We are faced with interest rate risks resulting from interest rate fluctuations. We have a variety of fixed and variable rate debt instruments. In an effort to manage interest rate exposures, we strive to achieve an acceptable balance between fixed and variable rate debt and have entered into interest rate swaps to maintain that balance. For interest rate derivative instruments, market risk is determined by calculating the impact to fair value of an assumed one-time change in interest rates across all maturities. Fair values were estimated based on market prices where available, or dealer quotes. A change in interest rates on variable rate debt is assumed to impact earnings and cash flow, but not fair value of debt. A change in interest rates on fixed rate debt is assumed to impact the fair value of debt, but not earnings and cash flow. Based on our overall interest rate exposure at February 2, 2002 and February 3, 2001, a 100 basis point change in interest rates would not have a material effect on our earnings or cash flows over a oneyear period. A 100 basis point increase in interest rates would decrease the fair value of our long-term debt at February 2, 2002 and February 3, 2001 by approximately $79 million and $29 million, respectively. A 100 basis point decrease in interest rates would increase the fair value of our long-term debt at February 2, 2002 and February 3, 2001 by approximately $87 million and $34 million, respectively.

See the notes to the consolidated financial statements for additional discussion of our outstanding derivative financial instruments at February 2, 2002.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of our operations is based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities as of the date of the financial statements and during the applicable periods. We base these estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ materially from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Inventories:
Merchandise inventories for the U.S. toy store division, which represent approximately 70% of total merchandise inventories, are stated at the lower of LIFO (last-in, first-out) cost or market value, as determined by the retail inventory method. All other merchandise inventories are stated at the lower of FIFO (first-in, first-out) cost or market as determined by the retail inventory method. We record adjustments to the value of inventory based upon forecasted plans and marketing events to sell merchandise inventories. These adjustments are estimates which could vary significantly, either favorably or unfavorably, from actual results if future economic conditions, consumer preference trends or competitive conditions differ from our expectations.

We receive various types of merchandise allowances from our vendors, which are based primarily on negotiated terms. We use estimates at interim periods to record our provisions for inventory shortage and to record vendor funded merchandise allowances. These estimates are based on historical and current available data and other factors and are adjusted to actual amounts at the completion of our physical inventories and finalization of all vendor allowances. Although we believe that these estimates are adequate and proper, the actual amounts could vary.

Deferred Tax Assets:
As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure, together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. The measurement of deferred tax assets is adjusted by a valuation allowance to recognize the extent to which, more likely than not, the future tax benefits will be recognized.

At February 2, 2002, we have recorded deferred tax assets, net of valuation allowances, of $289 million. We believe it is more likely than not that we will be able to realize these assets through reduction of future taxable income. We base this belief upon the levels of taxable income historically generated by our business, as well as projections of future taxable income. If future levels of taxable income are not consistent with our expectations, we may be required to record an additional valuation allowance, which could reduce our net income by a material amount.

Derivatives and Hedging Activities:
We enter into derivative financial arrangements to hedge a variety of risk exposures, including interest rate and currency risks associated with our long-term debt, as well as foreign currency risk relating to import merchandise purchases. We account for these hedges in accordance with SFAS No. 133, “Accounting for Derivatives Instruments and Hedging Activities,” and we record the fair value of these instruments within our consolidated balance sheet. Gains and losses from derivative financial instruments are largely offset by gains and losses on the underlying transactions. At February 2, 2002, we have reduced the carrying amount of our long-term debt by $84 million, representing the carrying amount of the debt in excess of fair value on that date. Also at February 2, 2002, we have recorded derivative assets of $42 million and derivative liabilities of $122 million. While we intend to continue to meet the conditions for hedge accounting, if hedges were not to be highly effective in achieving offsetting cash flows attributable to the hedged risk, the changes in the fair value of the derivatives used as hedges could have a material effect on our financial position or results of operations.