Notes 7. Financial Instruments

Foreign Currency and Interest Rate Instruments

Effective January 1, 2001, the company adopted Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended (SFAS No. 133). This statement requires that all derivative instruments be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. The company recorded a transition adjustment, which increased other comprehensive income by $47,000 upon adoption of SFAS No. 133 on January 1, 2001.

The company does not hold derivative financial instruments of a speculative nature. All of the company’s derivatives are recognized on the balance sheet at their fair value. On the date that the company enters into a derivative contract, it designates the derivative as (1) a hedge of (a) the fair value of a recognized asset or liability or (b) an unrecognized firm commitment (a “fair value” hedge), (2) a hedge of (a) a forecasted transaction or (b) the variability of cash flows that are to be received or paid in connection with a recognized asset or liability (a “cash flow” hedge); or (3) a foreign-currency fair-value or cash flow hedge (a “foreign currency” hedge). Changes in the fair value of a derivative that is highly effective as and that is designated and qualifies as a fair-value hedge, along with changes in the fair value of the hedged asset or liability that are attributable to the hedged risk (including changes that reflect losses or gains on firm commitments), are recorded in current-period earnings. Changes in the fair value of a derivative that is highly effective as and that is designated and qualifies as a cash flow hedge, to the extent that the hedge is effective, are recorded in other comprehensive income, until earnings are affected by the variability of cash flows of the hedged transaction. Any hedge ineffectiveness (which represents the amount by which the changes in the fair value of the derivative exceed the variability in the cash flows of the forecasted transaction) is recorded in current-period earnings. Changes in the fair value of a derivative that is highly effective as and that is designated and qualifies as a foreign-currency hedge is recorded in either current-period earnings or other comprehensive income, depending on whether the hedging relationship satisfies the criteria for a fair-value or cash-flow hedge.

The company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair-value, cash flow or foreign-currency hedges to (1) specific assets and liabilities on the balance sheet or (2) specific firm commitments or forecasted transactions. The company also formally assesses (both at the hedge’s inception and on an ongoing basis) whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the fair value or cash flows of hedging items and whether those derivatives may be expected to remain highly effective in future periods. When it is determined that a derivative is not (or has ceased to be) highly effective as a hedge, the company will discontinue hedge accounting prospectively. It is the company’s policy, however, that derivative instruments to be used in hedging transactions must always be highly effective as a hedge. As such, the company believes that on an ongoing basis its portfolio of derivative instruments will generally be highly effective as hedges. Hedge ineffectiveness during the year ended December 31, 2001 was not significant.

The company has entered into foreign currency forward contracts to hedge specific foreign currency exposures related to intercompany debt, its investment in Henkel-Ecolab, subsidiary royalties, product purchases, firm commitments and other intercompany transactions. The company uses these contracts to hedge against the effect that fluctuations in exchange rates may have on forecasted cash flows. These contracts generally expire within one year.

The company had foreign currency forward exchange contracts with a face amount denominated primarily in euros in 2001 and deutsche marks in 2000 and 1999 and totaling approximately $320 million at December 31, 2001, $65 million at December 31, 2000 and $77 million at December 31, 1999. Foreign currency forward exchange contracts at December 31, 2001 included contracts outstanding related to short-term financing of the acquisition of Henkel-Ecolab. These contracts were originated in December 2001 and matured in February 2002. As such, the unrealized gains and losses on these contracts were not significant at December 31, 2001.

The company also periodically uses interest rate swaps to manage the risk generally associated with interest volatility on variable-rate debt. The company has entered into an interest-rate swap agreement which is effective November 2001 through November 2004 and has used this agreement to provide for a fixed rate of interest on the first 50 million Australian dollars of Australian floating-rate debt. This interest-rate swap is a “cash flow hedge”.

Fair Value of Other Financial Instruments

The carrying amount and the estimated fair value of other financial instruments held by the company were:

The carrying amounts of cash equivalents and notes payable approximate fair value because of their short maturities.

The fair value of long-term debt is based on quoted market prices for the same or similar debt instruments.