CANON ANNUAL REPORT 2018 Fiscal Year Ended December 31, 2018 C A N O N A N N U A L R E P O R T 2 0 1 8 TABLE OF CONTENT S Strategy 1 Financial Highlights 2 To Our Shareholders 9 Business Strategy Business Segment/ Corporate Structure 18 At a Glance 20 Research & Development 22 Production 24 Sales & Marketing 26 ESG Financial Section 34 Financial Overview 48 Ten-Year Financial Summary 50 Consolidated Balance Sheets 51 Consolidated Statements of Income 51 Consolidated Statements of Comprehensive Income 52 Consolidated Statements of Equity 53 Consolidated Statements of Cash Flows 54 Notes to Consolidated Financial Statements 90 Schedule II Valuation and Qualifying Accounts 91 Management’s Report on Internal Control Over Financial Reporting 92 Reports of Independent Registered Public Accounting Firm Cover Photo: Canon Medical’s 320-row detector, Aquilion ONE™ Achieves high-quality, wide-area, and high- speed imaging with low radiation exposure. Used widely for diagnosis of cerebral aneu- rysms and cancer. Corporate Data 94 Transfer and Registrar’s Office 94 Shareholder Information 95 Major Consolidated Subsidiaries FINAN C IAL HIG HL IGHTS Millions of yen (except per share amounts) Thousands of U.S. dollars (except per share amounts) 2018 2017 Change (%) 2018 Net sales Operating profit Income before income taxes Net income attributable to Canon Inc. Net income attributable to Canon Inc. shareholders per share: —Basic —Diluted Total assets ¥ 3,951,937 ¥ 4,080,015 342,952 362,892 252,755 321,605 353,884 241,923 ¥ 234.09 ¥ 222.88 234.08 222.88 ¥ 4,899,465 ¥ 5,198,291 Canon Inc. shareholders’ equity ¥ 2,827,602 ¥ 2,870,630 -3.1 +6.6 +2.5 +4.5 +5.0 +5.0 -5.7 -1.5 $ 35,603,036 3,089,658 3,269,297 2,277,072 $ 2.11 2.11 $ 44,139,324 $ 25,473,892 Notes: 1. Canon’s consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles. 2. U.S. dollar amounts are translated from yen at the rate of JPY111=U.S.$1, the approximate exchange rate on the Tokyo Foreign Exchange Market as of December 28, 2018, solely for the convenience of the reader. Net Sales (Billions of yen) Net Income Attributable to Canon Inc. (Billions of yen) 4,000 3,000 2,000 1,000 0 300 200 100 0 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 Net Income Attributable to Canon Inc. Shareholders per Share (Yen) ROE/ROA (%) 300 200 100 0 10 8 6 4 2 0 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 Basic Diluted ROE ROA 1 CANON ANNUAL REPORT 2018 TO OUR SHARE HOL DERS FUJIO MITARAI Chairman & CEO Canon Inc. Canon will further promote a grand strategic transformation by accelerating reforms. 2 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA Performance in 2018 The global economy in 2018 was on a moderate recovery track for both interchangeable-lens digital cameras and digital overall, including signs of a steady economic recovery in the compact cameras. Unit sales of inkjet printers decreased due U.S., despite a serious rise in trade friction between the U.S. to a shrinking market for consumer products, despite solid and China, as well as a slowdown in the Chinese economy. sales of large-format printers. In the Medical System Business Against this backdrop, Canon strived to improve business Unit, sales increased due to an expansion of overseas demand, performance through such measures as pursuing efficiency in mainly in emerging economies, despite restrained purchasing all areas, ranging from R&D to production, sales and service, in Japan. In the Industry and Others Business Unit, although based on our corporate portfolio that comprises new busi- sales slowed for flat panel display (“FPD”) lithography equip- nesses—commercial printing, network cameras, medical and ment and OLED panel manufacturing equipment, unit sales industrial equipment—and Canon’s traditional core businesses of semiconductor lithography equipment grew significantly. including office equipment and cameras. Meanwhile, sales of network cameras enjoyed robust growth With regard to conditions in each business, in the Office thanks to market expansion. Business Unit, unit sales of office multifunction devices Consequently, consolidated net sales for 2018 decreased by (“MFDs”) grew mainly for color models, largely due to such 3.1% year on year to ¥3,951.9 billion, and the gross profit ratio factors as increased demand in emerging markets. As for was 46.4%. Operating profit increased by 6.6% year on year laser printers, although hardware sales were strong, sales to ¥343.0 billion, while net income attributable to Canon Inc. of consumables remained at the same level as the previous increased by 4.5% year on year to ¥252.8 billion. The full-year year. In the Imaging System Business Unit, the digital camera dividend is ¥160 per share, comprising an interim dividend of market continued to shrink, and sales declined significantly ¥80 per share and a year-end dividend of ¥80 per share. Cash Dividend (Yen) 160 80 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 3 CANON ANNUAL REPORT 2018 Excellent Global Corporation Plan Phase I 1996–2000 Phase II 2001–2005 Phase III 2006–2010 Phase IV 2011–2015 Phase V 2016–2020 To strengthen its finan- cial structure, Canon transformed its mindset to a focus on total optimization and profit- ability. The Company introduced various business innovations, including the selection and consolidation of business areas, and reform activities in such areas as production and development. Aiming to become No. 1 in all major business areas, Canon focused on strengthening product competitiveness along with the changing times stepping up efforts to digitalize its products. The Company also conducted structural re- forms across all Canon Group companies around the world. Canon moved ahead with such growth strategies as enhancing existing businesses and expanding into new areas while also thor- oughly implementing supply chain manage- ment and IT reforms. Responding to weak- ness in the global economy, Canon revised its management policy from a strategy target- ing expansion of scale to a strategy aimed at further strengthening its financial structure. While actively pursu- ing M&A activities, the Company restructured its business at a founda- tional level to introduce new growth engines for future expansion. From Phase I to Phase IV 1996–2015 Canon launched the Excellent Global to B2B. We subsequently reinforced and expanded our rap- Corporation Plan in 1996, and has idly growing network camera business by making Milestone strengthened its management base Systems (“Milestone”) a subsidiary in 2014, followed by through each of the plan’s five-year initia- Axis Communications (“Axis”) in 2015. Additionally, Canon tives, from Phase I to Phase IV. Nanotechnologies, formerly Molecular Imprints, became a During Phase I, we stressed thorough cash-flow manage- subsidiary in 2014, and we are accelerating the development ment and significantly boosted productivity through the of next-generation semiconductor manufacturing equipment introduction of our cell production system, along with other that uses nanoimprint lithography, which will make it pos- measures. In Phase II, we stepped up efforts to digitalize our sible to achieve both miniaturization and cost reductions for copying machines and camera offerings, while building the semiconductor devices. foundation for a robust financial structure. During Phase III, As a manufacturer, Canon strives unceasingly to achieve we actively carried out M&A activities, and welcomed Océ to production reforms and thorough cost reductions. At the the Group in 2010, clearing the way for a move into the com- same time, we stay on top of opportunities to add excellent mercial printing market, which has shown growth potential. companies to the Group, in order to shift our focus towards As the markets for our core businesses—such as cameras changing growth markets, with the aim of unlocking new and office equipment—were maturing, during Phase IV, growth potential. which began in 2011, we promoted diversification via the lateral expansion of our existing businesses—such as the Cinema EOS System and commercial photo printers—while also accelerating our M&A strategy. In this manner, we set a clear direction for shifting our focus for growth from B2C 4 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA Excellent Global Corporation Plan STRATEGIES 1 Establish a new production system to achieve a cost-of-sales ratio of 45% KEY STRATEGIES 1 2 3 4 5 Establish a new production system to achieve a cost-of-sales ratio of 45% Reinforce and expand new businesses while creating future businesses Restructure our global sales network in accordance with market changes Enhance R&D capabilities through open innovation Complete the Three Regional Headquarters management system capturing world dynamism Phase V 2016–2020 Under the Excellent Global Corporation Plan’s Phase V, the most recent five-year initiative that started in 2016, Canon is re- sponding to the weakened growth potential of the product portfolio that has supported our development thus far under the basic policy of “embracing the challenge of new growth through a grand strategic trans- formation.” In 2020, the final year of Phase V, Canon aims to achieve net sales of ¥5 trillion, a cost-of-sales ratio of 45% or less, an operating profit ratio of 15% or more, a net income ratio of 10% or more and a shareholder’s equity ratio of 70% or more (based on exchange rates of US$1 = ¥125 and €1 = ¥135). In 2018, we worked to enhance our business performance by thoroughly improving efficiency in all areas, ranging from R&D to production, sales and service, based on our corporate portfolio that comprises new businesses—commercial printing, network cameras, medical and industrial equipment—and Canon’s tradi- tional core businesses including office equipment and cameras. Explanations regarding the progress of the key strategies of Phase V, as well as our future course of action, are presented as follows. Aiming to boost productivity through automated camera production. In order to ensure the profit growth potential of our exist- ing businesses in maturing markets, we aim to achieve a cost-of-sales ratio of 45% through ongoing efforts of expanding market share through the development of Dantotsu products (unrivalled products with extraordinary features), and cost reduction initiatives beginning upstream in the manufacturing process. With regard to the development of Dantotsu products, we will accurately identify customer needs, and incorporate the latest technologies, such as the cloud, IoT, and AI, in order to introduce products that dominate the competition. In order to reduce costs across the entire Canon Group, we are making advances in assembly automation and robotization, promoting cost-efficient design starting at the development stage and pursuing in-house production of machinery, equipment and key components. In-house production is expected to yield such benefits as reduced lead times, improved inventory levels and lower distribu- tion costs. Meanwhile, we will actively provide guidance to our key suppliers on improving quality and cost in order to minimize external costs. Furthermore, we will strive to create a new cost structure through the use of common components and generic parts across several business divisions. 5 CANON ANNUAL REPORT 2018 STRATEGIES STRATEGIES 2 Reinforce and expand new businesses while creating future businesses 3 Restructure the global sales network in accordance with market changes The network camera market continues to expand. (Fukuoka, Japan) Canon China launched its own e-commerce site. The use of an independent platform has enabled an analysis of customer trends in greater detail. Through M&A, Canon has established four new businesses and is laying a foundation to ensure their development as future growth drivers. In the commercial printing business, we seek to build a foundation for commercial printing centered on Océ, and to establish a product system to handle high-variety, short- lot printing that realizes high image quality. In network cameras, we will strive to enhance and expand related soft- ware, while continuing to make inroads into a wide range of fields including crime prevention and disaster monitor- ing. The medical business will enhance sales performance and the competitiveness of its products for diagnostic equipment and explore the potential to expand operations into additional fields. In the industrial equipment business, Canon will accelerate development of next-generation OLED panel manufacturing equipment and pursue devel- opment of new types of industrial equipment. In addition, there is room for significant improvements in manufacturing costs within these new businesses. We aim to bring these costs down through the establishment of a new production system that will make possible a cost- of-sales ratio of 45%. Each business will also implement thorough and strict standards for quality control that are expected of B2B businesses. Amid the dramatic changes in the purchasing behavior of customers that has accompanied the development of the internet, Canon is pursuing major reforms of sales channels at all four of its regional sales headquarters. Canon Marketing Japan is shifting from a product- oriented organization to one with business units for each customer segment and a company-wide support structure. In the Americas, Canon U.S.A. is strengthen- ing partnerships with dealers based on a four-region management system. In Europe, the Middle East and Africa (“EMEA”), we have completed organizational restructuring at our regional headquarters and have em- barked upon reforms at sales companies in each country. In addition, we are working to strengthen our business in regions where future economic growth is expected through such actions as establishing a local subsidiary in Saudi Arabia. Meanwhile, in Asia, Canon China has established its own e-commerce site, an independent platform that en- ables analysis of customer trends in greater detail. In Australia, we are working together with Group companies on structural reforms. 6 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA STRATEGIES STRATEGIES 4 Enhance R&D capabilities through open innovation 5 Complete the Three Regional Headquarters management system capturing world dynamism The Research Frontiers Institute is a global research consortium led by IBM. Canon provides young technicians to the institute to con- duct R&D with a view to commercializing new technologies. (IBM Research, Almaden Research Center, United States) R&D on high-speed cut-sheet inkjet printers. (Océ, Netherlands) Canon is moving away from a policy of self-sufficiency and building an R&D system that actively utilizes external technologies and expertise, through such measures as promoting joint and contract research with universities and research institutions in Japan and abroad. Meanwhile, as development grows increasingly competi- tive worldwide, we are revising the support system for our business divisions by limiting R&D to technologies deemed highly necessary for future success in order to promote faster, more efficient development. In addition, we remain open to new M&A in all regions as we seek promising technologies that can be nurtured by Canon. With global headquarters in Japan, the United States and Europe, Canon aims to establish a system that promotes global development through diversification by leveraging the unique features of each region. In the United States, a country at the forefront of medi- cal research, Canon U.S.A.’s Healthcare Optics Research Laboratory is collaborating on research with Massachusetts General Hospital and Brigham and Women’s Hospital. In the near future, we anticipate practical applications for an ultra-miniature endoscope that enables real-time examina- tion of such areas as the interiors of joints and paranasal cavities, as well as a guided needle insertion system that assists with the insertion of needles in patients by guiding a needle to a precise position and depth. In Europe, our collaboration with Océ has enabled us to develop UV curable flatbed printers capable of printing on wood, metal, glass and other materials in addition to paper. We have also recently entered the package printing industry where we are pursuing technological innovation. 7 CANON ANNUAL REPORT 2018 Key Challenges for 2019 In Conclusion Canon views 2019 as a year of transformation, becom- With Japan entering a new era of its traditional calendar, ing a company that achieves productivity on par with other 2019 will mark the start of a new age and a significant turn- excellent global corporations in all areas, from R&D to pro- ing point for the country. Similarly, for Canon, we will enter duction, sales and service. We will undertake the following a new era in which great change is required to obtain new key challenges based on the theme, “Accelerating our grand growth potential in the face of evolving times. strategic transformation through dramatic improvements in The global economy in 2019 is marked by concerns re- productivity.” garding the growing impact of trade friction between the The first challenge is to reinforce our existing businesses. United States and China. In order to respond swiftly to rapid We will utilize such technologies as the cloud, IoT and AI changes in the business environment, chaotic political and to advance the development of Dantotsu products that economic situations, dramatic advances in such technolo- dominate the competition. We will also promote product gies as AI and also to create a strong corporate structure for design that is suited to automation, thereby strengthening continued growth, Canon will work as one to forge a path our assembly automation capabilities and pursue in-house toward further growth under Phase V of the Excellent Global production of equipment and key components on a company- Corporation Plan. wide basis. We look forward to your continued understanding The second challenge is to strengthen and expand new and support. businesses. We will accomplish this through concentrated in- vestments in commercial printing, network cameras, medical and industrial equipment, the four businesses Canon views as the pillars to its future success. The third challenge is to reform our R&D system to reflect changes in industry and society. We will categorize devel- opment themes into those related to the reinforcement of existing businesses, those aimed at commercialization in the near future and development for the mid to long term. We will organize an appropriate framework for each in order to improve development productivity. In addition, we will expand and enhance our global search for startup companies pos- sessing advanced technologies and new business models that show promise for significant growth. 8 Fujio Mitarai Chairman & CEO Canon Inc. CANON ANNUAL REPORT 2018 B U S I N E S S S T R A T E G Y EXISTING BUSINESS 1 0 NEW BUSINESS 1 2 MEDICAL .. .. .. .. .. .. .. .. .. .. . .... .. 12 NE TWO RK CAMERAS .. .. ... ... 14 COMMERCIAL PRI NT ING ... ... 16 INDUSTRIAL EQ UIPMENT ... .. 17 CANON ANNUAL REPORT 2018 9 EXIST IN G B USIN ESS A We seek to further expand market share and continually reinforce profitability 10 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA Multifunction Devices (“MFDs”) mount and realized even high image quality. We aim to keep Sales of Office MFDs were driven by the imageRUNNER adding attractive new products to our camera lineup in order ADVANCE Third Generation 2nd Edition series, which enables to maintain our leading market share and boost profitability. compatibility with external cloud services, and the imageRUN- NER C3020 series, which continued to perform strongly, Inkjet Printers mainly in emerging markets. Amid demands from users for For inkjet printers, demand is growing for large-refillable ink enhanced security due to growing risks of information leaks tank models in emerging markets, and sales were solid for from IT equipment connected to networks, we will work to the imagePROGRAF TX series of large format inkjet printers, expand sales by successively introducing new models that in- which are suitable for outputting CAD drawings and posters. corporate industry-leading security features. For large-refillable ink tank models, we aim to grow faster than Laser Printers the entire market, stepping up already active investment into sales in emerging markets. In addition, at the end of 2018 we In laser MFDs and laser printers, Canon introduced new prod- introduced the WG7000 series, Canon’s first A3 inkjet MFD ucts that achieve low power consumption, compact body with an in-line printhead, and are aiming to cultivate new designs, and high productivity. Going forward, we will focus users by targeting small and medium-sized businesses that pri- on raising the proportion of sales attributable to medium- and oritize high-speed, low-cost, and high-volume printing. high-speed models, where higher print volumes are expected, while continuing to pursue sales promotional activities in co- Lithography Equipment operation with our OEM partners, with the aim of improving Semiconductor devices are becoming increasingly diversified overall profitability and further increasing our market share. as a result of the rapid spread of IoT and an increase in auto- Cameras motive applications. In this environment, we aim to further expand the market share of Canon’s semiconductor lithogra- Canon maintained the global top share of the interchange- phy equipment by responding to the wide-ranging needs of able-lens digital camera market thanks to the popularity of our customers. The television market has seen flat-screen tele- new mirrorless camera models such as the EOS M50 (EOS visions spread, and is expected to demand expansion for large Kiss M in Japan). In digital compact cameras, sales of the high-resolution panels. We aim to tap demand for higher PowerShot G-series and other high-value-added products were definition by leveraging the strengths of our proprietary brisk. Moreover, the full-frame EOS R mirrorless camera that single-shot exposure system with which our FPD lithography went on sale in the second half of 2018 has newly adopted RF equipment can efficiently produce large panels. A. When used with our newly developed RF lenses, the Canon EOS R mirrorless camera featuring a 35mm full-frame CMOS sensor delivers high image quality and powers of expression. B. Our MFDs are equipped with robust security features and make working with documents a breeze. By connecting to the cloud and other networks, they contribute to the im- provement of productivity and the implementation of flexible working styles. B 11 CANON ANNUAL REPORT 2018 NEW BUSI NESS — ME D ICAL A Aiming to Expand Business Domains to Healthcare IT and In-vitro Diagnostics, with a Core Focus on Diagnostic Imaging 12 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA Sustainable Growth Expected in the Healthcare Business reconstruction technology, which was designed using deep learning. Installation of the leading-edge AI technology of AiCE In 1940, shortly after its founding, Canon succeeded in develop- in a high-precision CT scanner and area detector CT refines ing Japan’s first indirect X-ray camera, and has used its camera the scanner’s capabilities by maximizing the performance of its and optical technologies, along with its image processing resolution capabilities, while achieving image reconstruction in technologies to develop products such as digital radiography shorter times, and with lower radiation dosages. equipment and ophthalmic equipment. Amid an increasing In addition, in 2018 we also commenced sales of the global population and the graying of society, mainly in de- Vantage Orian, the first Canon brand MRI system. This prod- veloped countries, in December 2016, we welcomed Canon uct provides a high-level response to advanced clinical needs Medical Systems (“Canon Medical”) to the Group in order to through high-image-quality technology. At the same time, advance our medical equipment business to the next stage. the Vantage Orian makes a significant contribution to hospital Canon Medical, which holds the top market share in Japan and management through new technology that achieves major the fourth highest share worldwide* in X-ray computed tomog- reductions in scanning time, and through its energy- and raphy (“CT”) systems, provides diagnostic imaging equipment space-saving design. We are also working to achieve higher including CT, magnetic resonance imaging (“MRI”) systems, performance, greater compactness, and lighter weight for our diagnostic ultrasound systems, and diagnostic X-ray systems, as diagnostic ultrasound system, Aplio i-series, which covers a well as in-vitro diagnostic systems and healthcare IT solutions, in wide range of clinical fields. more than 150 countries and regions around the world. Meanwhile, Canon is also focusing on healthcare IT, which Canon aims to expand its business domains to healthcare IT provides high-value-added medical information systems and in-vitro diagnostics, with a core focus on diagnostic imaging. that consolidate and analyze vast amounts of data, includ- * Based on in-house research ing medical images and patient information, and on in-vitro diagnostics, which evaluate a patient’s health condition by an- Actively Introducing New Canon Brand Products that Incorporate the Latest Technologies alyzing blood and other substances, and which is expected to see a substantial growth in demand in the future. In addition, Canon Medical focuses on initiatives using AI and IoT, in order to we will accelerate business expansion by leveraging the syner- realize more efficient healthcare at optimal costs, and to provide gies between Canon and Canon Medical, based on our policy high-value-added solutions that maximize patient outcomes. of cultivating the medical business as a third business pillar As part of these efforts, Canon Medical led the world in de- following printing and cameras, including entry into business veloping Advanced Intelligent Clear-IQ Engine image (“AiCE”) fields outside of the area of diagnostic equipment. A. Canon Medical’s next-generation 3-Tesla MRI scanner, the Vantage Galan™ 3T, maximizes high-resolution imaging per- formance while minimizing space requirements and energy consumption. The device also employs noise-reduction tech- nology to provide greater comfort to patients. B. Canon Medical’s Aplio™ i-series of diagnostic ultrasound systems harness iBeam technology to send and receive detailed and uniform ultrasound beams at all depths and at high density. This technology delivers crystal-clear and high-definition images with little noise. (National Cancer Center, Japan) B 13 CANON ANNUAL REPORT 2018 NEW BUSI NESS — NE TWORK CAME RAS A Aiming to be the Global Leader in Network Visual Solutions 14 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA The Growing Network Camera Market Amid a rising awareness of security issues worldwide, the Expanding and Strengthening the Solutions Business shift from analog surveillance cameras to network cameras is The development of video analysis software harnessing AI advancing. At the same time, as we quickly approach the IoT technology holds the key to future growth in the network era in which everything connects to the Internet, the network camera market. camera market is exhibiting dramatic growth and changes, Canon has commercialized video analysis software that highlighted by the fact that the recordings captured by net- can count the number of people in a video, deduce personal work cameras are not only used for security purposes, but attributes (gender and age), and apply silhouettes to moving also beginning to be utilized in the areas of manufacturing people in order to protect their privacy. Furthermore, in 2018 and marketing. Canon welcomed to the Group Israel-based BriefCam, which Canon expanded its network camera business to solutions develops and markets video analysis software using video market in 2013, based on technologies cultivated in camera synopsis technology. BriefCam’s Video Synopsis® technology, development. It then welcomed to the Group Sweden-based which enables reviewing several hours of recorded video in Axis, which boasts around 90,000 partners worldwide, and a few minutes, is used by law enforcement agencies, public Denmark-based Milestone, a global leader in video manage- transportation organizations, healthcare and educational in- ment software, in order to establish a structure through which stitutions, and major corporations in more than 40 countries Canon can expand its network camera business in a compre- and regions around the world. hensive way. By incorporating high-quality, high-resolution video from With the market still developing, Canon’s network camera network cameras into image analysis software to analyze business continued to perform strongly in 2018. Axis tapped the movement of people and objects, there is potential demand to further boost sales, while Canon launched sales of for this technology to be utilized in a wide range of solu- the ME20F-SHN, an ultra-high-sensitivity network camera that tions business, for example, the monitoring of sports events uses their proprietary CMOS sensor technology to capture or production sites, or marketing at commercial facilities. images clearly even at night or in darkness. Wide-angle and Through collaboration with the new Group Companies, telephotographic monitoring even in an environment with Axis, Milestone, and BriefCam, Canon aims to become a low-illumination is made possible with the ME20F-SHN be- global leader in the field of network visual solutions by fusing cause it can incorporate a variety of EF lenses used in Canon’s cutting-edge technologies such as imaging, network image single-lens reflex cameras. processing, video management, and video synopsis. A. Fukuoka City Subway assures transportation of over 160 mil- lion people every year. Canon’s network cameras are installed in various locations, including above ticket gates and train platforms. They not only help provide safer and more secure transportation services, but also contribute to improving op- erational efficiency by facilitating the optimal deployment of station personnel according to the ever-changing congestion on platforms and stairwells. B. BriefCam’s software allows users to search by color, size, and other attributes of the condensed video recordings created, making it possible to efficiently extract target objects. B 15 CANON ANNUAL REPORT 2018 NEW BUSI NESS — CO MMERCIAL P RINTING The Océ ProStream 1000 continuous-feed color printer for the graphic arts market can print on offset coated paper thanks to Oce’s newly developed ink set and ColorGrip technology. (Océ, Germany) Expanding Business Areas in the Commercial Printing Market, which is Experiencing Solid Growth due to Digitalization Commercial Printing Market Entering a Period of Major Change Expanding Beyond Commercial Printing to Enter Industrial Printing Domain The adoption of digital printing is gaining traction in the com- In 2010, Canon welcomed Océ, a Netherlands-based com- mercial printing market for printed materials, including books, pany that has gained tremendous support in the commercial newspapers and magazines, sales promotion materials such as printing field in Europe and the Americas, to the Group, catalogs and flyers, as well as itemized statements, invoices, thereby expanding the Group’s digital printing potential in all and direct mail. This means, unlike traditional offset printing, areas of commercial printing, including continuous-feed, cut- data can be printed immediately without the use of printing sheet, and wide-format printing. plates. Subsequently, customers are increasingly requesting Going forward, in addition to building a foundation for the short-run production, quick turnaround and variable-data commercial printing business with Océ at its core, we aim to printing (where content is changed for each print). In the develop the technology capable of printing with high-image commercial printing industry in particular, demand for digital quality for a broad range of media, underpinned by a rock- printing is growing in the graphic arts market owing to the solid product framework. Also as you can see from the launch need for high-quality printing of premium quality catalogs, of our first industrial-scale digital label press, Océ LabelStream posters, and other items. 4000 series in 2018, we are now having our sights set on en- tering the enormous industrial printing domain as well. 16 CANON ANNUAL REPORT 2018 NEW BUSI NESS — IN D UST RIAL E QUI PME NT Canon Tokki produces OLED panel manufacturing equipment with unrivalled and high-level technologies, including vacuum evaporation technology for depositing organic materials onto panel substrates in a vacuum and automated supply lines for glass substrates. Canon Tokki continues to be the indus- try leader with an overwhelming market share. Supporting Cutting-Edge Manufacturing of the IoT Era with Canon Industrial Equipment Semiconductor Devices and FPDs Enter a New Period of Growth the conventional method of using light to engrave circuit patterns has reached its technological limit. The Canon The advent of the IoT era has resulted in an ever-increasing Group has therefore developed nanoimprint lithography demand for semiconductor devices owing to video streaming, technology, in which patterns are formed based on the basic data centers, 5G communication, AI/deep learning, and auto- principle of pressing a mask (mold) engraved with circuit mated driving moving into full swing. Demand is also expected patterns onto the surface of a wafer coated with resin. Using to increase for OLED panels for foldable smartphones, high- this innovative technology we expect to significantly reduce definition large televisions, and other applications. In response costs by simplifying the manufacturing process and hope to to these market conditions, the Canon Group’s industrial equip- lower chip defect rates thanks to the etching of extremely ment supports leading-edge manufacturing in a wide range of sharp circuit patterns. Furthermore, while Canon Tokki fields, including semiconductors and electronic devices. leads the world in OLED panel manufacturing equipment, Developing Next-Generation Manufacturing Equipment with Innovative Proprietary Technology boasting unrivalled technology for the vacuum evapora- tion equipment used to deposit organic material onto panel substrates and automated supply lines for glass substrates, we will pursue even greater equipment productivity, and The miniaturization of circuit patterns has improved semi- accelerate the development of next-generation OLED panel conductor chip performance. However, it is now said that manufacturing equipment. 17 CANON ANNUAL REPORT 2018 AT A G LANCE OFFICE BUSINESS UNIT Composition of Sales (%) Office multifunction devices (MFDs) Laser multifunction printers (MFPs) 45.7% Main Products • Office multifunction devices (MFDs) • Laser multifunction printers (MFPs) • Laser printers • Digital continuous feed presses • Digital sheet-fed presses • Wide-format printers • Document solutions Digital sheet-fed presses (Inkjet) Digital sheet-fed presses (Electrophotographic) IMAGING SYSTEM BUSINESS UNIT Composition of Sales (%) 25.5% Main Products • Interchangeable-lens digital cameras • Digital compact cameras • Digital camcorders • Digital cinema cameras • Interchangeable lenses • Compact photo printers • Inkjet printers • Large format inkjet printers • Commercial photo printers • Image scanners • Multimedia projectors • Broadcast equipment • Calculators Interchangeable-lens digital cameras —Mirrorless cameras Interchangeable-lens digital cameras —Digital SLR cameras Inkjet printers Large format inkjet printers 18 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA Composition of Sales (%) MEDICAL SYSTEM BUSINESS UNIT 11.1% Main Products • Diagnostic X-ray systems • Computed tomography (CT) systems • Magnetic resonance imaging (MRI) systems • Diagnostic ultrasound systems • Clinical chemistry analyzers • Digital radiography systems • Ophthalmic equipment Computed tomography (CT) systems Diagnostic X-ray systems Diagnostic ultrasound systems Digital radiography systems Composition of Sales (%) INDUSTRY AND OTHERS BUSINESS UNIT 20.4% Main Products • Semiconductor lithography equipment • FPD (Flat panel display) lithography equipment • Vacuum thin-film deposition equipment • Organic LED (OLED) panel manufacturing equipment • Die bonders • Micromotors • Network cameras • Handy terminals • Document scanners Semiconductor lithography equipment FPD (Flat panel display) lithography equipment Organic LED (OLED) panel manufacturing equipment Network cameras Note: The percentage figures for the four business units presented in the pie charts above do not add up to 100% because “Eliminations,” recorded in consolidation accounting, were not in- cluded in calculation considerations. 19 CANON ANNUAL REPORT 2018 RE SE AR CH & D EV ELOPMEN T A B A. An international rugby union match was projected live in 8K resolution at Canon’s headquarters. The impressive vision made it feel like one was watching the game in the stadium. B. Our newly developed ceramic material for 3D printers has the potential for application in a broad range of fields, including industrial equipment and healthcare. 20 2018 Top Ten U.S. Patent Holders by CompanyIBM*Samsung ElectronicsCANONIntelLG ElectronicsMicrosoftQualcommAppleFord*IBM is an abbreviation for International Business Machines Corporation.Source:Preliminary data released by IFI CLAIMS Patent Services, a U.S. research company specialized in patent information2,7352,4742,4652,3532,3002,1605,8502,1239,1003,056Taiwan SemiconductorManufacturingCANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA Canon is engaged in efforts to discover new technologies that will help create future businesses R&D Expenses and Patents of people’s lives. Canon is bolstering R&D activities to enable the ongoing de- New imaging solutions velopment of innovative products and services. In 2018, R&D We are working on the development of a Free Viewpoint expenses amounted to ¥315.8 billion, and the ratio of R&D Video System, as an imaging solution that utilizes the imag- expenses to net sales was 8.0%. This focus on R&D activities ing technology Canon has cultivated over many years. Images has cemented Canon’s high status in the field of intellectual taken by multiple high-resolution cameras placed around a property. In 2018, Canon was granted 3,056 patents in the stadium are processed in real time by an image processing United States, ranking it third in the world and the top ranked computer system that renders them into high-resolution 3D Japanese company for a fourteenth consecutive year. spatial data. This not only allows viewers to view images from various angles and viewpoints, but also produces a realistic, Initiatives to Establish New Businesses immersive viewing experience, giving viewers a sense that Canon has a long-term perspective as it concentrates its ef- they are really there. Canon is also working to provide high- forts on discovering new technologies for the future. resolution, immersive images using 8K cameras, with the aim Diagnostic imaging support of creating new ways to enjoy sports and entertainment. Canon is utilizing image processing and AI in its efforts to In addition, we are developing a wide-area security system develop technologies that will help doctors make a diag- using software that makes it possible to detect and track a nosis. Currently, we are working on joint R&D with Kyoto specific person from multiple camera images using Canon’s University Hospital to support the diagnosis of lung nodules network cameras, and that utilizes AI to count people with in CT images. By using a large database of cases and machine high accuracy, even in situations where many people are to- learning, the software we developed are able to infer a spe- gether in a crowded space. cific disease type and present the supporting evidence for the Materials research suspected nodules that appear in lung CT images. We aim To improve the competitiveness of Canon products, we un- to improve the quality of healthcare through our support for dertake research into the materials used in such areas as ink medical diagnosis. Visual inspection technologies colorant and coloring powders. With our inkjet printer ink, we have additionally succeeded in commercializing a magenta In the past, Canon has successfully worked to develop a dye that enhances image quality. We have also developed technology that utilizes AI to learn the normal appearance a technology for the highly accurate 3D printing of parts of parts and detect abnormalities automatically. Now, we are with complex geometries, using Canon’s proprietary ceramic using this technology further, to develop a technology that material. Canon continues to research and develop high automatically detects cracks in infrastructure. By using AI to value-added materials in order to generate various differenti- detect cracks, etc. in high-resolution images of infrastructure ated products of its own. taken by cameras equipped with Canon’s CMOS sensors, this technology increases the accuracy and efficiency of inspec- tions, and is expected to contribute to the safety and security 21 CANON ANNUAL REPORT 2018 PR ODUC TION A B C A. Production of components for inkjet printers. We seek to raise the bar in the manufacturing of high-quality products while striving to improve pro- duction efficiency. (Canon Hi-Tech (Thailand), Thailand) B. Master craftsmen, who hand down skills that are indispensable to Canon’s manufacturing ethos. C. At Japan’s National Skills Competition in 2018, our technicians submitted an entry in the precision instrument assembling category. Canon has collected prizes at this competition for fourteen successive years since 2005. 22 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA Canon aims to establish a new production system that achieves a cost-of-sales ratio of 45% through the evolution of our manufacturing capabilities Globally Optimized Production Human Resources for Manufacturing Canon employs a globally optimized production system in Canon conducts human resource training to nurture the skills which we determine ideal production locations based on such of employees at our production sites worldwide. Our programs factors as costs, taxes, logistics, ease of parts procurement, teach manufacturing techniques and craftsmanship and train and labor. Our aim is to leverage the strengths of each region. employees with leadership potential in Canon management In Japan, we are expanding production through automation, methods. Young technicians test their abilities by competing while in the United States and Europe, we are promoting the in Japan’s National Skills Competition, where they cultivate a localized production of consumables and other products. In spirit of challenge that is reflected in our manufacturing. emerging countries, we are boosting productivity by honing To encourage advancement in manufacturing engineering, our employees’ skills. This production method of Canon has Canon honors our most skilled technicians by awarding them been expanded to include companies such as Océ and Canon the title of Master Craftsman, while those who contribute to Medical, that joined the Group in recent years. Canon production through their skills and knowledge of as- Automation and In-house Production These technicians are the vanguard of Canon’s production Seeking to create innovative and original products, Canon is improvement and play the important role of passing on their actively pursuing in-house production of key devices and com- expertise to the next generation. sembly and component processing earn the title of Meister. ponents such as CMOS sensors, manufacturing equipment such as automated assembly machines and high-precision processing machines, as well as molding dies. To produce Initiatives for Environmentally Friendly Manufacturing and Enhanced Product Quality high-quality products at efficient costs, we strive to maintain From product design and development to production, logistics, highly reliable automated production lines. We have been product use, and recycling, throughout the product’s lifecycle in introducing fully automated production lines for toner car- all areas of our business, Canon is engaged in manufacturing ini- tridges, and are currently pursuing full automation for the tiatives that are friendly to the global environment and minimize manufacturing of cameras. At Oita Canon, our primary cam- environmental impact. era plant, we are working to fully automate digital camera In addition, in order to ensure that our products are safe, can production through the establishment of the Techno Wing be enjoyed with peace of mind, and provide satisfaction to our R&D facility that combines Canon’s manufacturing and prod- customers, we at Canon have established a quality management uct technologies. system that incorporates mechanisms unique to Canon on top of At Miyazaki Canon, the construction of a new digital cam- ISO9001 requirements. We have realized an adequate quality as- era plant is progressing, with operations due to commence surance system which sufficiently responds to laws and regulations in August 2019. By utilizing the automation technology culti- of countries and regions around the world, and thoroughly imple- vated at Oita Canon, Miyazaki Canon will pursue even greater ment operations. We drive quality improvement on an ongoing efficiency as an “ideal factory.” basis, while constantly carrying out strict evaluations using cutting- edge testing facilities that are at the forefront of the industry. 23 CANON ANNUAL REPORT 2018 SALES & M ARKETING A B C A. Canon’s display at PhotoPlus 2018, the largest photography and imaging exhibition in North America that showcases all of the latest products and services in the industry. B. The first Canon Business Imaging Solutions Lounge in India. Visitors can try out various B2B products such as MFDs, scanners, and projectors. C. Canon opened a Customer Experience Centre in Switzerland, showing our entire business portfolio, in particular, our com- mercial printing products and services. 24 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA Accelerating growth in commercial printing, network cameras, medical and industrial equipment as key drivers of Canon’s next-generation business Japan Middle East, Canon Saudi Arabia was launched to support grow- Sales in Japan amounted to ¥869.6 billion, or 22.0% of consoli- ing demand in the region for business solutions. In September, dated net sales. Sales in the IT solutions business increased due Canon Europe used Photokina 2018 as an important platform to to strong IT investment by domestic companies, in response to engage with consumer and professional audiences and enable workstyle reforms and labor shortages. Meanwhile, investment them to get hands on with the EOS R system. in business equipment was weak, and MFPs and other hardware declined. In the security business, sales of network cameras Asia and Oceania and software, etc. continued to grow. In addition, regarding Sales in the Asia and Oceania region amounted to ¥990.5 billion, products for consumers, although sales of mirrorless cameras or 25.1% of consolidated net sales. In the B2C field, we bolstered increased significantly, sales of digital single lens reflex (“DSLR”) marketing by strengthening e-commerce, and expanded our mar- cameras and inkjet printers decreased due to market shrinkage. ket share. Meanwhile, in the B2B field, we strengthened sales and The Americas branding for MFDs and commercial printers, and promoted the expansion of B2B business within the region. In particular, we intro- Sales in the Americas amounted to ¥1,076.4 billion, or 27.2% duced strategic products exclusively for Asia, in order to enhance of consolidated net sales. In recent years, Canon has promoted sales capabilities and branding for MFDs in the area. We are force- a shift to digital marketing, including improving the convenience fully promoting business expansion in Asia as a whole, led by India, of e-commerce based on customer-oriented marketing activities, which is experiencing remarkable growth. Furthermore, we partici- and enhancing after-marketing efficiency. In office equipment, we pated in the China International Import Expo, which was held for are continuing to implement the regional management system the first time in 2018, where we presented a wide range of prod- that was introduced last year, which organizes activities in the U.S. ucts and solutions in areas such as business and healthcare. We are into four regions. We held a nationwide summit for U.S. dealers, currently expanding our market share in the B2B field in China. In and forged even stronger relationships with our top dealers. In Oceania, Canon has strengthened its B2B business through M&A. addition, in order to accelerate new, original businesses by sales companies, we have established an organizational structure to promote innovation and are strengthening R&D. Canon is moving ahead with the cultivation of new businesses. Europe (Europe, Middle East, Africa) Sales in Europe amounted to ¥1,015.4 billion, or 25.7% of con- solidated net sales. In line with its strategy to drive an ever-deeper customer-centric approach, Canon Europe opened two Customer Composition of Sales by Region Asia and Oceania 25.1% ¥990.5 billion Net Sales ¥3,951.9 billion Experience Centres in 2018 — in Switzerland and France — giv- ing customers new opportunities to interact with Canon people, products and solutions. Highlighting Canon’s commitment to the Japan 22.0% ¥869.6 billion The Americas 27.2% ¥1,076.4 billion Europe 25.7% ¥1,015.4 billion 25 CANON ANNUAL REPORT 2018 ESG Environment Social E S G Governance In recent years, the ethical role of corporations has increased with the ideals laid out in the Sustainable Development Goals in importance amid wide-ranging societal expectations and (“SDGs”) adopted by the United Nations in 2015. As members responsibilities. Canon adopted kyosei as its corporate phi- of society, high expectations are being placed on corporations. losophy in 1988, and since then we have worked to fulfill our Accordingly, we will contribute to society by leveraging our responsibilities to society and build solid relationships not only technological capabilities to create new value, resolve social with our customers and business partners, but also with coun- issues, and engage in activities to preserve and protect the tries, communities, nature, and the global environment. The global environment, while continuing to be a company that approach we take with our corporate philosophy harmonizes always gives due consideration to people and society. Environment: Social: Governance: Canon’s Approach Canon’s Approach Canon’s Approach Based on the Canon Environmental Vision, Canon is working to reduce envi- ronmental burden throughout the entire product lifecycle, from procurement of raw materials and parts to collection and recycling of used products, in an effort to realize a society that promotes both enriched lifestyles and the global environment. Canon makes sincere efforts to engage in corporate social responsibilities, in- cluding product safety, human rights, labor management, and accountable procurement activities. In addition, as a good corporate citizen, we promote efforts such as disaster relief and sup- port for culture, and also work to resolve social issues through our technology and business activities. Canon maintains sound corporate gov- ernance as part of efforts to maximize its shareholders’ value and become a truly excellent global corporation. Key Activities Key Activities Key Activities • Contributing to a Low-Carbon Society • Promoting Diversity • Contributing to a Circular Economy • Addressing the Issue of Conflict • Eliminating Hazardous Substances and Minerals Preventing Pollution • Supporting Art and Culture • Board of Directors, Audit & Supervisory Board, Non-statutory Committees • Constructive Dialogue with Shareholders • Contributing to a Society in Harmony with Nature For details, please refer to the Canon Sustainability Report. https://global.canon/en/csr/report/index.html 26 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA Environment The Canon Eco Technology Park (Ibaraki Prefecture, Japan) was opened in 2018 as a hub for the Canon Group’s environmental activities. Canon has been working for the improvement activities with and those used in manufacturing processes to prevent envi- the goal of “achieving an average improvement of 3% per ronmental pollution and adverse effects on people’s health. year in the lifecycle CO2 emissions improvement index per With regard to chemical substances in products, in particular, product,” and, over the period from 2008 to 2018, achieved we have built a Group-wide environmental assurance system an average annual improvement of 5%. As of 2018, the over- and established in-house standards that are in line with the all improvement was 37.7%, compared to 2008. most stringent regulations in the world. Contributing to a Low-Carbon Society Canon tracks CO2 emissions throughout the product lifecycle Contributing to a Society in Harmony with Nature (materials and parts manufactured by supplier, activities at op- Canon engages in various activities worldwide based on erational sites, distribution, and customer use) and works to our Biodiversity Policy, and promotes the Canon Bird Branch reduce emissions at each stage. Project as a symbol of these activities. This project comprises Contributing to a Circular Economy project across the entire Canon Group in an effort to conserve activities at our sites that focus on birds. We promote this To ensure more efficient use of limited resources and reduce and protect biodiversity. waste, Canon is making products smaller and lighter, and reusing and recycling materials as much as possible. In par- ticular, we are pursuing product-to-product recycling—in other words, recycling used products into new ones. Canon has established five reuse and recycling centers in four regions around the world. With the aim of achieving more advanced and efficient recycling, we opened the Canon Eco Technology Park, a reuse and recycling plant equipped with a state-of-the- art automated recycling line. Eliminating Hazardous Substances and Preventing Pollution Lifecycle CO2 Emissions Improvement Index per Product Improvement index 100 37.7% Improvement 50 0 Canon thoroughly manages chemical substances in products 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 *Indexed to 2008=100 27 CANON ANNUAL REPORT 2018 Social An interactive exhibit organized by the NCPCP and Canon using the high-resolution facsimiles of the Pine Trees (Shorin-zu byobu by Hasegawa Tohaku, one of Japan’s national treasures). We aim to provide the public with more opportunities to view cultural assets and experience them on a more personal level. Diversity Promotion Under our corporate philosophy of kyosei, Canon respects Art and Culture diversity globally and actively encourages the fair hiring and As a company that contributes to the development of visual promotion of employees, regardless of gender, age, or dis- culture, Canon engages in activities to foster the richness of ability. In 2012, Canon established Vital workforce and Value human feelings and emotions. In 2007, Canon and the Kyoto Innovation through Diversity (“VIVID”), a company-wide hori- Culture Association (“NPO”) launched the Tsuzuri Project, zontally integrated organization to promote diversity, and in which is officially named the Cultural Heritage Inheritance 2018, the President’s Meeting on Diversity Promotion was held Project, with the aim of preserving original cultural assets and for 24 Group companies in Japan. In addition to promoting utilizing high-resolution facsimiles. By combining Canon’s the active participation of female employees, which has been advanced digital technologies, ranging from input to image our focus thus far, we have expanded the target to include processing and output, with skills from Kyoto’s traditional utilization of more diverse human resources, including sexual craft techniques, we have produced and presented high-reso- minorities such as the lesbian, gay, bisexual, and transgender lution facsimiles of important Japanese cultural assets passed (“LGBT”) community, veteran employees, and persons with down from ancient times, including folding screens, fusuma disabilities. (Japanese sliding doors), and handscrolls. As of March 2019, Socially Responsible Procurement and Conflict Minerals Canon has presented 38 facsimiles of artworks. In 2018, Canon and the National Center for the Promotion of Cultural Properties (“NCPCP”), part of the National Against the backdrop of increasingly global supply chains, a Institutes for Cultural Heritage, launched a joint project on the number of social issues relating to human rights and environ- creation of high-resolution facsimiles of important Japanese mental protection have been identified. In response, Canon works of art using the technologies employed by the Tsuzuri formulated the Canon Supplier CSR Guidelines to promote Project as well as research and testing to develop new applica- socially responsible procurement in partnership with suppli- tions for such technology. ers. To address the issues of conflict minerals in Africa, Canon Canon is working to support Para-sports through photography conducts a Reasonable Country of Origin Inquiry every year, as a Tokyo 2020 Gold Partner (Still Camera & Desktop Printer), by receives an independent assurance report from a third-party providing various supports such as sponsoring a graphic maga- auditor, and discloses its findings to the U.S. Securities and zine that introduces Para-sports to the public and taking photos Exchange Commission. of Para-sports athletes for a school educational material. 28 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA Governance At a monthly company-wide meeting of executive officers, the CEO provides updates on earnings progress and important matters to implement in the fu- ture as a way to share crucial information. Fundamental Policy Board of Directors In order to establish a sound corporate governance structure While the focus of the organizational structure of the Board and continuously raise corporate value, the Company believes of Directors is on Representative Directors that oversee com- that it is essential to improve management transparency and pany-wide business strategies or execution such as the CEO, strengthen management supervising functions. At the same COO, CFO, CTO, and Representative Directors or Executive time, a sense of ethics and mission held by each executive and Directors that oversee multiple business fields or headquarters employee of a company is very important in order to achieve functions, in order to secure sound management, an ad- continuous corporate growth and development. Details of equate number of at least two or more Independent Outside Canon Inc.’s corporate governance structure are available Directors are appointed. The Board of Directors, in accordance on the Company’s website under “an overview of Corporate with laws and regulations, makes important decisions and su- Governance at Canon Inc.” pervises the execution of duties by officers. (https://global.canon/en/ir/strategies/governance.html). Except for the above, the CEO and other Representative Governance Structure Fundamental Policy Directors are active in decision making and execution, and under the command and supervision of the Representative Directors, Executive Officers that are elected through resolu- The Company is globally expanding its businesses in various tion of the Board of Directors make decisions and execute business fields, including office equipment, consumer prod- operations of each business field or function. ucts, medical equipment, and industrial equipment, and aims The Board of Directors consists of six members, four to aggressively expand into new business fields in the future. Representative Directors from inside the Company and two In order to make prompt decisions in each business field, and Outside Directors that qualify as Independent Directors. make important decisions for the entire Canon Group or mat- Additionally, at a meeting of the Board of Directors held on ters that straddle several business fields from a company-wide January 30, 2019, 40 individuals, including two females and perspective and at the same time secure appropriate decision one non-Japanese, were elected as Executive Officers that making and execution of operation, the Company judges the assumed this position from April 1, 2019. corporate governance structure below to be effective. * Independent directors: Stock exchanges in Japan require listed companies to appoint out- side directors and/or outside Audit & Supervisory Board members and to report their name. Outside directors and Audit & Supervisory Board members should have no possible conflict of interests with regular shareholders. People related to the parent company or major busi- ness partners, consultants who receive large remunerations from the company, and their close relatives cannot be selected as independent directors. 29 CANON ANNUAL REPORT 2018 Governance Audit & Supervisory Board property of the Company and its subsidiaries. In this way, the As a body which is in charge of the audit of operations, Audit & Supervisory Board conducts strict audits of directors’ under the principles of autonomy, which is independent execution of duty, including the status of development of the from the Board of Directors, the Company has full-time internal control system. Audit & Supervisory Board Members that are familiar with Procedures in the Nomination of Directors etc. the Company’s businesses or its management structure, and The Company established the “Nomination and Independent Outside Audit & Supervisory Board Members Remuneration Advisory Committee,” a non-statutory com- that have extensive knowledge in specialized areas such as mittee, which consists of the CEO, two Independent Outside law, finance and accounting, and internal control. The Audit Directors, and one Independent Outside Audit & Supervisory & Supervisory Board, which is composed of these individuals, Board Member. At the time, Director and Audit & Supervisory cooperates with the Company’s accounting auditors and in- Board Member candidates are nominated and Executive ternal audit division, oversees the status of duty execution of Officers are appointed (includes the selection of a successor operations and corporate assets to secure the soundness for the chief executive officer position), the CEO recommends of management. candidates thereof from among individuals that have been The Audit & Supervisory Board consists of five individuals, recognized as having met the prescribed requirements, and three of which are Independent Outside Audit & Supervisory the Committee checks the fairness and validity of such rec- Board Members. In accordance with auditing policies and ommendation prior to submission to and deliberation by the plans decided at Audit & Supervisory Board meetings, Board of Directors. the Audit & Supervisory Board Members attend Board of Additionally, as for Audit & Supervisory Board Member Directors’ meetings, and other important gatherings such candidates, prior to deliberation of the Board of Directors, as Corporate Strategy Committee meetings. They are also consent of the Audit & Supervisory Board shall be acquired. able to listen to reports from directors and employees, re- Corporate Strategy Committee, Risk Management view documents related to important decisions, and conduct Committee, and Disclosure Committee audits by investigating etc. the situation of businesses and The Company established the Corporate Strategy Committee, Directors and Audit & Supervisory Board Members (as of April 1, 2019) Representative Director Executive Vice President & CTO & In charge of Office Business Toshio Homma Chief Executive of Office Imaging Products Operations Representative Director Chairman & CEO Fujio Mitarai Representative Director President & COO Masaya Maeda Representative Director Executive Vice President & CFO Toshizo Tanaka Group Executive of Finance & Accounting Headquarters Group Executive of Public Affairs Headquarters Group Executive of Facilities Management Headquarters Directors Kunitaro Saida (Outside) Attorney Haruhiko Kato (Outside) President & CEO of Japan Securities Depository Center, Incorporated Audit & Supervisory Board Members Masaaki Nakamura Hiroaki Sato Yutaka Tanaka (Outside) Hiroshi Yoshida (Outside) Koichi Kashimoto (Outside) Note: Although this annual report is for FY2018, the above list of Directors and Audit & Supervisory Board members is as of April 1, 2019. 30 CANON ANNUAL REPORT 2018 STRATEGY BUSINESS SEGMENT/ CORPORATE STRUCTURE FINANCIAL SECTION CORPORATE DATA consisting of Representative Directors and some Executive with improving systems to ensure reliability of financial re- Officers. Among items to be decided by the CEO, the porting; the Compliance Subcommittee, which is tasked with Committee undertakes prior deliberations on important mat- promoting corporate ethics and improving legal compliance ters pertaining to Canon Group strategies. Outside Directors systems; and the Business Risk Management Subcommittee, and Audit & Supervisory Board members attend Corporate which is charged with improving systems to manage overall Strategy Committee meetings and are able to express their business risks, including risks related to product quality and in- own opinions. formation leak. The Risk Management Committee verifies the Based on a resolution passed by the Board of Directors, risk management system’s improvement and implementation Canon set up the Risk Management Committee, which and reports the status to the CEO and the Board of Directors. formulates policy and action proposals regarding improve- In addition, the Disclosure Committee was established to ment of the Canon Group risk management system. The undertake deliberations pertaining to information disclosure, Risk Management Committee consists of three entities: the including content and timing, to ensure important corporate Financial Risk Management Subcommittee, which is tasked information will be disclosed in a timely and accurate manner. 31 Governance Structure (as of April 1, 2019)Audit & Supervisory Board5 Members(Includes 3 Independent Members)General Meeting of ShareholdersBoard of Directors6 Members(Includes 2 Independent Members)Representative DirectorsCEO and othersAccounting Auditor(Audit Firm)Executive Officers, and each General ManagerCorporate Audit CenterDisclosure CommitteeCorporate Strategy CommitteeRepresentative Directors and Executive Officers with direct control of an organizational divisionNomination and Remuneration Advisory Committee(CEO, two Independent Outside Directors, and one Independent Outside Audit & Supervisory Board Member)Financial Risk ManagementSubcommitteeCompliance SubcommitteeBusiness Risk ManagementSubcommitteeRisk Management CommitteeElect/DismissElect/DismissApprove/SuperviseInstruct/OrderApprove/SuperviseElect/DismissElect/DismissAuditCooperationFinancial AuditCooperationCooperationReportAuditReportReportReportReportReportInternal AuditConsultConsultReportCooperationReportCANON ANNUAL REPORT 2018 Governance Internal Audit Division of Corporate Governance at Canon Inc.” The Corporate Audit Center, the Company’s internal audit- As for the opinions or demands that are obtained through ing arm, as an independent and specialized organization and dialogue with shareholders, accordingly, the department in in accordance with internal audit rules, conducts audits and charge reports to the CFO and the CFO will report important evaluations and provides guidance on such matters as compli- ones to the CEO or the Board of Directors. ance with laws and the internal control system. Furthermore, Controlling Insider Information audits of particular themes such as quality, the environ- The Company has set the “Rules on Prevention of Insider ment, and information security are conducted mainly by the Trading,” which makes thorough control of undisclosed Corporate Audit Center in cooperation with each division in material information and provides the procedure of infor- charge. Additionally, based on top management policy, for all mation disclosure. work processes, audits must be conducted from a specialized viewpoint and there are plans to increase the number of its members from the current 80 to strengthen auditing functions by enabling audits from a specialized viewpoint in each theme. Constructive Dialogue with Shareholders Policy For sustainable growth and to help improve corporate value over a mid- to long-term perspective, the Company has con- structive dialogue with shareholders through an ordinary general meeting of shareholders, corporate strategy confer- ences, financial results conferences, and interviews with major institutional investors. The Structure to Promote Dialogue Finance & accounting (Investor Relations (“IR”)), legal affairs, corporate communications are responsible for working to- gether and promoting dialogue. The Executive Vice President & CFO oversees the entire structure to promote dialogue. For analysts and institutional investors, the CEO hosts a corporate strategy conference at the beginning of the year. Other than this, the CFO hosts quarterly financial results conferences. For individual investors, conferences are held when appropriate and on the Company’s official website, specific pages containing information about corporate strat- egy, financial results, and financial data etc. have been set up using descriptions that are easy to understand. Additionally, the Company works for dialog with domestic and overseas analysts and institutional investors, arranging interview oppor- tunities appropriately. For detail, please refer to “an Overview 32 CANON ANNUAL REPORT 2018 FINAN C IAL SEC TION TABLE OF CO NTENTS 34 Financial Overview 48 Ten-Year Financial Summary 50 Consolidated Balance Sheets 51 Consolidated Statements of Income 51 Consolidated Statements of Comprehensive Income 52 Consolidated Statements of Equity 53 Consolidated Statements of Cash Flows 54 Notes to Consolidated Financial Statements 90 Schedule II Valuation and Qualifying Accounts 91 Management’s Report on Internal Control Over Financial Reporting 92 Reports of Independent Registered Public Accounting Firm CANON ANNUAL REPORT 2018 33 FINAN C IAL OVE R VIEW GENERAL The following discussion and analysis provides information that management believes to be relevant to understanding Canon’s consolidated financial condition and results of opera- tions. References in this discussion to the “Company” are to Canon Inc. and, unless otherwise indicated, references to the financial condition or operating results of “Canon” refer to Canon Inc. and its consolidated subsidiaries. OVERVIEW Canon is one of the world’s leading manufacturers of office multifunction devices (“MFDs”), plain paper copying machines, laser printers, cameras, inkjet printers, medical equipment, semiconductor lithography equipment and flat-panel-display (“FPD”) lithography equipment. Canon earns revenues primarily from the manufacture and sale of these products domestically and internationally. Canon’s basic management policy is to contribute to the prosperity and well-being of the world while endeavoring to become a truly excellent global corporate group targeting continued growth and development. Canon divides its businesses into four segments: the Office Business Unit, the Imaging System Business Unit, the Medical System Business Unit which was newly established in 2017, and the Industry and Others Business Unit. Economic environment Looking back at the global economy in 2018, the U.S. econ- omy steadily recovered as corporate earnings and employ- ment conditions improved. In Europe, while domestic demand remained firm, the rate of growth decelerated due to sluggish export growth. In China, the economy slowed down due to sluggish capital investments and a decline in consumer spend- ing. The economies of other emerging markets also worsened, due to such factors as local currency depreciation. In Japan, the economy recovered moderately supported by continu- ing improvements in employment conditions. As a result, the global economy overall continued to realize a moderate re- covery. However, the pace of economic growth slowed down from the latter half of the year as a result of trade friction. Market environment As for the markets in which Canon operates amid these condi- tions, office MFDs and laser printers enjoyed solid demand due to the shift from monochrome to color models and robust demand in emerging markets. The decline of the camera market contin- ued and the market for inkjet printers was slightly below the level of the previous year. On the other hand, demand for medical equipment grew moderately. Within the Industry and Others sec- tor, capital investment in semiconductor lithography equipment increased, while capital investment in organic light-emitting diode (“OLED”) panel manufacturing equipment faced a temporary slowdown. Demand for network cameras enjoyed solid growth. The average value of the yen during the year was ¥110.43 against the U.S. dollar, a year-on-year appreciation of ap- proximately ¥2, and ¥130.29 against the euro, a year-on-year depreciation of approximately ¥4. Summary of operations During 2018, unit sales of office MFDs increased compared with the previous year due to the expanded sales of color models, mainly outside of Japan. Additionally, unit sales of both mono- chrome and color laser printers increased compared with the previous year, supported by the steady sales of newly launched models. Total sales volume of interchangeable-lens digital camer- as decreased compared with the previous year due to contraction of the market mainly for entry-class models. However, sales of mirrorless cameras increased. Looking at inkjet printers, although sales unit of refillable ink tank models increased in emerging markets, unit sales overall decreased compared with the previous year, due to decreasing demand in developed economies. For medical equipment, newly launched diagnostic ultrasound sys- tems and Magnetic resonance imaging (“MRI”) systems experi- enced solid demand, mainly outside of Japan, achieving increased sales compared with the previous year. For industrial equipment, sales of semiconductor lithography equipment increased sig- nificantly compared with the previous year, thanks to favorable market conditions. However, manufacturing equipment for OLED panels decreased compared with the previous year mainly due to a slowdown in investment in OLED panels. Sales of network cameras increased steadily in response to the growing market. Under these conditions, net sales for the year decreased by 3.1% year on year to ¥3,951,937 million. In addition, the gross profit ratio dropped by 2.4 points to 46.4%. This was mainly due to the fact that certain costs that were recorded under operating expenses in the prior years have been reclassified to cost of sales in 2018, following the adoption of new accounting standards related to revenue recognitions as described in Note 15 of the Notes to Consolidated Financial Statements. The reclassified amount for the year ended December 31, 2018 was ¥115,700 million. Excluding the impact of this reclassification, the gross profit ratio increased by 0.6 points to 49.4%. Operating expenses decreased by 10.6% year on year to ¥1,492,602 million, thanks to Group-wide efforts to thoroughly manage expenses as well as impairment loss on goodwill of commercial printing business dur- ing the previous year in addition to the impact of the aforemen- tioned reclassification of figures related to the adoption of new accounting standards. As a result, operating profit increased by 6.6% to ¥342,952 million. Other income (deductions) decreased by ¥12,339 million, mainly due to gain on securities contributed to the retirement benefit trust during the previous year, while income before income taxes increased by 2.5% year on year to ¥362,892 million and net income attributable to Canon Inc. increased by 4.5% to ¥252,755 million. Total assets decreased by ¥298,826 million to ¥4,899,465 million at December 31, 2018, compared to the end of previous year, mainly due to the decrease of cash and cash equivalents. Total liabilities decreased by ¥220,564 million to ¥1,881,552 million at December 31, 2018, compared to the end of previ- ous year, mainly due to the repayment of the long-term debt. Total equity decreased by ¥78,262 million to ¥3,017,913 million at December 31, 2018, compared to the end of previous year, mainly due to the increase of accumulated other comprehensive loss resulting from the appreciation of yen. 34 CANON ANNUAL REPORT 2018 Key performance indicators The following are the key performance indicators (“KPIs”) that Canon uses in managing its business. The changes from year to year in these KPIs are set forth in the table below. Net sales and profit ratio As Canon pursues the goal to become a truly excellent global company, one indicator upon which Canon’s management places strong emphasis is revenue. The following are some of the KPIs related to revenue that management considers to be important. Net sales is one such KPI. Canon derives net sales primarily from the sale of products and, to a lesser extent, provision of services associated with its products. Sales vary depending on such factors as product demand, the number and size of transactions within the reporting period, market acceptance for new products, and changes in sales prices. Other factors involved are market share and market environment. In addition, management considers the evaluation of net sales by segment to be important for the pur- pose of assessing Canon’s sales performance in various segments, taking into account recent market trends. Gross profit ratio (ratio of gross profit to net sales) is another KPI for Canon. Through its reforms of product development, Canon has been striving to shorten product development lead times in or- der to launch new, competitively priced products at a faster pace. Furthermore, Canon has further achieved cost reductions through enhancement of efficiency in its production. Canon believes that these achievements have contributed to improving Canon’s gross profit ratio, and will continue pursuing the curtailment of product development lead times and reductions of production costs. Operating profit ratio (ratio of operating profit to net sales), income before income taxes ratio (ratio of income before in- come taxes to net sales), and R&D expense to net sales ratio are considered to be KPIs by Canon. Canon is focusing on two ar- eas for improvement. Canon is striving to control and reduce its selling, general and administrative expenses as its first key point. Secondly, Canon’s R&D policy is designed to maintain adequate spending in core technology to sustain Canon’s leading position in its current business areas and to exploit opportunities in other KEY PERFORMANCE INDICATORS markets. Canon believes such investments will create the basis for future success in its business and operations. Cash flow management Canon also places significant emphasis on cash flow manage- ment. The following are the KPIs relating to cash flow man- agement that Canon’s management believes to be important. Inventory turnover measured in days is a KPI because it mea- sures the efficiency of supply chain management. Inventories have inherent risks of becoming obsolete, physically damaged or otherwise decreasing significantly in value, which may adversely affect Canon’s operating results. To mitigate these risks, manage- ment believes that it is crucial to continue reducing work-in-pro- cess inventories by decreasing production lead times in order to promptly recover related product expenses, while balancing risks of supply chain disruptions by optimizing finished goods invento- ries in order to avoid losing potential sales opportunities. The debt to total assets ratio is also one of the KPIs. For a manufacturing company like Canon, it generally takes consider- able time to realize profit from a business due to lead times re- quired for R&D, manufacturing and sales has to be followed for success. Therefore, management believes that it is important to have sufficient financial strength. Canon will continue to reduce its dependency on external funds for capital investments in fa- vor of generating the necessary funds from its own operations. Canon Inc. shareholders’ equity to total assets ratio is another KPI for Canon. Canon believes that its shareholders’ equity to total assets ratio measures its long-term sustainability. Canon also believes that achieving a high or rising shareholders’ equity ratio indicates that Canon has maintained a strong financial po- sition or further improved its ability to fund debt obligations and other unexpected expenses. In the long-term, Canon’s man- agement believes a high shareholders’ equity ratio will enable the company to maintain a high level of stable investments for its future operations and development. As Canon puts strong emphasis on its R&D activities, management believes that it is important to maintain a stable financial base and, accordingly, a high level of its shareholders’ equity to total assets ratio. Net sales (Millions of yen) Gross profit to net sales ratio R&D expense to net sales ratio Operating profit to net sales ratio Income before income taxes to net sales ratio Inventory turnover measured in days Debt to total assets ratio Canon Inc. shareholders’ equity to total assets ratio Notes: 1. Inventory turnover measured in days is determined by: Inventory divided by net sales for the previous six months, multiplied by 182.5. The increase of 2017 4,080,015 48.8% 8.2% 7.9% 8.7% 49 days 10.2% 55.2% 2016 3,401,487 49.2% 9.0% 6.4% 7.2% 59 days 11.9% 54.2% 2015 3,800,271 50.8% 8.8% 9.0% 9.1% 47 days 0.0% 67.0% 2018 3,951,937 46.4% 8.0% 8.7% 9.2% 56 days 8.2% 57.7% 2014 3,727,252 49.9% 8.4% 9.3% 10.3% 50 days 0.0% 66.8% inventory turnover in 2016 was primarily due to the acquisition of Canon Medical Systems Corporation (“CMSC”) on December 19, 2016. If this factor were excluded, the inventory turnover would show 50 days. 2. Canon adopted ASU No. 2017-07 from the quarter beginning January 1, 2018. The adoption of the new presentation requirement of the service cost component and the other components of net benefit cost resulted in reclassification from cost of sales, and selling, general and administrative expenses, and research and development expenses into other income (deductions) for the years ended December 31, 2017, 2016, 2015, and 2014 respectively. CANON ANNUAL REPORT 2018 35 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA FINANCIAL OVERVIEW CRITICAL ACCOUNTING POLICIES AND ESTIMATES The consolidated financial statements are prepared in accor- dance with U.S. generally accepted accounting principles (“U.S. GAAP”) and based on the selection and application of signifi- cant accounting policies which require management to make significant estimates and assumptions. These estimates and assumptions include future market conditions, net sales growth rate, gross margin and discount rate. Though Canon believes that the estimates and assumptions are reasonable, actual future results may differ from these estimates and assumptions. Canon believes that the following are the more critical judg- ment areas in the application of its accounting policies that currently affect its financial condition and results of operations. Revenue recognition Canon generates revenue principally through the sale of office, imaging system and medical system products, industrial equip- ment, supplies and related services under separate contractual arrangements. Revenue is recognized when, or as, control of promised goods or services transfers to customers in an amount that reflects the consideration to which Canon expects to be entitled in exchange for transferring these goods or services. Revenue from sales of office products, such as office MFDs and laser printers, and imaging system products, such as digital cameras and inkjet printers, is recognized upon ship- ment or delivery, depending upon when the customer obtains controls of these products. Revenue from sales of equipment that are sold with customer acceptance provisions related to their functionality including opti- cal equipment such as semiconductor lithography equipment and FPD lithography equipment, and certain medical equipment such as Computed tomography (“CT”) systems and MRI systems, is recognized when the equipment is installed at the customer site and the agreed-upon specifications are objectively satisfied. Most of Canon’s service revenue is generated from office and medical system products which is recognized over time. For the service contracts of office products, the customer typi- cally pays a variable amount based on usage, a stated fixed fee or a stated base fee plus a variable amount which frequently include the provision of consumables as well as break fix ac- tivities. The majority portion of service revenue from the office products is recognized as billed since invoiced amount directly correlates with the value to the customer of the underlying performance obligation to date. For the service contracts of medical system products, the customer typically pays a stated fixed fee for the stand ready maintenance service and revenue is recognized ratably over the contract period. The majority of service arrangements for office products are executed in combination with related products. Transaction prices for products and services need to be allocated to each performance obligation on a relative standalone selling price ba- sis where significant judgements are required. Canon estimates the standalone selling price using a range of prices that would meet the allocation objective based on all the information that is reasonably available including market conditions and other observable inputs. If transaction prices of the product or service contracts are not within the acceptable range then the revenue is subject to allocation based on the estimated standalone sell- ing prices. Canon recognizes the incremental costs of obtaining a contract as an expense when related office products are sold. Canon also provides leasing arrangement to the customers primarily for the sales of office products. Approximately 4% of total revenue is generated from these leasing arrangements for the year ended December 31, 2018. Revenue from the sale of these products under sales-type leases is recognized at the inception of the lease. Interest income on sales-type leases and direct-financing leases is recognized over the life of each re- spective lease using the interest method. Leases not qualifying as sales-type leases or direct-financing leases are accounted for as operating leases and related revenue is recognized ratably over the lease term. When product leases are bundled with maintenance contracts, revenue is allocated based upon the estimated standalone selling prices of the lease and non-lease components. Lease components generally include product, financing and executory costs, while non-lease components generally consist of maintenance contracts and supplies. The transaction prices that Canon is entitled to receive in exchange for transferring goods or services to the customer include certain forms of variable consideration, including product discounts, customer promotions and volume-based rebates mainly for imaging system products, which are sold predominantly through distributors and retailers. Canon includes estimated amounts in the transaction price only to the extent it is probable that a significant reversal of cumula- tive revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. Variable considerations are estimated based upon historical trends and other known factors at the time of sale, and are subsequently adjusted in each period based on current information. In ad- dition, Canon may provide a right of return on our products for a short time period after a sale. These rights are accounted for as variable consideration when determining the transaction price, and accordingly Canon recognizes revenue based on the estimated amount to which Canon expects to be entitled after considering expected returns. Taxes collected from customers and remitted to governmen- tal authorities are excluded from revenues in the consolidated statements of income. Allowance for doubtful receivables Allowance for doubtful receivables is determined using a com- bination of factors to ensure that Canon’s trade and financing receivables are not overstated due to uncollectibility. These factors include the length of time receivables are past due, the credit quality of customers, macroeconomic conditions and historical experience. Also, Canon records specific reserves for individual accounts when Canon becomes aware of a cus- tomer’s inability to meet its financial obligations to Canon, due for example to bankruptcy filings or deterioration in the cus- tomer’s operating results or financial position. If circumstances related to customers change, estimates of the recoverability of receivables are further adjusted. 36 CANON ANNUAL REPORT 2018 Valuation of inventories Inventories are stated at the lower of cost or net realizable value. Cost is determined by the average method for domes- tic inventories and principally the first-in, first-out method for overseas inventories. Net realizable value is the estimated selling price in the ordinary course of business less the esti- mated costs of completion and the estimated costs necessary to make a sale. Canon routinely reviews its inventories for their salability and for indications of obsolescence to deter- mine if inventories should be written-down to market value. Judgments and estimates must be made and used in con- nection with establishing such allowances in any accounting period. In estimating the net realizable value of its inventories, Canon considers the age of the inventories and the likelihood of spoilage or changes in market demand for its inventories. Impairment of long-lived assets Long-lived assets, such as property, plant and equipment, and acquired intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indi- cate that the carrying amount of an asset may not be recover- able. If the carrying amount of the asset exceeds its estimated undiscounted future cash flows, an impairment charge is recog- nized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Determining the fair value of the asset involves the use of estimates and assumptions. Property, plant and equipment Property, plant and equipment are stated at cost. Depreciation is calculated principally by the declining-balance method, except for certain assets which are depreciated by the straight- line method over the estimated useful lives of the assets. Business combinations The acquisition is accounted for using the acquisition method of accounting. The acquisition method of accounting requires the identification and measurement of all acquired tangible and intangible assets and assumed liabilities at their respective fair val- ues, as of the acquisition date. The determination of the fair value of net assets acquired involves significant judgment and esti- mates, such as future cash flow projections, appropriate discount and capitalization rates and other estimates based on available market information. Estimates of future cash flows are based on a number of factors including operating results, known and anticipated trends, as well as market and economic conditions. Goodwill and other intangible assets Goodwill and other intangible assets with indefinite useful lives are not amortized, but are instead tested for impairment annually in the fourth quarter of each year, or more frequently if indica- tors of potential impairment exist. All goodwill is assigned to the reporting unit or units that benefit from the synergies arising from each business combination. If the carrying amount assigned to the reporting unit exceeds the fair value of the reporting unit, Canon recognizes an impairment charge in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. Fair value of a reporting unit is determined primar- ily based on the discounted cash flow analysis which involves esti- mates of projected future cash flows and discount rates. Estimates of projected future cash flows are primarily based on Canon’s forecast of future growth rates. Estimates of discount rates are determined based on the weighted average cost of capital, which considers primarily market and industry data as well as specific risk factors. Canon has completed its impairment test in the fourth quarter of 2018. The fair values of all reporting units exceeded its respective carrying amount, and thus no impairment charge was recognized as a result of 2018 impairment test. However, with regard to goodwill attributed to commercial printing business in- cluded in Office Business Unit for which the impairment charge of ¥33,912 million was recognized for the year ended December 31, 2017, and goodwill attributed to Medical System Business Unit and network camera business included in Industry and Others Business Unit were resulted from recent acquisitions, fair values in excess of reported carrying values as a percentage are lower than other reporting units. As a result, a future reduction in cash flows of the related business, could trigger an impairment. The goodwill related to these reporting units are ¥28,066 million, ¥500,896 million and ¥211,598 million, respectively. Intangible assets with finite useful lives consist primarily of software, trademarks, patents and developed technology, license fees and customer relation- ships, which are amortized using the straight-line method. The estimated useful lives of software are from 3 years to 7 years, trademarks are 15 years, patents and developed technology are from 7 years to 17 years, license fees are 7 years, and customer relationships are from 11 years to 15 years, respectively. Income tax uncertainties Canon considers many factors when evaluating and estimat- ing income tax uncertainties. These factors include an evalu- ation of the technical merits of the tax positions as well as the amounts and probabilities of the outcomes that could be realized upon settlement. The actual resolutions of those un- certainties will inevitably differ from those estimates, and such differences may be material to the financial statements. Valuation of deferred tax assets Canon currently has significant deferred tax assets, which are subject to periodic recoverability assessments. Realization of Canon’s deferred tax assets is principally dependent upon its achievement of projected future taxable income. Canon’s judgments regarding future profitability may change due to future market conditions, its ability to continue to successfully execute its operating restructuring activities and other factors. Any changes in these factors may require possible recognition of significant valuation allowances to reduce the net carrying value of these deferred tax asset balances. When Canon de- termines that certain deferred tax assets may not be recover- able, the amounts, which may not be realized, are charged to income tax expense and will adversely affect net income. Employee retirement and severance benefit plans Canon has significant employee retirement and severance CANON ANNUAL REPORT 2018 37 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA FINANCIAL OVERVIEW benefit obligations that are recognized based on actuarial valuations. Inherent in these valuations are key assumptions, including discount rates and expected return on plan assets. Management must consider current market conditions, includ- ing changes in interest rates, in selecting these assumptions. Other assumptions include assumed rate of increase in com- pensation levels, mortality rate, and withdrawal rate. Changes in assumptions inherent in the valuation are reasonably likely to occur from period to period. Actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, generally affect future pension expens- es. While management believes that the assumptions used are appropriate, the differences may affect employee retirement and severance benefit costs in the future. In preparing its financial statements for 2018, Canon estimat- ed a weighted-average discount rate used to determine benefit obligations of 0.6% for Japanese plans and 2.4% for foreign plans and a weighted-average expected long-term rate of return on plan assets of 2.9% for Japanese plans and 4.4% for foreign plans. In estimating the discount rate, Canon uses avail- able information about rates of return on high-quality fixed-in- come government and corporate bonds currently available and expected to be available during the period to the maturity of the pension benefits. Canon establishes the expected long-term rate of return on plan assets based on management’s expecta- tions of the long-term return of the various plan asset catego- ries in which it invests. Management develops expectations with respect to each plan asset category based on actual historical returns and its current expectations for future returns. Decreases in discount rates lead to increases in actuarial CONSOLIDATED RESULTS OF OPERATIONS SUMMARY OF OPERATIONS Net sales Products and Equipment Services Operating profit Income before income taxes Net income attributable to Canon Inc. Note: See note to KEY PERFORMANCE INDICATORS Sales In the current business term, the world economy seemingly mounted a gradual recovery on the whole, yet decelerated in the latter half largely due to adverse effects of trade friction. In such an environment, although each of Canon Group’s businesses endeavored to expand sales particularly with respect to new products, Canon’s consolidated net sales in 2018 totaled ¥3,951,937 million, a decrease of 3.1% from the previous year largely due to adverse effect of a shrinking market. The adoption of the new revenue standard required the reconsideration of the scope of performance obligations related to service contracts, which has resulted in a change in 38 pension benefit obligations which, in turn, could lead to an increase in service cost and amortization cost through amortiza- tion of actuarial gain or loss, a decrease in interest cost, and vice versa. For 2018, a decrease of 50 basis points in the discount rate increases the projected benefit obligation by approximately ¥94,366 million. The net effect of changes in the discount rate, as well as the net effect of other changes in actuarial assump- tions and experience, is deferred until subsequent periods. Decreases in expected returns on plan assets may increase net periodic benefit cost by decreasing the expected return amounts, while differences between expected value and actual fair value of those assets could affect pension expense in the following years, and vice versa. For 2018, a change of 50 basis points in the expected long-term rate of return on plan assets would cause a change of approximately ¥4,657 million in net periodic benefit cost. Canon multiplies management’s expected long- term rate of return on plan assets by the value of its plan assets to arrive at the expected return on plan assets that is included in pension expense. Canon defers recognition of the difference be- tween this expected return on plan assets and the actual return on plan assets. The net deferral affects future pension expense. Canon recognizes the funded status (i.e., the difference between the fair value of plan assets and the projected benefit obligations) of its pension plans in its consolidated balance sheets, with a corresponding adjustment to accumulated other comprehensive income (loss), net of tax. Recently Issued Accounting Guidance Please refer to Note 1 of the Notes to Consolidated Financial Statements. Millions of yen 2018 3,951,937 3,194,724 2016 2017 change change -3.1% 4,080,015 +19.9% 3,401,487 -9.3% 3,521,156 +17.9% 2,986,188 415,299 558,859 +34.6% 216,425 321,605 +48.6% 244,651 353,884 +44.6% 150,650 241,923 +60.6% 757,213 +35.5% +6.6% 342,952 +2.5% 362,892 +4.5% 252,755 9 6 3 0 300 200 100 0 400 300 200 100 0 Return on Sales (%) Sales by Segment (Billions of yen) Sales by Geographic Area (Billions of yen) 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 Office Business Unit Imaging System Business Unit Medical System Business Unit Industry and Others Business Unit Eliminations Japan Americas Europe Asia and Oceania Increase in Property, Plant and Equipment (Billions of yen) Working Capital Ratio Return on Canon Inc. Shareholders’ Equity (%) 5,000 4,000 3,000 2,000 1,000 0 12 9 6 3 0 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 R&D Expenses (Billions of yen) Common Stock Price Range (Tokyo Stock Exchange) (Yen) 2014 2015 2016 2017 2018 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 5,000 4,000 3,000 2,000 1,000 0 3.0 2.5 2.0 1.5 1.0 0.5 0 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 CANON ANNUAL REPORT 2018 classification of revenues between the products and service revenues. As a result, net sales of products and equipment totaled ¥3,194,724 million, a year-on-year decrease of 9.3%, while net sales of services totaled ¥757,213 million, a year-on- year increase of 35.5%. For further information, please refer to Note 15 of the Notes to Consolidated Financial Statements. Overseas operations are significant to Canon’s operating results and generated 78.0% of total net sales in 2018. Such sales are denominated in the applicable local currency and are subject to fluctuations in the value of the yen relative to those currencies. Despite efforts to reduce the impact of currency fluctuations on operating results, including localization of manufacturing in some regions along with procuring parts and materials from overseas suppliers, Canon believes such fluc- tuations have had and will continue to have a significant effect on its results of operations. The average value of the yen during the year was ¥110.43 against the U.S. dollar, a year-on-year appreciation of ap- proximately ¥2, and ¥130.29 against the euro, a year-on-year depreciation of approximately ¥4. The effects of foreign exchange rate fluctuations positively affected net sales by approximately ¥1,024 million in 2018. This favorable impact consisted of approximately ¥17,800 million of unfavorable impact for the U.S. dollar denominated sales and favorable impact of ¥22,534 million for the euro denominated sales, and unfavorable impact of ¥3,710 million for other foreign currency denominated sales. Cost of sales Cost of sales principally reflects the cost of raw materials, parts and labor used by Canon in the manufacture of its products. A portion of the raw materials used by Canon is imported or includes imported materials. Many of these raw materials are subject to fluctuations in world market prices accompanied by fluctuations in foreign exchange rates that may affect Canon’s cost of sales. Other components of cost of sales include depreciation expenses, maintenance expenses, light and fuel expenses, and rent expenses. The ratios of cost of sales to net sales for 2018 and 2017 were 53.6% and 51.2%, respectively. Gross profit Canon’s gross profit in 2018 decreased by 7.8% to ¥1,835,554 million from 2017. The gross profit ratio also dropped by 2.4 points to 46.4%. This was mainly due to the fact that certain costs that were under operating expenses have been reclassified under cost of sales following the adoption of new accounting standards related to revenue recognitions as described in Note 15 of the Notes to Consolidated Financial Statements. The reclassified amount for the year ended December 31, 2018 was ¥115,700 million. Excluding the impact of this reclassification, the gross profit ratio increased by 0.6 points to 49.4%. Operating expenses The major components of operating expenses are payroll, R&D, advertising expenses and other marketing expenses. Operating expenses decreased by 10.6% year on year to ¥1,492,602 million, thanks to Group-wide efforts to thoroughly manage expenses as well as impairment loss on goodwill of commercial printing business during the previous year in addition to the impact of the aforementioned reclassification of figures related to the adoption of new accounting standards. Operating profit Operating profit in 2018 increased by 6.6% from 2017 to a total of ¥342,952 million. The ratio of operating profit to net sales increased by 0.8 points to 8.7% from 2017. Other income (deductions) Other income (deductions) for 2018 was ¥19,940 million, a decrease of ¥12,339 million from 2017 mainly due to gain on securities contributed to the retirement benefit trust during the previous year. Income before income taxes Income before income taxes in 2018 was ¥362,892 million, an increase of 2.5% from 2017, and constituted 9.2% of net sales. Return on Sales (%) Return on Sales (%) Sales by Segment (Billions of yen) Sales by Segment (Billions of yen) Sales by Geographic Area (Billions of yen) Sales by Geographic Area (Billions of yen) 2018 Office Business Unit Imaging System Business Unit Medical System Business Unit Industry and Others Business Unit Eliminations Office Business Unit Imaging System Business Unit Medical System Business Unit Industry and Others Business Unit Eliminations Japan Americas Europe Asia and Oceania Japan Americas Europe Asia and Oceania 2014 2016 2015 2017 2016 2018 2017 2018 CANON ANNUAL REPORT 2018 39 5,000 5,000 4,000 4,000 3,000 3,000 2,000 2,000 1,000 1,000 0 0 2015 2014 9 6 3 0 9 6 3 0 5,000 5,000 4,000 4,000 3,000 3,000 2,000 2,000 1,000 1,000 0 0 2014 2015 2016 2014 2017 2015 2018 2016 2017 2018 2014 2015 2016 2014 2017 2015 2016 2018 2017 9 6 3 0 400 300 200 100 0 9 6 3 0 400 300 200 100 0 200 200 100 100 0 0 Increase in Property, Increase in Property, Plant and Equipment (Billions of yen) Plant and Equipment (Billions of yen) 300 300 Working Capital Ratio Working Capital Ratio Return on Canon Inc. Return on Canon Inc. Shareholders’ Equity (%) Shareholders’ Equity (%) 12 12 2014 2015 2016 2014 2017 2015 2018 2016 2017 2018 2014 2015 2016 2014 2017 2015 2018 2016 2017 2018 2014 2015 2016 2014 2017 2015 2018 2016 2017 2018 R&D Expenses (Billions of yen) R&D Expenses (Billions of yen) Common Stock Price Range (Tokyo Stock Exchange) (Yen) Common Stock Price Range (Tokyo Stock Exchange) (Yen) 2014 2015 2016 2014 2017 2015 2018 2016 2017 2018 2009 2010 2009 2011 2010 2012 2011 2013 2012 2014 2013 2015 2014 2016 2015 2017 2016 2018 2017 2018 3.0 2.5 2.0 1.5 1.0 0.5 0 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 3.0 2.5 2.0 1.5 1.0 0.5 0 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA FINANCIAL OVERVIEW Income taxes Income taxes in 2018 decreased by ¥1,874 million from 2017. The effective tax rate for 2018 was 26.5%, which was lower than the statutory tax rate in Japan. This was mainly due to the tax credit for R&D expenses. Net income attributable to Canon Inc. As a result, net income attributable to Canon Inc. in 2018 in- creased by 4.5% to ¥252,755 million, which represents 6.4% of net sales. Segment information Canon divides its businesses into four segments: the Office Business Unit, the Imaging System Business Unit, the Medical System Business Unit which was newly established in 2017, and the Industry and Others Business Unit. The Office Business Unit mainly includes Office MFDs / Laser MFPs / Laser printers / Digital continuous feed presses / Digital sheet-fed presses / Wide-format printers / Document solutions The Imaging System Business Unit mainly includes Interchangeable-lens digital cameras / Digital compact cameras / Digital camcorders / Digital cinema cameras / Interchangeable lenses / Compact photo printers / Inkjet printers / Large format inkjet printers / Commercial photo printers / Image scanners / Multimedia projectors / Broadcast equipment / Calculators The Medical System Business Unit mainly includes Digital radiography systems / Diagnostic X-ray systems / CT systems / MRI systems / Diagnostic ultrasound systems / Clinical chemis- try analyzers / Ophthalmic equipment The Industry and Others Business Unit mainly includes Semiconductor lithography equipment / FPD (Flat panel dis- play) lithography equipment / Vacuum thin-film deposition equipment / Organic LED (OLED) panel manufacturing equip- ment / Die bonders / Micromotors / Network cameras / Handy terminals / Document scanners Sales by segment Within the Office Business Unit, unit sales of office MFDs increased from the previous year, thanks to expanded sales of such color models as the imageRUNNER ADVANCE Gen3 2nd Edition series, which enhances convenience through compat- ibility with external cloud services, and the imageRUNNER C3020 series of strategic models for emerging markets. As for laser printers, sales of hardware increased from the previous year, supported by steady sales mainly of new models that achieve low power consumption, compact body designs and high productivity. Sales of consumables remained at the same level as the previous year. These factors resulted in total sales for the business unit of ¥1,807,301 million, a year-on-year increase of 0.1%, while income before income taxes increased by 17.3% year on year to ¥229,187 million partly due to im- pairment loss on goodwill during the previous year. Within the Imaging System Business Unit, although unit sales of interchangeable-lens digital cameras decreased over- all compared with the previous year due to shrinking market, Canon maintained the top share of the overall interchangeable- lens digital cameras market, mainly in key countries in Europe and the Americas as well as in Japan and China. In mirrorless cameras, sales were strong for such new models as the EOS R, Canon’s first mirrorless camera equipped with a full-frame sensor, and the entry-class EOS Kiss M. As for digital compact cameras, although unit sales decreased compared with the previous year amid the shrinking market, sales of such high- value-added models as the PowerShot G-series enjoyed solid demand. For inkjet printers, unit sales of refillable ink tank mod- els increased significantly in emerging markets. However, unit sales decreased overall compared with the previous year, mainly due to the shrinking market in developed economies. For large format inkjet printers, the imagePROGRAF TX series, which is suitable for outputting CAD drawings and poster designs, gar- nered high praise from the market and enjoyed solid sales. As a result, sales for the business unit decreased by 11.3% year on year to ¥1,008,165 million, while income before income taxes decreased by 31.1% year on year to ¥121,254 million. Within the Medical System Business Unit, sales increased due to such newly launched products as the Alphenix-series of next- generation diagnostic X-ray systems and the Vantage Orian, a high-image-quality MRI system incorporating leading-edge tech- nology. As a result, sales for the business unit increased by 0.3% year on year to ¥437,578 million, while income before income taxes increased by 31.0% year on year to ¥29,479 million. In the Industry and Others Business Unit, unit sales of semiconductor lithography equipment increased from the previous year due to increasing demand for memory devices used in data centers. However, for FPD lithography equipment and OLED panel manufacturing equipment, sales decreased compared with the previous year mainly due to a temporary slowdown in investment in OLED panels. As for network cam- eras, Axis enjoyed solid sales amid increasing market demand. Consequently, sales for the business unit increased by 1.6% year on year to ¥805,211 million, while income before income taxes increased by 60.7% year on year to ¥67,607 million. Intersegment sales of ¥106,318 million are eliminated from total sales for the four segments, and are described as “Eliminations”. 40 CANON ANNUAL REPORT 2018 SALES BY SEGMENT Office Imaging System Medical System Industry and Others Eliminations Total SALES BY GEOGRAPHIC AREA Japan Americas Europe Asia and Oceania Total Millions of yen 2018 change 2017 change 2016 1,807,301 +0.1% 1,804,782 +3.4% 1,745,996 1,008,165 -11.3% 1,136,188 +3.7% 1,095,289 437,578 805,211 (106,318) +0.3% +1.6% — 436,187 792,850 (89,992) — +22.6% — — 646,483 (86,281) 3,951,937 -3.1% 4,080,015 +19.9% 3,401,487 Millions of yen 2018 869,577 1,076,402 1,015,428 990,530 change -1.7% -2.8% -1.3% -6.5% 2017 change 2016 884,828 +25.2% 1,107,515 +14.9% 1,028,415 +12.6% 1,059,257 +29.6% 706,979 963,544 913,523 817,441 3,951,937 -3.1% 4,080,015 +19.9% 3,401,487 Note: This summary of net sales by geographic area is determined by the location where the product is shipped to the customers. Sales by geographic area Please refer to the table of sales by geographic area in Note 22 of the Notes to Consolidated Financial Statements. In Japan, net sales decreased by 1.7% from the previous year mainly owing to the decline in sales of interchangeable- lens digital cameras and compact digital cameras. In Americas, despite solid sales of network cameras, net sales decreased by 2.8% from the previous year mainly owing to the negative effect of the yen’s appreciation and the decline in sales of interchangeable-lens digital cameras and compact digital cameras. In Europe, net sales decreased by 1.3% from the previous year mainly owing to the decline in sales of interchangeable- lens digital cameras and compact digital cameras. In Asia and Oceania, net sales decreased by 6.5% from the previous year mainly owing to the decline in sales of interchangeable-lens digital cameras, compact digital cameras, manufacturing equipment for OLED panels which is sold by Canon Tokki, and manufacturing equipment for FPD. Income before income taxes by segment Please refer to the table of segment information in Note 22 of the Notes to Consolidated Financial Statements. Income before income taxes for the Office Business Unit in 2018 increased by 17.3% from the previous year to ¥229,187 million, as impairment loss on goodwill incurred during the previous year. Income before income taxes for the Imaging System Business Unit in 2018 decreased by 31.1% from the previ- ous year to ¥121,254 million, owing to shrinking market for interchangeable-lens digital cameras. Income before income taxes for the Medical System Business Unit in 2018 increased by 31.0% from the previous year to ¥29,479 million, mainly due to cost reduction and favorable sales of diagnostic X-ray systems and MRI systems. Income before income taxes for the Industry and Others Business Unit in 2018 increased by 60.7% from the previous year to ¥67,607 million, thanks to strong sales of semiconduc- tor lithography equipment and network cameras. FOREIGN OPERATIONS AND FOREIGN CURRENCY TRANSACTIONS Canon’s marketing activities are performed by subsidiaries in various regions in local currencies, while the cost of sales is generally in yen. Given Canon’s current operating structure, appreciation of the yen has a negative impact on net sales and the gross profit ratio. To reduce the financial risks from changes in foreign exchange rates, Canon utilizes derivative financial instruments, which consist principally of forward cur- rency exchange contracts. The operating profit on foreign operation sales is usually lower than that from domestic operations because foreign operations consist mainly of marketing activities. Marketing activities are generally less profitable than production activities, which are mainly conducted by the Company and its domestic subsidiaries. Please refer to the table of geographic information in Note 22 of the Notes to Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents decreased by ¥201,169 million to ¥520,645 million in fiscal 2018 compared to the previ- ous year. Canon’s cash and cash equivalents are primarily CANON ANNUAL REPORT 2018 41 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA FINANCIAL OVERVIEW denominated in Japanese yen and in U.S. dollars, with the remainder denominated in other currencies. ¥136,094 million. The Company paid dividends in fiscal 2018 of ¥160.00 per share. Net cash provided by operating activities decreased by ¥225,264 million to ¥365,293 million in fiscal 2018 compared to the previous year due to increase of capital used for opera- tions and income tax paid. The major component of Canon’s cash inflow is cash received from customers, and the major components of Canon’s cash outflow are payments for parts and materials, selling, general and administrative expenses, R&D expenses and income taxes. For fiscal 2018, cash inflow from cash received from cus- tomers decreased due to sales deterioration. There were no significant changes in Canon’s collection rates. Cash outflow for payments for parts and materials increased due to an increase of inventory level resulting from sales decline. Cash outflow for payments for income taxes increased due to an increase in tax- able income in fiscal 2017. Net cash used in investing activities increased by ¥30,605 mil- Return on Sales (%) lion to ¥195,615 million in fiscal 2018 mainly due to an increase 9 in payment for acquisitions of businesses. Sales by Segment (Billions of yen) Sales by Segment (Billions of yen) 5,000 5,000 5,000 4,000 Canon defines “free cash flow” as cash flows from operating activities less cash flows from investing activities. For fiscal 2018, free cash flow decreased by ¥255,869 million to ¥169,678 mil- 6 lion as compared with ¥425,547 million for fiscal 2017. Note: “Free cash flow” is non-GAAP measure. Refer to “Non-GAAP Financial 3,000 3,000 4,000 4,000 3,000 To the extent Canon relies on external funding for its liquid- ity and capital requirements, it generally has access to various funding sources, including the issuance of additional share capital, issuance of corporate bond or loans. While Canon has been able to obtain funding from its traditional financing sources and from the capital markets, and believes it will con- tinue to be able to do so in the future, there can be no assur- ance that adverse economic or other conditions will not affect Canon’s liquidity or long-term funding in the future. Short-term loans (including the current portion of long-term debt) decreased by ¥801 million to ¥38,527 million at December 31, 2018 compared with ¥39,328 million at December 31, 2017. Long-term debt (excluding the current portion) decreased by ¥131,276 million to ¥361,962 million at December 31, 2018 compared with ¥493,238 million at December 31, 2017 thanks to the repayment for long-term loans. Sales by Segment (Billions of yen) Sales by Geographic Area (Billions of yen) Canon’s long-term debt mainly consists of bank borrowings and lease obligations. 5,000 5,000 In order to facilitate access to global capital markets, Canon 4,000 obtains credit ratings from two rating agencies: Moody’s Investors Services, Inc. (“Moody’s”) and Standard and Poor’s Ratings Services (“S&P”). In addition, Canon maintains a rating from Rating and Investment Information, Inc. (“R&I”), a rating agency in Japan, for access to the Japanese capital market. 3,000 3,000 4,000 3 0 1,000 2,000 2,000 1,000 2,000 1,000 2018 Measures” section for the explanation and the reconciliation to the reported GAAP measure. 2,000 Office Business Unit As of February 28, 2019, Canon’s debt ratings are: Moody’s: Imaging System Business Unit Canon’s management places importance on cash flow man- Aa3 (long-term); S&P: AA- (long-term), A-1+ (short-term); and Medical System agement and frequently monitors this indicator. Furthermore, R&I: AA+ (long-term). Canon does not have any rating down- Business Unit Canon’s management believes that this indicator is significant in grade triggers that would accelerate the maturity of a material Industry and Others 0 Business Unit 0 understanding Canon’s current liquidity and the alternatives of amount of its debt. A downgrade in Canon’s credit ratings or Eliminations 2016 2016 2014 2018 2018 2017 use in financing activities because it takes into consideration its outlook could, however, increase the cost of its borrowings. operating and investing activities and believes that such indica- Canon’s management policy in recent periods to optimize tor is beneficial to an investor’s understanding. Canon refers to inventory levels is intended to maintain an appropriate balance this indicator together with relevant U.S. GAAP financial mea- among relevant imperatives, including minimizing working sures shown in its consolidated statements of cash flows and capital, avoiding undue exposure to the risk of inventory ob- consolidated balance sheets for cash availability analysis. solescence, and maintaining the ability to sustain sales despite the occurrence of unexpected disasters. Office Business Unit Imaging System Business Unit 1,000 Medical System Business Unit Industry and Others Business Unit Eliminations Office Business Unit Imaging System Business Unit 1,000 Medical System Business Unit Industry and Others Business Unit Eliminations 0 2017 0 2017 2014 2018 2018 2016 2014 2015 2015 2014 2014 2017 2017 2016 2015 2014 2015 2017 2018 2016 2015 2,000 0 Net cash used in financing activities totaled ¥354,830 mil- lion in fiscal 2018, mainly resulting from the dividend payout of ¥178,159 million, the repayment for long-term loans of Canon’s total inventory turnover ratios were 56, 49, and 59 days at the end of the fiscal years 2018, 2017, and 2016, Sales by Geographic Area (Billions of yen) 1,000 Japan Americas Europe Asia and Oceania 0 Japan Americas Europe Japan Americas Europe Asia and Oceania Asia and Oceania 2015 2016 2017 2018 2014 2015 2016 2017 2018 Sales by Geographic Area (Billions of yen) 5,000 4,000 3,000 2,000 12 9 6 3 0 Increase in Property, Plant and Equipment (Billions of yen) Increase in Property, Plant and Equipment (Billions of yen) 3.0 Working Capital Ratio 300 200 100 2.5 2.0 1.5 1.0 0.5 Working Capital Ratio Working Capital Ratio Return on Canon Inc. Shareholders’ Equity (%) Return on Canon Inc. Shareholders’ Equity (%) Return on Canon Inc. Shareholders’ Equity (%) 3.0 2.5 2.0 1.5 1.0 0.5 3.0 2.5 2.0 1.5 1.0 0.5 12 9 6 3 12 9 6 3 2014 2015 2016 2017 2018 2014 2015 2016 0 2017 2018 2014 2015 0 2016 2017 2014 2018 2015 2016 0 2017 2018 2014 2015 2016 0 2017 2018 2014 2015 0 2016 2014 2017 2015 2018 2016 0 2017 2018 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 R&D Expenses (Billions of yen) R&D Expenses (Billions of yen) R&D Expenses (Billions of yen) Common Stock Price Range (Tokyo Stock Exchange) (Yen) Common Stock Price Range (Tokyo Stock Exchange) (Yen) Common Stock Price Range (Tokyo Stock Exchange) (Yen) 42 400 300 200 100 0 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 2009 2010 2011 2012 2009 2013 2010 2014 2011 2015 2012 2009 2016 2013 2010 2017 2014 2011 2018 2015 2012 2016 2013 2017 2014 2018 2015 2016 2017 2018 Return on Sales (%) Return on Sales (%) 2014 2015 2016 2017 2018 2014 2015 2016 Increase in Property, Plant and Equipment (Billions of yen) 9 6 3 0 300 200 100 0 400 300 200 100 0 9 6 3 0 300 200 100 0 400 300 200 100 0 CANON ANNUAL REPORT 2018 respectively. The inventory turnover in 2018 was reflecting the foregoing circumstances. The inventory turnover in 2016 was primarily impacted by acquisition of CMSC on December 19, 2016. If this factor were excluded, the inventory turnover would show 50 days. Increase in property, plant and equipment on an accrual basis in 2018 amounted to ¥159,316 million compared with ¥147,542 million in 2017 and ¥171,597 million in 2016. For 2019, Canon projects its increase in property, plant and equip- ment will be approximately ¥175,000 million. Employer contributions to Canon’s worldwide defined benefit pension plans were ¥35,044 million in 2018, ¥50,628 million in 2017 and ¥14,575 million in 2016. Employer contributions to Canon’s worldwide defined contribution pension plans were ¥19,570 million in 2018, ¥18,979 million in 2017, and ¥17,603 million in 2016. In addition, employer contributions to the mul- tiemployer pension plan of certain subsidiaries were ¥4,452 mil- lion in 2018, ¥4,165 million in 2017 and ¥3,482 million in 2016. Working capital in 2018 decreased by ¥102,642 million to ¥1,020,527 million, compared with ¥1,123,169 million in 2017 and ¥1,116,379 million in 2016. Canon believes its working capital will be sufficient for its requirements for the foreseeable future. Canon’s capital requirements are primar- ily dependent on management’s business plans regarding the levels and timing of purchases of fixed assets and investments. The working capital ratio (ratio of current assets to current liabilities) for 2018 was 1.99 compared to 2.01 for 2017 and to 2.14 for 2016. Return on assets (net income attributable to Canon Inc. divided by the average of total assets) was 5.0% in 2018, compared to 4.7% in 2017 and 3.1% in 2016. Return on Canon Inc. shareholders’ equity (net income at- tributable to Canon Inc. divided by the average of total Canon Inc. shareholders’ equity) was 8.9% in 2018 compared with 8.6% in 2017 and 5.2% in 2016. The debt to total assets ratios were 8.2%, 10.2% and 11.9% as of December 31, 2018, 2017 and 2016, respec- tively. Canon had short-term loans and long-term debt of ¥400,489 million as of December 31, 2018, ¥532,566 mil- lion as of December 31, 2017 and ¥613,139 million as of December 31, 2016. Non-GAAP Financial Measures We have reported our financial results in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). In ad- dition, we have discussed our results using the combination of two GAAP cash flow measures, Net cash provided by operat- ing activities and Net cash used for investing activities, which we refer to as “Free Cash Flow” which is non-GAAP measure. We believe this measure is beneficial to an investor’s under- standing on Canon’s current liquidity and the alternatives of use in financing activities because it takes into consideration its operating and investing activities. A reconciliation of these non-GAAP financial measures and the most directly comparable measures calculated and pre- sented in accordance with GAAP are set forth on the follow- ing table. FREE CASH FLOW Net cash provided by operating activities Net cash used in investing activities Free cash flow Millions of yen 2018 2017 365,293 (195,615) 590,557 (165,010) 169,678 425,547 OFF-BALANCE SHEET ARRANGEMENTS As part of its ongoing business, Canon does not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Canon provides guarantees for its employees, affiliates and other companies. The guarantees for the employees are principally made for their housing loans. The guarantees for affiliates and other companies are made for their lease obliga- tions and bank loans to ensure that those companies operate with less financial risk. Canon would have to perform under a guarantee if the borrower defaults on a payment within the contract terms. The contract terms are 1 year to 30 years in case of employ- ees with housing loans, and 1 year to 7 years in case of af- filiates and other companies with lease obligations and bank loans. The maximum amount of undiscounted payments Canon would have had to make in the event of default is ¥4,458 million at December 31, 2018. The carrying amounts of the liabilities recognized for Canon’s obligations as a guar- antor under those guarantees at December 31, 2018 were not significant. CANON ANNUAL REPORT 2018 43 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA FINANCIAL OVERVIEW Return on Sales (%) Sales by Segment (Billions of yen) Sales by Geographic Area (Billions of yen) CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS The following summarizes Canon’s contractual obligations at December 31, 2018. 9 6 3 Total Less than 1 year 1-3 years 3-5 years More than 5 years Payments due by period 0 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 360,000 4,602 115,084 — 2,640 29,817 360,000 1,443 41,239 — 509 23,730 — 10 20,298 Millions of yen Contractual obiligations: Long-term debt: Loan from the banks Other debt Operating lease obligations Purchase commitments for: Property, plant and equipment Parts and raw materials Other long-term liabilities: Contribution to defined benefit pension plans Total 54,905 120,344 54,905 120,344 32,400 687,335 32,400 240,106 — — — — — — — — — 402,682 24,239 Increase in Property, Plant and Equipment (Billions of yen) 20,308 Note: The table does not include provisions for uncertain tax positions and related accrued interest and penalties, as the specific timing of future payments related to these obligations cannot be projected with reasonable certainty. See Note 12, Income Taxes in the Notes to Consolidated Financial Statements for further details. Contribution to defined benefit pension plans reflects the expected amount only for the next fiscal year, since contributions beyond the next fiscal year are not currently determinable due to uncertainties related to changes in actuarial assumptions, returns on plan assets and changes to plan membership. 300 Canon provides warranties of generally less than one year against defects in materials and workmanship on most of its consumer products. Estimated product warranty related costs are established at the time revenue are recognized and are included in selling, general and administrative expenses. Estimates for accrued product warranty costs are primarily based on historical experience, and are affected by ongoing product failure rates, specific product class failures outside of the baseline experience, material usage and service delivery costs incurred in correcting a product failure. As of December 31, 2018 accrued product warranty costs amounted to ¥17,318 million. At December 31, 2018, commitments outstanding for the purchase of property, plant and equipment were approxi- mately ¥54,905 million, and commitments outstanding for the purchase of parts and raw materials were approximately ¥120,344 million, both for use in the ordinary course of its business. Canon anticipates that funds needed to fulfill these commitments will be generated internally through operations. During 2019, Canon expects to contribute ¥13,089 million to its Japanese defined benefit pension plans and ¥19,311 mil- lion to its foreign defined benefit pension plans. Canon’s management believes that current financial re- sources, cash generated from operations and Canon’s poten- tial capacity for additional debt and/or equity financing will be sufficient to fund current and future capital requirements. 200 RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES Canon has started its 5-year management plan, the Excellent Global Corporation Plan Phase V (“Phase V”) from the year 2016. In Phase V, our slogan is “Embrace the challenge of new growth through a grand strategic transformation” and there are three key strategies related to R&D: 100 • Establish a new production system to achieve a cost-of- sales ratio of 45%; 0 2018 • Reinforce and expand new businesses while creating 2014 2017 2016 2015 future businesses; and • Enhance R&D capabilities through open innovation. Canon has been striving to implement the three R&D re- lated strategies as follows: • Establish a new production system to achieve a cost-of- sales ratio of 45%: Strengthen domestic mother factories by integrating design, procurement, production engi- neering and manufacturing technology operations while pursuing total cost reduction by advancing production R&D Expenses (Billions of yen) Common Stock Price Range (Tokyo Stock Exchange) (Yen) 400 300 200 100 0 2014 2015 2016 2017 2018 44 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Office Business Unit Imaging System Business Unit Medical System Business Unit Industry and Others Business Unit Eliminations Japan Americas Europe Asia and Oceania Working Capital Ratio Return on Canon Inc. Shareholders’ Equity (%) 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 5,000 4,000 3,000 2,000 1,000 0 12 9 6 3 0 5,000 4,000 3,000 2,000 1,000 0 3.0 2.5 2.0 1.5 1.0 0.5 0 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 CANON ANNUAL REPORT 2018 engineering capabilities with more sophisticated robots and next-generation technologies such as the IoT, big data and artificial intelligence. • Reinforce and expand new businesses while creating future businesses: Create and expand new businesses by accelerating the horizontal expansion of existing busi- ness with the exploration of new application possibility of Canon’s technologies into new fields. Also, invest inten- sively on the R&D of promising businesses areas such as commercial printing, network cameras and life sciences while actively taking advantage of M&A to accelerate the early expansion of these businesses. comprehensive image processing including optical design, me- chanical noise analysis, and thermal air flow analysis. With these simulation systems, Canon has succeeded in further reducing the need for prototypes, lowering costs and shortening product development lead times. Canon believes that new products protected by the robust patent portfolio will not easily allow competitors to compete with them, and will give them an advantage in establishing standards in the market and industry. Canon obtained the third greatest number of patents in the United States in 2018, according to the annual ranking list, released by IFI CLAIMS® Patent Services. • Enhance R&D capabilities through open innovation: Construct a more open R&D system that proactively lever- ages external technologies and knowledge to accelerate and improve efficiency of the R&D. Especially in our fundamental research and development, Canon is promoting joint and contract research with various partners including universi- ties, research institutes, and startups around the world. Canon is currently working on collaborative research with Massachusetts General Hospital and Brigham and Women’s Hospital to develop medical robotics and ultra-miniature endo- scope at the Healthcare Optics Research Laboratory in Boston. Also, CMSC has started collaborative research on Deep Learning Reconstruction in MRI systems, together with Kumamoto University and the University of Bordeaux. Canon has developed simulation systems covering MARKET RISK EXPOSURES Canon is exposed to market risks, including changes in foreign currency exchange rates, interest rates and prices of market- able securities and investments. In order to hedge the risks of changes in foreign currency exchange rates, Canon uses derivative financial instruments. Equity price risk Canon holds marketable securities included in current assets, which consist generally of highly-liquid and low-risk instru- ments. Investments included in noncurrent assets are held as long-term investments. Canon does not hold marketable securities and investments for trading purposes. Maturities and fair values of such marketable securities and investments with original maturities of more than three months were as follows at December 31, 2018. Debt securities Due within one year Fund trusts and others Equity securities Millions of yen Fair value 630 1,038 13,787 15,455 CANON ANNUAL REPORT 2018 45 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA FINANCIAL OVERVIEW Foreign currency exchange rate and interest rate risk Canon operates internationally, exposing it to the risk of changes in foreign currency exchange rates. Derivative finan- cial instruments are comprised principally of foreign currency exchange contracts utilized by the Company and certain of its subsidiaries to reduce the risk. Canon assesses foreign curren- cy exchange rate risk by continually monitoring changes in the exposures and by evaluating hedging opportunities. Canon does not hold or issue derivative financial instruments for trad- ing purposes. Canon is also exposed to credit-related losses in the event of non-performance by counterparties to derivative financial instruments, but it is not expected that any counter- parties will fail to meet their obligations. Most of the counter- parties are internationally recognized financial institutions and selected by Canon taking into account their financial condi- tion, and contracts are diversified across a number of major financial institutions. Canon’s international operations expose Canon to the risk of changes in foreign currency exchange rates. Canon uses foreign exchange contracts to manage certain foreign currency exchange exposures principally from the exchange of U.S. dol- lars and euros into Japanese yen. These contracts are primarily used to hedge the foreign currency exposure of forecasted intercompany sales and intercompany trade receivables which are denominated in foreign currencies. In accordance with Canon’s policy, a specific portion of foreign currency exposure resulting from forecasted intercompany sales are hedged using foreign exchange contracts which principally mature within three months. The following table provides information about Canon’s major derivative financial instruments related to foreign currency ex- change transactions existing at December 31, 2018. All of the foreign exchange contracts described in the following table have a contractual maturity date in 2019. Millions of yen Forwards to sell foreign currencies: Contract amounts Estimated fair value Forwards to buy foreign currencies: Contract amounts Estimated fair value U.S.$ Euro Others Total 108,126 857 101,356 1,235 21,023 513 230,505 2,605 24,025 (158) 2,807 (11) 3,984 (59) 30,816 (228) Canon expects that fair value changes and cash flows result- ing from reasonable near-term changes in interest rates will be immaterial. Accordingly, Canon believes interest rate risk is insignificant. See also Note 9 of the Notes to Consolidated Financial Statements. Changes in the fair value of derivative financial instruments designated as cash flow hedges, including foreign currency exchange contracts associated with forecasted intercompany sales, are reported in accumulated other comprehensive income (loss). These amounts are subsequently reclassified into earnings through other income (deductions) in the same period as the hedged items affect earnings. Substantially all such amounts recorded in accumulated other comprehensive income (loss) at year-end are expected to be recognized in earnings over the next twelve months. Canon excludes the time value component from the assessment of hedge ef- fectiveness. Changes in the fair value of a foreign currency exchange contract for the period between the date that the forecasted intercompany sales occur and its maturity date are recognized in earnings and not considered hedge ineffective- ness. From the quarter beginning January 1, 2019, Canon will adopt ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. After the adoption of this guidance, gains and losses resulting from derivative financial instruments designated as cash flow hedges associated with forecasted intercompany sales, which are currently included in other income (deductions) in the con- solidated statements of income, will be included in net sales. The amount of the hedging ineffectiveness was not material for the years ended December 31, 2018, 2017 and 2016. The amounts of net losses excluded from the assessment of hedge effectiveness (time value component) which was recorded in other income (deductions) were ¥682 million, ¥332 million and ¥311 million for the years ended December 31, 2018, 2017 and 2016, respectively. Canon has entered into certain foreign currency exchange contracts to manage its foreign currency exposures. These foreign currency exchange contracts have not been designated as hedges. Accordingly, the changes in fair values of these contracts are recorded in earnings immediately. LOOKING FORWARD Under the corporate philosophy of kyosei—living and working together for the common good—Canon’s basic management policy is to contribute to the prosperity and well-being of the world while endeavoring to become a truly excellent global corporation targeting continued growth and development. Based on this basic management policy, Canon launched the Excellent Global Corporation Plan in 1996 and, from Phase I through to Phase IV, has worked to strengthen its manage- ment base and improve corporate value. In 2016, under the slogan “Embracing the challenge of new growth through a grand strategic transformation,” Canon embarked on a new five-year initiative: Phase V of the Excellent Global Corporation Plan. Under this plan, Canon aims to facilitate growth through structural transformation by reinforcing existing businesses 46 CANON ANNUAL REPORT 2018 and taking steps to cultivate and strengthen new businesses. The global economy is expected to continue to slow down from the latter half of 2018 and overall, there are concerns of further economic slowdown occurring as a result of intensify- ing trade friction. In the businesses in which Canon is involved, for office MFDs, color models are expected to grow steadily. Overall de- mand for laser printers is expected to remain at the same level as that of the previous year, supported by the trend of shifting from monochrome to color models and increasing demand in emerging markets. For interchangeable-lens digital cam- eras, while demand for interchangeable-lens digital cameras equipped with full-frame sensors is expected to grow steadily, overall demand is expected to decrease. Projections for digi- tal compact cameras indicate continued market contraction, centered mainly on low-priced models. With regard to inkjet printers, demand is expected to continue to decrease slightly from the previous year. As for the medical equipment market, demand is expected to remain firm, mainly outside of Japan, with increasing demand in emerging markets and increased demand for ad- vanced medical care in the United States and Europe. Looking at industrial equipment, as for the semiconductor lithography equipment, while demand for automotive devices is expected to increase, capital investment is expected to slow down for memory devices. For FPD lithography equipment and OLED panel manufacturing equipment, capital investment in small- and medium-size display panels is expected to continue to slow down. As for network cameras, demand is expected to continue expanding for high-spec models and image analysis software due to the growing use of network cameras for a widening range of applications. The Canon Group recognizes the Business Term in 2019 as a year for achieving transformation into an enterprise wielding high productivity on par with other excellent global corporations in every field of business ranging from R&D to production, sales and service, underpinned by a new busi- ness portfolio containing four additional new business areas (commercial printing, network cameras, medical system, and industrial equipment). Accordingly, we will work to address the following key challenges under the theme, “Accelerate Grand Strategic Transformation to achieve fundamental improvements in productivity.” (1) Revitalizing existing businesses • We promote efforts to strengthen development of DANTOTSU products that overwhelm competitors, making extensive use of cloud, AI and IoT technologies. • We will enhance assembly automation by turning out product designs suitable to automation, and promote in- house production of equipment and key parts throughout the Group. • We will make quality and cost improvements by strength- ening procurement functions and collaborating with suppliers, and promote in-house production and standard- ization of parts. (2) Bolstering and expanding new businesses • In commercial printing, our aims involve drawing up comprehensive strategy for all printing-related businesses, building platforms for the commercial printing business centered on Océ, and establishing product structures geared to high-resolution and high-mix, small-lot printing. • With network cameras, we will enhance and upgrade related software, and promote expansion into a wide range of fields beyond crime prevention and disaster monitoring applications. • In the medical field, we will enhance our product strengths and sales capabilities with respect to diagnostic equipment, and will explore possibilities for expanding our business into areas besides diagnostic equipment. • With industrial equipment, we will accelerate development of next-generation OLED panel manufacturing equipment and promote development of new industrial equipment. (3) Reforming R&D operation in anticipation of industrial and social changes • We will take an approach to the theme of development, grouped into the three areas of: 1. initiatives related to enhancing existing businesses, 2. initiatives aiming to commercialize opportunities in the near future, and 3. initiatives over the medium to long term. Accordingly, we will strive to improve development productivity by forming a development framework that is tailored to those three areas of focus. • We will expand and enhance our worldwide research into start-up companies that have substantial potential for growth drawing on their cutting-edge technologies and new business models. Forward looking statements The foregoing discussion and other disclosure in this report contains forward-looking statements that reflect manage- ment’s current views with respect to certain future events and financial performance. Actual results may differ materially from those projected or implied in the forward-looking state- ments. Further, certain forward-looking statements are based upon assumptions of future events that may not prove to be accurate. The following important factors could cause actual results to differ materially from those projected or implied in any forward-looking statements: foreign currency exchange rate fluctuations; the uncertainty of Canon’s ability to imple- ment its plans to localize production and other measures to reduce the impact of foreign currency exchange rate fluctua- tions; uncertainty as to economic conditions in Canon’s major markets; uncertainty of continued demand for Canon’s high- value-added products; Canon’s ability to continue to develop products and to market products that incorporate new tech- nology on a timely basis, are competitively priced, and achieve market acceptance; the possibility of losses resulting from foreign currency transactions designed to reduce financial risks from changes in foreign currency exchange rates; and inven- tory risk due to shifts in market demand. CANON ANNUAL REPORT 2018 47 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA 9 6 3 0 300 200 100 0 400 300 200 100 0 2014 2015 2016 2017 2018 Increase in Property, Plant and Equipment (Billions of yen) 2014 2015 2016 2017 2018 2014 2015 2016 2017 2018 Return on Sales (%) Sales by Segment (Billions of yen) Sales by Geographic Area (Billions of yen) TEN-YEAR FINANCIAL SUMMARY 5,000 4,000 3,000 2,000 1,000 0 Office Business Unit Imaging System Business Unit Medical System Business Unit Industry and Others Business Unit Eliminations 2016 2017 2018 2014 Net sales: 2015 Domestic Overseas Total Percentage of previous year Net income attributable to Canon Inc. Percentage of sales Advertising Research and development expenses Depreciation of property, plant and equipment Increase in property, plant and equipment Working Capital Ratio 3.0 2.5 2.0 Long-term debt, excluding current installments Canon Inc. shareholders’ equity Total assets 1.5 Per share data: 1.0 Net income attributable to Canon Inc. shareholders per share: 0.5 Basic 0 Diluted 2014 Dividend per share Stock price: 2018 2016 2015 2017 High Low 5,000 4,000 3,000 2,000 0 12 9 6 3 0 869,577 3,082,360 3,951,937 96.9% 252,755 6.4% 58,729 315,842 175,771 159,316 361,962 2,827,602 4,899,465 234.09 234.08 160.00 4,395 2,877 1,000 Millions of yen (except per share amounts) 2018 2017 2016 2015 2014 884,828 3,195,187 4,080,015 119.9% 2016 2018 2017 706,979 2,694,508 3,401,487 89.5% 241,923 5.9% 150,650 4.4% Return on Canon Inc. Shareholders’ Equity (%) 61,207 333,371 189,712 147,542 58,707 306,537 199,133 171,597 Japan Americas Europe 2015 Asia and Oceania 714,280 3,085,991 3,800,271 102.0% 220,209 5.8% 80,907 332,678 223,759 195,120 2014 2013 2012 2011 2010 2009 2018 Thousands of U.S. dollars (except per share amounts) 724,317 3,002,935 3,727,252 99.9% 254,797 6.8% 79,765 311,896 213,739 182,343 715,863 3,015,517 3,731,380 107.2% 230,483 6.2% 86,398 307,500 223,158 188,826 720,286 2,759,502 3,479,788 97.8% 694,450 2,862,983 3,557,433 96.0% 695,749 3,011,152 3,706,901 115.5% 224,564 6.5% 83,134 296,281 211,973 270,457 248,630 7.0% 81,232 308,900 210,179 226,869 246,603 6.7% 94,794 317,286 232,327 158,976 702,344 2,506,857 3,209,201 78.4% 131,647 4.1% 78,009 306,128 277,399 216,128 $ 7,834,027 27,769,009 35,603,036 96.9% 2,277,072 6.4% 529,090 2,845,423 1,583,523 1,435,279 493,238 2,870,630 5,198,291 611,289 2,783,129 5,138,529 881 2,966,415 4,427,773 1,148 2,978,184 4,460,618 1,448 2,910,262 4,242,710 2,117 2,598,026 3,955,503 3,368 2,551,132 3,930,727 4,131 2,645,782 3,983,820 4,912 $ 3,260,919 2,688,109 3,847,557 25,473,892 44,139,324 222.88 222.88 160.00 2014 2015 2016 137.95 137.95 150.00 2017 2018 4,472 3,218 3,656 2,780 201.65 201.65 150.00 4,539 3,402 229.03 229.03 150.00 4,045 2,889 200.78 200.78 130.00 4,115 2,913 191.34 191.34 130.00 4,015 2,308 204.49 204.48 120.00 4,280 3,220 199.71 199.70 120.00 4,520 3,205 106.64 106.64 110.00 4,070 2,115 $ 2.11 2.11 1.44 39.59 25.92 Average number of common shares in thousands Number of employees 1,079,753 195,056 1,085,439 197,776 1,092,071 197,673 1,092,018 189,571 1,112,510 191,889 1,147,934 194,151 1,173,648 196,968 1,215,832 198,307 1,234,817 197,386 1,234,482 168,879 R&D Expenses (Billions of yen) Common Stock Price Range (Tokyo Stock Exchange) (Yen) 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 48 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 CANON ANNUAL REPORT 2018 Millions of yen (except per share amounts) 869,577 3,082,360 3,951,937 96.9% 252,755 6.4% 58,729 315,842 175,771 159,316 884,828 3,195,187 4,080,015 119.9% 241,923 5.9% 61,207 333,371 189,712 147,542 706,979 2,694,508 3,401,487 89.5% 150,650 4.4% 58,707 306,537 199,133 171,597 714,280 3,085,991 3,800,271 102.0% 220,209 5.8% 80,907 332,678 223,759 195,120 Net sales: Domestic Overseas Total Percentage of previous year Net income attributable to Canon Inc. Percentage of sales Advertising Research and development expenses Depreciation of property, plant and equipment Increase in property, plant and equipment Long-term debt, excluding current installments Canon Inc. shareholders’ equity Net income attributable to Canon Inc. shareholders per share: Total assets Per share data: Dividend per share Stock price: Basic Diluted High Low 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2018 Thousands of U.S. dollars (except per share amounts) 724,317 3,002,935 3,727,252 99.9% 254,797 6.8% 79,765 311,896 213,739 182,343 715,863 3,015,517 3,731,380 107.2% 230,483 6.2% 86,398 307,500 223,158 188,826 720,286 2,759,502 3,479,788 97.8% 694,450 2,862,983 3,557,433 96.0% 695,749 3,011,152 3,706,901 115.5% 224,564 6.5% 83,134 296,281 211,973 270,457 248,630 7.0% 81,232 308,900 210,179 226,869 246,603 6.7% 94,794 317,286 232,327 158,976 702,344 2,506,857 3,209,201 78.4% 131,647 4.1% 78,009 306,128 277,399 216,128 $ 7,834,027 27,769,009 35,603,036 96.9% 2,277,072 6.4% 529,090 2,845,423 1,583,523 1,435,279 361,962 2,827,602 4,899,465 493,238 2,870,630 5,198,291 611,289 2,783,129 5,138,529 881 2,966,415 4,427,773 1,148 2,978,184 4,460,618 1,448 2,910,262 4,242,710 2,117 2,598,026 3,955,503 3,368 2,551,132 3,930,727 4,131 2,645,782 3,983,820 4,912 2,688,109 3,847,557 $ 3,260,919 25,473,892 44,139,324 234.09 234.08 160.00 4,395 2,877 222.88 222.88 160.00 4,472 3,218 137.95 137.95 150.00 3,656 2,780 201.65 201.65 150.00 4,539 3,402 229.03 229.03 150.00 4,045 2,889 200.78 200.78 130.00 4,115 2,913 191.34 191.34 130.00 4,015 2,308 204.49 204.48 120.00 4,280 3,220 199.71 199.70 120.00 4,520 3,205 106.64 106.64 110.00 4,070 2,115 $ 2.11 2.11 1.44 39.59 25.92 Average number of common shares in thousands Number of employees 1,079,753 195,056 1,085,439 197,776 1,092,071 197,673 1,092,018 189,571 1,112,510 191,889 1,147,934 194,151 1,173,648 196,968 1,215,832 198,307 1,234,817 197,386 1,234,482 168,879 Notes: 1. U.S. dollar amounts are translated from yen at the rate of U.S.$1 = JPY111, the approximate exchange rate on the Tokyo Foreign Exchange Market as of December 28, 2018. 2. Canon adopted ASU No. 2017-07 from the quarter beginning January 1, 2018. The adoption of the new presentation requirement of the service cost component and the other components of net benefit cost resulted in reclassification from cost of sales, and selling, general and administrative expenses, and research and development expenses into other income (deductions) for the years ended December 31 from 2017 to 2009 respectively. CANON ANNUAL REPORT 2018 49 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA CONS OLI DATE D B AL ANCE SHEE T S Canon Inc. and Subsidiaries December 31, 2018 and 2017 ASSETS Current assets: Cash and cash equivalents (Note 1) Short-term investments (Note 2) Trade receivables, net (Notes 3 and 15) Inventories (Notes 4 and 15) Prepaid expenses and other current assets (Notes 6, 15 and 18) Total current assets Noncurrent receivables (Note 19) Investments (Note 2) Property, plant and equipment, net (Notes 5 and 6) Intangible assets, net (Notes 7 and 8) Goodwill (Notes 7 and 8) Other assets (Notes 6, 11 and 12) Total assets LIABILITIES AND EQUITY Current liabilities: Short-term loans and current portion of long-term debt (Note 9) Trade payables (Note 10) Accrued income taxes (Note 12) Accrued expenses (Notes 11, 15 and 19) Other current liabilities (Notes 5, 15 and 18) Total current liabilities Long-term debt, excluding current installments (Notes 9 and 20) Accrued pension and severance cost (Note 11) Other noncurrent liabilities (Note 12) Total liabilities Commitments and contingent liabilities (Note 19) Equity: Canon Inc. shareholders’ equity: Common stock Authorized 3,000,000,000 shares; issued 1,333,763,464 shares in 2018 and 2017 Additional paid-in capital Legal reserve (Note 13) Retained earnings (Note 13) Accumulated other comprehensive income (loss) (Note 14) Treasury stock, at cost; 254,013,641shares in 2018 and 254,007,681shares in 2017 Total Canon Inc. shareholders’ equity Noncontrolling interests Total equity Total liabilities and equity See accompanying Notes to Consolidated Financial Statements. 50 Millions of yen 2018 2017 520,645 956 612,953 611,281 304,346 2,050,181 18,230 42,556 1,090,992 391,021 908,511 397,974 721,814 1,965 650,872 570,033 287,965 2,232,649 35,444 48,320 1,126,620 420,972 936,722 397,564 4,899,465 5,198,291 38,527 352,489 41,264 321,137 276,237 1,029,654 361,962 382,789 107,147 39,328 380,654 77,501 330,188 281,809 1,109,480 493,238 365,582 133,816 1,881,552 2,102,116 174,762 404,389 67,116 3,508,908 (269,071) (1,058,502) 2,827,602 190,311 174,762 401,386 66,879 3,429,312 (143,228) (1,058,481) 2,870,630 225,545 3,017,913 3,096,175 4,899,465 5,198,291 CANON ANNUAL REPORT 2018 CONS OLI DATE D S TAT EMENTS O F I N C O M E Canon Inc. and Subsidiaries Years ended December 31, 2018, 2017 and 2016 Net sales (Note 15) Products and Equipment Services Cost of sales (Notes 5, 8, 11, 15 and 19) Products and Equipment Services Gross profit Operating expenses (Notes 1, 5, 8, 11, 15, 16, 19 and 21): Selling, general and administrative expenses Research and development expenses Impairment losses on goodwill Operating profit Other income (deductions): Interest and dividend income Interest expense Other, net (Notes 1, 2, 11, 14 and 18) Income before income taxes Income taxes (Note 12) Consolidated net income Less: Net income attributable to noncontrolling interests Net income attributable to Canon Inc. Net income attributable to Canon Inc. shareholders per share (Note 17): Basic Diluted Cash dividends per share See accompanying Notes to Consolidated Financial Statements. Millions of yen 2018 2017 2016 3,194,724 757,213 3,951,937 3,521,156 558,859 4,080,015 2,986,188 415,299 3,401,487 1,762,171 354,212 2,116,383 1,835,554 1,176,760 315,842 — 1,492,602 342,952 1,875,581 213,880 2,089,461 1,990,554 1,301,666 333,371 33,912 1,668,949 321,605 1,574,679 154,810 1,729,489 1,671,998 1,149,036 306,537 — 1,455,573 216,425 6,604 (797) 14,133 19,940 362,892 96,150 266,742 13,987 252,755 234.09 234.08 160.00 6,012 (818) 27,085 32,279 353,884 98,024 255,860 13,937 241,923 Yen 222.88 222.88 160.00 4,762 (1,061) 24,525 28,226 244,651 82,681 161,970 11,320 150,650 137.95 137.95 150.00 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Canon Inc. and Subsidiaries Years ended December 31, 2018, 2017 and 2016 Consolidated net income Other comprehensive income (loss), net of tax (Note 14): Foreign currency translation adjustments Net unrealized gains and losses on securities Net gains and losses on derivative instruments Pension liability adjustments Comprehensive income (loss) Less: Comprehensive income attributable to noncontrolling interests Comprehensive income (loss) attributable to Canon Inc. See accompanying Notes to Consolidated Financial Statements. 2018 266,742 (93,146) (141) 488 (30,570) (123,369) 143,373 6,918 136,455 Millions of yen 2017 255,860 47,090 (9,362) 2,588 21,207 61,523 317,383 18,807 298,576 2016 161,970 (107,666) 997 (2,948) (70,355) (179,972) (18,002) 1,745 (19,747) CANON ANNUAL REPORT 2018 51 CONS OLI DATE D S TAT EMENTS O F E Q U I TY Canon Inc. and Subsidiaries Years ended December 31, 2018, 2017 and 2016 Common stock Additional paid-in capital Legal reserve Retained earnings Millions of yen Accumulated other comprehensive income (loss) Total Canon Inc. shareholders’ equity Non- controlling interests Treasury stock Total equity Balance at December 31, 2015 174,762 401,358 65,289 3,365,158 (29,742) (1,010,410) 2,966,415 218,048 3,184,463 Equity transactions with noncontrolling interests and other Dividends to Canon Inc. shareholders Dividends to noncontrolling interests Acquisition of subsidiaries Transfer to legal reserve Comprehensive income: Net income Other comprehensive income (loss), net of tax (Note 14): Foreign currency translation adjustments Net unrealized gains and losses on securities Net gains and losses on derivative instruments Pension liability adjustments Total comprehensive income (loss) Repurchases and reissuance of treasury stock 27 258 (163,810) 1,269 (1,269) 285 (163,810) — (5,270) (4,077) 1,047 (4,985) (163,810) (4,077) 1,047 — 150,650 150,650 11,320 161,970 (101,257) (101,257) (6,409) (107,666) 1,196 (2,924) (67,412) 1,196 (199) 997 (2,924) (67,412) (19,747) (24) (2,943) (2,948) (70,355) 1,745 (18,002) (1) (13) (14) (14) Balance at December 31, 2016 174,762 401,385 66,558 3,350,728 (199,881) (1,010,423) 2,783,129 211,493 2,994,622 Equity transactions with noncontrolling interests and other Dividends to Canon Inc. shareholders Dividends to noncontrolling interests Acquisition of subsidiaries Transfer to legal reserve Comprehensive income: Net income Other comprehensive income (loss), net of tax (Note 14): Foreign currency translation adjustments Net unrealized gains and losses on securities Net gains and losses on derivative instruments Pension liability adjustments Total comprehensive income (loss) Repurchases of treasury stock Reissuance of treasury stock 1 (162,887) 321 (321) 1 (162,887) — (1) (4,814) 60 — (162,887) (4,814) 60 — 241,923 241,923 13,937 255,860 44,168 (9,767) 2,562 19,690 44,168 2,922 47,090 (9,767) 405 (9,362) 2,562 19,690 26 1,517 2,588 21,207 298,576 18,807 317,383 (131) (50,036) 1,978 (50,036) 1,847 (50,036) 1,847 Balance at December 31, 2017 174,762 401,386 66,879 3,429,312 (143,228) (1,058,481) 2,870,630 225,545 3,096,175 Cumulative effects of accounting standard update—adoption of ASU No.2014-09 Cumulative effects of accounting standard update—adoption of ASU No. 2016-01 Equity transactions with noncontrolling interests and other Dividends to Canon Inc. shareholders Dividends to noncontrolling interests Transfers to legal reserve Comprehensive income: Net income Other comprehensive income (loss), net of tax (Note 14): Foreign currency translation adjustments Net unrealized gains and losses on securities Net gains and losses on derivative instruments Pension liability adjustments Total comprehensive income (loss) Repurchases of treasury stock Reissuance of treasury stock (106) 5,343 (5,343) 3,003 (4,200) (178,159) 237 (237) (106) — (76) — (182) — (1,197) (178,159) — (36,518) (5,558) (37,715) (178,159) (5,558) — 252,755 252,755 13,987 266,742 (89,823) (141) 488 (26,824) (89,823) (3,323) (93,146) (141) — (141) 488 (26,824) — (3,746) 488 (30,570) 136,455 6,918 143,373 0 (25) 4 (25) 4 (25) 4 Balance at December 31, 2018 174,762 404,389 67,116 3,508,908 (269,071) (1,058,502) 2,827,602 190,311 3,017,913 See accompanying Notes to Consolidated Financial Statements. 52 CANON ANNUAL REPORT 2018 CONS OLI DATE D S TAT EMENTS O F C A S H FL O WS Canon Inc. and Subsidiaries Years ended December 31, 2018, 2017 and 2016 Cash flows from operating activities: Consolidated net income Adjustments to reconcile consolidated net income to net cash provided by operating activities: Depreciation and amortization Loss on disposal of fixed assets Equity in earnings of affiliated companies Impairment losses on goodwill (Notes 8 and 21) Gain on securities contributed to retirement benefit trust (Note 2) Deferred income taxes (Increase) decrease in trade receivables (Increase) decrease in inventories Increase (decrease) in trade payables Increase (decrease) in accrued income taxes Increase (decrease) in accrued expenses Increase (decrease) in accrued (prepaid) pension and severance cost Other, net (Note 6) Net cash provided by operating activities Cash flows from investing activities: Purchases of fixed assets (Note 5) Proceeds from sale of fixed assets (Note 5) Purchases of securities Proceeds from sale and maturity of securities Decrease in time deposits, net Acquisitions of businesses, net of cash acquired (Note 7) Other, net Net cash used in investing activities Cash flows from financing activities: Proceeds from issuance of long-term debt (Note 9) Repayments of long-term debt (Note 9) Increase (decrease) in short-term loans, net (Note 9) Transactions with noncontrolling interests Dividends paid Repurchases and reissuance of treasury stock Other, net Millions of yen 2018 2017 2016 266,742 255,860 161,970 251,554 5,726 (1,414) — — (11,849) (17,724) (61,755) (31,212) (35,284) 2,541 (17,738) 15,706 365,293 (191,399) 9,634 (2,311) 1,615 401 (13,346) (209) 261,881 6,935 (1,196) 33,912 (17,836) (17,603) 3,563 2,967 4,951 46,296 18,503 522 (8,198) 590,557 (189,484) 26,444 (2,220) 970 3,373 (6,557) 2,464 250,096 5,203 (890) — — 7,188 (4,155) 6,156 56,844 (16,456) (5,256) 5,489 34,094 500,283 (206,971) 6,177 (84) 1,181 15,414 (649,570) (3,272) (195,615) (165,010) (837,125) 439 (136,094) 2,501 (37,942) (178,159) (21) (5,554) 1,570 (126,578) 5,628 — (162,887) (50,034) (8,163) 610,552 (856) (80,580) (4,993) (163,810) (14) (4,607) Net cash provided by (used in) financing activities (354,830) (340,464) 355,692 Effect of exchange rate changes on cash and cash equivalents Net change in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year (16,017) (201,169) 721,814 520,645 6,538 91,621 (22,270) (3,420) 630,193 633,613 721,814 630,193 Supplemental disclosure for cash flow information: Cash paid during the year for: Interest Income taxes See accompanying Notes to Consolidated Financial Statements. 749 131,616 1,026 71,473 738 76,714 CANON ANNUAL REPORT 2018 53 NOTES T O CONSOL ID ATED F INA N C I A L STATE ME N T S Canon Inc. and Subsidiaries 1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES (a) Description of Business Canon Inc. (the “Company”) and subsidiaries (collectively “Canon”) is one of the world’s leading manufacturers in such fields as office products, imaging system products, medical system products and industry and other products. Office prod- ucts consist mainly of office multifunction devices (“MFDs”), laser multifunction printers (“MFPs”), laser printers, digital continuous feed presses, digital sheet-fed presses, wide-format printers and document solutions. Imaging system products consist mainly of interchangeable-lens digital cameras, digital compact cameras, digital camcorders, digital cinema cameras, interchangeable lenses, compact photo printers, inkjet print- ers, large format inkjet printers, commercial photo printers, image scanners, multimedia projectors, broadcast equipment and calculators. Medical system products consist mainly of digital radiography systems, diagnostic X-ray systems, comput- ed tomography (“CT”) systems, magnetic resonance imaging (“MRI”) systems, diagnostic ultrasound systems, clinical chem- istry analyzers and ophthalmic equipment. Industry and other products consist mainly of semiconductor lithography equip- ment, FPD (Flat panel display) lithography equipment, vacuum thin-film deposition equipment, organic LED (“OLED”) panel manufacturing equipment, die bonders, micromotors, network cameras, handy terminals and document scanners. Sales are made principally under the Canon brand name, almost entirely through sales subsidiaries. These subsidiaries are responsible for marketing and distribution, and primarily sell to retail deal- ers in their geographic area. Further segment information is described in Note 22. Canon sells laser printers on an OEM basis to HP Inc.; such sales constituted 13.6%, 13.1% and 14.8% of consolidated net sales for the years ended December 31, 2018, 2017 and 2016, respectively, and are included in the Office Business Unit. Canon’s manufacturing operations are conducted primarily at 30 plants in Japan and 18 overseas plants which are located in countries or regions such as the United States, Germany, France, the Netherlands, Taiwan, China, Malaysia, Thailand, Vietnam and Philippines. (b) Basis of Presentation The Company and its domestic subsidiaries maintain their books of account in conformity with financial accounting standards of Japan. Foreign subsidiaries maintain their books of account in conformity with financial accounting standards of the countries of their domicile. Certain adjustments and reclassifications have been incorpo- rated in the accompanying consolidated financial statements to conform with U.S. generally accepted accounting principles (“U.S. GAAP”). These adjustments were not recorded in the statutory books of account. (c) Principles of Consolidation The consolidated financial statements include the accounts of the Company, its majority owned subsidiaries and those variable interest entities where the Company or its consoli- dated subsidiaries are the primary beneficiaries. All significant intercompany balances and transactions have been eliminated. (d) Use of Estimates The preparation of the consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial state- ments and the reported amounts of revenues and expenses during the period. Significant estimates and assumptions are reflected in valuation and disclosure of accounts including: revenue recognition, allowance for doubtful receivables, inven- tories, long-lived assets, goodwill and other intangible assets with indefinite useful lives, environmental liabilities, deferred tax assets, uncertain tax positions and employee retirement and severance benefit obligations. Actual results could differ materially from those estimates. (e) Translation of Foreign Currencies Assets and liabilities of the Company’s subsidiaries located outside Japan with functional currencies other than Japanese yen are translated into Japanese yen at the rates of exchange in effect at the balance sheet date. Income and expense items are translated at the average exchange rates prevailing during the year. Gains and losses resulting from translation of finan- cial statements are excluded from earnings and are reported in other comprehensive income (loss). Gains and losses resulting from foreign currency transac- tions, including foreign exchange contracts, and translation of assets and liabilities denominated in foreign currencies are included in other income (deductions) in the consolidated statements of income. Foreign currency exchange gains and losses were net losses of ¥6,044 million, ¥9,775 million and ¥2 million for the years ended December 31, 2018, 2017 and 2016, respectively. (f) Cash Equivalents All highly liquid investments acquired with original maturities of three months or less are considered to be cash equivalents. Certain debt securities with original maturities of less than three months, classified as available-for-sale securities of ¥70,500 mil- lion at December 31, 2018 and 2017, respectively, are included in cash and cash equivalents in the consolidated balance sheets. (g) Investments Investments consist primarily of time deposits with original maturities of more than three months, debt and equity securi- ties and investments in affiliated companies. Canon classifies investments in debt securities as available- for-sale securities. Canon does not hold any trading securities which are bought and held primarily for the purpose of sale in the near term, or any held-to-maturity securities. Canon 54 CANON ANNUAL REPORT 2018 reports investments with maturities of less than one year as short-term investments. inventories and principally by the first-in, first-out method for overseas inventories. Available-for-sales debt securities and equity securities with readily determinable fair value that are not accounted for under the equity method are recorded at fair value which is determined based on quoted market prices, projected dis- counted cash flows or other valuation techniques as appropri- ate. The changes in fair value are recognized in net income for equity securities and in other comprehensive income for available-for-sales debt securities. Available-for-sale debt securities are regularly reviewed for other-than-temporary declines in the carrying amount based on criteria that include the length of time and the extent to which the market value has been less than cost, the financial condition and near-term prospects of the issuer and Canon’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in market value. For available-for-sale securities for which the declines are deemed to be other-than-temporary and there is no intent to sell, the impairment are separated into the amount related to credit loss, which is recognized in earnings and the amount related to all other factors is recognized in other comprehen- sive income (loss). For available-for-sale securities for which the declines are deemed to be other-than-temporary and there is an intent to sell, the impairments in their entirety are recog- nized in earnings. Canon recognizes an impairment loss to the extent by which the cost basis of the investment exceeds the fair value of the investment. Canon measures non-marketable equity securities without readily determinable fair value at cost, minus impairment, if any, plus or minus changes resulting from observables price changes in orderly transactions for the identical or a similar investment of the same issuer. Realized gains and losses are determined by the average cost method and reflected in earnings. Investments in affiliated companies over which Canon has the ability to exercise significant influence, but does not hold a controlling financial interest, are accounted for by the equity method. (h) Allowance for Doubtful Receivables Allowance for doubtful trade and finance receivables is main- tained for all customers based on a combination of factors, in- cluding aging analysis, macroeconomic conditions and histori- cal experience. An additional reserve for individual accounts is recorded when Canon becomes aware of a customer’s inability to meet its financial obligations, such as in the case of bank- ruptcy filings. If circumstances related to customers change, estimates of the recoverability of receivables would be further adjusted. When all collection options are exhausted including legal recourse, the accounts or portions thereof are deemed to be uncollectable and charged against the allowance. (i) Inventories Inventories are stated at the lower of cost or net realizable value. Cost is determined by the average method for domestic (j) Impairment of Long-Lived Assets Long-lived assets, such as property, plant and equipment, and acquired intangible assets subject to amortization, are re- viewed for impairment whenever events or changes in circum- stances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the asset and the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of the asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the as- set. Assets to be disposed of by sale are reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. (k) Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is calculated principally by the declining-balance method, except for certain assets which are depreciated by the straight- line method over the estimated useful lives of the assets. The depreciation period ranges from 3 years to 60 years for buildings and 1 year to 20 years for machinery and equipment. Assets leased to others under operating leases are stated at cost and depreciated to the estimated residual value of the as- sets by the straight-line method over the lease term, generally from 2 years to 5 years. (l) Goodwill and Other Intangible Assets Goodwill and other intangible assets with indefinite useful lives are not amortized, but are instead tested for impairment annually in the fourth quarter of each year, or more frequently if indicators of potential impairment exist. All goodwill is as- signed to the reporting unit or units that benefit from the syn- ergies arising from each business combination. If the carrying amount assigned to the reporting unit exceeds the fair value of the reporting unit, Canon recognizes an impairment charge in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. Intangible assets with finite useful lives consist primarily of software, trademarks, patents and developed technology, license fees and customer relationships, which are amortized using the straight-line method. The estimated useful lives of software are from 3 years to 7 years, trademarks are 15 years, patents and developed technology are from 7 years to 17 years, license fees are 7 years, and customer relationships are from 11 years to 15 years, respectively. Certain costs incurred in connection with developing or obtaining internal-use soft- ware are capitalized. These costs consist primarily of payments made to third parties and the salaries of employees working on such software development. Costs incurred in connection with developing internal-use software are capitalized at the application development stage. In addition, Canon develops CANON ANNUAL REPORT 2018 55 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS or obtains certain software to be sold where related costs are capitalized after establishment of technological feasibility. (m) Environmental Liabilities Liabilities for environmental remediation and other environ- mental costs are accrued when environmental assessments or remedial efforts are probable and the costs can be reasonably estimated. Such liabilities are adjusted as further information develops or circumstances change. Costs of future obligations are not discounted to their present values. (n) Income Taxes Deferred tax assets and liabilities are recognized for the estimat- ed future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Canon records a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not realizable. Canon recognizes the financial statement effects of tax posi- tions when it is more likely than not, based on the technical merits, that the tax positions will be sustained upon examina- tion by the tax authorities. Benefits from tax positions that meet the more-likely-than-not recognition threshold are measured at the largest amount of benefit that is greater than 50% likely of being realized upon settlement. Interest and penalties accrued related to unrecognized tax benefits are included in income taxes in the consolidated statements of income. (o) Stock-Based Compensation Canon measures stock-based compensation cost at the grant date, based on the fair value of the award, and recognizes the cost on a straight-line basis over the requisite service period, which is the vesting period. (p) Net Income Attributable to Canon Inc. Shareholders per Share Basic net income attributable to Canon Inc. shareholders per share is computed by dividing net income attributable to Canon Inc. by the weighted-average number of common shares outstanding during each year. Diluted net income at- tributable to Canon Inc. shareholders per share includes the effect from potential issuances of common stock based on the assumptions that all stock options were exercised. (q) Revenue Recognition Canon generates revenue principally through the sale of office, imaging system and medical system products, indus- trial equipment, supplies and related services under separate contractual arrangements. Revenue is recognized when, or as, control of promised goods or services transfers to customers in an amount that reflects the consideration to which Canon expects to be entitled in exchange for transferring these goods or services. For further information, please refer to Note 15. (r) Research and Development Costs Research and development costs are expensed as incurred. (s) Advertising Costs Advertising costs are expensed as incurred. Advertising ex- penses were ¥58,729 million, ¥61,207 million and ¥58,707 million for the years ended December 31, 2018, 2017 and 2016, respectively. (t) Shipping and Handling Costs Shipping and handling costs totaled ¥54,844 million, ¥52,953 million and ¥44,296 million for the years ended December 31, 2018, 2017 and 2016, respectively, and are included in selling, general and administrative expenses in the consolidated state- ments of income. (u) Derivative Financial Instruments All derivatives are recognized at fair value and are included in prepaid expenses and other current assets, or other current liabilities in the consolidated balance sheets. Canon uses and designates certain derivatives as a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge). Canon formally documents all relation- ships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. Canon also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in cash flows of hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, Canon discontinues hedge accounting prospectively. Changes in the fair value of a derivative that is designated and qualifies as a cash flow hedge are recorded in other comprehensive income (loss), until earnings are affected by the variability in cash flows of the hedged item. Gains and losses from hedg- ing ineffectiveness are included in other income (deductions). Gains and losses related to the components of hedging instru- ments excluded from the assessment of hedge effectiveness are included in other income (deductions). Canon also uses certain derivative financial instruments which are not designated as hedges. The changes in fair val- ues of these derivative financial instruments are immediately recorded in earnings. Canon classifies cash flows from derivatives as cash flows from operating activities in the consolidated statements of cash flows. (v) Guarantees Canon recognizes, at the inception of a guarantee, a liability for the fair value of the obligation it has undertaken in issu- ing guarantees. 56 CANON ANNUAL REPORT 2018 (w) Recent Accounting Guidance Recently adopted accounting guidance In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606) Section C – Background Information and Basis for Conclusions, which is a new accounting standard related to revenue from contracts with customers, as amended. (Accounting Standards Codification (“ASC”) 606) This stan- dard requires an entity to recognize revenue when promised goods or services are transferred to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Canon adopted this standard from the quarter beginning January 1, 2018 with modified retrospective method of adoption to contracts that were not completed as of the adoption. The cumulative-effects to the retained earnings and the impact on the consolidated result of operations for the year ended December 31, 2018 from the adoption of this standard were not material. For further information, please refer to Note 15. In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which addresses certain aspects of recognition, measurement, presen- tation, and disclosure of financial instruments. This guidance includes the requirement that equity investments that do not re- sult in consolidation and are not accounted for under the equity method be measured at fair value with changes in the fair value recognized in net income. Canon adopted this standard from the quarter beginning January 1, 2018, and Canon recognized a cumulative-effect adjustment to retained earnings of ¥5,343 million as of January 1, 2018 for the unrealized gains, net of tax, on available-for-sale equity securities previously recognized in accumulated other comprehensive income. In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-entity Transfers of Assets other than Inventory, which requires an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. Consequently, the amend- ments in this guidance eliminate the exception for an intra- entity transfer of an asset other than inventory. Two common examples of assets included in the scope of this guidance are intellectual property and property, plant, and equipment. The amendments in this guidance should be applied on a modified retrospective basis through a cumulative effect adjustment directly to retained earnings as of the beginning of the period of adoption. Canon adopted this standard from the quarter beginning January 1, 2018. The adoption of this guidance did not have a material impact on its consolidated results of operation and financial condition. In March 2017, the FASB issued ASU No. 2017-07, Compensation – Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, which requires an entity to disag- gregate the service cost component from the other components of net benefit cost and present it in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other compo- nents of net benefit cost are required to be presented separately from the service cost component, such as in other income (de- ductions) in the income statement. The amendments also allow only the service cost component to be eligible for capitalization (for example, as a cost of internally manufactured inventory). The amendments were to be applied retrospectively for the presentation of the service cost component and the other com- ponents of net benefit cost, and prospectively for the capitaliza- tion of the service cost component of net benefit cost. Canon adopted this guidance from the quarter beginning January 1, 2018. The adoption of the new presentation requirement of the service cost component and the other components of net ben- efit cost resulted in reclassification of ¥2,137 million and ¥1,835 million from cost of sales, ¥4,419 million and ¥4,161 million from selling, general and administrative expenses and ¥3,318 million and ¥6,445 million from research and development expenses into other income (deductions) for the years ended December 31, 2017 and 2016, respectively. Please refer to Note 11 for additional information. The adoption of the capitalization of the service cost component of net benefit cost did not have a material impact on its consolidated results of operations and financial condition. Recently issued accounting guidance not yet adopted In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) Section A – Leases: Amendments to the FASB Accounting Standards Codification, which requires lessees to recognize most leases on their balance sheets but recognize expenses on their income statements in a manner similar to the current guidance. For lessors, the standard modifies the clas- sification criteria and the accounting for sales-type and direct financing leases. FASB also modified the definition of lease. Additionally, the guidance expands qualitative and quantitative disclosures related to lease. The guidance is effective for annual reporting periods beginning after December 15, 2018. Canon applies the guidance from the quarter beginning after January 1, 2019. Canon applies the package of practical expedients that allows us not to reassess whichever any existing contracts at or expired contracts prior to the adoption date are or contain leases, lease classification and whichever initial direct costs quali- fy for capitalization, in addition to short term lease exception. Canon also adopts the transition method which no restatement of comparative periods and no reassessment of land easements not previously accounted for as a lease that exist at or expired prior to the adoption date are required. The right of use assets for operating leases recognized at January 1, 2019 is ¥125,649 million almost same as the lease obligations and are included in noncurrent assets and liabilities in the accompanying consolidat- ed balance sheets. Canon does not expect the adoption of this guidance such as the modification the definition of lease and the changes in lessor accounting to have material impact on its consolidated results of operation. CANON ANNUAL REPORT 2018 57 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, which amends existing guidance to simplify the application of the hedge accounting in certain situations and enable an entity to better portray the economic results of an entity’s risk management activities in its financial statements. This guidance eliminates the require- ment to separately measure and report hedge ineffectiveness, and requires an entity to present the earnings effect of the hedging instrument in the same income statement line item which the earnings effect of the hedged item is reported. The amendments in this guidance should be applied on a modified retrospective basis through a cumulative effect adjustment directly to retained earnings as of the beginning of the period of adoption. This guidance is effective for Canon from the quarter beginning January 1, 2019. Gains and losses resulting from derivative financial instruments designated as cash flow hedges associated with forecasted intercompany sales, which are currently included in other income (deductions) in the con- solidated statements of income, will be included in net sales after the adoption of this guidance. Canon does not expect other material impacts from the adoption on its consolidated results of operation and financial condition. 2. INVESTMENTS The cost, gross unrealized holding gains, gross unrealized holding losses and fair value for available-for-sale debt securities and equity securities included in short-term investments and investments by major security type at December 31, 2018 and 2017 are as follows: December 31 Millions of yen 2018: Current: Corporate bonds Millions of yen 2017: Current: Corporate bonds Noncurrent: Government bonds Corporate bonds Fund trusts* Equity securities* Cost 630 630 Cost 1,222 1,222 305 640 122 10,965 12,032 Gross unrealized holding gains Gross unrealized holding losses Fair value — — — — 630 630 Gross unrealized holding gains Gross unrealized holding losses Fair value — — — 182 2 11,612 11,796 — — 16 — — 1,676 1,692 1,222 1,222 289 822 124 20,901 22,136 * After the adoption of ASU No. 2016-01, equity investments are measured at fair value with changes in the fair value recognized in net income from the quarter beginning January 1, 2018. Maturities of available-for-sale debt securities included in short-term investments in the accompanying consolidated balance sheet are as follows at December 31, 2018: Due within one year Millions of yen Cost 630 630 Fair value 630 630 The unrealized and realized gains and losses related to debt securities were not significant for the years ended December 31, 2018, 2017 and 2016, respectively. 58 CANON ANNUAL REPORT 2018 The unrealized and realized gains and losses related to equity securities for the year ended December 31, 2018 are as follows: Years ended December 31, 2018 Net gains and (losses) recognized during the period on equity securities Less: Net gains and (losses) recognized during the period on equity securities sold during the period Unrealized gains and (losses) recognized during the period on equity securities still held at December 31 Millions of yen (6,092) 675 (6,767) Gross realized gains related to equity securities were ¥18,514 million and ¥750 million for the years ended December 31, 2017 and 2016, respectively. Gross realized losses, including write-downs for impairments that were other- than-temporary, were ¥42 million and ¥1,032 million for the years ended December 31, 2017, 2016, respectively. During the year ended December 31, 2017, Canon contrib- uted certain marketable equity securities, not including those of its subsidiaries and affiliated companies, to an established employee retirement benefit trust, with no cash proceeds there on. The fair value of those securities at the time of contribution was ¥30,473 million. Upon contribution of those available-for-sale securities, the unrealized gains amounting to ¥17,836 million were realized and were included in “Other, net” in the consolidated statements of income. The carrying amount of non-marketable equity securities without readily determinable fair value totaled ¥4,629 million at December 31, 2018. Aggregate cost of non-marketable equity securities accounted for under the cost method totaled ¥3,760 million at December 31, 2017. The impairment or other adjustments resulting from observable price changes recorded during the year ended December 31, 2018 and 2017 were not significant. Time deposits with original maturities of more than three months are ¥326 million and ¥743 million at December 31, 2018 and 2017, respectively, and are included in short-term investments in the accompanying consolidated balance sheets. Investments in affiliated companies accounted for by the equity method amounted to ¥21,312 million and ¥20,496 million at December 31, 2018 and 2017, respectively. Canon’s share of the net earnings in affiliated companies ac- counted for by the equity method, included in other income (deductions), were earnings of ¥1,414 million, ¥1,196 million and ¥890 million for the years ended December 31, 2018, 2017 and 2016 respectively. 3. TRADE RECEIVABLES Trade receivables are summarized as follows: December 31 Notes Accounts Less allowance for doubtful receivables 4. INVENTORIES Inventories are summarized as follows: December 31 Finished goods Work in process Raw materials Millions of yen 2018 29,878 594,552 624,430 (11,477) 612,953 2017 37,077 627,173 664,250 (13,378) 650,872 Millions of yen 2018 393,820 165,003 52,458 611,281 2017 377,632 144,251 48,150 570,033 CANON ANNUAL REPORT 2018 59 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost less accumulated depreciation and are summarized as follows: December 31 Land Buildings Machinery and equipment Construction in progress Less accumulated depreciation Millions of yen 2018 272,443 1,629,927 1,793,499 67,045 3,762,914 (2,671,922) 1,090,992 2017 274,551 1,638,202 1,804,982 46,940 3,764,675 (2,638,055) 1,126,620 Depreciation expenses for the years ended December 31, 2018, 2017 and 2016 were ¥175,771 million, ¥189,712 mil- lion and ¥199,133 million, respectively. Amounts due for purchases of property, plant and equip- ment were ¥32,433 million and ¥23,432 million at December 31, 2018 and 2017, respectively, and are included in other current liabilities in the accompanying consolidated balance sheets. Fixed assets presented in the consolidated statements of cash flows include property, plant and equipment and intangible assets. 6. FINANCE RECEIVABLES AND OPERATING LEASES Finance receivables represent financing leases which consist of sales-type leases and direct-financing leases resulting from the sales of Canon’s and complementary third-party products. These receivables typically have terms ranging from 1 year to 7 years. The components of the finance receivables, which are included in prepaid expenses and other current assets, and other assets in the accompanying consolidated balance sheets, are as follows: December 31 Millions of yen Total minimum lease payments receivable Unguaranteed residual values Executory costs Unearned income Less allowance for credit losses Less current portion The activity in the allowance for credit losses is as follows: Years ended December 31 Balance at beginning of year Charge-offs Provision Translation adjustments and other Balance at end of year 60 2018 351,198 12,661 (2,112) (31,007) 330,740 (2,675) 328,065 (111,629) 216,436 2017 361,686 15,055 (2,216) (32,286) 342,239 (2,681) 339,558 (120,186) 219,372 Millions of yen 2018 2017 2,681 (1,284) 938 340 2,675 2,325 (1,523) 1,436 443 2,681 CANON ANNUAL REPORT 2018 Canon has policies in place to ensure that its products are sold to customers with an appropriate credit history, and con- tinuously monitors its customers’ credit quality based on infor- mation including length of period in arrears, macroeconomic conditions, initiation of legal proceedings against customers and bankruptcy filings. The allowance for credit losses of fi- nance receivables are evaluated collectively based on historical experience of credit losses. An additional reserve for individual accounts is recorded when Canon becomes aware of a cus- tomer’s inability to meet its financial obligations, such as in the case of bankruptcy filings. Finance receivables which are past due or individually evaluated for impairment at December 31, 2018 and 2017 are not significant. The cost of equipment leased to customers under operat- ing leases included in property, plant and equipment, net at December 31, 2018 and 2017 was ¥120,457 million and ¥103,078 million, respectively. Accumulated depreciation on equipment under operating leases at December 31, 2018 and 2017 was ¥82,698 million and ¥78,307 million, respectively. The following is a schedule by year of the future minimum lease payments to be received under financing leases and noncan- celable operating leases at December 31, 2018. Year ending December 31: 2019 2020 2021 2022 2023 Thereafter Millions of yen Financing leases Operating leases 127,068 98,772 66,719 37,181 14,792 6,666 351,198 9,207 6,409 2,917 1,202 317 60 20,112 Canon has a syndication arrangement to sell its entire inter- ests in finance receivables to a third-party financial institution. The transactions under the arrangement are accounted for as sales in accordance with ASC 860 “Transfers and Servicing.” The finance receivables sold and derecognized from its consoli- dated balance sheet was ¥21,909 million during the year end- ed December 31, 2018 and the amount remained uncollected was ¥22,956 million as of December 31, 2018. This amount includes uncollected finance receivables which were sold before 2018. Cash proceeds from the transaction are included in other, net under the cash flow from operating activities in the consolidated statement of cash flows. Canon continues to provide collection and administrative services for the financial institution. The amount associated with the servicing liability measured at fair value was not material as of December 31, 2018. Canon also retains limited recourse obligations which cover credit defaults. The recourse obligation was not material as of December 31, 2018. There were no significant transfers of finance receivables for the years ended December 31, 2017 and 2016. 7. ACQUISITIONS On March 17, 2016, Canon entered into a Shares and Other Securities Transfer Agreement with Toshiba Corporation and acquired the share options for consideration of cash to acquire all the ordinary shares of Toshiba Medical Systems Corporation which was renamed as Canon Medical Systems Corporation (“CMSC”), as of January 4, 2018, which was exercisable upon the clearances of necessary competition regulatory authori- ties. As such clearances were obtained, Canon exercised the share options and acquired all the ordinary shares of CMSC on December 19, 2016. The acquisition date was December 19, 2016 and the purchase price was ¥665,498 million, which approximates the fair value at that date. The acquisition was accounted for using the acquisition method of accounting. Acquisition-related costs were ex- pensed as incurred and were not material. Under Phase V of the Excellent Global Corporation Plan, a five-year initiative that Canon has been implementing since 2016, “embracing the challenge of new growth through a grand strategic transformation” has been set as a basic policy. With regard to “strengthening and growing new businesses, and creating future businesses,” a particularly important strat- egy, Canon intends to develop medical system business within the realm of “safety and security,” as a next-generation pillar of growth. CMSC is one of the leading global companies in the medical equipment industry. Within the field of medical X-ray com- puted tomography systems in particular, CMSC is the over- whelming market share leader in Japan and has been steadily increasing its global market share. By maximizing the com- bination of both companies’ management resources, Canon aims to solidify its business foundation for medical system that can contribute to the world. CANON ANNUAL REPORT 2018 61 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The purchase price allocation was based on estimated fair values of the assets acquired and liabilities assumed at acquisition date. Since the acquisition date of CMSC was near the balance sheet date in 2016, and CMSC is composed of various entities located around the world, the purchase price allocation was preliminary at December 31, 2016. The purchase price allocation was finalized in the fourth quarter of 2017. The certain underlying inputs for inventories and intangible assets have been updated during the measure- ment period. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at acquisition date. Millions of yen Cash and cash equivalents Other current assets Intangible assets Other noncurrent assets Total assets acquired Current liabilities Noncurrent liabilities Total liabilities assumed Noncontrolling interest Net identifiable assets acquired Goodwill Net assets acquired Preliminary 25,301 169,545 227,500 42,975 465,321 199,223 92,231 291,454 1,047 172,820 492,678 665,498 Measurement Period Adjustment — (1,962) 627 — (1,335) (877) (1,049) (1,926) — 591 (591) — Final 25,301 167,583 228,127 42,975 463,986 198,346 91,182 289,528 1,047 173,411 492,087 665,498 Intangible assets acquired, which are subject to amortiza- tion, mainly consist of customer relationships of ¥143,600 million, and patents and developed technology of ¥73,000 million. Canon has estimated the amortization period for the customer relationships, and patents and developed technol- ogy to be 15 years and 10 years, respectively. The weighted average amortization period for all intangible assets is approxi- mately 13 years. Goodwill recorded is attributable primarily to expected synergies from combining operations of CMSC and Canon, such as accelerating entry into new fields, further improve- ment in quality through shared production technology and ex- panding business domains through the enhancement of R&D capabilities. None of the goodwill is expected to be deductible for tax purposes. Canon acquired businesses other than that described above during the years ended December 31, 2018 and 2017 that were not material to its consolidated financial statements. 8. GOODWILL AND OTHER INTANGIBLE ASSETS Intangible assets subject to amortization acquired during the year ended December 31, 2018, including those recorded from businesses acquired, totaled ¥48,004 million, which pri- marily consist of software of ¥36,859 million, and patent and developed technology of ¥6,109 million. The weighted aver- age amortization periods for intangible assets in total acquired during the year ended December 31, 2018 are approximately 6 years. The weighted average amortization periods for soft- ware, and patent and developed technology acquired during the year ended December 31, 2018 are approximately 5 years and 11 years, respectively. Intangible assets subject to amortization acquired during the year ended December 31, 2017, including those recorded from businesses acquired, totaled ¥35,112 million, which primarily consist of software of ¥33,437 million and customer relationships of ¥1,203 million. The weighted average amorti- zation periods for intangible assets in total acquired during the year ended December 31, 2017 are approximately 5 years. The weighted average amortization periods for software and cus- tomer relationships acquired during the year ended December 31, 2017 are approximately 5 years and 8 years, respectively. 62 CANON ANNUAL REPORT 2018 The components of intangible assets subject to amortization at December 31, 2018 and 2017 were as follows: December 31 Millions of yen Software Customer relationships Patents and developed technology Trademarks License fees Other 2018 2017 Gross carrying amount Accumulated amortization Gross carrying amount Accumulated amortization 362,130 156,679 123,831 44,449 16,071 19,319 722,479 244,188 27,263 36,029 12,062 6,461 9,859 335,862 342,322 162,832 121,886 48,823 13,565 18,592 708,020 217,654 22,463 27,085 9,890 6,375 8,136 291,603 Aggregate amortization expense for the years ended December 31, 2018, 2017 and 2016 was ¥75,783 million, ¥72,169 million and ¥50,963 million, respectively. Estimated amortization expense for intangible assets currently held for the next five years ending December 31 is ¥68,730 million in 2019, ¥54,115 million in 2020, ¥46,067 million in 2021, ¥37,158 million in 2022, and ¥31,202 million in 2023. Intangible assets not subject to amortization other than goodwill at December 31, 2018 and 2017 were not significant. For management reporting purposes, goodwill is not al- located to the segments. Goodwill has been allocated to its respective segment for impairment testing. The changes in the carrying amount of goodwill by segment for the years ended December 31, 2018 and 2017 were as follows: Years ended December 31 Millions of yen 2018: Goodwill -gross Accumulated impairment losses Balance at beginning of year Goodwill acquired during the year Translation adjustments and other Goodwill -gross Accumulated impairment losses Balance at end of year Years ended December 31 Millions of yen 2017: Balance at beginning of year*3 Goodwill acquired during the year Transfer*1 Impairment loss*2,3 Translation adjustments and other*3 Balance at end of year Office 135,125 (22,069) 113,056 — (5,966) 127,860 (20,770) 107,090 Office 124,993 857 — (21,721) 8,927 113,056 Imaging System 52,561 — 52,561 — (3,891) 48,670 — 48,670 Imaging System 49,034 236 — — 3,291 52,561 Medical System 499,915 — 499,915 1,521 (540) 500,896 — 500,896 Medical System — — 499,855 — 60 499,915 Industry and Others Unallocated Total 283,577 (12,387) 271,190 6,106 (25,441) 263,513 (11,658) 251,855 Industry and Others 269,719 2,394 (7,177) (12,191) 18,445 271,190 — — — — — — — — 971,178 (34,456) 936,722 7,627 (35,838) 940,939 (32,428) 908,511 Unallocated*1 Total 492,678 — (492,678) — — 936,424 3,487 — (33,912) 30,723 — 936,722 *1 Canon did not complete the allocation of goodwill to the segments for impairment testing which was attributable to the acquisition of CMSC as of December 31, 2016. Based on the realignment of Canon’s internal reporting and management structure, Canon newly established Medical System Business Unit effec- tive at the beginning of the second quarter of 2017. Goodwill related to CMSC as well as goodwill related to certain medical business which was previously included in Industry and Others Business Unit have been transferred to Medical System Business Unit. *2 After entering the commercial printing business through the acquisition of Océ N.V. in 2010, the market environment surrounding this business has become significantly competitive and rapid technological changes have required increasing investments into R&D. These factors resulted in lower operating margin than expected, which led to the decline in the estimated fair value of this business which was determined based on the income approach. As the result of the annual goodwill impairment test as of October 1, 2017, it was determined that the estimated fair value of commercial printing business was less than its carry- ing value of the reporting unit. Based on the accounting policy described in Note 1, Canon recognized an impairment charge of ¥33,912 million representing the excess of the carrying amount over the reporting unit’s fair value. *3 Based on the realignment of Canon’s internal reporting and management structure, from the beginning of the third quarter of 2018, Canon has reclassified certain businesses from Office Business Unit to Industry and Others Business Unit. The goodwill balance at the beginning of the year ended December 31, 2017 has been restated to reflect the transfer of ¥11,263 million in goodwill between the segments. Impairment loss of ¥12,191 million and translation adjustments and other of ¥928 million for the year ended December 31, 2017 related to the reclassified business were restated from Office Business Unit to Industry and Others Business Unit, accordingly. CANON ANNUAL REPORT 2018 63 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. SHORT-TERM LOANS AND LONG-TERM DEBT Short-term loans consisting of bank borrowings at December 31, 2018 and 2017 were ¥35,887 million and ¥33,398 million, respectively. The weighted average interest rate on short-term borrowings outstanding at December 31, 2018 and 2017 were 0.43% and 0.52%, respectively. Long-term debt consisted of the following: December 31 Loan from the banks; bearing interest of 0.07% at December 31, 2018 and 0.06% at December 31, 2017*1 Other debt*2 Less current portion Millions of yen 2018 2017 360,000 4,602 364,602 (2,640) 361,962 490,000 9,168 499,168 (5,930) 493,238 *1 Canon entered into the unsecured revolving credit facility contracts expiring in December 2021. Canon prepaid ¥130,000 million of the loan with cash flows generated during the year ended December 31, 2018. The outstanding loans under the credit facilities are ¥360,000 million at a floating interest of 0.07% and Canon has no unused credit facilities as of December 31, 2018. *2 The other debt consisted of term-loans and capital lease obligations as of December 31, 2018 and 2017. The aggregate annual maturities of long-term debt outstanding at December 31, 2018 were as follows: Year ending December 31: 2019 2020 2021 2022 2023 Thereafter Millions of yen 2,640 638 360,805 427 82 10 364,602 Both short-term and long-term bank loans are primarily made under general agreements which provide that security and guar- antees for present and future indebtedness will be given upon request of the bank, and that the bank shall have the right to offset cash deposits against obligations that have become due or, in the event of default, against all obligations due to the bank. 10. TRADE PAYABLES Trade payables are summarized as follows: December 31 Notes Accounts Millions of yen 2018 68,140 284,349 352,489 2017 81,002 299,652 380,654 11. EMPLOYEE RETIREMENT AND SEVERANCE BENEFITS The Company and certain of its subsidiaries have contribu- tory and noncontributory defined benefit pension plans covering substantially all of their employees. Benefits payable under the plans are based on employee earnings and years of service. The Company and certain of its subsidiaries also have defined contribution pension plans covering substantially all 64 CANON ANNUAL REPORT 2018 of their employees. CMSC temporarily participated in Toshiba Corporate Pension Funds (“Toshiba Funds”) after CMSC was acquired by Canon in 2016. In April 2018, CMSC established a new pension provision which provides participants an equiva- lent level of benefits as compared to the Toshiba Funds. As of December 31, 2018, a majority of plan participants have been transferred from the Toshiba Funds into the new pension provision. Participants who have not transferred are still part of Toshiba Funds as of December 31, 2018. Canon calculated the projected benefit obligations for the participants with Toshiba Funds based on the benefit level of Toshiba Funds and included the proportional share of the plan assets of CMSC to which they have legal right in the following tables. Obligations and funded status Reconciliations of beginning and ending balances of the projected benefit obligations and the fair value of the plan assets are as follows: December 31 Change in benefit obligations: Projected benefit obligations at beginning of year Service cost Interest cost Plan participants’ contributions Actuarial (gain) loss Benefits paid Acquisition Plan amendments Curtailments and settlements Foreign currency exchange rate changes Projected benefit obligations at end of year Change in plan assets: Fair value of plan assets at beginning of year Actual return on plan assets Employer contributions Plan participants’ contributions Benefits paid Acquisition Settlements Foreign currency exchange rate changes Fair value of plan assets at end of year Funded status at end of year Japanese plans Millions of yen Foreign plans Millions of yen 2018 2017 2018 2017 929,630 31,241 5,419 — (1,844) (33,477) — (3,963) — — 927,006 735,513 (38,010) 12,651 — (27,459) — — — 682,695 (244,311) 906,007 30,889 5,689 — 11,112 (29,020) 4,239 1,149 (435) — 929,630 667,436 47,376 43,468 — (23,967) 1,223 (23) — 735,513 (194,117) 423,579 7,982 8,691 1,535 (24,297) (10,135) — 3,257 (1,149) (23,514) 385,949 254,020 (6,042) 22,393 1,535 (10,135) — (1,150) (11,979) 248,642 (137,307) 392,086 6,962 8,691 1,644 (1,760) (7,884) — (1,069) — 24,909 423,579 224,939 14,262 7,160 1,644 (7,884) — — 13,899 254,020 (169,559) Employer contributions for the year ended December 31, 2017 include contribution of equity securities to a retirement benefit trust. The fair value of those securities at the time of contribution was ¥30,473 million. Amounts recognized in the consolidated balance sheets at December 31, 2018 and 2017 are as follows: December 31 Other assets Accrued expenses Accrued pension and severance cost Japanese plans Millions of yen Foreign plans Millions of yen 2018 2017 2018 2017 1,536 (679) (245,168) (244,311) 1,695 — (195,812) (194,117) 1,306 (992) (137,621) (137,307) 1,215 (1,004) (169,770) (169,559) CANON ANNUAL REPORT 2018 65 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Amounts recognized in accumulated other comprehensive income (loss) at December 31, 2018 and 2017 before the effect of income taxes are as follows: December 31 Actuarial loss Prior service credit Japanese plans Millions of yen Foreign plans Millions of yen 2018 2017 2018 2017 267,355 (48,392) 221,106 (57,430) 95,121 (227) 105,883 (3,638) 218,963 163,676 94,894 102,245 The accumulated benefit obligation for all defined benefit plans was as follows: December 31 Accumulated benefit obligation Japanese plans Millions of yen Foreign plans Millions of yen 2018 2017 2018 2017 893,154 894,329 371,653 402,390 The projected benefit obligations and the fair value of plan assets for the pension plans with projected benefit obligations in excess of plan assets, and the accumulated benefit obligations and the fair value of plan assets for the pension plans with accu- mulated benefit obligations in excess of plan assets are as follows: December 31 Plans with projected benefit obligations in excess of plan assets: Projected benefit obligations Fair value of plan assets Plans with accumulated benefit obligations in excess of plan assets: Accumulated benefit obligations Fair value of plan assets Japanese plans Millions of yen Foreign plans Millions of yen 2018 2017 2018 2017 918,736 672,889 924,536 728,724 384,167 245,554 420,383 249,609 891,204 670,826 889,652 728,724 369,215 244,826 394,840 245,247 Components of net periodic benefit cost and other amounts recognized in other comprehensive income (loss) Net periodic benefit cost for Canon’s employee retirement and severance defined benefit plans for the years ended December 31, 2018, 2017 and 2016 consisted of the following components: Years ended December 31 Service cost Interest cost Expected return on plan assets Amortization of prior service credit Amortization of actuarial loss (Gain) loss on curtailments and settlements Japanese plans Millions of yen Foreign plans Millions of yen 2018 2017 2016 2018 2017 2016 31,241 5,419 (21,983) (13,001) 11,900 — 30,889 5,689 (20,493) (12,860) 14,220 (63) 29,367 8,238 (19,443) (13,230) 10,944 — 7,982 8,691 (12,601) (217) 5,108 — 6,962 8,691 (10,722) (83) 5,747 — 6,816 8,792 (10,012) 85 2,185 — 13,576 17,382 15,876 8,963 10,595 7,866 Service cost component of net periodic benefit cost for Canon’s employee retirement and severance defined benefit plans is included in cost of sales and operating expenses in the consolidated statements of income. The components other than the service cost component are included in other, net of other income (deductions) in the consolidated statements of income. 66 CANON ANNUAL REPORT 2018 Other changes in plan assets and benefit obligations recognized in other comprehensive income (loss) for the years ended December 31, 2018, 2017 and 2016 are summarized as follows: Years ended December 31 Current year actuarial (gain) loss Current year prior service credit Amortization of actuarial loss Amortization of prior service credit Curtailments and settlements Japanese plans Millions of yen Foreign plans Millions of yen 2018 2017 2016 2018 2017 2016 58,149 (3,963) (11,900) 13,001 — (15,771) 1,149 (14,220) 12,860 19 53,076 (4,734) (10,944) 13,230 — (5,654) 3,257 (5,108) 217 (63) (5,300) (1,069) (5,747) 83 — 47,365 — (2,185) (85) — 55,287 (15,963) 50,628 (7,351) (12,033) 45,095 The estimated prior service credit and actuarial loss for the defined benefit pension plans that will be amortized from accumu- lated other comprehensive income (loss) into net periodic benefit cost over the next year are summarized as follows: Prior service credit Actuarial loss Japanese plans Foreign plans Millions of yen Millions of yen (11,887) 15,230 (57) 4,852 Assumptions Weighted-average assumptions used to determine benefit obligations are as follows: December 31 Discount rate Assumed rate of increase in future compensation levels Japanese plans Foreign plans 2018 0.6% 2.6% 2017 0.6% 2.6% 2018 2.4% 1.9% 2017 2.2% 1.8% Weighted-average assumptions used to determine net periodic benefit cost are as follows: Years ended December 31 Discount rate Assumed rate of increase in future compensation levels Expected long-term rate of return on plan assets Japanese plans Foreign plans 2018 2017 2016 2018 2017 2016 0.6% 0.7% 1.1% 2.6% 2.6% 3.0% 2.9% 3.1% 3.1% 2.2% 2.2% 3.0% 1.8% 2.1% 2.0% 4.4% 4.2% 4.4% Canon determines the expected long-term rate of return based on the expected long-term return of the various asset categories in which it invests. Canon considers the current expectations for future returns and the actual historical returns of each plan asset category. Plan assets Canon’s investment policies are designed to ensure adequate plan assets are available to provide future payments of pension benefits to eligible participants. Taking into account the expect- ed long-term rate of return on plan assets, Canon formulates a “model” portfolio comprised of the optimal combination of equity securities and debt securities. Plan assets are invested in individual equity and debt securities using the guidelines of the “model” portfolio in order to produce a total return that will match the expected return on a mid-term to long-term basis. Canon evaluates the gap between expected return and actual return of invested plan assets on an annual basis to determine if such differences necessitate a revision in the formulation of the “model” portfolio. Canon revises the “model” portfolio when and to the extent considered necessary to achieve the expected long-term rate of return on plan assets. Canon’s model portfolio for Japanese plans consists of three major components: approximately 25% is invested in equity securities, approximately 50% is invested in debt securities, and approximately 25% is invested in other investment ve- hicles, primarily consisting of investments in life insurance company general accounts. CANON ANNUAL REPORT 2018 67 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Outside Japan, investment policies vary by country, but the long-term investment objectives and strategies remain con- sistent. Canon’s model portfolio for foreign plans has been developed as follows: approximately 35% is invested in equity securities, approximately 25% is invested in debt securities, and approximately 40% is invested in other investment ve- hicles, primarily consisting of investments in real estate assets. The equity securities are selected primarily from stocks that are listed on the securities exchanges. Prior to investing, Canon has investigated the business condition of the investee companies, and appropriately diversified investments by type of industry and other relevant factors. The debt securities are selected primarily from government bonds, public debt instruments, and corporate bonds. Prior to investing, Canon has investigated the quality of the issue, including rating, inter- est rate, and repayment dates, and has appropriately diversified the investments. Pooled funds are selected using strategies consistent with the equity and debt securities described above. As for investments in life insurance company general accounts, the contracts with the insurance companies include a guaran- teed interest rate and return of capital. With respect to invest- ments in foreign investment vehicles, Canon has investigated the stability of the underlying governments and economies, the market characteristics such as settlement systems and the taxa- tion systems. For each such investment, Canon has selected the appropriate investment country and currency. The three levels of input used to measure fair value are more fully described in Note 21. The fair values of Canon’s pension plan assets at December 31, 2018 and 2017, by asset category, are as follows: December 31, 2018 Millions of yen Equity securities: Japanese companies (a) Foreign companies Pooled funds (b) Debt securities: Government bonds (c) Municipal bonds Corporate bonds Pooled funds (d) Mortgage backed securities (and other asset backed securities) Life insurance company general accounts Other assets Investment measured at net asset value Japanese plans Foreign plans Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 Total 67,283 5,451 — — — 137,712 — 137,858 — 1,483 — 12,595 — 140,712 — 67,283 — 5,451 — 137,712 — 137,858 — 1,483 — 12,595 — 140,712 — 8,567 — — — 49,312 — — 2,642 — — 6,318 — 59,419 — — — 8,567 — 49,312 — — 2,642 — — 6,318 — 59,419 — 8,489 — 8,489 — — — — — 123,747 — 30,009 — — 210,592 454,747 1,451 — 123,747 31,460 — 15,905 1,451 682,695 9,019 — — 95,844 — — 8,567 222,554 9,019 — — 95,844 — 17,521 — 248,642 December 31, 2017 Millions of yen Japanese plans Foreign plans Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 Total Equity securities: Japanese companies (e) Foreign companies Pooled funds (f) Debt securities: Government bonds (g) Municipal bonds Corporate bonds Pooled funds (h) Mortgage backed securities (and other asset backed securities) Life insurance company general accounts Other assets Investment measured at net asset value 83,765 8,261 — — — 164,946 — 138,092 — 1,166 — 15,246 — 130,507 — 83,765 — 8,261 — 164,946 — 138,092 — 1,166 — 15,246 — 130,507 — 8,076 — 8,076 — 126,985 — 126,985 — 32,240 — — — 73,968 — 9,343 — 2,901 — 22,045 — 25,821 — — 3 8,683 — 43,070 — — 230,118 489,996 — 43,070 — 15,399 — 735,513 — 73,320 — — 41,583 206,741 — — — 32,240 — 73,968 9,343 — — 2,901 — 22,045 — 25,821 — — 3 8,683 — 73,320 5,696 — — 254,020 68 CANON ANNUAL REPORT 2018 (a) The plan’s equity securities include common stock of the Company and certain of its subsidiaries in the amounts of ¥147 million. (b) These funds invest in listed equity securities consisting of approximately 30% Japanese companies and 70% foreign companies for Japanese plans, and mainly foreign compa- nies for foreign plans. (c) This class includes approximately 90% Japanese govern- ment bonds and 10% foreign government bonds for Japanese plans, and mainly foreign government bonds for foreign plans. (d) These funds invest in approximately 30% Japanese gov- ernment bonds, 50% foreign government bonds, 5% Japanese municipal bonds, and 15% corporate bonds for Japanese plans. These funds invest in approximately 35% foreign government bonds and 65% corporate bonds for foreign plans. (e) The plan’s equity securities include common stock of the Company and certain of its subsidiaries in the amounts of ¥381 million. (f) These funds invest in listed equity securities consisting of approximately 30% Japanese companies and 70% foreign companies for Japanese plans, and mainly foreign compa- nies for foreign plans. (g) This class includes approximately 90% Japanese govern- ment bonds and 10% foreign government bonds for Japanese plans, and mainly foreign government bonds for foreign plans. (h) These funds invest in approximately 30% Japanese government bonds, 45% foreign government bonds, 5% Japanese municipal bonds, and 20% corporate bonds for Japanese plans. These funds invest in approximately 70% foreign government bonds and 30% corporate bonds for foreign plans. Each level into which assets are categorized is based on inputs used to measure the fair value of the assets, and does not necessarily indicate the risks or ratings of the assets. Level 1 assets are comprised principally of equity securities and government bonds, which are valued using unadjusted quoted market prices in active markets with sufficient volume and frequency of transactions. Level 2 assets are comprised principally of pooled funds that invest in equity and debt secu- rities, corporate bonds, investments in life insurance company general accounts and other assets. Pooled funds are valued at their net asset values that are calculated by the sponsor of the fund and have daily liquidity. Corporate bonds are valued using quoted prices for identical assets in markets that are not active. Investments in life insurance company general accounts are valued at conversion value. Other assets are comprised principally of interest bearing cash and hedge funds. The fair value of Level 3 asset, consisting of hedge funds, was ¥1,451 million at December 31, 2018. Amounts of actual returns on, purchases and sales of these assets during the year ended December 31, 2018 were not significant. The fair values of plan assets for the participants with Toshiba Funds by each asset category are calculated based on a pro-rata basis of total plan assets of Toshiba Funds. Contributions Canon expects to contribute ¥13,089 million to its Japanese defined benefit pension plans and ¥19,311 million to its foreign defined benefit pension plans for the year ending December 31, 2019. Estimated future benefit payments The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid: Year ending December 31: 2019 2020 2021 2022 2023 2024 – 2028 Japanese plans Foreign plans Millions of yen Millions of yen 35,604 36,896 38,524 41,775 43,119 226,704 12,077 12,214 13,221 13,927 14,562 87,006 Multiemployer pension plans The amounts of cost recognized for the multiemployer pen- sion plans primarily in the Netherlands for the years ended December 31, 2018, 2017 and 2016 were ¥4,452 million, ¥4,165 million and ¥3,482 million, respectively. The multiem- ployer pension plan in which the subsidiaries in the Netherlands participated was 102% funded as of December 31, 2017. The collective bargaining agreements have no expiration date. Canon is not liable for other participating employers’ obliga- tions under the terms and conditions of the agreements. Defined contribution plans The amounts of cost recognized for the defined contribution pen- sion plans of the Company and certain of its subsidiaries for the years ended December 31, 2018, 2017 and 2016 were ¥19,570 million, ¥18,979 million and ¥17,603 million, respectively. CANON ANNUAL REPORT 2018 69 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. INCOME TAXES Domestic and foreign components of income before income taxes and the current and deferred income tax expense attributable to such income are summarized as follows: Years ended December 31 2018: Income before income taxes Income taxes: Current Deferred Japanese 241,474 75,556 (6,552) 69,004 Millions of yen Foreign 121,418 32,443 (5,297) 27,146 Total 362,892 107,999 (11,849) 96,150 2017: Income before income taxes 276,149 77,735 353,884 Income taxes: Current Deferred 80,225 (7,453) 72,772 35,402 (10,150) 25,252 115,627 (17,603) 98,024 2016: Income before income taxes 135,131 109,520 244,651 Income taxes: Current Deferred 47,687 4,126 51,813 27,806 3,062 30,868 75,493 7,188 82,681 The Company and its domestic subsidiaries are subject to a number of income taxes, which, in the aggregate, represent a statutory income tax rate of approximately 31%, 31% and 33% for the years ended December 31, 2018, 2017 and 2016, respectively. The statutory income tax rate utilized for deferred tax assets and liabilities which are expected to be settled or realized in the future period is approximately 31%. The adjustments of deferred tax assets and liabilities for amendments to the Japanese tax regulations enacted on March 29, 2016 which have been reflected in income taxes in the consolidated statements of income for the years ended December 31, 2016 were ¥3,498 million. The United States enacted tax reform legislation (the “Tax Reform Legislation”) on December 22, 2017. Due to the Tax Reform Legislation, the federal corporate income tax rate in the U.S. is reduced from 35% to 21% from the fiscal year commencing on January 1, 2018. The adjustment to deferred tax assets and liabilities for the tax rate change was tax benefit of ¥14,563 million for the year ended December 31, 2017. The impacts related to other changes from the Tax Reform Legislation are not material. A reconciliation of the Japanese statutory income tax rate and the effective income tax rate as a percentage of income before income taxes is as follows: Years ended December 31 Japanese statutory income tax rate Increase (reduction) in income taxes resulting from: Expenses not deductible for tax purposes* Income of foreign subsidiaries taxed at lower than Japanese statutory tax rate Tax credit for research and development expenses Change in valuation allowance Effect of enacted changes in tax laws and rates on Japanese tax Effect of enacted changes in U.S. tax laws Other Effective income tax rate 2018 31.0% 0.7 (3.0) (3.4) 0.4 — — 0.8 26.5% 2017 31.0% 3.7 (2.1) (4.8) 1.7 — (3.6) 1.8 27.7% 2016 33.0% 0.8 (3.0) (3.0) (0.8) 1.4 — 5.4 33.8% * Expenses not deductible for tax purposes for the year ended December 31, 2017 primarily consist of impairment losses on goodwill. 70 CANON ANNUAL REPORT 2018 Net deferred income tax assets and liabilities are included in the accompanying consolidated balance sheets under the follow- ing captions: December 31 Other assets Other noncurrent liabilities Millions of yen 2018 160,541 (70,336) 90,205 2017 150,854 (90,010) 60,844 The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities at December 31, 2018 and 2017 are presented below: December 31 Deferred tax assets: Inventories Accrued business tax Accrued pension and severance cost Research and development – costs capitalized for tax purposes Property, plant and equipment Accrued expenses Net operating losses carried forward Other Less valuation allowance Total deferred tax assets Deferred tax liabilities: Undistributed earnings of foreign subsidiaries Tax deductible reserve Financing lease revenue Intangible assets Other Total deferred tax liabilities Net deferred tax assets Millions of yen 2018 2017 10,739 2,361 105,933 4,690 33,738 28,015 28,549 38,683 252,708 (30,734) 221,974 (7,615) (4,050) (26,441) (66,189) (27,474) (131,769) 90,205 11,921 4,705 98,114 5,383 33,488 30,126 29,006 38,526 251,269 (30,783) 220,486 (9,859) (4,396) (38,287) (74,377) (32,723) (159,642) 60,844 The net changes in the total valuation allowance were a decrease of ¥49 million, an increase of ¥4,096 million and a decrease of ¥6,244 million for the years ended December 31, 2018, 2017 and 2016, respectively. Based on the level of historical taxable income and projections for future taxable income over the periods which the net deductible temporary differences are expected to reverse, management believes it is more likely than not that Canon will realize the benefits of these deferred tax assets, net of the valuation allowance, at December 31, 2018. At December 31, 2018, Canon had net operating losses which can be carried forward for income tax purposes of ¥186,114 million to reduce future taxable income. Periods available to reduce future taxable income vary in each tax jurisdiction and gener- ally range from one year to an indefinite period as follows: Within one year After one year through five years After five years through ten years After ten years through twenty years Indefinite period Total Millions of yen 5,854 26,802 38,687 48,642 66,129 186,114 CANON ANNUAL REPORT 2018 71 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Income taxes have not been accrued on undistributed earn- ings of domestic subsidiaries as the tax law provides a means by which the dividends from a domestic subsidiary can be received tax free. Canon has not recognized deferred tax liabilities of ¥27,278 million for a portion of undistributed earnings of foreign subsidiaries of ¥1,001,310 million as of December 31, 2018 because Canon currently does not expect to have such amounts distributed or paid as dividends to the Company in the foreseeable future. Deferred tax liabilities will be recog- nized when Canon expects that it will realize those undistrib- uted earnings in a taxable manner, such as through receipt of dividends or sale of the investments. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows: Years ended December 31 Balance at beginning of year Additions for tax positions of the current year Additions for tax positions of prior years Reductions for tax positions of prior years Settlements with tax authorities Other Balance at end of year* 2018 10,282 45 178 (17) (1,286) (553) 8,649 Millions of yen 2017 7,318 2,956 250 (915) — 673 10,282 2016 6,056 2,741 — (665) (370) (444) 7,318 * The total amounts of unrecognized tax benefits presented in other noncurrent liabilities in the consolidated balance sheets were offset by deferred tax assets in the amount of ¥2,043 million, ¥124 million and ¥32 million as of December 31, 2018, 2017 and 2016. The total amounts of unrecognized tax benefits that would reduce the effective tax rate, if recognized, were ¥8,649 million and ¥10,282 million at December 31, 2018 and 2017, respectively. Although Canon believes its estimates and assumptions of unrecognized tax benefits are reasonable, uncertainty regarding the final determination of tax examination settlements and any related litigation could affect the effective tax rate in a future period. Based on each of the items of which Canon is aware at December 31, 2018, no significant changes to the unrecog- nized tax benefits are expected within the next twelve months. Canon recognizes interest and penalties accrued related to unrecognized tax benefits in income taxes. Both interest and penalties accrued at December 31, 2018 and 2017, and interest and penalties included in income taxes for the years ended December 31, 2018, 2017 and 2016 were not significant. Canon files income tax returns in Japan and various for- eign tax jurisdictions. In Japan, Canon is no longer subject to regular income tax examinations by the tax authority for years before 2017 with few exceptions. Canon is also no longer subject to a transfer pricing examination by the tax author- ity for years before 2017 with few exceptions. In other major foreign tax jurisdictions, including the United States and the Netherlands, Canon is no longer subject to income tax exami- nations by tax authorities for years before 2009 with few ex- ceptions. The tax authorities are currently conducting income tax examinations of Canon’s income tax returns for years after 2008 in some foreign tax jurisdictions. 72 CANON ANNUAL REPORT 2018 13. LEGAL RESERVE AND RETAINED EARNINGS The Corporation Law of Japan provides that an amount equal to 10% of distributions from retained earnings paid by the Company and its Japanese subsidiaries be appropriated as a legal reserve. No further appropriations are required when the total amount of the additional paid-in capital and the legal reserve equals 25% of their respective stated capital. The Corporation Law of Japan also provides that additional paid- in capital and legal reserve are available for appropriations by resolution of the shareholders. Certain foreign subsidiaries are also required to appropriate their earnings to legal reserves under the laws of their respective countries. Cash dividends and appropriations to the legal reserve charged to retained earnings for the years ended December 31, 2018, 2017 and 2016 represent dividends paid out during those years and the related appropriations to the legal re- serve. Retained earnings at December 31, 2018 did not reflect current year-end dividends in the amount of ¥86,380 million which were approved by the shareholders in March 2019. The amount available for dividends under the Corporation Law of Japan is based on the amount recorded in the Company’s nonconsolidated books of account in accordance with financial accounting standards of Japan. Such amount was ¥984,692 million at December 31, 2018. Retained earnings at December 31, 2018 included Canon’s equity in undistributed earnings of affiliated companies account- ed for by the equity method in the amount of ¥18,265 million. 14. OTHER COMPREHENSIVE INCOME (LOSS) Changes in accumulated other comprehensive income (loss) for the years ended December 31, 2018, 2017 and 2016 are as follows: Millions of yen Foreign currency translation adjustments Unrealized gains and losses on securities Gains and losses on derivative instruments Pension liability adjustments Balance at December 31, 2015 87,038 14,055 (131,017) Total (29,742) Equity transactions with noncontrolling interests and other Other comprehensive income (loss) before reclassifications Amounts reclassified from accumulated other comprehensive income (loss) Net change during the year Balance at December 31, 2016 Equity transactions with noncontrolling interests and other Other comprehensive income (loss) before reclassifications Amounts reclassified from accumulated other comprehensive income (loss) Net change during the year Balance at December 31, 2017 Cumulative effects of accounting standard update—adoption of ASU No. 2016-01* Equity transactions with noncontrolling interests and other Other comprehensive income (loss) before reclassifications Amounts reclassified from accumulated other comprehensive income (loss) Net change during the year Balance at December 31, 2018 259 (101,350) 93 (100,998) (13,960) — 814 382 1,196 15,251 182 — 938 (3,862) (2,924) (2,742) (1) 258 (67,511) (167,109) 99 (67,413) (198,430) (3,288) (170,139) (199,881) — — — — — 44,184 2,813 (1,452) 14,785 60,330 (16) 44,168 30,208 (12,580) (9,767) 5,484 — (5,343) (4,200) (89,823) — (94,023) (63,815) — — (141) (5,484) — 4,014 2,562 (180) — — 4,905 19,690 (3,677) 56,653 (178,740) (143,228) — — (5,343) (4,200) (457) (29,909) (120,189) 945 488 308 3,085 (26,824) (205,564) 3,889 (125,843) (269,071) * Represents the impact of adopting the new accounting standard related to financial instruments. Please refer to Note 1(w) for more detailed information. CANON ANNUAL REPORT 2018 73 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Reclassifications out of accumulated other comprehensive income (loss) for the years ended December 31, 2018, 2017 and 2016 are as follows: Years ended December 31 Foreign currency translation adjustments Unrealized gains and losses on securities Gains and losses on derivative instruments Pension liability adjustments Amount reclassified from accumulated other comprehensive income (loss) *1 Millions of yen 2018 2017 2016 Affected line items in consolidated statements of income — — — — — (178) 37 (141) — (141) 1,341 (392) 949 (4) 945 3,853 (699) 3,154 (69) 3,085 (39) 12 (27) 11 (16) (18,472) 5,727 (12,745) 165 (12,580) 5,772 (1,732) 4,040 (26) 4,014 7,005 (1,832) 5,173 (268) 4,905 139 Other, net (46) Income taxes 93 Consolidated net income Net income attributable to noncontrolling interests Net income attributable to Canon Inc. — 93 282 Other, net (94) Income taxes 188 Consolidated net income Net income attributable to noncontrolling interests Net income attributable to Canon Inc. 194 382 (5,890) Other, net 2,049 Income taxes (3,841) Consolidated net income Net income attributable to noncontrolling interests (21) (3,862) Net income attributable to Canon Inc. (16) Other, net 164 148 (49) Income taxes Consolidated net income Net income attributable to noncontrolling interests 99 Net income attributable to Canon Inc. Total amount reclassified, net of tax and noncontrolling interests 3,889 (3,677) (3,288) *1 Amounts in parentheses indicate gains in consolidated statements of income. 74 CANON ANNUAL REPORT 2018 Tax effects allocated to each component of other comprehensive income (loss) and reclassification adjustments, including Before-tax amount Millions of yen Tax (expense) or benefit Net-of-tax amount amounts attributable to noncontrolling interests, are as follows: Years ended December 31 2018: Foreign currency translation adjustments: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Net unrealized gains and losses on securities: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Net gains and losses on derivative instruments: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Pension liability adjustments: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Other comprehensive income (loss) 2017: Foreign currency translation adjustments: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Net unrealized gains and losses on securities: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Net gains and losses on derivative instruments: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Pension liability adjustments: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Other comprehensive income (loss) 2016: Foreign currency translation adjustments: (93,955) — (93,955) — (178) (178) (586) 1,341 755 (51,789) 3,853 (47,936) (141,314) 47,825 (39) 47,786 5,100 (18,472) (13,372) (2,080) 5,772 3,692 20,991 7,005 27,996 66,102 Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year (108,280) 139 (108,141) Net unrealized gains and losses on securities: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Net gains and losses on derivative instruments: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Pension liability adjustments: Amount arising during the year Reclassification adjustments for gains and losses realized in net income Net change during the year Other comprehensive income (loss) 1,184 282 1,466 1,619 (5,890) (4,271) (95,707) (16) (95,723) (206,669) 809 — 809 — 37 37 125 (392) (267) 18,065 (699) 17,366 17,945 (708) 12 (696) (1,717) 5,727 4,010 628 (1,732) (1,104) (4,957) (1,832) (6,789) (4,579) 521 (46) 475 (375) (94) (469) (726) 2,049 1,323 25,204 164 25,368 26,697 (93,146) — (93,146) — (141) (141) (461) 949 488 (33,724) 3,154 (30,570) (123,369) 47,117 (27) 47,090 3,383 (12,745) (9,362) (1,452) 4,040 2,588 16,034 5,173 21,207 61,523 (107,759) 93 (107,666) 809 188 997 893 (3,841) (2,948) (70,503) 148 (70,355) (179,972) CANON ANNUAL REPORT 2018 75 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 15. REVENUE Revenue from sales of office products, such as office MFDs and laser printers, and imaging system products, such as digital cameras and inkjet printers, is recognized upon ship- ment or delivery, depending upon when the customer obtains controls of these products. Revenue from sales of equipment that are sold with custom- er acceptance provisions related to their functionality including optical equipment such as semiconductor lithography equip- ment and FPD lithography equipment, and certain medical equipment such as CT systems and MRI systems, is recognized when the equipment is installed at the customer site and the agreed-upon specifications are objectively satisfied. Most of Canon’s service revenue is generated from office and medical system products which is recognized over time. For the service contracts of office products, the customer typi- cally pays a variable amount based on usage, a stated fixed fee or a stated base fee plus a variable amount which frequently include the provision of consumables as well as break fix ac- tivities. The majority portion of service revenue from the office products is recognized as billed since invoiced amount directly correlates with the value to the customer of the underlying performance obligation to date. For the service contracts of medical system products, the customer typically pays a stated fixed fee for the stand ready maintenance service and revenue is recognized ratably over the contract period. The majority of service arrangements for office products are executed in combination with related products. Transaction prices for products and services need to be allocated to each performance obligation on a relative standalone sell- ing price basis where significant judgements are required. Canon estimates the standalone selling price using a range of prices that would meet the allocation objective based on all the information that is reasonably available including market conditions and other observable inputs. If transaction prices of the product or service contracts are not within the accept- able range then the revenue is subject to allocation based on the estimated standalone selling prices. Canon recognizes the incremental costs of obtaining a contract as an expense when related office products are sold. Canon also provides leasing arrangement to the customers primarily for the sales of office products. Approximately 4% of total revenue is generated from these leasing arrangements for the year ended December 31, 2018. Revenue from the sale of these products under sales-type leases is recognized at the inception of the lease. Interest income on sales-type leases and direct-financing leases is recognized over the life of each re- spective lease using the interest method. Leases not qualifying as sales-type leases or direct-financing leases are accounted for as operating leases and related revenue is recognized ratably over the lease term. When product leases are bundled with maintenance contracts, revenue is allocated based upon the estimated standalone selling prices of the lease and non-lease components. Lease components generally include product, financing and executory costs, while non-lease components generally consist of maintenance contracts and supplies. The transaction prices that Canon is entitled to receive in exchange for transferring goods or services to the customer include certain forms of variable consideration, including product discounts, customer promotions and volume-based rebates mainly for imaging system products, which are sold predominantly through distributors and retailers. Canon includes estimated amounts in the transaction price only to the extent it is probable that a significant reversal of cumula- tive revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. Variable considerations are estimated based upon historical trends and other known factors at the time of sale, and are subsequently adjusted in each period based on current information. In ad- dition, Canon may provide a right of return on our products for a short time period after a sale. These rights are accounted for as variable consideration when determining the transaction price, and accordingly Canon recognizes revenue based on the estimated amount to which Canon expects to be entitled after considering expected returns. 76 CANON ANNUAL REPORT 2018 Disaggregated revenue by timing is as follows. Disaggregated revenue by business unit, product and geographic area are described in Note 22. 2018: Office Imaging System Medical System Industry and Others Corporate and eliminations Consolidated Millions of yen Revenue recognized at a point in time Revenue recognized over time Total 1,286,100 521,201 1,807,301 993,658 14,507 1,008,165 305,457 132,121 437,578 599,766 205,445 805,211 (106,318) — (106,318) 3,078,663 873,274 3,951,937 Revenue recognized over time includes primarily revenue from maintenance service in the office and medical system products and sales of certain industrial equipment which do not have alternative use and for which Canon has enforceable right to payment to the customers for the performance com- pleted to date. The adoption of the new revenue standard required the re- consideration of the scope of performance obligations related to service contracts, which has resulted in a change in classi- fication of revenues between the products and service rev- enues. Specifically, certain revenue historically classified within products revenues, including consumables provided under the service contracts and certain outsourcing business, is currently classified within service revenues and cost of sales in the con- solidated statement of income under the new revenue stan- dard. Canon has started separating revenues and cost of sales into products and services in the consolidated statements of income starting from the quarter beginning January 1, 2018, including prior period’s presentation. However, prior period’s presentation is not retrospectively adjusted and is presented in accordance with the historical accounting policy. In addition, in conjunction with the application of the new standard, Canon has reclassified certain expenses related to service revenues from operating expenses to cost of sales in the accompanying consolidated statement of income. The amount reclassified for the year ended December 31, 2018 was ¥115,700 million. The reconsideration of the scope of performance obligations did not materially affect the timing of revenue recognition. The impacts of adoption of new revenue standard on Canon’s consolidated balance sheet as of December 31, 2018 and the consolidated statement of income for the year ended December 31, 2018 were as follows. CANON ANNUAL REPORT 2018 77 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA Millions of yen 2018 Balance under historical accounting policy Effect of change As reported 612,953 611,281 304,346 397,974 657,419 614,243 253,547 397,949 4,899,465 4,896,069 321,137 276,237 319,416 274,741 1,881,552 1,878,335 3,508,908 190,311 3,017,913 3,508,704 190,336 3,017,734 (44,466) (2,962) 50,799 25 3,396 1,721 1,496 3,217 204 (25) 179 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Consolidated Balance Sheet December 31 ASSETS Trade receivables, net Inventories Prepaid expenses and other current assets Other assets Total assets LIABILITIES AND EQUITY Accrued expenses Other current liabilities Total liabilities Retained earnings Noncontrolling interests Total equity 78 CANON ANNUAL REPORT 2018 Consolidated Statement of Income For the year ended December 31 Net sales Products and Equipment Services Cost of sales Products and Equipment Services Gross profit Selling, general and administrative expenses Operating profit Income before income taxes Income taxes Consolidated net income Less: Net income attributable to noncontrolling interests Net income attributable to Canon Inc. Millions of yen 2018 As reported Amount under historical accounting policy Effect of change 3,194,724 757,213 3,951,937 1,762,171 354,212 2,116,383 1,835,554 1,176,760 342,952 362,892 96,150 266,742 13,987 252,755 3,383,566 567,582 3,951,148 1,783,798 216,513 2,000,311 1,950,837 1,292,460 342,535 362,475 96,094 266,381 13,936 252,445 (188,842) 189,631 789 (21,627) 137,699 116,072 (115,283) (115,700) 417 417 56 361 51 310 Canon recognized contract assets primarily for unbilled receivables mainly arising from services contracts for office products totaled to ¥42,915 million at the adoption date and included in prepaid expenses and other current assets in the consolidated balance sheet with an offsetting impact to trade receivables. Contract assets at December 31, 2018 were ¥50,799 million. Canon typically bills to the customer when performance obligation is satisfied and collects the payment in relatively short term except for certain maintenance service of office and medical products and certain industrial equipment for which Canon occasionally receives the payment in advance from cus- tomers. The amount received in excess of revenue recognized is recognized as deferred revenue until the performance obli- gation for distinct goods or services are satisfied. Deferred rev- enue at December 31, 2018 and 2017 were ¥123,686 million and ¥125,965 million, respectively, and are included in other current liabilities in the accompanying consolidated balance sheets. Revenue recognized for the year ended December 31, 2018, which had been included in the deferred revenue bal- ance at December 31, 2017, was ¥104,678 million. Remaining performance obligations for products and equip- ment at December 31, 2018 primarily arise from the sales of certain industrial equipment, amounting to ¥72,708 million, 75% of which is expected to be recognized as revenue within one year and remaining 25% is within two years. Disclosure of remaining performance obligations is not required for the majority of service since the revenue is recognized as billed basis applying the right to invoice practical expedient or is generated from the contracts with original expected duration of less than one year. The portion of fixed maintenance service contract for office and medical products with original expected duration of more than one year is approximately 11% of total service revenue and the average remaining period for these fixed contracts as of December 31, 2018 is about 2 years. Taxes collected from customers and remitted to governmen- tal authorities are excluded from revenues in the consolidated statements of income. CANON ANNUAL REPORT 2018 79 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 16. STOCK-BASED COMPENSATION On May 2, 2018, based on the approval of the shareholders, the Company granted stock options to its directors and execu- tive officers to acquire 74,000 shares of common stock. Those to whom stock acquisition rights are granted (the “Holder(s)”) shall be entitled to exercise all the stock acquisition rights together within 10 days (in case the last day is not a business day, the following business day) from after the date when they cease to hold any position as a director or an executive officer of the Company. These option awards have a 30 year exercis- able period. The grant-date fair value per share of the stock options granted during the year ended December 31, 2018 was ¥2,948. On May 1, 2011, based on the approval of the sharehold- ers, the Company granted stock options to its directors, execu- tive officers and certain employees to acquire 912,000 shares of common stock. These option awards vest after two years of continued service beginning on the grant date and have a four year exercisable period. The grant-date fair value per share of the stock options granted during the year ended December 31, 2011 was ¥772. On May 1, 2010, based on the approval of the sharehold- ers, the Company granted stock options to its directors, execu- tive officers and certain employees to acquire 890,000 shares of common stock. These option awards vest after two years of continued service beginning on the grant date and have a four year exercisable period. The grant-date fair value per share of the stock options granted during the year ended December 31, 2010 was ¥988. The compensation cost recognized for these stock options for the years ended December 31, 2018 was ¥218 million and 2017 and 2016 was nil, and it is included in selling, general and administrative expenses in the consolidated statements of income. The fair value of the option award was estimated on the date of grant using the Black-Sholes option pricing model that incor- porates the assumptions presented below: Year ended December 31 Expected term of option (in years) Expected volatility Dividend yield Risk-free interest rate 2018 6.0 23.02% 4.14% (0.07%) A summary of option activity under the stock option plans as of and for the years ended December 31, 2018, 2017 and 2016 is presented below: Outstanding at January 1, 2016 Exercised Forfeited/Expired Outstanding at December 31, 2016 Exercised Forfeited/Expired Outstanding at December 31, 2017 Granted Exercised Forfeited/Expired Outstanding at December 31, 2018 Exercisable at December 31, 2018 Weighted- average exercise price Weighted-average remaining contractual term Yen 4,263 — 4,500 3,990 — Year 0.4 0.2 Shares 1,296,000 — (693,000) 603,000 — (603,000) 3,990 Aggregate intrinsic value Millions of yen — — — — 74,000 — — 74,000 74,000 — 1 — — 1 1 29.3 29.3 222 222 The total fair value of shares vested during the years ended December 31, 2018 was ¥218 million and 2017 and 2016 was nil. Cash received from the exercise of stock options for the years ended December 31, 2018, 2017 and 2016 was nil. 80 CANON ANNUAL REPORT 2018 17. NET INCOME ATTRIBUTABLE TO CANON INC. SHAREHOLDERS PER SHARE A reconciliation of the numerators and denominators of basic and diluted net income attributable to Canon Inc. shareholders per share computations is as follows: Years ended December 31 Millions of yen 2018 2017 2016 Net income attributable to Canon Inc. 252,755 241,923 150,650 Average common shares outstanding Effect of dilutive securities: Stock options Number of shares 1,079,753,008 1,085,439,370 1,092,070,680 49,319 — — Diluted common shares outstanding 1,079,802,327 1,085,439,370 1,092,070,680 Net income attributable to Canon Inc. shareholders per share: Basic Diluted Yen 222.88 222.88 137.95 137.95 234.09 234.08 The computation of diluted net income attributable to Canon Inc. shareholders per share for the years ended December 31, 2017 and 2016 excludes outstanding stock options because the effect would be anti-dilutive. 18. DERIVATIVES AND HEDGING ACTIVITIES Risk management policy Canon operates internationally, exposing it to the risk of changes in foreign currency exchange rates. Derivative fi- nancial instruments are comprised principally of foreign ex- change contracts utilized by the Company and certain of its subsidiaries to reduce the risk. Canon assesses foreign cur- rency exchange rate risk by continually monitoring changes in the exposures and by evaluating hedging opportunities. Canon does not hold or issue derivative financial instruments for trading purposes. Canon is also exposed to credit-related losses in the event of non-performance by counterparties to derivative financial instruments, but it is not expected that any counterparties will fail to meet their obligations. Most of the counterparties are internationally recognized financial institu- tions and selected by Canon taking into account their financial condition, and contracts are diversified across a number of major financial institutions. Foreign currency exchange rate risk management Canon’s international operations expose Canon to the risk of changes in foreign currency exchange rates. Canon uses foreign exchange contracts to manage certain foreign currency exchange exposures principally from the exchange of U.S. dol- lars and euros into Japanese yen. These contracts are primarily used to hedge the foreign currency exposure of forecasted intercompany sales and intercompany trade receivables that are denominated in foreign currencies. In accordance with Canon’s policy, a specific portion of foreign currency exposure resulting from forecasted intercompany sales are hedged using foreign exchange contracts which principally mature within three months. CANON ANNUAL REPORT 2018 81 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Cash flow hedge Changes in the fair value of derivative financial instruments designated as cash flow hedges, including foreign exchange contracts associated with forecasted intercompany sales, are reported in accumulated other comprehensive income (loss). These amounts are subsequently reclassified into earnings through other income (deductions) in the same period as the hedged items affect earnings. Substantially all amounts re- corded in accumulated other comprehensive income (loss) at year-end are expected to be recognized in earnings over the next twelve months. Canon excludes the time value compo- nent from the assessment of hedge effectiveness. Changes in the fair value of a foreign exchange contract for the period between the date that the forecasted intercompany sales oc- cur and its maturity date are recognized in earnings and not considered hedge ineffectiveness. Derivatives not designated as hedges Canon has entered into certain foreign exchange contracts to primarily offset the earnings impact related to fluctuations in foreign currency exchange rates associated with certain assets denominated in foreign currencies. Although these foreign exchange contracts have not been designated as hedges as required in order to apply hedge accounting, the contracts are effective from an economic perspective. The changes in the fair value of these contracts are recorded in earnings immediately. Contract amounts of foreign exchange contracts at December 31, 2018 and 2017 are set forth below: December 31 To sell foreign currencies To buy foreign currencies Millions of yen 2018 230,505 30,816 2017 272,563 46,168 Fair value of derivative instruments in the consolidated balance sheets The following tables present Canon’s derivative instruments measured at gross fair value as reflected in the consolidated balance sheets at December 31, 2018 and 2017. Derivatives designated as hedging instruments December 31 Assets: Balance sheet location 2018 2017 Fair value Millions of yen Foreign exchange contracts Prepaid expenses and other current assets Liabilities: Foreign exchange contracts Other current liabilities Derivatives not designated as hedging instruments 521 323 255 367 Fair value Millions of yen December 31 Assets: Balance sheet location 2018 2017 Foreign exchange contracts Prepaid expenses and other current assets 2,622 289 Liabilities: Foreign exchange contracts Other current liabilities 443 2,892 82 CANON ANNUAL REPORT 2018 Effect of derivative instruments in the consolidated statements of income The following tables present the effect of Canon’s derivative instruments in the consolidated statements of income for the years ended December 31, 2018, 2017 and 2016. Derivatives in cash flow hedging relationships Years ended December 31 Gain (loss) recognized in OCI (effective portion) Gain (loss) reclassified from accumulated OCI into income (effective portion) Gain (loss) recognized in income (ineffective portion and amount excluded from effectiveness testing) Millions of yen Amount Location Amount Location Amount 2018: Foreign exchange contracts (586) Other, net 2017: Foreign exchange contracts (2,080) Other, net 2016: Foreign exchange contracts 1,619 Other, net (1,341) (5,772) 5,890 Other, net Other, net Other, net (682) (332) (311) Derivatives not designated as hedging instruments Years ended December 31 Gain (loss) recognized in income on derivative Foreign exchange contracts Location Other, net 2018 5,284 Millions of yen 2017 (7,932) 2016 7,018 19. COMMITMENTS AND CONTINGENT LIABILITIES Commitments At December 31, 2018, commitments outstanding for the pur- chase of property, plant and equipment approximated ¥54,905 million, and commitments outstanding for the purchase of parts and raw materials approximated ¥120,344 million. Canon occupies sales offices and other facilities under lease arrangements accounted for as operating leases. Deposits made under such arrangements aggregated ¥12,728 mil- lion and ¥13,740 million at December 31, 2018 and 2017, respectively, and are included in noncurrent receivables in the accompanying consolidated balance sheets. Rental expenses of cancelable and noncancelable operating leases amounted to ¥49,394 million, ¥47,619 million and ¥42,714 million for the years ended December 31, 2018, 2017 and 2016, respectively. Future minimum lease payments required under noncancelable operating leases that have initial or remaining lease terms in excess of one year at December 31, 2018 are as follows: Year ending December 31: 2019 2020 2021 2022 2023 Thereafter Total future minimum lease payments Millions of yen 29,817 23,402 17,837 13,565 10,165 20,298 115,084 CANON ANNUAL REPORT 2018 83 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Guarantees Canon provides guarantees for its employees, affiliates and other companies. The guarantees for the employees are princi- pally made for their housing loans. The guarantees for affili- ates and other companies are made for their lease obligations and bank loans to ensure that those companies operate with less financial risk. Canon would have to perform under a guarantee if the borrower defaults on a payment within the contract terms. The contract terms are 1 year to 30 years in case of employ- ees with housing loans, and 1 year to 7 years in case of af- filiates and other companies with lease obligations and bank loans. The maximum amount of undiscounted payments Canon would have had to make in the event of default is ¥4,458 million at December 31, 2018. The carrying amounts of the liabilities recognized for Canon’s obligations as a guar- antor under those guarantees at December 31, 2018 were not significant. Canon also issues contractual product warranties under which it generally guarantees the performance of products delivered and services rendered for a certain period or term. Changes in accrued product warranty costs for the years ended December 31, 2018 and 2017 are summarized as follows: Years ended December 31 Millions of yen Balance at beginning of year Additions Utilization Other Balance at end of year 2018 17,452 18,870 (14,707) (4,297) 17,318 2017 13,168 18,893 (12,957) (1,652) 17,452 Legal proceedings Canon is involved in various claims and legal actions arising in the ordinary course of business. Canon has recorded provi- sions for liabilities when it is probable that liabilities have been incurred and the amount of loss can be reasonably estimated. Canon reviews these provisions at least quarterly and ad- justs these provisions to reflect the impact of the negotia- tions, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. Based on its experience, although litigation is inherently unpredict- able, Canon believes that any damage amounts claimed in outstanding matters are not a meaningful indicator of Canon’s potential liability. In the opinion of management, any reason- ably possible range of losses from outstanding matters would not have a material adverse effect on Canon’s consolidated financial position, results of operations, or cash flows. 84 CANON ANNUAL REPORT 2018 20. DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS AND CONCENTRATIONS OF CREDIT RISK Fair value of financial instruments The estimated fair values of Canon’s financial instruments at December 31, 2018 and 2017 are set forth below. The following summary excludes cash and cash equivalents, trade receivables, finance receivables, noncurrent receivables, short-term loans, trade payables and accrued expenses for which fair values approximate their carrying amounts. The summary also excludes investments and derivative instruments which are disclosed in Note 2 and Note 21, and Note 18, respectively. December 31 Millions of yen 2018 2017 Carrying amount Estimated fair value Carrying amount Estimated fair value Long-term debt, including current installments (364,602) (364,570) (499,168) (499,126) The following methods and assumptions are used to esti- mate the fair value in the above table. Long-term debt Canon’s long-term debt instruments are classified as Level 2 instruments and valued based on the present value of future cash flows associated with each instrument discounted using current market borrowing rates for similar debt instruments of comparable maturity. The levels are more fully described in Note 21. Limitations of fair value estimates Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instruments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Concentrations of credit risk At December 31, 2018 and 2017, one customer accounted for approximately 12% and 8% of consolidated trade receiv- ables, respectively. Although Canon does not expect that the customer will fail to meet its obligations, Canon is potentially exposed to concentrations of credit risk if the customer failed to perform according to the terms of the contracts. 21. FAIR VALUE MEASUREMENTS Fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. A three-level fair value hierarchy that prioritizes the inputs used to measure fair value is as follows: Level 1— Inputs are quoted prices in active markets for identi- cal assets or liabilities. Level 2— Inputs are quoted prices for similar assets or liabili- ties in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable, and inputs that are derived principally from or corroborated by observable market data by correlation or other means. Level 3— Inputs are derived from valuation techniques in which one or more significant inputs or value drivers are unobservable, which reflect the reporting entity’s own assumptions about the assumptions that mar- ket participants would use in establishing a price. CANON ANNUAL REPORT 2018 85 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Assets and liabilities measured at fair value on a recurring basis The following tables present Canon’s assets and liabilities that are measured at fair value on a recurring basis consistent with the fair value hierarchy at December 31, 2018 and 2017. December 31 Millions of yen 2018: Assets: Cash and cash equivalents Short-term investments: Available-for-sale: Corporate bonds Investments: Available-for-sale: Government bonds Corporate bonds Fund trusts and others Equity securities Prepaid expenses and other current assets: Derivatives Total assets Liabilities: Other current liabilities: Derivatives Total liabilities Millions of yen 2017: Assets: Cash and cash equivalents Short-term investments: Available-for-sale: Corporate bonds Investments: Available-for-sale: Government bonds Corporate bonds Fund trusts Equity securities Prepaid expenses and other current assets: Derivatives Total assets Liabilities: Other current liabilities: Derivatives Total liabilities Level 1 Level 2 Level 3 Total — 70,500 630 — — 630 13,787 — 15,047 — — — — — 408 — 3,143 74,051 766 766 — — — — — — — — — — 70,500 630 — — 1,038 13,787 3,143 89,098 766 766 Level 1 Level 2 Level 3 Total — 70,500 1,222 289 605 13 20,901 — 23,030 — — — — 217 111 — 544 71,372 3,259 3,259 — — — — — — — — — — 70,500 1,222 289 822 124 20,901 544 94,402 3,259 3,259 Level 1 investments are comprised principally of Japanese equity securities, which are valued using an unadjusted quoted market price in active markets with sufficient volume and frequency of transactions. Level 2 cash and cash equivalents are valued based on market approach, using quoted prices for identical assets in markets that are not active. Derivative financial instruments are comprised of foreign exchange contracts. Level 2 derivatives are valued using quotes obtained from counterparties or third parties, which are periodically validated by pricing models using observable market inputs, such as foreign currency exchange rates and interest rates, based on market approach. 86 CANON ANNUAL REPORT 2018 Assets and liabilities measured at fair value on a nonrecurring basis There were no assets or liabilities to be measured at fair value on a nonrecurring basis during the year ended December 31, 2018. The following table presents the Canon’s asset that was measured at fair value on a nonrecurring basis consistent with the fair value hierarchy and related impairment charge recognized during the year ended December 31, 2017. Year ended December 31 Millions of yen 2017: Asset: Goodwill Total loss Level 1 Level 2 Level 3 Total (33,912) — — 29,370 29,370 Goodwill was classified as Level 3 items and valued based on an income approach using unobservable inputs. Canon performed the annual goodwill impairment test as of October 1, 2017, which indicated that the fair value of the reporting unit was less than its carrying value. Canon recog- nized the impairment charge for the amount representing the excess of the carrying amount over the reporting unit’s fair value. The fair value for the reporting unit was mea- sured based on the discounted cash flow method with 6.0% of weighted average cost of capital and estimated future cash flows. Future cash flows are based on management’s estimates of projected revenues, gross profits, operating expenses, a long-term growth rate, taking into consideration industry trends and market conditions. 22. SEGMENT INFORMATION Canon operates its business in four segments: the Office Business Unit, the Imaging System Business Unit, the Medical System Business Unit, and the Industry and Others Business Unit, which are based on the organizational structure and information reviewed by Canon’s management to evaluate results and allocate resources. Based on the realignment of Canon’s internal reporting and management structure, from the beginning of the third quarter of 2018, Canon has reclassified certain businesses from Office Business Unit to Industry and Others Business Unit. Segment information for the year ended December 31, 2018 have reflected this change. Prior period amounts also have been restated. Canon newly established Medical System Business Unit effective at the beginning of the second quar- ter of 2017, and certain businesses included in Industry and Others Business Unit have been reclassified. Operating results for the year ended December 31, 2017 have been reclassified and for the year ended December 31, 2016 have not been restated since they have not been material. Total assets as of December 31, 2016 have been restated. The primary products included in each segment are as follows: Office Business Unit: Office multifunction devices (MFDs) / Laser multifunction printers (MFPs) / Laser printers / Digital continuous feed presses / Digital sheet-fed presses / Wide-format printers / Document solutions Imaging System Business Unit: Interchangeable-lens digital cameras / Digital compact cameras / Digital camcorders / Digital cinema cameras / Interchangeable lenses / Compact photo printers /Inkjet printers / Large format inkjet printers / Commercial photo printers / Image scanners / Multimedia projectors / Broadcast equipment / Calculators Medical System Business Unit: Digital radiography systems / Diagnostic X-ray systems / Computed tomography (CT) systems / Magnetic resonance imaging (MRI) systems / Diagnostic ultrasound systems / Clinical chemistry analyzers / Ophthalmic equipment Industry and Others Business Unit: Semiconductor lithography equipment / FPD (Flat panel display) lithography equipment / Vacuum thin-film deposition equipment / Organic LED (OLED) panel manufacturing equipment / Die bonders / Micromotors / Network cameras / Handy terminals / Document scanners The accounting policies of the segments are substantially the same as those described in the significant accounting policies in Note 1. While Canon previously disclosed operating profit as segment profit, Canon has newly adopted income before in- come taxes as segment profit for the year ended December 31, 2018. Due to the increase of other income (deductions) from the adoption of ASU No. 2017-07, Compensation – Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, Canon has changed its business performance measure. Please refer to Note 1 (w) for more detailed information about the change in the accounting standard. CANON ANNUAL REPORT 2018 87 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Information about operating results and assets for each segment as of and for the years ended December 31, 2018, 2017 and 2016 is as follows: Millions of yen 2018: Net sales: External customers Intersegment Total Operating cost and expenses Operating profit Other income (deductions) Income before income taxes Total assets Depreciation and amortization Capital expenditures 2017: Net sales: External customers Intersegment Total Operating cost and expenses Operating profit Other income (deductions) Income before income taxes Total assets Depreciation and amortization Impairment losses on goodwill Capital expenditures 2016: Net sales: External customers Intersegment Total Operating cost and expenses Operating profit Other income (deductions) Income before income taxes Total assets Depreciation and amortization Capital expenditures Office Imaging System Medical System Industry and Others Corporate and eliminations Consolidated 1,804,002 3,299 1,807,301 1,586,497 220,804 8,383 229,187 923,261 64,964 48,127 1,802,542 2,240 1,804,782 1,615,521 189,261 6,108 195,369 946,213 72,346 21,721 46,769 1,743,039 2,957 1,745,996 1,583,588 162,408 7,467 169,875 947,602 76,500 71,841 1,007,365 800 1,008,165 891,210 116,955 4,299 121,254 393,004 40,541 25,796 1,135,584 604 1,136,188 962,663 173,525 2,388 175,913 387,088 41,695 — 28,508 1,094,291 998 1,095,289 953,567 141,722 2,691 144,413 391,661 47,386 25,564 437,305 273 437,578 408,739 28,839 640 29,479 247,282 9,365 7,454 434,985 1,202 436,187 414,246 21,941 564 22,505 238,824 5,212 — 8,963 — — — — — — — 204,755 — — 703,265 101,946 805,211 739,665 65,546 2,061 67,607 383,568 38,582 24,091 706,904 85,946 792,850 752,122 40,728 1,339 42,067 376,064 39,736 12,191 16,620 564,157 82,326 646,483 641,082 5,401 1,658 7,059 354,602 42,872 29,694 — (106,318) (106,318) (17,126) (89,192) 4,557 (84,635) 2,952,350 98,102 95,036 — (89,992) (89,992) 13,858 (103,850) 21,880 (81,970) 3,250,102 102,892 — 80,529 — (86,281) (86,281) 6,825 (93,106) 16,410 (76,696) 3,239,909 83,338 81,280 3,951,937 — 3,951,937 3,608,985 342,952 19,940 362,892 4,899,465 251,554 200,504 4,080,015 — 4,080,015 3,758,410 321,605 32,279 353,884 5,198,291 261,881 33,912 181,389 3,401,487 — 3,401,487 3,185,062 216,425 28,226 244,651 5,138,529 250,096 208,379 Intersegment sales are recorded at the same prices used in transactions with third parties. Expenses not directly as- sociated with specific segments are allocated based on the most reasonable measures applicable. Corporate expenses include certain corporate research and development expenses. Amortization costs of identified intangible assets resulting from the purchase price allocation of CMSC are also included in corporate expenses. Segment assets are based on those di- rectly associated with each segment. Corporate assets primar- ily consist of cash and cash equivalents, investments, deferred tax assets, goodwill, identified intangible assets from acquisi- tions and corporate properties. Capital expenditures represent the additions to property, plant and equipment and intangible assets measured on an accrual basis. 88 CANON ANNUAL REPORT 2018 Information about sales by product to external customers for each segment for the years ended December 31, 2018, 2017 and 2016 is as follows: Years ended December 31 Office Monochrome copiers Color copiers Printers Others Total Imaging System Cameras Inkjet printers Others Total Medical System Diagnostic equipment Industry and Others Lithography equipment Others Total Consolidated Millions of yen 2018 2017 2016 280,035 403,522 702,378 418,067 287,823 405,576 702,491 406,652 289,532 386,193 664,846 402,468 1,804,002 1,802,542 1,743,039 599,578 318,382 89,405 702,598 333,721 99,265 666,868 329,066 98,357 1,007,365 1,135,584 1,094,291 437,305 434,985 — 199,722 503,543 703,265 193,113 513,791 706,904 121,090 443,067 564,157 3,951,937 4,080,015 3,401,487 Information by major geographic area as of and for the years ended December 31, 2018, 2017 and 2016 is as follows: Net sales: Japan Americas Europe Asia and Oceania Total Long-lived assets: Japan Americas Europe Asia and Oceania Total Millions of yen 2018 2017 2016 869,577 1,076,402 1,015,428 990,530 3,951,937 1,046,065 129,989 169,357 136,602 1,482,013 884,828 1,107,515 1,028,415 1,059,257 4,080,015 1,081,522 141,937 174,889 149,244 1,547,592 706,979 963,544 913,523 817,441 3,401,487 1,163,374 147,129 166,734 164,007 1,641,244 Net sales are attributed to areas based on the location where the product is shipped and the service is performed to the customers. Other than in Japan and the United States, Canon does not conduct business in any individual country in which its sales in that country exceed 10% of consolidated net sales. Net sales in the United States were ¥995,245 million, ¥1,022,305 million and ¥884,083 million for the years ended December 31, 2018, 2017 and 2016, respectively. Long-lived assets represent property, plant and equipment and intangible assets for each geographic area. CANON ANNUAL REPORT 2018 89 STRATEGYBUSINESS SEGMENT/CORPORATE STRUCTUREFINANCIAL SECTIONCORPORATE DATA SCHEDULE II VA L UATION AND Q U A L I FY I N G A C C O U NTS Years ended December 31 Millions of yen 2018: Allowance for doubtful receivables Trade receivables Finance receivables 2017: Allowance for doubtful receivables Trade receivables Finance receivables 2016: Allowance for doubtful receivables Trade receivables Finance receivables Balance at beginning of period Addition-charged to income Deduction bad debts written off Translation adjustments and other Balance at end of period 13,378 2,681 11,075 2,325 12,077 2,878 1,347 938 3,574 1,436 1,460 398 (2,789) (1,284) (1,787) (1,523) (1,824) (978) (459) 340 516 443 (638) 27 11,477 2,675 13,378 2,681 11,075 2,325 90 CANON ANNUAL REPORT 2018 MA NA GEME NT’S R EPOR T ON INTERNAL C ON TROL OVER FINA N C I A L R EP O R TI N G The management of Canon is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934, as amended, as a process designed by, or under the supervision of, the company’s principal executive and principal financial officers and effected by the company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with gener- ally accepted accounting principles and includes those policies and procedures that (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide rea- sonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, pro- jections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Canon’s management assessed the effectiveness of internal control over financial reporting as of December 31, 2018. In making this assessment, management used the criteria established in internal Control –Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the “COSO criteria”). Based on its assessment, management concluded that, as of December 31, 2018, Canon’s internal control over financial report- ing was effective based on the COSO criteria. Canon’s independent registered public accounting firm, Ernst & Young ShinNihon LLC, has issued an audit report on the effec- tiveness of Canon’s internal control over financial reporting. This report appears in Item 18 of FORM 20-F. CANON ANNUAL REPORT 2018 91 RE POR T OF INDEPEN DENT RE GIST E R ED PUBLIC ACCOU NTING FIR M Ernst & Young ShinNihon LLC Hibiya Mitsui Tower, Tokyo Midtown Hibiya 1-1-2 Yurakucho, Chiyoda-ku Tokyo 100-0006, Japan Tel: +81 3 3503 1100 Fax: +81 3 3503 1197 ey.com Ernst & Young ShinNihon LLC Hibiya Mitsui Tower, Tokyo Midtown Hibiya 1-1-2 Yurakucho, Chiyoda-ku Tokyo 100-0006, Japan Tel: +81 3 3503 1100 Fax: +81 3 3503 1197 ey.com To the Shareholders and the Board of Directors of Canon Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Canon Inc. and subsidiaries (the Company) as of December 31, 2018 and 2017, the related consolidated statements of income, comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2018, and the related notes and schedule of valuation and qualifying accounts (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 28, 2019 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with re- spect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing pro- cedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. We have served as the Company’s auditor for SEC reporting purposes since 2004, and as its Japanese statutory auditor since 1978. March 28, 2019 92 CANON ANNUAL REPORT 2018 RE POR T OF INDEPEN DENT RE GIST E R ED PUBLIC ACCOU NTING FIR M Ernst & Young ShinNihon LLC Hibiya Mitsui Tower, Tokyo Midtown Hibiya 1-1-2 Yurakucho, Chiyoda-ku Tokyo 100-0006, Japan Tel: +81 3 3503 1100 Fax: +81 3 3503 1197 ey.com Ernst & Young ShinNihon LLC Hibiya Mitsui Tower, Tokyo Midtown Hibiya 1-1-2 Yurakucho, Chiyoda-ku Tokyo 100-0006, Japan Tel: +81 3 3503 1100 Fax: +81 3 3503 1197 ey.com To the Shareholders and the Board of Directors of Canon Inc. Opinion on Internal Control over Financial Reporting We have audited Canon Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Canon Inc. and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2018 and 2017, the related consolidated statements of income, comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2018, and the related notes and schedule of valuation and qualifying accounts and our report dated March 28, 2019 expressed an unqualified opinion thereon. Basis for Opinion The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the ef- fectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, test- ing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial re- porting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transac- tions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. March 28, 2019 CANON ANNUAL REPORT 2018 93 TR AN SF ER AN D RE GISTRAR’S OF FICE SHA REHOLDER INF ORMATI ON Canon Inc. 30-2, Shimomaruko 3-chome, Ohta-ku, Tokyo 146-8501, Japan Stock Exchange Listings: Tokyo, Nagoya, Fukuoka, Sapporo and New York stock exchanges Manager of the Register of Shareholders Mizuho Trust & Banking Co., Ltd. 2-1, Yaesu 1-chome, Chuo-ku, Tokyo 103-8670, Japan Depositary and Agent with Respect to American Depositary Receipts for Common Shares JPMorgan Chase Bank, N.A. 4 New York Plaza Floor 12, New York, NY 10004, USA American Depositary Receipts are traded on the New York Stock Exchange (CAJ). Ordinary General Meeting of Shareholders: March 28, 2019, in Tokyo Further Information: For publications or information, please contact the Public Affairs Headquarters, Canon Inc., Tokyo, or access Canon’s Website at global.canon/en 94 CANON ANNUAL REPORT 2018 MAJOR CONSOLIDATED SUBSIDIARIES (As of December 31, 2018) Manufacturing Canon Precision Inc. Canon Tokki Corporation Fukushima Canon Inc. Canon Medical Systems Corporation Canon Electron Tubes & Devices Co., Ltd. Canon Components, Inc. Canon Semiconductor Equipment Inc. Canon Chemicals Inc. Canon Electronics Inc. Canon Finetech Nisca Inc. Canon ANELVA Corporation Nagahama Canon Inc. Canon Machinery Inc. Oita Canon Materials Inc. Oita Canon Inc. Nagasaki Canon Inc. Miyazaki Canon Inc. Canon Virginia, Inc. Canon Bretagne S.A.S. Océ-Technologies B.V. Marketing & Other Canon Marketing Japan Inc. Canon System and Support Inc. Canon IT Solutions Inc. Canon Medical Finance Co., Ltd. Canon U.S.A., Inc. Canon Canada Inc. Canon Solutions America, Inc. Canon Financial Services, Inc. Canon Medical Systems USA, Inc. Axis AB Canon Europa N.V. Canon Europe Ltd. Canon Ru LLC Canon (UK) Ltd. Canon Deutschland GmbH Canon (Schweiz) AG Canon Nederland N.V. Canon France S.A.S. Canon Middle East FZ-LLC Canon Italia S.p.A. Océ Printing Systems G.m.b.H. & Co. KG Canon Medical Systems Europe B.V. Milestone Systems A/S Canon (China) Co., Ltd. Canon Hongkong Co., Ltd. Canon Singapore Pte. Ltd. Canon India Pvt. Ltd. Canon Australia Pty. Ltd. Axis Communications AB Canon Dalian Business Machines, Inc. Canon (Suzhou) Inc. Canon Zhongshan Business Machines Co., Ltd. Canon Zhuhai, Inc. Canon Inc., Taiwan Canon Vietnam Co., Ltd. Canon Hi-Tech (Thailand) Ltd. Canon Prachinburi (Thailand) Ltd. Canon Business Machines (Philippines), Inc. Canon Opto (Malaysia) Sdn. Bhd. Canon Medical Systems Manufacturing Asia Sdn. Bhd. Research & Development Canon Research Centre France S.A.S. Canon Information Systems Research Australia Pty. Ltd. 95 CANON ANNUAL REPORT 2018 C A N O N A N N U A L R E P O R T 2 0 1 8 CANON INC. 30-2, Shimomaruko 3-chome, Ohta-ku, Tokyo 146-8501, Japan ©Canon Inc. 2019 PUB.BEP028-01 0419