Basis of presentation
The consolidated financial statements include the accounts of Sears, Roebuck and Co. and all majority-owned domestic and international companies ("the Company"). Investments in companies in which the Company exercises significant influence, but not control, are accounted for using the equity method of accounting. Investments in companies in which the Company has less than a 20% ownership interest, and does not exercise significant influence, are accounted for at cost.

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Certain reclassifications have been made in the 1997 and 1996 financial statements to conform with the current year presentation.

Fiscal Year
The Company's fiscal year ends on the Saturday nearest December 31. Unless otherwise stated, references to years in this report relate to fiscal years rather than to calendar years.

Merchandise Sales and Services
Revenues from merchandise sales and services are net of estimated returns and allowances and exclude sales tax. Included in merchandise sales and services are gross revenues of licensees of $1.71, $1.82 and $1.80 billion for 1998, 1997 and 1996, respectively.

Service Contracts
The Company sells extended service contracts with terms of coverage generally between 12 and 36 months. Revenues and incremental direct acquisition costs from the sale of these contracts are deferred and amortized over the lives of the contracts. Costs related to performing the services under the contracts are expensed as incurred.

Store Pre-opening Expenses
Costs associated with the opening of new stores are expensed as incurred.

Earnings Per Common Share
Basic earnings per common share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding. Diluted earnings per common share also includes the dilutive effect of potential common shares (dilutive stock options) outstanding during the period.

Cash and Cash Equivalents
Cash equivalents include all highly liquid investments with maturities of three months or less at the date of purchase.

Retained Interest in Transferred Credit Card Receivables
As part of its domestic credit card securitizations, the Company transfers credit card receivables to a Master Trust ("Trust") in exchange for certificates representing undivided interests in such receivables. Effective January 3, 1998, the Company reclassified, for all periods presented, its retained interest in transferred credit card receivables to a separate balance sheet account and presented the related charge-offs of transferred credit card receivables as a reduction of credit revenues. Subsequent to January 3, 1998, amounts transferred from the Company's credit card portfolio to the Trust become securities upon transfer. Accounts are transferred net of the related allowance for uncollectible accounts and income is recognized generally on an effective yield basis over the collection period of the transferred balances. The retained interest consists of investor certificates held by the Company and the seller's certificate, which represents both contractually required seller's interest and excess seller's interest in the credit card receivables in the Trust. The contractually required seller's interest represents the dollar amount of credit card receivables that, according to the terms of the Company's securitization agreements, must be included in the Trust in addition to the amount of receivables which back the securities sold to third parties. The excess seller's interest is the dollar amount of receivables that exist in the Trust to provide for future securitizations, but is not contractually required to be in the Trust.

Retained interests are as follows:

The Company intends to hold the investor certificates and contractually required seller's interest to maturity. The excess seller's interest is considered available for sale. Due to the revolving nature of the underlying credit card receivables, the carrying value of the Company's retained interest in transferred credit card receivables approximates fair value and is classified as a current asset.

Credit Card Receivables
Credit card receivables arise primarily under open-end revolving credit accounts used to finance purchases of merchandise and services offered by the Company. These accounts have various billing and payment structures, including varying minimum payment levels and finance charge rates. Based on historical payment patterns, the full receivable balance will not be repaid within one year.

Credit card receivables are shown net of an allowance for uncollectible accounts. The Company provides an allowance for uncollectible accounts based on impaired accounts, historical charge-off patterns and management judgement.

Under the Company's proprietary credit system, uncollectible accounts are generally charged off automatically when the customer's past due balance is eight times the scheduled minimum monthly payment, except that accounts may be charged off sooner in the event of customer bankruptcy. Finance charge revenue is recorded until an account is charged off, at which time uncollected finance charge revenue is recorded as a reduction of credit revenues. The Company has primarily used this proprietary system for all periods presented in the financial statements. However, in the fourth quarter of 1998, the Company converted 12% of its managed portfolio of credit card receivables to a new credit processing system. Under the new system, uncollectible accounts will be charged off automatically when the customer fails to make a payment in each of the last eight billing cycles. Finance charge revenue that is charged off will continue to be recorded as a reduction of credit revenue. The remaining 88% of accounts on the proprietary credit system will be converted to the new system in 1999.

The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" in 1997. SFAS No. 125 requires that the Company recognize gains on its credit card securitizations which qualify as sales and that an allowance for uncollectible accounts not be maintained for receivable balances which are sold. Prior to adoption of SFAS No. 125, the Company maintained an allowance for uncollectible sold accounts as a recourse liability and did not recognize gains on securitizations. Accordingly, the adoption of SFAS No. 125 increased net income by $36 million in 1998 and $136 million in 1997 versus the net income that would have been recognized under the previous accounting method.

Merchandise Inventories
Approximately 88% of merchandise inventories are valued at the lower of cost (using the last-in, first-out or "LIFO" method) or market using the retail method. To estimate the effects of inflation on inventories, the Company utilizes internally developed price indices.

The LIFO adjustment to cost of sales was a credit of $34 and $17 million in 1998 and 1997, respectively, and a charge of $19 million in 1996. Partial liquidation of merchandise inventories valued under the LIFO method resulted in credits of $2 million in 1997. No layer liquidation occurred in 1998 or 1996. If the first-in, first-out ("FIFO") method of inventory valuation had been used instead of the LIFO method, merchandise inventories would have been $679 and $713 million higher at January 2, 1999, and January 3, 1998, respectively.

Merchandise inventories of International operations, operations in Puerto Rico, and certain Sears Tire Group formats, which in total represent approximately 12% of merchandise inventories, are recorded at the lower of cost or market based on the FIFO method.

Property and Equipment
Property and equipment is stated at cost less accumulated depreciation. Depreciation is provided principally by the straight-line method over the estimated useful lives of the related assets, generally 3 to 10 years for furniture, fixtures and equipment, 40 to 50 years for buildings and building improvements, and over the expected term of the lease or estimated useful lives, whichever is shorter, for leasehold improvements.

Long-Lived Assets
Long-lived assets, identifiable intangibles and goodwill related to those assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable.

Goodwill
Included in other assets is the excess of purchase price over net assets of businesses acquired ("goodwill"), which is amortized using the straight-line method over periods not exceeding 40 years. The Company periodically assesses the recoverability of the carrying value and the appropriateness of the remaining life of goodwill.

Advertising
Costs for newspaper, television, radio and other media advertising are expensed the first time the advertising occurs. The total cost of advertising charged to expense was $1.67, $1.59 and $1.53 billion in 1998, 1997 and 1996, respectively.

Direct-Response Marketing
The Company direct markets insurance (credit protection, life and health), clubs and services memberships, merchandise through specialty catalogs, and impulse and continuity merchandise. For insurance and clubs and services, deferred revenue is recorded when the member is billed (upon expiration of any free trial period), and revenue is recognized over the insurance or membership period. Otherwise, revenue is recognized when merchandise is shipped.

Membership acquisition and renewal costs, which primarily relate to membership solicitations, are capitalized since such direct-response advertising costs result in future economic benefits. Such costs are amortized over the shorter of the program's life or five years, primarily in proportion to when revenues are recognized. For specialty catalogs, costs are amortized over the life of the catalog, not to exceed one year. The consolidated balance sheets include deferred direct-response advertising costs of $131 and $90 million at January 2, 1999, and January 3, 1998, respectively, and that are included in prepaid expenses and deferred charges, or other assets.

Off-Balance Sheet Financial Instruments
The Company utilizes various off-balance sheet financial instruments to manage the interest rate and foreign currency risk associated with its borrowings. The counterparties to these instruments are major financial institutions with credit ratings primarily of AA.

Interest rate swap agreements modify the interest characteristics of a portion of the Company's debt. Any differential to be paid or received is accrued and is recognized as an adjustment to interest expense in the statement of income. The related accrued receivable or payable is included in other assets or liabilities. The fair values of the swap agreements are not recognized in the financial statements.

Interest rate caps are used to lock in a maximum rate if rates rise, but enable the Company to otherwise pay lower market rates. The cost of interest rate caps is amortized to interest expense over the lives of the caps. Payments received based on interest rate cap agreements reduce interest expense. The unamortized cost of interest rate caps is included in other assets.

Gains or losses on terminations of interest rate swaps are deferred and amortized to interest expense over the remaining life of the original swap period to the extent the related debt remains outstanding.

Financial instruments used as hedges must be effective at reducing the type of risk associated with the exposure being hedged and must be designated as hedges at inception of the hedge contract. Accordingly, changes in market values of financial instruments must be highly correlated with changes in market values of the underlying items being hedged. Any financial instrument designated but ineffective as a hedge would be marked to market and recognized in earnings immediately.

Effect of New Accounting Standards
Effective January 4, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income," which requires the Company to report the change in its net assets from nonowner sources. Accumulated other comprehensive income is comprised of foreign currency translation adjustments of $125 and $94 million at January 2, 1999, and January 3, 1998, respectively, and adjustments to the Company's minimum pension liability of $299 and $217 million as of January 2, 1999, and January 3, 1998, respectively. The Company has chosen to disclose comprehensive income in the Consolidated Statements of Shareholders' Equity, and prior year information has been restated to conform to the SFAS No. 130 requirements.

Effective January 4, 1998, the Company adopted AICPA Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," which requires the Company to capitalize certain software development costs. Generally, once the capitalization criteria of the SOP have been met, external direct costs of materials and services used in development of internal-use software, payroll and payroll-related costs for employees directly involved in the development of internal-use software and interest costs incurred when developing software for internal use are to be capitalized. The adoption of this SOP did not have a material effect on the Company's consolidated financial position, results of operations or cash flows during 1998.

Effective January 2, 1999, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," and SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." SFAS No. 131 establishes revised standards for the reporting of information about the Company's operating segments, and SFAS No. 132 standardizes the disclosure requirements for pension and other postretirement benefit plans. The adoption of these statements did not impact the Company's consolidated financial position, results of operations or cash flows, but did affect the disclosures contained in Notes 5 and 15. Prior year information has been restated to conform with the requirements of these statements.

In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which is required to be adopted in years beginning after June 15, 1999. The Company is currently evaluating the effect this statement might have on the consolidated financial position or results of operations of the Company.