Company s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America and International Standards on Auditing. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nestlé Holdings, Inc. and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for the years then ended in conformity with International Financial Reporting Standards as issued by the International Accounting Standards Board. April 29, 2010 KPMG LLP, a U.S. limited liability partnership, is the U.S. member firm of KPMG International, a Swiss cooperative.

9 Consolidated Income Statement For the Years Ended Net sales (a) (note 26) $ 21,719,086 21,093,098 Cost of goods sold (10,072,403) (10,166,222) Distribution expenses (1,723,454) (1,860,922) Marketing, general and administrative expenses (a) (note 26) (6,368,013) (5,806,430) Royalties to affiliated company (1,035,210) (972,867) Earnings before interest, taxes and other expenses (b) 2,520,006 2,286,657 Net financing costs (note 18) (688,255) (764,363) Share of results from associated companies (note 9) 289 (2,182) Net other expense (note 19) (103,001) (14,723) Income from continuing operations before income taxes 1,729,039 1,505,389 Income tax expense (note 20) (698,192) (1,194,188) Income from continuing operations 1,030, ,201 (Loss) income from discontinued operations, net of taxes (5,131) 6,373 Net income $ 1,025, ,574 (a) 2008 comparatives have been restated following the first application of IFRIC 13 Customer Loyalty Programs. (b) Other expenses include share of results from associated companies, net other expense and discontinued operations. 8

10 Consolidated Statement of Comprehensive Income (Loss) For the Years Ended Net income $ 1,025, ,574 Other comprehensive income (loss): Fair value adjustments on cash flow hedges: Recognized in other equity reserves 88,281 (238,806) Removed from other equity reserves 219,285 5,446 Net change in fair value of available-for-sale assets: Unrealized results 126,562 (123,199) Recognition of realized results in the income statement (13,981) 5,645 Foreign currency translation differences for foreign operations 104 (4,033) Defined benefit plan actuarial gains (loss) (note 8) 119,322 (989,997) Income tax on other comprehensive income (note 20) (205,918) 518,226 Other comprehensive income (loss) for the period, next of tax 333,655 (826,718) Total comprehensive income (loss) $ 1,359,371 (509,144) 9

11 Consolidated Balance Sheet (Dollars in Thousands, Except Capital Stock Par Value and Shares) Assets Current assets: Cash and cash equivalents $ 47, ,842 Trade and other receivables, net (notes 3 and 13) 2,577,558 3,106,986 Assets held for sale (note 15) 24,673 37,204 Inventories, net (note 4) 1,301,993 1,454,131 Derivative assets (notes 5 and 13) 594, ,689 Prepayments 69,135 76,940 4,614,725 5,227,792 Non-current assets: Property, plant and equipment, net (note 7) 4,127,853 3,919,157 Employee benefits assets (note 8) 117,421 92,311 Investments in associated companies (note 9) 9,447 10,314 Deferred tax assets (note 10) 1,034,994 1,150,674 Financial assets (notes 6 and 13) 2,445,699 2,108,791 Goodwill (note 11) 17,001,369 16,859,223 Intangible assets, net (note 12) 889, ,356 25,626,647 24,931,826 Total assets $ 30,241,372 30,159,618 Liabilities and Equity Current liabilities: Trade and other payables (note 13) $ 1,309,151 1,176,603 Financial liabilities (note 13) 9,699,901 9,232,157 Derivative liabilities (notes 5 and 13) 157, ,223 Income taxes payable 5,171 Accruals (note 16) 1,298,802 1,438,065 12,465,641 12,430,219 Non-current liabilities: Financial liabilities (note 13) 9,871,102 11,589,275 Employee benefits liabilities (note 8) 1,424,236 1,582,045 Deferred tax liabilities (note 10) 1,176, ,863 Other accrued liabilities 2,063,343 1,786,886 Provisions (note 17) 196, ,220 14,731,250 16,044,289 Total liabilities 27,196,891 28,474,508 Equity: Share capital, $100 par value. Authorized, issued, and outstanding, 1,000 shares Share premium 1,650,353 1,650,353 Other equity reserves (850,841) (1,184,496) Retained earnings 2,244,869 1,219,153 Total equity 3,044,481 1,685,110 Total liabilities and equity $ 30,241,372 30,159,618 10

12 Consolidated Statement of Cash Flows For the Years Ended Cash flows from operating activities: Net income $ 1,025, ,574 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation of property, plant, and equipment (note 7) 460, ,471 Loss (gain) on sales of property, plant, and equipment 28,996 (3,022) Provision for impairment of property, plant, and equipment (note 7) 20,762 35,516 Amortization of intangible assets (note 12) 121,558 92,935 Gain on disposal of assets held for sale and other (707) (10,783) (Increase) decrease in cash surrender value of Company-owned life insurance policies (72,870) 56,336 Increase in provisions 85,205 21,591 Increase (decrease) in deferred income taxes 359,568 (579,299) Change in working capital (excluding effects from acquisitions and divestitures): Trade and other receivables, net 600,828 (651,050) Inventories, net 165,997 (152,714) Income taxes payable (9,463) 5,142 Prepayments and other current assets 9,197 10,806 Trade and other payables and other liabilities 378, ,486 Accruals (150,517) 143,393 Increase in working capital 994,156 10,063 Taxes on other comprehensive income (loss) (205,918) 518,226 Other movements, net 18,350 (164,579) Total adjustments 1,809, ,455 Net cash provided by operating activities 2,835, ,029 Cash flows from investing activities: Expenditure on property, plant and equipment (note 7) (704,425) (801,890) Proceeds from sale of property, plant and equipment 7,516 18,577 Business acquisitions, net of cash acquired (notes 23 & 24) (206,186) (122,633) Disposals of assets held for sale and other 31,465 1,157,345 Expenditure on intangible assets (note 12) (225,694) (179,419) Investments in available-for-sale securities (121,633) (155,602) Other movements (6,005) 11,234 Net cash used in investing activities (1,224,962) (72,388) Cash flows from financing activities: Net repayment of commercial paper (114,004) (2,189,514) Net (repayment) borrowings of line of credit (16,814) 29,099 Bonds issued 588,667 2,585,288 Bonds repaid (1,316,141) (1,636,437) Notes to affiliates issued 250,000 1,600,068 Notes to affiliates repaid (1,250,229) (801,555) Other changes in financial liabilities 154,162 (228,175) Net cash used in financing activities (1,704,359) (641,226) Net (decrease) increase in cash and cash equivalents (93,742) 8,415 Cash and cash equivalents at beginning of year 138, ,460 Effect of exchange rate changes on opening balances 2,061 (4,033) Cash and cash equivalents at end of year $ 47, ,842 Supplemental information: Cash paid for: Interest $ 618, ,154 Taxes 446, ,461 11

13 Consolidated Statement of Changes in Equity For the Years Ended Share Share Other Equity Retained Capital Premium Reserves Earnings Total Balance restated at December 31, 2007 $ 100 1,650,353 (357,778) 901,579 2,194,254 Total comprehensive income (loss): Net income 317, ,574 Other comprehensive income (loss): Fair value adjustments on cash flow hedges (233,360) (233,360) Net change in fair value of available for sale assets (117,554) (117,554) Foreign currency translation differences for foreign operations (4,033) (4,033) Defined benefit plan actuarial gains (loss) (note 8) (989,997) (989,997) Taxes on other comprehensive income (loss) 518, ,226 Total other comprehensive income (loss) (826,718) (826,718) Total comprehensive income (loss) (826,718) 317,574 (509,144) Balance at December 31, ,650,353 (1,184,496) 1,219,153 1,685,110 Total comprehensive income (loss): Net income 1,025,716 1,025,716 Other comprehensive income (loss): Fair value adjustments on cash flow hedges 307, ,566 Net change in fair value of available for sale assets 112, ,581 Foreign currency translation differences for foreign operations Defined benefit plan actuarial gains (loss) (note 8) 119, ,322 Taxes on other comprehensive income (loss) (205,918) (205,918) Total other comprehensive income (loss) 333, ,655 Total comprehensive income (loss) 333,655 1,025,716 1,359,371 Balance at December 31, 2009 $ 100 1,650,353 (850,841) 2,244,869 3,044,481 12

14 (1) Significant Accounting Policies and Changes in Accounting Policies Nestlé Holdings, Inc. ( NHI ) (hereinafter, together with its subsidiaries, referred to as the Company ) is a wholly owned subsidiary of Nestlé S.A., incorporated in Switzerland, which is the holding company of the Nestlé group of companies. NHI is the holding company for Nestlé S.A. s principal operating subsidiaries in the United States, other than Nestlé Waters North America, Inc. and Alcon Laboratories, Inc. NHI was incorporated in the State of Delaware in 1983 under registration number NHI is a corporation and has unlimited duration. The address of the registered office of NHI is 1209 Orange Street, Wilmington, Delaware The Company manufactures food and beverages, with a strategic focus on areas of nutrition, health and wellness. Its products primarily are distributed in the United States of America. Such products include: soluble coffee, chocolate-based drinks, dairy products, infant nutrition, healthcare nutrition, performance nutrition, ice cream, frozen and chilled food, culinary aids and chocolate and confectionary. Other business activities include pet care products juvenile life insurance and weight management products. The consolidated financial statements were authorized for issue by the Company s directors on April 29, (a) Significant Accounting Policies Basis of Preparation The consolidated financial statements of the Company have been prepared in accordance with International Financial Reporting Standards ( IFRS ) as issued by the International Accounting Standards Board ( IASB ), and with the interpretations issued by the International Financial Reporting Interpretations Committee ( IFRIC ) and its predecessor. The consolidated financial statements have been prepared on an accrual basis and under the historical cost convention, except as noted specifically in the following significant accounting policies. The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the application of policies, the reported amounts of revenues, expenses, assets and liabilities and disclosures. These estimates and associated assumptions are based on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results could differ from those estimates. The estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognized in the period in which the estimate is revised if the revision affects only that period or in the period of the revision and future periods if the revision affects both current and future periods. The areas affected by estimation include goodwill, employee benefits, allowance for doubtful receivables, provisions, impairment tests, share based payments, income taxes and financial assets and liabilities. 13

15 Scope of Consolidation The consolidated financial statements are comprised of those of NHI and its subsidiaries. All material intercompany profits, transactions and balances have been eliminated. The subsidiary companies, which are wholly and directly owned by NHI and incorporated in the United States, are as follows: Gerber Products Company Jenny Craig Holdings, Inc. Nespresso USA, Inc. Nestlé Capital Corporation Nestlé HealthCare Nutrition, Inc. (formerly Novartis Nutrition Corporation) Nestlé Insurance Holdings Inc. Nestlé Purina PetCare Company Nestlé USA, Inc. TSC Holdings, Inc. Newly acquired companies are consolidated from the effective date of control using the purchase method. Associates Investments in associated companies, including joint ventures, in which the Company either owns at least a 20% but less than a 50% interest, or where the Company owns less than a 20% interest but has significant influence but does not exercise control, are accounted for under the equity method. The net assets are adjusted to comply with the Company s accounting policies. The carrying amount of goodwill arising from the acquisition of associates is included in the carrying amount of investments in associates. Investments in which the Company has less than a 20% interest and does not have significant influence are reported at cost. Foreign Currency For the Company, transactions in currencies other than the Company s functional currency (U.S. Dollars) are recorded at the rate of exchange at the transaction date. Monetary assets and liabilities that are denominated in foreign currencies are translated at the year-end rates of exchange. Any resulting exchange differences are taken to the consolidated income statement. On consolidation, assets and liabilities of the Company denominated in their local currencies are translated into U.S. Dollars at year end exchange rates. Income and expense items are translated into U.S. Dollars at the annual weighted average rate of exchange or at the rate on the date of the transaction for significant items. Differences arising from the retranslation of opening net assets of the Company, together with differences arising from the restatement of the net results for the year of the Company and its 14

16 subsidiaries from average or actual rates to year-end rates, are recognized in other comprehensive income. Segment Reporting Operating segments reflect the Company s management structure and the way financial information is regularly reviewed by the chief operating decision maker (CODM). The CODM has been defined as a body comprised of the members of the Nestlé Group Executive Board to whom the various operating segments report, since this is the level at which resources are allocated and results are assessed. The Company s management structure is aligned with the Nestlé Group management structure, and is organized around products. The Nestlé USA Brands segment forms part of the Nestlé Group Zone Americas segment. It consists primarily of beverages, confections, snacks, frozen prepared foods, ice cream, and other food products. The PetCare segment also forms part of the Nestlé Group Zone Americas segment, and sells products and services for domestic pets. The Nutrition segment is part of the Nestlé Nutrition Globally Managed Business (GMB) segment. The Other Segments category is comprised of other operating segments that do not meet the criteria for separate reporting, such as Nestlé Professional (forming part of the Nestlé Professional GMB) which sells products for the foodservices industry and Nespresso. Both Nestlé Professional and Nespresso form part of the Nestlé Group Other Food and Beverage segment. Segment assets are aligned with information reported internally to the CODM. Segment assets comprise property, plant and equipment, intangible assets, trade and other receivables, assets held for sale, inventories, prepayments and accrued income. Eliminations represent inter-company balances between the different segments. Segment assets by operating segment represent the situation at the end of the year. Capital expenditures represent the investment in property, plant and equipment. Depreciation of segment assets includes depreciation of property, plant and equipment and amortization of intangible assets. Impairment of assets includes impairment related to property, plant and equipment, and intangible assets. Unallocated items represent non-specific items whose allocation to a segment would be arbitrary. They mainly comprise of corporate expenses and related assets. The Company generates substantially all of its net sales within the United States. 15

17 Revenue Revenue represents amounts received and receivable from third parties for goods supplied to the customers and for services rendered. Revenue from the sales of goods is recognized in the income statement at the moment when the significant risks and rewards of ownership of the goods have been transferred to the buyer, which is mainly upon shipment. It is measured at the list price applicable to a given distribution channel after deduction of all returns, sales taxes, pricing allowances and similar trade discounts. Payments made to the customers for commercial services received are expensed. Expenses Cost of goods sold is determined on the basis of the cost of production or of purchase, adjusted for the variation of inventories. All other expenses, including those in respect of advertising and promotions, are recognized when the Company receives the risks and rewards of ownership of the goods or when it receives the services. Net Other Expense These comprise all exit costs including but not limited to profit and loss on disposal of property, plant and equipment, profit and loss on disposal of businesses, onerous contracts, restructuring costs, impairment of property, plant and equipment, intangibles and goodwill. Restructuring costs are restricted to dismissal indemnities and employee benefits paid to terminated employees upon the reorganization of a business. Dismissal indemnities paid for normal attrition are part of the expenses by function. Net Financing Costs Net financing costs include interest on borrowings from third parties and affiliated companies as well as financial income earned on funds invested outside the Company. Net financing costs also include other financial income and expense such as exchange differences on loans and borrowings, results on foreign currency and interest rate hedging instruments that are recognized in the income statement. Certain borrowing costs are capitalized as explained under the section on property plant and equipment. Taxation Taxes include current taxes on income and other taxes such as taxes on capital and adjustments relating to prior years. Income tax is recognized in the consolidated income statement, except to the extent that it relates to items directly taken to other comprehensive income. Deferred taxation is the tax attributable to the temporary differences that appear when taxation authorities recognize and measure assets and liabilities with rules that differ from those of the consolidated financial statements. 16

18 Deferred taxes are calculated under the liability method at the rates of tax expected to prevail when the temporary differences reverse. Any changes of tax rates are recognized in the consolidated income statement unless related to items directly recognized in other comprehensive income. Deferred tax liabilities are recognized on all taxable temporary differences excluding non-deductible goodwill. Deferred tax assets are recognized on all deductible temporary differences provided that it is probable that future taxable income will be available. Financial Instruments Classes of financial instruments The Company aggregates its financial instruments into classes based on their nature and characteristics. Financial assets Financial assets are initially recognized at fair value plus directly attributable transaction costs. However when a financial asset at fair value through profit and loss is recognized the transaction costs are expensed immediately. Subsequent remeasurement of financial assets is determined by their designation that is revisited at each reporting date. Derivatives embedded in other contracts are separated and treated as stand-alone derivatives when their risks and characteristics are not closely related to those of their host contracts and the respective host contracts are not carried at fair value. At each balance sheet date, the Company assesses whether its financial assets are impaired. Impairment losses are recognized in the consolidated income statement when there is objective evidence of impairment. These losses are never reversed unless they refer to a financial instrument measured at fair value and classified as available-for-sale and the increase in fair value can objectively be related to an event occurring after the recognition of the impairment loss. Financial assets are derecognized (in full or partly) when the Company s rights to cash flows from the respective asset have expired or have been transferred and the Company has neither exposure to the risks inherent in those assets nor entitlement to rewards from them. The Company designates its financial assets into the following categories: loans and receivables, held-for-trading assets (financial assets at fair value through profit and loss), held-to-maturity investments and available-for-sale assets. Loans and receivables Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. This category includes the following classes of financial assets: loans, trade, tax and other receivables. 17

19 Subsequent to initial measurement, loans and receivables are carried at amortized cost using the effective interest rate method less appropriate allowances for doubtful receivables. Allowances for doubtful receivables represent the Company s estimates of incurred losses arising from the failure or inability of customers to make payments when due. These estimates are based on the aging of customers balances, specific credit circumstances and the Company s historical bad debt experience. Loans and receivables are further classified as current and non-current depending whether these are expected to be realized within twelve months after the balance sheet date or beyond. Financial assets at fair value through profit and loss Held-for-trading assets mainly include trading derivatives, which are derivatives for which hedge accounting is not applied because these are either not designated as hedging instruments or not effective as hedging instruments. Additional information can be found in the Derivative financial instruments section below. Company owned life insurance policies are categorized as Held-for-trading assets. They are reported at their cash surrender value with any changes in cash surrender value being recognized in the consolidated income statement. Held-to-maturity investments Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturities. The Company uses this designation when it has an intention and ability to hold them until maturity and when the re-sale of such investments is prohibited. Subsequent to initial recognition, held-to-maturity investments are recognized at amortized cost less impairment losses. Held-to-maturity investments are further classified as current and non-current depending whether they will mature within twelve months after the balance sheet date or beyond. As the Company currently does not hold any of these investments, this is not expected to have an impact on financial reporting. Available-for-sale assets Available-for-sale assets are those non-derivative financial assets that are either designated as such upon initial recognition or are not classified in any of the other financial assets categories. This category includes the following classes of financial assets: cash and cash equivalents, investments in securities and investments in companies where the Company does not exercise management control or have significant influence. They are split into: - cash and cash equivalents if their maturity is less than 3 months at inception. 18

20 - short term investments if their maturity is more than three months at inception, and if they are due within a period of 12 months; and - non-current financial assets. Subsequent to initial measurement, available-for-sale assets are stated at fair value with all unrealized gains or losses recognized in other comprehensive income until their disposal, at which time such gains or losses are recognized in the consolidated income statement, except as noted below. An investment in a foreign entity comprised of unquoted equity securities in which the Company holds a non-controlling interest and no significant influence over operations is measured at cost. Interest on available-for-sale assets is calculated using the effective interest rate method and is recognized in the income statement as part of interest income under net financing cost. Financial liabilities at amortized cost Financial liabilities are initially recognized at the fair value of consideration received less directly attributable transaction costs. Subsequent to initial measurement, financial liabilities are recognized at amortized cost unless they are part of a fair value hedge relationship (see fair value hedges). The difference between the initial carrying amount of the financial liabilities and their redemption value is recognized in the consolidated income statement over the contractual terms using the effective interest rate method. This category includes the following classes of financial liabilities: trade, tax and other payables, commercial paper, bonds and other financial liabilities. Financial liabilities at amortized cost are further classified as current and non-current depending whether these will fall due within twelve months after the balance sheet date or beyond. Financial liabilities are derecognized (in full or partly) when the Company is discharged from its obligation, they expire, they are cancelled or replaced by a new liability with substantially modified terms. Derivative financial instruments A derivative is a financial instrument that changes its values in response to changes in the underlying variable, requires no or little net initial investment and is settled at a future date. Derivatives are mainly used to manage exposures to foreign exchange, interest rate and commodity price risk. While some derivatives are also acquired with the aim of managing the return of marketable securities portfolios, these derivatives are only acquired when there are underlying financial assets. The classification of derivatives is determined upon initial recognition and monitored on a regular basis. Derivatives are initially recognized at fair value. These are subsequently remeasured at fair value on a quarterly basis. The fair values of exchange-traded derivatives are based on respective market 19

21 prices, while the fair values of the over-the-counter derivatives are based on accepted mathematical models based on market data and assumptions. Derivatives are carried as assets when their fair value is positive and as liabilities when their fair value is negative. The Company s derivatives mainly consist of currency forwards and options, commodity futures and options, interest rate swaps and interest rate and currency swaps. The use of derivatives is governed by policies approved by the Nestlé S.A. Board of Directors, which provide written principles on the use of derivatives consistent with the Company s overall risk management strategy. Hedge accounting The Company designates and documents certain derivatives as hedging instruments against changes in fair values of recognized assets and liabilities (fair value hedges) and highly probable forecast transactions (cash flow hedges). The effectiveness of such hedges is demonstrated at inception and verified on a quarterly basis, using prospective and retrospective testing. Fair value hedges The Company uses fair value hedges to mitigate the foreign currency and interest rate risks of its recognized assets and liabilities. The changes in fair values of hedging instruments are recognized in the consolidated income statement. Hedged items are also stated at fair value in respect of the risk being hedged, with any gain/loss being recognized in the consolidated income statement. Cash flow hedges The Company uses cash flow hedges to mitigate currency and/or commodity risks of highly probable forecasted transactions, such as purchases of raw materials, finished goods and equipment as well as the variability of expected interest payments. The effective part of the changes in fair value of hedging instruments are recognized in other comprehensive income, while any ineffective part is recognized immediately in the consolidated income statement. When the hedged item results in the recognition of a non-financial asset or liability, the gains or losses previously recognized in other comprehensive income are included in the measurement cost of the asset or of the liability. Otherwise the gains or losses previously recognized in other comprehensive income are removed and recognized in the consolidated income statement at the same time the hedged transaction affects profit or loss. Undesignated derivatives Undesignated derivatives are comprised of derivatives that are acquired in the frame of risk management policies for which hedge accounting is not applied because either the hedge is not 20

22 effective or does not qualify under International Accounting Standards ( IAS ) 39, Financial Instruments: Recognition and Measurement. Subsequent to initial measurement, undesignated derivatives are carried at fair value and all their gains and losses, realized and unrealized, are recognized in the income statement. Fair values The Company determines the fair values of its financial instruments on the basis of the following hierarchy: i) The fair value of financial instruments quoted in active markets is based on their quoted closing price at the balance sheet date. Examples include commodity derivative assets and liabilities, and other financial assets such as investments in equity securities. ii) The fair value of financial instruments that are not traded in an active market is determined by using valuation techniques using observable market data. Such valuation techniques include discounted cash flows, standard valuation models based on market parameters, dealer quotes for similar instruments and use of comparable arm s length transactions. For example, the fair value of forward exchange contracts, currency swaps and interest rate swaps is determined by discounting estimated future cash flows using a risk-free interest rate. iii) The fair value of a small number of instruments are determined on the basis of entity specific valuations using inputs that are not based on observable market data (unobservable input). When fair value of unquoted instruments cannot be measured with sufficient reliability, the Company carries such instruments at cost less impairment, if applicable. Inventories Raw materials and purchased finished goods are valued at purchase cost. Work in progress and manufactured finished goods are valued at production cost. Production cost includes direct production costs and an appropriate proportion of production overheads and factory depreciation. Raw materials inventories and purchased finished goods are accounted for using the FIFO (first-in, first-out) method. The weighted average cost method is used for other inventories. An allowance is established when the net realizable value of any inventory item is lower than the value calculated using the methods noted above. Prepayments and Accrued Income Prepayments and accrued income comprise payments made in advance relating to the following year, and income relating to the current year, which will not be invoiced until after the balance sheet date. 21

23 Property, Plant and Equipment Property, plant and equipment are shown in the balance sheet at their historical cost. Depreciation is provided on components that have homogenous useful lives by using the straight-line method so as to depreciate the initial cost down to the residual value over the estimated useful lives. The residual values are 30% on head offices and nil for all other asset types. The useful lives are as follows: Buildings and Land Improvements Plant and Machinery Tools, Furniture and sundry Vehicles Information Technology Equipment years years 5 years 5-8 years 3-4 years Useful lives, components and residual amounts are reviewed annually. Such a review takes into consideration the nature of the assets, their intended use including but not limited to the closure of facilities and the evolution of technological and competitive pressures that may lead to technical obsolescence. Depreciation of property, plant and equipment is allocated to the appropriate headings of expenses by function in the income statement. Borrowing costs incurred during the course of construction are capitalized if the assets under construction are significant and if their construction requires a substantial period to complete (typically more than one year). The capitalization rate is determined on the basis of the short term borrowing rate for the period of construction. Premiums capitalized for leasehold land or buildings are amortized over the length of the lease. Government grants are recognized in accordance with the deferral method, whereby the grant is set up as deferred income which is released to the income statement over the useful life of the related assets. Grants that are not related to assets are credited to the income statement when they are received. Leased Assets Assets acquired under finance leases are capitalized and depreciated in accordance with the Company s policy on property, plant and equipment, unless the lease term is shorter. Land and building leases are recognized separately provided an allocation of the lease payments between these categories is reliable. The associated obligations are included in financial liabilities. Leasehold improvements are amortized over their useful life or lease term, whichever is shorter. Rents payable under operating leases are expensed on a straight-line basis over the term of the lease. The costs of the agreements that do not take the legal form of a lease but convey the right to use an asset are separated into lease payments and other payments if the Company has the control of the use 22

24 or of the access to the asset or takes essentially all of the output of the asset. Then, the entity determines whether the lease component of the agreement is a finance or an operating lease. Goodwill Goodwill, representing the excess of the cost of acquisitions over the fair value of the identifiable net assets acquired, is capitalized. Goodwill is not amortized but tested for impairment at least annually and upon the occurrence of an indication of impairment. The impairment testing process is described in the appropriate section of these policies. Intangible Assets This heading includes intangible assets which are internally generated or are acquired either separately or in a business combination when they are identifiable and can be reliably measured. Intangible assets are considered to be identifiable if they arise from contractual or other rights, or if they are separable (i.e., they can be disposed of either individually or together with other assets). Intangible assets comprise indefinite life intangible assets and finite life intangible assets. Internally generated intangible assets are capitalized, provided they generate future economic benefits and their costs are clearly identifiable. Borrowing costs incurred during the development of internally generated intangible assets are capitalized if the assets are significant and if their development requires a substantial period to complete (typically more than one year). Indefinite life intangible assets are usually rights connected with a business activity. There is no foreseeable limit to their useful economic lives as they arise from contractual or other legal rights that can be renewed without significant cost and are the subject of continuous marketing support. They are not amortized but tested for impairment annually or more frequently if an impairment indicator is triggered. The assessment of the classification of intangible assets as indefinite is reviewed annually. Finite life intangible assets are those for which there is an expectation of obsolescence that limits their useful economic lives or where the useful life is limited by contractual or other terms. These are usually items such as software and customer lists. They are amortized over the shorter of their contractual or useful economic lives. Finite life intangible assets are amortized on a straight-line basis, usually between 3 and 20 years. Amortization of intangible assets is reflected in marketing, general and administrative expenses in the consolidated income statement. Impairment Goodwill and indefinite life intangible assets are reviewed for impairment at least annually and upon the occurrence of an indication of impairment. Finite life intangible assets and property, plant and equipment are reviewed for impairment upon the occurrence of an indication of impairment. Indications could be unfavorable development of a business under competitive pressures or severe 23

25 economic slowdown in a given market as well as reorganization of the operations to leverage their scale. If any such indication exists, the asset s recoverable amount is estimated. For goodwill, assets that have an indefinite useful life and for intangible assets recoverable amount is estimated at each balance sheet date. An impairment loss is recognized whenever the carrying amount of an asset or its cash-generating unit exceeds its recoverable amount. Impairment losses are recognized in the consolidated income statement. (i) Calculation of recoverable amount The recoverable amount is the greater of fair value less cost to sell and value in use. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. For an asset that does not generate largely independent cash inflows, the recoverable amount is determined for the cash-generating unit to which the asset belongs. (ii) Reversals of impairment Impairments are reviewed at each balance sheet date. An impairment loss is reversed if there has been a change in the estimates used to determine the recoverable amount, and is reversed only to the extent that the asset s carrying amount does not exceed the carrying amount that would have been determined, net of depreciation or amortization, if no impairment loss had been recognized. Impairment losses related to investments in equity instruments classified as available-for-sale are not reversed through the consolidated income statement. An impairment loss in respect of goodwill is never subsequently reversed. Assets Held for Sale and Discontinued Operations Non-current assets held for sale (and disposal groups) are presented separately in the current section of the balance sheet. Immediately before classification of the assets (and disposal groups) as held for sale, the carrying amounts of the assets (or all assets and liabilities in a disposal group) are measured in accordance with applicable accounting policies. Then, on initial classification as held for sale, non-current assets held for sale (and disposal groups) are measured at the lower of their carrying amount or fair value less cost to sell. Non-current assets held for sale (and disposal groups) are no longer depreciated. Impairment losses are included in the consolidated income statement. A discontinued operation is a component of the Company s business that represents a separate major line of business or geographical area of operations or is a subsidiary acquired exclusively with a view to resell. Classification as a discontinued operation occurs upon disposal or when the operation meets the criteria to be classified as held for sale, if earlier. 24