Cochlear
Annual Report 2016

Plain-text annual report

2016 COCHLEAR ANNUAL REPORT Innovation for life Little sounds. Big sounds. Life is full of sounds. Little sounds, big sounds, fun sounds, urgent sounds. These sounds might be different for each of us, but whatever we do, and however we do it, we need to hear them. In FY16, Cochlear continued to deliver products and services that help improve our customers’ lives by making their hearing clearer, easier and more enjoyable. We aim to give more people access to technologies that reflect their lifestyle. Our lifetime commitment means that when they eat out with friends, play sports or stream favourite movies from iPads, they get the hearing experience they want. Contents 4 Chairman’s Report FY16 Performance Overview 5 Chief Executive Officer & President’s Report 6 Environment, Social and Governance 9 Innovation for Life 13 14 People and Culture 16 Board of Directors 17 Senior Executive Team 19 Financial Report 90 Glossary, Company ASX Announcement Record and Company Information M u s i c i s w h o I am. There is no reason I h a v e t o g i v e up anything at all. Lindy Crocker Recipient since 2013 2 2 Dr Lindy Crocker • Musician, music teacher, Doctor of Philosophy • Cochlear™ Nucleus® 6 recipient since 2013 • Enjoys integrated stereo sound with her Nucleus 6 sound processor and her GN ReSound hearing aid – ‘bimodal hearing’ 3 Lindy Crocker 4 Chairman’s Report and from 2017 we will commence a process of Board renewal, ensuring we have a smooth transition of longer-serving Board members over the next few years. Remuneration Remuneration oversight of the Chief Executive Officer & President, the other key management personnel, and employees generally, is an important aspect of the Board’s responsibilities. The role is carried out by the newly defined People & Culture Committee. The Remuneration Report sets out our approach to remuneration, and provides the FY16 details. We need to ensure our remuneration practices are continually evolving to keep us competitive, ensure we can attract the best people, and effectively contribute to aligning performance and effort to our key business objectives. For FY17, we have introduced changes to our short-term incentives to strengthen alignment around global integration priorities under the banner of One Cochlear. Building transparency and openness with shareholders In FY16 we published a number of online shareholder reports aimed at improving transparency and making information easier to access. These include Cochlear’s Corporate Governance Statement, Tax Contribution Report and Investor Handbook. Cochlear’s Corporate Governance Statement summarises the Company’s corporate governance practices and incorporates the disclosures required by the ASX Corporate Governance Council’s Corporate Governance Principles and Recommendations (3rd Edition). The Board is committed to achieving and demonstrating the highest standards of corporate governance. We continue to refine and improve the governance framework and practices in place to ensure they meet the interests of shareholders. The Tax Contribution Report reports on Cochlear’s taxes paid in Australia and globally and provides detail on our global tax strategy. Cochlear has a strong commitment to transparency and compliance from a regulatory and financial perspective and values the principles of being transparent with respect to its tax strategy and compliance in Australia and globally. The Investor Handbook is an all-in-one reference for shareholders covering Cochlear’s history, our global footprint, our product portfolio, the hearing loss market and how our products work, as well as providing summary financial information. These publications are a great companion to the Annual Report and I encourage you to read them. They are all available at the Investor Centre of our website, www.cochlear.com. Our employees We all recognise Cochlear has a diverse global workforce focused on our business and on transforming the lives of people with hearing loss. We employ around 3,000 people from over 75 nationalities, and we operate in 20 different countries. The knowledge, expertise and passion of our employees is key to our future and the focus on delivering excellence for our customers is an important part of our success and our market leadership position. On behalf of the Board, I congratulate and thank all of Cochlear’s employees for their outstanding efforts and contributions this year. Rick Holliday-Smith Chairman Cochlear reported a record net profit of $189 million, an increase of 30% on the FY15 full year result. Earnings per share (EPS) increased by 29% to $3.31 per share. FY16 has been an important year for Cochlear involving renewal at the top level with incoming Chief Executive Officer & President, Chris Smith, transitioning into his new role, injecting a sharp focus on customer and market growth activities, while maintaining the Company’s strong commitment to product development and innovation. I have been pleased to see steady progress made throughout the year, with the suite of products launched over the past few years across all product categories laying the foundations for solid sales and earnings growth. Additional focus has been on more broadly reshaping the senior executive team with the addition of new and experienced talent. It has also been a year where the balance sheet has been carefully reviewed and the new Chief Executive Officer & President has taken the opportunity to make some adjustments, as may be expected, in the first year of the new role. It has also been a year to continue the effort to focus on growth into the future and to make longer- term investments. Dividends up 21% Earnings growth, combined with strong free cash flow generation, has supported a 20% increase in the fully franked final dividend to $1.20 per share. This takes dividends for the year to $2.30 per share, fully franked, an increase of 21% on FY15. The dividend payout ratio of 70% of net profit is in line with the Board’s target dividend payout ratio. Australian company. Global presence As a significant proportion of our activities are overseas, the Board meets each year in one of our global regions. This year we travelled to the United Kingdom (UK) and Europe and gained a stronger appreciation of the region generally, and the issues facing the UK and European markets, in particular. Our business is performing well and we are confident that we have an appropriate strategy to grow over the coming years. We do however recognise that we are operating in an environment of global uncertainty as characterised by recent events including the UK’s decision to withdraw from the European Union. While these events are not expected to have an immediate impact on our business, we remain alert to the potential for uncertainty to curtail economic growth and put pressure on health budgets. The Board During FY16 we involved an external consultant to independently review the Board with positive results in terms of the balance of backgrounds, experience and mix of tenure on the Board. We recognise the importance of undergoing a regular process of renewal 5 FY16 Performance Overview Net profit adjusted1,2 FY16 30 on FY15 189 Dividends per share FY16 21 on FY15 180 155 158 131 133 146 110 115 100 $2.52 $2.54 $2.45 $2.25 $2.30 $1.90 $2.00 $1.75 $1.50 $1.25 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 10 year financial summary Cochlear implant system sales (units) 30,172 26,838 25,997 26,674 23,087 24,661 21,023 18,553 18,228 15,947 FY16 FY15 FY14 FY13 FY12 FY11 FY10 FY09 FY08 FY07 Total revenue ($million) R&D expenses ($million) EBITDA ($million) EBIT ($million) Net profit - adjusted ($million) Net profit - reported ($million) 1,131 143 296 263 189 189 926 128 237 206 146 146 805 128 1772 1502 1102 94 753 125 202 179 133 133 779 119 2391 2151 1581 57 810 109 270 243 180 180 735 95 244 221 155 155 695 97 206 183 131 131 602 80 193 167 115 115 559 66 171 150 100 100 Basic EPS ($) $3.31 $2.56 $1.65 $2.33 $1.00 $3.18 $2.76 $2.34 $2.08 $1.83 Dividends per share ($) $2.30 $1.90 $2.54 $2.52 $2.45 $2.25 $2.00 $1.75 $1.50 $1.25 Closing share price as at 30 June ($) $121.25 $80.15 $61.70 $61.71 $65.84 $72.00 $74.32 $57.70 $43.65 $61.00 Market capitalisation as at 30 June ($million) 6,935 4,565 3,513 3,512 3,744 4,081 4,198 3,230 2,423 3,341 Number of permanent employees 2,934 2,632 2,536 2,531 2,390 2,319 2,006 1,888 1,789 1,655 1. Excludes product recall costs of $139 million before tax and $101 million after tax. 2. Excludes patent dispute provision of $23 million before tax and $16 million after tax. The following non-International Financial reporting Standards (IFRS) financial measures are included in this report: • excluding patent dispute provisions; • excluding product recall costs; and • constant currency. refer to page 90 for a discussion of these items. 6 Chief Executive Officer & President’s Report Chris Smith Chief Executive Officer & President The positive momentum we saw in FY15 has continued throughout FY16 with strong growth delivered across all product categories and regions. The business achieved a major milestone with sales revenue increasing by 23% (12% in constant currency) to $1.158 billion, exceeding $1 billion for the first time. The cochlear implant business delivered revenue growth of 21% (10% in constant currency) and unit growth of 12%. Our leading developed markets, including the United States (US), the United Kingdom (UK), Germany and Australia, each grew implant units by around 10%. Emerging markets performed well with highlights including China, both in the private pay and tender market, India and the Middle East. We have strengthened our market-leading position with the success of a suite of product releases made over the past 18 months. In FY16 we introduced Cochlear’s first off-the-ear sound processor Cochlear™ Kanso™; expanded the bone conduction portfolio with Baha® 5 Power and SuperPower sound processors; introduced the Nucleus® Profile™ Slim Modiolar electrode, the world’s slimmest electrode and launched the next generation True Wireless™ Mini Microphone 2+. Cochlear continues to demonstrate its commitment to being the technology leader in our industry with ongoing investment in research and development (R&D). Our aim is to improve hearing outcomes and expand the indications for implantable solutions so our recipients can have the quality of life they expect. In FY16, R&D spend increased by 12% to $143 million, representing approximately 12% of sales revenue. As we move forward, we are injecting greater discipline into our R&D processes to ensure our investments are customer-driven and returns focused. We expect to deliver new products across all categories over the next 18 months as well as advance our long-term technology development pipeline. The Services business, which includes sound processor upgrades and accessories, continues to perform well with sales revenue increasing 30% (20% in constant currency). Services now represents approximately 25% of sales revenue and has been established as a separate business unit. We expect its sales contribution to continue to trend upward over time as both the recipient base and service offering expand. You can find a detailed review of the Product & Service Highlights and Regional Review on page 22. Strong financial position Cochlear has delivered a strong profit result with net profit of $189 million, up 30%, the high end of the guidance range. Free cash flow remains strong and has supported the 21% increase in full year dividends. We have benefited from the devaluation of the Australian dollar and have taken the opportunity to accelerate our investment in market growth initiatives, including direct-to-consumer marketing and expansion of the sales force, as well as increasing our investment in R&D. We believe these investments have contributed to market growth this year and will help underpin growth in the coming years. At the same time, we have undertaken a balance sheet review in the context of new generation products launched over the past 18 months. The review has contributed to a $16 million non-cash inventory write-off, pre tax, reflecting old and obsolete parts and products. Our corporate strategy is centred on the customer The hearing loss market offers an incredible business opportunity with over 360 million people worldwide experiencing disabling hearing loss, with nearly one in three people over the age of 65 affected by hearing loss. With global market penetration for implantable hearing solutions less than 5%, there remains a significant, unmet and addressable clinical need that will continue to underpin the long-term sustainable growth of our business. Hearing loss market 360 million Over 5% of the world’s population - 360 million people - has disabling hearing* loss (328 million adults and 32 million children).1 1 in 3 Nearly 1 out of every 3 people over the age of 65 are affected by hearing loss. It affects communication and can contribute to social isolation, anxiety, depression and cognitive decline.2 <5% Market penetration3 1. Who.int. WHO | Deafness and hearing loss [Internet]. 2015. 2. Who.int. WHO | 10 facts on deafness [Internet]. 2015. 3. Market penetration. This figure is a global estimate based on Cochlear sourced data. * Disabling hearing loss refers to hearing loss greater than 40 decibels (dB) in the better hearing ear in adults and a hearing loss greater than 30 dB in the better hearing ear in children. 7 Our corporate strategy is centred on the customer As Cochlear looks forward, priorities will be centred on the customer with activities aimed at expanding awareness and increasing patient access to the industry for implant candidates. And with a growing recipient base, now numbering over 450,000, the business is actively strengthening its servicing capability to provide products, programmes and services to support its lifetime relationship with recipients we well as drive revenue growth. • improve access for candidates by expanding the cochlear implant clinic base as well as continuing to work with the referral channel to assist the Company’s clinic partners to grow and become more efficient. The development of hybrid and acoustic implants, together with a broader range of electrodes, play an important role in broadening the indications for Cochlear’s implantable hearing solutions; and • business model innovation. Exploring new referral pathways and servicing models and where appropriate open Company-operated Cochlear clinics to manage the aftercare of recipients. Focus on the Customer Grow the Core Build a Service Business We have made solid progress in FY16. The highlights include: • successfully introduced a range of new market-leading products including Kanso, Baha 5 Power and SuperPower, Nucleus Profile Slim Modiolar electrode and Mini Microphone 2+; • appointed a Chief Medical Officer to expand clinical programs, enhance the regulatory path to market and strengthen the value proposition of Cochlear’s products; and • expanded the direct-to-consumer programs in the US and strengthened direct-to-consumer activities in other developed markets including in Australia, Germany and the UK. Shape the Organisation Build a service business With an ever growing base of recipients, now totalling over 450,000, Cochlear has both a lifetime responsibility and a significant business opportunity to service these recipients. Throughout the life of a recipient, Cochlear provides support with upgrades and services that improve their quality of life by improving hearing performance. The Company will: • support the growing recipient base with upgrades, accessories and seamless recipient service and repair; • increase connectivity and engagement with recipients with enhanced digital services; and • introduce technology solutions for clinicians to help the Company’s clinic partners grow and make aftercare for recipients more seamless. The FY16 highlights include: • established Services as a separate business unit and appointed a President; • expanded the recipient recruitment program and clinical support tools with the roll out of Cochlear Family, MyCochlear.com and CochlearLink; and • expanded the wireless product offering. Value Creation Grow the core Implantable hearing devices will continue to be the driver of growth for the coming years. The focus will be to: • strengthen the Company’s technology leadership position. Over the next 18 months a series of new products are expected to be launched across all categories of the business focused on both share and market growth; • stimulate market growth by increasing awareness of hearing loss, especially around severe to profound hearing loss, affecting nearly 40 million people world-wide. Over the last two years Cochlear has developed a direct-to-consumer marketing strategy in the US to target potential candidates, follow up leads and nurture candidates through the channel, which has contributed to higher market growth rates. Learnings from the US market are now being taken into other countries; 8 Chief Executive Officer & President’s Report — continued Shape the organisation The organisation is being reshaped to better utilise and deploy resources to enhance capabilities, leverage best practice and improve the efficiency and effectiveness of operations and market initiatives. Cochlear will: • expand its presence in customer facing activities across developed markets by expanding the field force and marketing activities to be closer to customers and clinic partners. The Company will also increase its presence in emerging markets like China; • globally integrate enabling activities to fund market growth initiatives; and • build organisational capabilities to support customer focused activities. The FY16 highlights include: 2017 financial outlook For FY17, net profit is expected to be within a range of $210-225 million, an increase of around 10-20% on FY16. Cochlear expects positive momentum to continue, with investments made in product development and market growth initiatives expected to underpin growth for FY17. Key considerations for FY17: • expect continued strong uptake of the Nucleus 6 and Kanso sound processors over the next few years with the current penetration rate for the Nucleus 6 at around 22% of potential recipients; • Chinese Central Government tender units expected to be at similar levels to FY16 with delivery of units biased to the first half; • in Europe, Cochlear does not expect any immediate impact on the business from the UK’s decision to withdraw from the European Union. However, the Company remains alert to the potential for uncertainty to curtail economic growth and put pressure on health budgets; • expect FY17 R&D expenditure to be broadly in line with that for • expanded the sales force across major markets with over 50 FY16, representing a lower percentage of sales revenue; additional professional, clinical and customer-focused employees; • forecasting a weighted average AUD/USD FX rate of 75 cents for • expanded the sales office in Dubai to improve service in the FY17 versus 73 cents in FY16; and Middle East and established an office in Vienna to service Central and Eastern Europe; and • appointed a Chief Operating Officer to drive global integration of support functions and focus the organisation on operating as one global company to drive efficiencies and effectiveness. • the balance sheet position and free cash flow generation remain strong. The Company will continue to target a dividend payout ratio of around 70% of net profit. Value creation To deliver long-term sustainable growth, Cochlear will: • develop alliances and partnerships, like the Smart Hearing Alliance with GN ReSound, that enable the Company to leverage its technology and leadership position to either expand the market or fast-track growth. The FY16 highlights include: • strengthened the Smart Hearing Alliance commercial relationship with GN ReSound; and • established an innovation fund to focus on innovative technologies which potentially assist Cochlear’s future business activities. $14 million was invested in FY16. Environment, Social and Governance (ESG) 9 Supporting environment awareness activities Engaging with universities and research groups Our approach to ESG reflects the Company’s commitment to excellence. The importance we place on ESG issues can be seen in the work we do to deliver quality, innovative products and services. Cochlear is involved in a range of ESG related activities and initiatives, some of which are highlighted in this report. High performance and strict legal compliance on environmental, privacy and safety issues are also integral to our culture. For more information on Cochlear’s Governance reporting, see our Corporate Governance Statement 2016, which is available on Cochlear’s website, www.cochlear.com. Our products and performance reflect the quality of our people. We seek the best people and support them to be successful in their work. We are proud of our environmental and governance record as well as our social contribution. Cochlear follows a global Code of Business Conduct, which helps us best serve our recipients and give them the best hearing possible. Environmental awareness Cochlear is committed to improving the lives of its recipients, driving innovation within the medical device industry, and in doing so, promoting best practice business principles. Property footprint Cochlear seeks to ensure that global offices reflect Cochlear’s commitment to creating and maintaining consistent and high quality work environments. We have prepared guidelines to help with establishing work environments that are efficient and effective in the use of space and resources, utilising environmentally sustainable materials and conducive to productivity. Cochlear Limited global headquarters Cochlear’s global headquarters on the Macquarie University campus, Sydney, which also houses our Asia Pacific regional headquarters, was awarded a 4 Star Green Star rating by the Green Building Council of Australia, confirming good practice in environmentally sustainable design/construction of the building. The headquarters building achieved a rating equivalent to a 5 star NABERS rating¹ (carbon emissions associated with electricity and gas consumption are 270% better than those for an “average performance” building). This high rating was achieved through a high efficiency façade design, energy efficient lighting and an innovative air conditioning system. Water efficient fittings and fixtures have been used throughout the building. The building reuses rainwater that is collected from the roof and is stored in underground reuse tanks. The tanks have a capacity of 350 cubic metres. The water is filtered and then used to supply all the toilets and the cooling towers within the building and used to irrigate the landscape outside. The waste recycling systems in place at the Sydney headquarters include: • commingle recycle waste collection in all break-out and kitchen areas, collecting approximately 20 tonnes a year; • paper and recyclable collection at workstations and utility areas; • 1 x 10 tonne cardboard compactor, replaced approximately every three months; • battery recycle collection, collecting approximately 225 kilograms of waste a year; • used machine oil recycling of approximately 2,000 litres per year; • e-waste recycle collection, collecting approximately 600 kilograms of waste a year; • fluorescent tube recycling, collecting approximately 400 kilograms of waste a year; • 240 litre capacity security paper destruction bins, collecting approximately 180 bins a year; and • pallet recycling of approximately 300 wooden pallets per year. We maximise office recycling, for instance with batteries, toner cartridges and used IT equipment, by providing employees with instructions as well as clear stations for materials to be collected. We encourage cycling to work and a reduction in car use, by providing 160 bicycle parking spaces as well as change rooms and bike storage facilities. Carpooling is encouraged with 11 car spaces allocated for users. One of Cochlear’s key procurement principles is the requirement to consider the economic, social and environmental impact when acquiring goods or services from selected suppliers. Consideration where appropriate is given to energy usage, emissions, water usage, resource use, waste generation, recyclability, toxicity, biodiversity, land use, social responsibility, economic viability, innovation and health and safety. 1. NABERS (National Australian Built Environment Rating System) is a national rating scheme managed by the NSW Government in Australia. 10 Environment, Social and Governance (ESG) Encouraging participation in national debate Increasing global awareness of hearing loss Cochlear Bone Anchored Solutions (CBAS) headquarters The CBAS headquarters in Mölnlycke, Sweden, makes extensive efforts to reduce electricity use and waste. A Green Building Silver level fulfils mainly demands for highly efficient use of energy, healthy materials, good indoor environment, good ventilation and high moisture resistance. The business works with Sweden’s leading recycling and environmental company, Ragn-Sells, to ensure best environmental practice. This involves a commitment to continuously improve waste separation and ensure that whenever possible waste products are reused, recycled or used for energy recovery before disposal. Waste sorting includes for: • combustibles; • office and confidential paper; • corrugated paper; • metallic packaging; • shrink and stretch wrap; • glass; • sharps; • electronics; • small batteries; • light bulbs; • wood; • mixed waste; • dangerous goods (chemicals); and • toners. We also place focus on the supply chain so that all transport is conducted in an environmentally safe and efficient manner. The CBAS building has been awarded a Green Building Silver Certificate by the Sweden Green Building Council. Designed for Swedish conditions, the Green Building Certificate system certifies buildings in terms of energy efficiency, indoor climate and materials. The system has been developed by researchers in collaboration with companies in the construction and real estate industries. The system gives the awards of Gold, Silver or Bronze Certificates and are used for both residential and commercial premises. Cochlear Technology Centre The Cochlear Technology Centre in Mechelen, Belgium, which is Cochlear’s largest R&D facility outside Australia, makes similar efforts to reduce the operation’s impact on the environment. Showers and lockers have been installed to encourage cycling to work and sport at lunch time. Company cars are costed proportionally to carbon gas emissions, to encourage employees to choose more environmentally-friendly cars. Sun protection film on all windows reduces the need for cooling. Special ‘waste lanes’ have been created to more efficiently separate and collect recyclable materials. Batteries, electrical devices and wooden pallets are also collected separately. Cochlear Americas headquarters In our regional headquarters in Denver, US, an extensive ongoing program is run to boost environmental sustainability and ensure compliance with the requirements of local authorities. Some of these activities include: • installation of sink fixture aerators in the rest rooms to reduce water consumption; • single source recycling in all kitchens, break rooms and printer stations to reduce waste going to landfill; • use of a cardboard compactor for all used boxes; recycling of all fluorescent bulbs (per United States Environmental Protection Agency mandate); and • recycling of all used or out-of-date batteries and e-waste. The office has locker rooms with shower facilities to allow individuals to cycle to work or exercise during off hours. Cochlear Europe, Middle East and Africa (EMEA) headquarters Cochlear has undertaken two key initiatives to promote environmental sustainability in our EMEA headquarters in Basel, Switzerland. These comprise: • a new agreement with an energy provider to use power from renewable energy sources; and • office-wide education programs to reduce workspace and IT energy usage. 11 Supporting employee participation in community fundraising and activities Educating visitors to headquarters with facility tours Manufacturing The majority of Cochlear’s manufacturing is located at the global and CBAS headquarters sites. Cochlear actively manages all inputs and outputs to promote environmental best practice. Cochlear holds environmental licences governing generation and control of waste and pollution in Australia. Cochlear retains or recycles nearly all of its waste product material from manufacturing in Australia. A lean philosophy in Cochlear’s manufacturing process, which is a systematic method for the elimination of waste. This enables us to reduce overproduction, reprocessing and defects, and increase recycling and paperless operation documentation. Redesigned packaging and flexible printing have also reduced packaging waste. Social support Supporting the tertiary education sector Cochlear is a knowledge based organisation and strongly supports and engages with the tertiary education sector. The Australian Hearing Hub is adjacent to Cochlear’s global headquarters at Macquarie University. The Hub brings together over 2,000 people, across a range of disciplines, dedicated to promoting hearing health. The Cochlear Clinical Skills Institute, a world-class surgical training centre in the Australian Hearing Hub, was recently opened and Cochlear’s Australian and New Zealand sales office has moved there to be close to key customers. There is a range of activities where Cochlear engages with Macquarie University, including placement opportunities for students, guest lecturing and public advocacy. There are also a number of research projects underway involving both organisations, into areas such as engineering, computing, audiology, linguistics and cognitive science. Cochlear has research agreements and arrangements with over 100 external research partners around the world. Cochlear’s support is focused on increasing the understanding and treatment of hearing loss. Cochlear is a core member of The HEARing Cooperative Research Centre based in Australia, which combines academic, business and government interests to further understanding and development of technologies for diagnosis and remediation of hearing loss. Since 2007, 38 students have engaged in postgraduate doctoral studies in hearing related topics under this scheme. Supporting the community In 2007, the Cochlear Foundation was established to promote community leadership and the awareness of, and research into, treatments for hearing loss. The foundation has provided support for a range of projects including STELR (Science and Technology Education Leveraging Relevance), an initiative to advance Science, Technology, Engineering and Mathematics (STEM) education. The Cochlear Foundation also supported other Australian educational awareness activities in FY16 as well as charity events and clinical research associated with the treatment of hearing loss. Cochlear encourages its employees to participate in volunteering and community fundraising and corporate sporting activities and directly supports its employees in a number of activities. Employees who are engaged in eligible community service activities are granted time off. In Europe, Cochlear supported community activities in several countries in FY16 through team involvement and financial help. In the United States, Cochlear continues its support of several non-profit hearing loss organisations including the Hearing Loss Association of America, AG Bell, Ear Community, Songs for Sound and the American Cochlear Implant Alliance. During FY16, scholarships were awarded to eight gifted students in the US who have overcome hearing loss and achieved academic and personal success. Cochlear has awarded more than US$568,000 in scholarships to 80 college students in the US since 2002. Supporting employees Cochlear’s global team operates in safe and healthy work environments. Numerous workplace health and safety activities are undertaken and support is provided for healthy living initiatives as well as access to a range of health services. More information can be found in the People and Culture section of the Annual Report. Industry and advocacy Cochlear has many professional staff involved in helping relevant research and community programs in their regions, partnering with academic, industry and health professionals to assist Cochlear recipients gain access to services and support and also advocates for resources for the institutions that support them. This is particularly important in developing countries. 12 Environment, Social and Governance (ESG) Introducing Cochlear Global Hearing Ambassador Offering tiered products in developing markets Many Cochlear employees are engaged in advocacy to improve hearing health policies around the world. Cochlear proactively supports the World Health Organisation’s global effort to highlight the need for prevention and treatment of hearing loss. Cochlear encourages its executives to participate in forums and bodies that advance Australia’s competitiveness and the promotion of innovation and technology. Hearing loss awareness Hearing loss is a global public health issue and Cochlear is engaged in raising awareness of it and the relevant treatments available to address it. In Australia and New Zealand, Cochlear sponsored the Power of Speech public speaking competition for deaf children to challenge the common perceptions of what a deaf child can achieve. Cochlear has also set up and works closely with the Cochlear Awareness Network of volunteers who connect candidates in the community and offer support. On 25 February, Cochlear launched a global social media campaign for International Cochlear Implant Day to celebrate the successes of people with Cochlear implants using the hashtag #CelebrateCochlear. International Ear Care Day is an annual advocacy event held on 3 March. In 2016, it was elevated in status by the World Health Organisation to World Hearing Day and aims to raise awareness, and promote ear and hearing care across the world. The theme for World Hearing Day 2016 was ‘Childhood hearing loss: act now, here is how!’. Macquarie University, with Cochlear’s support, issued a media release calling for more action on hearing loss by governments, communities and individuals. On World Hearing Day, comprehensive education and awareness activities took place in Australia, the UK, Benelux, Poland, Ukraine, Russia and Lebanon. In May, the Australian Deafness Forum and partners launched a national campaign, Break the Sound Barrier, in Australia to call for hearing loss to be made the 10th national health priority. Every year, Cochlear supports Hearing Awareness Week in August to raise awareness of hearing loss and treatments for hearing loss, such as Cochlear implants, especially among adults. Cochlear’s Global Hearing Ambassador, Brett Lee, launched the Sounds of Cricket campaign in the UK, the Middle East, India, Sri Lanka and Australia. The campaign draws attention to hearing loss through the iconic sounds of the game watched by a quarter of the world’s population. The campaign has generated extensive media coverage and social media engagement, especially in India. Brett has used his personal experience with his son’s hearing loss to drive public awareness of the issue. Cochlear makes an effort to educate visitors to its headquarters by giving tours of the facility and providing information about the significant medical, social and economic impacts of hearing loss. Plans are underway for a new hi-tech, interactive tour to enhance this experience. Cochlear Americas initiated a Million Ear Challenge campaign for Better Speech and Hearing Month (May) that urged people to share the facts about hearing loss with one million people via social media. The campaign teamed up with the Hearing Loss Association of America in over 20 awareness events (Walk4Hearing). The team also held over 90 Hearing Health Seminars to educate people on hearing loss and Cochlear solutions. Access to healthcare Cochlear sells its products in over 100 countries. Cochlear provides, particularly in emerging markets, support to professionals in the healthcare area. We facilitate partnering of surgeons and supporting education of local professionals. Part of enabling access to our products in developing markets is our ability to provide tiered products to suit the needs and financial ability of customers. Governance Cochlear’s key corporate governance principles and practices are outlined in the Corporate Governance Statement 2016, which is available on Cochlear’s website, www.cochlear.com. 13 Innovation for Life Cochlear continues to make investment in innovation a priority so as to deliver products and services that best meet our customers’ needs. Cochlear has invested more than $600 million in global R&D activities over the past five years. In FY16, Cochlear’s total R&D investment was $143 million, which was around 12% of sales revenue. More than 350 specialists from a range of technical disciplines are employed in the Company’s Design and Development department. These teams are based in Australia, Belgium, Sweden and the United States. Cochlear also works with over 100 external research partners based in 20 countries. Cochlear continues to develop solutions that drive improved hearing performance outcomes, improved lifestyle solutions and expanded indications for candidates and recipients of the Company’s products. Research covers scientific research, new technology development and new product development. This includes work on Cochlear’s sound processing algorithms, electrode technology, totally invisible hearing implants, wireless connectivity, biology research and the continued expansion of Cochlear’s portfolio of implantable hearing devices. The Company also continues to expand its offering of clinical care tools that support professionals with a growing set of options to manage their customers, including cloud based connection technologies. Product highlights during FY16 included: • CE approval and market introduction of Kanso; • CE, Canada Health and FDA approval of the Cochlear Nucleus Profile Implant with Slim Modiolar electrode (CI532), including regulatory approval and roll-out in the US; • CE and FDA regulatory approval of the Cochlear True Wireless Mini Microphone 2 and Mini Microphone 2+; • CE and FDA regulatory approval of the Cochlear Nucleus Profile Auditory Brainstem Implant (ABI541) and market introduction; • market introduction of Cochlear Custom Sound 4.3 and Nucleus Fitting Software 1.4; • market introduction of Cochlear Baha 5 Power and SuperPower sound processors, to complete the Baha 5 portfolio; • market roll-out of the next generation of Cochlear Baha 5 smart App for iPhone and for Android; • market roll-out of the next generation Cochlear Baha Fitting Software 5.2; and • continued market development and roll-out of Cochlear’s acoustic implants in Europe and Latin America. Manufacturing and supply chain operations Cochlear has a global supply chain with sales into more than 100 countries. Components are sourced across Europe, Asia and the Americas. Manufacturing operations are primarily located in Australia and Sweden, with smaller sites in Belgium and the US. Suppliers and the manufacturing sites are aligned to enable the Company to deliver products of the highest quality and reliability. The structure and execution of the supply chain play an important part in our customers’ experience as well as for the introduction of new products and technologies. Over 1,000 people are currently employed in Cochlear’s manufacturing facilities around the world. The Company’s manufacturing strategy is to make sure that capacity production methods deliver the highest quality products to meet demand whilst at the same time improving the operational efficiency. To achieve this, Cochlear adopts continuous improvement programs, which incorporate lean manufacturing principles and ongoing investment in new manufacturing technologies. These programs are designed to deliver the capacity, flexibility and productivity to satisfy our customer requirements. Non-military use Other than where our products are used by military personnel, Cochlear produces or contributes to no products or services designed or used for military purposes. Quality management system Cochlear has implemented a quality management system to ensure the quality of its products and services. This system is regularly assessed by external regulators. Certificates include (but are not limited to): ISO 13485, ISO 9001, Medical Device Directive and Active Implantable Medical Device Directive. Device approvals Medical devices must be approved by relevant regulatory authorities. At present, Cochlear (or an affiliate or distributor/representative) has the necessary licences and approvals to enable the marketing of each product in the jurisdictions in which the product is marketed. Ongoing approvals are regularly being sought for new products in a variety of jurisdictions. Intellectual property The creation and protection of our intellectual property remain a key strategic imperative for the business. Cochlear currently holds over 1,100 patents and patent applications globally, and filed many new patent applications in FY16. 14 People and Culture Cochlear delivers industry leading products and services through a highly skilled, passionate workforce of approximately 3,000 people in over 20 countries. Cochlear people represent a diverse range of disciplines, nationalities and working styles all dedicated to our mission. Our people strategies focus on engaging everyone in delivering the mission, aligning to our business priorities and building capabilities to deliver future growth. Our People Cochlear strives to attract and retain passionate and highly skilled professionals. We achieve this through interesting and challenging work, the opportunity for development within a growing business but most importantly through our passion to achieve a common purpose – our mission. We have a high level of engagement built on our shared goals to improve the experience we provide to our customers. In FY16, we continued to be an Employer of Choice, attracting over 18,000 applications from around the world to fill just over 500 permanent and fixed-term positions, a record for the company. The Company maintains high staff retention levels with global annualised turnover under 10%, which is low by industry standards. Over the year, Cochlear continued to focus on building the capabilities of our workforce to meet business needs by promoting from within and providing employees with opportunities to build their careers. In FY16, 29% of positions were filled internally. The year saw an increase in the number of employees moving internationally to broaden their experience and facilitate learning and sharing. At the executive level, we had nine appointments over the year: • Chief Executive Officer & President, Chris Smith, formerly the President, Americas Region; • Tony Manna, President, Americas Region, formerly General Manager, CBAS; • Rom Mendel, General Manager, Cochlear Acoustics, formerly General Manager CBAS; • David Hackshall, Chief Information Officer, joining Cochlear from Wesfarmers Insurance; • Dig Howitt, Chief Operating Officer, moving from President, Asia Pacific Region. This position was created to support the integration and alignment of Cochlear’s global operations and to ensure efficiencies and effectiveness are maximised as the Company grows globally; • Stu Sayers, inaugural President, Services. The Services business provides aftercare support, product and direction for cochlear implant recipients. It generates revenue from the sale of sound processor upgrades and accessories as well as focusing on the development of software solutions that will serve our customer over a lifetime; • Dr Rich Toselli, inaugural Chief Medical Officer. Rich will lead the Global Clinical and Regulatory teams, bringing greater global coordination and integration of these activities as well as leading Cochlear’s Health Economics and Outcome Research activities; • Amanda Lampe, Senior Vice President, Corporate Affairs, Strategic Alignment and Public Health, moves from SVP Global Marketing. The new role will build public health policy advocacy and hearing loss awareness initiatives, lead global alignment of communications and coordinate and deliver corporate strategy; • Dean Phizacklea, Senior Vice President, Global Marketing, bringing to Cochlear many years of marketing experience with both the medical device and pharmaceutical industries across the world; and • Katharine McLennan, Senior Vice President, People & Culture, responsible for building out Cochlear’s strategic capability in talent management, acquisition, development, remuneration, performance, engagement and succession planning. Cochlear has continued its commitment to developing a strong talent pipeline for future growth, employing the largest cohort of engineering summer students since the program began in 2008. In February 2016, we welcomed a record number of graduates who were selected from the students who completed the summer student intern program in the summer of 2014/2015. In FY16, we launched our first ever Graduate Lawyer program. Throughout the year, Cochlear also hired new employees into new and specialised skill areas to support key global projects, transforming our customer experience and communications capabilities. Cochlear employs a highly flexible workforce in our manufacturing department by providing ongoing opportunities for job enrichment through the Manufacturing People Program. Our Learn about Cochlear program connects the manufacturing workforce with our recipients to ensure we are regularly focusing on our customers. We celebrate a highly diverse workforce and consult and engage regularly through our Employee Communications Committee, providing a forum for collaboration between the manufacturing and leadership groups. Development Cochlear continues to invest in employee development programs to help individuals and enhance organisational capabilities. During the year, we launched a new approach to goal setting and performance called My Performance Pathway. My Performance Pathway is designed to increase employee engagement by helping employees to create strategically aligned goals. The program includes a focus on building the skills of people managers to help their teams set goals and coach them in achieving their goals on a regular basis. Performance in Cochlear means not only what employees achieve in outcomes but how they achieve it with our new HEAR behaviours, which we expect all employees to exhibit: • Hear the customer; • Embrace change and innovate; • Aspire to win; and • Remove boundaries. 15 Cochlear accelerated its development of leadership capability amongst its global executive cohort with a total of 78 Cochlear leaders completing programs in Leading Innovative Change, Leading Strategic Growth and Leading Operational Excellence. This development was aligned to key business projects, to facilitate rapid transfer of learning back to the workplace and to ensure leaders are supported and equipped to move our business forward. Improvements to our learning management system have delivered an even stronger learner experience for employees, providing employees with access to an expanding range of learning programs through different media. Manufacturing Academy was further rolled out to support the delivery of training and skill-building processes in our manufacturing environment in Brisbane. Diversity As a global business, Cochlear strongly encourages all forms of diversity to support our leadership and innovation strategies. In our Sydney offices, employees come from 75 different countries and approximately 80% of our workforce was born outside Australia. The Company’s global workforce is 51% female and women make up 34% of our senior manager population. Of the new permanent employees recruited globally in FY16, 57% were women. This outcome was achieved even though 37% of all job applicants were women. During FY16, Cochlear maintained programs to promote diversity in its workforce, including support for the Women in Leadership initiative, Leadership Presence programs aimed at developing the pipeline of female leaders at Cochlear and Talent planning also focused on engendering a more diverse talent pipeline. We consider gender and STEM talent needs in all talent process design, and we measure and monitor outcomes to continuously improve our employee value proposition and minimise any potential sources of bias in areas like selection, promotion and performance assessment and reward. Health and Safety Cochlear always seek to provide innovative Health and Safety solutions to enhance the working and personal lives of all our people. Cochlear views Health and Safety as an integrated element of our overall operations and seeks to involve all levels of the organisation in the solutions and continual improvement of all aspects of the execution of Health and Safety. During FY16, the Australian operations expanded on last year’s introduction of the Enterprise Risk Management solution, refining the elements of the Risk Management and Inspection and Audit Modules. These two modules will increase the capability of our people to participate in the ongoing continual improvement of the management of risk at Cochlear. The Health and Safety team and personnel from Design, Engineering, People and Culture and Production collaborated substantially across the year to look closely at the process of design and manufacture to improve Health and Safety outcomes for production personnel and drive efficient processes. This will contribute to the continued drive for improvement of the production process to be safer and more efficient. The Health and Safety team provided support and expertise to coach and collaborate with all personnel, driving improvement in risk management, hazardous substances and emergency management across the organisation. FY16 saw the focus on safe, simple and collaborative process, building a responsive and flexible framework for personnel to operate within. Workers compensation and health insurance premiums have reduced substantially across the organisation and we are tracking favourably against our comparative industry; the continued improvements in the manufacturing process should see this favourable trend continue. Wellness continues to be a focus across the organisation and the provision of preventive programs to enhance wellness was offered to all personnel, with a focus on physical, social, financial and occupational wellness. Lifestyle programs, vaccinations and support for external events, sports and challenges were provided during FY16. The provision of an Employee Assistance Program as a resource to all personnel and eligible family members is a continuing priority. All aspects of wellness and wellbeing are a continuing and very high priority and will play an increasing factor in how Cochlear will differentiate itself in talent attraction and retention. Our Culture Most important to all that we do is our focus on a culture of One Cochlear, which is about: • integrating our operations, strategy and behaviour across our 25 countries; • standardising our processes; • collaborating across the world to generate new ideas and better ways of working; and • sharing resources to drive innovation, effectiveness and efficiency. We are building out our talent mobility as we begin to create “global citizens” whose functions, presence, influence and travel cover the world. We are increasingly globalising all of our functions as our global footprint continues to expand. In FY16, we began the process of globalising our approach to IT, quality, talent management, repair, manufacturing and inventory management, and we will extend this process to all of our functions in the coming year. Having created the approach to My Performance Pathway, we have further reinforced One Cochlear by setting 12 global goals so that all 3,000 employees can align their individual goals commonly, understand how they fit across the world of Cochlear, and identify their counterparts and collaborators across the world. Now more than ever before, we will insist all of our people know our end customers’ needs, desires and motivations as we expand the education, experience and exposure we give our people to our customers, our audiologists, our reimbursement parties and our surgeons all over the world. Hearing the customer is at the core of everything we do – and we are now instilling the importance of candidates and customers that we serve for their lifetime, which is at the heart of our mission. 16 Board of Directors 1. Rick Holliday-Smith Age 66. BA (Hons), FAICD, CA 3. Yasmin Allen Age 52. BCom, FAICD Appointed 1 March 2005. Eleven years’ service. Director of Servcorp Limited since 1999. Director of ASX Limited since 2006 and Chairman since March 2012. Former Chairman of Snowy Hydro Limited (not publicly listed) (2006–2012) and SFE Corporation Limited since 1999 until it merged with ASX Limited in 2006. Former director of St George Bank Limited (2007–2008), Exco Resources NL (1999–2006), DCA Group Limited (2004– 2006) and MIA Group Limited (2000–2004). Former President of NationsBank-CRT, Chicago and Managing Director of Hong Kong Bank Limited, London. Chairman of the Board of Directors and Nomination Committee. Member of the Audit and People & Culture Committees. 2. Chris Smith Chief Executive Officer & President Age 53. BSc Appointed 1 September 2015. Nine months’ service. Joined Cochlear in 2004. Has more than 20 years’ experience in the healthcare and medical device industry in the United States including assisting Warburg Pincus in identifying market opportunities for investment. Prior to this, was Group President for Gyrus Group (ENT and Surgical Divisions). Previous Cochlear roles include President, Americas Region and Senior Vice President, Cochlear Bone Anchored Solutions and Global Support Operations. Member of the Medical Science and Technology & Innovation Committees. Appointed 2 August 2010. Six years’ service. Director of Santos Limited and member of the Santos Environment, Safety and Sustainability Committee and Audit Committee. Director of ASX Limited and member of ASX Audit Committee and ASX Clearing and Settlement Board. Director of National Portrait Gallery since 2013. Member of the George Institute for Global Health Board. Former Director of Insurance Australia Group Limited (IAG). Former National director of the Australian Institute of Company Directors. Former member of The Salvation Army Advisory Board. Former Chair of Macquarie Specialised Asset Management. Former Vice President of Deutsche Bank AG, Director of ANZ Investment Bank and Associate Director, HSBC London. Chairman of the Audit Committee. Member of the People & Culture, Nomination and Technology & Innovation Committees. 4. Prof Edward Byrne, AC Age 64. DSc, MD, MBA, FRCP, FRACP, FTSE Appointed 1 July 2002. Fourteen years’ service. Chairman of King’s Health Partners. President and Principal of King’s College London since 1 September 2014. Former Deputy Chairman of Group of Eight Vice Chancellors, Australia, and Chairman of Global Foundation. Former director of Bupa Group Board, London and Bupa Australia Pty Limited. Former Vice Chancellor of Monash University (June 2009 – August 2014). Former executive Dean of the Faculty of Biomedical Sciences, Vice Provost and Head of the Medical School at University College London. Former Dean of Faculty of Medicine, Nursing and Health Sciences at Monash University, Melbourne (2003–2006). Chairman of the Medical Science Committee. Member of the Nomination and Technology & Innovation Committees. 5. Andrew Denver Age 67. BSc (Hons), MBA, FAICD Appointed 1 February 2007. Nine years’ service. Chairman of Universal Biosensor Pty Limited since 2005 (director since 2002) and SpeeDx Pty Limited since 2009. Director of Vaxxas Pty Limited since 2012. Former director of Principals Cornerstone Management Pty Limited. Former Managing Director of Memtec Limited and President Asia for Pall Corporation. Chairman of the Technology & Innovation Committee. Member of the Audit, Medical Science and Nomination Committees. 6. Donal P O’Dwyer Age 63. BE Civil, MBA Appointed 1 August 2005. Eleven years’ service. Chairman of Atcor Medical since 2004 and a director of Mesoblast Limited since 2004 and Fisher & Paykel Healthcare Limited since 2012. Non-executive Director of NIB Holdings Ltd since 2016. Former director of Sunshine Heart Inc (2004–2013). Former Worldwide President of Cordis Cardiology (Johnson & Johnson medical device business unit) between 2000 and 2004. Member of the Audit, Medical Science, Nomination and Technology & Innovation Committees. 7. Glen Boreham, AM Age 51. BEc, FAICD Appointed 1 January 2015. Eighteen months’ service. Director of Southern Cross Austereo since 2014 and Link Group since 2015. Chairman of Advance since 2012 and the Industry Advisory Board for the University of Technology, Sydney, since 2010. Former Director of Data#3 (2011- 2015). Former Chairman of Screen Australia (2008–2014). Former Managing Director of IBM Australia and New Zealand (2006–2010). Chairman of the People & Culture Committee. Member of the Audit, Nomination and Technology & Innovation Committees. 8. Alison Deans Age 48. BA, MBA, GAICD Appointed 1 January 2015. Eighteen months’ service. Director of Westpac Banking Corporation since 2014, Insurance Australia Group Limited since 2013 and kikki.K Holdings Pty Limited. Former Chief Executive Officer of the technology-based investment company Netus Pty Limited (2006–2013), Hoyts Cinemas (2003–2004), eCorp Limited (2000–2003) and eBay Australia and New Zealand (1999–2000). Member of the Audit, People & Culture, Nomination and Technology & Innovation Committees. 17 3 7 3 7 4 8 4 8 Board of Directors 1 5 Senior Executive Team 1 5 9 2 6 2 6 10 1. Chris Smith Chief Executive Officer & President See “Board of Directors” on page 16. 2. Richard Brook President, Europe, Middle East and Africa Region BSc Management, MBA Richard is responsible for the development and execution of the strategic direction for all our operations in Europe, Middle East and Africa (EMEA) and Latin America. This includes sales in over 60 countries. Operations in EMEA and Latin America include sales, marketing, distribution, service, finance, clinical, regulatory and administration across these complex and diverse regions. Before joining Cochlear in 2003, Richard held senior roles in Guidant Corporation and Alaris Medical Systems. He has over 20 years’ experience in the medical device industry. 3. Dig Howitt Chief Operating Officer BE (Hons), MBA Dig was President, Asia Pacific Region in FY16 and was appointed Chief Operating Officer (COO) in July 2016. The COO will support the integration and alignment of Cochlear’s global activities to ensure efficiency and effectiveness are maximised as the Company grows globally. Functions included in the COO remit include global marketing, global IT, global quality, global supply chain, Bone Conduction and Acoustics. Dig will also retain responsibility for the China business. Dig joined Cochlear in 2000 and has a wealth of experience across the Company in roles including SVP, Manufacturing and Logistics and President, Asia Pacific. Prior to joining Cochlear, Dig worked for Boral and Boston Consulting Group. 4. Jan Janssen Senior Vice President, Design and Development, Clinical and Regulatory MScEE Jan leads a team of over 300 highly qualified engineers and scientists who implement the R&D strategy. This includes responsibility for identifying and developing cutting- edge technologies and commercial products. Jan joined Cochlear in 2000 as Head of the Cochlear Technology Centre based in Belgium, having previously worked with Philips Electronics 18 Senior Executive Team — continued where he was involved in R&D in the fields of high- tech electronics and cochlear implants. Jan was promoted to Senior Vice President, Design and Development in 2005. Since August 2013, Jan has also had responsibility for Clinical and Regulatory. 5. Amanda Lampe Senior Vice President, Corporate Affairs, Strategic Alignment & Public Health BPE, GAICD Amanda joined Cochlear in 2014. Previously held the role of SVP, Global Marketing in Cochlear. Has extensive senior management experience in government and corporate sectors. Previous experience includes ASX Group Executive for Corporate Affairs and Government Relations, chief of staff for a former Prime Minister and media director for a former NSW Premier. 6. Tony Manna President, Americas Region BS EET Tony joined Cochlear in 2005. Has over 30 years medical device experience, including senior commercial management roles at BEI Medical and Gyrus Medical. Prior roles in Cochlear include VP, Sales USA, General Manager, Cochlear Bone Anchored Solutions, USA and President, Cochlear Bone Anchored Solutions, Sweden. He joined the Company in 1990 and has been Chief Financial Officer since listing in 1995. He is a director of Osprey Medical Inc., President of the Group of 100 and a member of the Board of Taxation. 7. Katharine McLennan 9. Stuart (Stu) Sayers Senior Vice President, People & Culture President, Services BEc (Hons), MBA BS Biology (Hons), History (Hons), MBA, MA Political Science Katharine joined Cochlear in March 2016 with experience in corporate strategy, talent and leadership development, and executive psychotherapy. Katharine has held leadership roles in Booz & Co, QBE Insurance and Commonwealth Bank of Australia. 8. Neville Mitchell Chief Financial Officer and Company Secretary BComm, CA (SA), CA Neville is responsible for accounting, corporate finance, treasury and audit, together with investor relations, company secretarial and the corporate legal functions at Cochlear. Stu was appointed as Cochlear’s inaugural President, Services in May 2016. The Services business provides aftercare services for Cochlear recipients and professionals, generating revenue from post-implant products and other offerings. Stu comes with a wealth of experience in establishing and building customer- focused B2C and B2B service businesses, online and at scale. Most recently, Stu led the Amazon subsidiary Audible in Asia Pacific. Prior to Amazon, Stu ran E*TRADE and then Yahoo!7 in Australia and New Zealand. He previously held senior roles with Procter & Gamble and McKinsey & Company. 10. Dr Richard (Rich) Toselli Chief Medical Officer BA Biology, MD, MBA Rich was appointed as Cochlear’s inaugural Chief Medical Officer in June 2016. Rich will lead the Global Clinical, Regulatory and Health Economics teams to bring more strategic global coordination and integration. His focus will be on bringing stronger voice of customer to the product development process and sharpening the value proposition on our products by creating high quality clinical and health economic data. Rich joined Cochlear from Sanofi Genzyme Biologics Division where he was Head of Global Medical Affairs for Immunology. Rich trained as a neurosurgeon and has more than 12 years of experience in R&D, medical affairs and evidence based medicine. He previously held senior roles with Sanofi, Covidien and Johnson & Johnson. Financial Report Cochlear Limited ACN 002 618 073 and its controlled entities for the year ended 30 June 2016 Contents Directors’ Report Principal activities and review of operations and results Remuneration Report Lead Auditor’s Independence Declaration Income Statement Statement of Comprehensive Income Balance Sheet Statement of Changes in Equity Statement of Cash Flows Notes to the Financial Statements 1. Basis of preparation 1.1 Reporting entity 1.2 Basis of preparation 2. Performance for the year 2.1 Operating segments 2.2 Revenue 2.3 Expenses 2.4 Other income 2.5 Earnings per share 2.6 Dividends 2.7 Notes to the statement of cash flows 3. Income taxes 3.1 Income tax expense 3.2 Current and deferred tax assets and liabilities 4. Employee benefits 4.1 Employee expenses 4.2 Employee benefit liabilities 4.3 Share based payments 4.4 Key management personnel 5. Operating assets and liabilities 5.1 Inventories 5.2 Property, plant and equipment 5.3 Intangible assets 5.4 Investments 5.5 Provisions 5.6 Contingent liabilities 6. Capital and financial structure 6.1 Capital management 6.2 Capital and reserves 6.3 Net debt and finance costs 6.4 Financial risk management 7. Other notes 7.1 Auditors’ remuneration 7.2 Commitments 7.3 Controlled entities 7.4 Parent entity disclosures 7.5 Changes in accounting policies 7.6 New standards and interpretations not yet adopted 7.7 Events subsequent to the reporting date Directors’ Declaration Independent Audit Report Additional Information 20 20 31 51 52 53 54 55 56 57 57 57 57 59 59 60 60 60 61 61 62 63 63 64 65 65 65 66 68 68 68 68 69 71 71 72 73 73 73 74 75 80 80 80 81 82 82 82 83 84 85 89 19 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 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 2016, 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 (Chairman), Mrs YA Allen, Mr G Boreham, AM, Prof E Byrne, AC, Ms A Deans, Mr A Denver, Mr DP O’Dwyer, Dr CG Roberts and Mr C Smith. 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 People & Culture Committee Medical Science Committee Nomination 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 G Boreham, AM Prof E Byrne, AC Ms A Deans Mr A Denver Mr DP O’Dwyer Dr CG Roberts1 9 9 9 9 9 9 9 2 9 9 9 9 9 9 9 2 Mr C Smith2 1. Dr CG Roberts retired 31 August 2015. 2. Mr C Smith was appointed on 1 September 2015. 7 7 5 5 5 - 4 5 5 - - 5 5 5 - 4 5 5 - - 4 4 4 - 3 - - - - 4 4 4 - 3 - - - - - - - 4 - 4 4 1 3 - - - 4 - 4 4 1 3 2 2 2 2 2 2 2 - - 2 2 2 2 2 2 2 - - - 2 2 2 2 2 2 1 1 - 1 1 1 2 2 2 1 1 Principal activities and review of operations and results Operations Business model 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. Cochlear estimates that over 450,000 recipients have been implanted with one of its implants. Cochlear’s business model includes supporting its customers with innovative and compatible products, through the sale of sound processor upgrades and accessories and ongoing product support. 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 (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 over 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 are manufactured at Cochlear’s Macquarie University headquarters including the Nucleus Profile implant. The Brisbane site is responsible for manufacturing non-implant components. The bone conduction implant product range is manufactured in Sweden. 20 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 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. Cochlear’s mission 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. Strategic priorities The hearing loss market offers an incredible business opportunity with over 360 million people worldwide experiencing disabling hearing loss, with nearly one in three people over the age of 65 affected by hearing loss. With global market penetration for implantable hearing solutions being at less than 5%, there remains a significant, unmet and addressable clinical need that will continue to underpin the long-term sustainable growth of the business. Cochlear’s priorities will be centred on the customer with activities aimed at growing awareness and access to the industry for implant candidates. And with a growing recipient base, now numbering over 450,000, the Company is actively strengthening its servicing capability to provide products, programs and services to support the lifetime relationship with recipients. Cochlear will continue with its commitment to being the technology leader in the industry by investing in research and development to improve hearing outcomes and expand the indications for implantable solutions so recipients can have the quality of life they expect. Priorities are centred on four strategic platforms for the business: 1. Grow the core business Implantable hearing devices will continue to be the driver of growth for the coming years. The focus will be to:  Strengthen the technology leadership position. Over the next 18 months, there are plans to launch a series of new products across all categories of the business focused on both share and market growth;  Stimulate market growth by increasing awareness of hearing loss. Over the last two years, Cochlear has developed a direct-to- consumer marketing strategy in the US to target potential candidates, follow up leads and nurture candidates through the channel. These learnings are now being taken to other countries;  Improve access for candidates by expanding the cochlear implant clinic base as well as continuing to work with the referral channel to assist clinic partners to grow and become more efficient. The development of hybrid and acoustic implants, together with a broader range of electrodes, plays an important role in broadening the indications for implantable hearing solutions; and  Business model innovation. Exploring new referral pathways and servicing models and where appropriate open company- owned Cochlear clinics to manage the aftercare of recipients. 2. Build a service business With an ever growing base of recipients, now totalling over 450,000, Cochlear has both a lifetime responsibility and a significant business opportunity to service these recipients with upgrades and services that improve their quality of life by improving hearing performance. Cochlear will:  Support the growing recipient base with upgrades, accessories and seamless service and repair;   Increase connectivity and engagement with recipients with enhanced digital services; and Introduce technology solutions for clinicians to help clinic partners grow and make aftercare for recipients seamless. 3. Shape the organisation Cochlear is reshaping the organisation to better-utilise and deploy resources. The focus is to:  Expand the Company’s presence in customer facing activities across developed markets by expanding the field force and marketing activities to be closer to customers and clinic partners. Cochlear will also increase its presence in emerging markets like China;  Globally integrate enabling activities such as information technology (IT) to drive efficiencies and leverage best practice to fund market growth activities; and  Build organisational capabilities to support customer-focused activities. 21 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 4. Value creation To deliver long-term sustainable growth, Cochlear will:  Develop alliances and partnerships, like the Smart Hearing Alliance with GN ReSound, which enables the Company to leverage its technology and leadership position to either expand the market or fast track growth. Operating result FY16 Product highlights Cochlear implants (units) Sales revenue Cochlear implants Services (sound processor upgrades and accessories) Acoustics (bone conduction and acoustic implants) Total sales revenue 2016 $000 30,172 729,171 289,418 139,542 1,158,131 2015 $000 Change % Constant currency 26,838  12% 604,346 222,458 115,096 941,900  21%  30%  21%  23%  10%  20%  9%  12% Cochlear implants – 63% of sales revenue Cochlear implant revenue grew 21% (10% in constant currency) and unit sales grew 12% (8% excluding the benefit of China tender units) with solid growth experienced across developed and emerging markets. Leading developed markets, including the US, UK, Germany and Australia, all grew implant units by around 10%. Emerging markets performed well with highlights including strong growth in China, both in the private pay and tender markets, India and the Middle East. There has been a strong uptake of the Nucleus Profile implants since release in FY15. The Profile series are the most reliable implants on the market and feature the world’s thinnest electrodes, allowing for a reduction in surgery time and a less traumatic insertion. The Profile series implants are providing recipients with significant improvements in hearing performance in challenging listening situations when used with True Wireless accessories1. During the second half of FY16, we commenced a controlled market release of the new Slim Modiolar electrode (CI532) in Europe, the US and Canada. The CI532 is 60% thinner than the previous generation Contour Advance electrode, allowing for optimised surgical placement and an even less traumatic insertion. Cochlear extended its sound processor portfolio during the second half with the introduction of Kanso. Kanso is a discrete, easy-to-use, off-the-ear sound processor that delivers the same hearing performance as the Nucleus 6 Sound Processor. The increase in sales revenue also reflects earlier investments in sales and marketing capabilities including direct-to-consumer activities and field expansion across many markets. These initiatives help build awareness of implantable hearing solutions and support further penetration into the adult segment. Services (sound processor upgrades and accessories) – 25% of sales revenue Services sales revenue increased 30% (20% in constant currency) driven by the continuing strong uptake of the Nucleus 6 Sound Processor. With the launch of the Nucleus 6 for Nucleus 22 recipients, the latest sound processor is now compatible with all generations of implants released over the last 30 years. Accessories growth was supported by the continued uptake of True Wireless and the Aqua+ for Nucleus 6 users. Wireless Mini Microphone 2+, which streams speech directly to the Cochlear sound processor, was launched during the second half, providing further enhancements in hearing performance to the True Wireless range. As part of the commitment to provide recipients with great customer experience, the business commenced the rollout of a number of service-oriented products. These products include the recipient membership program, Cochlear Family; a personalised online portal to connect recipients directly with Cochlear, MyCochlear.com; and Cochlear Link, which uses cloud based technology to provide recipients with simpler and faster servicing of their sound processors. 1 Wolfe J, Morais M, Schafer E. Improving hearing performance for cochlear implant recipients with use of a digital, wireless, remote-microphone, audio-streaming accessory. J Am Acad Audiol. 2015 Jun;26(6):532-9. 22 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Acoustics (bone conduction and acoustic implants) – 12% of sales revenue Acoustics, which includes bone conduction and acoustic implant sales revenue, grew 21% (9% in constant currency) with solid performances across all regions. The bone conduction portfolio grew 10% in constant currency. The Baha 5 portfolio was extended during the second half with the launch of Baha 5 Power and Baha 5 SuperPower Sound Processors, designed for recipients with higher degrees of hearing loss. The Baha 5 System now provides the widest range of sound processors, including the industry’s smallest, smartest and most powerful head-worn bone conduction solutions for those with single-sided deafness or who have conductive or mixed hearing loss. The Baha 5 System is also the only hearing implant system with MFi (made for iPhone) capabilities, allowing direct streaming between the sound processor and iPhones. The Baha 5 Power and SuperPower Sound Processors are now commercially available in most key markets. They will be made available in other markets over the next 12 months as regulatory approvals are obtained. Regional review Sales revenue Americas EMEA (Europe, Middle East and Africa) Asia Pacific Total sales revenue 2016 $000 519,688 427,896 210,547 1,158,131 2015 $000 402,962 377,633 161,305 941,900 Change %  29%  13%  31%  23% Constant currency  12%  7%  23%  12% Americas (US, Canada and Latin America) – 45% of sales revenue Sales revenue increased 29% to $519.7 million (12% in constant currency). The highlight was the growth in the US with revenue growth of 16% in constant currency and cochlear implant unit sales up around 10%. Growth overall has been driven by new product introductions and growing services revenue, supported by strategic growth initiatives commenced over the past few years. The expanded field sales organisation, direct-to-consumer marketing and new customer relationship management system (Salesforce.com) have supported accelerated market growth. Services revenue increased by over 20% in constant currency driven by upgrades to the Nucleus 6 Sound Processor. The uptake by Nucleus 22 recipients has been enthusiastic since launch in November 2015. Overall Latin American sales revenue declined in constant currency as a result of deteriorating economic conditions. EMEA (Europe, Middle East and Africa) – 37% of sales revenue Sales revenue increased 13% to $427.9 million (7% in constant currency) with solid performances across the whole region. The highlight was the performance of Germany, the largest market in EMEA, which grew units by around 10%. The German result reflects the impact of an expanded field sales team and investment in direct-to-consumer marketing activities. Other key markets in Western Europe, particularly the UK and France, performed well with units also growing around 10% driven by investments in market growth initiatives and the positive impact of a strong product portfolio across all product categories. Despite a challenging political and macro-economic year, sales revenue in the Middle East grew strongly, coming off a low base in FY15. The Middle East is benefiting from Cochlear’s expanded presence since the opening of a new Middle East headquarters in Dubai in 2014. A headquarters was established in Vienna to service Central and Eastern Europe in April 2016. Asia Pacific (Australasia and Asia) – 18% of sales revenue Sales revenue increased 31% to $210.5 million (23% in constant currency) with solid growth experienced across most markets. Australia continues to grow consistently with unit growth of around 10% as the combination of field sales expansion and new marketing programs contributes to growing awareness. China performed strongly in both the private pay and tender markets. Private pay sales and services revenue were boosted by the expansion of Cochlear’s field sales presence. The region benefited from Chinese Central Government tenders of around 3,300 units. India represents a small but rapidly growing market. The growing number of clinics, expansion of the field force and improvements in reimbursement all contributed to double-digit unit growth. 23 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Financial review Major expenses Cost of goods sold % of sales revenue Selling and general expenses Administration expenses Research and development expenses % of sales revenue Other income EBIT % of total revenue 2016 $000 333,593 28.8% 326,090 79,287 143,134 12.4% (14,156) 262,604 23.2% 2015 $000 275,320 29.2% 260,809 59,536 127,985 13.6% (4,428) 206,408 22.3% Change $000 58,273 (0.4%) 65,281 19,751 15,149 (1.2%) (9,728) 56,196 0.9% EBIT increased by $56.2 million, up 27%, to $262.6 million, with the operating margin (EBIT to total revenue) increasing by 0.9% to 23.2%. Cost of goods sold (COGS) increased $58.3 million to $333.6 million, primarily as a result of growing volumes. COGS as a percentage of sales revenue improved by 0.4% to 28.8%, reflecting the impact of changes in foreign exchange (FX) rates, product and geographic mix as well as the higher COGS associated with the initial introduction of the Nucleus Profile series implant. A balance sheet review was conducted in the context of new generation products launched over the past 18 months. This review has contributed to a $16.3 million non-cash inventory write-off, pre tax, reflecting old and obsolete parts and products. Selling and general expenses increased by $65.3 million to $326.1 million. The 25% increase reflects the increased investment in market growth initiatives as well as the impact on translation of the depreciation of the Australian dollar. In constant currency, the increase in selling and general expenses was 15%. Administration expenses increased by $19.8 million to $79.3 million, an increase of 33%. More than half of the increase is related to investments in IT systems. The investment in global IT platforms will enable the business to strengthen its sales processes and build upon its services offering. Investment in research and development (R&D) increased 12% to $143.1 million, which is consistent with Cochlear’s stated commitment to continue to invest in R&D to strengthen its technology leadership position. It follows several years of limited incremental investment in R&D. Other income increased by $9.7 million. A $7.5 million increase in FX gains on asset translation is included in this line item. Foreign currency impacts on the income statement Income statement impacts Reported FX contract gains/(losses) on hedged sales (transaction impact) - - FX losses – FY16 FX losses – FY15 Sales revenue and expenses (translation impact)1 - - Sales revenue Total expenses including tax Reported asset translation impacts (translation impact) - - FX gain on asset translation – FY16 FX gain on asset translation – FY15 1. FY16 actual v FY15 at FY16 rates. $000 (27,579) (16,270) (11,309) 93,467 (44,688) 48,779 8,695 1,178 7,517 24 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Transaction impacts Cochlear utilises currency hedging to provide some certainty around near-term cash flow. Over 90% of revenue and around 50% of costs are denominated in foreign currency. Most of the cash that is generated is repatriated to Australia to fund operating and investing activities, including R&D and dividends. In order to provide some certainty around near-term cash flow, expected cash flows are hedged back to Australian dollars (AUD). In FY16, the AUD depreciated against most of the major currencies. As a result, FX losses on hedged sales were $28 million. This compared to FX losses on hedged sales of $16 million in FY15. Translation impacts The key translation impacts from translating foreign sales and expenses into AUD include:    a net benefit to sales revenue of $93.5 million; a net increase in expenses of $44.7 million; and a net benefit to net profit of $8.7 million from the translation of assets, primarily trade receivables. This compares to a $1.2 million net benefit in FY15. Capital employed Trade receivables Inventories Less: Trade and other payables Working capital Debtor days Inventory days Property, plant and equipment Intangible assets Other net liabilities Capital employed 2016 $000 268,538 154,103 (110,354) 312,287 85 169 86,878 224,338 (57,125) 566,378 2015 $000 236,728 145,861 (99,858) 282,731 83 193 80,809 228,531 (96,182) 495,889 Change $000 31,810 8,242 (10,496) 29,556 2 (24) 6,069 (4,193) 39,057 70,489 Capital employed increased by $70.5 million to $566.4 million since 30 June 2015 primarily as a result of an increase in working capital and a reduction in other net liabilities. Working capital increased by $29.6 million to $312.3 million largely reflecting increased sales. Trade receivables increased $31.8 million to $268.5 million. In constant currency, trade receivables increased by 11%, reflecting sales growth during the year. Debtors days increased by two days to 85 days. Inventories increased $8.2 million to $154.1 million. Inventory days reduced 24 days to 169 days, reflecting the reduction in stock which had been built up in June 2015 ahead of tender shipments made during the first half and the higher sales, as well as the $16.3 million inventory write off (as detailed in the prior major expenses commentary). Net property, plant and equipment remained largely unchanged. Intangible assets decreased by $4.2 million to $224.3 million, largely a result of revaluation to period end FX rates. All intangible assets are tested for impairment on an annual basis. There were no impairments or write-downs of intangible assets in FY16. Other net liabilities reduced by $39.0 million, largely reflecting higher tax payments made during the year. 25 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Cash flow EBIT Depreciation and amortisation Changes in working capital and other Net interest paid Income taxes paid Operating cash flow Capital expenditure Other investments Free cash flow 2016 $000 262,604 33,491 (20,006) (10,291) (80,685) 185,113 (28,858) (21,276) 134,979 2015 $000 206,408 30,252 (8,418) (7,330) (32,211) 188,701 (23,897) (4,530) 160,274 Change $000 56,196 3,239 (11,588) (2,961) (48,474) (3,588) (4,961) (16,746) (25,295) The business generated strong cash flow with cash realisation of operating cash flow approximately equating to net profit. An increase in EBIT of $56.2 million was offset by a $48.5 million increase in income taxes paid and a net $11.5 million investment in working capital and other to fund business growth. Income taxes paid increased by $48.5 million, reflecting improved profitability and $18.1 million of timing related payments following a change in the timing of Australian tax instalment payments. The effective tax rate has remained at approximately 26%. Further details are included in the 2016 Tax Contribution report which is available at the Investor Centre of the website, www.cochlear.com. Net debt Loans and borrowings: Current Non-current Total debt Cash and cash equivalents Net debt Total loan facilities Unused portion of debt facilities 2016 $000 3,978 189,260 193,238 (75,417) 117,821 350,000 155,000 2015 $000 168,159 44,552 212,711 (72,208) 140,503 350,000 135,000 Change $000 (164,181) 144,708 (19,473) (3,209) (22,682) Net debt reduced by $22.6 million to $117.9 million since 30 June 2015. During FY16, the $250 million debt facility was renewed for a further three years at lower interest rates. At 30 June 2016, there was $350.0 million in total loan facilities and the unused portion of the bank facility was $155.0 million. Dividends Interim ordinary dividend (dollars per share) Franking % Final ordinary dividend (dollars per share) Franking % Total ordinary dividends (dollars per share) Payout ratio % Franking % 2016 $1.10 100% $1.20 100% $2.30 70% 100% 2015 $0.90 35% $1.00 100% $1.90 74% 69% Change % 22% 20% 21% 26 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Strong free cash flow and the continued strength of the balance sheet have supported the payment of a final dividend of $1.20 per share, franked at 100%. Total fully franked dividends of $2.30 per share were declared for the year, an increase of 21% on dividends paid last year, representing a payout of 70% of net profit. The record date for determining dividend entitlements is 8 September 2016 and the final dividend will be paid on 29 September 2016. 2017 financial outlook For FY17, net profit is expected to be within a range of $210-225 million, an increase of around 10-20% on FY16. Cochlear expects positive momentum to continue, with investments made in product development and market growth initiatives expected to underpin growth for FY17. Key considerations for FY17:  expect continued strong uptake of the Nucleus 6 and Kanso sound processors over the next few years with the current penetration rate for the Nucleus 6 at around 25% of potential recipients;  Chinese Central Government tender units expected to be at similar levels to FY16 with delivery of units biased to the first half;  in Europe, Cochlear does not expect any immediate impact on the business from the UK’s decision to withdraw from the European Union. However, the Company remains alert to the potential for uncertainty to curtail economic growth and put pressure on health budgets; expect FY17 R&D expenditure to be broadly in line with that for FY16, representing a lower percentage of sales revenue; forecasting a weighted average AUD/USD FX rate of 75 cents for FY17 versus 73 cents in FY16; and the balance sheet position and free cash flow generation remain strong. The Company will continue to target a dividend payout ratio of around 70% of net profit.    Non-International Financial Reporting Standards (IFRS) financial measures Given the significance of 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:  Constant currency: restatement of IFRS financial measures in comparative years using FY16 FX rates. 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. Forward looking statements Cochlear advises that this document contains forward looking statements which may be subject to significant uncertainties outside of Cochlear’s control. No representation is made as to the accuracy or reliability of forward looking statements or the assumptions on which they are based. Actual future events may vary from these forward looking statements and it is cautioned that undue reliance not be placed on any forward looking statement. Business risks Cochlear has a sound and robust Risk Management Framework to identify, assess and appropriately manage risks. Details of Cochlear’s Risk Management Framework can be found in the Corporate Governance Statement 2016 which is available at the Investor Centre on the website (www.cochlear.com). Cochlear’s principal business risks are outlined below. These are significant risks that may materially 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. Risk Description and potential consequences Strategies used by Cochlear to mitigate the risk 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. In FY16, Cochlear invested around 12% of sales 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. 27 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Risk Description and potential consequences Strategies used by Cochlear to mitigate the risk 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 penalties or royalties to be able to continue to manufacture product, or injunctions preventing Cochlear selling products it had developed. Cochlear has a comprehensive patent portfolio across its technologies. Cochlear has a Legal department and utilises internal and external legal resources to deal with any litigation issues. 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. Cochlear monitors its systems and considers that it 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 Reimbursement Product liability Interruption to product supply 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. Regulatory bodies periodically perform audits at Cochlear’s manufacturing sites. If Cochlear or a third-party supplier fails to satisfy regulatory requirements or the regulations change and modifications are not made, this could result in the imposition of sanctions or Cochlear’s products being subject to recall and/or the loss of sales and reputational harm. Delays in achieving regulatory approval can impact Cochlear’s ability to sell its latest technology. 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 may also be subject to healthcare related taxes imposed by government agencies and this could negatively impact the ability of candidates to access Cochlear’s products. 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 relies on third-party suppliers 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. Cochlear manufactures its latest generation products across six sites globally. 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. Political, economic or social instability Cochlear sells in over 100 countries. Several of the emerging markets are heavily biased to tender sales, including the Central Government of China’s tenders. The future outcome of tender sales is uncertain. Regional political, economic or social instability could negatively impact sales and the receipt of payment for sales. Cochlear has a worldwide quality assurance system in place. Cochlear continues to work with reimbursement and government agencies throughout the world to emphasise the benefits and cost effectiveness of the intervention. Cochlear maintains product liability insurance and operates a worldwide quality assurance system related to the design, testing and manufacture of its products. Cochlear monitors its suppliers and identifies any available second-source supply. Inventories are managed and purchased in sufficient quantities for continued product supply in the short term. Where appropriate, lifetime buys, strategic raw materials purchases and supply chain interventions are made. Cochlear also regularly reviews its disaster recovery plans for its manufacturing sites. Cochlear assesses the countries it sells into and does not have a significant concentration of sales in countries impacted by political, economic or social instability. Cochlear utilises global scanning software to assess partners, distributors and suppliers against sanctions and police checklists on an ongoing basis. Cochlear reviews tenders carefully and participates at a level that makes commercial sense. 28 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Risk Description and potential consequences Strategies used by Cochlear to mitigate the risk FX 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 Australian dollar (AUD), US dollar (USD), Euro (EUR), Japanese yen (JPY), Sterling, 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. 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. Interest rates Cochlear is exposed to interest rate risks in Australia. Operations Operational risk is the risk of direct and indirect loss arising from a wide variety of causes associated with Cochlear’s processes, personnel (including executive transitions), technology and infrastructure and generally accepted standards of corporate behaviour. Operational risks arise from all of Cochlear’s operations. These risks could result in the loss of sales and reputational harm. 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 level of cover out to three years. Policies and procedures for credit management and administration of receivables are established and executed at a regional level. 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 potential restrictions on future trading, including suspending future shipments and administering dispatches on a prepayment basis. In addition, where appropriate, 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 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 2016, no hedging had been entered into. Standards for the management of operational risk are in place in the following areas:  requirements for appropriate segregation of duties, including the independent authorisation of transactions; requirements for the reconciliation and monitoring of transactions; 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; internal and external audit programs; development of contingency plans; succession planning for key management personnel; training and professional development; employee health and safety programs; and ethical and business standards.          29 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Consolidated results The consolidated results for the financial year are: Revenue Profit before income tax Net profit Basic earnings per share (cents) Diluted earnings per share (cents) 2016 $000 1,130,552 254,266 188,921 330.6 330.0 2015 $000 925,630 196,303 145,840 256.1 254.8 Dividends Dividends paid or declared by the Company to members since the end of the previous financial year are: Dollars per share Total amount $000 Franked/ unfranked Date of payment Interim 2016 ordinary Final 2015 ordinary Total amount Subsequent event Since the end of the financial year, the directors declared the following dividends: Final 2016 ordinary Total amount 1.10 1.00 2.10 1.20 1.20 62,925 100% Franked 1 April 2016 57,168 100% Franked 1 October 2015 120,093 68,646 100% Franked 29 September 2016 68,646 The financial effect of the 2016 final dividend will be recognised in the subsequent financial year as it was declared after 30 June 2016. Franked dividends paid or declared during the financial year were franked at the tax rate of 30% (2015: 30%). Environmental regulations Cochlear’s operations are subject to 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, 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 - audit and review of financial reports - other regulatory compliance services Total audit services Non-audit services - taxation compliance and other 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 2016 $ 2015 $ 1,583,831 58,734 1,642,565 1,051,398 1,051,398 1,559,738 72,094 1,631,832 988,156 988,156 30 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Remuneration Report Contents Section Title Description 1. 2. 3. 4. 5. Introduction Non-executive director remuneration Executive remuneration Employee share scheme and other share information Describes the scope of the Remuneration Report and the individuals whose remuneration details are disclosed. Outlines the link between performance and remuneration. Provides details regarding the fees paid to non-executive directors. Details the remuneration provided to executives. Outlines the principles applied to executive remuneration decisions and the framework used to deliver the various components of remuneration. Provides details regarding Cochlear’s employee equity plans including that information required by the Corporations Act 2001 and applicable accounting standards. Remuneration governance Describes the role of the Board and the People & Culture Committee, and the use of remuneration consultants when making remuneration decisions. 31 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 1. 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. Cochlear’s policies must also be flexible enough to enable the Company to attract, motivate and retain high performing executives in many locations in a dynamic environment. The Board’s philosophy and approach to the remuneration of directors and executives are outlined in the Remuneration Policy, along with the role of the Board and the People & Culture Committee, and the use of remuneration consultants when making remuneration decisions. The Remuneration Policy is available in the Investor Centre/Corporate Governance/Company Policies section of our website (www.cochlear.com). This report refers to several other policies also available in the same section of the website. During the year, the Board changed the name of the Human Resources Committee to the People & Culture Committee (P&CC) to better reflect the nature of the work of the P&CC, particularly in the context of the One Cochlear strategic initiative. Our Chief Executive Officer/President (CEO/P) retired in FY16, and the role transitioned from Chris Roberts to Chris Smith on 1 September 2015 as Chief Executive Officer & President (CEO&P). The Board believes Cochlear’s approach to Board and executive remuneration remains balanced, fair and equitable and rewards and motivates a successful and experienced executive team to deliver ongoing business growth, which meets the expectations of shareholders over the long term. 1.1 Key management personnel This Remuneration Report sets out, in accordance with the Corporations Act 2001 and accounting standard requirements, the remuneration arrangements in place for key management personnel (KMP) of Cochlear during FY16. KMP have authority and responsibility for planning, directing and controlling the activities of Cochlear and comprise the non-executive directors (NEDs), and executive KMP (being the senior executives named in this report, including the CEO&P who is an executive director). Details of the KMP during the year are set out in the table below: Title Non-executive directors Rick Holliday-Smith Chairman Chairman, Nomination Committee Member, Audit Committee, People & Culture Committee Yasmin Allen Glen Boreham, AM Edward Byrne, AC Alison Deans Andrew Denver Donal O'Dwyer Director Chairman, Audit Committee Member, People & Culture Committee, Nomination Committee, Technology and Innovation Committee Director Chairman, People & Culture Committee Member, Audit Committee, Nomination Committee, Technology and Innovation Committee Director Chairman, Medical Science Committee Member, Nomination Committee, Technology and Innovation Committee Director Member, Audit Committee, People & Culture Committee, Nomination Committee, Technology and Innovation Committee Director Chairman, Technology and Innovation Committee Member, Audit Committee, Medical Science Committee, Nomination Committee Director Member, Audit Committee, Medical Science Committee, Nomination Committee, Technology and Innovation Committee 32 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Title Executive director Chris Roberts Retired 31 August 2015 Chief Executive Officer/President (CEO/P) Member, Medical Science Committee Member, Technology and Innovation Committee Chris Smith Appointed 1 September 2015 Chief Executive Officer & President (CEO&P) Member, Medical Science Committee Member, Technology and Innovation Committee Other executive KMP Richard Brook President, European, Middle East and African Regions Dig Howitt Jan Janssen President, Asia Pacific Region Senior Vice President, Design and Development, Clinical and Regulatory Neville Mitchell Chief Financial Officer and Company Secretary Tony Manna Appointed 1 July 2015 President, Americas Region 1.2 Relationship between Cochlear performance and executive KMP remuneration 1.2.1 Cochlear financial performance (FY11 to FY16) Sales revenue ($million) Earnings before interest and tax (EBIT) ($million) Net profit after tax ($million) Basic earnings per share (EPS) (cents) FY11 732.2 242.7 180.1 318.2 FY121 704.6 76.5 56.8 100.0 EPS growth (3 years compound annual growth rate) 15.2% -24.6% Total dividend per share ($) Share price as at 30 June ($) 2.25 72.00 70.8% 2.45 65.84 24.1% FY13 715.0 178.9 132.6 233.0 -5.5% 2.52 61.71 -14.5% FY142 820.9 127.1 93.7 164.6 FY15 941.9 206.4 145.8 256.1 FY16 1,158.1 262.6 188.9 330.6 -19.7% 36.8% 12.4% 2.54 61.70 -6.6% 1.90 80.15 2.30 121.25 41.7% 127.2% Total shareholder return (TSR) (3 years) TSR percentile ranking3 1. 2. 3. 65th FY12 includes product recall expenses of $138.8 million before tax and $101.3 million after tax. FY14 includes the patent dispute provision of $22.5 million before tax and $15.8 million after tax. TSR ranking is shown over three financial years to 30 June. For long-term incentives performance is compared to TSR for ASX 100 companies. 32nd 28th 96th 38th 94th 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 20 to 30. 1.2.2 Cochlear one year performance and relationship to executive KMP remuneration Cochlear sales revenue grew 23% year on year. New product launches combined with investments in market growth initiatives drove this growth. EBIT in FY16 was 27% above that for FY15. 33 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 The short-term incentive (STI) payouts to executive KMP this year ranged from 97% to 112% of their target STI opportunity, reflecting the strong performance against targets and performance at expectations against personal objectives. Individual details are provided in table 3.2. The payout ratios on STI in FY16 reflect individual, business and Cochlear performance against targets in accordance with plan rules. The Board has worked to ensure the overall executive KMP remuneration recognises Company performance and enables the business to retain a talented leadership team and allows Cochlear to promote internal candidates. 1.2.3 Cochlear three year performance and relationship to executive KMP remuneration As explained in the Remuneration Policy (available on the website www.cochlear.com), Cochlear’s remuneration framework aims to incentivise executive KMP towards long-term sustainable growth of the business and the creation of shareholder value in the short, medium and long term. The focus towards the longer term is developed in two ways:  Equity STI, although dependent on sales revenue and EBIT performance and outcomes for the completed performance year (as  explained in section 3.6) is deferred for a further two years; and Long-term incentive (LTI), in the form of options and performance rights, is linked to compound annual growth in EPS and relative TSR performance (as explained in section 3.6). EPS growth (internal) and relative TSR (external) are generally accepted proxies for creation of shareholder value. The Board reviews the suitability of these performance criteria and settings on a regular basis to ensure they best serve shareholders’ interests. Earnings per share (EPS) Vesting of the EPS portion of Cochlear executives’ LTI over the last five years is displayed in the graphs below, overlaid with the compound annual growth rate (CAGR) of EPS for the corresponding performance period: Cochlear’s basic EPS in FY16 was 330.6 cents, which is a 12.4% compound annual growth rate (CAGR) over the three year vesting period. The vesting scale for our LTI plan generates 61.8% of the award at this growth level. This is the second time any part of the EPS portion has vested in the past five years. While this provides a strong alignment to shareholders’ interests to grow EPS, the Board considers that the alignment is less strong if a lack of vesting results in executives not actually owning the shares that they are striving for. Total shareholder return (TSR) Cochlear’s relative TSR performance over the relevant performance periods up to 30 June in respect of vested equity grants is displayed in the graphs below. This information was provided by an independent third party. TSR is a function of share price growth and dividends reinvested. 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 variability in other sectors. The ASX 100 is biased towards high performance as lower performing companies drop out of the index and are replaced by growing companies. Cochlear’s TSR for the three years ended 30 June 2016 was ranked at the 94th percentile in the ASX 100. As a result, 100% of the TSR portion of the LTI has vested this year. 34 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Vesting outcomes (performance shares/rights and options granted FY10 to FY14) Grant date Vesting date1 EPS 3 year CAGR2 % vested3 % forfeited3 % vested3 Relative 3 year TSR percentile ranking % forfeited3 Performance rights Market price as at 30 June ($)4 Options Exercise price ($) 17-Aug-09 Aug 2012 -24.6% 0.0% 100.0% 16-Aug-10 Aug 2013 -5.5% 0.0% 100.0% 15-Aug-11 Aug 2014 -19.7% 0.0% 100.0% 13-Aug-12 Aug 2015 36.8% 100.0% 0.0% 65th 28th 32nd 38th 79.3% 20.7% 65.84 0.0% 100.0% 0.0% 100.0% N/A N/A 0.0% 100.0% 80.15 60.04 69.80 68.56 62.78 Net market value as at 30 June ($)4 5.80 N/A N/A 17.37 15-Oct-135 94th 1. While the vesting period ends on 30 June of each year, participants are not able to exercise any awards until the Board approves the opening of the first trading window Aug 2016 100.0% 121.25 61.8% 12.4% 38.2% 62.12 59.13 0.0% under the Cochlear Trading Policy (typically immediately following the Cochlear full-year results announcement). Compound annual growth rate. All plan participants had the same vesting and forfeiture percentage outcome. 30 June of applicable vesting date. The performance hurdles for the LTI plans are considered demanding such that in the last four years, only 33% of allocations have vested. 2. 3. 4. 5. 1.2.4 Minimum shareholding guidelines Executive KMP are requested to retain vested equity until they hold and maintain a holding of Cochlear shares equivalent to their annual salary in the previous year. The Board considers the minimum shareholding guideline to be best practice to strengthen the alignment of executives’ interests to those of shareholders. New executives are likely to take some length of time to build such a holding if the LTI plan fails to vest as it has in recent times. With that in mind, the Board intends to review the performance hurdles for future LTI equity grants. The table in section 4.4 details the current holdings of executive KMP. 1.3 Fee changes Board fees must recognise the effort required to fulfil the responsibilities of the non-executive directors. Reflecting the increasing governance requirements, the work of the Board and its various committees has increased, and the Board considered it appropriate to revise committee fees for FY16. This is detailed in section 2.1 and base fees represent 74.0% of the $2.5 million aggregate amount approved by shareholders at the October 2015 AGM. The Board approved a 4.6% increase in total Board remuneration effective 1 July 2016. This increase will apply to base fees which have not changed since 2011. 2. Non-executive director remuneration 2.1 NED fees FY16 Board fees Committee fees Board Chairman fee1 Board NED base fee $438,000 $146,000 Audit People & Culture Medical Science Nomination Technology and Innovation 1. Committee fees are not paid to the Chairman of the Board. 2.2 Post-employment benefits and other policy items FY16 Committee Chair $50,000 $30,000 $30,000 No fee $40,000 FY15 Committee member $25,000 $15,000 $15,000 No fee $20,000 Committee Chair $40,000 $30,000 $20,000 No fee $20,000 Committee member $20,000 $10,000 $10,000 No fee $10,000 Superannuation Retirement scheme Where required, superannuation contributions have been made in accordance with Australian superannuation legislation, at a rate of 9.5% of the base fee up to the Australian Government’s prescribed maximum contributions limit. Contributions are not included in the base fee. Prior to 2003, Cochlear operated a directors’ retirement scheme which provided retirement benefits of three times their average annual remuneration over the previous three years. In 2006, the Board resolved to discontinue the ongoing accrual of benefits subject to a transition period to 2011. The benefits accrued are indexed by reference to the bank bill rate. At 30 June 2016, 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 2016 was $442,034. Equity instruments NEDs do not receive any performance related remuneration, options or performance shares/rights. Other fees/benefits NEDs receive reimbursement for costs directly related to Cochlear business. Minimum shareholding guidelines NEDs are requested to hold shares equivalent to the fees received in the previous 12 months. The Share Ownership Policy is available on the website. 35 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 2.3 NED total remuneration Amounts $ Rick Holliday-Smith (Chairman) Yasmin Allen Paul Bell2 Glen Boreham3 Edward Byrne Alison Deans3 Andrew Denver Donal O'Dwyer Total4 Short-term benefits Post-employment benefits Fees 438,000 438,000 230,731 196,000 54,154 220,654 85,969 195,846 176,000 192,154 76,200 225,769 196,000 205,846 186,000 Accrued interest1 - Superannuation benefits 19,308 Total 457,308 - - - - - - 9,586 10,729 - - - - - - 18,783 456,783 19,308 250,039 17,986 213,986 5,145 59,299 19,308 239,962 8,167 94,136 18,248 223,680 16,720 203,449 18,255 210,409 7,239 83,439 19,308 245,077 17,986 213,986 18,686 224,532 17,547 203,547 1,709,000 9,586 132,421 1,851,007 Year FY16 FY15 FY16 FY15 FY15 FY16 FY15 FY16 FY15 FY16 FY15 FY16 FY15 FY16 FY15 FY16 1. 2. 3. 4. 1,408,323 Amounts accrued for interest during the financial year relating to the directors’ retirement scheme. Retired 17 October 2014. Appointed 1 January 2015. The year-on-year changes in Board fees reflect the appointment of two additional directors half way through FY15 and loss of one, changes in Board committee membership and increases to committee fees. There have been no increases in Board NED base fees for four years. 109,573 1,528,625 10,729 FY15 The table below indicates Cochlear Limited shareholdings: Held at 1 July 2015 Purchases Sales Cochlear Limited ordinary shares held as at 30 June 2016 Rick Holliday-Smith Yasmin Allen Glen Boreham Edward Byrne Alison Deans Andrew Denver Donal O’Dwyer 9,250 3,500 - 3,250 2,000 4,000 6,000 750 - 2,800 - - - - Total intrinsic value of Cochlear Limited securities as at year end ($)1 968,300 338,905 271,124 314,698 193,660 387,320 580,980 10,000 3,500 2,800 3,250 2,000 4,000 6,000 - - - - - - - - Total 1. In line with the Share Ownership Policy (available on our website), the intrinsic value of Cochlear Limited ordinary shares is calculated using the average daily share price over the previous 12 months ($96.83), as at closing on the ASX up to 30 June 2016, times the number of shares. 28,000 3,550 31,550 3,054,987 All NEDs are compliant with the Share Ownership Policy which allows an additional three year window to increase holdings where increased directors’ committee responsibilities have resulted in increased fees. 36 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 3. Executive remuneration 3.1 Executive remuneration table – Audited statutory disclosure (accounting cost to Cochlear) Year Fixed remuneration Variable remuneration Short-term Other employee costs Total Short-term incentive (STI)2 Long-term incentive (LTI)6, 7 Total Salary Non- monetary benefits1 Superann- uation benefits Long service leave Cash STI and special incentive3 Deferred STI4,5 Value of options FY16 609,526 FY15 1,431,029 - - 9,654 - 619,180 204,759 32,056 80,829 18,783 32,349 1,482,161 1,338,462 518,549 1,055,244 Value of performance shares/ rights - - 317,644 - 936,824 33.9% 2,912,255 1,548,418 5,942,834 49.0% End of service Total Proportion of total remuneration Performance related % FY16 1,341,409 285,865 - FY15 786,650 26,797 16,290 FY16 674,740 105,353 126,953 FY15 611,858 91,970 103,860 - - - - 1,627,274 1,200,924 192,418 481,906 252,384 2,127,632 829,737 464,806 72,305 186,605 81,625 805,341 907,046 374,074 91,517 150,138 188,994 804,723 807,688 342,690 55,609 141,217 58,134 597,650 FY16 528,951 FY15 387,709 FY16 552,032 FY15 515,161 - - - - 19,308 13,563 561,822 371,964 54,991 249,140 61,731 737,826 14,088 - 401,797 212,412 21,145 51,190 104,771 389,518 19,308 (2,274) 569,066 348,992 79,795 140,048 162,097 730,932 18,783 6,416 540,360 311,250 46,396 115,591 85,174 558,411 FY16 585,992 26,073 22,451 - 634,516 335,386 32,039 56,921 18,284 442,630 FY16 583,293 FY15 543,609 FY15 143,181 - - - 191,351 27,680 802,324 435,969 98,370 147,082 223,846 905,267 157,325 17,325 718,259 381,709 56,973 78,902 168,892 686,476 5,743 9,852 158,776 23,397 (15,737) (10,692) 145,943 142,911 Total FY16 4,875,943 417,291 389,025 38,969 5,721,228 3,272,068 581,186 1,306,064 907,336 6,066,654 - - - - - - - - - - - - - 3,754,906 56.7% 1,635,078 49.3% 1,711,769 47.0% 1,405,338 42.5% 1,299,648 56.8% 791,315 49.2% 1,299,998 56.2% 1,098,771 50.8% 1,077,146 41.1% 1,707,591 53.0% 1,404,735 48.9% 301,687 47.4% 11,787,882 51.5% Amounts $ Name Chris Roberts8, 9 Chris Smith9, 10 Richard Brook Dig Howitt11 Jan Janssen Tony Manna12 Neville Mitchell13 Mark Salmon14 FY15 4,419,197 118,767 334,872 65,942 4,938,778 3,074,726 755,240 1,618,057 644,539 6,092,562 1,548,418 12,579,758 48.4% 1. Benefits include housing allowances for expatriate KMP, car allowances and health insurance which are market based payments. 2. STI and LTI are awarded annually, with cash incentives paid half yearly. The service and performance criteria are set out in this report. 3. During the year the Board approved a Special Incentive program specific to the One Cochlear change initiative. 4. Deferred STI is granted in performance rights and deferred for a further two years. The cost of the plan is expensed across three years. The FY16 amount represents the portion of the FY14, FY15 and FY16 deferred STI expensed in FY16. The FY15 amount represents the portion of the FY14 and FY15 deferred STI expensed in FY15. The Cochlear Executive Incentive Plan (CEIP) was introduced in FY14, so there was no FY13 grant to be included in the FY15 expense. 5. FY15 deferred STI for Chris Roberts includes an expense of $298,234 that would normally have been amortised over future years for awards that remain subject to vesting timeframes. FY15 also includes a credit of $15,737 for Mark Salmon, reversing prior years’ expenses on plans that have been forfeited. 6. 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 non-market 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 of 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. 7. FY15 includes an expense of $391,834 for Chris Roberts and $34,179 for Mark Salmon that would normally have been amortised over future years for awards that remain subject to vesting hurdles and timeframes and may not be paid out. Also includes a credit of $46,401 for Mark Salmon, reversing prior years’ expenses on plans that have been forfeited. 8. FY15 included an accrual of contractual end of service payments of approximately one year of salary for Chris Roberts, payable at the end of his employment, and statutory entitlements to bring his total reward for FY15 to $5,942,834. In FY16, Chris Roberts did not accrue any more end of service amounts. 9. Chris Roberts was an executive director and retired on 31 August 2015. Chris Smith is an executive director in FY16. 10. Chris Smith’s remuneration increase reflects an increase in base salary due to his promotion to the CEO&P role, allowances due to his relocation to Sydney, overachievement on STI and currency variations. 11. Dig Howitt became a KMP on 29 September 2014. Values in this table relate only to the period he was a KMP. 12. Tony Manna became a KMP on 1 July 2015. Values in this table relate only to the period he was a KMP. 13. Neville Mitchell remains on a transitional defined contribution superannuation plan based on a fixed percentage of base and STI. 14. Mark Salmon retired on 26 September 2014. 37 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 3.2 Executive remuneration table - Unaudited The table below aims to show actual remuneration received during the year including equity vesting from prior years, and separately to show actual remuneration granted during the year including equity deferred to future years: Amounts $ Year Fixed remuneration and cash incentives received Proportion of STI Past at risk remuneration received during year Actual remuneration received Name Fixed remuneration1 Special incentive2 STI Cash Incentives3 Achieved % Forfeited % Value of vested deferred STI Intrinsic value of vested performance shares (LTI)4 Future at risk remuneration received Deferred STI5 LTI (equity) granted during year6 Chris Roberts7 Chris Smith FY16 FY15 FY16 FY15 619,180 1,449,812 1,627,274 829,737 - - - - 204,759 108.1% 1,338,462 120.0% 1,200,924 107.7% 464,806 109.4% - - - - Richard Brook FY16 907,046 15,000 359,074 96.8% 3.2% Dig Howitt8 Jan Janssen Tony Manna9 FY15 FY16 FY15 FY16 FY15 FY16 807,688 - 342,690 101.8% 548,259 33,500 338,464 112.0% - - 401,797 - 212,412 97.9% 2.1% 571,340 15,000 333,992 106.1% 533,944 - 311,250 106.6% 634,516 15,000 320,386 108.7% Neville Mitchell FY16 774,644 22,000 413,969 107.3% Mark Salmon10 Total FY15 FY15 FY16 FY15 700,934 148,924 - - 381,709 106.8% 23,397 100.0% 5,682,259 100,500 3,171,568 4,872,836 - 3,074,726 - - - - - - - - - - Intrinsic value of vested options4 2,583,213 - - - - - - - - - - - - - - - - - - - 3,407,152 - - 2,788,274 401,538 1,300,967 490,489 66,980 3,385,667 360,340 1,306,785 - 469,399 - - - - - - 1,294,543 139,442 329,947 1,750,519 107,722 328,759 1,150,378 102,807 249,928 260,427 1,180,650 101,539 253,191 - 614,209 63,724 234,804 302,913 105,863 1,329,108 100,197 254,020 - 287,046 - - 845,194 93,375 238,188 1,256,948 96,116 193,307 124,962 262,089 1,597,664 124,191 306,439 - - - - 1,082,643 114,513 281,347 172,321 - - 4,258,022 695,359 13,907,708 890,105 2,642,501 - - 7,947,562 915,399 2,635,181 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. During the year the Board approved a Special Incentive program specific to the One Cochlear change initiative. 3. Represents STI payments earned during the financial year. For example, FY16 data includes first half STI payments received in February, and second half STI payments which are accrued at year end, and received in August 2016, after the reporting year end. 4. Reflects the intrinsic value of vested employee share scheme benefits at the date of exercise. In the case of options, this represents the market price on the date of exercise (or market price on date of vesting in the case of unvested options) less the exercise price multiplied by the number of options. For performance shares, this represents the share price on the date of exercise. 5. Deferred STI in FY16 reflects STI achievement of between 97% and 112% for performance in FY16. 6. Represents the value of equity grants (options and/or performance rights) calculated at the date of grant using the percentage of salary reflected in the remuneration mix. These grants were awarded during the year, are unvested and will be subject to achievement of future performance hurdles. 7. For FY15, Chris Roberts also received an end of service payment of $1,548,418. 8. Dig Howitt became a KMP on 29 September 2014. Values included in this table relate only to the period he was a KMP. Both the deferred STI value (scheduled for conversion to performance rights in August 2017) and the LTI value (granted in October 2014) are included in full as they were granted after he became a KMP. 9. Tony Manna became a KMP on 1 July 2015. 10. Mark Salmon retired on 26 September 2014. The table is not mandatory, and there is no prescribed approach to providing it. Our approach in FY16 has changed from FY15 as follows:  Cochlear’s STI is paid half yearly. In the FY15 report, the STI shown comprised the payments paid during the year i.e. August 2014 payment relating to second half performance FY14, and February 2015 payment relating to first half performance FY15. We believe shareholders are interested in the STI earned during the year. The FY16 approach adds the two half year performances for FY16. We have restated the FY15 numbers to include the February 2015 and the August 2015 payments; and  in the FY15 report, the value disclosed for the LTI granted in the year and deferred to future years was calculated in accordance with IFRS-2. For FY16, we have shown the intended value of the grant under the remuneration framework (i.e. a percentage of base or fixed remuneration). We believe this simpler approach meets the needs of shareholders. We have restated the FY15 numbers to reflect this new approach. 38 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 3.3 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. Executive KMP remuneration objectives are delivered through three categories of remuneration, as illustrated below: Executive KMP remuneration objectives Attract, motivate and retain executive talent across diverse geographies Differentiate reward to drive performance including values and behaviours components An appropriate balance of fixed and at risk components focused on long-term strategy and shorter-term milestones Alignment to shareholder interests and 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 relative to market, 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 strategic 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 a further 2 years Equity in options and 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 quantum will take account of relevant market data considering the individual’s expertise and performance in the role Performance incentive is directed to achieving Board approved targets, reflective of market circumstances LTI is intended to reward executive KMP for sustainable long-term growth aligned to shareholders’ interests Total target remuneration TTR is positioned to achieve the remuneration objectives outlined above. Outperformance generates higher reward. The remuneration structure is designed to ensure top quartile executive KMP remuneration and is only achieved if Cochlear outperforms 39 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 3.4 Remuneration composition mix and timing of receipt 3.4.1 Current remuneration mix Cochlear aims 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: 3.4.2 Remuneration - Timing of receipt of remuneration 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 FY16 TFR STI cash opportunity STI equity deferral (2 years) LTI TFR FY17 STI cash opportunity STI equity deferral (2 years) LTI TFR FY18 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 rolling 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. 3.5 Total fixed remuneration explained Total fixed remuneration includes all remuneration and benefits paid to executive KMP calculated on a total employment cost basis. In addition to base salary, executives may receive benefits in line with local practice, such as health insurance, car allowances and relocation allowances. Retirement benefits are generally paid in line with local legislation and practice. Executive KMP remuneration is tested regularly for market competitiveness by reference to appropriate independent and externally sourced comparable benchmark information, taking into account an executive’s responsibilities, performance, qualifications, experience and geographic location. The review examines fixed and variable components separately and in totality. Any adjustments to executive KMP remuneration are approved by the Board, based on P&CC and CEO&P recommendations. 40 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 3.6 Variable (at risk) remuneration explained As set out in section 3.4, variable remuneration forms a significant portion of executive KMP remuneration opportunity. Cochlear’s performance hurdles are at the higher end of the “difficult to achieve” spectrum compared to market practice within ASX 100 companies. 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: 3.6.1 Short-term incentives (STI) Purpose The STI arrangements at Cochlear are designed to reward executives for achievement against annual performance targets set by the Board at the beginning of the performance period. The STI program is reviewed annually by the P&CC and approved by the Board. All STI awards to executive KMP are approved by the P&CC and Board. The deferred STI is designed to encourage a longer-term focus, and ensure reward is linked to longer-term outcomes from shorter- term goals. Performance targets For FY16, 80% of STI was based on financial targets set by the Board and having regard to prior year performance, global market conditions, the competitive environment, future prospects and the Board approved budgets. The specific targets are not detailed in this report due to their commercial sensitivity. For FY16, two financial targets (sales revenue and EBIT) had equal weighting. The weighting between Cochlear group and regional financial goals depends on the responsibilities and scope of influence of the individual executive KMP. In FY16, individual performance goals accounted for a 20% weighting for executive KMP based on a range of strategic objectives determined each year. For FY17, the weighting will change to 60% financial and 40% One Cochlear goals. One Cochlear goals are specific to the individual and aligned to Cochlear’s strategic priorities. Mandatory deferral of STI A mandatory deferral of a portion of STI (in the form of performance rights) is intended to reinforce alignment with shareholder interests. The deferred STI target is a percentage of base pay. Based on performance as measured under the (cash) STI plan, grants are calculated at the end of each year and then held for two years until vesting. This achieves additional retention and alignment of executives with longer-term shareholder interests. The number of performance rights is determined based on Black-Scholes-Merton valuations (without discounting for performance) using the Cochlear five day volume weighted average share price following the announcement of full-year results in August each year. Once the performance rights are awarded, there are no further performance measures other than continued tenure for the vesting period (two years). 3.6.2 Long-term incentives (LTI) The LTI provides an annual opportunity for executive KMP and other selected senior executives (based on their ability to influence and execute strategy) to receive an equity award deferred for three years. This 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 target 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 FY13 was provided under the Cochlear Executive Long Term Incentive Plan (CELTIP). Previous reports have detailed that plan. The Cochlear Executive Incentive Plan (CEIP) was introduced in July 2013. See section 4.1 for further details. Under the CEIP, selected senior executives are offered options (being an option at a pre-set exercise price to acquire a fully paid ordinary share of Cochlear Limited) or performance rights (being a nil exercise price right to a fully paid ordinary share of Cochlear Limited). A minimum 30% of the LTI value must be taken as options. The share price at vesting must be greater than share price at grant in order for any reward to be delivered under the option program. Time of grant All equity grants will be made after the AGM each year but based on values determined in the preceding August. Time restrictions Equity grants 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 and performance rights lapse. 41 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 Performance hurdles and vesting schedule Equity grants to executive KMP are in two equal tranches assigned 50% to growth in EPS and 50% subject to relative TSR. The performance conditions applying to the latest grant (FY16) were as follows: Compound annual growth rate in EPS (3 years) Ranking of TSR against S&P/ASX 100 (3 years) Performance < 10% 10% to 20% > 20% % of equity to vest 0% 50% to 100% pro-rata 100% Performance < 50th percentile 50th to 75th percentile > 75th percentile % of equity to vest 0% 40% to 100% pro-rata 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. Under the CEIP, after the three year vesting schedule, any vested options expire after seven months if they have not been exercised. 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 the LTI plan. LTI allocation The size of individual LTI grants for executive KMP is determined in accordance with the Board approved remuneration strategy mix. See section 3.4. The target LTI dollar value for each executive is converted to options and performance rights according to LTI allocation values 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:  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. 3.7 Other remuneration elements and disclosures relevant to executive KMP 3.7.1 Minimum shareholding guidelines In March 2007, the Board approved minimum shareholding guidelines for NEDs and executive KMP. All NEDs are requested to accumulate a minimum shareholding in Cochlear shares equivalent in value to the prior year’s fees. NEDs have three years in which to build this requirement, and an additional three years if an increase is required resulting from increased committee responsibilities. All executive KMP are requested to accumulate a minimum shareholding in Cochlear shares or vested options equivalent to the prior year’s total fixed remuneration. They are not required to purchase shares for this purpose, but are restricted from selling shares derived from vesting equity plan awards until they accumulate their minimum shareholding. The value of shareholdings for the purpose of these guidelines is based on the 365 day average Cochlear Limited closing share price for the prior year. All NEDs and executive KMP are compliant with the share ownership guidelines. The guidelines are available on the Cochlear website. 3.7.2 Clawback Cochlear implemented a Clawback Policy to take effect from 1 July 2014 to meet good governance practice. The policy is available on the Cochlear website. There have been no circumstances to date where the policy was invoked. 3.7.3 Hedging and margin lending prohibition In line with good corporate governance, Cochlear 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. Under the Cochlear Trading Policy and in accordance with the Corporations Act 2001, equity granted under Cochlear equity incentive schemes must remain at risk until vested, or until exercised if options. 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 options or performance rights allocated. Cochlear also prohibits 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. 42 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 3.7.4 Cessation of employment provisions On 26 May 2015, the Company announced that Chris Roberts would be stepping down as CEO/P on 31 August 2015. In keeping with the terms of Chris Roberts’ executive service contract entered into on 1 February 2004, Chris Roberts received an end of service payment of $1,410,801, plus $137,617 in statutory entitlements. In line with IFRS, these were accrued at 30 June 2015 and were paid on 31 August 2015. The Board used its discretion to permit Chris Roberts to retain 123,023 options from the 2013 CEIP and 2,781 performance rights from the 2013 CEIP (deferred STI) subject to existing performance hurdles and timeframes. Awards from the 2014 CEIP LTI grant were forfeited (see the table in section 4.2.3 for more details). 3.7.5 Service contracts Cochlear does not enter into service contracts for executive KMP. The terms for executive KMP meet local employment law requirements. Key provisions are similar but do, on occasion, vary to suit different needs. The following sets out details of the employment agreements relating to executive KMP: Length of contract Permanent contracts until notice is given by either party. Notice periods Executive KMP are required to give between 60 days’ and six months’ written notice. Cochlear is required to give between 60 days’ and 12 months’ written notice (exact period specified in each contract). Resignation On resignation, unless the Board determines otherwise, all unvested STI or LTI benefits are forfeited. Redundancy If Cochlear terminates employment for reasons of redundancy, under Cochlear policy a severance payment comprises up to 12 months’ fixed pay. STI and LTI benefits may be allowed to remain subject to performance criteria and vesting date, on a pro- rata basis, 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, in full or on a pro-rata basis. Termination for serious misconduct Cochlear may immediately terminate employment at any time in the case of serious misconduct, and executive KMP will only be entitled to payment of fixed pay 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 equity instruments provided to the employee on vesting of STI or LTI awards that are held in trust, or subject to a holding lock, will be forfeited. At the Board’s discretion, Cochlear may seek reimbursement of amounts previously paid (see section 3.7.2 (Clawback)). 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, Middle East and African Regions will receive:  a maximum of CHF 30,000 for repatriation costs in the case of termination or resignation. Post-employment restraints All executive KMP are subject to post-employment restraints for up to 12 months. 43 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 4. 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 in relation to ESS instruments that Cochlear has issued; and 4. disclosures required in relation to Cochlear Limited shares and other ESS instruments held by executive KMP. 4.1 Employee share schemes operated by Cochlear Plan details Type of instruments Details Purpose Issue of ordinary shares annually to eligible employees. Cochlear Employee Share Plan (CESP) Ordinary shares held under holding lock Date established: 1999 APAC Employee Equity Plan (AEEP) Service rights held under holding lock Issue of service rights annually to eligible employees within the Asia Pacific region. Date established: 2016 Cochlear Executive Incentive Plan (CEIP) Date established: 2013 Performance rights and options 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. 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 of shares annually per eligible employee. Under the September 2015 (FY16) grant, 1,343 employees in Australia and Belgium each received an award of 12 shares. Executive KMP are not eligible for this program. The AEEP replaces the Cash Incentive Plan that was previously in place for selected Asian countries and aligns with the CESP via provision of up to $1,000 of service rights annually per eligible employee. Upon vesting, each service right converts to one share. Under the FY16 grant, 112 employees each received an award of 13 service rights. Executive KMP are not eligible for this program. The purpose of the CEIP is to encourage employees and executives to hold Cochlear shares, and to align their interests to shareholders’ interests. Under the LTI, vesting of options or performance rights occurs only if Cochlear achieves challenging and market competitive EPS growth and relative TSR hurdles. The first grant of options and performance rights under the CEIP was made on 15 October 2013. Also refer to section 3.6.2. Under the deferred STI, grants are based on performance in the prior year, and provide more certainty of building an equity holding as no further performance hurdles apply other than tenure. 44 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 4.2 Employee share scheme grants to executive KMP 4.2.1 Analysis of share based payments granted as remuneration The vesting profile of the options and performance shares/rights granted as remuneration to each executive KMP is set out below: Name Reward vehicle Grant date Vesting date Number granted Options Number vested Number forfeited/ lapsed Performance shares/rights1 Number granted Number vested Number forfeited/ lapsed Chris Roberts FY13 CELTIP 13-Aug-12 17-Aug-15 231,161 115,580 115,581 FY14 CEIP LTI 15-Oct-13 15-Aug-16 123,023 FY14 CEIP deferred STI 12-Aug-14 12-Aug-16 - FY15 CEIP LTI 14-Oct-14 12-Aug-17 60,771 FY15 CEIP deferred STI 18-Aug-15 18-Aug-17 FY16 CEIP LTI 2-Nov-15 17-Aug-18 - - - - - - - Total 414,955 115,580 Chris Smith FY13 CELTIP 13-Aug-12 17-Aug-15 FY14 CEIP LTI 15-Oct-13 15-Aug-16 FY14 CEIP deferred STI 12-Aug-14 12-Aug-16 45,063 14,955 - FY15 CEIP LTI 14-Oct-14 12-Aug-17 15,412 FY15 CEIP deferred STI 18-Aug-15 18-Aug-17 FY16 CEIP LTI 2-Nov-15 17-Aug-18 Total Richard Brook FY13 CELTIP 13-Aug-12 17-Aug-15 FY14 CEIP LTI 15-Oct-13 15-Aug-16 FY14 CEIP deferred STI 12-Aug-14 12-Aug-16 FY15 CEIP LTI 14-Oct-14 12-Aug-17 FY15 CEIP deferred STI 18-Aug-15 18-Aug-17 FY16 CEIP LTI 2-Nov-15 17-Aug-18 Total Dig Howitt FY13 CELTIP 13-Aug-12 17-Aug-15 - 69,047 144,477 41,448 7,249 - 7,256 - 12,601 68,554 - FY14 CEIP LTI 15-Oct-13 15-Aug-16 21,900 FY14 CEIP deferred STI 12-Aug-14 12-Aug-16 - FY15 CEIP LTI 14-Oct-14 12-Aug-17 10,970 FY15 CEIP deferred STI 18-Aug-15 18-Aug-17 FY16 CEIP LTI 2-Nov-15 17-Aug-18 Total Jan Janssen FY13 CELTIP 13-Aug-12 17-Aug-15 FY14 CEIP LTI 15-Oct-13 15-Aug-16 FY14 CEIP deferred STI 12-Aug-14 12-Aug-16 - 18,682 51,552 26,491 6,664 - FY15 CEIP LTI 14-Oct-14 12-Aug-17 11,127 FY15 CEIP deferred STI 18-Aug-15 18-Aug-17 FY16 CEIP LTI 2-Nov-15 17-Aug-18 Total Tony Manna FY13 CELTIP 13-Aug-12 17-Aug-15 FY14 CEIP LTI 15-Oct-13 15-Aug-16 FY14 CEIP deferred STI 12-Aug-14 12-Aug-16 FY15 CEIP LTI 14-Oct-14 12-Aug-17 FY15 CEIP deferred STI 18-Aug-15 18-Aug-17 FY16 CEIP LTI 2-Nov-15 17-Aug-18 Total Neville Mitchell FY13 CELTIP 13-Aug-12 17-Aug-15 FY14 CEIP LTI 15-Oct-13 15-Aug-16 FY14 CEIP deferred STI 12-Aug-14 12-Aug-16 FY15 CEIP LTI 14-Oct-14 12-Aug-17 FY15 CEIP deferred STI 18-Aug-15 18-Aug-17 FY16 CEIP LTI 2-Nov-15 17-Aug-18 - 9,736 54,018 18,124 - - - - 10,216 28,340 10,928 13,723 - 8,168 - 7,159 - - 60,771 - - 176,352 22,532 - - - - - 22,531 - - - - - 22,531 20,724 22,532 20,724 - - - - - - - - - - - 3,617 993 3,293 1,448 2,402 - - 2,781 11,821 5,063 - 19,665 1,577 3,198 1,199 2,998 2,027 5,641 - - - - - - - 788 - - - - - - - - 11,821 - - 11,821 789 - - - - - 16,640 788 789 - - - - - - - - - - - - - - 20,724 20,724 11,753 - - - - - - - - - - - - - - 13,245 13,246 - - - - - - - - - - 13,245 9,062 13,246 9,062 - - - - - - - - - - 9,062 5,464 9,062 5,464 - - - - - - - - - - 6,095 3,047 3,048 - 714 2,133 1,066 - 10,008 2,473 3,325 725 2,164 1,177 1,856 - - - - - - - - - - 3,047 1,236 3,048 1,237 - - - - - - - - - - 11,720 1,236 1,237 - - 1,359 - 1,542 834 3,735 6,120 2,934 893 3,707 1,444 3,184 - - - - - - - - - - - - - - 3,060 3,060 - - - - - - - - - - 1. 39,978 For grants made under the CELTIP for 2012, participants were granted either options or performance shares, so all holdings referred to under the “Performance shares/rights” columns granted for 2012 represent performance shares. Under the CEIP, participants were granted either options or performance rights, so all holdings referred to under “Performance shares/rights” columns granted from 2013 onwards represent performance rights. 18,282 3,060 5,464 5,464 3,060 Total 45 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 The options granted in FY16 have an exercise price of $82.89 and an expiration date of 16 March 2019. Fair values of FY16 option and performance rights granted under the LTI plan are as follows: Fair value (IFRS-2) EPS based TSR based Options $14.70 $12.41 Performance rights $77.11 $54.43 4.2.2 Exercise of options and performance shares/rights granted as remuneration During FY16, 182,044 options were exercised by executive KMP. The FY13 CEIP grant met the EPS hurdle so there was a 50% vesting from this grant. There are no amounts unpaid on the shares issued as a result of the exercise of the options in prior years. 4.2.3 Analysis of movement in options and shares The tables below detail movements in number and value during FY16 of:   held by executive KMP. options over ordinary shares of Cochlear Limited acquired under the CELTIP and CEIP LTI; and performance shares/rights acquired under the CELTIP, CEIP LTI and CEIP deferred STI, Options Opening Granted in year Exercised in year Chris Roberts3 Chris Smith Richard Brook Dig Howitt Jan Janssen Tony Manna Neville Mitchell Total Performance shares/rights Number Number Value ($)1 Number 414,955 75,430 55,953 32,870 44,282 18,124 32,819 - 69,047 12,601 18,682 9,736 10,216 7,159 - 115,580 935,771 170,777 253,191 131,949 138,454 97,024 22,531 20,724 - 13,245 4,500 5,464 Intrinsic value ($)2 2,583,213 490,489 469,399 - 302,913 185,085 124,962 Forfeited/ lapsed in year Number 176,352 22,532 20,724 - 13,246 9,062 5,464 Closing Number N/A 99,414 27,106 51,552 27,527 14,778 29,050 674,433 127,441 1,727,166 182,044 4,156,061 247,380 249,427 Opening Granted in year Exercised in year Number LTI number LTI value ($)1 Deferred STI number Deferred STI value ($)4 Number Intrinsic value ($)5 Forfeited/ lapsed in year Number Closing Number Chris Roberts3, 6 14,602 Chris Smith Richard Brook Dig Howitt Jan Janssen Tony Manna 8,972 7,903 8,942 8,687 1,359 - 5,641 2,402 - - 371,014 157,982 - 1,856 122,071 834 54,853 Neville Mitchell 13,654 3,184 209,415 5,063 2,027 1,448 1,066 1,177 1,542 1,444 401,496 160,741 114,826 84,534 93,336 122,281 114,509 - 788 - 3,047 1,236 - - 11,821 66,980 - 260,427 105,863 - 789 - 3,048 1,237 - N/A 15,063 11,753 3,913 9,247 3,735 3,060 262,089 3,060 12,162 13,767 Total 1. 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 discounted for vesting probabilities of performance criteria. The total value of the options and performance rights granted is included in the table above. This amount is allocated to remuneration over the vesting period (i.e. in each of FY16 to FY18). 1,091,723 695,359 915,335 13,917 55,873 64,119 19,955 8,131 2. The intrinsic value of exercised options is calculated as the closing market price of Cochlear shares on the ASX on the date of exercise less the applicable exercise price times the number of options. 3. For Chris Roberts closing balances at 30 June 2016 have not been disclosed as he retired on 31 August 2015. 4. Deferred STI value represents performance rights under the CEIP deferred STI plan. 5. The intrinsic 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. 6. The “Granted in year” deferred STI performance rights were forfeited at the discretion of the Board at the end of Chris Roberts’ service on 31 August 2015. 46 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 4.3 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 Exercise price per share ($) Exercise period Issued Exercised Forfeited/lapsed At report date Current net value of outstanding options as at 30 June 2016 ($)1 13-Aug-12 15-Oct-132 14-Oct-142 2-Nov-152 759,828 328,885 416,948 224,314 138,963 162,451 - - - 10,239 60,771 12,460 13,995 214,075 78,192 149,991 Total 328,885 1. Share price as at 30 June 2016 was $121.25. 2. Lapsed options from unvested grants relate to plan members who have departed Cochlear. 1,285,556 500,418 456,253 62.78 Aug-15 to 30-Jun-17 818,288 59.13 Aug-16 to 10-Mar-17 13,298,339 68.56 Aug-17 to 9-Mar-18 82.89 Aug-18 to 16-Mar-19 4,119,936 5,753,655 23,990,218 The total current net value of the options is equivalent to 197,857 shares. In addition, there are 140,058 unvested performance rights and 56,959 shares held under holding lock. The total potential dilution under employee equity plans is equivalent to 394,874 shares or 0.7% of issued capital. 4.4 KMP equity interests - Audited In accordance with the Corporations Act 2001 (section 205G(1)), Cochlear is required to notify the interests (shares and rights to shares) of directors to the ASX. In the interests of transparency and completeness of disclosure, this information is provided for each NED in section 2.3 (as required under the Corporations Act 2001) and all executive KMP as well. Please refer sections 3.7.1 and 3.7.3 (Minimum shareholding guidelines and Hedging and margin lending prohibition). The table below indicates Cochlear Limited shareholding including any vested but unexercised options and performance shares: Executive KMP Held at 1 July 2015 Purchases Received on exercise of options and perform- ance shares Sales Cochlear Limited ordinary shares held as at 30 June 2016 Vested options over Cochlear Limited ordinary shares1 Policy value of Cochlear Limited securities as at year end ($)2 Executive director Chris Smith Other executive KMP Richard Brook Dig Howitt Jan Janssen Tony Manna Neville Mitchell - 7,700 21,351 5,898 - 11,000 Total executive KMP 1. The number of vested but unexercised options. 2. 45,949 - - - - - - - 23,319 5,031 18,288 8,000 21,398 15,379 20,724 3,047 14,481 4,500 8,524 74,595 20,424 3,000 5,000 4,500 8,524 46,479 - - - - 1,770,827 774,640 2,071,968 1,489,149 - 4,562 77,668 11,000 74,065 - 1,065,130 4,562 7,249,382 In line with the Share Ownership Policy (available on our website), the Policy value of Cochlear Limited ordinary shares is calculated using the average daily share price over the previous 12 months as at closing on the ASX up to 30 June 2016, times the number of shares. The Policy value of vested options is calculated using the average daily share price over the previous 12 months as at closing on the ASX up to 30 June 2016 less the applicable exercise price times the number of options (negative values are treated as zero in the totals). The Policy allows only half of the monetary gain of vested but unexercised options. Total Policy value of securities is therefore the sum of the value of shares plus half of the monetary gain of unexercised options. All executive KMP are compliant with the minimum shareholding guidelines. 47 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 The table below indicates any unvested options and performance rights issued to executive KMP but still subject to performance hurdles and deferred STI service conditions: Executive director Chris Smith Other executive KMP Richard Brook Dig Howitt Jan Janssen Tony Manna Neville Mitchell Unvested options over Cochlear Limited ordinary shares1 Unvested LTI performance rights over Cochlear Limited ordinary shares2 Unvested deferred STI performance rights over Cochlear Limited ordinary shares3 Total intrinsic value of unvested options and performance rights as at year end ($)4 99,414 11,837 3,226 3,788,427 27,106 51,552 27,527 14,778 29,050 9,312 2,133 7,345 834 9,825 2,441 1,780 1,902 2,901 2,337 2,079,118 1,870,611 1,822,701 595,288 2,322,688 Total executive KMP 249,427 41,286 14,587 12,478,833 1. The number of unvested options. 2. The number of unvested CEIP LTI performance rights. 3. The number of unvested CEIP deferred STI performance rights. 4. The intrinsic value of unvested performance rights calculated as at the closing Cochlear Limited share price on the ASX on 30 June 2016 times the number of performance rights and the intrinsic value of unvested options calculated as at the closing Cochlear Limited share price on the ASX on 30 June 2016 less the applicable exercise price times the number of options (negative values are treated as zero in the totals). All executive KMP are compliant with the Share Ownership Policy (minimum shareholding requirements). XX 48 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 5. Remuneration governance This section of the Remuneration Report describes the role of the Board and the P&CC, and the use of remuneration consultants when making remuneration decisions. The Board is responsible for all areas of Cochlear’s strategy and policy related to its people. Consistent with this responsibility, the Board has established the P&CC which comprises solely independent NEDs. The role of the P&CC is set out in its Terms of Reference, which is reviewed annually and was last revised and approved by the Board in May 2016. It is available on the Cochlear website (www.cochlear.com) through the Investor Centre. In addition, the Remuneration Policy and the Corporate Governance Statement are available on the Cochlear website. The Corporate Governance Statement shows how the ASX Corporate Governance Council’s Corporate Governance Principles and Recommendations are met. Principle 8 relates to remuneration. The Remuneration Policy for both NEDs and executive KMP is designed to attract and retain high calibre people. The P&CC’s role and interaction with Board, internal and external advisors, as illustrated below: Reviews, applies judgement and, as appropriate, approves the P&CC’s recommendations. The Board The People & Culture Committee The P&CC operates under the delegated authority of the Board. The P&CC 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 In FY16, data was provided in relation to salary benchmarking, but the P&CC did not seek advice from external consultants. Fees paid for this data were not material to either party (i.e. less than $50,000). 49 DIRECTORS’ REPORT Cochlear Limited for the year ended 30 June 2016 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. 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 matter 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 2016, see Note 2.6 to the financial statements. Lead auditor’s independence declaration The lead auditor’s independence declaration is set out on page 51 and forms part of the Directors’ Report for the financial year ended 30 June 2016. Rounding off The Company is of a kind referred to in Australian Securities and Investments Commission (ASIC) (Rounding in Financial/Directors’ Reports) Instrument 2016/191 (Rounding instrument) dated 24 March 2016 and in accordance with that Instrument, 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 9th day of August 2016. Signed in accordance with a resolution of the directors: Director Director 50 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 2016 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 Cameron Slapp, Partner Sydney, 9 August 2016 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. Liability limited by a scheme approved under Professional Standards Legislation. 51 INCOME STATEMENT Cochlear Limited and its controlled entities for the year ended 30 June 2016 Revenue Cost of sales Gross profit Selling and general expenses Administration expenses Research and development expenses Other income Results from operating activities Finance income - interest Finance expense - interest 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 57 to 83 are an integral part of these consolidated financial statements. Note 2.2 2016 $000 2015 $000 1,130,552 925,630 2.3(a) (333,593) (275,320) 796,959 650,310 (326,090) (260,809) (79,287) (59,536) (143,134) (127,985) 2.4 3.1 2.5 2.5 14,156 262,604 468 (8,806) (8,338) 254,266 (65,345) 188,921 330.6 330.0 4,428 206,408 300 (10,405) (10,105) 196,303 (50,463) 145,840 256.1 254.8 52 STATEMENT OF COMPREHENSIVE INCOME Cochlear Limited and its controlled entities for the year ended 30 June 2016 Net profit Other comprehensive (loss)/income Items that will not be reclassified subsequently to the income statement: Defined benefit plan actuarial 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), net of tax Total comprehensive income The notes on pages 57 to 83 are an integral part of these consolidated financial statements. 2016 $000 2015 $000 188,921 145,840 (2,000) (2,000) (1,806) (1,806) (15,832) 5,431 19,305 8,904 6,904 20,089 (32,412) 11,389 (934) (2,740) 195,825 143,100 53 BALANCE SHEET Cochlear Limited and its controlled entities as at 30 June 2016 Assets Cash and cash equivalents Trade and other receivables Forward exchange contracts Inventories Current tax assets Prepayments Total current assets Other receivables Forward exchange contracts Property, plant and equipment Intangible assets Investments Deferred tax assets Total non-current assets Total assets Liabilities Trade and other payables Forward exchange contracts Loans and borrowings Current tax liabilities Employee benefit liabilities Provisions Deferred revenue Total current liabilities Forward exchange contracts Loans and borrowings Employee benefit liabilities Provisions Deferred tax liabilities Total non-current liabilities Total liabilities Net assets Equity Share capital Reserves Retained earnings Total equity Note 2.7(a) 6.4(b) 5.1 3.2 5.2 5.3 5.4 3.2 6.3 3.2 4.2 5.5 6.3 4.2 5.5 3.2 The notes on pages 57 to 83 are an integral part of these consolidated financial statements. 2016 $000 2015 $000 75,417 281,925 11,454 154,103 6,208 13,921 543,028 1,507 10,713 86,878 224,338 13,755 77,144 414,335 957,363 110,354 12,643 3,978 13,701 45,485 33,675 31,264 251,100 3,547 189,260 13,750 44,027 7,122 257,706 508,806 448,557 158,940 (14,662) 304,279 448,557 72,208 249,744 3,853 145,861 3,606 13,754 489,026 63 1,910 80,809 228,531 - 75,063 386,376 875,402 99,858 24,162 168,159 20,645 43,223 26,652 20,585 403,284 10,961 44,552 11,479 43,394 6,346 116,732 520,016 355,386 144,136 (26,201) 237,451 355,386 54 STATEMENT OF CHANGES IN EQUITY Cochlear Limited and its controlled entities for the year ended 30 June 2016 Amounts $000 Issued capital Treasury reserve Translation reserve Hedging reserve Retained earnings Total equity Share based payment reserve 2015 Balance at 1 July 2014 Total comprehensive income/(loss) 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 transferred 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 Deferred tax recognised in equity Dividends to shareholders Balance at 30 June 2015 2016 Balance at 1 July 2015 Total comprehensive income/(loss) 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 transferred to the income statement, net of tax Total other comprehensive (loss)/income Total comprehensive (loss)/income Transactions with owners, recorded directly in equity Performance shares vested 152,599 (8,463) (52,630) 476 19,963 217,260 329,205 - - - - - - - - - - - - - - - - - - - - - - 20,089 - - - - - (32,412) 11,389 20,089 20,089 (21,023) (21,023) - - - - - - - 145,840 145,840 (1,806) (1,806) - - - 20,089 (32,412) 11,389 (1,806) (2,740) 144,034 143,100 - - - - - - 6,004 920 - - 6,004 920 - (123,843) (123,843) 152,599 (8,463) (32,541) (20,547) 26,887 237,451 355,386 152,599 (8,463) (32,541) (20,547) 26,887 237,451 355,386 - - - - - - - - - - - - - - - 2,099 6,001 - - - - - (15,832) - - (15,832) (15,832) - - - - - - - - 5,431 19,305 24,736 24,736 - - - - - - - 188,921 188,921 (2,000) (2,000) - - - (15,832) 5,431 19,305 (2,000) 6,904 186,921 195,825 - - - - - (2,099) (3,502) 8,342 (106) - - - - - 9,203 8,342 (106) - (120,093) (120,093) Share options exercised 6,704 Share based payment transactions Deferred tax recognised in equity Dividends to shareholders - - - Balance at 30 June 2016 159,303 (363) (48,373) 4,189 29,522 304,279 448,557 The notes on pages 57 to 83 are an integral part of these consolidated financial statements. 55 STATEMENT OF CASH FLOWS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Note 2016 $000 2015 $000 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 Proceeds from sale of non-current assets Acquisition of enterprise resource planning system Acquisition of other intangible assets Acquisition of investments Net cash used in investing activities Cash flows from financing activities Repayments of borrowings Proceeds from borrowings Net proceeds from exercise of share options Dividends paid Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents, net of overdrafts at 1 July Effect of exchange rate fluctuations on cash held 2.7(b) 5.4 2.6 Cash and cash equivalents, net of overdrafts at 30 June 2.7(a) The notes on pages 57 to 83 are an integral part of these consolidated financial statements. 1,105,512 (834,884) 5,461 454 (10,745) (80,685) 185,113 919,280 (694,288) 3,250 297 (7,627) (32,211) 188,701 (28,858) (23,897) 1,175 (7,556) (1,140) (13,755) (50,134) (332,971) 312,971 9,203 (120,093) (130,890) 4,089 72,208 (880) 75,417 - (4,530) - - (28,427) (148,701) 123,701 - (123,843) (148,843) 11,431 56,127 4,650 72,208 56 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 1. Basis of preparation This section 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. 1.1 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 2016 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. 1.2 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 Board of directors approved the consolidated financial statements on 9 August 2016. (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 fair value measurement method of derivative instruments is discussed further in Note 6.4(d). (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 Corporations (Rounding in Financial/Directors’ Reports) Instrument 2016/191 (Rounding instrument) dated 24 March 2016 and in accordance with that Instrument, all financial information presented in AUD 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 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 are translated to the Company’s functional currency at foreign exchange rates ruling at the reporting date. The revenues and expenses of foreign operations are translated to the Company’s functional currency at rates approximating the foreign exchange rates ruling at the dates of transactions. Foreign currency differences arising from translation of controlled entities are recognised in the foreign currency translation reserve (translation reserve) in equity. 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. (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. 57 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 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 4.2 – Employee benefit liabilities Note 4.3 – Share based payments Note 5.3 – Intangible assets Note 5.5 – Provisions Note 5.6 – Contingent liabilities Note 6.4 – Financial risk management. (f) Basis of consolidation Controlled entities 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 investment purposes. A SPE is consolidated if 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) Goods and services tax (GST) Revenues, expenses and assets are recognised net of the amount of GST. Where the amount of GST incurred is not recoverable from the taxation authority, 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. 58 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 2. Performance for the year 2.1 Operating segments Cochlear’s three reportable segments, determined on a geographical basis, 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. Performance is measured based on segment earnings before interest and income tax (EBIT) as included in the internal management reports that are reviewed by Cochlear’s Chief Executive Officer & President, who is also the chief operating decision- maker. Information about reportable segments Americas EMEA1 Asia Pacific Total 2016 $000 2015 $000 2016 $000 2015 $000 2016 $000 2015 $000 2016 $000 2015 $000 Reportable segment revenue 519,688 402,962 427,896 377,633 210,547 161,305 1,158,131 941,900 Reportable segment EBIT 276,931 204,879 180,925 172,113 64,842 47,292 522,698 424,284 Reportable segment assets 184,881 149,767 213,843 225,300 124,775 89,096 523,499 464,163 Reportable segment liabilities 49,257 41,524 47,132 42,721 32,772 18,719 129,161 102,964 Other material items Depreciation and amortisation Write-down in value of inventories Acquisition of non-current assets 1. Europe, Middle East and Africa. 1,016 302 741 865 14 351 2,179 2,097 1,046 1,180 250 534 1,769 1,842 175 973 308 347 4,241 727 3,483 4,142 856 2,540 Reconciliations of reportable segment revenues, profit or loss, assets and liabilities and other material items Revenues Cochlear implants Services $000 729,171 604,346 $000 289,418 222,458 2016 2015 Profit or loss Total Cochlear implants $000 1,018,589 826,804 Acoustics Reportable segment revenue Foreign exchange losses on hedged sales Consolidated revenue $000 139,542 115,096 $000 1,158,131 941,900 $000 (27,579) (16,270) $000 1,130,552 925,630 Reportable segment EBIT Corporate and other net expenses $000 522,698 424,284 $000 (232,515) (201,606) Foreign exchange losses on hedged sales $000 (27,579) (16,270) Net finance expense Consolidated profit before income tax $000 (8,338) (10,105) $000 254,266 196,303 Reportable segment assets Corporate and manufacturing assets Consolidated total assets Reportable segment liabilities Corporate and manufacturing liabilities Consolidated total liabilities $000 523,499 464,163 $000 433,864 411,239 $000 957,363 875,402 $000 129,161 102,964 $000 379,645 417,052 $000 508,806 520,016 Other material items Reportable segment total Corporate and manufacturing total Consolidated total Depreciation and amortisation Write-down in value of inventories Acquisition of non-current assets 2016 $000 4,241 727 3,483 2015 $000 4,142 856 2,540 2016 $000 29,250 15,566 47,826 2015 $000 26,110 9,269 25,887 2016 $000 33,491 16,293 51,309 2015 $000 30,252 10,125 28,427 59 2016 2015 Assets and liabilities 2016 2015 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 2.2 Revenue Sales revenue is revenue earned from the provision of products or services, net of returns, discounts and allowances. Revenue from the sale of goods is recognised when the significant risks and rewards of ownership have been transferred to the buyer, recovery of the consideration is probable, the associated costs and possible return of goods can be estimated reliably, there is no continuing management involvement with the goods and the amount of revenue can be measured reliably. 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. The accounting policy for foreign exchange gains/losses arising from hedges of forecast sales transactions is set out in Note 6.4(a). Sale of goods before hedging Foreign exchange losses on hedged sales Revenue from sale of goods Rendering of services Total revenue 2.3 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) Profit before income tax has been arrived at after charging the following item: Operating lease rental expense 2.4 Other income 2016 $000 1,145,492 (27,579) 1,117,913 12,639 1,130,552 2016 $000 308,990 8,310 16,293 333,593 2015 $000 931,390 (16,270) 915,120 10,510 925,630 2015 $000 256,593 8,602 10,125 275,320 26,261 24,420 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. If the costs have already been incurred, the amount is recognised in the year the entitlement is confirmed. Foreign exchange gains are recognised in accordance with the accounting policy at Note 1.2(d). Grant received or due and receivable Net foreign exchange gain Other income Total other income 2016 $000 2,579 8,695 2,882 14,156 2015 $000 1,809 1,178 1,441 4,428 60 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 2.5 Earnings per share Cochlear presents basic and diluted earnings per share (EPS) for its ordinary shares. Basic earnings per share The calculation of basic EPS has been based on the following net profit attributable to equity holders of the parent entity and weighted average number of ordinary shares of the Company: Net profit attributable to equity holders of the parent entity 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 2016 2015 $188,921,000 $145,840,000 56,957,274 56,937,519 175,635 11,669 - 13,693 57,144,578 56,951,212 330.6 256.1 The calculation of diluted EPS has been based on the following net profit attributable to equity holders of the parent entity and weighted average number of shares outstanding after adjustments for the effects of all dilutive potential ordinary shares: Net profit attributable to equity holders of the parent entity Weighted average number of ordinary shares (diluted): Weighted average number of shares (basic) (number) Effect of options and performance shares and rights unvested (number) Weighted average number of ordinary shares (diluted) at 30 June Diluted earnings per share (cents) 2016 2015 $188,921,000 $145,840,000 57,144,578 98,707 57,243,285 330.0 56,951,212 277,028 57,228,240 254.8 2.6 Dividends A liability for dividends payable is recognised in the financial year in which the dividends are declared. Dividends recognised in the current financial year by the Company are: Dollars per share Total amount $000 Franked/ unfranked Date of payment 2016 Interim 2016 ordinary Final 2015 ordinary Total amount 2015 Interim 2015 ordinary Final 2014 ordinary Total amount Subsequent event Since the end of the financial year, the directors declared the following dividends: Final 2016 ordinary Total amount 1.10 1.00 2.10 0.90 1.27 2.17 1.20 1.20 62,925 100% Franked 1 April 2016 57,168 100% Franked 1 October 2015 120,093 51,374 72,469 123,843 35% Franked 26 March 2015 20% Franked 25 September 2014 68,646 100% Franked 29 September 2016 68,646 The financial effect of the 2016 final dividend will be recognised in the subsequent financial year as it was declared after 30 June 2016. Dividend franking account Franked dividends paid during the financial year were franked at the tax rate of 30% (2015: 30%). There are no further tax consequences as a result of paying dividends other than a reduction in the franking account. 61 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 At 30 June 2016, there are $25,101,000 of franking credits (2015: $21,820,000) available to shareholders of Cochlear Limited for subsequent financial years. The dividend franking account at year end is 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. 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 $29,409,152 (2015: $24,463,618). Dividends in excess of the dividend franking account balance will be unfranked. 2.7 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 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: Depreciation and amortisation 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/liabilities Change in trade and other payables Change in current tax assets/liabilities Change in employee benefit liabilities Change in provisions Change in deferred revenue Effects of movements in foreign exchange Net cash provided by operating activities 2016 $000 43,367 32,050 75,417 2015 $000 46,864 25,344 72,208 188,921 145,840 335 617 33,491 8,342 30,252 6,004 231,089 182,713 (33,625) (8,242) (167) (11,186) 10,496 (9,546) 4,533 7,656 10,679 (16,574) 185,113 (39,358) (17,248) (1,168) (5,536) 21,214 17,197 14,885 (1,049) 5,434 11,617 188,701 The operating cash account received an average interest rate of 0.47% (2015: 0.58%) per annum. Cash held on deposit for periods not exceeding 90 days received an average interest rate of 1.51% (2015: 1.70%) per annum. 62 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 3. Income taxes 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. 3.1 Income tax expense Income tax expense includes current and deferred tax. Current and deferred tax are recognised in the income statement except to the extent that they relate to items recognised directly in other comprehensive income or equity. Current tax is the expected tax payable or receivable on the taxable income or loss for the year and any adjustment to tax payable in respect of previous years. It is measured using tax rates enacted or substantively enacted at the reporting date. Income tax expense recognised in the income statement Current year Adjustment for prior years Total current tax expense 2016 2015 $000 77,907 54,051 $000 (1,270) 1,028 $000 76,637 55,079 Origination and reversal of temporary differences $000 (11,292) (4,616) Total deferred tax benefit Total income tax expense $000 (11,292) (4,616) Consolidated Entity - Numerical reconciliation between income tax expense and profit before income tax Profit before income tax Tax at the Australian tax rate of 30% (2015: 30%) Increase in income tax expense due to: Non-deductible expenses Effect of tax rate in foreign jurisdictions Decrease in income tax expense due to: Research and development allowances Effect of tax rate in foreign jurisdictions Adjustment for prior years Income tax expense on profit before income tax Tax expense relating to items relating to other comprehensive income/(loss) or equity Total deferred tax recognised in other comprehensive income/(loss) relating to derivative financial instruments Total deferred tax recognised directly in equity relating to share based payments Note 3.2 3.2 Consolidated Entity - Numerical reconciliation between income tax expense and cash taxes paid Income tax expense on profit before income tax Timing differences recognised in deferred tax Effect of tax rate in foreign jurisdictions Current year tax instalments payable next year Prior year tax instalments paid this year Cash taxes paid per statement of cash flows 2016 $000 254,266 76,280 1,604 6 (11,275) - 66,615 (1,270) 65,345 2016 $000 10,601 106 2016 $000 65,345 6,333 (66) (9,028) 18,101 80,685 $000 65,345 50,463 2015 $000 196,303 58,891 1,252 - (9,029) (1,679) 49,435 1,028 50,463 2015 $000 (9,010) (920) 2015 $000 50,463 (1,195) 631 (18,101) 413 32,211 63 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Cochlear Limited’s Australian tax-consolidated group - Numerical reconciliation between income tax expense and profit before income tax Profit before income tax (excluding dividends from wholly owned foreign subsidiaries) Add: Dividends from wholly owned foreign subsidiaries Profit before income tax Tax at the Australian tax rate of 30% (2015: 30%) Increase in income tax expense due to: Controlled foreign company income Other non-deductible expenses Decrease in income tax expense due to: Research and development allowances Exempt foreign sourced dividends from wholly owned subsidiaries Other non-assessable income Adjustment for prior years Income tax expense on profit before income tax 3.2 Current and deferred tax assets and liabilities 2016 $000 200,913 9,645 210,558 63,167 2,337 758 (10,163) (2,894) - 53,205 203 53,408 2015 $000 154,528 14,068 168,596 50,579 851 - (8,417) (4,220) (1,037) 37,756 (321) 37,435 Deferred tax is recognised on all temporary differences between the carrying amounts of assets and liabilities for financial reporting and taxation purposes. The measurement of deferred tax mirrors the tax consequences that the Consolidated Entity expects 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. A deferred tax asset is recognised 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 if it is no longer probable that the related tax benefit will be realised. Recognised deferred tax assets and liabilities Assets Liabilities Net 2016 $000 121 63 29,116 33,932 1,488 - 13,877 340 78,937 (1,793) 77,144 2015 $000 98 57 23,575 30,338 1,380 8,808 10,244 563 75,063 - 75,063 2016 $000 (2,500) (1,762) - - - (1,793) (2,860) - (8,915) 1,793 (7,122) 2015 $000 (1,523) (1,893) - - - - (2,930) - (6,346) - 2016 $000 (2,379) (1,699) 29,116 33,932 1,488 (1,793) 11,017 340 70,022 - 2015 $000 (1,425) (1,836) 23,575 30,338 1,380 8,808 7,314 563 68,717 - (6,346) 70,022 68,717 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 Deferred tax assets/(liabilities) Unrecognised deferred tax liabilities At 30 June 2016, a deferred tax liability of $11.0 million (2015: $16.7 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. 64 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 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 Current tax assets and liabilities Note 3.1 3.1 3.1 2016 $000 68,717 11,292 (10,601) (106) 720 70,022 2015 $000 52,761 4,616 9,010 920 1,410 68,717 The current tax assets for the Consolidated Entity of $6.2 million (2015: $3.6 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 $13.7 million (2015: $20.6 million) represent the amount of income taxes payable in respect of current and prior financial years. 4. Employee benefits 4.1 Employee expenses Wages and salaries Contributions to superannuation plans Increase in leave liabilities Equity settled share based payment transactions End of service payment Total employee expenses 4.2 Employee benefit liabilities Wages, salaries and annual leave 2016 $000 278,083 21,583 2,925 8,342 - 2015 $000 243,822 19,007 2,806 6,004 1,548 310,933 273,187 Liabilities for employee benefits for wages, salaries and annual leave are recognised in other payables and provisions if Cochlear has a present obligation to pay an amount as a result of past services provided by the employee. The liability is calculated on remuneration rates as at the reporting date including related on-costs, such as workers’ compensation insurance and payroll tax. Long service leave The provision for long service leave is the present value of the estimated future cash outflows as a result of services provided by the employee 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 corporate bond rates which most closely match the terms to maturity of the related liabilities. Defined benefit plans The defined benefit obligations are calculated annually by a qualified actuary using the projected unit credit method. Remeasurements of the net defined benefit liability (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 period to the opening net defined benefit liability (asset), adjusted for any changes in the net defined benefit liability (asset) during the period resulting from contributions and benefit payments. Net interest expense related to defined benefit plans is recognised in the income statement. These defined benefit plans cover, in aggregate, 91 employees. Cochlear contributed cash of $1.5 million (2015: $1.3 million) to defined benefit plans in the year ended 30 June 2016 and expects to contribute $2.4 million in the year ending 30 June 2017. 65 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 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 2016, Prof E Byrne, AC is the only non-executive director entitled to this benefit. Current Provision for long service leave Provision for annual leave Provision for short-term incentives Provision for end of service 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 4.3 Share based payments 2016 $000 8,478 20,075 16,932 - 45,485 5,429 7,879 442 13,750 59,235 2015 $000 7,370 18,582 15,723 1,548 43,223 5,105 5,941 433 11,479 54,702 From 1 July 2013, the Company grants options and performance rights to certain employees under the Cochlear Executive Incentive Plan (CEIP). Prior to July 2013, the Company granted options and performance shares to certain employees under the Cochlear Executive Long Term Incentive Plan (CELTIP). The fair value of options, performance shares and performance rights granted is recognised as an employee expense, with a corresponding increase in equity. The expense is adjusted by the actual number of options, shares and rights that are expected to vest except where forfeiture is due to market related conditions. The fair value is measured using the Black-Scholes-Merton pricing model at the date the options, performance shares or performance rights are granted, taking into account market based criteria and the terms and conditions attached to the instruments. The options, performance shares or performance rights are expensed over the vesting period after which the employees become unconditionally entitled to them. 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 in the Company’s accounts. 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. 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. At 30 June 2016, 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 August 20121 October 20131 August 20142 October 20141 August 20152 November 20151 Total 1. Options and performance shares/rights offered under long-term incentives. 2. Performance rights offered under deferred short-term incentives. Exercise price of options Number of options Number of performance rights Contractual life $62.78 $59.13 N/A $68.56 N/A $82.89 13,995 214,075 - 78,192 - 149,991 456,253 - 16,419 32,836 18,702 53,061 17,584 138,602 5 years 4 years 2 years 4 years 2 years 4 years 66 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Grants are split between short-term incentives (STI) and long-term incentives (LTI). For STI, certain employees under the CEIP are granted performance rights based on achievement of a mandatory portion of their STI. Grants are calculated at the end of each year and then held for two years until vesting. Grants under LTI are in two equal tranches assigned to compound annual growth in EPS and ranking of TSR against the S&P/ASX 100. The conditions for minimum vesting are three years of service and:  a minimum compound annual growth rate in EPS of 10% assigned to 50% of grant; or  the Consolidated Entity’s TSR is above the 50th percentile against the S&P/ASX 100 over three years assigned to 50% of grant. 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 the grant date are the following: 2 November 2015 EPS performance based conditions $14.70 TSR based conditions $12.41 18 August 2015 STI deferral service based conditions N/A 14 October 2014 EPS performance based conditions $11.93 TSR based conditions $11.33 12 August 2014 STI deferral service based conditions N/A $77.11 $54.43 $85.13 $82.89 $85.13 $82.89 $79.30 $85.13 N/A $61.33 $39.21 $67.85 $68.56 $67.85 $68.56 $63.11 $67.85 N/A 24.47% 24.47% 24.47% 29.49% 29.49% 29.49% Fair value of options at grant date Fair value of performance rights at grant date Share price at valuation date Option exercise price Expected volatility (weighted average volatility) Option life 3 - 4 years 3 - 4 years 2 years 3 - 4 years 3 - 4 years Expected dividend yield 3.41% 3.41% 3.41% 3.48% 3.48% 2 years 3.48% Risk free interest rate (based on government bonds) 1.98% 1.98% 1.98% 2.54% 2.54% 2.54% 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 2016 $62.80 $64.23 $62.78 $82.89 $68.67 $62.78 Number of options 2016 1,038,834 (416,147) (328,885) 162,451 456,253 13,995 Weighted average exercise Number of options price 2015 $64.18 $68.13 - $68.56 $62.80 - 2015 1,416,328 (516,457) - 138,963 1,038,834 - 328,885 options were exercised in 2016. The weighted average market share price on the ASX at date of exercise was $86.35 (2015: no options were exercised). The weighted average remaining contractual life of options outstanding at the end of the year is three years (2015: three years). Employee Share Plan 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 2016, the Company issued 16,116 shares under the Plan; see Note 6.2. 67 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 4.4 Key management personnel The following were key management personnel (KMP) of Cochlear at any time during the financial year and unless otherwise indicated were KMP for the entire financial year: Non-executive directors Mr R Holliday-Smith (Chairman), Mrs YA Allen, Mr G Boreham, AM, Prof E Byrne, AC, Ms A Deans, Mr A Denver and Mr DP O’Dwyer Executive director Dr CG Roberts1 and Mr C Smith2 Other executive KMP Mr R Brook, Mr D Howitt, Mr J Janssen, Mr NJ Mitchell and Mr T Manna. 1. Retired on 31 August 2015, therefore, only a KMP from 1 July 2015 to 31 August 2015. 2. Appointed executive director on 1 September 2015 and was an other executive KMP from 1 July 2015 to 31 August 2015. Key management personnel disclosures The KMP compensation is included in employee expenses as follows: Short-term employee benefits $ 10,274,302 9,021,013 Post- employment benefits $ 521,446 444,445 Other long- term benefits $ 38,969 65,942 Directors’ retirement benefits $ 9,586 10,729 Share based payments End of service provision Total $ 2,794,586 3,017,836 $ - $ 13,638,889 1,548,418 14,108,383 2016 2015 Information regarding individual KMP 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 49. The KMP have not received any loans from Cochlear and there have been no other related party transactions with any of Cochlear’s KMP. 5. Operating assets and liabilities 5.1 Inventories Inventories are measured at the lower of cost and net realisable value. Cost is based on the first-in-first-out principle including 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 production overheads based on normal operating capacity. 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. 2016 2015 5.2 Property, plant and equipment Owned assets Raw materials $000 49,248 40,315 Work in progress $000 25,512 20,162 Finished goods $000 79,343 85,384 Total inventories $000 154,103 145,861 The value of property, plant and equipment is measured as the cost of the asset, minus accumulated depreciation and impairment losses (see Note 5.3). The cost of the asset is the consideration provided plus incidental costs directly attributable to the acquisition. The value of self-constructed assets includes the cost of material and direct labour 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 capitalised in the carrying amount of the item if it is probable that future economic benefits will flow to Cochlear and its cost can be measured reliably. All other costs are recognised in the income statement as incurred. 68 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Leased assets 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 to expense the cost of items of property, plant and equipment less their estimated residual values on a straight-line basis over their estimated useful lives. The estimated useful lives in the current and comparative years are as follows: leasehold improvements between one to 15 years and plant and equipment three to 14 years. Depreciation is recognised in the income statement from the date of acquisition or, in respect of internally constructed assets, from the time an asset is completed and held ready for use. 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. Total property, plant and equipment at net book value Leasehold improvements 2015 $000 2016 $000 Plant and equipment 2015 $000 2016 $000 Total net book value 2015 $000 2016 $000 At cost Accumulated depreciation Net book value 34,657 (21,774) 12,883 32,325 193,401 193,703 228,058 226,028 (20,941) (119,406) (124,278) (141,180) (145,219) 11,384 73,995 69,425 86,878 80,809 Reconciliations of the carrying amounts are: Opening balance Additions Disposals Depreciation Effect of movements in foreign exchange Net book value 5.3 Intangible assets Goodwill 11,384 3,930 (185) (2,359) 113 12,883 7,947 4,796 - 69,425 24,928 (3,398) 67,829 19,101 (617) 80,809 28,858 (3,583) 75,776 23,897 (617) (1,867) (17,508) (18,005) (19,867) (19,872) 508 11,384 548 73,995 1,117 69,425 661 86,878 1,625 80,809 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 tested annually for impairment. Enterprise resource planning system System costs are recognised as an intangible asset where Cochlear controls future economic benefits as a result of the costs incurred, and are stated at cost less accumulated amortisation. Costs include expenditure directly related to the development and implementation (hardware and software costs) of the system including direct labour. Other intangible assets Other intangible assets, comprising acquired technology, patents and licences, customer relationships, capitalised development expenditure and intellectual property, are acquired individually or through business combinations and are stated at cost less accumulated amortisation and impairment losses (see below). Both customer relationships and capitalised development expenditure had a written down value of nil as at 30 June 2016. 69 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Amortisation Amortisation is calculated to expense the cost of intangible assets less their estimated residual values on a straight-line basis over their estimated useful lives. The estimated useful lives for the current and comparative years are as follows: acquired technology, patents and licences are between four to 15 years and enterprise resource planning system between two to seven years. Amortisation is recognised in the income statement from the date the assets are available for use unless their lives are indefinite. Goodwill and intangible assets with an indefinite useful life are systematically tested for impairment annually. Intangible assets with indefinite useful life Goodwill Technology relationship $000 $000 2016 At cost Accumulated amortisation 171,356 - Net book value Reconciliations of the carrying amounts are: 171,356 1,800 - 1,800 Opening balance 170,503 1,800 Acquisitions Amortisation Effect of movements in foreign exchange Net book value 2015 At cost Accumulated amortisation - - 853 171,356 170,503 - Net book value Reconciliations of the carrying amounts are: 170,503 - - - 1,800 1,800 - 1,800 170,259 1,800 Opening balance Acquisitions Amortisation Effect of movements in foreign exchange Net book value Impairment - - 244 170,503 - - - 1,800 25,859 Intangible assets with finite useful life Intangible assets Total Enterprise resource planning system $000 Acquired technology, patents and licences $000 Other intangible assets $000 $000 56,880 (33,929) 22,951 25,859 7,556 (10,353) (111) 22,951 73,278 (47,419) 25,859 28,243 4,530 (6,920) 6 65,322 (37,848) 27,474 29,308 1,140 (2,972) (2) 27,474 64,110 (34,802) 29,308 32,498 - (3,165) (25) 29,308 16,966 (16,209) 757 1,061 - (299) (5) 757 16,936 (15,875) 1,061 1,315 - (295) 41 1,061 312,324 (87,986) 224,338 228,531 8,696 (13,624) 735 224,338 326,627 (98,096) 228,531 234,115 4,530 (10,380) 266 228,531 Cochlear annually tests goodwill and other intangible assets with indefinite useful life for impairment. Other non-financial assets, other than inventories (see Note 5.1) and deferred tax assets (see Note 3.2), are tested if there is any indication of impairment or if there is any indication that an impairment loss recognised in a prior period may no longer exist or may have decreased. Assets are impaired if their carrying value exceeds their recoverable amount. The asset’s recoverable amount is estimated based on its value in use. An asset that does not generate independent cash flows and its individual value in use cannot be estimated is tested for impairment as part of a cash generating unit (CGU). An impairment loss is recognised in the income statement when the carrying amount of an asset or CGU exceeds its recoverable amount. 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. An impairment loss in respect of goodwill is not reversed. 70 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Impairment tests for CGUs Cochlear allocates goodwill and other intangible assets to CGUs based on the expected benefits that each CGU will receive from use of those assets. The aggregate carrying amounts of goodwill allocated to each CGU are: 2016 2015 Americas $000 86,141 85,540 EMEA $000 75,341 74,918 Asia Pacific $000 9,874 10,045 Total $000 171,356 170,503 The recoverable amount of each CGU is based on value-in-use calculations. Those calculations use five year cash flow projections based on actual operating results, the next year’s budget and the mid-term business plan. Cash flows for year 6 onwards are extrapolated using a conservative terminal growth rate of 3.0% (2015: 3.0%) per annum which is consistent with long-term economic growth rates. The pre-tax discount rate for each CGU is as follows: Americas 13.7% (2015: 14.7%), EMEA 12.4% (2015: 12.3%) and Asia Pacific 13.9% (2015: 14.1%). 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 reflecting current market assessments of the time value of money and risks specific to the CGU. Sales volume growth rate Based on a five year cash flow projection taking into account historical growth rates and product lifecycle. Terminal value growth rate Based on a five year cash flow projection taking into account historical growth rates and product lifecycle. The recoverable amount of each CGU including unallocated corporate assets is in excess of the 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. 5.4 Investments The available for sale equity securities were acquired during 2016. These assets are initially measured at fair value, plus any directly attributable transaction costs. Subsequent to initial recognition, they are measured at fair value and changes therein, other than impairment losses which are recognised in the income statement, are recognised in other comprehensive income and accumulated in the fair value reserve. When these assets are derecognised, the gain or loss accumulated in equity is reclassified to profit or loss. 5.5 Provisions A provision is recognised in the balance sheet when:  Cochlear has a present obligation (legal or constructive) as a result of a past event;  a reliable estimate can be made of the amount of the obligation; 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. 2016 Warranties Opening balance Provision made Provision used Effect of movements in foreign exchange Total provisions Represented by: Current Non-current Total provisions $000 25,573 45,759 (34,999) 271 36,604 26,101 10,503 36,604 Legal and insurance $000 Product recall Make good lease costs $000 $000 5,012 2,607 (3,228) 10 4,401 4,401 - 4,401 15,918 - (2,898) - 13,020 3,173 9,847 13,020 2,210 164 (67) 37 2,344 - 2,344 2,344 Patent dispute Total $000 21,333 - - - 21,333 - 21,333 21,333 $000 70,046 48,530 (41,192) 318 77,702 33,675 44,027 77,702 71 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Warranties A provision for warranty claims is recognised 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 insurance 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. They 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. 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. No amount has been recognised as a charge or released as a credit in the year ended 30 June 2016. 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 and overhauls. Patent dispute In a trial of the patent infringement lawsuit by the Alfred E. Mann Foundation for Scientific Research and Advanced Bionics LLC in January 2014, a Jury found that Cochlear Limited and its US subsidiary Cochlear Americas infringed four claims across two patents, the infringement was “willful” and awarded USD 131,216,325 in damages. On 1 April 2015, a Judge in the United States District Court in Los Angeles, California held that three of the four patent claims were invalid and Cochlear’s infringement of the remaining claim was not “willful”. The Judge overturned the damages awarded because three of the four claims were held to be invalid. On 21 April 2015, the Court entered Judgment on liability only and stayed a new trial on damages pending the outcome of the appeals by all parties from the Judgment to the United States Court of Appeals for the Federal Circuit. Oral argument before a panel of Federal Circuit judges was held on 7 July 2016 and a decision on all appeals is expected during financial year 2017. As the patents have expired, the trial Judgment and the Court of Appeals decision will not disrupt Cochlear’s business or customers in the United States. The directors have obtained external advice and are of the opinion that the facts and the law do not support the District Court’s decision on infringement of the one remaining claim. 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. A provision was expensed in the half year ended 31 December 2013 in relation to this dispute. No additional amount has been provided since that initial provision. 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. 5.6 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/or 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 and lawsuits in various countries including 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. 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 72 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 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. 6. Capital and financial structure 6.1 Capital management Cochlear’s capital management objectives are to safeguard its ability to continue as a going concern, provide returns to shareholders, provide benefits to other stakeholders and 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. Senior management tracks, manages and reports against these capital management metrics periodically as part of broader corporate governance responsibilities. The Board undertakes periodic reviews 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. 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. 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 6.2 Capital and reserves Share capital The Company does not have authorised capital or par value in respect of its issued shares. Note 6.3 2016 $000 117,821 448,557 21% 2015 $000 140,503 355,386 28% Number of issued shares in market circulation Number of shares held in Trust Total number of issued shares 2016 2015 2016 2015 2016 2015 56,957,274 56,937,519 124,501 124,501 57,081,775 57,062,020 On issue 1 July – fully paid Issued for nil consideration under Employee Share Plan 16,116 19,755 Issued from the exercise of options 106,746 Options vesting from Trust Performance shares vesting from Trust 88,098 31,030 - - - - - (88,098) (31,030) - - - - 16,116 19,755 106,746 - - - - - On issue 30 June – fully paid 57,199,264 56,957,274 5,373 124,501 57,204,637 57,081,775 During 2016, Cochlear purchased 134,041 shares on market to satisfy exercise of options. Cochlear has also issued shares to employees under the Employee Share Plan (see Note 4.3). Ordinary shares are classified as equity and 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. 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. 73 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 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. Shares purchased by the Trust 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 payment 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 1.2(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, performance shares and performance rights granted to eligible executives under the CELTIP and CEIP, as detailed in Note 4.3 less any payments made to meet Cochlear’s obligations through the acquisition of shares on market, together with any deferred tax asset/liability on such payments. 6.3 Net debt and finance costs (a) Net debt Loans and borrowings are recognised initially at fair value less attributable transaction costs. Subsequently, 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. Debt establishment costs are capitalised and recognised as a reduction in loans and borrowings. They are recorded initially at cost and are amortised over the period of the loan. Included within loans and borrowings is an amount of $739,755 (2015: $448,093) in relation to unamortised loan establishment fees. Loans and borrowings: Current Non-current Total loans and borrowings Less: Cash and cash equivalents Net debt (b) Financing arrangements 2016 Utilised at reporting date Not utilised at reporting date Total facilities 2015 Utilised at reporting date Not utilised at reporting date Total facilities Note 2.7(a) 2016 $000 3,978 189,260 193,238 (75,417) 117,821 2015 $000 168,159 44,552 212,711 (72,208) 140,503 Multi-option bank facilities Other credit facilities Secured bank loan $000 190,000 155,000 345,000 210,000 135,000 345,000 Standby letters of credit $000 6,916 10,951 17,867 4,926 12,856 17,782 Bank guarantees $000 2,133 - 2,133 2,218 - 2,218 Unsecured bank overdrafts $000 Secured bank loan Bank guarantees $000 $000 - 299 299 - 292 292 3,978 1,989 5,967 3,159 1,579 4,738 1,393 222 1,615 1,370 224 1,594 74 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Multi-option bank facilities - Secured bank loan Cochlear has two bank 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 letters of credit or bank guarantees. This letter of credit sub-limit currently is AUD 5.0 million. This facility was extended in June 2016 for a further three year period to 14 June 2019. 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 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. Other credit facilities Unsecured bank overdrafts Certain unsecured bank overdrafts are payable on demand and are subject to annual review. Interest on unsecured bank overdrafts is variable and is charged at prevailing market rates. Secured bank loan Cochlear has a Japanese yen (JPY) 450.0 million loan facility. It is secured by a letter of guarantee and reviewed annually. Interest is charged at prevailing market rates. Bank guarantees As at 30 June 2016, Cochlear had additional contingent liability facilities denominated in United States dollars (USD), Euros (EUR), Sterling (GBP), Indian rupees and New Zealand dollars totalling AUD 1.6 million (2015: AUD 1.6 million). (c) Finance costs Interest income is recognised as it accrues in the income statement. Borrowing costs are recognised as they accrue in the income statement as a finance expense. 6.4 Financial risk management The activities of Cochlear are exposed to a variety of risks, including market risk (comprising currency and interest rate risk), credit risk and liquidity risk. Cochlear’s overall risk management program considers the unpredictability of financial markets and seeks to appropriately manage the potential adverse effects on financial performance. The Board of directors has overall responsibility for the establishment and oversight of the Risk Management Framework. Under instruction of the Board, management has established a Risk Management Committee which is responsible for identifying, assessing and appropriately managing risk throughout Cochlear. Key risks are reported to the Audit Committee on a regular basis. A Treasury Management Committee has been established to administer aspects of risk management involving currency exposure, cash and funding, to manage the impact of short-term fluctuations on Cochlear’s earnings. The Audit Committee oversees how management monitors compliance with Cochlear’s Risk Management Framework, policies and procedures and is assisted by Internal Audit which undertakes reviews of key management controls and procedures. (a) 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 by buying and selling forward exchange contracts and incurring financial liabilities, within acceptable parameters, whilst optimising the return, all in accordance with the treasury risk policy. 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). 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 not hedged. 75 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Cochlear’s exposure to foreign currency risk in relation to non-derivative financial instruments was as follows, based upon notional amounts: Amounts local currency/thousands USD EUR GBP SEK JPY CHF 30 June 2016 Trade receivables Secured bank loan Trade payables Gross balance sheet exposure 30 June 2015 Trade receivables Secured bank loan Trade payables Gross balance sheet exposure 72,845 46,439 - (13,234) 59,611 - (5,348) 41,091 5,818 - (5,025) 793 6,690 752,963 - (300,000) (63,160) (56,470) (63,133) 389,830 64,746 47,484 6,824 10,384 670,937 - (14,535) 50,211 - (4,657) 42,827 - (5,029) 1,795 - (300,000) (58,466) (48,082) (87,752) 283,185 616 - (2,219) (1,603) 881 - (2,446) (1,565) Derivative assets and liabilities - Forward exchange contracts In order to reduce the impact of short-term fluctuations on Cochlear’s earnings, 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. In the year ended 30 June 2016, Cochlear designated all forward exchange contracts as cash flow hedges. 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. At the start of a hedge relationship, Cochlear designates and documents the relationship between the hedging instrument and hedged item. This includes identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged and how Cochlear will assess the effectiveness of the hedging relationship. Cochlear regularly assesses whether the hedging instruments are expected to be highly effective in offsetting the changes in the cash flows of the respective hedged items. Forward exchange contracts are recognised initially at fair value. Subsequently, forward exchange contracts are measured at fair value. Changes in the fair value are recognised directly in equity to the extent that the hedge is effective. The ineffective part of any hedging instrument is recognised immediately in the income statement. If the forward exchange contract 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. For cash flow hedges, the associated cumulative gain or loss is removed from equity and recognised in the income statement in the same period the hedged forecast transaction affects the income statement and on the same line item as that hedged forecast transaction. For the year ended 30 June 2016, all cash flow hedges were effective at the reporting date. 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: 30 June 2016 Sell USD Sell EUR Sell JPY 30 June 2015 Sell USD Sell EUR Sell JPY Weighted < 1 year 1 - 2 years 2 - 5 years average rate 0.74 0.64 83.76 0.84 0.67 89.17 $000 $000 $000 195,817 188,358 12,210 164,538 151,143 10,335 117,236 109,493 6,575 91,800 87,390 5,392 23,468 27,203 1,359 27,079 24,167 1,447 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 2016, including hedging results and after income tax, by approximately $8.5 million (2015: $2.3 million) and decreased Cochlear’s equity by $51.8 million (2015: $16.6 million). A 10 percent general decrease in the value of the AUD against other foreign currencies would have increased Cochlear’s profit by $12.2 million (2015: $8.1 million) and increased equity by $50.2 million (2015: $11.6 million). 76 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 The following significant exchange rates applied to Cochlear during the year: AUD 1 = USD EUR GBP SEK JPY Interest rate risk Average rate Reporting date spot rate 2016 0.729 0.658 0.494 6.141 2015 0.844 0.697 0.532 6.483 2016 0.740 0.669 0.557 6.285 2015 0.766 0.686 0.487 6.367 85.089 95.725 75.410 94.969 Cochlear is exposed to interest rate risks in Australia and Japan. See Note 6.4(c) for effective interest rates, repayment and repricing analysis of outstanding debt. At the reporting date, the interest rate profile of Cochlear’s interest-bearing financial instruments is financial assets of $75.4 million (2015: $72.2 million) and financial liabilities of $193.2 million (2015: $212.7 million). For the year ended 30 June 2016, 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 $1.1 million (2015: $1.3 million). A one percent general decrease in interest rates would have had the equal but opposite effect on Cochlear’s profit and equity. (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. Cochlear is exposed to credit risk from its operating activities (primarily from trade and other receivables) and from financing activities, including deposits with financial institutions and foreign exchange contracts. The carrying amounts of these financial assets at year end represent Cochlear’s maximum exposure to credit risk. Credit risk management - Trade and other receivables Customer credit risk is managed at a regional level, subject to Board approved policies and procedures. The ageing profile of total receivables balances, individually significant debtors by geographic region, high risk customers and collection activities are reported to management and the Board of directors on a monthly basis. Where high risk customers are identified, regional management is responsible for placing restrictions on future trading, including suspending future shipments and administering dispatches on a prepayment basis. 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. The maximum exposure to credit risk for trade receivables at the reporting date by geographic region was: 2016 2015 Americas EMEA Asia Pacific $000 86,115 74,153 $000 108,937 108,374 $000 73,486 54,201 Total $000 268,538 236,728 Depending on the region, Cochlear’s credit terms are generally 30 days; however, there are certain jurisdictions where it is customary practice for customers to make payment beyond 270 days. Although Cochlear discloses the balance as overdue, it is not indicative of a higher than normal credit risk as payments are typically received by Cochlear within the extended timeframes. At each reporting date, Cochlear assesses the collectability of trade and other receivables by reference to historical collection trends and timing of recoveries and makes an adjustment if current economic and credit conditions are such that the actual losses are likely to be greater or lesser than suggested by historical trends. Cochlear has established an allowance for impairment that represents its estimate of incurred losses in respect of trade receivables based on individually significant exposures, 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. Based upon past experience, Cochlear believes that no impairment allowance is necessary in respect of trade receivables not past due. 77 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Trade and other receivables are stated at amortised cost less impairment losses. The ageing of Cochlear’s trade receivables at the reporting date was: Trade receivables Not past due Past due 1 – 60 days Past due 61 – 180 days Past due 181 – 360 days Past due 361 days and over Impairment losses Trade receivables net of allowance for impairment losses Other receivables – current Trade and other receivables Credit risk management - Cash deposits and forward exchange contracts 2016 $000 2015 $000 199,164 162,018 33,162 13,469 14,924 19,749 280,468 (11,930) 268,538 13,387 281,925 26,644 25,315 13,252 15,192 242,421 (5,693) 236,728 13,016 249,744 The majority of Cochlear’s cash deposits and all hedging transactions are only executed with leading financial institutions whose credit rating is at least A on the Standard & Poor’s rating index. (c) Liquidity risk Liquidity risk is the risk that Cochlear will not be able to meet its financial obligations as they fall due. Cochlear manages liquidity risk by ensuring, as far as possible, that it will always have sufficient liquidity to meet its liabilities when due. Non-derivative liabilities Contractual maturities of non-derivative financial liabilities, including estimated interest payments and excluding the impact of netting agreements, are as follows: 30 June 2016 AUD floating rate loan JPY floating rate loan Trade and other payables Total 30 June 2015 AUD floating rate loan JPY floating rate loan Trade and other payables Total Effective interest rate Per annum Carrying amount Contractual cash flows $000 $000 < 1 year $000 1 - 2 years $000 2 - 5 years $000 3.76% 0.61% - 3.99% 0.64% - 189,260 207,650 3,978 110,354 303,592 3,994 110,354 321,998 7,152 3,994 110,354 121,500 107,110 93,388 - - - - 107,110 93,388 209,552 221,698 173,122 1,798 46,778 3,159 99,858 3,172 99,858 3,172 99,858 - - - - 312,569 324,728 276,152 1,798 46,778 It is not expected that the cash flows included in the maturity analysis could occur significantly earlier or at significantly different amounts. 78 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 Derivative assets and liabilities - Forward exchange contracts 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 2016 Assets Liabilities Total 30 June 2015 Assets Liabilities Total Carrying amount $000 Contractual cash flows $000 22,167 (16,190) 5,977 5,763 (35,123) (29,360) 22,634 (16,400) 6,234 5,877 (35,807) (29,930) < 1 year $000 11,573 (12,756) (1,183) 3,899 (24,422) (20,523) 1 - 2 years $000 8,642 (3,416) 5,226 1,897 (9,445) (7,548) 2 - 5 years $000 2,419 (228) 2,191 81 (1,940) (1,859) The expected impact on the income statement is not considered to be significantly different to the cash flow impact noted above. (d) Fair value The carrying amounts and estimated fair values of Cochlear’s financial assets and liabilities are materially the same. 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 benchmark bill futures and swap rates. These fair values are provided by independent third parties. Valuation of financial assets and liabilities For financial asset and liabilities measured and carried at fair value, Cochlear uses the following levels to categorise the valuation methods used:  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). All of Cochlear’s forward exchange contracts were valued using observable market inputs (Level 2) and there were no transfers between levels during the year. The equity securities classified as available for sale financial assets are valued using unobservable market inputs (Level 3). Unobservable inputs are those not readily available in an active market. These inputs are generally derived from other observable inputs that match the risk profile of the financial instruments and validated against current market assumptions and historical transactions where available. 79 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 7. Other notes 7.1 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 and other services Total non-audit services 7.2 Commitments Operating lease commitments 2016 $ 2015 $ 1,583,831 1,559,738 58,734 72,094 1,642,565 1,631,832 1,051,398 1,051,398 988,156 988,156 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. 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 2016 $000 22,372 82,528 65,312 2015 $000 22,028 79,308 88,387 170,212 189,723 As at 30 June 2016, Cochlear entered into contracts to purchase property, plant and equipment for $4,426,000 (2015: $5,408,000). 80 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 7.3 Controlled entities Subsidiaries conduct business transactions with various controlled entities. Such transactions include purchases and sales of certain products, dividends, interest and loans. Interest held Country of incorporation/ formation 2016 % 2015 % Company Cochlear Limited Controlled entities Acoustic Implants Limited Cochlear AG Cochlear Americas Cochlear Austria GmbH 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 Shared Services S.A. Cochlear Sweden Holdings AB Cochlear Tempe LLC 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 Medical Insurance Pte Limited Miaki NV Nihon Cochlear Co Limited (i) Divested on 14 December 2015. (ii) Dormant. (iii) Deregistered during the year ended 30 June 2016. (i) (ii) (iii) 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 100 Switzerland 100 USA 100 Austria 100 Belgium 100 Sweden 100 USA 100 Canada 100 USA 100 Germany 100 100 Australia 100 Germany 100 UK 100 Australia 100 Australia 100 France 100 Australia 100 Belgium 100 Australia 100 Australia 100 Italy 100 Korea 100 Panama 100 Malaysia 100 USA 100 China 100 India UAE 100 100 Sweden 100 New Zealand 100 UK Panama 100 100 Sweden USA 100 100 Turkey 100 Germany 100 Hong Kong 100 UK Turkey 100 100 Australia 100 Singapore 100 Belgium 100 Japan 81 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 7.4 Parent entity disclosures At, and throughout the financial year ended, 30 June 2016, 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: Issued capital Treasury reserve Translation reserve Hedging reserve Share based payment reserve Retained earnings Total equity 2016 $000 158,544 24,751 183,295 392,777 816,734 141,427 486,883 159,303 (363) 83 4,189 27,023 139,616 329,851 2015 $000 118,597 (20,967) 97,630 387,569 713,614 306,808 461,904 152,599 (8,463) 69 (20,547) 26,887 101,165 251,710 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 5.6. Parent entity capital commitments for acquisition of plant and equipment As at 30 June 2016, the parent entity entered into contracts but had not provided for or paid to purchase plant and equipment for $4,420,000 (2015: $4,823,000). 7.5 Changes in accounting policies There have been no changes to accounting standards impacting Cochlear in the current financial year. 7.6 New standards and interpretations not yet adopted A number of new standards, amendments to standards and interpretations are effective for financial years beginning on or after 1 July 2016, and have not been applied in preparing these consolidated financial statements. Of the new standards, only the below are expected to have an effect on the consolidated financial statements of Cochlear. Cochlear is currently assessing the impact of the changes in the below standards and it is not expected that the changes will have a significant impact on Cochlear:  AASB 9 Financial Instruments, which becomes mandatory for Cochlear’s 2019 consolidated financial statements; and  AASB 15 Revenue from Contracts with Customers, which becomes mandatory for Cochlear’s 2019 consolidated financial statements. Cochlear is currently assessing the impact of the changes in the below standard:  AASB 16 Leases, which becomes mandatory for Cochlear’s 2020 consolidated financial statements. Cochlear does not plan to adopt these standards early. 82 NOTES TO THE FINANCIAL STATEMENTS Cochlear Limited and its controlled entities for the year ended 30 June 2016 7.7 Events subsequent to the reporting date Other than the matter 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 2016, see Note 2.6. 83 DIRECTORS’ DECLARATION Cochlear Limited and its controlled entities for the year ended 30 June 2016 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 49, 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 2016 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 Chief Executive Officer & President and Chief Financial Officer for the financial year ended 30 June 2016. 3. The directors draw attention to Note 1.2(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 9th day of August 2016. Director Director 84 INDEPENDENT AUDIT REPORT to the Members of Cochlear Limited Report on the financial report Opinion We have audited the accompanying financial report of Cochlear Limited (the Company), which comprises the balance sheet as at 30 June 2016, the income statement, the statement of comprehensive income, the statement of changes in equity and the statement of cash flows for the year then ended, notes 1 to 7.7, 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. In our opinion: (a) the accompanying 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 2016 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 1.2(a). Emphasis of matter We draw attention to note 5.5 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. Basis for opinion We conducted our audit in accordance with Australian Auditing Standards. Those standards require that we comply with relevant ethical requirements relating to audit engagements and plan and perform the audit to obtain reasonable assurance about whether the financial report is free from material misstatement. Our responsibilities under those standards are further described in the Auditor’s responsibility section of our report. We are independent of the Consolidated Entity in accordance with the Corporations Act 2001 and the ethical requirements of the Accounting Professional and Ethical Standards Board’s APES 110 Code of Ethics for Professional Accountants (the Code) that are relevant to our audit of the financial report in Australia. We have also fulfilled our other ethical responsibilities in accordance with the Code. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion. Key audit matters Key audit matters are those matters that, in our professional judgement, were of most significance in our audit of the financial report of the current period. These matters were addressed in the context of our audit of the financial report as a whole, and in forming our opinion thereon, and we do not provide a separate opinion on these matters. Key audit matter How our audit addressed the key audit matter Patent dispute provision $21.3 million Refer to note 5.5 Provisions The patent dispute provision relates to a specific claim that has been made against the Consolidated Entity. Our procedures included, amongst others:  Making enquiries of management and the directors to obtain We focused on this area as a key audit matter due to the: their view on this significant legal matter;  Quantum of amounts involved; and  Inherent uncertainty in the application of the measurement aspects of accounting standards to determine the amount, if any, to be provided for when an item is subject to dispute and a legal process between parties.  Evaluating the information held by the Consolidated Entity and assessing the impact of this evidence on the appropriateness of the provision in relation to the measurement criteria in the accounting standards;  Issuing requests for confirmation of all significant litigation to the Consolidated Entity’s external lawyers. We assessed the correspondence received from external lawyers by comparing this to our understanding of views expressed by management and the directors, and the consistency to facts and conditions gathered across our work; and  Assessing the Consolidated Entity’s disclosures of the quantitative and qualitative considerations in relation to the provision, by comparing these disclosures to our understanding of the matter. KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. Liability limited by a scheme approved under Professional Standards Legislation. 85 INDEPENDENT AUDIT REPORT to the Members of Cochlear Limited Key audit matter How our audit addressed the key audit matter CI500 product recall provision $13.0 million Refer to note 5.5 Provisions On 11 September 2011, the Consolidated Entity announced the voluntary recall of unimplanted Nucleus CI500 series implantable devices as a consequence of an increase in the number of Nucleus CI500 series implant failures. Certain assumptions have been made by the Consolidated Entity in providing for costs associated with the recall. The CI500 series product recall provision was considered a key audit matter due to:  The inherent uncertainty associated with estimating device return and claim rates, and associated future warranty claim costs;  The inherent subjectivity in assessing the associated level of insurance cover; and  The potentially significant amounts involved. These conditions necessitated greater involvement by our senior team members to challenge the forward looking assumptions adopted by the Consolidated Entity in their model that determined the amount provided. Recoverability of trade receivables $268.5 million Refer to note 6.4(b) Financial risk management, credit risk Recoverability of trade receivables is a key audit matter due to:  The wide ranging characteristics of individual customers;  The large number of different geographic locations of customers;  Some customers and locations having experienced higher days sales outstanding than the Consolidated Entity’s average days sales outstanding, increasing their inherent exposure to credit risk;  The use of non-standard and unique contracts with customers, some of which have longer than average payment terms specifically negotiated by the Consolidated Entity; and  The inherent subjectivity involved in the Consolidated Entity making judgements in relation to credit risk exposures. These conditions gave rise to additional audit effort to gather evidence across the unique profiles of customers and their accounts receivable, including focusing our work on those with greater credit risk exposures, whether driven from relative exposure or location characteristics. Our procedures included, amongst others:  Assessing the key forward looking assumptions used by the Consolidated Entity in their model to estimate the provision, including estimated device return rates and estimated warranty and associated claim costs, by comparing with historical actuals;  Assessing the impact on the provision of insurance cover by comparing the forward looking insurance recovery assumptions with historical actuals;  Assessing correspondence from the Consolidated Entity’s external lawyers in response to our requests for information on claims regarding known or alleged CI500 implant failures to assist us in challenging the CI500 provision. We compared this to our understanding of facts and conditions gathered across our work;  Challenging the key forward looking assumptions used by the Consolidated Entity in their model to estimate the provision by performing sensitivity analysis in relation to estimated device return and claim rates, and estimated warranty and associated claim costs; and  Assessing the Consolidated Entity’s disclosures of the quantitative and qualitative considerations in relation to the provision, by comparing these disclosures to our understanding of the matter. Our procedures included, amongst others:  Testing key controls within the credit control process including credit account application approvals and credit limit review;  Assessing the recoverability of a sample of outstanding trade receivable balances by comparing management’s views of recoverability of amounts outstanding to historical patterns of receipts, in conjunction with assessing cash received subsequent to year end for its effect in reducing amounts outstanding at year end;  Challenging management’s view of credit risk and recoverability in certain locations by selecting a sample of overdue customer balances and: - noting the historical patterns for long outstanding trade receivables in those locations; - assessing cash received subsequent to year end for its effect in reducing amounts outstanding at year end; - evaluating other evidence including customer correspondence; and - questioning management’s knowledge of future conditions that may impact expected customer receipts.  Assessing the Consolidated Entity’s disclosures of the quantitative and qualitative considerations in relation to trade receivables credit risk, by comparing these disclosures to our understanding of the matter. KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. Liability limited by a scheme approved under Professional Standards Legislation. 86 INDEPENDENT AUDIT REPORT to the Members of Cochlear Limited 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 gives a true and fair view and is free from material misstatement, whether due to fraud or error. In note 1.2(a), the directors also state, in accordance with Australian Accounting Standard AASB 101 Presentation of Financial Statements, that the financial report complies with International Financial Reporting Standards. In preparing the financial report, the directors are responsible for assessing the Consolidated Entity’s ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the going concern basis of accounting unless the directors either intend to liquidate the Consolidated Entity or to cease operations, or have no realistic alternative but to do so. Auditor’s responsibility Our responsibility is to express an opinion on the financial report based on our audit. Our objectives are to obtain reasonable assurance about whether the financial report as a whole is free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with Australian Auditing Standards will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of this financial report. As part of an audit in accordance with Australian Auditing Standards, we exercise professional judgement and maintain professional scepticism throughout the audit. 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. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of 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 conclude on the appropriateness of the directors’ use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the Consolidated Entity’s ability to continue as a going concern. If we conclude that a material uncertainty exists, we are required to draw attention in our auditor’s report to the related disclosures in the financial report or, if such disclosures are inadequate, to modify our opinion. Our conclusions are based on the audit evidence obtained up to the date of our auditor’s report. However, future events or conditions may cause the Consolidated Entity to cease to continue as a going concern. We evaluate the overall presentation, structure and content of the financial report, including the disclosures, and whether the financial report represents the underlying transactions and events in a manner that achieves fair presentation. We obtain sufficient appropriate audit evidence regarding the financial information of the entities or business activities within the Consolidated Entity to express an opinion on the financial report. We are responsible for the direction, supervision and performance of the Consolidated Entity audit. We remain solely responsible for our audit opinion. KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. Liability limited by a scheme approved under Professional Standards Legislation. 87 INDEPENDENT AUDIT REPORT to the Members of Cochlear Limited We communicate with the directors regarding, amongst other matters, the planned scope and timing of the audit and significant audit findings, including any significant deficiencies in internal control that we identify during our audit. The Auditing Standards require that we comply with relevant ethical requirements relating to audit engagements. We also provide the directors with a statement that we have complied with relevant ethical requirements regarding independence, and to communicate with them all relationships and other matters that may reasonably be thought to bear on our independence, and where applicable, related safeguards. From the matters communicated with the directors, we determine those matters that were of most significance in the audit of the consolidated financial report of the current period and are therefore key audit matters. We describe these matters in our auditor’s report unless law or regulation precludes public disclosure about the matter or when, in extremely rare circumstances, we determine that a matter should not be communicated in our report because the adverse consequences of doing so would reasonably be expected to outweigh the public interest benefits of such communication. Report on the remuneration report We have audited the Remuneration Report included in pages 31 to 49 of the Directors’ Report for the year ended 30 June 2016. 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 Australian Auditing Standards. Opinion In our opinion, the Remuneration Report of Cochlear Limited for the year ended 30 June 2016, complies with Section 300A of the Corporations Act 2001. KPMG Cameron Slapp, Partner Sydney, 9 August 2016 KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. Liability limited by a scheme approved under Professional Standards Legislation. 88 ADDITIONAL INFORMATION Additional information required by Australian Securities Exchange Listing Rules and not disclosed elsewhere in this report – the information presented is as at 29 July 2016: Number of ordinary shares held 6,019,800 2,861,780 8,881,580 % 10.52 5.00 15.52 Number of ordinary shareholders Shareholdings Substantial investors Investor Baillie Gifford & Co 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 – 141 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) AMP Life Limited RBC Investor Services Australia Nominees Pty Limited (Bkcust a/c) Dr Christopher Graham Roberts BNP Paribas Nominees Pty Ltd (Agency Lending DRP a/c) Citicorp Nominees Pty Limited (Colonial First State Inv a/c) HSBC Custody Nominees (Australia) Limited – a/c 2 HSBC Custody Nominees (Australia) Limited (NT-Comnwlth Super Corp a/c) RBC Investor Services Australia Nominees Pty Ltd (Bkmini a/c) PGA (Investments) Pty Ltd RBC Investor Services Australia Pty Limited (VFA a/c) National Nominees Limited (DB a/c) Australian Foundation Investment Company Limited Share Direct Nominees Pty Ltd (10015 a/c) HSBC Custody Nominees (Australia) Limited Navigator Australia Ltd (MLC Investment Sett a/c) The 20 largest shareholders held 75.47% of the ordinary shares of the Company. Number of ordinary shares held 15,158,679 10,084,945 9,567,204 2,958,943 1,701,927 763,871 517,403 396,348 385,555 375,868 295,460 287,366 132,400 100,000 100,000 77,361 75,000 74,594 72,518 53,954 25,556 2,542 152 69 14 28,333 % 26.50 17.63 16.72 5.17 2.98 1.34 0.90 0.69 0.67 0.66 0.52 0.50 0.23 0.17 0.17 0.14 0.13 0.13 0.13 0.09 75.47 89 XX 90 Glossary, Key Company ASX Announcement Record and Company Information Glossary AGM Annual General Meeting. ASIC Australian Securities & 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. FY11 Financial year 2011: 1 July 2010 to 30 June 2011. FY12 Financial year 2012: 1 July 2011 to 30 June 2012. FY13 Financial year 2013: 1 July 2012 to 30 June 2013. FY14 Financial year 2014: 1 July 2013 to 30 June 2014. FY15 Financial year 2015: 1 July 2014 to 30 June 2015. FY16 Financial year 2016: 1 July 2015 to 30 June 2016. FY17 Financial year 2017: 1 July 2016 to 30 June 2017. FDA United States Food and Drug Administration. FX Foreign exchange. IFRS International Financial Reporting Standards. KMP Key management personnel. Processor/sound processor The externally worn part of the cochlear implant. R&D Research and development. STEM Science, Technology, Engineering and Mathematics. TSR Total shareholder return. Key Company ASX Announcement Record 11 August 2015 Full year results for year ended 30 June 2015 11 February 2016 Half year results announced Cochlear announced that sales revenue increased 15% to $941.9 million on the previous financial year. Total dividends for the year were $1.90, 71% franked, a decrease of 25% on the prior year. Cochlear announced that sales revenue increased 32% to $581.7 million on the previous half year. An interim dividend of $1.10 was declared, 100% franked, and an increase of 22% on the prior half. 31 August 2015 CEO handover effective 28 April 2016 Cochlear hosts investor day Cochlear hosted an investor day for institutional shareholders and analysts with presentations made by senior management across a number of areas of the business. Cochlear confirmed the appointment of Chief Executive Officer & President Chris Smith effective from 1 September 2015. He was appointed as an Executive Director from that same date. 20 October 2015 AGM Chairman’s address Cochlear Chairman, Rick Holliday-Smith, addressed shareholders at the Annual general Meeting. 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 product recall costs: IFRS measures adjusted for the costs of the product recall; and • constant currency: restatement of IFRS financial measures in comparative years using FY16 FX rates. 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 18 October 2016 at the Australian Securities Exchange, Exchange Square Auditorium, 20 Bridge Street, Sydney. Financial calendar 2016 Dividend record date 8 September Payment of final dividend 29 September Annual General Meeting 18 October 2017 Interim profit announcement 14 February* Interim dividend record date 16 March* Payment of interim dividend 6 April* Final profit announcement 17 August* Annual General Meeting 17 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, Hugfit, Hybrid, inHear, Invisible Hearing, MET, MP3000, myCochlear, NRT, Nucleus, 科利耳, Off-Stylet, SmartSound, Softip, SPrint, True Wireless, the elliptical logo and Whisper are either trademarks or registered trademarks of Cochlear Limited. Ardium, Baha, Baha SoftWear, BCDrive, DermaLock, EveryWear, Vistafix and WindShield are either trademarks or registered trademarks of Cochlear Bone Anchored Solutions AB. Design Cross Media Communications Pty Ltd As the global leader in implantable hearing solutions, Cochlear is dedicated to bringing the gift of sound to people with moderate to profound hearing loss. We have helped over 400,000 people of all ages live full and active lives by reconnecting them with family, friends and community. We give our recipients the best lifelong hearing experience and access to innovative future technologies. For our professional partners, we offer the industry's largest clinical, research and support networks. That’s why more people choose Cochlear than any other hearing implant company. 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 www.cochlear.com © Cochlear Limited 2016 D1062277 ISS1 AUG16 

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