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SmileDirectClub- + – – – Previous Next Contents Investor Centre COCHLEAR ANNUAL REPORT 2014 A hearing life 22 Pg Financial Report Pg Notes to Financial Statements Pg Additional Reporting 23 Directors’ Report Basis of preparation 77 17. Inventories 106 Directors’ Declaration 107 Independent Audit Report 108 Additional information 109 Glossary, Company ASX Announcement Record and Company Information 23 Principal activities and review of operations and results 61 1. Reporting entity 61 2. Basis of preparation 31 Remuneration Report Performance for the year 55 Lead Auditor’s Independence Declaration 62 3. Operating segments 56 Income Statement 57 Statement of Comprehensive Income 58 Balance Sheet 59 Statement of Changes in Equity 64 4. Revenue 65 5. Expenses 65 6. Other income 66 7. Earnings per share 67 8. Dividends 78 18. Property, plant and equipment 80 19. Intangible assets 84 20. Provisions Financial and capital structure 87 21. Net debt and finance costs 89 22. Financial risk management Capital and reserves 99 23. Capital and reserves 60 Statement of Cash Flows 68 9. Notes to the statement of cash flows 100 24. Capital management Income taxes Other notes 69 10. Income tax expense 101 25. Auditors’ remuneration 70 11. Current and deferred tax assets and liabilities 101 26. Commitments Employee benefits 71 12. Employee expenses 71 13. Employee benefit liabilities 73 14. Share based payments 76 15. Key management personnel 101 27. Contingent liabilities 102 28. Controlled entities 103 29. Parent entity disclosures 104 30. Changes in accounting policies 105 31. New standards and interpretations not yet adopted Operating assets and liabilities 105 32. Events subsequent to the reporting date 77 16. Trade and other receivables AR 14InvestorCentreContentsNextPrevious-– – –+ 23 Directors’ Report Cochlear Limited for the year ended 30 June 2014 The directors present their report, together with the Consolidated Financial Report of the Consolidated Entity (Cochlear), being Cochlear Limited (the Company) and its controlled entities, for the year ended 30 June 2014, and the Auditor’s Report thereon. Directors The directors of the Company at any time during or since the end of the financial year were Mr R Holliday-Smith, Mrs YA Allen, Mr PR Bell, Prof E Byrne, AC, Mr A Denver, Mr DP O’Dwyer and Dr CG Roberts. Information on the directors is presented in the Annual Report. This information includes the qualifications, experience and special responsibilities of each director. It also gives details of the directors’ other directorships. Information on the Company Secretary including his qualifications and experience is presented in the Annual Report. Directors’ meetings The number of directors’ meetings (including meetings of committees of directors) and number of meetings attended by each of the directors of the Company during the financial year are: Board of directors Audit Committee Medical Science Committee Nomination Committee Human Resources Committee Technology and Innovation Committee Held Attended Held Attended Held Attended Held Attended Held Attended Held Attended Mr R Holliday-Smith Mrs YA Allen Mr PR Bell Prof E Byrne, AC Mr A Denver Mr DP O’Dwyer Dr CG Roberts 10 10 10 10 10 10 10 10 10 9 10 10 10 10 6 6 - - 6 6 - 6 6 - - 6 6 - - - - 2 2 2 2 - - - 2 2 2 2 2 2 2 2 2 2 - 2 2 2 2 2 2 - 4 4 4 - - - - 4 4 4 - - - - - - - 3 3 3 3 - - - 3 3 3 3 Principal activities and review of operations and results Operations Business model Cochlear’s mission is: “We help people hear and be heard. We empower people to connect with others and live a full life. We transform the way people understand and treat hearing loss. We innovate and bring to market a range of implantable hearing solutions that deliver a lifetime of hearing outcomes.” Cochlear’s strategy is focused on customer experience, operational excellence, product innovation, people engagement and value creation. Cochlear’s customer experience strategy is to actively grow the market for implantable hearing solutions. Part of this strategy is increasing Cochlear’s support for the market. This is being done through directed programs including greater direct to consumer connection, and increased consumer awareness. Cochlear invested an additional approximate $10 million during the financial year ended 30 June 2014 (F14) in focused Strategic Growth Initiatives to grow and support the market. Cochlear’s product innovation strategy is to create and bring to market an extensive segmented portfolio of innovative and quality products. Cochlear offers a range of advanced solutions to address different types of hearing loss such as: • cochlear implants, designed to help those people with moderate to profound sensorineural hearing loss; • bone conduction implants, designed to help those people with conductive hearing loss, mixed hearing loss or single-sided deafness; and • acoustic implants, designed to help those people with moderate to severe sensorineural or mixed hearing loss. Cochlear’s implant systems comprise an implant which is inserted during surgery and an external sound processor. This external sound processor can be upgraded with new technology as it becomes available. For F14, 88% of Cochlear’s sales revenue was from cochlear implant (Nucleus) products and 12% from bone conduction (Baha) products. Sound processor upgrade sales revenue accounted for 13% of total sales revenue (15% of the cochlear implant products sales). The barriers to increasing the penetration of the candidate base include: • awareness of implantable solutions as a viable option; • patient motivation; AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 24 • lack of clear referral paths; • affordability and funding availability; and • clinic capacity. Cochlear operates in a global environment. Each of the over 100 countries that Cochlear sells into has differing penetration rates and reasons for that level of penetration owing to differing cultural and economic situations. Cochlear estimates that hundreds of thousands of people have been implanted with one of its implants. Cochlear’s business model includes supporting these customers with innovative and compatible products, through the sale of sound processor upgrades and accessories and ongoing product support. In F14, the launch of the Nucleus 6 Sound Processor into major markets in the second quarter (Q2) led to an increase in upgrade sales in the second half (H2) as customers upgraded to the new technology. Cochlear aims to remain the market leader in implantable hearing solutions. There is no independent published market share data but Cochlear estimates it has a market leading share of implantable hearing solutions. Cochlear’s global headquarters is based on the Macquarie University campus in Sydney, Australia. At this location are the corporate offices, manufacturing, research and development as well as the Asia Pacific regional headquarters. Cochlear manages its sales and distribution through three geographical regions. There are several principal regional head offices plus many local offices: • Americas, which includes the United States of America (US), Canada and Latin America; • EMEA, which includes Europe, Middle East and Africa; and • Asia Pacific, which includes Australasia and Asia. Cochlear has a deep geographical reach, selling in over 100 countries. Cochlear has a direct presence in approximately 20 countries and uses distributors and agents in other areas. Manufacturing for the cochlear implant product range is based in Australia, at three sites: Lane Cove and Macquarie University, in Sydney, and Brisbane. Lane Cove continues to manufacture Cochlear’s legacy products. New implant ranges will be manufactured at Cochlear’s Macquarie University headquarters including the Nucleus Profile implant recently launched. The Brisbane site is responsible for manufacturing non-implant components. The bone conduction implant product range is manufactured in Sweden. The acoustic implant product range is manufactured across sites in Australia, the US and Belgium. Cochlear’s supply chain operates with product being distributed from its manufacturing sites in Australia and Sweden to its regional distribution centres in the US, the United Kingdom (UK) and Panama. The product is then further distributed to the end customer. The proportion of Cochlear’s sales revenue to end customers by region is approximately: Americas 39%, EMEA 44% and Asia Pacific 17%. Foreign exchange has a significant impact on Cochlear’s consolidated results. Cochlear has a partial natural hedge with over 90% of sales in foreign currency and over 50% of costs in foreign currency. To help manage the portion not covered by the natural hedge, foreign exchange contracts on foreign currency cash flows back to Australia are taken out. These contracts cover a three year period at a declining level of cover. The Australian dollar (AUD) strengthened during the year against the Japanese yen (JPY) but has weakened against the United States dollar (USD) and the Euro (EUR). These are hedged currencies. Operating result F14 Revenue F14 was an important year for Cochlear as new products were launched and progress made on growth initiatives. The year commenced without regulatory approvals for key new products, but with the market anticipating imminent launches. This had the result of a slowdown of sales in Q1 F14 ahead of new product launches. As the year progressed, regulatory approvals came through for a range of new and innovative products. By the end of the year, Cochlear had launched the largest number of new products in a single year. These included: • Nucleus 6 Sound Processor • a fully featured Nucleus 6 Sound Processor was launched in key European markets in Q1. While not all features on Nucleus 6 Sound Processor were approved in the US, the sound processor started being sold in that region in Q2. Further approvals for the remaining features are being received on a progressive basis; • Nucleus Profile Implant Series • the world’s thinnest cochlear implant (Nucleus CI512) was launched in Europe and Asia in Q4 and is awaiting approval in other markets; Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 25 • Hybrid System • the Hybrid System was launched in the US in Q4; • Baha 4 and Baha Attract Systems • since being launched in Q2, these bone conduction products have been well received; • Aqua+ Accessory • the Aqua+ Accessory was launched in the US in Q3 and is pending approval In Europe; and • Codacs System • the Codacs System, part of the acoustics range, received European regulatory approval during F14. Cochlear believes this segment remains an important part of its product offering and will further broaden the indications for new candidates. As anticipated, sales in Q2 recovered and were up over 30% from Q1 following approval and the launch of the new products. This momentum continued in H2. Sales of cochlear implant units were down 3% to 25,997 for the year. H2 F14 unit sales were up 22% on H1 F14 and up 10% on H2 F13. Sales revenue was up 15% from that for last year to $820.9 million. In constant currency terms (i.e. restating F13 at F14 foreign exchange rates), sales revenue was up 3%. The tale of two halves was evident with H2 F14 sales revenue up 18% on H1 F14 and up 28% on H2 F13. In constant currency, H2 F14 sales revenue was up 16% on H2 F13. Cochlear implant sales revenue, which included sound processor upgrades, was up 13% to $720.8 million, and up 2% in constant currency. Revenue from sound processor upgrades (i.e. sales of new sound processors to existing recipients) can be cyclical. In F14, sound processor upgrade sales were up 27% to $108.0 million from those for the prior year, up 14% in constant currency. Sound processor upgrade sales increased in H2 F14 following the release of new products. Sales of bone anchored solutions (including acoustic implant sales) of $100.1 million were up 27% from those for last year and up 13% in constant currency. Again, the launch of new products in H1 F14 positively impacted sales growth and H2 F14 sales revenue was up 18% on H1 F14 and up 35% (up 21% in constant currency) on H2 F13. The AUD depreciated against most of Cochlear’s major currencies during the year which benefited sales revenue in AUD. From a translation perspective, Cochlear benefited by net $82.1 million i.e. AUD sales revenue was $82.1 million higher when translated at F14 foreign exchange rates than when translated at F13 foreign exchange rates. Offsetting this was a reduction in profit from foreign currency contracts. Hedges taken out in prior years and used in line with policy were at higher rates than the average spot foreign exchange rates applicable during the year on exercise of the foreign currency contracts. This resulted in a loss of $16.0 million compared to a profit of $37.7 million last year. Future foreign exchange contracts are detailed in Note 22 to the financial statements and indicate future foreign exchange contract rates closer to the current spot rates for the USD and EUR. Regional sales • Americas sales revenue of $320.8 million increased 13% (up 2% in constant currency). The launch of the Nucleus 6 together with the positive impact of the launched Aqua+ Accessory and the regulatory approval of the Hybrid System in April 2014 meant that H2 F14 sales revenue was up 14% on H1 F14 and up 27% (up 16% in constant currency) on H2 F13. In Q4 F13, the US business introduced a Future Technology Exchange Program (FTEP) where new implant recipients could exchange their sound processors for new technology at no additional cost once the new technology is approved for sale. In F13, revenue on cochlear implant system sales of $4.6 million was deferred under the FTEP and was recognised in F14 when the new sound processors were delivered to customers. There is no remaining FTEP deferred revenue at 30 June 2014. • EMEA sales revenue of $358.5 million increased 27% (increased 10% in constant currency). EMEA revenue growth continues to reflect the portfolio of geographies in the region, with varying growth rates in different countries. The launch of Nucleus 6 and Baha 4 and Baha Attract positively impacted sales and H2 F14 sales revenue was up 12% on H1 F14 and up 32% (up 17% in constant currency) on H2 F13. In Q4 F13, the EMEA business introduced an FTEP in selected countries. In F13, revenue on cochlear implant system sales of $1.8 million was deferred under the FTEP and was recognised in F14 when the Nucleus 6 Sound Processors were delivered to customers. There is no remaining FTEP deferred revenue at 30 June 2014. • Asia Pacific sales revenue of $141.6 million decreased 4% (decreased 9% in constant currency). Asia Pacific revenue growth continues to reflect the portfolio of geographies in the region, with varying growth rates in different countries. A Central Government tender sale into China of approximately 1,800 units was recognised in H2 F14 (down from 2,800 units in F13). In F14, the decrease in sales revenue was a consequence of the lower tender sales in China. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 26 Australia again achieved double digit cochlear implant unit sales growth. This demonstrates that there continues to be solid growth prospects for the other regions as they are well below the Australian penetration rates. For example, sales in the UK are approximately those in Australia, but the UK population is nearly three times the size of that of Australia. There are no statistically different demographics applicable to hearing impairment in the two countries. Product sales As well as a portfolio of geographies, there is also a comprehensive portfolio of products driving Cochlear’s revenue growth: • cochlear implant sales revenue increased 13% (increased 2% in constant currency) to $720.8 million, with H2 F14 being up 18% on H1 F14 and up 27% (up 15% in constant currency) on H2 F13. Sound processor upgrade sales revenue for F14 increased 27% (increased 14% in constant currency) to $108.0 million following the release of Cochlear’s Nucleus 6 Sound Processor in H1 F14; and • bone conduction and acoustic implant sales revenue grew 27% (increased 13% in constant currency) to $100.1 million. Cochlear introduced its Baha 4 and Baha Attract during F14 and this biased growth to H2 which was up 18% on H1 F14 and up 35% (up 21% in constant currency) on H2 F13. Profit Net profit after tax (NPAT) in H2 F14 was $72.7 million. This was in line with guidance provided in February 2014 and up 32% on H2 F13. Full year NPAT for F14 was $93.7 million. Cochlear’s cost of sales to sales revenue of 30.2% is above that for last year of 29.1%. Lower manufacturing volumes in the first half of F14 adversely impacted manufacturing variances. By H2, volumes had recovered and margins were improved. The cost of sales to sales revenue margin was 32.8% for H1 F14, but in H2 F14 had returned to historical levels and was 28.1%. Selling, general and administration (SG&A) expenses were up 16% but up 6% in constant currency. This followed a disciplined approach to expenditure. Cochlear invested approximately an additional $10 million during F14 in focused Strategic Growth Initiatives aimed at growing the market. Excluding foreign exchange movements and additional investment in Strategic Growth Initiatives, SG&A expenses increased 3%. The SG&A expense increase covered product launch costs as well as cost increases flagged last year such as the USA Medical Device Excise Tax and amortisation of enterprise resource planning system upgrades that had been completed late in F13. Research and development (R&D) expenses of $127.6 million increased 2% but decreased 2% in constant currency. This reflects the deliberate strategy to hold the R&D expenditure at F13 levels. As detailed earlier, a number of new products were released in F14. The regulatory and reimbursement regimen differ in the various countries Cochlear sells into and launch timing is governed by these approvals. A provision of USD 20 million ($22.5 million) was expensed in H1 F14 in relation to the patent dispute lawsuit by the Alfred E. Mann Foundation for Scientific Research (AMF) and Advanced Bionics LLC (AB) in the US. The directors are of the opinion that the facts and the law do not support the jury’s findings and Cochlear has applied to overturn the verdict in post-trial motions filed with the District Court. The directors will appeal any significant adverse Judgment to the United States Court of Appeals for the Federal Circuit. Full year earnings before interest and tax (EBIT) of $127.1 million was 29% lower than that for the prior year. Excluding the patent dispute provision in H1 F14, EBIT was $149.6 million and the EBIT to sales revenue of 18.2% was below that for last year of 25.0%. The H2 profit growth benefited from the higher sales and H2 F14 EBIT was $100.2 million, up 42% on H2 F13. H2 F14 EBIT was up 103% on H1 F14 EBIT, excluding the patent dispute provision. Net interest expense increased $3.8 million to $10.0 million due to higher borrowings. Interest cover was 13 times (2013: 29 times). The effective tax rate of 20.0% decreased by 3.2 percentage points. Excluding the patent dispute provision, the effective tax rate of 21.6% decreased by 1.6 percentage points, as the R&D tax concession benefit remained largely unchanged at $11.2 million reflecting the continued investment in R&D in Australia. NPAT decreased 29% to $93.7 million. Excluding the patent dispute provision, NPAT was $109.5 million, again heavily biased to H2. Overall, NPAT was negatively impacted by $12.5 million due to both translation and transaction movements in foreign exchange rates during the year. Financial position Inventories of $128.6 million at 30 June 2014 were down 2% from 30 June 2013 ($131.6 million). Inventory days decreased to 189 days (30 June 2013: 231 days). This reflects the strong sales in H2 F14 and careful inventory management. Trade receivables of $201.3 million were up 7% from 30 June 2013 ($187.6 million), reflecting the strong sales in H2 F14. In constant currency, trade receivables were up 6%. Debtor days decreased to 74 days (30 June 2013: 80 days). Debtor days decreased in all regions following a concerted effort to improve collections. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 27 The product recall provision was utilised by a net $15.0 million, with $21.6 million remaining at 30 June 2014. No further amount has been recognised as a charge or released as a credit in F14. Intangible assets of $234.1 million (30 June 2013: $235.8 million) are a significant proportion of Cochlear’s total assets. Foreign exchange movements accounted for $0.7 million of the decrease. Some $170.3 million of the asset total relates to goodwill arising from the earlier acquisitions of businesses, principally the Entific (Baha) business in 2005. All intangible assets are tested for impairment on an annual basis. There were no impairments or write-downs of intangible assets in F14. The final dividend of $1.27 per share brought the full year dividend to $2.54 per share, up 1%. This is in line with guidance provided at the F13 Annual General Meeting, held in October 2013. The Board anticipates the F15 dividend will return to a more historical payout ratio of approximately 70% of NPAT. Net debt was $181.3 million at 30 June 2014 (30 June 2013: $117.8 million). The increase in net debt was driven by: • profit generated of $93.7 million, with free cash flow of $79.5 million; used by • payment of dividends of $144.9 million; and • movements in working capital as discussed above. Free cash flow was $79.5 million for the year, up from $20.2 million for F13. The free cash flow for F14 was heavily biased to H2, with $65.1 million being generated in H2 F14. At 30 June 2014, debt facilities of $350 million were in place with remaining terms of two and four years. At 30 June 2014, the unused portion of the facilities was $110.0 million. All bank covenants were met at year end. Outlook There continue to be more people in the world diagnosed with hearing loss who could benefit from Cochlear’s products than are treated each year. There remains a significant, unmet and addressable clinical need which will continue to underpin long-term sustainable growth. The clinical and business environments in which Cochlear operates are dynamic and evolving. Cochlear is committed to identifying and supporting the clinical trends as they will shape its future operating environment. A good example of this is the ongoing trend for bilateral implantation. The impact of recently launched products as well as the impact of new products to be launched in F15 will continue to underpin demand and sales growth for the business. Cochlear’s latest generation sound processor, Nucleus 6, has now been launched in its major markets and will continue to be launched in the remaining markets as local regulatory approvals are received. Baha 4 and Baha Attract have also been launched in major markets and will continue to roll out to other markets as approvals are received. Cochlear benefits from a geographic portfolio effect, selling into a range of countries. In any year, some countries experience strong growth, some remain flat and some experience a slowdown. Overall, the trend is for long-term sustainable growth. Cochlear’s strong relationships with its customers and professionals will continue to underpin demand and sales growth for the business. Several of the emerging markets are heavily biased to tender sales, including the Central Government of China’s tenders. Cochlear reviews these tenders carefully and participates at a level that makes commercial sense. In F14, the Chinese tender of approximately 1,800 units was delivered in H2. The future outcome of tender sales is uncertain. Cochlear remains committed to funding market growth initiatives. These include candidate identification and support; reimbursement and government policy aimed at enhancing cochlear implantation; referral path initiatives; and geographic expansion. These will remain a focus in F15 and will augment overall market growth. At 30 June 2014, Cochlear had foreign currency equivalent of $431.9 million in foreign exchange contracts. In F15, the average exchange rate for the USD contracts is 0.93 and the average for EUR contracts is 0.72. At rates applicable on 30 June 2014, a net loss on foreign exchange contracts in F15 is forecast. Business risks Cochlear’s principal business risks are outlined below. These are significant risks that may adversely affect Cochlear’s business strategy, financial position or future performance. It is not possible to identify every risk that could affect Cochlear’s business, and the actions taken to mitigate the risks described below cannot provide absolute assurance that a risk will not materialise. • Product innovation and competition Cochlear is exposed to the risk of failing to develop and produce innovative products for customers. Increased competition exposes Cochlear to the risk of losing market share as well as a decrease in average selling prices in the industry. Cochlear is also exposed to the risk of medical, biological and/or technological advancement by third parties where alternative products or treatments are developed and commercialised that render Cochlear’s products obsolete. This could result in a loss of business. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 28 In F14, Cochlear invested 16% of revenue in R&D. Cochlear also works with over 100 external research partners. The creation of new intellectual property and the protection of new and existing intellectual property are a key focus for Cochlear. Cochlear currently has patents over a range of features of its technologies. • Infringement litigation Cochlear operates in an industry that has substantial intellectual property and patents, designs and trademarks protecting that intellectual property. Cochlear is exposed to the risk that it will be litigated against for claims of infringement. This could result in Cochlear paying royalties to be able to continue to manufacture product, or injunctions preventing Cochlear selling products it had developed. In F14, a provision of USD 20 million ($22.5 million) was expensed in relation to a patent infringement lawsuit by AMF and AB in the US. The directors are of the opinion that the facts and the law do not support the jury’s findings and Cochlear has applied to overturn the verdict in post-trial motions filed with the District Court. The directors will appeal any significant adverse Judgment to the United States Court of Appeals for the Federal Circuit. • Misappropriation of know-how and intellectual property Cochlear is exposed to the risk of its know-how and intellectual property being misappropriated either through hacking of its systems or by employees, consultants and others who from time to time have access to Cochlear’s know-how and intellectual property. This could result in competitors using this information and increasing their competitiveness. Cochlear could lose market share as a result of this. Cochlear monitors its systems and has appropriate safeguards and processes in place. Confidentiality agreements are in place with key employees and third parties that are exposed to Cochlear’s know-how and intellectual property. • Regulation Cochlear operates in a highly regulated industry. Medical devices are subject to strict regulations, including data security, of regulatory bodies in the US, Europe, Asia and Australia as well as many other local bodies in countries where Cochlear’s products are sold. If Cochlear or a third-party supplier fails to satisfy regulatory requirements or the regulations change and amendments are not made, this could result in the imposition of sanctions. Delays in achieving regulatory approval can impact Cochlear’s ability to sell its latest technology. These risks could result in Cochlear’s products being subject to recall and/or the loss of sales and reputational harm. Cochlear has a worldwide quality assurance system in place. • Reimbursement The majority of Cochlear’s customers rely on a level of reimbursement from insurers and government health authorities to fund their purchases. There is increasing pressure on healthcare budgets globally. Cochlear is also subject to healthcare related taxes imposed by government agencies and this could negatively impact the ability of candidates to access Cochlear’s products (e.g. the Medical Device Excise Tax in the US). Government reimbursement for Baha products in the US is currently under review by the Centers for Medicare and Medicaid Services (CMS). Cochlear continues to work with reimbursement and government agencies throughout the world to emphasise the benefits and cost effectiveness of the intervention. • Product liability The manufacturing, testing, marketing and sale of Cochlear’s products involve product liability risk. As the developer, manufacturer, marketer and distributor of certain products, Cochlear may be held liable for damages arising from use of its products during development or after the product has been approved for sale. Cochlear maintains product liability insurance and operates a worldwide quality assurance system related to the design, testing and manufacture of its products. • Interruption to product supply Cochlear relies on third-party companies for the supply of key materials and services. This carries the risk of delays and disruptions in supplies. Certain materials are available from a single source only and regulatory requirements make substitution costly, time-consuming or commercially unviable. Lifetime and strategic purchases of certain inventory items are made. Cochlear manufactures its cochlear implant products from two sites in Sydney. The latest generation products are manufactured at Cochlear’s Macquarie University headquarters and legacy products at a manufacturing site in Lane Cove. Cochlear manufactures its bone conduction implant products in Sweden. The acoustic implant product range is manufactured across sites in Australia, the US and Belgium. There is the potential risk of disruption to sales should a manufacturing facility be unable to operate. Any new manufacturing facility will require regulatory approval prior to being able to produce and sell product from it. This approval could take many months. Cochlear monitors its suppliers and identifies second-source supply where possible. Inventories are managed and purchased in sufficient quantities for continued product supply in the short term. Where appropriate, lifetime buys and strategic raw materials purchases are made. Cochlear also regularly reviews its disaster recovery plans for its manufacturing sites. Two discreet approved manufacturing sites for implants will be maintained. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 29 • Political or social instability Cochlear sells in over 100 countries. Regional political or social instability could negatively impact sales and the receipt of payment for sales. Cochlear assesses the countries it sells into and does not have a significant concentration of sales in countries impacted by political or social instability. • Foreign exchange rates Cochlear is exposed to currency risk on sales and purchases that are denominated in a currency other than the respective functional currencies of the legal entities. The currencies in which these transactions primarily are denominated are AUD, USD, EUR, JPY, Sterling (GBP), Swedish kroner (SEK) and Swiss francs (CHF). Over 90% of Cochlear’s revenues and over 50% of costs are denominated in currencies other than AUD. Currency risk is hedged in accordance with the Board approved treasury risk policy. The treasury risk policy aims to manage the impact of short-term fluctuations on Cochlear’s earnings. Over the longer term, permanent changes in market rates will have an impact on earnings. Derivative financial instruments (forward exchange contracts) are used to hedge exposure to fluctuations in foreign exchange rates in a declining ratio of coverage out to three years. • Credit Cochlear’s exposure to credit risk is influenced by the geographical location and characteristics of individual customers. Cochlear does not have a significant concentration of credit risk with a single customer. The majority of debtors are government supported clinics or major hospital chains. Policies and procedures for credit management and administration of receivables are established and executed at a regional level. Individual regions deliver reports to management and the Board on debtor ageing and collection activities on a monthly basis. In monitoring customer credit risk, the ageing profile of total receivables balances and individually significant debtors is reported by geographic region to the Board on a monthly basis. Regional management is responsible for identifying high risk customers and placing restrictions on future trading, including suspending future shipments and administering dispatches on a prepayment basis. In addition, absolute country limits are in place and Chief Financial Officer approval is required to increase a limit. These limits are periodically reviewed by the Audit Committee. • Interest rates Cochlear is exposed to interest rate risks in Australia. Interest rate risk is hedged on a case-by-case basis by assessing the term of borrowings and the purpose for which the funds are obtained. Hedging against interest rate risk is achieved by entering into interest rate swaps. At 30 June 2014, no hedging had been entered into. Note: Given the significance of the patent dispute and foreign exchange movements, the directors believe the presentation of non-International Financial Reporting Standards (IFRS) financial measures is useful for the users of this document as they reflect the underlying financial performance of the business. The non-IFRS financial measures included in this document have been calculated on the following basis: • constant currency: restatement of IFRS measures in comparative years using F14 foreign exchange rates; • free cash flow: IFRS cash flow from operating and investing activities excluding interest and tax paid related to non-operating activities; and • excluding patent dispute provision: IFRS measures adjusted for the expense of the patent dispute provision. These non-IFRS financial measures have not been subject to review or audit. However, KPMG has separately undertaken a set of procedures to agree the non-IFRS financial measures disclosed to the books and records of the Consolidated Entity. Consolidated results The consolidated results for the financial year are: Revenue Profit before income tax Net profit after tax but before patent dispute provision* Patent dispute provision, net of tax* Net profit Basic earnings per share (cents) Diluted earnings per share (cents) * The patent dispute provision was $22,545,000 before tax and $15,781,000 after tax. 2014 $000 804,936 117,114 109,490 15,781 93,709 164.6 164.2 2013 $000 752,721 172,637 132,563 - 132,563 233.0 232.4 Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 30 Dividends Dividends paid or declared by the Company to members since the end of the previous financial year are: Type Cents per share Total amount $000 Date of payment % franked Tax rate for franking credit In respect of the previous financial year: Final – ordinary shares In respect of the current financial year: Interim – ordinary shares 127.0 127.0 72,442 19 September 2013 30% 72,469 27 March 2014 0% 30% 30% The final dividend in respect of the current financial year has not been provided for in the Financial Report as it was not declared until after 30 June 2014. Since the end of the financial year, the directors declared a final 127 cents per share dividend, 20% franked at the tax rate of 30%, amounting to a total of $72,468,765. Environmental regulations Cochlear’s operations are subject to significant environmental regulations under the Commonwealth of Australia and State/Territory legislation. The Board believes that Cochlear has adequate systems in place to manage its environmental obligations and is not aware of any breach of those environmental requirements as they apply to Cochlear. Non-audit services During the year, KPMG, the Company’s auditor, has performed certain other services in addition to its statutory duties. The Board has considered the non-audit services provided during the year by the auditor and in accordance with written advice provided by resolution of the Audit Committee, is satisfied that the provision of those non-audit services during the year by the auditor is compatible with, and did not compromise, the auditor independence requirements of the Corporations Act 2001 for the following reasons: • all non-audit services were subject to the corporate governance procedures adopted by the Company and have been reviewed by the Audit Committee to ensure that they do not impact the integrity and objectivity of the auditor; and • the non-audit services provided do not undermine the general principles relating to auditor independence as set out in APES 110 Code of Ethics for Professional Accountants, as they did not involve reviewing or auditing the auditor’s own work, acting in a management or decision-making capacity for the Company, acting as an advocate for the Company or jointly sharing risks and rewards. Details of the amounts paid to the auditor of the Company, KPMG, and its related practices for audit and non-audit services during the year are set out below: Audit services Auditors of the Company: KPMG: – audit and review of financial reports – other regulatory compliance services Total audit services Non-audit services Auditors of the Company: KPMG: – taxation compliance services Total non-audit services State of affairs There were no significant changes to the state of affairs of Cochlear during the financial year. Consolidated 2014 $ 2013 $ 1,422,391 42,875 1,465,266 1,336,981 58,925 1,395,906 818,282 818,282 1,211,162 1,211,162 Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 31 Remuneration Report Contents Section 1.0 Title Introduction Description Describes the scope of the Remuneration Report and the individuals whose remuneration details are disclosed. 2.0 3.0 4.0 5.0 6.0 Remuneration governance Describes the role of the Board and the Human Resources Committee, and the use of remuneration consultants when making remuneration decisions. Non-executive director remuneration Provides details regarding the fees paid to non-executive directors. Executive remuneration Outlines the principles applied to executive remuneration decisions and the framework used to deliver the various components of remuneration, including explanation of the performance and remuneration linkages. Employee share scheme and other share information Service contracts and employment agreements Provides details regarding Cochlear’s employee equity plans including that information required by the Corporations Act 2001 and applicable accounting standards. Provides details regarding the contractual arrangements between Cochlear and the executives whose remuneration details are disclosed. 1.0 Introduction Cochlear is a geographically diverse business, subject to rapid and changing competitive forces, including currency variations, and with a long history of growth. The Board remains committed to a strong growth focus and designs its executive remuneration strategies to direct behaviours towards achieving sustainable growth in shareholder value over the long term. However, as noted last year, these policies must be flexible enough to enable Cochlear to attract, motivate and retain high performing executives in many locations in a dynamic environment. The Board’s philosophy and approach to executive remuneration have always been to balance fair remuneration for skills and expertise with a risk and reward framework that supports longer-term growth of Cochlear as a global business. The comprehensive review of executive remuneration during the financial year ended 30 June 2013 (F13) was implemented in F14. Following last year’s review, a number of changes were adopted in respect of Cochlear’s executive key management personnel (KMP) remuneration policies. As a reminder to shareholders, specific changes adopted are summarised as follows: 1. the Remuneration Report was reformatted with improved disclosure principles adopted; 2. the use of performance shares for long-term incentives (LTI) was suspended; 3. performance rights for executive KMP LTI were introduced; 4. changes in the eligibility criteria for participation in the LTI resulted in fewer executive participants; 5. the remuneration mix for the Chief Executive Officer (CEO)/President and other executive KMP was reweighted; 6. the short-term incentive (STI) opportunity for selected executives was increased; 7. the deferral of STI into performance rights has been introduced effective from 1 July 2013 equivalent to 30% of STI cash earned. The first allocation of rights under the deferred STI program occurred in August 2014; 8. the use of options for selected executive KMP LTI was retained because options are consistent with Cochlear’s objective to be a growth company. The use of options as an LTI alternative remains under constant review; 9. the LTI allocation methodology (including the option valuation for LTI dollar value) was changed to ‘gross contract value’ of the option at the calculation date, before any discounts for performance or service; 10. the performance conditions to apply to the F14 LTI were reviewed. The earnings per share (EPS) hurdle rates remained unchanged at the high end of market expectations. The total shareholder return (TSR) hurdle rate has been modified after consideration of shareholder feedback. These settings remain for the F15 LTI program. See section 4.4.2; Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 32 11. selected Board and executive KMP remuneration was independently benchmarked to ensure the remuneration of these key roles meets external expectations. This remains an ongoing process; 12. director fees remained unchanged in F14, apart from a minor increase in Chairman fees for the Audit Committee and Human Resources Committee (HRC) to reflect the additional responsibilities and time commitments required; and 13. the remuneration mix for all executive KMP was reviewed to ensure it met external benchmark standards. Changes adopted have been explained in the Remuneration Report. The changes adopted in F14 are reviewed annually. At this stage, no material Board or executive KMP remuneration strategy changes are under consideration for F15. The Board believes Cochlear’s approach to Board and executive KMP remuneration is a balanced, fair and equitable approach designed to reward and motivate a successful and experienced executive team to deliver ongoing business growth which meets the expectations of shareholders over the long term. The Board will continue to welcome feedback from shareholders on Cochlear’s remuneration practices or on the communication of remuneration matters in the F14 Remuneration Report and beyond. 1.1 Scope This Remuneration Report sets out, in accordance with the relevant Corporations Act 2001 (Corporations Act) and accounting standard requirements, the remuneration arrangements in place for KMP of Cochlear during F14. 1.2 Key management personnel Key management personnel have authority and responsibility for planning, directing and controlling the activities of Cochlear and comprise the non-executive directors, and executive KMP (being the executive director and other senior executives named in this report). Details of the KMP as at year end are set out in the table below: Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 33 Non-executive directors Rick Holliday-Smith Yasmin Allen Paul Bell Edward Byrne, AC Andrew Denver Donal O’Dwyer Executive director Chris Roberts Other executive KMP Richard Brook Jan Janssen Title (at year end) Change in F14 Chairman Member, Audit Committee Member, Human Resources Committee Chairman, Nomination Committee Director Chairman, Audit Committee Member, Human Resources Committee Member, Nomination Committee Director Chairman, Human Resources Committee Member, Nomination Committee Director Chairman, Medical Science Committee Member, Nomination Committee Member, Technology and Innovation Committee Director Member, Audit Committee Member, Medical Science Committee Member, Nomination Committee Chairman, Technology and Innovation Committee Director Member, Audit Committee Member, Medical Science Committee Member, Nomination Committee Member, Technology and Innovation Committee Changed committee membership from 1 July 2013 Changed committee membership from 1 July 2013 Changed committee membership from 1 July 2013 No change. Full year Changed committee membership from 1 July 2013 Changed committee membership from 1 July 2013 CEO/President Member, Medical Science Committee Member, Technology and Innovation Committee No change. Full year President, European Region Senior Vice President, Design and Development, Clinical and Regulatory No change. Full year No change. Full year Neville Mitchell Chief Financial Officer and Company Secretary No change. Full year Mark Salmon Chris Smith President, Asia Pacific Region President, Americas Region No change. Full year No change. Full year There were no key management personnel departures during F14. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 34 2.0 Remuneration governance This section of the Remuneration Report describes the role of the Board and the HRC, and the use of remuneration consultants when making remuneration decisions. 2.1 Role of the Board and the Human Resources Committee The Board is responsible for Cochlear’s remuneration strategy and policy. Consistent with this responsibility, the Board has established the HRC which comprises solely independent non-executive directors (NEDs). The role of the HRC is set out in its Charter, which is reviewed annually and was last revised and approved by the Board in December 2012. In summary, the HRC’s role includes: • ensure that the appropriate procedures exist to assess the remuneration levels of the Chairman, other NEDs, executive directors, direct reports to the CEO/President, Board committees and the Board as a whole; • ensure that Cochlear meets the requirements of the ASX Corporate Governance Council’s gender diversity principles and recommendations, and other relevant guidelines; • ensure that Cochlear adopts, monitors and applies appropriate remuneration policies and procedures; • ensure that reporting disclosures related to remuneration meet the Board’s disclosure objectives and all relevant legal requirements; • develop, maintain and monitor appropriate talent management programs including succession planning, recruitment, development; and retention and termination policies and procedures for senior management; and • develop, maintain and monitor appropriate superannuation and other pension benefit arrangements for Cochlear. The HRC’s role and interaction with Board, internal and external advisors, are further illustrated below: The Board Reviews, applies judgement and, as appropriate, approves the HRC’s recommendations. The Human Resources Committee The HRC operates under the delegated authority of the Board. The HRC is empowered to source any internal resources and obtain external independent professional advice it considers necessary to enable it to make recommendations to the Board on the following: Remuneration policy, composition and quantum of remuneration components for executive KMP, and performance targets Remuneration policy in respect of NEDs Talent management policies and practices including superannuation arrangements Design features of employee and executive STI and LTI plan awards, including setting of performance and other vesting criteria External consultants Internal resources Further information on the HRC’s role, responsibilities and membership is contained in the Corporate Governance Report of this Annual Report. The HRC terms of reference can also be viewed in the Investor Centre, corporate governance section of the Cochlear website, www.cochlear.com. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 35 2.2 Use of remuneration consultants During F14, remuneration consultancy contracts were entered into by Cochlear and accordingly the disclosures required under section 300A(1)(h) of the Corporations Act are set out as follows: Advisor/consultant — F14 Services provided Remuneration consultant for the purpose of the Corporations Act Ian Crichton, Remuneration Consultant, CRA Plan Managers Pty Limited Review of F14 Remuneration Report No Key questions regarding use of remuneration consultants Did the remuneration consultant provide remuneration recommendations in relation to any of the executive KMP for F14? No How much was the remuneration consultant paid by Cochlear for remuneration related and other services? What arrangements did Cochlear make to ensure that the making of the remuneration recommendations would be free from undue influence by the executive KMP? Is the Board satisfied that the remuneration information provided was free from any such undue influence? What are the reasons for the Board being so satisfied? CRA Plan Managers Pty Limited – remuneration services $43,070; other services $33,212. Cochlear maintains a protocol which governs the procedure for procuring advice relating to KMP remuneration. The protocol contains a summary of the process for the engagement of the remuneration consultant, the provision of information to the remuneration consultant and the communication of remuneration recommendations. Yes, the Board is satisfied. The reasons are as follows: the Chairman of the HRC had oversight of all requests for remuneration information; and the protocol with respect to the procurement of remuneration related advice remains in place. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 36 3.0 Non-executive director remuneration 3.1 NED remuneration Principle Fees are set by reference to key considerations Comment Fees for NEDs are based on the nature of the NEDs’ work and their responsibilities. The remuneration rates reflect the complexity of Cochlear and the extent of the geographical regions in which Cochlear operates. In determining the level of fees, survey data on comparable companies is considered. NEDs’ fees are recommended by the HRC and determined by the Board. Shareholders approve the aggregate amount available for the remuneration of NEDs. A minor increase in Audit Committee Chairman and Human Resource Committee fees was introduced in F14. Remuneration is structured to preserve independence whilst creating alignment (see also section 3.4) To preserve independence and impartiality, NEDs are not entitled to any form of incentive payments including options and the level of their fees is not set with reference to measures of Cochlear performance. However, to create alignment between directors and shareholders, the Board has adopted guidelines that request NEDs to hold (or have a benefit in) shares in Cochlear equivalent in value to at least one year’s base fees. Cochlear does not offer loans to fund share ownership. Aggregate Board and committee fees are approved by shareholders The total amount of fees paid to NEDs in F14 is within the aggregate amount approved by shareholders at the AGM in October 2011 of $2,000,000 per year. 3.2 NED fees and other benefits Elements Board/committee fees per annum – F14 Details Board Chairman fee1 Board NED base fee Committee fees Audit Human Resources Nomination Medical Science Technology and Innovation $438,000 $146,000 Committee Chair Committee member $40,000 $30,000 No fee $20,000 $20,000 $20,000 $10,000 No fee $10,000 $10,000 Post-employment benefits Superannuation Retirement scheme Superannuation contributions have been made at a rate of 9.25% of the base fee (but only up to the Australian Government’s prescribed maximum contributions limit) which satisfies the Company’s statutory superannuation contributions. The contribution rate increased on 1 July 2014 to 9.5%. Contributions are not included in the base fee. From 2003, no new NED was entitled to join the Cochlear directors’ retirement scheme. NEDs appointed prior to this were members of the scheme, which provided NEDs with more than five years’ service, retirement benefits of up to three times their annual remuneration over the previous three years. On 23 October 2006, the Board determined that it should implement changes to NED remuneration consistent with developing market practice and guidelines, by discontinuing the ongoing accrual of benefits under the existing retirement scheme once the remaining members of the scheme reached their five year service period. The benefits accrued to that date are indexed by reference to the bank bill rate. All directors transitioned from the retirement scheme during F07. As at 30 June 2014, Edward Byrne is the only NED entitled to this benefit. The accrued entitlement for Edward Byrne under the Cochlear directors’ retirement scheme as at 30 June 2014 was $421,719. Other benefits Equity instruments Other fees/benefits NEDs do not receive any performance related remuneration, options or performance shares/rights. NEDs receive reimbursement for costs directly related to Cochlear business. No payments were made to NEDs during F14 for travel allowances, extra services or special exertions. 1. Committee fees are not paid to the Chairman of the Board. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 37 3.3 NED total remuneration Amounts $ Rick Holliday-Smith (Chairman) Yasmin Allen2,3 Paul Bell4 Edward Byrne3 Andrew Denver3 Donal O’Dwyer Total Short-term benefits Fees Post-employment benefits Termination benefits1 Superannuation benefits 438,000 438,000 196,000 185,192 176,000 171,000 176,000 166,000 196,000 186,000 186,000 186,000 - - - - - - 10,902 12,293 - - - - 17,775 16,470 17,255 15,888 16,280 15,338 16,280 14,940 17,255 15,753 16,828 15,961 Total 455,775 454,470 213,255 201,080 192,280 186,338 203,182 193,233 213,255 201,753 202,828 201,961 1,368,000 1,332,192 10,902 12,293 101,673 94,350 1,480,575 1,438,835 Year F14 F13 F14 F13 F14 F13 F14 F13 F14 F13 F14 F13 F14 F13 1. Amounts accrued for interest during the financial year relating to the directors’ retirement scheme. 2. Increased fee for Chair of Audit Committee. 3. Increases related to serving new Board committee responsibilities for the full year. 4. Increased fee for Chair of Human Resources Committee. 3.4 Minimum shareholding guidelines The Board has approved minimum shareholding guidelines for NEDs, the CEO/President and those executives who report directly to the CEO/President. Under these guidelines, all NEDs are requested to accumulate a minimum shareholding in Cochlear shares equivalent in value to one year’s base fees and all executive KMP are requested to accumulate a minimum shareholding in Cochlear shares equivalent to one year’s total fixed remuneration, calculated using the prior 365 day average closing share price. The guidelines were implemented in March 2007. As at 30 June 2014, all executive KMP and NEDs were in compliance with the guidelines. 4.0 Executive remuneration 4.1 Executive KMP remuneration Cochlear’s executive remuneration policies are designed to attract, motivate and retain a highly qualified and experienced group of executives employed across diverse geographies. Fixed remuneration components are determined having regard to the specific skills and competencies of the executive KMP with reference to both internal and external relativities, particularly local market conditions. The ‘at risk’ components of remuneration are strategically directed to encourage management to strive for superior (risk balanced) performance by rewarding the achievement of targets that are challenging, clearly defined, understood and communicated within the ambit of accountability of the relevant executive KMP. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 38 Executive KMP remuneration objectives are exemplified through three categories of remuneration, as illustrated below: Executive KMP remuneration objectives Attract, motivate and retain executive talent across diverse geographies The creation of reward differentiation to drive performance values and behaviours components An appropriate balance of ‘fixed’ and ‘at risk’ components Shareholder value creation through equity components Total target remuneration (TTR) is set by reference to the relevant geographic market Fixed At risk Total fixed remuneration (TFR) Short-term incentives (STI) Long-term incentives (LTI) TFR is set based on relevant market relativities, reflecting responsibilities, performance, qualifications, experience and geographic location STI performance criteria are set by reference to Cochlear group and/or regional revenue and EBIT and individual performance targets relevant to the specific position LTI targets are linked to both Cochlear group internal EPS growth and external relative TSR outperformance measures Remuneration will be delivered as: Base salary plus any fixed elements related to local markets, including superannuation or equivalents Part cash and part equity (performance rights). The equity component will be subject to service and deferred for 2 years Equity in options and/or performance rights. All equity is held subject to service and performance for 3 years from grant date. The equity is at risk until vesting. Performance is tested once at the vesting date Strategic intent and market positioning TFR will generally be positioned at the median compared to relevant market based data considering expertise and performance in the role Performance incentive is directed to achieving Board approved targets, reflective of market circumstances. TFR + STI is intended to be positioned in the 3rd quartile of the relevant benchmark comparisons LTI is intended to reward executive KMP for sustainable long-term growth aligned to shareholders’ interests. LTI allocation values are intended to be positioned at the top of the 3rd quartile of the relevant benchmark comparisons Total target remuneration TTR is intended to be positioned in the 3rd quartile compared to relevant market benchmark comparisons. 4th quartile TTR may result if outperformance is achieved. The remuneration structure is designed to ensure top quartile executive KMP remuneration is only achieved if Cochlear outperforms Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 39 4.2 Remuneration composition mix and timing of receipt 4.2.1 Current remuneration mix and amendments for F15 Cochlear endeavours to provide an appropriate and competitive mix of remuneration components balanced between fixed and at risk and paid in both cash and deferred equity. The broad remuneration composition mix for executive KMP can be illustrated as follows: Remuneration mix for F14 The review of executive remuneration last year (F13) involved shareholder feedback and market benchmarks to understand context and positioning and detailed analysis of past remuneration outcomes using the new valuation methodology. Following the review of remuneration, the Board decided to reweight the performance based elements of total target remuneration and to introduce a deferred equity component to the STI plan for executive KMP. The effect of this reweighting and application of the new LTI allocation valuation delivered a lower effective LTI value (through lower LTI allocations) offset by a higher STI opportunity and with a component value equivalent to 30% of STI cash deferred into equity with a further two year vesting period. This change was made in response to the detailed remuneration strategy review and to ensure executives are rewarded for sustained performance. The Board believes the new arrangements better reflect contemporary standards and remuneration benchmark comparisons. Position CEO/President Other executive KMP TFR (Cash) at target 33.4% of TTR STI at target LTI at target 33.3% of TTR 33.3% of TTR At least 45.1% of TTR Up to 32.3% of TTR Up to 22.6% of TTR The mix of remuneration for the CEO/President and other executive KMP will remain unchanged in F15. Total fixed remuneration (TFR) Cochlear’s approach to TFR settings is to aim to position all executives between the median and 75th percentile, but at the lower end of this range where possible to control fixed costs, exchange rate movements notwithstanding. Only modest increases in TFR were approved in F14 to maintain this balanced approach. Cochlear’s approach to TFR settings will remain largely unchanged in F15. Short-term incentives (STI) Cochlear has consistently focused STI on achieving annual revenue and EBIT targets and personal objectives. To support Cochlear’s balanced approach to TFR, Cochlear has set STI targets aimed at achieving a market competitive TFR + STI between the median and the 75th percentile when budgets are met. STI opportunity was increased in F14 following an independent assessment comprising a higher STI opportunity and with the introduction of a component value, equivalent to 30% of STI cash earned, deferred into equity for the first time. The LTI value was also reduced primarily as a function of changing the allocation value. The changes adopted in F14 will remain largely unchanged in F15. Long-term incentives (LTI) As announced last year, the LTI opportunity is now calculated using the ‘gross contract value’. The change from ‘accounting value’ to ‘gross contract value’ materially reduced the number of equity units available for the designated LTI dollar opportunity. Accordingly, some reweighting of the LTI was adopted in F14. The approach and methodology remain in F15. Total target remuneration (TTR) TTR under the remuneration mix adopted will, in the opinion of the Board, deliver an overall risk adjusted reward opportunity which is fair and market competitive. Shareholders should note that Cochlear has performance hurdles, particularly for LTI that are at the higher end of the market (S&P/ASX 100 companies) in terms of degrees of difficulty. Further, any LTI award will only have value to the executive if the performance hurdles are met to enable vesting to occur, and for option related awards, the equity outcomes are positive in terms of share price movement (i.e. the share price on vesting exceeds the exercise price). In F14, the LTI program delivered a nil outcome and the STI program within a range around 50%. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 40 4.2.2 Remuneration – timing of receipt of the benefit for F15 onwards The three complementary components of executive KMP remuneration are ‘earned’ over multiple time ranges. This is illustrated in the following chart: Year 1 Year 2 Year 3 Year 4 Year 5 F14 F15 F16 TFR STI cash opportunity STI equity deferral (2 years) LTI TFR STI cash opportunity STI equity deferral (2 years) LTI TFR STI cash opportunity STI equity deferral (2 years) LTI Note: LTI is awarded in year 1 and earned at the end of year 3 but expensed over the three year service period. As illustrated, executive KMP remuneration is delivered on a cascading basis, with a material component deferred for two (STI) and three (LTI) years and awarded as equity. This remuneration mix is designed to ensure executive KMP are focused on delivering results over the short, medium and long term if they are to maximise their remuneration opportunity. The Board believes this approach aligns executive KMP remuneration to shareholder interests and expectations. 4.3 Total fixed remuneration explained Total fixed remuneration (TFR) includes all remuneration and benefits paid to an executive KMP calculated on a total employment cost basis. In addition to base salary, selected overseas executives receive benefits that may include health insurance, car allowances and relocation allowances. In Australia, retirement benefits are generally paid in line with the statutory Superannuation Guarantee legislation prevailing. Globally, retirement benefits are generally paid in line with local legislation and practice. Executive KMP TFR is tested regularly for market competiveness by reference to appropriate independent and externally sourced comparable benchmark information, including for comparable ASX listed companies, and based on a range of size criteria including market capitalisation, taking into account an executive’s responsibilities, performance, qualifications, experience and geographic location. Job evaluation methodologies are applied to assist with managing internal relativities. TFR adjustments, if any, are made with reference to individual performance, an increase in job role or responsibility, changing market circumstances as reflected through independent benchmark assessments or through promotion. Any adjustments to executive KMP remuneration are approved by the Board, based on HRC and CEO/President recommendations. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 41 4.4 Variable (at risk) remuneration explained As set out in section 4.2, variable remuneration forms a significant portion of the CEO/President and other executive KMP remuneration opportunity. Apart from being market competitive, the purpose of variable remuneration is to direct executives’ behaviours towards maximising Cochlear’s short, medium and long-term performance. The key aspects are summarised below: 4.4.1 Short-term incentives (STI) Purpose Performance targets The STI arrangements at Cochlear are designed to reward executives for the achievement against annual performance targets set by the Board at the beginning of the performance period. The STI program is reviewed annually by the HRC and approved by the Board. Any STI award in excess of the 100% budget opportunity is individually approved by the HRC. All STI awards to the CEO/President and other executive KMP are approved by the HRC and Board. The key performance objectives of Cochlear are currently directed to achieving Board approved sales revenue and EBIT targets, and by the achievement of individual performance goals. For the current year, sales revenue and EBIT targets had equal weighting. The weighting between Cochlear group and regional sales revenue and EBIT will depend on the responsibilities and scope of influence of the executive KMP. Individual performance goals account for a 20% weighting for executive KMP based on a range of individual performance objectives including strategic objectives determined each year. 80% of STI is based on financial targets set by the Board and having regard to prior year performance, global market conditions, competitive environment, future prospects and the Board approved budgets. The specific targets are not detailed in this report due to their commercial sensitivity. Validation of performance against the measures set for: • the CEO/President involves an independent review and endorsement by the Chief Financial Officer (CFO), reviewed and approved by the HRC and Board; and • other executive KMP involves a review by the CEO/President based on inputs from the CFO. Final review is undertaken by the HRC and Board. Any anomalies or discretionary elements are validated and approved by the Board. Rewarding performance The STI performance ratings are determined under a predetermined matrix with the Board determination final. Mandatory deferral of STI Effective from 1 July 2013, a mandatory deferral of a portion of STI was introduced to reinforce alignment with shareholder interests. Grants will be calculated at the end of each year based on EBIT, revenue and individual performance outcomes and then held for two years until vesting. This achieves additional retention and alignment of executives with shareholder interests. The deferred STI component for F14 will be calculated based on 30% of the STI cash amount earned and will be delivered as performance rights. The equity component will be independently determined based on the gross contract value using Cochlear’s five day volume weighted average price following the announcement of full year results in August 2014, that is, based on a Black-Scholes-Merton pricing model without discounting for service or performance hurdles. Once the STI awarded as performance rights has been granted, there are no further performance measures attached to the performance rights other than continued tenure for the vesting period (two years). Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 42 Table 1 – Executive KMP STI opportunity and actual F14 STI awarded1 Executive KMP Position Chris Roberts Richard Brook Jan Janssen CEO/President President, European Region2 Senior Vice President, Design and Development, Clinical and Regulatory Neville Mitchell CFO and Company Secretary Mark Salmon Chris Smith President, Asia Pacific Region President, Americas Region2 Target STI as a % of F14 TTR STI awarded as a % of TTR Actual cash and deferred STI award in F14 ($) Actual STI forfeited in F14 as a % of TTR 33.3% 24.5% 32.3% 32.3% 32.3% 31.5% 18.1% 21.1% 17.7% 17.7% 15.9% 22.2% 760,572 277,426 198,521 244,433 204,584 335,718 15.2% 3.4% 14.6% 14.6% 16.4% 9.4% 1. Includes the monetary value of STI cash combined with the monetary value of STI deferral. 2. European and US based Regional Presidents’ total target remuneration is benchmarked and paid in local currency. F14 STI payments are similar to those paid in F13 for the KMP. This reflects a number of factors: • increase in STI target opportunity; • business performance with EBIT, revenue and individual outcomes resulting in payments within a range between 49.1% – 86.1% of target; • the patent dispute provision detailed in Note 20 to the financial statements was excluded for the calculation of STI; • currency fluctuations; and • momentum built with increased revenues, and careful investment in growth initiatives and cost management and second half guidance met. 4.4.2 Long-term incentives (LTI) The LTI provides an annual opportunity for executive KMP and other selected executives (based on their ability to influence and execute strategy) to receive an equity award deferred for three years, that is intended to align a significant portion of executives’ overall remuneration to shareholder value over the longer term. All LTI awards remain at risk and subject to forfeiture or lapse until vesting and must meet or exceed EPS growth rates and/or relative TSR performance hurdles over the vesting period. Purpose To align executive KMP remuneration opportunity with shareholder value and provide retention stimulus. Types of equity awarded LTI up to F13 was provided under the Cochlear Executive Long Term Incentive Plan. See section 5.1 for further details. A new plan, the Cochlear Executive Incentive Plan (CEIP), was introduced in July 2013. See section 5.1 for further details. Under the CEIP, selected senior executives are offered options (being an option at a pre-set exercise price to acquire ordinary shares of Cochlear Limited) or performance rights (being a nil exercise price right to fully paid ordinary shares of Cochlear Limited) or a combination of both. Time of grant All equity grants will be made after the AGM each year but based on values determined in August. Time restrictions Equity grants awarded to the CEO/President and other executive KMP are tested against the performance hurdles set, at the end of three financial years. If the performance hurdles are not met at the vesting date, options or performance rights lapse. Performance hurdles and vesting schedule Equity grants to the CEO/President and other executive KMP are in two equal tranches assigned 50% to compound annual growth in EPS and 50% subject to ranking of TSR against the S&P/ASX 100. The performance conditions applying to the latest grant (F14) were as follows: Compound annual growth in EPS (3 years) Ranking of TSR against S&P/ASX 100 (3 years) Performance % of equity to vest Performance % of equity to vest < 10% 0% < 50th percentile 0% 10% to 20% 50% to 100% pro-rata 50th to 75th percentile 40% to 100% pro-rata > 20% 100% > 75th percentile 100% Options and performance rights vest if the time restrictions and relevant performance hurdles are met. The Board must approve any special provisions, in accordance with Company policies, in the event of termination of employment or a change of control. After the three year vesting schedule, any vested options expire after seven months if they have not been exercised. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 43 Dividends No dividends are attached to options or performance rights. Voting rights There are no voting rights attached to options or performance rights. Retesting There is no retesting of performance hurdles under Cochlear LTI. LTI allocation The size of individual LTI grants for the CEO/President and other executive KMP is determined in accordance with the Board approved remuneration strategy mix. See section 4.2. The allocation methodology for options and performance rights was changed effective from 1 July 2013. The target LTI dollar value for each executive is converted to options and/or performance rights according to new LTI allocation values and is independently determined based on the gross contract value of the relevant equity instrument and based on a Black-Scholes-Merton pricing model without discounting for service or EPS and TSR performance hurdles: • performance option allocation = LTI dollar value/Black-Scholes-Merton value before service or EPS and TSR performance discounts; and/or • performance right allocation = LTI dollar value/Black-Scholes-Merton value before service or EPS and TSR performance discounts. Table 2 – Vesting outcomes (performance shares and options granted F10 to F12) Performance shares Grant date Vesting timeframe EPS 3 year CAGR1 % vested2 % forfeited Relative 3 year TSR ranking percentile % vested2 % forfeited Market price on vesting date 17-Aug-09 Vested June 2012 16-Aug-10 Vested June 2013 15-Aug-11 Vested June 2014 -24.6% -5.5% -19.7% 0.0% 0.0% 0.0% 100.0% 100.0% 100.0% 65th 28th 32nd 79.3% 0.0% 0.0% 20.7% 100.0% 100.0% $64.40 N/A N/A Options Grant date Vesting timeframe Exercise price EPS 3 year CAGR1 % vested2 % forfeited 17-Aug-09 Vested June 2012 16-Aug-10 Vested June 2013 15-Aug-11 Vested June 2014 $60.04 $69.80 $68.56 -24.6% -5.5% -19.7% 0.0% 0.0% 0.0% 100.0% 100.0% 100.0% 1. Compound annual growth rate. 2. All plan participants had the same vesting and forfeiture percentage outcome. Relative 3 year TSR ranking percentile 65th 28th 32nd % vested2 % forfeited Net market value at vesting 79.3% 20.7% $4.36 0.0% 0.0% 100.0% 100.0% N/A N/A Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 44 4.5 Other remuneration elements and disclosures relevant to executive KMP 4.5.1 Clawback Cochlear implemented a clawback policy to take effect from 1 July 2014 to ensure compliance with ASX requirements. There have been no circumstances where the policy would have applied. 4.5.2 Hedging and margin lending prohibition Under the Cochlear Trading Policy and in accordance with the Corporations Act, equity granted under Cochlear equity incentive schemes must remain at risk until vested, or until exercised if options or performance rights. It is a specific condition of grant that no schemes are entered into, by an individual or their associates that specifically protect the unvested value of performance shares, options or performance rights allocated. Cochlear also prohibits the CEO/President or ‘Designated Persons’ (including other executive KMP) providing Cochlear securities in connection with a margin loan or similar financing arrangement unless that person has received a specific notice of no objection in compliance with the policy. Cochlear, in line with good corporate governance, has a formal policy setting down how and when employees of Cochlear may deal in Cochlear securities. Cochlear’s Trading Policy is available on the Cochlear website www.cochlear.com under Investor Centre, corporate governance. 4.5.3 Cessation of employment provisions The provisions that apply for STI and LTI awards in the case of cessation of employment are detailed in sections 6.1 (Service contracts) and 6.2 (Employment agreements). 4.5.4 Conditions of LTI grants The conditions under which LTI (performance rights and options) are granted, and are approved by the Board in accordance with the relevant scheme rules, are as summarised in section 5. 4.5.5 Minimum shareholding guidelines The purpose of the Cochlear NED and executive share ownership guidelines is to ensure appropriate alignment of the interests of Cochlear’s KMP with the financial interests of Cochlear’s shareholders. The guidelines aim to create a share ownership focus and culture and to build long-term commitment to the Company by providing direction to KMP as to minimum levels of share ownership. Each executive KMP should hold Cochlear Limited shares or vested options to an amount that is equivalent to the prior year’s TFR, or one time’s base fees for NEDs, based on the 365 day average Cochlear Limited share price for the prior year. The guidelines were introduced in March 2007 and all executive KMP were expected to acquire the relevant number of shares over three years from implementation of the guidelines. As at 30 June 2014, all executive KMP were in compliance with the guidelines. 4.6 Relationship between Cochlear performance and executive KMP remuneration 4.6.1 Cochlear financial performance (F10 to F14) Sales revenue ($million) EBIT ($million) NPAT ($million) Basic EPS (cents) Total dividend per share (cents) Share price as at 30 June ($) F10 696.2 220.5 155.2 275.7 200.0 74.32 F11 732.2 242.7 180.1 318.2 225.0 72.00 F12 704.6 76.5 56.8 100.0 245.0 65.84 F13 715.0 178.9 132.6 233.0 252.0 61.71 F14 820.9 127.1 93.7 164.6 254.0 61.70 For further explanation of details on Cochlear performance, see the Principal activities and review of operations and results section of the Directors’ Report on pages 23 to 30. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 45 4.6.2 Cochlear current year performance and relationship to executive KMP remuneration Cochlear sales grew 15% year on year with second half sales revenue up 28% on the corresponding period last year. New product launches combined with investments in market growth initiatives drove this growth. In F14, a provision of $22.5 million was expensed in relation to the patent dispute lawsuit. A loss of $16.0 million (F13 profit of $37.7 million) was made on foreign exchange contracts. Earnings per share in F14 of 164.6 cents was 29% below F13. The Board evaluates STI each six months and considers the mix of components and targets to ensure they remain focused but sensitive to market challenges. The STI payouts to KMP this year ranged from 49.1% to 54.9% of their opportunity, with the exception of the President of the Americas Region and the President of the European Region who earned 70.3% and 86.1% of their opportunity respectively. This reflects the relatively stronger bone anchored solutions and European regional performance in F14 as explained in the Principal activities and review of operations and results section. The executive KMP again performed at expectations with respect to their personal objectives. The Board believes that the payout ratios on STI in F14 fairly reflected individual, business and Cochlear performance expectations and that overall executive KMP remuneration remain aligned to Company performance. 4.6.3 Cochlear EPS and TSR performance (F10 to F14) and relationship to executive KMP remuneration As explained in section 4.1, Cochlear’s remuneration framework aims to incentivise executive KMP towards long-term sustainable growth of the business internationally and the creation of shareholder value in the short, medium and long term. This is developed in two ways: • cash (and equity) STI, whether paid immediately or deferred, depend on revenue and EBIT performance and outcomes for the completed performance year (as explained in section 4.4.1); and • LTI, in the form of options and performance rights, are linked to compound annual growth in EPS and relative TSR performance (as explained in section 4.4.2). EPS (internal) and relative TSR (external) are generally accepted proxies for creation of shareholder value. It is the Board’s intention to review the suitability of these performance criteria and settings on a regular basis to ensure they best serve shareholders’ interests. Earnings per share (EPS) Cochlear’s basic EPS over the last five years is displayed in the graph below: 318.2 275.7 F10 F11 For more information, see the Directors’ Report. 233.0 164.6 F13 F14 100.0 F12 The table below illustrates Cochlear’s compound annual growth in basic EPS in respect of performance for grants from F10 to F12: Grant date 17-Aug-09 16-Aug-10 15-Aug-11 Compound annual EPS growth EPS vesting performance F10 18.0% F11 16.7% 15.4% F12 -24.6% -39.8% -68.6% F13 F14 -5.5% -14.4% -19.7% 0.0% 0.0% 0.0% Refer the Principal activities and review of operations and results section of the Directors’ Report on pages 23 to 30 for details on the performance of Cochlear. As a result of Cochlear underachieving the EPS growth targets set, none of the 2011 equity grants vested. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 46 Total shareholder return (TSR) – unaudited Cochlear’s relative TSR performance over the relevant performance periods up to 30 June 2014 in respect of vested equity grants is set out below. This information is unaudited. Grant date 17-Aug-09 16-Aug-10 15-Aug-11 Relative 3 year TSR percentile ranking TSR vesting performance 65th 28th 32nd 79.3% 0.0% 0.0% TSR is a function of share price growth and dividends reinvested. However, Cochlear’s performance over time, is affected by a range of variables, including currency volatility, global economic and geopolitical conditions, market growth for its products and other competitive pressures. Cochlear did not meet the minimum threshold of TSR performance for the 2011 equity grants, so none of the 2011 equity grants vested. 4.7 Executive remuneration table – audited statutory disclosure (accounting cost to Cochlear) Year Fixed remuneration Variable remuneration Total Proportion of total remuneration Amounts $ Name Short-term Other employment costs Total Salary Non- monetary benefits1 Super- annuation benefits Long service leave Short- term2 Bonus Deferred STI3 Value of options Chris Roberts6 F14 1,384,305 F13 1,349,920 - - 17,775 40,218 1,442,298 585,055 58,506 767,593 16,470 36,468 1,402,858 701,125 - 538,118 Value of perform- ance shares/ rights - - Long- term4,5 Total Performance related Equity related % % 1,411,154 2,853,452 49.5% 29.0% 1,239,243 2,642,101 46.9% 550,499 77,685 90,433 461,027 65,909 77,526 - - 718,617 213,405 21,340 126,994 27,480 389,219 1,107,836 604,462 166,468 - 123,627 - 290,095 894,557 487,444 473,605 524,363 507,936 567,844 550,889 - - - - - - 17,775 17,165 522,384 152,708 15,271 82,980 71,230 322,189 844,573 16,470 40,906 530,981 136,314 - 79,450 36,435 252,199 783,180 129,280 15,001 668,644 188,025 18,803 90,228 103,626 400,682 1,069,326 134,724 17,895 660,555 168,523 - 72,697 78,284 319,504 980,059 17,775 28,534 614,153 157,372 15,737 64,668 131,483 369,260 983,413 16,470 (540) 566,819 216,151 - 50,833 102,536 369,520 936,339 35.1% 32.4% 38.1% 32.2% 37.5% 32.6% 37.5% 39.5% 20.4% 15.9% 13.8% 20.1% 14.8% 19.9% 15.4% 21.5% 16.4% 670,243 22,264 13,562 540,868 20,708 12,235 - - 706,069 258,245 25,824 140,147 59,964 484,180 1,190,249 40.7% 19.0% 573,811 132,934 - 138,301 11,954 283,189 857,000 4,184,698 99,949 286,600 100,918 4,672,165 1,554,810 155,481 1,272,610 393,783 3,376,684 8,048,849 3,884,245 86,617 273,895 94,729 4,339,486 1,521,515 - 1,003,026 229,209 2,753,750 7,093,236 33.0% 42.0% 38.8% 17.5% 22.6% 17.4% 1. Benefits include the provision of pension plans, car allowances, health insurance, and relocation costs which are market based payments. 2. Short-term and long-term incentive bonuses are awarded annually. The service and performance criteria are set out in this report. See section 4.4.1 Table 1 for more detail on F14 STI payments delivery. For F14, STI paid represent 49.1% to 54.9% of executive KMP opportunity, with the exceptions of the President of the Americas Region and the President of the European Region who earned 70.3% and 86.1% of their opportunity respectively. 3. Deferred STI is ‘invested’ in performance rights and deferred for two years. The cost of the plan is expensed across three years, and this amount represents the portion of F14 STI deferral expensed in F14. 4. The value of options and performance shares/rights is calculated at the date of grant using the Black-Scholes-Merton pricing model discounted for vesting probabilities of performance criteria. The value of options and performance shares/rights is allocated to each reporting period evenly over the period from grant date to vesting date. The amount expensed each reporting period includes adjustments to the life-to-date expense of grants based on the reassessed estimate of achieving non-market performance criteria and final vesting amounts for the non-market performance criteria options and performance shares/rights. The value disclosed above is the portion of the value of the options and performance shares/rights recognised as an expense in the financial year. The ability to exercise the options and performance shares/rights is conditional on Cochlear achieving certain performance hurdles. Further details of options and performance rights granted during the financial year are set out in this report. The total value of options and performance shares/rights recognised in the current financial year for each executive KMP is higher than in the previous financial year due to a change in assumptions on discounts used for vesting probabilities related to plans that are yet to vest. 5. 6. Chris Roberts is an executive director. 7. Year on year increases in fixed remuneration are largely attributable to currency fluctuations. 8. CFO remains on a defined contribution superannuation plan based on a fixed percentage of salary. 9. Total remuneration increase reflects a 3% base increase and increased long service leave accrual. 10. Year on year increases in fixed remuneration are attributable to currency fluctuation and market based salary increase. Richard Brook7 Jan Janssen Neville Mitchell8 Mark Salmon9 Chris Smith10 Total Total F14 F13 F14 F13 F14 F13 F14 F13 F14 F13 F14 F13 Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 47 4.8 Executive remuneration table – unaudited This table represents the value to the executive of cash paid and vested equity awards (intrinsic value) received during the year and unvested equity awards (IFRS-2 value) granted during the financial year, at risk. The LTI equity granted is a value determined under IFRS-2 which may or may not vest depending on future outcomes that are uncertain. Accordingly, this table incorporates data that could represent the accumulation of outcomes arising from multiple years. Year Fixed remuneration and cash incentives received Past at risk remuneration received during year Actual remuneration received Future at risk remuneration received Amounts $ Fixed remuneration1 Incentives2 Total cash Intrinsic value of vested options3 Intrinsic value of vested performance shares3 Incentives (deferred as cash)4 Deferred STI LTI (equity) granted during year5 Chris Roberts Richard Brook Jan Janssen Neville Mitchell Mark Salmon Chris Smith Total Total F14 F13 F14 F13 F14 F13 F14 F13 F14 F13 F14 F13 F14 F13 1,402,080 509,264 1,911,344 - 1,366,390 780,312 2,146,702 38,802 718,617 167,620 886,237 - 604,462 162,124 766,586 13,019 505,219 114,439 619,658 - 490,075 148,124 638,199 9,507 653,643 141,000 794,643 - 642,660 183,638 826,298 13,697 585,619 160,541 746,160 - 567,359 192,616 759,975 12,809 706,069 161,941 868,010 - 573,811 160,574 734,385 14,818 4,571,247 1,254,805 5,826,052 - 4,244,757 1,627,388 5,872,145 102,652 - - - - - - - - - - - - - - 1,911,344 375,483 175,517 1,030,699 2,185,504 299,692 - 1,026,353 886,237 130,730 64,021 170,649 779,605 619,658 647,706 84,945 97,871 59,602 - 184,030 45,813 156,874 - 196,030 794,643 120,615 56,408 204,133 839,995 73,590 - 242,593 746,160 112,690 47,212 185,579 772,784 115,859 - 254,190 868,010 148,052 77,473 222,477 749,203 51,748 - 250,102 5,826,052 5,974,797 985,441 685,436 466,444 1,970,411 - 2,153,298 1. Represents the value of base salary, non-monetary benefits and superannuation received during the year (excludes the accrued value of long service leave). 2. Represents STI payments received during the financial year. For example, F14 data includes F13 second half-year STI and F14 first-half year STI payments. 3. Reflects the intrinsic value of vested employee share scheme benefits at the end of the financial year. 4. Reflects STI payments related to the current financial year but paid in future years. For example, F14 data includes the F14 second-half year STI payment scheduled for payment during F15. 5. Represents the value of equity grants (options and/or performance rights) calculated at the date of grant using the Black-Scholes-Merton pricing model discounted for vesting probabilities of performance criteria. These grants were awarded during the year, are unvested and will be subject to achievement of future performance hurdles. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 48 5.0 Employee share scheme and other share information This section provides: 1. a description of the employee share schemes (ESS) Cochlear uses to provide equity rewards to Cochlear employees; 2. disclosures required in relation to ESS grants provided to executive KMP; 3. disclosures required about ESS instruments that Cochlear has issued; 4. disclosures required in relation to Cochlear Limited shares and other ESS instruments held by executive KMP; 5. Cochlear’s share ownership guidelines; and 6. Cochlear’s Trading Policy. 5.1 Employee share schemes operated by Cochlear Plan details Cochlear Employee Share Plan (CESP) Date established: 1999 Type of instruments Ordinary shares Details Issue of ordinary shares annually to eligible employees. Cochlear Executive Long Term Incentive Plan (CELTIP) Date established: 2003 AGM Ordinary shares (options and/or performance shares) Cochlear Executive Incentive Plan (CEIP) Date established: July 2013 Awards consisting of ordinary shares; performance rights; options; and/or share appreciation rights A long-term performance incentive scheme designed to reward participants for achieving market competitive EPS growth and relative TSR, as approved. Participants receive options and/ or performance shares based on a predetermined formula. A performance incentive scheme designed to reward participants for achieving market competitive business outcomes. Participants receive an award based on a predetermined formula, as approved by the Board from time to time based on market standards and trends. Purpose The purpose of the CESP is to encourage general employee equity participation through tax concessional legislation which currently facilitates tax effective issues of up to $1,000 worth of shares annually per eligible employee. Under the 2013 (FY14) grant, 1,318 employees each received an award of 16 shares under the plan. Executive KMP and other executives rewarded under the Cochlear Executive Long Term Incentive Plan or the Cochlear Executive Incentive Plan are not eligible for this program. The purpose of the CELTIP is to encourage employees and executives of Cochlear to receive performance shares or performance options. Vesting of performance shares and performance options occurs only if Cochlear achieves challenging and market competitive EPS growth and relative TSR hurdles. Target allocations are made based on seniority, the ascribed LTI remuneration value and a value formula approved by shareholders in 2003. The purpose of the CEIP is to develop the principles established with the CELTIP but to create greater flexibility in award structure to cater for Cochlear’s expanding geography and to meet changing market standards and expectations. The offer terms for CEIP awards will be flexible but will meet contemporary LTI design standards. The first grant of options and performance rights under this plan was made on 15 October 2013. Also refer section 4.4.2. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 49 5.2 Employee share scheme grants to executive KMP 5.2.1 Analysis of share based payments granted as remuneration Details of vesting profile of the options and performance shares/rights granted as remuneration to each executive KMP are set out below: Chris Roberts Richard Brook Jan Janssen Neville Mitchell Mark Salmon Chris Smith Grant date Number granted Number vested 17-Aug-09 16-Aug-10 15-Aug-11 13-Aug-12 58,599 86,272 117,620 231,161 15-Oct-13 123,023 23,235 - - - - Options Number forfeited/ lapsed1 58,599 86,272 - - - Total 616,675 23,235 144,871 17-Aug-09 16-Aug-10 15-Aug-11 13-Aug-12 15-Oct-13 19,663 17,674 23,495 41,448 7,249 Total 109,529 17-Aug-09 16-Aug-10 15-Aug-11 13-Aug-12 15-Oct-13 Total 17-Aug-09 16-Aug-10 15-Aug-11 13-Aug-12 15-Oct-13 Total 17-Aug-09 16-Aug-10 15-Aug-11 13-Aug-12 15-Oct-13 Total 17-Aug-09 16-Aug-10 15-Aug-11 13-Aug-12 15-Oct-13 14,358 17,559 11,128 26,491 6,664 76,200 20,686 21,302 27,538 10,928 13,723 94,177 19,344 22,363 28,859 - 10,239 80,805 22,379 - 20,823 45,063 14,955 7,796 - - - - 7,796 5,693 - - - - 5,693 8,202 - - - - 8,202 7,670 - - - - 19,663 17,674 - - - 37,337 14,358 17,559 - - - 31,917 12,484 21,302 - - - 33,786 11,674 22,363 - - - 7,670 8,873 34,037 22,379 - - - - - - - - Total 103,220 8,873 22,379 Performance shares/rights3 Market value of exercised options ($)2 Number granted Number vested Number forfeited/ lapsed Market value of vested shares ($)4 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 3,617 3,617 - - 2,234 2,473 3,325 8,032 - - - 6,120 2,934 9,054 - - - 8,016 3,284 11,300 - 5,781 1,045 1,577 3,198 11,601 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 5,781 - - - 5,781 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 1. For the F10 grant, this column includes options that were forfeited due to not having met performance hurdles and options that vested that were not exercised and subsequently lapsed. 2. The market value of exercised options calculated as at the closing market price of shares of the Company on the ASX on the date of exercise less the applicable exercise price times the number of options. 3. Under grants made under CELTIP from 2009 to 2012, participants could elect to receive options or performance shares, so all holdings referred to under “Performance shares/rights” granted from 2009 to 2012 represent performance shares. Under the CEIP, participants could elect to receive options or performance rights, so all holdings referred to under “Performance shares/rights” granted in 2013 represent performance rights. 4. The market value of vested performance shares calculated as at the closing market price of shares of the Company on the ASX on the date of vesting times the number of performance shares. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 50 The options granted in F14 have an exercise price of $59.13 and an expiration date of 10 March 2017. The options granted during the year have a fair value (IFRS-2) of $11.38 at grant date for options with EPS performance based conditions and $9.93 at grant date for options with TSR based conditions. The performance rights granted during the financial year had a fair value (IFRS-2) at grant date of $53.22 for performance rights with EPS performance based conditions and $28.85 at grant date for performance rights with TSR based conditions. 5.2.2 Exercise of options and performance shares/rights granted as remuneration During F14, no options were exercised by the CEO/President or by other executive KMP. Those executives with vested options remaining from the F10 CELTIP grant were unable to exercise them due to market conditions, and the F11 CELTIP grant did not meet the performance hurdles so there was no vesting from this grant. There are no amounts unpaid on the shares issued as a result of the exercise of the options in prior years. 5.2.3 Analysis of movement in options and shares The movement in number and value during the financial year of options over ordinary shares of Cochlear Limited acquired under the CELTIP and CEIP held by executive KMP is detailed below: Opening value Granted in year Exercised in year Forfeited/lapsed in year Closing value Number Value ($)1 Number Value ($)2 Number Value ($)3 Number Value ($)4 Number Intrinsic value ($)5 Chris Roberts 458,288 3,022,568 123,023 1,030,699 Richard Brook Jan Janssen Neville Mitchell Mark Salmon Chris Smith 90,413 60,871 59,768 51,222 74,759 769,505 535,382 7,249 6,664 60,733 55,832 607,332 13,723 114,973 571,647 10,239 85,783 556,004 14,955 125,294 Total 795,321 6,062,438 175,853 1,473,314 - - - - - - - - - - - - - - 109,507 1,280,015 471,804 316,169 25,470 291,167 72,192 18,630 23,252 269,711 44,283 17,126 21,302 261,373 52,189 35,268 22,363 274,391 39,098 26,314 8,873 84,575 80,841 38,434 210,767 2,461,232 760,407 451,941 The movement in number and value during the financial year of performance shares/rights acquired under the CELTIP and CEIP held by executive KMP is detailed below: Opening value Granted in year Exercised in year Forfeited/lapsed in year Closing value Number Value ($)1 Number Value ($)2 Number Value ($)3 Number Value ($)4 Number Intrinsic value ($)5 Chris Roberts Richard Brook Jan Janssen - - - - - - 3,617 109,916 4,707 215,217 3,325 101,042 Neville Mitchell 6,120 249,027 8,016 326,177 8,403 414,055 2,934 3,284 3,198 89,160 99,796 97,183 27,246 1,204,476 16,358 497,097 Mark Salmon Chris Smith Total - - - - - - - - - - - - - - - - - - - - - - - - - - 3,617 223,169 8,032 495,574 9,054 558,632 11,300 697,210 5,781 296,284 5,820 359,094 5,781 296,284 37,823 2,333,679 1. 2. 3. The value derived under IFRS-2 of remaining options and performance shares granted but not yet forfeited, lapsed or exercised at the beginning of the financial year is the value of the options and performance shares calculated at grant date using the Black-Scholes-Merton pricing model and discounted for vesting probabilities of performance criteria. The total value of the options and performance shares granted is included in the table above. The value derived under IFRS-2 of options and performance rights granted during the financial year is the value of the options and performance rights calculated at grant date using the Black-Scholes-Merton pricing model and discounted for vesting probabilities of performance criteria. The total value of the options and rights granted is included in the table above. This amount is allocated to remuneration over the vesting period (i.e. in each of F14 to F16). The calculated value of options exercised during the year is calculated as the market price of shares of the Company on the ASX as at close of trading on the date the options were exercised after deducting the price paid or payable to exercise the option. 4. Value is calculated under IFRS-2 on date of grant. 5. The intrinsic value of options and performance shares/rights calculated as at the closing market price of shares of the Company on the ASX on 30 June 2014 less the applicable exercise price times the number of options (negative values are treated as zero in the totals) and performance shares/rights as at the closing market price of shares of the Company on the ASX on 30 June 2014. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 51 5.3 Potential dilution if options vest and ordinary shares issued – unaudited At the date of this report, the number of ordinary shares that would be issued if all options were vested, having met the service and performance conditions, and exercised and assuming ordinary shares were issued, is as follows: Grant date Number of options Issued Exercised Forfeited/ lapsed At report date Exercise price per share ($) Exercise period Current net value of outstanding options as at 30 June 2014 ($)1 17-Aug-092 16-Aug-103 15-Aug-114 13-Aug-124 15-Oct-13 Total 85,674 399,869 517,065 735,392 224,314 1,962,314 - - - - - - 85,674 399,869 - - 60.04 Aug-12 to 30-Jun-14 69.80 Aug-13 to 30-Jun-15 32,178 484,887 68.56 Aug-14 to 30-Jun-16 28,265 707,127 62.78 Aug-15 to 30-Jun-17 - 224,314 59.13 Aug-16 to 10-Mar-17 545,986 1,416,328 - - - - 576,487 576,487 1. Price as at 30 June 2014 was $61.70. The exercise price for options granted in F12 and F13 was above the market price as at 30 June 2014. 2. Lapsed options from the F10 grant relate to vested options that were not exercised and expired. 3. No options from the F11 grant vested. 4. Lapsed options from unvested grants (granted in F12 and F13) relate to plan members who have departed Cochlear. 5.4 KMP equity interests – unaudited In accordance with the Corporations Act (section 205G(1)), Cochlear is required to notify the interests (shares and rights to shares) of directors to the ASX. In the interests of transparency and completeness of disclosure, this information is provided for each NED (as required under the Corporations Act) and all executive KMP as well. Please refer sections 4.5.2 (Hedging and margin lending prohibition) and 4.5.5 (Minimum shareholding guidelines). The table below indicates Cochlear Limited shareholding: NEDs Held at 1 July 2013 Purchases Sales Cochlear Limited ordinary shares as at 30 June 2014 Total intrinsic value of Cochlear Limited securities as at year end ($)3 Rick Holliday-Smith Yasmin Allen Paul Bell Edward Byrne Andrew Denver Donal O’Dwyer Total NEDs 9,250 2,950 3,000 3,250 4,000 5,000 27,450 - - - - - 1,000 1,000 - - - - - - - 9,250 2,950 3,000 3,250 4,000 6,000 570,725 182,015 185,100 200,525 246,800 370,200 28,450 1,755,365 Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 52 The table below indicates Cochlear Limited shareholding including any vested but unexercised options and performance shares: Executive KMP Held at 1 July 2013 Purchases Received on exercise of options and performance shares Sales Cochlear Limited ordinary shares as at 30 June 2014 Vested options over Cochlear Limited ordinary shares1 Vested performance shares over Cochlear Limited ordinary shares2 Total intrinsic value of Cochlear Limited securities as at year end ($)3 Executive director Chris Roberts Other executives Richard Brook Jan Janssen Neville Mitchell Mark Salmon Chris Smith Total executive KMP 719,803 - 7,700 13,328 10,000 7,240 10,000 768,071 - 3,500 - 908 - 4,408 - - - - - - - - 719,803 - (10,930) - - - (10,930) 7,700 5,898 10,000 8,148 10,000 761,549 - - - - - - - - - - - - - - 44,411,845 475,090 363,907 617,000 502,732 617,000 46,987,574 1. The number of vested but unexercised options. 2. The number of vested but unexercised performance shares. 3. The intrinsic value of Cochlear Limited ordinary shares and vested performance shares as at the closing Cochlear Limited share price on the ASX on 30 June 2014, plus the intrinsic value of vested options calculated as at the closing Cochlear Limited share price on the ASX on 30 June 2014 less the applicable exercise price times the number of options (negative values are treated as zero in the totals). Please note the share ownership guidelines apply an average share price to NEDs’ and executive KMP’s holdings, not intrinsic value at year end. The table below indicates any unvested options and performance shares/rights issued to executive KMP but still subject to performance hurdles: Unvested options over Cochlear Limited ordinary shares1 Unvested performance shares/rights over Cochlear Limited ordinary shares2 Total intrinsic value of unvested options and performance shares/rights as at year end ($)3 Executive director Chris Roberts Other executives Richard Brook Jan Janssen Neville Mitchell Mark Salmon Chris Smith Total executive KMP 471,804 72,192 44,283 52,189 39,098 80,841 760,407 - 3,617 8,032 9,054 11,300 5,820 37,823 316,169 241,799 512,700 593,900 723,524 397,528 2,785,620 1 . The number of unvested options. 2. The number of unvested performance shares/rights. 3. The intrinsic value of unvested performance shares/rights as at the closing Cochlear Limited share price on the ASX on 30 June 2014 and the intrinsic value of unvested options calculated as at the closing Cochlear Limited share price on the ASX on 30 June 2014 less the applicable exercise price times the number of options (negative values are treated as zero in the totals). 6.0 Service contracts and employment agreements – audited 6.1 Service contracts Cochlear does not enter into service contracts for executive KMP, other than the CEO/President. The following sets out details of the service contract terms for the current CEO/President, Dr Roberts: Length of contract Dr Roberts is on a permanent contract, which is an ongoing employment contract until notice is given by either party. Notice periods In order to terminate the employment arrangements, Dr Roberts is required to provide Cochlear with six months’ written notice. Cochlear must provide Dr Roberts with 12 months’ written notice. Termination on notice by Cochlear Cochlear may terminate employment by providing six months’ written notice or payment in lieu of the notice period based on total fixed remuneration (TFR). On termination on notice by Cochlear, unless the Board determines otherwise Dr Roberts shall receive: • payment equivalent to 12 months’ TFR; • pro-rated STI benefits for the months of service in the financial year to which the plan relates; and • if determined by the Board, in its sole discretion, the entitlements (if any) to LTI benefits. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 53 Death or total and permanent disability If Cochlear terminates employment for reasons of death or total and permanent disability, a severance payment will be made that is equal to 12 months’ TFR. All STI and LTI benefits are either: • released in full or on a pro-rata basis; or • remain subject to performance requirements clawback and are released at the original vesting date, at the discretion of the Board with regard to the circumstances. On death or total and permanent disability, the Board has discretion to allow unvested STI and LTI benefits to vest. Statutory entitlements Payment of statutory entitlements of long service leave and annual leave applies in all events of separation. Post-employment restraints For a period of 12 months after termination date without the consent of Cochlear for engagement in business competition or to induce Cochlear NEDs or staff to terminate their employment. 6.2 Employment agreements Other executive KMP operate under employment agreements. The following sets out details of the employment agreements relating to other executive KMP. The terms for all other executive KMP are similar but do, on occasion, vary to suit different needs. Length of contract All other executive KMP are on permanent contracts, which is an ongoing employment contract until notice is given by either party. Notice periods Resignation In order to terminate the employment arrangements, other executive KMP are required to provide Cochlear with between 60 days’ and six months’ written notice. On resignation, unless the Board determines otherwise: • all unvested STI or LTI benefits are forfeited. Termination on notice by Cochlear Cochlear may terminate employment by providing between 60 days’ and 12 months’ written notice or payment in lieu of the notice period based on TFR. On termination by Cochlear, unless the Board determines otherwise: • unvested STI or LTI benefits may be exercised or paid within 30 days of notice being given. Redundancy If Cochlear terminates employment for reasons of redundancy, under Cochlear policy a severance payment will be made of up to 12 months’ TFR. All STI and LTI benefits are either: • released in full or on a pro-rata basis; or • remain subject to performance criteria and vesting date, at the discretion of the Board with regard to the circumstances. Death or total and permanent disability On death or total and permanent disability, the Board has discretion to allow all unvested STI and LTI benefits to vest. Termination for serious misconduct Cochlear may immediately terminate employment at any time in the case of serious misconduct, and other executive KMP will only be entitled to payment of TFR up to the date of termination. On termination without notice by Cochlear in the event of serious misconduct: • all unvested STI or LTI benefits will be forfeited; and • any ESS instruments provided to the employee on vesting of STI or LTI awards that are held in trust, will be forfeited. Statutory entitlements Payment of statutory entitlements of long service leave and annual leave applies in all events of separation. Other arrangements Richard Brook – President, European Region will receive: • a maximum of Swiss francs (CHF) 30,000 for repatriation costs in the case of termination or resignation. Post-employment restraints All other executive KMP are subject to post-employment restraints for up to 12 months. Directors’ Report Cochlear Limited for the year ended 30 June 2014AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ AR 14 54 Directors’ Report Cochlear Limited for the year ended 30 June 2014 - + – – – Previous Next Contents Investor Centre Indemnification of officers Under the terms of Article 35 of the Company’s Constitution, and to the extent permitted by law, the Company has indemnified the directors of the Company named in this Directors’ Report, the Company Secretary, Mr NJ Mitchell, and other persons concerned in or taking part in the management of the Consolidated Entity. The indemnity applies when persons are acting in their capacity as officers of the Company in respect of: • liability to third parties (other than the Company or related bodies corporate), if the relevant officer has acted in good faith; and • costs and expenses of successfully defending legal proceedings in which relief under the Corporations Act 2001 is granted to the relevant officer. Insurance premiums During the financial year, the Company paid a premium for a Directors’ and Officers’ Liability Insurance policy and a Supplementary Legal Expenses Insurance policy. The insurance provides cover for the directors named in this Directors’ Report, the Company Secretary, and officers and former directors and officers of the Company. The insurance also provides cover for present and former directors and officers of other companies in the Consolidated Entity. The directors have not included in this report details of the nature of the liabilities covered and the amount of the premium paid in respect of the Directors’ and Officers’ Liability and Supplementary Legal Expenses Insurance policies, as such disclosure is prohibited under the terms of the contract. Events subsequent to the reporting date Other than the matters noted below, there has not arisen in the interval between the end of the financial year and the date of this Directors’ Report, any item, transaction or event of a material and unusual nature likely, in the opinion of the directors of the Company, to affect significantly the operations of Cochlear, the results of those operations, or the state of affairs of Cochlear in future financial years: Dividends For dividends declared after 30 June 2014, see Note 8 to the financial statements. Lead auditor’s independence declaration The lead auditor’s independence declaration is set out on page 55 and forms part of the Directors’ Report for the financial year ended 30 June 2014. Rounding off The Company is of a kind referred to in Australian Securities and Investments Commission (ASIC) Class Order 98/100 dated 10 July 1998 and in accordance with that Class Order, amounts in the Directors’ Report and Financial Report have been rounded off to the nearest one thousand dollars, unless otherwise indicated. Dated at Sydney this 5th day of August 2014. Signed in accordance with a resolution of the directors: Director Director Investor Centre AR 14 55 Lead Auditor’s Independence Declaration - + – – – Previous Next Contents Investor Centre Lead auditor’s independence declaration under section 307C of the Corporations Act 2001 To: the directors of Cochlear Limited I declare that, to the best of my knowledge and belief, in relation to the audit for the year ended 30 June 2014 there have been: (i) no contraventions of the auditor independence requirements as set out in the Corporations Act 2001 in relation to the audit; and (ii) no contraventions of any applicable code of professional conduct in relation to the audit. KPMG Sydney, 5 August 2014 Cameron Slapp, Partner 56 Income Statement Cochlear Limited and its controlled entities for the year ended 30 June 2014 Revenue Cost of sales Gross profit Selling and general expenses Administration expenses Patent dispute provision Research and development expenses Other income Other expenses Results from operating activities Finance income Finance expense Net finance expense Profit before income tax Income tax expense Net profit Basic earnings per share (cents) Diluted earnings per share (cents) The notes on pages 61 to 105 are an integral part of these consolidated financial statements. Note 4 5(a) 20 6 5(b) 21(d) 21(d) 10 7 7 2014 $000 2013 $000 804,936 752,721 (248,285) (208,072) 556,651 (234,711) (44,162) (22,545) 544,649 (202,781) (38,157) - (127,562) (124,715) 2,532 (3,112) 2,379 (2,515) 127,091 178,860 324 (10,301) (9,977) 117,114 (23,405) 93,709 164.6 164.2 659 (6,882) (6,223) 172,637 (40,074) 132,563 233.0 232.4 AR 14InvestorCentreContentsNextPrevious-– – –+ 57 Statement of Comprehensive Income Cochlear Limited and its controlled entities for the year ended 30 June 2014 Net profit Other comprehensive income/(loss) Items that will not be reclassified subsequently to the income statement: Defined benefit plan actuarial gains/(losses)* Total items that will not be reclassified subsequently to the income statement Items that may be reclassified subsequently to the income statement: Foreign currency translation differences Effective portion of changes in fair value of cash flow hedges, net of tax Net change in fair value of cash flow hedges transferred to the income statement, net of tax Total items that may be reclassified subsequently to the income statement Other comprehensive income/(loss) for the period, net of tax Total comprehensive income * Restated for change in accounting policy, refer Note 30. The notes on pages 61 to 105 are an integral part of these consolidated financial statements. 2014 $000 93,709 306 306 2,344 6,007 11,149 19,500 19,806 113,515 2013 $000 Restated* 132,563 (230) (230) 29,179 (21,206) (26,384) (18,411) (18,641) 113,922 AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 58 Balance Sheet Cochlear Limited and its controlled entities as at 30 June 2014 Assets Cash and cash equivalents Trade and other receivables Inventories Current tax assets Prepayments Total current assets Trade and other receivables Property, plant and equipment Intangible assets Deferred tax assets* Total non-current assets Total assets Liabilities Trade and other payables Forward exchange contracts Loans and borrowings Current tax liabilities Provisions Deferred revenue Total current liabilities Forward exchange contracts Loans and borrowings Provisions* Total non-current liabilities Total liabilities Net assets Equity Share capital Reserves Retained earnings Total equity * Restated for change in accounting policy, refer Note 30. The notes on pages 61 to 105 are an integral part of these consolidated financial statements. Note 9(a) 16 17 11 16 18 19 11 21(c) 11 20 21(c) 20 2014 $000 2013 $000 Restated* 56,127 214,953 128,613 8,600 12,586 52,689 203,748 131,574 6,207 11,004 420,879 405,222 5,505 75,776 234,115 52,761 944 65,898 235,774 57,422 368,157 360,038 789,036 765,260 78,644 6,643 3,141 8,442 57,557 15,151 81,874 14,915 3,309 6,002 63,224 22,506 169,578 191,830 2,624 234,274 53,355 290,253 459,831 329,205 144,136 (32,191) 217,260 329,205 13,242 167,160 38,517 218,919 410,749 354,511 118,788 (32,433) 268,156 354,511 AR 14InvestorCentreContentsNextPrevious-– – –+ 59 Statement of Changes in Equity Cochlear Limited and its controlled entities for the year ended 30 June 2014 Shares repurchased, net 2,331 (4,679) Amounts $000 2013 Balance at 1 July 2012 Total comprehensive income Net profit Other comprehensive (loss)/income Defined benefit plan actuarial losses* Foreign currency translation differences Effective portion of changes in fair value of cash flow hedges, net of tax Net change in fair value of cash flow hedges reclassified to the income statement, net of tax Total other comprehensive income/(loss) Total comprehensive income/(loss) Transactions with owners, recorded directly in equity Share based payment transactions Dividends to shareholders Balance at 30 June 2013 2014 Balance at 1 July 2013 Total comprehensive income Net profit Other comprehensive income Defined benefit plan actuarial gains Foreign currency translation differences Effective portion of changes in fair value of cash flow hedges, net of tax Net change in fair value of cash flow hedges reclassified to the income statement, net of tax Total other comprehensive income Total comprehensive income Transactions with owners, recorded directly in equity Treasury shares issued to employees Share based payment transactions Deferred tax recognised in equity Dividends to shareholders Balance at 30 June 2014 Issued capital Treasury reserve Translation reserve Hedging reserve Share based payment reserve Retained earnings Restated* Total equity Restated* 125,865 (4,729) (84,153) 30,910 36,481 278,334 382,708 - - - - - - - - - - - - - - - - - - - - 29,179 - - - - - (21,206) (26,384) 29,179 (47,590) 29,179 (47,590) - - - - - - - - - - - - - - 2,740 132,563 132,563 (230) - - - (230) 29,179 (21,206) (26,384) (230) (18,641) 132,333 113,922 - - (2,348) 2,740 - (142,511) (142,511) 128,196 (9,408) (54,974) (16,680) 39,221 268,156 354,511 128,196 (9,408) (54,974) (16,680) 39,221 268,156 354,511 - - - - - - - - - - - - - - - - - - - 945 - - - - - 2,344 - - 2,344 2,344 - - - - - - - - 6,007 11,149 17,156 17,156 - - - - - - - - - - - - 93,709 93,709 306 - - - 306 2,344 6,007 11,149 306 19,806 94,015 113,515 (24,403) (945) 4,971 1,119 - - - - - - 4,971 1,119 - (144,911) (144,911) 152,599 (8,463) (52,630) 476 19,963 217,260 329,205 Transfer between reserves 24,403 * Restated for change in accounting policy, refer Note 30. The notes on pages 61 to 105 are an integral part of these consolidated financial statements. AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 60 Statement of Cash Flows Cochlear Limited and its controlled entities for the year ended 30 June 2014 Cash flows from operating activities Cash receipts from customers Cash paid to suppliers and employees Grant and other income received Interest received Interest paid Income taxes paid Net cash provided by operating activities Cash flows from investing activities Acquisition of property, plant and equipment Acquisition of enterprise resource planning system Acquisition of other intangible assets Net cash used in investing activities Cash flows from financing activities Repayments of borrowings Proceeds from borrowings Shares repurchased, net Dividends paid Net cash used in financing activities Net increase/(decrease) in cash and cash equivalents Cash and cash equivalents, net of overdrafts at 1 July Effect of exchange rate fluctuations on cash held Cash and cash equivalents, net of overdrafts at 30 June The notes on pages 61 to 105 are an integral part of these consolidated financial statements. Note 2014 $000 2013 $000 809,039 669,311 (665,370) (555,798) 2,532 344 (10,558) (24,570) 111,417 (23,497) (6,997) (1,452) 2,379 617 (6,967) (39,815) 69,727 (21,074) (14,477) (14,868) (31,946) (50,419) (79,500) 146,500 - (144,911) (77,911) 1,560 52,689 1,878 56,127 (89,000) 195,000 (2,348) (142,511) (38,859) (19,551) 68,486 3,754 52,689 9(b) 8 9(a) AR 14InvestorCentreContentsNextPrevious-– – –+ 61 Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014 Basis of preparation This section of the Financial Report sets out the Company’s accounting policies that relate to the financial statements as a whole. Where an accounting policy is specific to one note, the policy is described in the note to which it relates. 1. Reporting entity Cochlear Limited (the Company) is a company domiciled in Australia. The consolidated financial statements of the Company as at and for the year ended 30 June 2014 comprise the Company and its controlled entities (together referred to as Cochlear or the Consolidated Entity). Cochlear is a for-profit entity and operates in the implantable hearing device industry. 2. Basis of preparation (a) Statement of compliance The Financial Report is a general purpose financial report which has been prepared in accordance with Australian Accounting Standards (AASBs) adopted by the Australian Accounting Standards Board and the Corporations Act 2001. The consolidated financial statements comply with International Financial Reporting Standards (IFRS) and Interpretations adopted by the International Accounting Standards Board. The consolidated financial statements were approved by the Board of directors on 5 August 2014. (b) Basis of measurement The consolidated financial statements have been prepared on the historical cost basis except for derivative financial instruments which are measured at fair value. The method used to measure the fair value of derivative instruments is discussed further in Note 22. (c) Functional and presentation currency These consolidated financial statements are presented in Australian dollars (AUD), which is the Company’s functional currency. The Company is of a kind referred to in ASIC Class Order 98/100 dated 10 July 1998 and in accordance with that Class Order, all financial information presented in Australian dollars has been rounded to the nearest one thousand dollars unless otherwise stated. (d) Foreign currency Foreign currency transactions Transactions in foreign currencies are translated to the respective functional currencies of controlled entities at the foreign exchange rate ruling at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies at the reporting date are translated to the functional currency at the foreign exchange rate ruling at that date. Non-monetary assets and liabilities denominated in foreign currencies that are stated at historical cost are translated using the exchange rate at the date of the transaction. Non-monetary assets and liabilities denominated in foreign currencies that are stated at fair value are translated to the functional currency at the foreign exchange rates ruling at the date the fair value was determined. Foreign exchange differences arising on translation are recognised in the income statement. Financial statements of foreign operations The assets and liabilities of foreign operations, including goodwill and fair value adjustments arising on acquisition, generally are translated to the functional currency at foreign exchange rates ruling at the reporting date. The revenues and expenses of foreign operations are translated to the functional currency at rates approximating the foreign exchange rates ruling at the dates of transactions. Foreign currency differences arising from translation of controlled entities with a different functional currency to that of the Company are recognised in the foreign currency translation reserve (translation reserve). When a foreign operation is disposed of, in part or in full, the relevant amount of its translation reserve is transferred to the income statement and reported as part of the gain or loss on disposal. Foreign exchange gains and losses arising from a monetary item receivable from or payable to a foreign operation, the settlement of which is neither planned nor likely in the foreseeable future, are considered to form part of a net investment in a foreign operation and are recognised in other comprehensive income, and presented in the translation reserve in equity. (e) Use of judgements and estimates The preparation of financial statements in conformity with IFRS requires management to make judgements, estimates and assumptions that affect the application of accounting policies and the reported amounts of assets, liabilities, income and expenses. Actual results may differ from these estimates. Estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognised in the financial year in which the estimate is revised and in any future years affected. AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 62 2. Basis of preparation (continued) Management discussed with the Audit Committee the development, selection and disclosure of Cochlear’s critical accounting policies and estimates and the application of these policies and estimates. Information about critical judgements in applying accounting policies that have the most significant effect on the amounts recognised in the consolidated financial statements is included in the following notes: Note 13 – Employee benefit liabilities Note 14 – Share based payments Note 19 – Intangible assets Note 20 – Provisions Note 22 – Financial risk management Note 27 – Contingent liabilities. (f) Basis of consolidation Controlled entities Controlled entities are entities controlled by the Company. The Consolidated Entity controls an entity when it is exposed to, or has rights to, variable returns from its involvement with the entity and has the ability to affect those returns through its power over the entity. The financial statements of controlled entities are included in the consolidated financial statements from the date that control commences until the date that control ceases. Transactions eliminated on consolidation Intra-group balances and transactions, and any unrealised income and expenses arising from intra-group transactions, are eliminated in preparing the consolidated financial statements. Special purpose entities Cochlear has established special purpose entities (SPEs) for trading and investment purposes. A SPE is consolidated if, based upon an evaluation of the substance of its relationship with Cochlear and the SPE’s risks and rewards, Cochlear concludes that it controls the SPE. SPEs controlled by Cochlear were established under terms that impose strict limitations on decision-making powers of the SPE’s management. (g) Comparatives Comparative information is reclassified where appropriate to enhance comparability. (h) Goods and services tax (GST) Revenues, expenses and assets are recognised net of the amount of GST, except where the amount of GST incurred is not recoverable from the taxation authority. In these circumstances, the GST is recognised as part of the cost of acquisition of the asset or as part of the expense. Receivables and payables are stated with the amount of GST included. The net amount of GST recoverable from, or payable to, the relevant taxation authority is included as a current asset or liability in the balance sheet. Cash flows are included in the statement of cash flows on a gross basis. The GST components of cash flows arising from investing and financing activities which are recoverable from, or payable to, the relevant taxation authority are classified as operating cash flows. Performance for the year 3. Operating segments An operating segment is a component of Cochlear that engages in business activities from which it may earn revenues and incur expenses, including revenues and expenses that relate to transactions with any of Cochlear’s other components if separately reported and monitored. Cochlear has three reportable segments, which are determined on a geographical basis and are the strategic business units of Cochlear. Segment results, assets and liabilities include items directly attributable to a segment, as well as those that can be allocated on a reasonable basis. Unallocated items comprise corporate and other net expenses and corporate and manufacturing assets and liabilities. Information about each reportable segment is included below. Performance is measured based on segment profit before income tax as included in the internal management reports that are reviewed by Cochlear’s CEO/President, who is also the chief operating decision-maker. Segment profit before income tax is used to measure performance as management believes that such information is the most relevant in evaluating the results of each operating segment. The CEO/President regularly reviews an operating segment’s operating results to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 63 Information about reportable segments Americas EMEA(1) Asia Pacific Total 2014 $000 2013 $000 2014 $000 2013 $000 Restated* 2014 $000 2013 $000 2014 $000 2013 $000 Restated* Reportable segment revenue 320,800 284,394 358,459 283,023 141,604 147,613 820,863 715,030 Reportable segment profit before income tax 149,083 134,439 167,182 131,523 43,464 57,672 359,729 323,634 Reportable segment assets* Reportable segment liabilities* Other material items Depreciation and amortisation Write-down in value of inventories Acquisition of non-current assets 111,592 111,905 194,073 177,353 81,231 70,146 386,896 359,404 24,029 31,349 39,174 55,325 13,009 12,633 76,212 99,307 850 310 478 720 139 1,997 1,672 112 141 1,812 2,547 1,035 920 133 568 1,020 3,767 3,412 267 255 555 547 3,593 3,102 (1) Europe, Middle East and Africa. * Restated for change in accounting policy, refer Note 30. Reconciliations of reportable segment revenues, profit or loss, assets and liabilities and other material items Revenues Reportable segment revenue Foreign exchange (losses)/gains on hedged sales Consolidated revenue Profit or loss Reportable segment profit before income tax Corporate and other net expenses Foreign exchange (losses)/gains on hedged sales Patent dispute provision Net finance expense Consolidated profit before income tax Assets Reportable segment assets* Unallocated corporate and manufacturing assets Consolidated total assets Liabilities Reportable segment liabilities* Unallocated corporate and manufacturing liabilities Consolidated total liabilities * Restated for change in accounting policy, refer Note 30. 2014 $000 820,863 (15,927) 804,936 359,729 (194,166) (15,927) (22,545) (9,977) 117,114 2014 $000 386,896 402,140 789,036 76,212 383,619 459,831 2013 $000 715,030 37,691 752,721 323,634 (182,465) 37,691 - (6,223) 172,637 2013 $000 359,404 405,856 765,260 99,307 311,442 410,749 AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 64 3. Operating segments (continued) 2014 Other material items Depreciation and amortisation Write-down in value of inventories Acquisition of non-current assets 2013 Other material items Depreciation and amortisation Write-down in value of inventories Acquisition of non-current assets Revenue by product Cochlear implants Bone anchored hearing aids (Baha) Total 4. Revenue Sale of goods before hedging Foreign exchange (losses)/gains on hedged sales Revenue from sale of goods Rendering of services Total revenue Reportable segment total Corporate and manufacturing total $000 $000 Consolidated total $000 3,767 555 3,593 3,412 547 3,102 23,088 981 28,353 19,592 935 34,880 2014 $000 720,762 100,101 820,863 2014 $000 813,004 (15,927) 797,077 7,859 804,936 26,855 1,536 31,946 23,004 1,482 37,982 2013 $000 636,393 78,637 715,030 2013 $000 708,710 37,691 746,401 6,320 752,721 Sales revenue comprises revenue earned (net of returns, discounts and allowances) from the provision of products or services. Revenue from the sale of goods is recognised in the income statement when the significant risks and rewards of ownership have been transferred to the buyer. No revenue is recognised if there are significant uncertainties regarding recovery of the consideration due or if there is a risk of return of goods or there is continuing management involvement with the goods. Revenue from the sale of services is recognised when the service has been provided to the customer and where there are no continuing unfulfilled service obligations. Revenues are recognised at the fair value of the consideration received net of the amount of GST. The accounting policy for foreign exchange gains/losses arising from hedges of forecast sales transactions is set out in Note 22. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 65 5. Expenses (a) Cost of sales Carrying amount of inventories recognised as an expense Other Write-down in value of inventories Total cost of sales (b) Other expenses Net foreign exchange loss Total other expenses (c) Profit before income tax has been arrived at after charging the following items: Operating lease rental expense Loss on disposal of property, plant and equipment 6. Other income Grant received or due and receivable Other income Total other income 2014 $000 2013 $000 239,462 202,124 7,287 1,536 4,466 1,482 248,285 208,072 3,112 3,112 20,415 2,611 2014 $000 1,378 1,154 2,532 2,515 2,515 15,485 1,482 2013 $000 1,401 978 2,379 Other income, including government grants, is recognised on a systematic basis over the years necessary to match it with the related costs for which it is intended to compensate or, if the costs have already been incurred, in the year in which it becomes receivable. The income is deemed to be receivable when the entitlement is confirmed. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 66 7. Earnings per share Basic earnings per share The calculation of basic earnings per share for the year ended 30 June 2014 was based on net profit attributable to equity holders of the parent entity of $93,709,000 (2013: $132,563,000) and a weighted average number of ordinary shares on issue during the year ended 30 June 2014 of 56,930,736 (2013: 56,890,261) calculated as follows: 2014 2013 Net profit attributable to equity holders of the parent entity $93,709,000 $132,563,000 Weighted average number of ordinary shares (basic): Issued ordinary shares at 1 July (number) Effect of options and performance shares exercised (number) Effect of shares issued under Employee Share Plan (number) Weighted average number of ordinary shares (basic) at 30 June Basic earnings per share (cents) Diluted earnings per share 56,915,289 56,865,878 599 14,848 13,619 10,764 56,930,736 56,890,261 164.6 233.0 The calculation of diluted earnings per share for the year ended 30 June 2014 was based on net profit attributable to equity holders of the parent entity of $93,709,000 (2013: $132,563,000) and a weighted average number of ordinary shares on issue during the year ended 30 June 2014 of 57,055,237 (2013: 57,047,096) calculated as follows: Net profit attributable to equity holders of the parent entity $93,709,000 $132,563,000 Weighted average number of ordinary shares (diluted): Weighted average number of shares (basic) (number) Effect of options and performance shares and rights (number) Weighted average number of ordinary shares (diluted) at 30 June Diluted earnings per share (cents) 56,930,736 124,501 57,055,237 164.2 56,890,261 156,835 57,047,096 232.4 Cochlear presents basic and diluted earnings per share (EPS) for its ordinary shares. Basic EPS is calculated by dividing the net profit attributable to equity holders of the parent entity for the financial year, after excluding any costs of servicing equity (other than ordinary shares) by the weighted average number of ordinary shares of the Company, adjusted for any bonus issue. Diluted EPS is calculated using the basic EPS earnings as the numerator. The weighted average number of shares used as the denominator is adjusted by the after-tax effect of financing costs associated with the dilutive potential ordinary shares and the effect on revenues and expenses of conversion to ordinary shares associated with dilutive potential ordinary shares adjusted for any bonus issue. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 67 8. Dividends Cents per share Total amount $000 Franked/unfranked Date of payment Dividends recognised in the current financial year by the Company are: 2014 Interim 2014 ordinary Final 2013 ordinary Total amount 2013 Interim 2013 ordinary Final 2012 ordinary Total amount 127.0 127.0 254.0 125.0 125.0 250.0 72,469 72,442 144,911 71,295 71,216 142,511 0% Franked 27 March 2014 30% Franked 19 September 2013 40% Franked 12 March 2013 35% Franked 20 September 2012 A liability for dividends payable is recognised in the financial year in which the dividends are declared. Franked dividends declared or paid during the financial year were franked at the tax rate of 30%. Subsequent events Since the end of the financial year, the directors declared the following dividends: Final 2014 ordinary Total amount 127.0 127.0 72,469 72,469 20% Franked 25 September 2014 The financial effect of the 2014 final dividend has not been brought to account in the financial statements for the year ended 30 June 2014 and will be recognised in the subsequent financial year. There are no further tax consequences as a result of paying dividends other than a reduction in the franking account as shown below: Dividend franking account 30% franking credits available to shareholders of Cochlear Limited for subsequent financial years The above amounts are based on the balance of the dividend franking account at year end adjusted for: • franking credits that will arise from the payment of the current tax liability; • franking debits that will arise from the payment of dividends recognised as a liability at the year end; and • franking credits that the Company may be prevented from distributing in subsequent financial years. Company 2014 $000 2,392 2013 $000 696 The ability to utilise the franking account credits is dependent upon the ability to declare dividends. The impact on the dividend franking account of dividends proposed after the balance sheet date but not recorded as a liability is to reduce it by $6,211,608 (2013: $9,313,969). No additional current tax liability will arise to the extent that franking credits are available with which to pay fully franked dividends. Dividends in excess of the balance of the dividend franking account will either be unfranked or result in a franking deficit tax liability payable by the Company to the extent that franking credits are provided that do not exist. The Company’s policy is not to pay dividends with franking credits that will result in a franking deficit tax liability. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 68 9. Notes to the statement of cash flows (a) Cash and cash equivalents Cash and cash equivalents comprise cash balances and call deposits with an original maturity of three months or less. Bank overdrafts that are repayable on demand and form an integral part of Cochlear’s cash management are included as a component of cash and cash equivalents for the purpose of the statement of cash flows. Cash and cash equivalents at the reporting date as shown in the statement of cash flows are reconciled to the related items in the balance sheet as follows: Cash on hand Cash on deposit Cash and cash equivalents (b) Reconciliation of net profit to net cash provided by operating activities Net profit Add items classified as investing activities Loss on disposal of property, plant and equipment Add non-cash items Amounts set aside to provisions* Depreciation and amortisation Reversal of impairment of property, plant and equipment Equity settled share based payment transactions Net cash provided by operating activities before changes in assets and liabilities Changes in assets and liabilities Change in trade and other receivables Change in inventories Change in prepayments Change in deferred tax assets* Change in trade and other payables Change in current tax liabilities Change in provisions* Change in deferred revenue Effects of movements in foreign exchange Net cash provided by operating activities * Restated for change in accounting policy, refer Note 30. 2014 $000 41,432 14,695 56,127 2013 $000 Restated* 31,455 21,234 52,689 93,709 132,563 2,611 1,482 60,865 26,855 (6,346) 4,971 182,665 (15,766) 2,961 (1,582) 4,661 (3,230) 47 (51,694) (7,355) 710 111,417 60,639 23,004 - 2,740 220,428 (43,677) (30,276) (2,596) (6,240) (6,618) 6,485 (75,409) 4,417 3,213 69,727 Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 69 Income taxes 10. Income tax expense Recognised in the income statement Current tax expense Current year Adjustment for prior years Deferred tax benefit Origination and reversal of temporary differences Total income tax expense Numerical reconciliation between income tax expense and profit before income tax Net profit Income tax expense Profit before income tax Note 2014 $000 2013 $000 25,412 (420) 31,440 (3,143) 24,992 28,297 11 (1,587) (1,587) 23,405 11,777 11,777 40,074 2014 2014 2014 2013 Reported Patent dispute provision Before patent dispute provision Reported $000 $000 $000 $000 93,709 23,405 15,781 109,490 132,563 6,764 30,169 40,074 117,114 22,545 139,659 172,637 Income tax expense using the Company’s domestic tax rate of 30% (2013: 30%) 35,134 6,764 41,898 51,791 Increase in income tax expense due to: Non-deductible expenses Decrease in income tax expense due to: Research and development allowances Share based payment deductions Effect of tax rate in foreign jurisdictions Adjustment for prior years 1,437 (11,221) (357) (1,168) - - - - 23,825 6,764 30,589 (420) - (420) 1,437 2,637 (11,221) (10,560) (357) (1,168) (332) (319) 43,217 (3,143) Income tax expense on profit before income tax 23,405 6,764 30,169 40,074 Deferred tax recognised in other comprehensive income/(loss) relating to derivative financial instruments* Total deferred tax recognised in other comprehensive income/(loss) Deferred tax recognised directly in equity relating to share based payments Total deferred tax recognised directly in equity * Restated for change in accounting policy, refer Note 30. Note 11 11 2014 $000 2013 $000 Restated* 7,353 (20,819) 7,353 (20,819) (1,119) (1,119) 2,537 2,537 Income tax expense comprises current and deferred tax. Current and deferred tax are recognised in the income statement except to the extent that they relate to a business combination, or items recognised directly in equity or in other comprehensive income. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 70 10. Income tax expense (continued) Current tax is the expected tax payable or receivable on the taxable income or loss for the year, using tax rates enacted or substantively enacted at the reporting date, and any adjustment to tax payable in respect of previous years. Current tax payable also includes any tax liability arising from the declaration of dividends. Deferred taxes are explained in more detail in Note 11. Additional income tax expenses that arise from the distribution of cash dividends are recognised at the same time that the liability to pay the related dividend is recognised. Cochlear does not distribute non-cash assets as dividends to its shareholders. The Company and its wholly-owned Australian resident entities are part of a tax-consolidated group. As a consequence, all members of the tax-consolidated group are taxed as a single entity. The head entity within the tax-consolidated group is Cochlear Limited. 11. Current and deferred tax assets and liabilities Assets 2014 $000 2013 $000 Restated* Liabilities 2014 $000 2013 $000 Net 2014 $000 Recognised deferred tax assets and liabilities Property, plant and equipment Intangible assets Inventories Provisions* Deferred revenue Forward exchange contracts Other Tax losses carried forward Deferred tax assets/(liabilities) Set off of tax Net deferred tax assets 3,608 53 17,519 29,665 792 - 5,806 1,118 58,561 (5,800) 52,761 4,395 55 16,063 26,326 3,382 6,407 4,713 1,297 62,638 (5,216) 57,422 (977) (1,610) - (5) - (229) (2,979) - (5,800) 5,800 - 2013 $000 Restated* 3,666 (1,754) 16,063 26,326 3,382 6,407 2,035 1,297 2,631 (1,557) 17,519 29,660 792 (229) 2,827 1,118 (729) (1,809) - - - - (2,678) - (5,216) 5,216 52,761 57,422 - - - 52,761 57,422 * Restated for change in accounting policy, refer Note 30. Deferred tax is recognised in respect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for taxation purposes. Deferred tax is not recognised for: • temporary differences on the initial recognition of assets or liabilities in a transaction that is not a business combination and that affects neither accounting nor taxable profit or loss; • temporary differences related to investments in controlled entities to the extent that it is probable that they will not reverse in the foreseeable future; and • taxable temporary differences arising on the initial recognition of goodwill. The measurement of deferred tax reflects the tax consequences that would follow the manner in which the Consolidated Entity expects, at the end of the financial year, to recover or settle the carrying amount of its assets and liabilities. Deferred tax is measured at the tax rates that are expected to be applied to temporary differences when they reverse, based on the laws that have been enacted or substantively enacted by the reporting date. Deferred tax assets and liabilities are offset if there is a legally enforceable right to offset current tax liabilities and assets, and they relate to income taxes levied by the same taxation authority on the same taxable entity, or on different tax entities, but they intend to settle current tax liabilities and assets on a net basis or their tax assets and liabilities will be realised simultaneously. A deferred tax asset is recognised for unused tax losses, tax credits and deductible temporary differences, to the extent that it is probable that future taxable profits will be available against which they can be utilised. Deferred tax assets are reviewed at each reporting date and are reduced to the extent that it is no longer probable that the related tax benefit will be realised. Unrecognised deferred tax liabilities At 30 June 2014, a deferred tax liability of $37.6 million (2013: $23.3 million) relating to investments in subsidiaries has not been recognised because the Company controls whether the asset will be recovered or the liability will be incurred and it is satisfied that it will not be incurred in the foreseeable future. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 71 Movement in temporary differences during the year Carrying amount at beginning of financial year Recognised in the income statement Recognised in other comprehensive income/(loss)* Recognised directly in equity Effects of movements in foreign exchange Carrying amount at end of financial year * Restated for change in accounting policy, refer Note 30. Note 10 10 10 2014 $000 57,422 1,587 (7,353) 1,119 (14) 52,761 2013 $000 Restated* 50,495 (11,777) 20,819 (2,537) 422 57,422 Current tax assets and liabilities The current tax assets for the Consolidated Entity of $8.6 million (2013: $6.2 million) represent the amount of income taxes recoverable in respect of current and prior years and arise from the payment of tax in excess of the amounts due to the relevant taxation authority. The current tax liabilities for the Consolidated Entity of $8.4 million (2013: $6.0 million) represent the amount of income taxes payable in respect of current and prior financial years. Employee benefits 12. Employee expenses Wages and salaries Contributions to superannuation plans Increase in leave liabilities Equity settled share based payment transactions Total employee benefits expense 13. Employee benefit liabilities Current Provision for long service leave Provision for annual leave Provision for short-term incentives Wages and salaries accrued Total current employee benefit liabilities Non-current Provision for long service leave Defined benefit plan* Provision for directors’ retirement scheme Total non-current employee benefit liabilities Total employee benefit liabilities * Restated for change in accounting policy, refer Note 30. 2014 $000 233,432 17,633 488 4,971 2013 $000 208,585 15,846 2,069 2,740 256,524 229,240 2014 $000 6,016 17,035 8,014 31,065 1,857 32,922 5,200 3,130 422 8,752 2013 $000 Restated* 7,325 16,850 6,275 30,450 515 30,965 3,589 3,161 411 7,161 41,674 38,126 Note 20 20 20 20 AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 72 13. Employee benefit liabilities (continued) Wages, salaries and annual leave Liabilities for employee benefits for wages, salaries and annual leave represent present obligations resulting from employees’ services provided up to the reporting date, calculated based on remuneration wage and salary rates that Cochlear expects to pay as at the reporting date including related on-costs, such as workers’ compensation insurance and payroll tax. Long service leave The provision for employee benefits for long service leave represents the present value of the estimated future cash outflows to be made by the employer resulting from employees’ services provided up to the reporting date. The provision is calculated using expected future increases in remuneration rates, including related on-costs, and expected settlement dates based on turnover history, and is discounted using the rates attaching to national government securities at the reporting date, which most closely match the terms to maturity of the related liabilities. The unwinding of the discount is treated as a long service leave expense. Defined contribution plans A defined contribution plan is a post-employment benefit plan under which the entity pays fixed contributions into a separate entity and will have no legal or constructive obligation to pay further amounts. Obligations for contributions to defined contribution plans are recognised as an expense in the income statement as incurred. Cochlear makes contributions to defined contribution plans. The amount recognised as expense was $16.5 million for the year ended 30 June 2014 (2013: $14.9 million). Defined benefit plans A defined benefit plan is a post-employment benefit plan other than a defined contribution plan. The Company’s net obligation in respect of defined benefit plans is calculated separately for each plan by estimating the amount of future benefit that employees have earned in the current and prior periods, discounting that amount and deducting the fair value of any plan assets. The calculation of defined benefit obligations is performed annually by a qualified actuary using the direct to equity method. When the calculation results in a potential asset for the Company, the recognised asset is limited to the present value of economic benefits available in the form of any future refunds from the plan or reductions in future contributions to the plan. To calculate the present value of economic benefits, consideration is given to any applicable minimum funding requirements. Remeasurements of the net defined benefit liability, which comprise actuarial gains and losses, the return on plan assets (excluding interest) and the effect of the asset ceiling (if any, excluding interest), are recognised immediately in other comprehensive income. The Company determines the net interest expense (income) on the net defined benefit liability (asset) for the period by applying the discount rate used to measure the defined benefit obligation at the beginning of the annual period to the then net defined benefit liability (asset), taking into account any changes in the net defined benefit liability (asset) during the period as a result of contributions and benefit payments. Net interest expense and other expenses related to defined benefit plans are recognised in profit or loss. When the benefits of a plan are changed or when a plan is curtailed, the resulting change in benefit that relates to past service or the gain or loss on curtailment is recognised immediately in profit or loss. The Company recognises gains and losses on the settlement of a defined benefit plan when the settlement occurs. Cochlear makes contributions to defined benefit plans. These defined benefit plans cover, in aggregate, 84 employees. Cochlear contributed cash of $1.1 million (2013: $0.9 million) to defined benefit plans in the year ended 30 June 2014 and expects to contribute $1.1 million in the year ending 30 June 2015. Directors’ retirement scheme Non-executive directors appointed prior to 2003 were entitled to retirement benefits of up to three times their annual remuneration over the previous three years once they had more than five years’ service. The ongoing accrual of benefits under the directors’ retirement scheme ceased from 30 June 2007. The benefits accrued to that date are indexed by reference to the bank bill rate. As at 30 June 2014, Prof E Byrne, AC is the only non-executive director entitled to this benefit. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 73 14. Share based payments Prior to July 2013, the Company granted options and performance shares to certain employees under the Cochlear Executive Long Term Incentive Plan (CELTIP). From 1 July 2013, the Company grants options and performance rights to certain employees under the Cochlear Executive Incentive Plan (CEIP). The fair value of options, performance shares and performance rights granted is recognised as an employee expense with a corresponding increase in equity. The fair value is measured at the date the options, shares or rights are granted taking into account market based criteria and expensed over the vesting period after which the employees become unconditionally entitled to the options, shares and rights. The fair value of the options, performance shares and performance rights granted is measured using the Black-Scholes-Merton pricing model, taking into account the terms and conditions attached to the instruments. The amount recognised as an expense is adjusted to reflect the actual number of options, shares and rights that are expected to vest except where forfeiture is due to market related conditions. When the Company grants options over its shares to employees of controlled entities, the fair value at grant date is recognised as an increase in the investment in subsidiaries, with a corresponding increase in equity over the vesting period of the grant. The Company operates the Cochlear Executive Long Term Incentive Plan (Performance Shares) Trust (Trust). The main purpose of the Trust is to hold unvested performance shares as part of the CELTIP and the CEIP. Under IFRS, the Trust qualifies as an equity compensation plan special purpose entity and its results are included in those for the Company and the Consolidated Entity. Any shares held by the Trust are accounted for as treasury shares and treated as a reduction in the share capital of the Company and the Consolidated Entity. Cochlear’s Employee Share Plan (Plan) was approved by special resolution at the AGM held on 19 October 1999. Under the Plan, the directors can at their discretion, allocate at nil consideration up to a maximum of $2,000 worth of shares per eligible employee in any one year. In practice, the directors issue shares worth up to the tax concessional limit, currently $1,000 per eligible employee each year. The fair value of shares issued during the financial year is the market price of the Company’s shares on the ASX as at the start of trading on the issue date. Shares under the Plan vest with the employee immediately but are non-transferable for a period of up to three years. For the year ended 30 June 2014, the Company issued 21,088 shares under the Plan. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 74 14. Share based payments (continued) At 30 June 2014, unissued ordinary shares of the Company under option and rights, and issued shares held in the Trust and the terms and conditions of the grants and issues are as follows: Grant date Option grant in August and October 2011 Number of instruments Conditions for minimum vesting Contractual life of options 242,443 Three years of service, a minimum compound annual growth rate in EPS of 10%. 242,444 Three years of service, the Consolidated Entity’s TSR is above the 50th percentile against the S&P/ASX 100 over three years. Option grant in August 2012 353,563 Three years of service, a minimum compound annual growth rate in EPS of 10%. 353,564 Three years of service, the Consolidated Entity’s TSR is above the 50th percentile against the S&P/ASX 100 over three years. Option grant in October 2013 112,157 Three years of service, a minimum compound annual growth rate in EPS of 10%. 112,157 Three years of service, the Consolidated Entity’s TSR is above the 50th percentile against the S&P/ASX 100 over three years. Total options(1) 1,416,328 (1) No options granted in August 2010 were outstanding as at 30 June 2014. 5 years 5 years 5 years 5 years 4 years 4 years Issue date Performance shares issued in August 2011 Performance shares issued in August 2012 Number of instruments Conditions for minimum vesting 10,090 Three years of service, a minimum compound annual growth rate in EPS of 10%. 10,090 Three years of service, the Consolidated Entity’s TSR is above the 50th percentile against the S&P/ASX 100 over three years. 32,034 Three years of service, a minimum compound annual growth rate in EPS of 10%. 32,033 Three years of service, the Consolidated Entity’s TSR is above the 50th percentile against the S&P/ASX 100 over three years. Contractual life of shares in the Trust 5 years 5 years 5 years 5 years Total performance shares 84,247 Issue date Performance rights issued in October 2013 Number of instruments Conditions for minimum vesting Contractual life of rights 9,851 Three years of service, a minimum compound annual growth rate in EPS of 10%. 9,852 Three years of service, the Consolidated Entity’s TSR is above the 50th percentile against the S&P/ASX 100 over three years. 4 years 4 years Total performance rights 19,703 Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 75 The number and weighted average exercise prices of options are as follows: Outstanding at 1 July Forfeited Exercised Granted Outstanding at 30 June Exercisable at 30 June Weighted average exercise price $ Number of options Weighted average exercise price $ Number of options 2014 65.98 67.83 - 59.13 64.18 - 2014 1,738,000 (545,986) - 224,314 1,416,328 - 2013 64.33 61.62 52.73 62.78 65.98 60.04 2013 1,635,440 (402,069) (255,199) 759,828 1,738,000 85,674 No options were exercised in 2014. In 2013, the weighted average share price at the date of exercise was $69.77. The estimated value of options for the current financial year is calculated at the date of grant using the Black-Scholes-Merton pricing model. For options outstanding at 30 June 2014, 484,887 options have an exercise price of $68.56, 707,127 options have an exercise price of $62.78 and 224,314 options have an exercise price of $59.13 (2013: 85,674 options had an exercise price of $60.04, 399,869 options had an exercise price of $69.80, 517,065 options had an exercise price of $68.56 and 735,392 options had an exercise price of $62.78). The weighted average remaining contractual life of options outstanding at the end of the year is three years (2013: three years). Inputs for measurement of grant date fair values The grant date fair value of options, performance rights and performance shares was measured based on the Black-Scholes-Merton pricing model. Expected volatility is estimated by considering historic average share price volatility. The inputs used in the measurement of the fair values at grant date are the following: 15 October 2013 13 August 2012 Fair value of options at grant date with: – EPS performance based conditions – TSR based conditions Fair value of performance rights at grant date with: – EPS performance based conditions – TSR based conditions Fair value of performance shares at grant date with: – EPS performance based conditions – TSR based conditions Share price at grant date Option exercise price Expected volatility (weighted average volatility) Option life Expected dividends Risk free interest rate (based on government bonds) $11.38 $9.93 $53.22 $28.85 - - $58.42 $59.13 31.83% 3–4 years 3.20% 2.51% $8.56 $5.70 - - $62.78 $39.55 $62.97 $62.78 23.99% 3–5 years 3.80% 2.71% AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 76 15. Key management personnel The following were key management personnel of Cochlear at any time during the financial year and unless otherwise indicated were key management personnel for the entire financial year: Non-executive directors Mr R Holliday-Smith (Chairman) Mrs YA Allen Mr PR Bell Prof E Byrne, AC Mr A Denver Mr DP O’Dwyer Executive director Dr CG Roberts Executives Mr R Brook Mr J Janssen Mr NJ Mitchell Mr MD Salmon Mr CM Smith. Key management personnel disclosures The key management personnel compensation is included in employee expenses as follows: Short-term employee benefits Post-employment benefits Other long-term benefits Directors’ retirement benefits Share based payments 2014 $ 7,207,457 388,273 100,918 10,902 1,821,874 9,529,424 2013 $ 6,824,569 368,245 94,729 12,293 1,232,235 8,532,071 Information regarding individual directors’ and executives’ remuneration and some equity instruments disclosures as permitted by section 300A of the Corporations Act 2001 is provided in the Remuneration Report in the Directors’ Report on pages 31 to 53. The key management personnel have not received any loans from Cochlear and there have been no other related party transactions with any of Cochlear’s key management personnel. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 77 Operating assets and liabilities 16. Trade and other receivables Current Trade receivables net of allowance for impairment losses Other receivables Forward exchange contracts Total current trade and other receivables Non-current Other receivables Forward exchange contracts Total non-current trade and other receivables 2014 $000 201,295 9,099 4,559 2013 $000 187,593 12,691 3,464 214,953 203,748 55 5,450 5,505 46 898 944 Trade and other receivables are stated at amortised cost less impairment losses. Cochlear’s exposure to credit and currency risks and impairment losses related to trade and other receivables is disclosed in Note 22. 17. Inventories Raw materials and stores Work in progress Finished goods Total inventories 2014 $000 40,593 19,214 68,806 2013 $000 48,653 15,333 67,588 128,613 131,574 Inventories are measured at the lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less estimated costs of completion and selling, marketing and distribution expenses. Cost is based on the first-in-first-out principle and includes expenditure incurred in acquiring the inventories and bringing them to their existing condition and location. In the case of manufactured inventories and work in progress, cost includes an appropriate share of both variable and fixed overhead costs. Fixed overhead costs are allocated on the basis of normal operating capacity. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 78 18. Property, plant and equipment Leasehold improvements At cost Accumulated amortisation Plant and equipment At cost Accumulated depreciation and impairment Total property, plant and equipment, at net book value Reconciliations Reconciliations of the carrying amounts of each class of property, plant and equipment are set out below: Leasehold improvements Carrying amount at beginning of financial year Additions Depreciation Effect of movements in foreign exchange Carrying amount at end of financial year Plant and equipment Carrying amount at beginning of financial year Additions Disposals Depreciation Impairment reversal Effect of movements in foreign exchange Carrying amount at end of financial year 2014 $000 26,458 (18,511) 7,947 180,780 (112,951) 67,829 75,776 6,444 3,256 (1,868) 115 7,947 59,454 20,241 (2,611) 2013 $000 23,057 (16,613) 6,444 155,923 (96,469) 59,454 65,898 5,466 2,171 (1,525) 332 6,444 54,145 18,903 (1,028) (15,580) (13,876) 6,346 (21) 67,829 - 1,310 59,454 Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 79 Owned assets Items of property, plant and equipment are measured at cost less accumulated depreciation (see below) and impairment losses (see Note 19). An asset’s cost is determined as the consideration provided plus incidental costs directly attributable to the acquisition. The cost of self-constructed assets includes the cost of material and direct labour, an appropriate share of fixed and variable overheads, and capitalised interest and any other costs directly attributable to bringing the asset to a working condition for its intended use. Subsequent costs in relation to replacing a part of property, plant and equipment are recognised in the carrying amount of the item if it is probable that future economic benefits embodied within the part will flow to Cochlear and its cost can be measured reliably. All other costs are recognised in the income statement as incurred. In respect of borrowing costs relating to qualifying assets, Cochlear capitalises borrowing costs directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. Leased assets Operating leases Payments made under operating leases are expensed on a straight-line basis over the term of the lease, except where an alternative basis is more representative of the pattern of benefits to be derived from the leased property. Minimum lease payments include fixed rate increases. Depreciation Depreciation is calculated over the depreciable amount, which is the cost of an asset, or other amount substituted for cost, less its residual value. Depreciation is recognised in the income statement on a straight-line basis. Items of property, plant and equipment, including leasehold assets, are depreciated using the straight-line method over their estimated useful lives, taking into account estimated residual values. Assets are depreciated from the date of acquisition or, in respect of internally constructed assets, from the time an asset is completed and held ready for use. Leased assets are depreciated over the shorter of the lease term and their useful lives unless it is reasonably certain that Cochlear will obtain ownership by the end of the lease term. Depreciation rates and methods, useful lives and residual values are reviewed at each balance sheet date. When changes are made, adjustments are reflected prospectively in current and future financial years only. The estimated useful lives in the current and comparative years are as follows: Leasehold improvements 1 – 15 years Plant and equipment 3 – 14 years. Impairment reversal During the year ended 30 June 2014, plant and equipment previously impaired due to the recall was reassessed. Of the $14.0 million impaired, $6.3 million has been reversed as it can be used with the Nucleus Profile cochlear implant. Cochlear has increased the product recall provision (refer Note 20) by this amount to cover the uncertain outcomes. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 80 19. Intangible assets Intangible assets with indefinite useful lives Goodwill, at cost Technology relationship, at cost Total intangible assets with indefinite useful lives Intangible assets with finite useful lives Acquired technology, patents and licences At cost Accumulated amortisation and impairment Enterprise resource planning system At cost Accumulated amortisation Customer relationships At cost Accumulated amortisation Capitalised development expenditure At cost Accumulated amortisation Other intangible assets At cost Accumulated amortisation Total intangible assets with finite useful lives Total intangible assets 2014 $000 170,259 1,800 172,059 64,176 (31,678) 32,498 67,968 (39,725) 28,243 4,401 (4,401) - 7,759 (7,759) - 4,064 (2,749) 1,315 62,056 234,115 2013 $000 170,959 1,800 172,759 62,811 (28,733) 34,078 60,941 (33,614) 27,327 4,449 (4,449) - 7,759 (7,759) - 4,013 (2,403) 1,610 63,015 235,774 Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 81 Reconciliations Reconciliations of the carrying amounts of each class of intangible assets are set out below: Note 2014 $000 2013 $000 Goodwill Carrying amount at beginning of financial year Effect of movements in foreign exchange Carrying amount at end of financial year Technology relationship Carrying amount at beginning of financial year Carrying amount at end of financial year Acquired technology, patents and licences Carrying amount at beginning of financial year Acquisitions Amortisation Reclassification from other intangible assets Effect of movements in foreign exchange Carrying amount at end of financial year Enterprise resource planning system Carrying amount at beginning of financial year Acquisitions Amortisation Disposals Effect of movements in foreign exchange Carrying amount at end of financial year Other intangible assets Carrying amount at beginning of financial year Amortisation (a) Reclassification to acquired technology, patents and licences (a) Effect of movements in foreign exchange Carrying amount at end of financial year 170,959 (700) 170,259 1,800 1,800 34,078 1,452 (3,030) - (2) 151,066 19,893 170,959 1,800 1,800 24,165 2,431 (2,770) 9,934 318 32,498 34,078 27,327 6,997 (6,086) - 5 28,243 1,610 (291) - (4) 1,315 17,721 14,477 (4,432) (454) 15 27,327 11,963 (401) (9,934) (18) 1,610 (a) Purchase of intellectual property from Otologics LLC As at 30 June 2012, Cochlear recorded an asset being the “Right to acquire intellectual property” of United States dollars (USD) 10.0 million to reflect its security interest in the intellectual property assets of Otologics LLC being the same value as its amount payable to Wells Fargo Bank as guarantor to Otologics LLC loan, following Otologics LLC’s declaration of bankruptcy. During year ended 30 June 2013, Cochlear settled the loan and acquired intellectual property and certain other assets of Otologics LLC for a total consideration of USD 14.0 million. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 82 19. Intangible assets (continued) Goodwill All business combinations are accounted for by applying the acquisition method. Goodwill represents the difference between the cost of the acquisition and the fair value of the net identifiable assets acquired. Goodwill is stated at cost less any accumulated impairment losses. Goodwill is allocated to cash generating units (CGUs) and is tested annually for impairment (see below). Negative goodwill arising on an acquisition is recognised directly in the income statement. Enterprise resource planning system The expenditure incurred on hardware and software and the costs necessary for the implementation of the system are recognised as an intangible asset, to the extent that Cochlear controls future economic benefits as a result of the costs incurred, and are stated at cost less accumulated amortisation. Costs include expenditure that is directly attributable to the development and implementation of the system and includes direct labour. Research and development expenditure Expenditure on research activities, undertaken with the prospect of gaining new scientific or technical knowledge and understanding, is recognised in the income statement as an expense as incurred. Development activities involve a plan or design for production of new or substantially improved products or processes before the start of commercial production or use. Development expenditure is capitalised only if development costs can be measured reliably, the product or process is technically and commercially feasible, future economic benefits are probable and Cochlear intends to and has sufficient resources to complete development and use or sell the asset. The expenditure capitalised includes the cost of materials, direct labour and an appropriate proportion of overheads. Other development expenditure is recognised in the income statement as an expense as incurred. Capitalised development expenditure is stated at cost less accumulated amortisation and impairment losses (see below). Other intangible assets Other intangible assets, comprising acquired technology, patents and licences, customer relationships and intellectual property, are acquired individually or through business combinations and are stated at cost less accumulated amortisation and impairment losses (see below). Expenditure on internally generated goodwill and brands is recognised in the income statement as an expense as incurred. Subsequent expenditure Subsequent expenditure on capitalised intangible assets is capitalised only when it increases the future economic benefits embodied in the specific asset to which it relates. All other expenditure is expensed as incurred. Amortisation Amortisation is calculated over the cost of the asset, or an other amount substituted for cost, less its residual value. Amortisation is recognised in the income statement on a straight-line basis over the estimated useful lives of the intangible assets from the date they are available for use unless such lives are indefinite, except for amortisation of capitalised development expenditure which is recognised in the research and development expenses line. Goodwill and intangible assets with an indefinite useful life are systematically tested for impairment annually. The estimated useful lives for the current and comparative years are as follows: Acquired technology, patents and licences 4 – 15 years Enterprise resource planning system 2.5 – 7 years Customer relationships 4 years Capitalised development expenditure 1 – 3 years. Impairment The carrying amounts of Cochlear’s non-financial assets, other than inventories (see Note 17) and deferred tax assets (see Note 11), are reviewed at each reporting date to determine whether there is any indication of impairment. If any such indication exists, the asset’s recoverable amount is estimated (see below). For goodwill and intangible assets that have indefinite useful lives, and intangible assets that are not yet available for use, the recoverable amount is estimated at each balance sheet date. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 83 The recoverable amount of an asset or CGU is the greater of its value in use, and its fair value less costs to sell. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset or CGU. For the purpose of impairment testing, assets are grouped together into the smallest group of assets that generates cash inflows from continuing use that is largely independent of the cash inflows of other assets or groups of assets (CGU). The goodwill acquired in a business combination, for the purpose of impairment testing, is allocated to CGUs that are expected to benefit from the processes, intellectual property acquired and synergies of the combination. An impairment loss is recognised whenever the carrying amount of an asset or its CGU exceeds its recoverable amount. Impairment losses are recognised in the income statement unless the asset has previously been revalued, in which case the impairment loss is recognised as a reversal to the extent of that previous revaluation, with any excess recognised through the income statement. Impairment losses recognised in respect of CGUs are allocated first to reduce the carrying amount of any goodwill allocated to the CGU or a group of units and then, to reduce the carrying amount of the other assets in the unit or a group of units on a pro-rata basis. An impairment loss in respect of goodwill is not reversed. In respect of other assets, impairment losses recognised in prior years are assessed at each reporting date for indications that the loss has decreased or no longer exists. An impairment loss is reversed if there has been a change in the estimates used to determine the recoverable amount. An impairment loss is reversed only to the extent that the asset’s carrying amount does not exceed the carrying amount that would have been determined, net of depreciation or amortisation, if no impairment loss had been recognised. Impairment tests for CGUs Impairment testing is performed over the carrying amounts of goodwill, other intangible assets and property, plant and equipment at Cochlear’s CGUs. For the purpose of impairment testing, goodwill is allocated to Cochlear’s operating divisions which represent the lowest level within Cochlear at which the goodwill is monitored for internal management purposes, which is not higher than Cochlear’s operating segments as reported in Note 3. The aggregate carrying amounts of goodwill allocated to each CGU are as follows: Americas EMEA Asia Pacific 2014 $000 85,808 74,553 9,898 170,259 2013 $000 86,438 74,709 9,812 170,959 The recoverable amount of each CGU is based on value-in-use calculations. Those calculations use cash flow projections based on actual operating results, the next year’s budget and the three year business plan. Cash flows for subsequent years are extrapolated using a conservative terminal growth rate of 3.0% (2013: 3.0%) per annum which is consistent with long-term economic growth rates. A pre-tax discount rate of 13.4% (2013: 13.5%) per annum has been used in discounting the projected pre-tax cash flows. The key assumptions and the approach to determining their value in the current year are: Assumption Discount rate How determined Based on weighted average cost of capital Sales volume growth rate Based on a three year forecast taking into account historical growth rates and product lifecycle Terminal value growth rate Based on a three year forecast taking into account historical growth rates and product lifecycle. The recoverable amount of each CGU including unallocated corporate assets is in excess of their carrying amount and therefore no impairment charge was required. The excess of recoverable amount over carrying amount is such that a reasonably possible change in assumptions is unlikely to reduce the recoverable amount below the carrying amount. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 84 20. Provisions Current Employee benefit liabilities Warranties Legal and other Product recall Total current provisions Non-current Employee benefit liabilities Defined benefit plan* Warranties Directors’ retirement scheme Make good lease costs Product recall Patent dispute Total non-current provisions * Restated for change in accounting policy, refer Note 30. Reconciliations Reconciliations of the carrying amounts of each class of provision, except for the employee benefit liabilities provision, are set out below: Warranties Carrying amount at beginning of financial year Provisions made Provisions used Effects of movements in foreign exchange Carrying amount at end of financial year Legal and other Carrying amount at beginning of financial year Provisions made Provisions used Effects of movements in foreign exchange Carrying amount at end of financial year Make good lease costs Carrying amount at beginning of financial year Provisions made Provisions used Provisions released Effects of movements in foreign exchange Carrying amount at end of financial year Note 13 13 13 13 2014 $000 31,065 16,469 4,465 5,558 57,557 5,200 3,130 5,082 422 2,139 16,049 21,333 53,355 2013 $000 Restated* 30,450 13,231 7,487 12,056 63,224 3,589 3,161 4,683 411 2,143 24,530 - 38,517 17,914 30,036 13,991 29,152 (26,355) (25,439) (44) 21,551 7,487 2,634 (5,658) 2 4,465 2,143 - - - (4) 2,139 210 17,914 7,523 5,218 (5,294) 40 7,487 4,024 400 (416) (1,857) (8) 2,143 Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 85 Defined benefit plan* Carrying amount at beginning of financial year Provisions made Effects of movements in foreign exchange Carrying amount at end of financial year Directors’ retirement scheme Carrying amount at beginning of financial year Provisions made Carrying amount at end of financial year Product recall Carrying amount at beginning of financial year Provisions made Provisions used Carrying amount at end of financial year Patent dispute Carrying amount at beginning of financial year Provisions made Effects of movements in foreign exchange Carrying amount at end of financial year 2014 $000 3,161 306 (337) 3,130 411 11 422 36,586 6,346 (21,325) 21,607 - 22,545 (1,212) 21,333 2013 $000 Restated* 2,858 303 - 3,161 399 12 411 52,970 - (16,384) 36,586 - - - - * Restated for change in accounting policy, refer Note 30. A provision is recognised in the balance sheet when Cochlear has a present legal or constructive obligation as a result of a past event that can be estimated reliably, and it is probable that an outflow of economic benefits will be required to settle the obligation. Provisions are determined by discounting the expected future cash flows at a pre-tax rate that reflects current market assessments of the time value of money and the risk specific to the liability. The unwinding of the discount rate is recognised as a finance expense. Warranties Provisions for warranty claims are made for claims in relation to sales made prior to the reporting date, based on historical claim rates and respective product populations. Warranty periods on hardware products extend for three to 10 years. Legal and other Onerous contracts A provision for onerous contracts is recognised when expected benefits to be derived by Cochlear from a contract are lower than the unavoidable cost of meeting contractual obligations. The provision is measured at the lower of the expected cost of terminating the contract and the expected net cost of continuing with the contract. Before a provision is established, Cochlear recognises any impairment loss on the assets associated with the contract. Self-insurance Cochlear self-insures to manage certain risks associated with operating in its line of business. Claims are recognised when an incident occurs that may give rise to a claim and are measured at the cost that Cochlear expects to incur in settling the claims, discounted using a rate that reflects current market assessments of the time value of money and the risks specific to the liability. Make good lease costs Cochlear has a number of operating leases over its offices that require the premises to be returned to the lessor in their original condition. The operating lease payments do not include an element for the repairs/overhauls. A provision for make good lease costs is recognised at the time it is determined that it is probable that such costs will be incurred in a future year, measured at the expected cost of returning the asset to the lessor in its original condition. An offsetting asset of the same value is also recognised and is classified in property, plant and equipment. This asset is amortised to the income statement over the life of the lease. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 86 20. Provisions (continued) Product recall On 11 September 2011, the Company initiated a worldwide voluntary recall of its unimplanted Nucleus CI500 cochlear implant range. Management has made judgements, estimates and assumptions related to probable costs arising from the recall which affect the reported amounts of assets, liabilities, income and expenses. Actual outcomes may differ from these estimates as further information is identified. During the year ended 30 June 2014, plant and equipment previously impaired due to the recall was reassessed. Of the $14.0 million impaired, $6.3 million has been reversed as it can be used with the Nucleus Profile cochlear implant. Cochlear has increased the recall provision by this amount to cover the uncertain outcomes. No further amount has been recognised as a charge or released as a credit in the year ended 30 June 2014. Patent dispute On 24 January 2014, a jury verdict in the patent infringement lawsuit by the Alfred E. Mann Foundation for Scientific Research and Advanced Bionics LLC in the United States District Court in Los Angeles, California was reached. The jury found direct, contributory and wilful, but not induced infringement against Cochlear Limited and its USA subsidiary Cochlear Americas and awarded damages of USD 131.2 million against Cochlear. No Judgment has been entered based on the verdict as important issues still remain to be decided by the Judge. These decisions may negate some of the findings of the jury and could alter the damages awarded by the jury. The directors have obtained external advice and are of the opinion that the facts and the law do not support the jury’s findings and Cochlear has applied to overturn the verdict in post-trial motions filed with the District Court. A Judgment is pending and the timing for entry of the Judgment is uncertain. The directors will appeal any significant adverse Judgment to the United States Court of Appeals for the Federal Circuit. If an appeal is necessary, Cochlear will provide non-cash security to stay the execution of the Judgment against Cochlear. Providing this security will avoid the requirement for Cochlear to pay the Judgment amount prior to the outcome of the appeal. A provision of USD 20 million ($22.5 million) was expensed in the half year ended 31 December 2013 in relation to this dispute. No additional amount has been provided since the half year accounts. For the purpose of determining this provision, Cochlear considered its independent damages expert’s assessment prepared for the trial to estimate the liability that could result from the dispute. The nature of the above legal process is such that final future outcomes are uncertain. The directors have made judgements and assumptions relating to their best estimate of the outcome of this litigation and actual outcomes may differ from the estimated liability. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 87 Financial and capital structure 21. Net debt and finance costs (a) Net debt Total loans and borrowings Less: Cash and cash equivalents Net debt (b) Total cash and cash equivalents Note 21(c) 9(a) 2014 $000 237,415 (56,127) 181,288 The operating cash account received an average interest rate of 0.58% (2013: 0.82%) per annum. Cash held on deposit for periods not exceeding 90 days received an average interest rate of 1.77% (2013: 3.27%) per annum. (c) Loans and borrowings Current Secured bank loans Total current loans and borrowings Non-current Secured bank loans(i) Total non-current loans and borrowings Financing arrangements Cochlear had access to the following lines of credit at the reporting date: Multi-option credit facilities Secured bank loan Standby letters of credit Bank guarantees Other credit facilities Unsecured bank overdrafts Secured bank loan Bank guarantees Facilities utilised at the reporting date Multi-option credit facilities Secured bank loan Standby letters of credit Bank guarantees Other credit facilities Unsecured bank overdrafts Secured bank loan Bank guarantees 2013 $000 170,469 (52,689) 117,780 2013 $000 3,309 3,309 167,160 167,160 295,000 19,736 264 352 4,963 1,198 2014 $000 3,141 3,141 234,274 234,274 345,000 17,705 2,295 363 4,711 1,456 371,530 321,513 235,000 3,374 2,295 - 3,141 1,066 168,000 1,924 264 - 3,309 1,193 244,876 174,690 AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 88 21. Net debt and finance costs (continued) Facilities not utilised at the reporting date Multi-option credit facilities Secured bank loan Standby letters of credit Bank guarantees Other credit facilities Unsecured bank overdrafts Secured bank loan Bank guarantees 2014 $000 110,000 14,331 - 363 1,570 390 2013 $000 127,000 17,812 - 352 1,654 5 126,654 146,823 (i) Included within secured bank loans is an amount of $725,606 (2013: $840,028) in relation to unamortised loan establishment fees. Loans and borrowings are recognised initially at fair value less attributable transaction costs. Subsequent to initial recognition, loans and borrowings are stated at amortised cost, with any difference between amortised cost and redemption value being recognised in the income statement over the period of the borrowings on an effective interest rate basis. Secured bank loan – multi-option credit facilities Cochlear has two corporate loan facilities. The first was amended and extended in June 2013 for a period of three years and a total commitment limit of AUD 200.0 million. In December 2013, the total commitment limit was increased to AUD 250.0 million. The facility has an option to allocate a letter of credit sub-facility limit of up to AUD 30.0 million for the purpose of drawing either bank guarantees or letters of credit. This letter of credit sub-limit currently sits at AUD 5.0 million. In June 2013, Cochlear negotiated a second loan facility for a period of five years. The facility has a total commitment limit of AUD 115.0 million made up of an AUD 100.0 million loan sub-facility limit and incorporates an existing AUD 15.0 million letter of credit facility that was negotiated in August 2011. Both facilities are secured by interlocking guarantees provided by certain controlled entities. Interest on the facilities is variable and charged at prevailing market rates. Unsecured bank overdrafts Certain unsecured bank overdrafts are payable on demand and are subject to annual review. Interest on unsecured bank facilities is variable and is charged at prevailing market rates. Secured bank loan Cochlear has a Japanese yen (JPY) 450.0 million loan. It is secured by a letter of guarantee and reviewed annually. Interest is charged at prevailing market rates. Bank guarantees As at 30 June 2014, Cochlear had additional contingent liability facilities denominated in USD, Euros (EUR), Sterling (GBP), Indian rupees (INR) and New Zealand dollars (NZD) totalling AUD 1.5 million (2013: AUD 1.2 million). (d) Net finance expense Recognised in the income statement Interest income Finance income Interest expense Finance expense Net finance expense recognised in the income statement 2014 $000 324 324 (10,301) (10,301) (9,977) 2013 $000 659 659 (6,882) (6,882) (6,223) Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 89 Interest income is recognised as it accrues in the income statement using the effective interest rate method. Borrowing costs are recognised as they accrue in the income statement as a finance expense except to the extent that borrowing costs relate to the purchase of qualifying assets in which case they are capitalised into the purchase cost of the qualifying asset. Debt establishment costs are capitalised and recognised as a reduction in loans and borrowings. They are calculated based on the effective interest rate method and are amortised over the period of the loan. 22. Financial risk management Cochlear has exposure to the following risks from the use of financial instruments: • Credit risk; • Liquidity risk; • Market risk; and • Operational risk. (a) Risk management framework This note presents Cochlear’s exposure to each of the above risks, its objectives, policies and processes for measuring and managing risk, and the management of capital. The Board of directors has overall responsibility for the establishment and oversight of the risk management framework. The fundamentals of risk management are set by the risk policy. Under instruction of the Board, management has established a Risk Management Committee which is responsible for monitoring operational and financial risk management throughout Cochlear. Monitoring risk management includes ensuring appropriate policies and procedures are published and adhered to. The Risk Management Committee reports to the Audit Committee on a regular basis. A Treasury Management Committee has been established to administer aspects of risk management involving currency exposure and cash and funding management in accordance with the treasury risk policy. The treasury risk policy aims to manage the impact of short-term fluctuations on Cochlear’s earnings. Over the longer term, permanent changes in market rates will have an impact on earnings. Cochlear is exposed to risks from movements in exchange rates and interest rates that affect revenues, expenses, assets, liabilities and forecast transactions. Financial risk management aims to limit these market risks through ongoing operational and finance activities. Selected derivative and non-derivative hedging instruments are used for this purpose. Exposure to credit, foreign exchange and interest rate risks arises in the normal course of Cochlear’s business. Derivative financial instruments are used to hedge exposure to fluctuations in foreign exchange rates and interest rates. The Company only hedges the risks that affect the cash flows between the parent entity and the controlled entities. Cochlear does not enter, hold or issue derivative financial instruments for trading purposes. Hedging transactions are only concluded with leading financial institutions whose credit rating is at least A on the Standard & Poor’s rating index. The Audit Committee oversees how management monitors compliance with Cochlear’s risk management policies and procedures and reviews the adequacy of the risk management framework in relation to the risks faced by Cochlear. The Audit Committee is assisted in its oversight by Internal Audit. Internal Audit undertakes regular reviews of risk management controls and procedures, the results of which are reported to the Audit Committee. (b) Credit risk Credit risk is the risk of financial loss to Cochlear if a customer or counterparty to a financial instrument fails to meet its contractual obligations and arises principally from Cochlear’s receivables from customers. Cochlear’s exposure to credit risk is influenced mainly by the geographical location and characteristics of individual customers. Cochlear does not have a significant concentration of credit risk with a single customer. Policies and procedures of credit management and administration of receivables are established and executed at a regional level. Individual regions deliver reports to management and the Board on debtor ageing and collection activities on a monthly basis. In monitoring customer credit risk, the ageing profile of total receivables balances and individually significant debtors is reported by geographic region to the Board of directors on a monthly basis. Regional management is responsible for identifying high risk customers and placing restrictions on future trading, including suspending future shipments and administering dispatches on a prepayment basis. These actions are also reported to the Board on a monthly basis. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 90 22. Financial risk management (continued) Exposure to credit risk The carrying amount of financial assets represents the maximum credit exposure. The maximum exposure to credit risk at the reporting date was: Cash and cash equivalents Trade receivables and other receivables Forward exchange contracts The maximum exposure to credit risk for trade receivables at the reporting date by geographic region was: Americas EMEA Asia Pacific 2014 $000 56,127 210,449 10,009 276,585 2014 $000 56,979 91,991 52,325 2013 $000 52,689 200,330 4,362 257,381 2013 $000 59,110 84,173 44,310 201,295 187,593 Impairment losses Cochlear’s financial assets (cash and cash equivalents and trade and other receivables) are assessed at each reporting date to determine whether there is any objective evidence of impairment. A financial asset is considered impaired if objective evidence indicates that one or more events have had a negative effect on the estimated future cash flows of that asset. The recoverable amount of financial assets is calculated as the present value of estimated future cash flows, discounted at the original effective interest rate (i.e. the effective interest rate computed at initial recognition of these financial assets). Financial assets with a short duration are not discounted. An impairment loss of a financial asset is measured as the difference between the asset’s carrying amount and its recoverable amount. Impairment of financial assets is not recognised until objective evidence is available that a loss event has occurred. Individual significant financial assets are individually assessed for impairment. Impairment testing of financial assets not assessed individually is performed by placing them into portfolios of similar risk profiles and undertaking a collective assessment of impairment based on objective evidence from historical experience adjusted for any effects of conditions existing at the balance date. All impairment losses are recognised in the income statement. An impairment loss is reversed if the reversal can be related objectively to an event occurring after the impairment loss was recognised. The reversal of impairment losses on financial assets is recognised in the income statement. In assessing collective impairment, Cochlear uses historical trends of the probability of default, timing of recoveries and the amount of loss incurred, adjusted for management’s judgement as to whether current economic and credit conditions are such that the actual losses are likely to be greater or less than suggested by historical trends. The ageing of Cochlear’s trade receivables at the reporting date was: Gross receivables Not past due Past due 0 – 30 days Past due 31 – 120 days Past due 121 – 270 days Past due 271 days and over Impairment losses Trade receivables net of allowance for impairment losses 2014 $000 152,076 18,373 19,102 6,805 8,464 204,820 (3,525) 201,295 2013 $000 138,570 18,651 15,680 5,877 12,379 191,157 (3,564) 187,593 Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 91 There are certain jurisdictions in which Cochlear operates where it is customary practice for customers to make payment beyond 270 days. As such, Cochlear discloses the balance as overdue; however, it is not indicative of a higher than normal credit risk as payments are typically received by Cochlear within the extended timeframes. The movement in the allowance for impairment losses in respect of trade receivables during the year was as follows: Balance at 1 July Net impairment losses utilised/(recognised) Effect of movements in foreign exchange Balance at 30 June 2014 $000 (3,564) 153 (114) (3,525) 2013 $000 (2,770) (562) (232) (3,564) Cochlear has established an allowance for impairment that represents its estimate of incurred losses in respect of trade and other receivables. The main components of this allowance are a specific loss component that relates to individually significant exposures and a collective loss component established for groups of assets meeting certain ageing profiles and customer types which have been assessed as impaired under Cochlear’s accounting policy as detailed above. Based upon past experience, Cochlear believes that no impairment allowance is necessary in respect of trade receivables not past due. The allowance accounts used in respect of trade receivables are used to record impairment losses unless Cochlear is satisfied that no recovery of the amount owing is possible; at that point, the amount considered non-recoverable is written off against the financial asset directly. (c) Liquidity risk Liquidity risk is the risk that Cochlear will not be able to meet its financial obligations as they fall due. Cochlear’s approach to managing liquidity is to ensure, as far as possible, that it will always have sufficient liquidity to meet its liabilities when due, under both normal and stressed conditions, without incurring unacceptable losses or risking damage to Cochlear’s reputation. Cochlear monitors cash flow requirements and produces cash flow projections for the short and long term with a view to optimising return on investments. Typically, Cochlear ensures that it has sufficient funds on demand to meet expected operational net cash flows for a period of at least 30 days, including the servicing of financial obligations. This excludes the potential impact of extreme circumstances that cannot reasonably be predicted, such as natural disasters. In addition, Cochlear maintains lines of credit which are set out in Note 21(c). Non-derivative assets and liabilities The following are the contractual maturities of non-derivative financial liabilities, including estimated interest payments and excluding the impact of netting agreements: Effective interest rate Per annum Carrying amount $000 Contractual cash flows $000 6 months or less $000 6 – 12 months $000 1 – 2 years 2 – 5 years $000 $000 More than 5 years $000 Non-derivative financial liabilities 30 June 2014 AUD floating rate loan JPY floating rate loan 4.04% 0.65% 234,274 256,496 3,141 3,154 4,791 10 Trade and other payables - 78,644 78,644 78,644 4,713 3,144 - 209,176 37,816 - - - - Total 316,059 338,294 83,445 7,857 209,176 37,816 - - - - Effective interest rate Per annum Carrying amount $000 Contractual cash flows $000 6 months or less $000 6 – 12 months $000 1 – 2 years 2 – 5 years $000 $000 More than 5 years $000 Non-derivative financial liabilities 30 June 2013 AUD floating rate loan JPY floating rate loan Trade and other payables Total 4.63% 0.67% - 167,160 190,151 3,309 81,874 3,324 81,874 3,917 12 81,874 3,853 3,312 - 7,770 174,611 - - - - 252,343 275,349 85,803 7,165 7,770 174,611 - - - - AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 92 22. Financial risk management (continued) It is not expected that the cash flows included in the maturity analysis could occur significantly earlier, or at significantly different amounts. Derivative assets and liabilities The following table indicates the periods in which the cash flows associated with Cochlear’s derivatives that are cash flow hedges are expected to occur: 30 June 2014 Amounts $000 Forward exchange contracts Assets Liabilities Total 30 June 2013 Amounts $000 Forward exchange contracts Assets Liabilities Total Carrying amount $000 Expected cash flows $000 6 months or less $000 6 – 12 months $000 10,009 (9,244) 765 10,358 (9,456) 902 2,444 (3,202) (758) 2,183 (3,519) (1,336) 1 – 2 years $000 4,118 (1,670) 2,448 2 – 5 years $000 1,613 (1,065) 548 Carrying amount $000 Expected cash flows $000 6 months or less $000 4,362 4,454 (28,134) (29,081) 1,821 (7,097) 6 – 12 months $000 1,697 (7,999) (23,772) (24,627) (5,276) (6,302) 1 – 2 years $000 2 – 5 years $000 936 (9,980) (9,044) - (4,005) (4,005) The expected impact on the income statement is not considered to be significantly different to the cash flow impact noted above. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 93 (d) Market risk Market risk is the risk that changes in market prices such as foreign exchange rates, interest rates and equity prices will affect Cochlear’s net profit or the value of its holdings of financial instruments. The objective of market risk management is to manage and control market risk exposures within acceptable parameters, while optimising the return. Cochlear buys and sells derivatives in accordance with the treasury risk policy, and also incurs financial liabilities, in order to manage market risks. All such transactions are carried out within the guidelines set out by the treasury risk policy. Generally, Cochlear seeks to apply hedge accounting in order to manage volatility in earnings. Currency risk Cochlear is exposed to currencies other than the respective functional currencies of the controlled entities, primarily AUD, USD, EUR, GBP, Swedish kroner (SEK), JPY and Swiss francs (CHF). The currencies in which these transactions primarily are denominated are AUD, USD, EUR, GBP, SEK and JPY. Over 90% of Cochlear’s revenues and over 50% of costs are denominated in currencies other than AUD. Currency risk is hedged in accordance with the treasury risk policy. Risk resulting from the translation of assets and liabilities of foreign operations into Cochlear’s reporting currency is generally not hedged. Exposure to currency risk Cochlear’s exposure to foreign currency risk was as follows, based upon notional amounts: Amounts local currency thousands USD EUR GBP SEK JPY 30 June 2014 Trade receivables Secured bank loan Trade payables Gross balance sheet exposure 65,453 35,167 - (10,572) 54,881 - (4,299) 30,868 5,955 - (5,919) 36 5,662 765,565 - (300,000) (33,040) (27,378) (60,776) 404,789 Amounts local currency thousands USD EUR GBP SEK JPY 30 June 2013 Trade receivables Secured bank loan Trade payables Gross balance sheet exposure 62,627 38,978 - (14,820) 47,807 - (4,931) 34,047 3,211 - (6,844) (3,633) 6,100 669,529 - (300,000) (47,429) (65,556) (41,329) 303,973 Cochlear enters into forward exchange contracts to hedge anticipated sales and purchases in USD, EUR and JPY. The amounts of forward cover taken are in accordance with approved policy and internal forecasts. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 94 22. Financial risk management (continued) The following table sets out the gross value to be received (sell) under forward exchange contracts and the weighted average contracted exchange rates of outstanding contracts: Foreign exchange rates Gross value Sell USD Not later than one year Later than one year but not later than two years Later than two years but not later than five years Weighted average exchange rates contracted Sell EUR Not later than one year Later than one year but not later than two years Later than two years but not later than five years Weighted average exchange rates contracted Sell JPY Not later than one year Later than one year but not later than two years Later than two years but not later than five years 2014 2013 0.91 0.97 0.68 0.72 2014 $000 137,518 70,077 20,014 102,714 67,665 18,320 9,724 4,626 1,220 Weighted average exchange rates contracted 87.27 83.72 The following significant exchange rates applied to Cochlear during the year: AUD1 = USD EUR GBP SEK JPY Average rate Reporting date spot rate 2014 0.922 0.679 0.567 6.022 2013 1.022 0.794 0.654 6.796 2014 0.937 0.689 0.552 6.311 92.916 89.349 95.514 90.666 2013 $000 142,467 71,113 20,256 113,740 59,473 15,111 9,246 4,960 1,259 2013 0.928 0.711 0.603 6.239 Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 95 Interest rate risk Cochlear is exposed to interest rate risks in Australia and Japan. See Note 22(c) for effective interest rates, repayment and repricing analysis of outstanding debt. Interest rate risk is hedged on a case-by-case basis by assessing the term of borrowings and the purpose for which the funds are obtained. Hedging against interest rate risk is achieved by entering into interest rate swaps. Profile At the reporting date, the interest rate profile of Cochlear’s interest-bearing financial instruments was as follows: Carrying amount Variable rate instruments Financial assets Financial liabilities 2014 $000 2013 $000 56,127 237,415 52,689 170,469 At 30 June 2014, no interest rate hedging had been entered into. Sensitivity analysis In managing interest rate and currency risks, Cochlear aims to reduce the impact of short-term fluctuations on Cochlear’s earnings. However, over the longer term, permanent changes in interest rates and foreign exchange rates will have an impact on profit. For the year ended 30 June 2014, it is estimated that a general increase of one percent in interest rates would have decreased Cochlear’s profit after income tax and equity by approximately $1.3 million (2013: $0.6 million). A one percent general decrease in interest rates would have had the equal but opposite effect on Cochlear’s profit and equity. It is estimated that a general increase of 10 percent in the value of the AUD against other foreign currencies would have decreased Cochlear’s profit for the year ended 30 June 2014, including hedging results and after income tax, by approximately $4.7 million (2013: $6.1 million) and decreased Cochlear’s equity by $12.9 million (2013: $14.5 million). A 10 percent general decrease in the value of the AUD against other foreign currencies would have increased Cochlear’s profit by $5.8 million (2013: $7.2 million) and increased equity by $14.1 million (2013: $14.2 million). (e) Operational risk Operational risk is the risk of direct and indirect loss arising from a wide variety of causes associated with Cochlear’s processes, personnel, technology and infrastructure, and from external factors other than credit, liquidity and market risks such as those arising from legal and regulatory requirements and generally accepted standards of corporate behaviour. Operational risks arise from all of Cochlear’s operations. Cochlear’s objective is to manage operational risk so as to balance the avoidance of financial losses and damage to Cochlear’s reputation with overall cost effectiveness and to avoid control procedures that restrict initiative and creativity. The primary responsibility for the development and implementation of controls to address operational risk is assigned to the Risk Management Committee. This responsibility is supported by the development of standards for the management of operational risk in the following areas: • requirements for appropriate segregation of duties, including the independent authorisation of transactions; • requirements for the reconciliation and monitoring of transactions; • compliance with regulatory and other legal requirements; • documentation of controls and procedures; • requirements for the periodic assessment of operational risks faced, and the adequacy of controls and procedures to address the risks identified; • development of contingency plans; • training and professional development; • ethical and business standards; and • risk mitigation, including insurance where this is effective. Compliance with standards is supported by a program of periodic reviews undertaken by Internal Audit. The results of Internal Audit reviews are discussed with the management of the business unit to which they relate, with summaries submitted to the Audit Committee and senior management of Cochlear. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 96 22. Financial risk management (continued) (f) Fair values The fair values of financial assets and liabilities, together with carrying amounts shown in the balance sheet, are as follows: Cash and cash equivalents Trade and other receivables – current Trade and other receivables – non-current Trade and other payables – current Forward exchange contracts – liabilities current Forward exchange contracts – liabilities non-current Secured bank loans – current Secured bank loans – non-current(i) Total 2014 2013 Carrying amount Fair value Carrying amount Fair value Note 9(a) 16 16 21(c) 21(c) $000 56,127 214,953 5,505 (78,644) (6,643) (2,624) (3,141) $000 56,127 214,953 5,505 (78,644) (6,643) (2,624) (3,141) (234,274) (235,000) (48,741) (49,467) $000 52,689 203,748 944 (81,874) (14,915) (13,242) (3,309) (167,160) (23,119) $000 52,689 203,748 944 (81,874) (14,915) (13,242) (3,309) (168,000) (23,959) (i) Included within the carrying amount of secured bank loans is an amount of $725,606 (2013: $840,028) in relation to unamortised loan establishment fees. Basis for determining fair values The following summarises the significant methods and assumptions used in estimating the fair values of financial instruments reflected in the table above. Forward exchange contracts The fair value of forward exchange contracts is based upon the listed market price, if available. If a listed market price is not available, the fair value is estimated by discounting the difference between the contractual forward price and the current forward price for the residual maturity of the contract using a risk free interest rate based upon government bonds. These fair values are provided by independent third parties. Non-derivative financial assets and liabilities The fair value of cash, receivables, payables and short-term borrowings is considered to approximate their carrying amount because of their short maturity. The directors consider the carrying amount of long-term borrowings recorded in the financial statements approximates their fair value as interest rates on loans and borrowings are variable. Other Other non-derivative financial instruments are measured at amortised cost using the effective interest rate method, less any impairment losses. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 97 Fair value hierarchy The table below analyses financial instruments carried at fair value, by the levels in the value hierarchy. The different levels have been defined as follows: • Level 1: quoted prices (unadjusted) in active markets for identical assets or liabilities; • Level 2: inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly (i.e. as prices) or indirectly (i.e. derived from prices); and • Level 3: inputs for the asset or liability that are not based on observable market data (unobservable inputs). 30 June 2014 Derivative financial assets Forward exchange contracts used for hedging Total assets Derivative financial liabilities Forward exchange contracts used for hedging Other forward exchange contracts Total liabilities 30 June 2013 Derivative financial assets Forward exchange contracts used for hedging Total assets Derivative financial liabilities Forward exchange contracts used for hedging Other forward exchange contracts Total liabilities Level 2 $000 10,009 10,009 (9,244) (23) (9,267) 4,362 4,362 (28,134) (23) (28,157) Total $000 10,009 10,009 (9,244) (23) (9,267) 4,362 4,362 (28,134) (23) (28,157) There have been no transfers between levels during the year. There are no other financial instruments carried at fair value or valued using a Level 1 or Level 3 valuation method. (g) Accounting policy for financial instruments Non-derivative financial assets Cochlear initially recognises loans and receivables and deposits on the date that they are originated. All other financial assets (including assets designated at fair value through profit or loss) are recognised initially on the trade date at which Cochlear becomes a party to the contractual provisions of the instrument. Cochlear derecognises a financial asset when the contractual rights to the cash flows from the asset expire, or it transfers the rights to receive the contractual cash flows on the financial asset in a transaction in which substantially all the risks and rewards of ownership of the financial asset are transferred. Any interest in transferred financial assets that is created or retained by Cochlear is recognised as a separate asset or liability. Financial assets and liabilities are offset and the net amount presented in the balance sheet when, and only when, Cochlear has a legal right to offset the amounts and intends either to settle on a net basis or to realise the asset and settle the liability simultaneously. Cochlear has the following non-derivative financial assets: financial assets at fair value through profit or loss and loans and receivables. Financial assets at fair value through profit or loss A financial asset is classified as at fair value through profit or loss if it is classified as held for trading or is designated as such upon initial recognition. Financial assets are designated at fair value through profit or loss if Cochlear manages such investments and makes purchase and sale decisions based on their fair value in accordance with Cochlear’s documented risk management or investment strategy. Attributable transaction costs are recognised in profit or loss when incurred. Financial assets at fair value through profit or loss are measured at fair value, and changes therein are recognised in profit or loss. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 98 22. Financial risk management (continued) Loans and receivables Loans and receivables are financial assets with fixed or determinable payments that are not quoted in an active market. Such assets are recognised initially at fair value plus any directly attributable transaction costs. Subsequent to initial recognition, loans and receivables are measured at amortised cost using the effective interest rate method, less any impairment losses. Loans and receivables comprise cash and cash equivalents, and trade and other receivables. Non-derivative financial liabilities Cochlear initially recognises debt securities issued and subordinated liabilities on the date that they are originated. All other financial liabilities (including liabilities designated at fair value through profit or loss) are recognised initially on the trade date at which Cochlear becomes a party to the contractual provisions of the instrument. Cochlear derecognises a financial liability when its contractual obligations are discharged or cancelled or expire. Financial assets and liabilities are offset and the net amount presented in the balance sheet when, and only when, Cochlear has a legal right to offset the amounts and intends either to settle on a net basis or to realise the asset and settle the liability simultaneously. Cochlear classifies non-derivative financial liabilities into the other financial liabilities category. Such financial liabilities are recognised initially at fair value less any directly attributable transaction costs. Subsequent to initial recognition, these financial liabilities are measured at amortised cost using the effective interest rate method. Other financial liabilities comprise bank overdrafts, other loans and borrowings and trade and other payables. Bank overdrafts that are repayable on demand and form an integral part of Cochlear’s cash management are included as a component of cash and cash equivalents for the purpose of the statement of cash flows. Accounting for finance income and expense is discussed in Note 21(d). Derivative assets and liabilities Cochlear holds derivative financial instruments to hedge its exposure to foreign exchange risk and interest rate risk arising from operating, investing and financing activities. In accordance with its treasury policy, Cochlear does not hold or issue derivative financial instruments for trading purposes. However, derivatives that do not qualify for hedge accounting are accounted for as trading instruments. On initial designation of the hedge, Cochlear formally documents the relationship between the hedging instrument and hedged item, including the risk management objectives and strategy in undertaking the hedge transaction, together with the methods that will be used to assess the effectiveness of the hedging relationship. Cochlear makes an assessment, both at inception of the hedge relationship as well as on an ongoing basis, whether the hedging instruments are expected to be highly effective in offsetting the changes in the fair value or cash flows of the respective hedged items during the year for which the hedge is designated, and whether the actual results of each hedge are within a range of 80% to 125%. For a cash flow hedge of a forecast transaction, the transaction should be highly probable to occur and should present an exposure to variations in cash flows that could ultimately occur. Derivative financial instruments are recognised initially at fair value. Attributable transaction costs are recognised in the income statement when incurred. Subsequent to initial recognition, derivative financial instruments are measured at fair value with changes in fair value accounted for as described below. In the year ended 30 June 2014, Cochlear designated some sales and purchases of various currencies as cash flow hedges to hedge the amount converted into AUD for forecast future transactions. These are hedges of forecast future transactions to manage the currency risk arising from exchange rate fluctuations. The hedged items were highly probable foreign currency transactions. The effectiveness of the hedging relationship is calculated prospectively using regression analysis on market values. An effectiveness test is carried out retrospectively using the cumulative dollar offset method. For this, the changes in the fair values of the hedged item and the hedging instrument attributable to spot rate changes are calculated and a ratio is created. If this ratio is between 80% and 125%, the hedge is effective. All material hedges were effective at the reporting date. Changes in the fair value of a derivative financial instrument designated as a cash flow hedge are recognised directly in equity to the extent that the hedge is effective. To the extent that the hedge is ineffective, changes in fair value are recognised in the income statement. If the derivative financial instrument no longer meets the criteria for hedge accounting, expires or is sold, terminated or exercised, then hedge accounting is discontinued prospectively. The cumulative gain or loss previously recognised in equity remains there until the forecast transaction occurs or when cash flows arising from the transaction are received. When the forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability, the associated cumulative gain or loss is removed from equity and transferred to the carrying amount of the non-financial asset or liability. If a hedge of a forecast transaction subsequently results in the recognition of a financial asset or a financial liability, then the associated gains and losses that were previously recognised directly in equity are reclassified into the income statement in the same year or years during which the asset acquired or liability assumed affects the income statement. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 99 For cash flow hedges, other than those covered by the preceding statement, the associated cumulative gain or loss is removed from equity and recognised in the income statement in the same year or years during which the hedged forecast transaction affects the income statement and on the same line item as that hedged forecast transaction. The ineffective part of any gain or loss is recognised immediately in the income statement. 23. Capital and reserves Share capital Number of issued shares in market circulation Number of shares held in Trust under CELTIP Total number of issued shares 2014 2013 On issue 1 July – fully paid 56,915,289 56,865,878 Issued for nil consideration under Employee Share Plan Shares purchased from the market Issued from the exercise of options Performance shares issued from Trust 21,088 16,302 - - 1,142 (68,872) 95,198 6,783 2014 125,643 2013 2014 2013 63,554 57,040,932 56,929,432 - 21,088 16,302 - - - 68,872 - (1,142) (6,783) - - - - 95,198 - On issue 30 June – fully paid 56,937,519 56,915,289 124,501 125,643 57,062,020 57,040,932 Cochlear has also issued options (see Note 14). The Company does not have authorised capital or par value in respect of its issued shares. Ordinary shares The holders of ordinary shares are entitled to receive dividends as declared from time to time and are entitled to one vote per share at shareholders’ meetings. Ordinary shares are classified as equity. Incremental costs directly attributable to the issue of ordinary shares and share options are recognised as a deduction from equity, net of any income tax benefit. Repurchase of share capital (treasury shares) When share capital recognised as equity is repurchased, the amount of the consideration paid, including directly attributable costs, is recognised as a deduction from equity, net of any tax effects. Repurchased shares are classified as treasury shares and are presented as a deduction from total equity. When treasury shares are subsequently sold or reissued, the amount received is recognised as an increase in equity, and the surplus or deficit on the transaction is transferred to or from the share based payments reserve. Treasury reserve The treasury reserve comprises the cost of shares acquired by the Trust at the date of purchase. Translation reserve The translation reserve records the foreign currency differences arising from the translation of the financial statements of foreign operations as well as from the translation of liabilities that hedge the Company’s net investment in a foreign subsidiary, where their functional currency is different to the presentation currency of the reporting entity. See Note 2(d) for further details. Hedging reserve The hedging reserve comprises the effective portion of the cumulative net change in the fair value of cash flow hedging instruments related to underlying transactions that have not yet occurred. Share based payment reserve The share based payment reserve comprises the cost of shares, options and rights granted to eligible executives under the CELTIP and CEIP, as detailed in Note 14 less any payments made to meet its obligations through the acquisition of shares on market, together with any deferred tax asset/liability on such payments. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 100 24. Capital management Cochlear’s objectives when managing capital are to safeguard its ability to continue as a going concern, to provide returns to shareholders, to provide benefits to other stakeholders and to maintain an optimal capital structure to reduce the cost of capital. The Board aims to maintain and develop a capital base appropriate to Cochlear’s objectives and monitors a number of qualitative metrics as follows: • net gearing ratio – defined as net debt as a proportion of net debt plus total equity; • dividend payout ratio – defined as dividends as a proportion of net profit after tax for a given period; • growth in EPS – defined as the compound annual growth percentage in EPS over a three year period; and • TSR – defined as the percentage growth in share price over a three year period plus the cumulative three year dividend return calculated against the opening share price in the same three year period. In order to maintain or adjust the capital structure, Cochlear may adjust the amount of dividends paid to shareholders, return capital to shareholders, issue new shares or sell assets to reduce debt. Senior management tracks, manages and reports against these capital management metrics periodically as part of broader corporate governance responsibilities. In addition, the Board of directors undertakes periodic reviews of Cochlear’s capital management position to assess whether the metrics continue to be appropriate and whether the capital management structure is appropriate to meet Cochlear’s medium and long-term strategic requirements. Neither the Company nor any of its subsidiaries is subject to externally imposed capital requirements. There were no significant changes in Cochlear’s approach to capital management during the year. Cochlear’s net gearing ratio was as follows: Net debt Total equity* Net gearing ratio at 30 June * Restated for change in accounting policy, refer Note 30. Note 21(a) 2014 $000 181,288 329,205 36% 2013 $000 Restated* 117,780 354,511 25% Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 101 Other notes 25. Auditors’ remuneration Audit services Auditors of the Company: KPMG: – audit and review of financial reports – other regulatory compliance services Total audit services Non-audit services Auditors of the Company: KPMG: – taxation compliance services Total non-audit services 26. Commitments Operating lease commitments Future non-cancellable operating lease rentals not provided for in the financial statements are payable as follows: Not later than one year Later than one year but not later than five years Later than five years Total operating lease commitments Capital expenditure commitments Contracted but not provided for and payable: Not later than one year Total capital expenditure commitments 2014 $ 2013 $ 1,422,391 1,336,981 42,875 58,925 1,465,266 1,395,906 818,282 818,282 1,211,162 1,211,162 2014 $000 2013 $000 20,716 74,934 97,163 192,813 21,763 62,709 100,059 184,531 1,972 1,972 1,553 1,553 Cochlear leases property under non-cancellable operating leases expiring from one to 15 years. Leases generally provide Cochlear with a right of renewal at which time all terms are renegotiated. Lease payments comprise a base amount plus an incremental contingent rental. Contingent rentals are based on movements in the Consumer Price Index. 27. Contingent liabilities The details of contingent liabilities are set out below. The directors are of the opinion that provisions are either adequate or are not required in respect of these matters, as it is either not probable that a future sacrifice of economic benefits will be required, or the amount is not capable of reliable measurement. Product liability claims Cochlear is currently and is likely from time to time to be involved in claims and lawsuits incidental to the ordinary course of business, including claims for damages relating to its products and services. In addition, Cochlear has received legal claims in various countries and lawsuits in the United States by recipients who have had Cochlear implant CI500 series devices stop functioning for the reason that led to the September 2011 voluntary recall of unimplanted CI500 series devices. The claims are being negotiated and the lawsuits defended by Cochlear. Cochlear carries product liability insurance and has made claims under the policies. The insurers have agreed to indemnify Cochlear in accordance with the terms and conditions of the policies including deductibles and exclusions. In the opinion of the directors, the details of the product liability insurance policies are commercially sensitive and any disclosure of these details may be prejudicial to the interests of Cochlear. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 102 28. Controlled entities Interest held Country of incorporation/formation 2014 % 2013 % Particulars in relation to controlled entities Company Cochlear Limited Controlled entities Acoustic Implants Limited Cochlear AG Cochlear Americas Cochlear Benelux NV Cochlear Bone Anchored Solutions AB Cochlear Boulder LLC Cochlear Canada Inc Cochlear Clinical Services LLC Cochlear Deutschland GmbH & Co KG Cochlear Employee Share Trust Cochlear Europe Finance GmbH Cochlear Europe Limited Cochlear Executive Long Term Incentive Plan (Performance Shares) Trust Cochlear Finance Pty Limited Cochlear France SAS Cochlear German Holdings Pty Limited Cochlear Holdings NV Cochlear Incentive Plan Pty Limited Cochlear Investments Pty Ltd Cochlear Italia SRL Cochlear Korea Limited Cochlear Latinoamerica S.A. Cochlear Malaysia Sdn. Bhd. Cochlear Manufacturing Corporation Cochlear Medical Device (Beijing) Co., Ltd Cochlear Medical Device Company India Private Limited Cochlear Middle East FZ-LLC Cochlear Nordic AB Cochlear NZ Limited Cochlear Research and Development Limited Cochlear Sweden Holdings AB Cochlear Technologies Pty Limited Cochlear Tibbi Cihazlar ve Saglik Hizmetleri Limited Sirketi Cochlear Verwaltungs GmbH Cochlear (HK) Limited Cochlear (UK) Limited Isitme Implantlari Tibbi Cihazlar ve Saglik Hizmetleri Ltd Sti Lachlan Project Development Pty Ltd Lachlan Project Holdings Pty Ltd (i) (i) 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 - 100 100 100 100 100 100 100 100 100 100 100 100 Australia UK Switzerland USA Belgium Sweden USA Canada USA Germany Australia Germany UK Australia Australia France Australia Belgium Australia Australia Italy Korea Panama Malaysia USA China India UAE Sweden New Zealand UK Sweden Australia Turkey Germany Hong Kong UK Turkey Australia Australia Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 103 Interest held Country of incorporation/formation Lachlan Project Security Holdings Pty Ltd Medical Insurance Pte Limited Miaki NV Neopraxis Pty Limited Nihon Cochlear Co Limited Percutis AB (i) Dormant. 2014 % 100 100 100 100 100 - 2013 % 100 100 100 100 100 100 (i) 29. Parent entity disclosures At, and throughout the financial year ended, 30 June 2014, the parent company of Cochlear was Cochlear Limited. Result of the parent entity Net profit Other comprehensive income/(loss) Total comprehensive income Financial position of the parent entity at year end Current assets Total assets Current liabilities Total liabilities Total equity of the parent entity comprising of: Issued capital Treasury reserve Translation reserve Hedging reserve Share based payment reserve Retained earnings Total equity Company 2014 $000 136,541 17,155 153,696 209,772 683,453 85,981 412,679 152,599 (8,463) 13 476 19,963 106,186 270,774 Dividend income from subsidiaries is recognised by the parent entity when the dividends are declared by the subsidiary. Parent entity contingencies The details of all contingent liabilities in respect to Cochlear Limited are disclosed in Note 27. Australia Singapore Belgium Australia Japan Sweden 2013 $000 158,414 (47,449) 110,965 197,014 636,642 110,457 382,022 128,196 (9,408) 123 (16,680) 39,221 113,168 254,620 AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 104 29. Parent entity disclosures (continued) Parent entity capital commitments for acquisition of plant and equipment Plant and equipment Contracted but not yet provided for and payable: Within one year Total parent entity capital commitments for acquisition of plant and equipment Company 2014 $000 1,972 1,972 2013 $000 1,553 1,553 30. Changes in accounting policies Cochlear has adopted the following new standards and amendments to standards, including any consequential amendments to other standards, with a date of initial application of 1 July 2013: AASB 10 Consolidated Financial Statements (2011) In accordance with the transitional provisions of AASB 10 (2011), the Consolidated Entity reassessed the control conclusion for its investees at 1 July 2013 and there have been no changes. AASB 13 Fair Value Measurement In accordance with the transitional provisions of AASB 13, the Consolidated Entity has applied the new fair value measurement guidance prospectively, and has not provided any comparative information for new disclosures (refer Note 22). Notwithstanding the above, the change had no significant impact on the measurements of the Consolidated Entity’s assets and liabilities. AASB 119 Employee Benefits (2011) As a result of AASB 119 (2011), the Consolidated Entity has changed its accounting policy with respect to the basis for determining the income or expense related to defined benefit plans. Under AASB 119 (2011), the Consolidated Entity determines the net interest expense/(income) for the period on the net defined benefit liability/(asset) by applying the discount rate used to measure the defined benefit obligation at the beginning of the annual period to the net defined benefit liability/(asset) at the beginning of the annual period, taking into account any changes in the net defined benefit liability/(asset) during the period as a result of contributions and benefit payments. Consequently, the net interest on the net defined benefit liability/(asset) now comprises: • interest cost on the defined benefit obligation; • interest income on plan assets; and • interest on the effect on the asset ceiling. Previously, the Consolidated Entity determined interest income on plan assets based on their long-term rate of expected return. Under AASB 119 (2011), the Consolidated Entity changed its accounting policy for recognition of actuarial gains and losses arising from its defined benefit plan from the corridor method to the direct to equity method. Previously unrecognised actuarial gains and losses under the corridor method have been recognised on the balance sheet as part of the net defined benefit obligation. Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014AR 14InvestorCentreContentsNextPrevious-– – –+ 105 The overall impact to the financial statements is considered immaterial. The following table summarises the adjustments made to the balance sheet on implementation of the new accounting policy: Balance at 1 July 2012, as previously reported Impact of the change in accounting policy at 1 July 2012 Restated balance at 1 July 2012 Balance at 30 June 2013, as previously reported Impact of the change in accounting policy at 1 July 2012 Impact of the change in accounting policy during the year ended 30 June 2013 Restated balance at 30 June 2013 The effect on the statement of comprehensive income was as follows: Increase in other comprehensive loss for the year ended June 2013 by $230,000. Provisions – non- current Deferred tax assets Retained earnings $000 35,056 2,858 37,914 35,356 2,858 303 38,517 $000 50,495 686 51,181 56,663 686 73 57,422 $000 280,506 (2,172) 278,334 270,558 (2,172) (230) 268,156 The change in accounting policy had an immaterial impact on EPS for the comparative period. 31. New standards and interpretations not yet adopted A number of new standards, amendments to standards and interpretations are effective for financial years beginning after 1 July 2013, and have not been applied in preparing these consolidated financial statements. Of the new standards, only the following is expected to have an effect on the consolidated financial statements of Cochlear: • AASB 9 Financial Instruments, which becomes mandatory for Cochlear’s 2018 consolidated financial statements. Cochlear is currently assessing the impact of the changes in the above standard and it is not expected that the changes will have a significant impact on Cochlear. As such, Cochlear does not plan to adopt this standard early. 32. Events subsequent to the reporting date Other than the matters noted below, there has not arisen in the interval between the reporting date and the date of this Financial Report, any item, transaction or event of a material and unusual nature likely, in the opinion of the directors of the Company, to significantly affect the operations of Cochlear, the results of those operations, or the state of affairs of Cochlear in future financial years: Dividends For dividends declared after 30 June 2014, see Note 8. AR 14Notes to the Financial Statements Cochlear Limited and its controlled entities for the year ended 30 June 2014InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 106 Directors’ Declaration Cochlear Limited and its controlled entities for the year ended 30 June 2014 1. In the opinion of the directors of Cochlear Limited (the Company): (a) the consolidated financial statements and notes and the Remuneration Report in the Directors’ Report set out on pages 31 to 105, are in accordance with the Corporations Act 2001, including: (i) giving a true and fair view of the Consolidated Entity’s financial position as at 30 June 2014 and of its performance for the financial year ended on that date; and (ii) complying with Australian Accounting Standards and the Corporations Regulations 2001; and (b) there are reasonable grounds to believe that the Company will be able to pay its debts as and when they become due and payable. 2. The directors have been given the declarations required by section 295A of the Corporations Act 2001 from the CEO/President and Chief Financial Officer for the financial year ended 30 June 2014. 3. The directors draw attention to Note 2(a) to the consolidated financial statements, which includes a statement of compliance with International Financial Reporting Standards. Signed in accordance with a resolution of the directors: Dated at Sydney this 5th day of August 2014. Director Director AR 14InvestorCentreContentsNextPrevious-– – –+ 107 Independent Audit Report to the Members of Cochlear Limited. Report on the financial report We have audited the accompanying financial report of Cochlear Limited (the company), which comprises the consolidated balance sheet as at 30 June 2014, and consolidated income statement, consolidated statement of comprehensive income, consolidated statement of changes in equity and consolidated statement of cash flows for the year ended on that date, notes 1 to 32 comprising a summary of significant accounting policies and other explanatory information and the directors’ declaration of the Consolidated Entity comprising the company and the entities it controlled at the year’s end or from time to time during the financial year. Directors’ responsibility for the financial report The directors of the company are responsible for the preparation of the financial report that gives a true and fair view in accordance with Australian Accounting Standards and the Corporations Act 2001 and for such internal control as the directors determine is necessary to enable the preparation of the financial report that is free from material misstatement whether due to fraud or error. In note 2(a), the directors also state, in accordance with Australian Accounting Standard AASB 101 Presentation of Financial Statements, that the financial statements of the Consolidated Entity comply with International Financial Reporting Standards. Auditor’s responsibility Our responsibility is to express an opinion on the financial report based on our audit. We conducted our audit in accordance with Australian Auditing Standards. These Auditing Standards require that we comply with relevant ethical requirements relating to audit engagements and plan and perform the audit to obtain reasonable assurance whether the financial report is free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial report. The procedures selected depend on the auditor’s judgement, including the assessment of the risks of material misstatement of the financial report, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation of the financial report that gives a true and fair view in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by the directors, as well as evaluating the overall presentation of the financial report. We performed the procedures to assess whether in all material respects the financial report presents fairly, in accordance with the Corporations Act 2001 and Australian Accounting Standards, a true and fair view which is consistent with our understanding of the Consolidated Entity’s financial position and of its performance. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Independence In conducting our audit, we have complied with the independence requirements of the Corporations Act 2001. Auditor’s opinion In our opinion: (a) the financial report of the Consolidated Entity is in accordance with the Corporations Act 2001, including: (i) giving a true and fair view of the Consolidated Entity’s financial position as at 30 June 2014 and of its performance for the year ended on that date; and (ii) complying with Australian Accounting Standards and the Corporations Regulations 2001. (b) the financial report also complies with International Financial Reporting Standards as disclosed in note 2(a). Emphasis of matter We draw attention to note 20 to the financial statements which describes the uncertainty related to the outcome of the lawsuit filed against the Consolidated Entity for alleged patent infringement. Our audit report is not modified in respect of this matter. Report on the remuneration report We have audited the remuneration report included in pages 31 to 53 of the directors’ report for the year ended 30 June 2014. The directors of the company are responsible for the preparation and presentation of the remuneration report in accordance with Section 300A of the Corporations Act 2001. Our responsibility is to express an opinion on the remuneration report, based on our audit conducted in accordance with auditing standards. Auditor’s opinion In our opinion, the remuneration report of Cochlear Limited for the year ended 30 June 2014, complies with Section 300A of the Corporations Act 2001. KPMG Sydney, 5 August 2014 Cameron Slapp, Partner AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 108 Additional information Additional information required by Australian Securities Exchange Listing Rules and not disclosed elsewhere in this report – the information presented is as at 30 July 2014: Number of ordinary shares held 6,733,235 4,176,928 3,501,751 3,396,738 3,394,696 2,857,097 24,060,445 % 11.80 7.32 6.14 5.95 5.95 5.01 42.17 Number of ordinary shareholders Shareholdings Substantial shareholders Shareholder Baillie Gifford & Co Schroders PLC Generation Investment Management LLP Veritas Asset Management (UK) Ltd Harding Loevner LP Hyperion Asset Management Limited Total Distribution of shareholders Number of shares held 1 – 1,000 1,001 – 5,000 5,001 – 10,000 10,001 – 100,000 100,001 and over Total Non-marketable parcels – 196 shareholders held less than a marketable parcel of ordinary shares Twenty largest shareholders Shareholder HSBC Custody Nominees (Australia) Limited JP Morgan Nominees Australia Limited National Nominees Limited Citicorp Nominees Pty Limited BNP Paribas Noms Pty Ltd (DRP) Dr Christopher Graham Roberts HSBC Custody Nominees (Australia) Limited (NT-Comnwlth Super Corp a/c) UBS Nominees Pty Limited RBC Investor Services Australia Nominees Pty Limited (Bkcust a/c) Citicorp Nominees Pty Limited (BHP Billiton ADR Holders a/c) Citicorp Nominees Pty Limited (Colonial First State Inv a/c) BNP Paribas Nominees Pty Ltd (Agency Lending DRP a/c) National Nominees Limited (DB a/c) Cochlear Incentive Plan Pty Ltd AMP Life Limited PGA (Investments) Pty Ltd ECapital Nominees Pty Limited (Settlement a/c) Netwealth Investments Limited (Wrap services a/c) BNP Paribas Noms (NZ) Ltd (DRP) USB Wealth Management Australia Nominees Pty Ltd The 20 largest shareholders held 69.54% of the ordinary shares of the Company. On market buy-back There is no current on market buy-back. Number of ordinary shares held 13,518,047 10,392,855 9,141,537 2,014,156 1,045,771 703,803 668,761 381,948 269,177 266,567 235,999 190,864 166,432 124,501 111,635 100,000 93,268 88,572 88,039 85,151 29,954 3,146 184 77 16 33,377 % 23.69 18.21 16.02 3.53 1.83 1.23 1.17 0.67 0.47 0.47 0.41 0.33 0.29 0.22 0.20 0.18 0.16 0.16 0.15 0.15 69.54 AR 14InvestorCentreContentsNextPrevious-– – –+ 109 109 AR14 Glossary, Company ASX Announcement Record and Company Information Glossary AGM Annual General Meeting. ASIC Australian Securities and Investments Commission. ASX Australian Securities Exchange. EBIT Earnings before interest and tax. EBITDA Earnings before interest, tax, depreciation and amortisation. EMEA Europe, Middle East and Africa. EPS Earnings per share. F12 Financial year 2012: 1 July 2011 to 30 June 2012. F13 Financial year 2013: 1 July 2012 to 30 June 2013. F14 Financial year 2014: 1 July 2013 to 30 June 2014. F15 Financial year 2015: 1 July 2014 to 30 June 2015. FDA United States Food and Drug Administration. FX Foreign exchange. IFRS International Financial Reporting Standards. KMP Key management personnel. NPAT Net profit after tax. Previous GAAP Previous Australian Generally Accepted Accounting Principles. Processor/sound processor The externally worn part of the cochlear implant. R&D Research and development. TSR Total shareholder return. Company ASX Announcement Record 2 June 2014 Cochlear to launch Nucleus Profile Implant Series Cochlear Limited announced it would be launching the Cochlear Nucleus Profile Series across Europe in June 2014. The first implant in the series, the Cochlear Nucleus Profile implant with Contour Advance electrode, has the thinnest implant body on the market. 27 March 2014 Half year report 2014 Cochlear Limited provided an F14 half year report to shareholders listing half year revenues and sales. 21 March 2014 FDA approves Cochlear Nucleus Hybrid for sale in USA Cochlear Limited announced that the US FDA had approved the Cochlear Nucleus Hybrid L24 Cochlear Implant System for commercial release. 11 February 2014 Half year results announced Cochlear Limited announced revenue down 5% to $371.1 million, with cochlear implant sales down by 14% for the six months ended 31 December 2013. The interim dividend of $1.27 per share was up 2%. 24 January 2014 Jury trial verdict on USA Patent Infringement Case Cochlear Limited announced that a jury verdict in the patent infringement lawsuit by the Alfred E. Mann Foundation for Scientific Research and Advanced Bionics had been reached. Non-IFRS financial measures Given the significance of the patent dispute, product recall and FX movements the directors believe the presentation of non-IFRS financial measures is useful for the users of this document as they reflect the underlying financial performance of the business. The non-IFRS financial measures included in this document have been calculated on the following basis: • excluding patent dispute provision: IFRS measures adjusted for the expense of the patent dispute provision; • excluding recall costs: IFRS measures adjusted for the costs of the product recall; • constant currency: restatement of IFRS financial measures in comparative years using F14 FX rates; and • free cash flow: IFRS cash flow from operating and investing activities excluding interest and tax paid related to non-operating activities. The above non-IFRS financial measures have not been subject to review or audit. However, KPMG has separately undertaken a set of procedures to agree the non-IFRS financial measures disclosed to the books and records of the Consolidated Entity. Company Information Stock exchange listing Australian Securities Exchange ASX code COH Solicitors Clayton Utz Share registrar Computershare Investor Services Pty Limited Level 4, 60 Carrington Street Sydney NSW 2000, Australia Tel: 61 3 9415 4000 Auditor KPMG Bankers Australia Westpac Banking Corporation and HSBC Bank Australia Limited Japan The Bank of Tokyo-Mitsubishi UFJ, Limited Sweden Skandinaviska Enskilda Banken AB (publ) United Kingdom HSBC Bank plc United States Wells Fargo Bank West, NA Annual General Meeting The Annual General Meeting will be held at 10am on Tuesday 14 October 2014 at the Australian Securities Exchange, Exchange Square Auditorium, 20 Bridge Street, Sydney. A Notice of Annual General Meeting and Proxy Form are enclosed with this Annual Report. Financial calendar 2014 Dividend record date 4 September Payment of final dividend 25 September Annual General Meeting 14 October 2015 Interim profit announcement 10 February* Interim dividend record date 5 March* Payment of interim dividend 26 March* Final profit announcement 11 August* Annual General Meeting 20 October* * Indicative dates only. ACE, Advance Off-Stylet, AOS, AutoNRT, Autosensitivity, Beam, Button, Carina, Cochlear, コクレア, Codacs, Contour, Contour Advance, Custom Sound, ESPrit, Freedom, Hear now. And always, Hybrid, inHear, Invisible Hearing, MET, MP3000, myCochlear, NRT, Nucleus, Nucleus in Chinese characters, Off-Stylet, SmartSound, Softip, SPrint, the elliptical logo and Whisper are either trademarks or registered trademarks of Cochlear Limited. Ardium, Baha, Baha Divino, Baha Intenso, Baha PureSound, Baha SoftWear, DermaLock, Vistafix and WindShield are either trademarks or registered trademarks of Cochlear Bone Anchored Solutions AB. Design Cross Media Communications Pty Ltd AR 14InvestorCentreInvestorCentreContentsNextPrevious-– – –+ 110 Cochlear Ltd (ABN 96 002 618 073) 1 University Avenue, Macquarie University, NSW 2109, Australia Tel: +61 2 9428 6555 Fax: +61 2 9428 6352 Cochlear Ltd (ABN 96 002 618 073) 14 Mars Road, Lane Cove, NSW 2066, Australia Tel: +61 2 9428 6555 Fax: +61 2 9428 6352 Cochlear Bone Anchored Solutions AB Konstruktionsvägen 14, SE - 435 33 Mölnlycke, Sweden Tel: 46 31 792 44 00 Fax: 46 31 792 46 95 Cochlear Americas 13059 E Peakview Avenue, Centennial, CO 80111, USA Tel: +1 303 790 9010 Fax: +1 303 792 9025 Cochlear Canada Inc 2500-120 Adelaide Street West, Toronto, ON M5H 1T1, Canada Tel: +1 416 972 5082 Fax: +1 416 972 5083 Cochlear AG EMEA Headquarters, Peter Merian-Weg 4, 4052 Basel, Switzerland Tel: +41 61 205 0404 Fax: +41 61 205 0405 Cochlear Deutschland GmbH & Co. KG Karl-Wiechert-Allee 76A, 30625 Hannover, Germany Tel: +49 511 542 770 Fax: +49 511 542 7770 Cochlear Europe Ltd 6 Dashwood Lang Road, Bourne Business Park, Addlestone, Surrey KT15 2HJ, United Kingdom Tel: +44 1932 26 3400 Fax: +44 1932 26 3426 Cochlear Benelux NV Schaliënhoevedreef 20 i, B-2800 Mechelen, Belgium Tel: +32 15 79 55 11 Fax: +32 15 79 55 70 Cochlear France S.A.S. Route de l’Orme aux Merisiers, Z.I. Les Algorithmes – Bât. Homère, 91190 Saint-Aubin, France Tel: +33 805 200 016 Fax: +33 160 196 499 Cochlear Italia S.r.l. Via Larga 33, 40138 Bologna, Italy Tel: +39 051 601 53 11 Fax: +39 051 39 20 62 Cochlear Nordic AB Konstruktionsvägen 14, 435 33 Mölnlycke, Sweden Tel +46 31 335 14 61 Fax +46 31 335 14 60 Cochlear Tıbbi Cihazlar ve Sağlık Hizmetleri Ltd. Şti. Çubuklu Mah. Boğaziçi Cad., Boğaziçi Plaza No: 6/1, Kavacık, TR-34805 Beykoz-Istanbul, Turkey Tel: +90 216 538 5900 Fax: +90 216 538 5919 Cochlear (HK) Limited Room 1204, 12/F, CRE Building, No 303 Hennessy Road, Wanchai, Hong Kong SAR Tel: +852 2530 5773 Fax: +852 2530 5183 Cochlear Korea Ltd 1st floor, Cheongwon building, 828-5, Yuksam dong, Kangnam gu, Seoul, Korea Tel: +82 2 533 4663 Fax: +82 2 533 8408 Cochlear Limited (Singapore Branch) 6 Sin Ming Road, #01-16 Sin Ming Plaza Tower 2, Singapore 575585 Tel: +65 6553 3814 Fax: +65 6451 4105 Cochlear Medical Device (Beijing) Co., Ltd Unit 2208 Gemdale Tower B, 91 Jianguo Road, Chaoyang District, Beijing 100022, P.R. China Tel: +86 10 5909 7800 Fax: +86 10 5909 7900 Cochlear Medical Device Company India Pvt. Ltd. Ground Floor, Platina Building, Plot No C-59, G-Block, Bandra Kurla Complex, Bandra (E), Mumbai – 400 051, India Tel: +91 22 6112 1111 Fax: +91 22 6112 1100 株式会社日本コクレア（Nihon Cochlear Co Ltd）〒113-0033 東京都文京区本郷2-3-7 お茶の水元町ビル Tel: +81 3 3817 0241 Fax: +81 3 3817 0245 Cochlear Middle East FZ-LLC Dubai Healthcare City, Al Razi Building 64, Block A, Ground Floor, Offices IR1 and IR2, Dubai, United Arab Emirates Tel: +971 4 818 4400 Fax: +971 4 361 8925 Cochlear Latinoamérica S.A. International Business Park, Building 3835, Office 103, Panama Pacifico, Panama Tel: +507 830 6220 Fax: +507 830 6218 Cochlear NZ Limited Level 4, Takapuna Towers, 19-21 Como St, Takapuna, Auckland 0622, New Zealand Tel: + 64 9 914 1983 Fax: +61 2 8002 2800 www.cochlear.com © Cochlear Limited 2014 557296 ISS1 SEPT14 AR 14InvestorCentreContentsNextPrevious-– – –+
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