Financial Review (1 of 5)

Abbott’s revenues are derived primarily from the sale of a broad line of health care products under short-term receivable arrangements. Patent protection and licenses, technological and performance features, and inclusion of Abbott’s products under a contract or by a pharmacy benefit manager most impact which products are sold; price controls, competition and rebates most impact the net selling prices of products; and foreign currency translation impacts the measurement of net sales. Abbott’s primary products are prescription pharmaceuticals, nutritional products and diagnostic testing products. Abbott also owns 50 percent of TAP Pharmaceutical Products Inc. (TAP) that Abbott accounts for on the equity method.

The worldwide launch of HUMIRA, the spin-off of Hospira, integration and restructuring activities and the loss of patent protection for some products have impacted Abbott’s sales, costs and financial position over the last three years.

Subsequent to Abbott’s 2001 acquisition of the Knoll pharmaceutical business, which significantly increased the scale of Abbott’s pharmaceutical business, Abbott focused on reorganizing and growing its global pharmaceutical business. Abbott has established a global research and development organization and a global manufacturing and distribution organization to serve its domestic and international commercial pharmaceutical operations. Pharmaceutical research and development is focused on five therapeutic areas—immunology, oncology, neuroscience, diabetes/metabolism, and viral diseases. U.S. commercial pharmaceutical operations are focused mainly on primary care and specialty pharmaceuticals. In 2003, Abbott began the worldwide launch of HUMIRA, which increased its worldwide sales to $1.4 billion in 2005 compared to $852 million in 2004. In 2005, Abbott and Boehringer Ingelheim (BI) amended their agreement whereby Abbott distributed and promoted BI products. Effective January 1, 2006, Abbott will no longer distribute BI products but will receive residual commissions. Abbott’s gross margins for BI products from the prior agreement in effect through December 31, 2005 were substantially lower than its average gross margin. 2005 sales of BI products were $2.3 billion. Increased generic competition resulted in U.S. sales of Synthroid declining 22 percent in 2005 while holding a 36 percent market share.

In 2004, Abbott separated its diagnostic segment into four separate divisions—immunoassay/hematology, diabetes care, molecular, and point of care—to better focus on commercial and scientific opportunities. In early 2004, Abbott acquired TheraSense for $1.2 billion, and began to integrate it with Abbott’s diabetes care business. In late 2003, Abbott was informed by the FDA that it may distribute the immunoassay products in the U.S. that were impacted by regulatory restrictions imposed in 1999. Net sales and profits for this business declined over the restricted period, but stabilized in 2004 and 2005. In 2005, Abbott diagnostics launched more than 50 new products. In the Ross segment in 2003, Abbott settled its portion of an industrywide investigation of the enteral nutritional business for $614 million.

In 2004, Abbott completed the spin-off of Hospira, Abbott’s former hospital products business. Annual sales of Hospira were approximately $2.4 billion. As part of the spin-off, Hospira assumed $700 million of debt. The historical operating and cash flow results of Hospira are presented as discontinued operations. Hospira is contractually obligated to purchase the international hospital assets and operations that were not included in the spin-off. The legal transfer of certain remaining operations and assets (net of liabilities) outside the United States is expected to occur in the first half of 2006.

In early 2006, Abbott reached agreement to acquire Guidant’s vascular intervention and endovascular solutions businesses, subject to Boston Scientific’s acquisition of Guidant. Guidant’s annual revenues from these businesses are approximately $1 billion. The purchase price would be $4.1 billion, plus contingent milestone payments of $500 million.

TAP’s contribution to Abbott’s earnings declined in 2004 and 2003. A part of the decline was due to increased competition for Prevacid, TAP’s largest selling product, and due to market contraction for prescription proton pump inhibitors. In 2004, TAP recorded additional litigation reserves of $125 million for an anticipated legal settlement.

Abbott’s short- and long-term debt totaled $6.6 billion at December 31, 2005, largely incurred to finance acquisitions. Operating cash flows in excess of capital expenditures and cash dividends have allowed Abbott to reduce debt and fund acquisitions over the last three years. At December 31, 2005, Abbott’s long-term debt rating was AA by Standard and Poor’s and A1 by Moody’s Investors Service.

In 2006, Abbott will focus on several key initiatives. In the global pharmaceutical business, Abbott will launch newly approved indications for HUMIRA. Abbott will also focus on appropriate market support for Synthroid, which became subject to generic U.S. competition in mid-2004, and for sevoflurane, which became subject to generic competition in December 2005. In 2005, TAP received an approvable letter from the FDA for febuxostat. Contingent upon FDA approval, TAP plans to launch febuxostat in 2006. Pharmaceutical research and development efforts will continue to be focused in the five therapeutic areas noted above with a significant portion of the development expenditures allocated to new HUMIRA indications. Abbott expects to submit additional pharmaceutical regulatory filings in 2006. In the immunoassay business, attention will be focused on improving revenue growth by capitalizing on recent product launches, including the U.S. launch of the blood screening system, PRISM, launching additional products, and commercial execution of the existing broad product portfolio. In the hematology business, attention will be focused on the continued launch of CELL-DYN Sapphire and other analyzers. For diabetes care, Abbott will continue the launch of FreeStyle Connect and Abbott anticipates the approval of FreeStyle Navigator in 2006. Upon closure of the acquisition of Guidant’s vascular business, planning for its integration would be a key activity in the vascular business. Focus in this business will also be on the 2005 launch of Xact Carotid Stent and Emboshield Embolic Protection System and the projected approval of ZoMaxx, Abbott’s drug-eluting stent, in Europe. With a greater focus on consumer marketing, Ross will maximize the strength of its core brands and further develop its healthy-living market presence. In the other business segments, Abbott will focus on developing or acquiring differentiated technologies in higher growth segments of those markets.

Critical Accounting Policies

Sales Rebates — Approximately 40 percent of Abbott’s consolidated gross revenues are subject to various forms of rebates and allowances that Abbott records as reductions of revenues at the time of sale. Most of these rebates and allowances are in two of Abbott’s domestic segments—the Pharmaceutical Products segment and the Ross Products segment. Abbott provides rebates to pharmacy benefit management companies, to state agencies which administer the federal Medicaid program and the Special Supplemental Food Program for Women, Infants, and Children (WIC), wholesalers, group purchasing organizations, and other government agencies and private entities. Rebate amounts are usually based upon the volume of purchases using contractual or statutory prices for a product. Factors used in the rebate calculations include the identification of which products have been sold subject to a rebate, which customer or government agency price terms apply, and the estimated lag time between sale and payment of a rebate. Using historical trends, adjusted for current changes, Abbott estimates the amount of the rebate that will be paid, and records the liability as a reduction of gross sales when Abbott records its sale of the product. Settlement of the rebate generally occurs from two to 24 months after sale. Abbott regularly analyzes the historical rebate trends and makes adjustments to reserves for changes in trends and terms of rebate programs. Rebates and chargebacks charged against gross sales in 2005, 2004 and 2003 amounted to approximately $2.5 billion, $2.4 billion and $1.8 billion, respectively, or 22.9 percent, 25.6 percent, and 22.7 percent, respectively, based on gross sales of approximately $10.9 billion, $9.3 billion and $8.0 billion, respectively, subject to rebate. A one-percentage point increase in the percentage of rebates to related gross sales would decrease net sales and operating earnings by approximately $109 million in 2005. Other allowances charged against gross sales were approximately $284 million, $233 million and $191 million for cash discounts in 2005, 2004 and 2003, respectively, and $162 million, $163 million and $171 million for returns in 2005, 2004 and 2003, respectively. Cash discounts are known within 15 to 30 days of sale, and therefore can be reliably estimated. Returns can be reliably estimated because Abbott’s historical returns are low, and because sales returns terms and other sales terms have remained relatively unchanged for several periods.

Management analyzes the adequacy of ending accrual balances each quarter. In the Ross nutritional business, management uses both internal and external data available to estimate the level of inventory in the distribution channel. Management internally estimates the inventory in the retail channel that is not on the retail shelf. A third party continuously measures time on the retail shelf, which is a relatively significant portion of the time inventory is in the distribution channel. Except for a transition period before or after a change in the supplier for the WIC business in a state, inventory in the distribution channel does not vary substantially. Management also estimates the states’ processing lag time based on claims data. In addition, internal processing time is a factor in estimating the accrual. In the WIC business, the state where the sale is made, which is the determining factor for the applicable price, is reliably estimable. Estimates are required for the amount of WIC sales within each state where Abbott has the WIC business. External data sources utilized for that estimate are participant data from the U.S. Department of Agriculture (USDA), which administers the WIC program, participant data from some of the states, and internally administered market surveys. The USDA has been making its data available for many years. Internal data includes historical redemption rates and pricing data. At December 31, 2005, Ross had the exclusive WIC business in 11 states.

In the domestic pharmaceutical business, the most significant charges against gross sales are for Medicaid Rebates, Pharmacy Benefit Manager Rebates and Wholesaler Chargebacks. In order to evaluate the adequacy of the ending accrual balances, management uses both internal and external estimates of the level of inventory in the distribution channel and the rebate claims processing lag time. External data sources used to estimate the inventory in the distribution channel include inventory levels periodically reported by wholesalers and third party market data purchased by Abbott. Management estimates the processing lag time based on periodic sampling of claims data. To estimate the price rebate percentage, systems and calculations are used to track sales by product by customer and to estimate the contractual or statutory price. Abbott’s systems and calculations have developed over time as rebates have become more significant, and Abbott believes they are reliable.

The following table is an analysis of the four largest rebate accruals, which comprise approximately 80 percent of the consolidated rebate provisions charged against revenues in 2005. Remaining rebate provisions charged against gross sales are not significant in the determination of operating earnings. (dollars in thousands)

				Pharmaceutical Products
	Ross Products WIC Rebates			Medicaid Rebates			Pharmacy Benefit Manager Rebates			Wholesaler Charge- backs
Balance at January 1, 2003	$	65,979		$	196,200		$	115,539		$	24,586
Provisions		527,803			358,173			244,037			338,316
Payments		(480,420	)		(325,303	)		(214,381	)		(325,809	)
Balance at December 31, 2003		113,362			229,070			145,195			37,093
Provisions		671,817			596,330			279,681			419,486
Payments		(687,132	)		(452,342	)		(271,078	)		(412,526	)
Balance at December 31, 2004		98,047			373,058			153,798			44,053
Provisions		641,189			663,043			253,499			450,901
Payments		(644,460	)		(581,098	)		(273,166	)		(446,867	)
Balance at December 31, 2005	$	94,776		$	455,003		$	134,131		$	48,087

 

Adjustments for prior years’ rebate accruals have not been material. Abbott employs various techniques to verify the accuracy of claims submitted to it, and where possible, works with the organizations submitting claims to gain insight into changes that might affect the rebate amounts. For Medicaid and other government agency programs, the calculation of a rebate involves interpretations of relevant regulations, which are subject to challenge or change in interpretation.

Income Taxes — Abbott operates in numerous countries where its income tax returns are subject to audits and adjustments. Because Abbott operates globally, the nature of the audit items are often very complex, and the objectives of the government auditors can result in a tax on the same income in more than one country. Abbott employs internal and external tax professionals to minimize audit adjustment amounts where possible. As part of Abbott’s calculation of the provision for taxes on earnings, Abbott records the amount that it expects to incur as a result of audits. Each quarter, Abbott reviews its exposures in accordance with Statement of Financial Accounting Standards (SFAS) No. 5, “Accounting for Contingencies.” In the U.S., Abbott’s federal income tax returns through 2000 are settled, and the income tax returns for years after 2000 are open. Except for taxes on dividends that were remitted under the American Jobs Creation Act of 2004, Abbott does not record deferred income taxes on earnings reinvested indefinitely in foreign subsidiaries.

Pension and Post-Employment Benefits — Abbott offers pension benefits and post-employment health care to many of its employees. Abbott engages outside actuaries to calculate its obligations and costs under these programs. With the assistance of outside actuaries, Abbott must develop long-term assumptions, the most significant of which are the health care cost trend rate, discount rate and the expected return on plan assets. The discount rate used to measure liabilities as of December 31, 2005 was determined based on high-quality fixed income investments that match the duration of the expected retiree benefits. Prior to December 31, 2005, the discount rate was determined by reference to a composite corporate AA bond index. The health care cost trend rate represents Abbott’s expected annual rates of change in the cost of health care benefits and is a forward projection of health care costs as of the measurement date. A difference between the assumed rates and the actual rates, which will not be known for decades, can be significant in relation to the obligations and the annual cost recorded for these programs. Recent low interest rates have significantly increased unrecognized actuarial losses for these plans. At December 31, 2005, the unrecognized actuarial losses for Abbott’s defined benefit plans and medical and dental plans were $1.5 billion and $698 million, respectively. Unrecognized actuarial losses and gains are amortized over the remaining service periods of the employees under the corridor method, in accordance with the rules for accounting for post-employment benefits. Differences between the expected long-term return on plan assets and the actual annual return are amortized over a five-year period. Footnote 4 to the consolidated financial statements describes the impact of a one-percentage point change in the health care cost trend rate; however, there can be no certainty that a change would be limited to only one percentage point. In 2005, Abbott reversed previously recorded minimum pension liability adjustments of $562 million because the assets of certain defined benefit plans were now in excess of the accumulated benefit obligations due primarily to plan contributions in 2005. This resulted in a credit to Accumulated other comprehensive income (loss) of $346 million, net of taxes. In 2004 and 2003, Abbott recorded minimum pension liability adjustments of $120 million and $155 million, respectively, because the accumulated benefit obligations for certain defined benefit plans exceeded the market value of the plans’ assets. This resulted in charges to Accumulated other comprehensive income (loss) of $76 million and $99 million, net of taxes, in 2004 and 2003, respectively.

Valuation of Intangible Assets — Abbott has acquired and continues to acquire significant intangible assets that Abbott records at fair value. Those assets which do not yet have regulatory approval and for which there are no alternative uses are expensed as acquired in-process research and development, and those that have regulatory approval are capitalized. Transactions involving the purchase or sale of intangible assets occur with some frequency between companies in the health care field, and valuations are usually based on a discounted cash flow analysis using market participant assumptions. Abbott uses a discounted cash flow model to value most of its acquired intangible assets. The discounted cash flow model requires assumptions about the timing and amount of future net cash inflows, risk, the cost of capital, and terminal values. Each of these factors can significantly affect the value of the intangible asset. Abbott engages independent valuation experts who review Abbott’s critical assumptions and calculations for significant acquisitions of intangibles. Abbott reviews intangible assets for impairment each quarter using an undiscounted net cash flows approach. If the undiscounted cash flows of an intangible asset are less than the carrying value of an intangible asset, the intangible asset is written down to its fair value, which is usually the discounted cash flow amount. Where cash flows cannot be identified for an individual asset, the review is applied at the lowest group level for which cash flows are identifiable. Goodwill is reviewed for impairment annually or when an event that could result in an impairment of goodwill occurs. At December 31, 2005 goodwill and intangibles amounted to $5.2 billion and $4.7 billion, respectively, and amortization expense for intangible assets amounted to approximately $490 million in 2005. There were no impairments of goodwill in 2005, 2004 or 2003.

Litigation — Abbott accounts for litigation losses in accordance with SFAS No. 5, “Accounting for Contingencies.” Under SFAS No. 5, loss contingency provisions are recorded for probable losses at management’s best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount is recorded. These estimates are often initially developed substantially earlier than the ultimate loss is known, and the estimates are refined each accounting period, as additional information becomes known. Accordingly, Abbott is often initially unable to develop a best estimate of loss, and therefore the minimum amount, which could be zero, is recorded. As information becomes known, either the minimum loss amount is increased, resulting in additional loss provisions, or a best estimate can be made, also resulting in additional loss provisions. Occasionally, a best estimate amount is changed to a lower amount when events result in an expectation of a more favorable outcome than previously expected. For its legal proceedings and environmental exposures, Abbott estimates the range of possible loss to be from approximately $15 million to $60 million. Reserves of approximately $35 million have been recorded at December 31, 2005 for these proceedings and exposures. These reserves represent management’s best estimate of probable loss, as defined by SFAS No. 5.

Stock Compensation — Through December 31, 2005, Abbott measured compensation cost using the intrinsic value-based method of accounting for stock options and replacement stock options granted to employees and disclosed the impact of the fair value method in the footnotes to the consolidated financial statements. In 2006, Abbott will adopt SFAS No. 123 (revised 2004), “Share-Based Payment,” which requires that fair value be recorded in the results of operations. Since there is no market for trading employee stock options, management must use a fair value method. There is no certainty that the results of a fair value method would be the value at which employee stock options would be traded for cash. Fair value methods require management to make several assumptions, the most significant of which are the selection of a fair value model, stock price volatility and the average life of an option. Abbott began preparing for adoption of the new standard in 2004. Abbott has readily available grant-by-grant historical activity for several years in its option administration system. Using this data, Abbott compared valuation results using the binomial method to the Black-Scholes method Abbott had been using and found the results to be comparable. Abbott evaluated whether certain holders of stock options exercised their options differently than other holders and did not find any differentiating pattern among holders. Abbott studied its implied volatility and concluded that a combination of historical and implied volatility will be a better measure than historical volatility alone. Abbott also quantified the additional paid in capital amount available for use in determining tax effects of early exercise for measurement of tax expense. Abbott will use the modified prospective method of adoption. Under this method, prior years’ financial results will not include the impact of recording stock options using fair value. Footnote 10 quantifies the effect of application of fair value to 2005 and prior awards. Based upon the valuation of stock options granted in the 2006 annual grant, which comprise the majority of the grant activity for the year, Abbott estimates the impact of the 2006 change in stock compensation expense on diluted earnings per share of approximately $0.15, which includes $0.14 per diluted share for the impact of expensing the fair value of stock options. The 2006 expense for stock compensation is dependent on the number of options granted in the future, the terms of those awards and their fair value, and therefore, the effect on diluted earnings per share could change.