Note 2. Summary of Significant Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of the company and all majority-owned subsidiaries. Prior to November 30, 2001, the company accounted for its investment in Henkel-Ecolab under the equity method of accounting. As discussed further in Note 4, on November 30, 2001, the company acquired the remaining 50 percent interest of the Henkel-Ecolab joint venture that it did not previously own, and Henkel-Ecolab became a wholly-owned subsidiary of the company. Because the company consolidates its international operations on the basis of their November 30 fiscal year ends, the balance sheet of Henkel-Ecolab as of November 30, 2001 has been consolidated with the company’s balance sheet as of year-end 2001. The income statement, however, for the European operations will be consolidated with the company’s operations beginning in 2002. International subsidiaries, including Henkel-Ecolab, are included in the financial statements on the basis of their November 30 fiscal year ends to facilitate the timely inclusion of such entities in the company’s consolidated financial reporting.

Foreign Currency Translation

Financial position and results of operations of the company’s international subsidiaries, including Henkel-Ecolab, generally are measured using local currencies as the functional currency. Assets and liabilities of these operations are translated at the exchange rates in effect at each fiscal year end. The translation adjustments related to assets and liabilities that arise from the use of differing exchange rates from period to period are included in accumulated other comprehensive loss in shareholders’ equity. Income statement accounts are translated at the average rates of exchange prevailing during the year. The different exchange rates from period to period impact the amount of reported income from the company’s International operations.

Cash and Cash Equivalents

Cash equivalents include highly-liquid investments with a maturity of three months or less when purchased.

Inventory Valuations

Inventories are valued at the lower of cost or market. Domestic chemical inventory costs are determined on a last-in, first-out (lifo) basis. Lifo inventories represented 29 percent, 47 percent and 41 percent of consolidated inventories at year-end 2001, 2000 and 1999, respectively. All other inventory costs are determined on a first-in, first-out (fifo) basis, including the inventory of Henkel-Ecolab which was included in consolidated inventories at year-end 2001.

Property, Plant and Equipment

Property, plant and equipment are stated at cost. Merchandising equipment consists principally of various systems that dispense cleaning and sanitizing products and low-temperature dishwashing machines. The dispensing systems are accounted for on a mass asset basis, whereby equipment is capitalized and depreciated as a group and written off when fully depreciated. Depreciation and amortization are charged to operations using the straight-line method over the assets’ estimated useful lives ranging from 5 to 50 years for buildings, 3 to 7 years for merchandising equipment, and 3 to 11 years for machinery and equipment.

Goodwill and Other Intangible Assets

Goodwill and other intangible assets arise principally from business acquisitions. Goodwill represents the excess of purchase price over fair value of net assets acquired. Other intangible assets include primarily customer relationships, noncompete agreements and trademarks. These assets are amortized on a straight-line basis over their estimated economic lives, generally not exceeding 30 years.

Long-Lived Assets

The company periodically reviews its long-lived assets for impairment and assesses whether significant events or changes in business circumstances indicate that the carrying value of the assets may not be recoverable. An impairment loss is recognized when the carrying amount of an asset exceeds the anticipated future undiscounted cash flows expected to result from the use of the asset and its eventual disposition. The amount of the impairment loss to be recorded, if any, is calculated by the excess of the asset’s carrying value over its fair value.

Revenue Recognition

The company has historically recognized revenue as services were performed or products were shipped to customers. During 2000, the company completed an analysis of the Securities and Exchange Commission’s Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements.” As a result of this analysis, the company changed certain policies to recognize revenue on product sales at the time title transfers to the customer. The cumulative effect of this change on periods prior to 2000 was $2,428,000 (net of income tax benefits of $1,592,000), or $0.02 per diluted share, and has been included in the company’s consolidated statement of income for 2000.

Income Per Common Share

The computations of the basic and diluted per share amounts for the company’s operations were as follows:

Stock options to purchase approximately 3.7 million shares for 2001, 6.3 million shares for 2000 and 3.6 million shares for 1999 were not dilutive and, therefore, were not included in the computations of diluted income per common share amounts.

Comprehensive Income

For the company, comprehensive income includes net income, foreign currency translation adjustments and gains and losses on derivative instruments designated and effective as cash flow hedges that are charged or credited to the accumulated other comprehensive loss account in shareholders’ equity.

Use of Estimates

The preparation of the company’s financial statements requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates.

New Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets.”

The most significant changes made by SFAS No. 141 are: 1) requiring that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, and 2) establishing specific criteria for the recognition of intangible assets separately from goodwill.

SFAS No. 142 primarily addresses the accounting for acquired goodwill and other intangible assets (i.e., the post-acquisition accounting). The provisions of SFAS No. 142 will be effective for the company beginning in 2002. The most significant changes made by SFAS No. 142 are: 1) goodwill and indefinite-lived intangible assets will no longer be amortized; 2) goodwill and indefinite-lived intangible assets will be tested for impairment at least annually; and 3) the amortization period of intangible assets with finite lives will no longer be limited to forty years.

The company adopted SFAS No. 141 effective July 1, 2001, and SFAS No. 142 will be adopted effective January 1, 2002. Goodwill and other intangible assets acquired after June 30, 2001, are subject immediately to the nonamortization and amortization provisions of this statement. These standards only permit prospective application of the new accounting; accordingly, adoption of these standards will not affect previously reported financial information. The principal effect of SFAS No. 142 will be the elimination of goodwill amortization. The company estimates the impact of not amortizing historical goodwill existing prior to the new goodwill generated by the Henkel-Ecolab transaction described in Note 4 to be an after-tax benefit of approximately $19 million, or 15 cents per diluted share for the year ended December 31, 2001. The company is currently assessing whether it will record a cumulative effect of a change in accounting for transitional goodwill impairment in 2002 upon adoption of SFAS No. 142.

Reclassifications

Certain reclassifications have been made to the previously reported 2000 and 1999 balance sheet amounts to conform with the 2001 presentation. These reclassifications had no impact on previously reported net income or shareholders’ equity. In addition, in connection with adopting EITF 01-09 “Accounting for Consideration Given by a Vendor to a Customer”, the company will reclassify certain customer incentive costs from selling, general and administrative expenses to a component of revenue during 2002, the impact of which will decrease revenue by approximately $35 million. Also beginning in 2002, the company will reclassify repair part costs from selling, general and administrative expense to cost of sales, the impact of which will increase cost of sales by approximately $30 million.