could result in an impairment charge. Reduction in our net income caused by impairment charges could harm our financial results. We may not realize the anticipated benefits of future acquisitions or those benefits may be delayed or reduced in their realization. Although we have not made any major acquisitions in the last few years, acquisitions have been a significant part of our historical growth and have enabled us to further broaden and diversify our product offerings. In making acquisitions, we target companies that we believe offer attractive family entertainment products. However, we cannot be certain that the products of companies we may acquire in the future will achieve or maintain popularity with consumers. In some cases, we expect that the integration of the product lines of the companies that we acquire into our operations will create production, marketing and other operating synergies which will produce greater revenue growth and profitability and, where applicable, cost savings, operating efficiencies and other advantages. However, we cannot be certain that these synergies, efficiencies and cost savings will be realized. Even if achieved, these benefits may be delayed or reduced in their realization. In other cases, we acquire companies that we believe have strong and creative management, in which case we plan to operate them autonomously rather than fully integrating them into our operations. We cannot be certain that the key talented individuals at these companies will continue to work for us after the acquisition or that they will continue to develop popular and profitable products or services. From time to time, we are involved in litigation, arbitration or regulatory matters where the outcome is uncertain and which could entail significant expense. As is the case with many large multinational corporations, we are subject from time to time to regulatory investigations, litigation and arbitration disputes. Because the outcome of litigation, arbitration and regulatory investigations is inherently difficult to predict, it is possible that the outcome of any of these matters could entail significant expense for us and harm our business. We rely on external financing, including our credit facilities and accounts receivable securitization facility, to fund our operations. If we were unable to obtain or service such financing, or if the restrictions imposed by such financing were too burdensome, our business would be harmed. Due to the seasonal nature of our business, in order to meet our working capital needs, particularly those in the third and fourth quarters, we rely on our revolving credit facility and our other credit facilities for working capital. We currently have an amended and restated revolving credit agreement, which provides for a $350,000 revolving credit facility. The credit agreement contains certain restrictive covenants setting forth minimum cash flow and coverage requirements, and a number of other limitations, including restrictions on capital expenditures, investments, acquisitions, share repurchases, incurrence of indebtedness and dividend payments. These restrictive covenants may limit our future actions, and financial, operating and strategic flexibility. In addition, our financial covenants were set at the time we entered into our credit facility. Our performance and financial condition may not meet our original expectations, causing us to fail to meet such financial covenants. If we were unable to meet our financial covenants, or if we failed to comply with other covenants in our credit facility, we could face significant negative consequences, including loss of the ability to raise capital under these facilities to fund our operations. As an additional source of working capital and liquidity, we currently have a $250,000 accounts receivable securitization program. Under this program, we sell on an ongoing basis, substantially all of our U.S. dollar denominated trade accounts receivable to a bankruptcy remote special purpose entity. Under this facility, the special purpose entity is able to sell, on a revolving basis, undivided ownership interests in the eligible receivables to bank conduits. During the term of the facility, we must maintain certain performance ratios. If we fail to maintain these ratios, we could be prevented from accessing this cost-effective source of working capital and short-term financing. We believe that our cash flow from operations, together with our cash on hand and access to existing credit facilities and our accounts receivable securitization facility, are adequate for current and planned needs 14

result in an approximate $9,200 decrease in the fair value of these instruments. A decrease in the fair value of these instruments would be substantially offset by decreases in the related forecasted foreign currency transaction. The Company is also exposed to foreign currency risk with respect to its net cash and cash equivalents or short-term borrowing positions in currencies other than the U.S. dollar. The Company believes, however, that the on-going risk on the net exposure should not be material to its financial condition. In addition, the Companys revenues and costs have been and will likely continue to be affected by changes in foreign currency rates. From time to time, affiliates of the Company may make or receive intercompany loans in currencies other than their functional currency. The Company manages this exposure at the time the loan is made by using foreign exchange contracts. Other than as set forth above, the Company does not hedge foreign currency exposures. The Company reflects all derivatives at their fair value as an asset or liability on the balance sheet. The Company does not speculate in foreign currency exchange contracts. At December 25, 2005, the Company had fixed rate long-term debt, including current portions and excluding fair value adjustments, of $527,726. At December 25, 2005, the Company had fixed-for-floating interest rate swaps with notional amounts of $100,000. The interest rate swaps are designed to adjust the amount of the Companys debt subject to a fixed interest rate. The interest rate swaps are matched with specific long-term debt issues and are designated and effective as hedges of the change in the fair value of the associated debt. Changes in fair value of these contracts are wholly offset in earnings by changes in the fair value of long-term debt. At December 25, 2005, these contracts had a fair value of $663, with $636 included in other assets, and the remaining $27 included in prepaid expenses and other current assets, with corresponding fair value adjustments to increase long-term debt and current portions of long-term debt, respectively. Changes in interest rates affect the fair value of fixed rate debt not hedged by interest rate swap agreements while affecting the earnings and cash flows of the long-term debt hedged by the interest rate swaps. The Company estimates that a hypothetical one percentage point decrease or increase in interest rates would increase or decrease the fair value of this long-term debt by approximately $15,900 or $13,600, respectively. A hypothetical one percentage point change in interest rates would increase or decrease 2006 pretax earnings and cash flows by $729 and $375, respectively. The Economy and Inflation The Company continued to experience difficult economic environments in some parts of the world during 2005. The principal market for the Companys products is the retail sector. Revenues from the Companys top 5 customers, all retailers, accounted for approximately 53%, 50%, and 52% of its consolidated net revenues in 2005, 2004 and 2003, respectively. In the past two years certain customers in the retail sector have experienced economic difficulty. The Company monitors the creditworthiness of its customers and adjusts credit policies and limits as it deems appropriate. The Companys revenue pattern continues to show the second half of the year, and within that half, the fourth quarter, to be more significant to its overall business for the full year. The Company expects that this concentration will continue, particularly as more of its business shifts to larger customers with order patterns concentrated in the second half of the year. The concentration of sales in the second half of the year and, specifically, the fourth quarter increases the risk of (a) underproduction of popular items, (b) overproduction of less popular items, and (c) failure to achieve tight and compressed shipping schedules. The business of the Company is characterized by customer order patterns which vary from year to year largely because of differences in the degree of consumer acceptance of a product line, product availability, marketing strategies, inventory levels, policies of retailers and differences in overall economic conditions. The trend of larger retailers has been to maintain lower inventories throughout the year and purchase a greater percentage of product within or close to the fourth quarter holiday consumer selling season, which includes Christmas. Quick response inventory management practices now being used result in more orders being placed for immediate delivery and fewer orders being placed well in advance of shipment. To the extent that retailers do not sell as much of their year-end inventory purchases during this holiday selling season as they had anticipated, their demand for additional product earlier in the following fiscal year may be curtailed, thus 36

Item 8. Financial Statements and Supplementary Data Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders Hasbro, Inc.: We have audited the accompanying consolidated balance sheets of Hasbro, Inc. and subsidiaries as of December 25, 2005 and December 26, 2004, and the related consolidated statements of operations, shareholders equity, and cash flows for each of the fiscal years in the three-year period ended December 25, 2005. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hasbro, Inc. and subsidiaries as of December 25, 2005 and December 26, 2004, and the results of their operations and their cash flows for each of the fiscal years in the three-year period ended December 25, 2005, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Hasbro, Inc.s internal control over financial reporting as of December 25, 2005, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 21, 2006, expressed an unqualified opinion on managements assessment of, and the effective operation of, internal control over financial reporting. As discussed in note 1 to the consolidated financial statements, during the fourth quarter of 2004, the Company adopted Emerging Issues Task Force Issue 04-08, The Effect of Contingently Convertible Instruments on Diluted Earnings per Share. As discussed in note 6 to the consolidated financial statements, effective June 30, 2003, the first day of the Companys third quarter of fiscal 2003, the Company adopted the provisions of Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of Liabilities and Equity.

HASBRO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (Thousands of Dollars and Shares Except Per Share Data) projected future foreign currency transactions. These over-the-counter contracts, which hedge future purchases of inventory and other cross-border currency requirements not denominated in the functional currency of the unit, are primarily denominated in United States and Hong Kong dollars, Euros and United Kingdom pound sterling and are entered into with counterparties who are major financial institutions. The Company believes any risk related to default by a counterparty to be remote. Hasbro does not enter into derivative financial instruments for speculative purposes. At the inception of the contracts, Hasbro designates its derivatives as either cash flow or fair value hedges. The Company formally documents all relationships between hedging instruments and hedged items as well as its risk management objectives and strategies for undertaking various hedge transactions. All hedges designated as cash flow hedges are linked to forecasted transactions and the Company assesses, both at the inception of the hedge and on an on-going basis, the effectiveness of the derivatives used in hedging transactions in offsetting changes in the cash flows of the hedged items. The ineffective portion of a hedging derivative is immediately recognized in the consolidated statements of operations. The Company records all derivatives, such as foreign currency exchange contracts, on the balance sheet at fair value. Changes in the derivative fair values that are designated effective and qualify as cash flow hedges are deferred and recorded as a component of accumulated other comprehensive earnings (AOCE) until the hedged transactions occur and are then recognized in the consolidated statements of operations. The Companys foreign currency contracts hedging anticipated cash flows are designated as cash flow hedges. When it is determined that a derivative is not highly effective as a hedge, the Company discontinues hedge accounting prospectively. Any gain or loss deferred through that date remains in AOCE until the forecasted transaction occurs, at which time it is reclassified to the consolidated statements of operations. To the extent the transaction is no longer deemed probable of occurring, hedge accounting treatment is discontinued prospectively and amounts deferred would be reclassified to the consolidated statements of operations. In the event hedge accounting requirements are not met, gains and losses on such instruments are included currently in the statements of operations. The Company uses derivatives to hedge intercompany loans denominated in foreign currencies. Due to the short-term nature of the contracts involved, the Company does not use hedge accounting for these contracts. The Company also uses interest rate swap agreements to adjust the amount of long-term debt subject to fixed interest rates. The interest rate swaps are matched with specific long-term debt obligations and are designated and effective as fair value hedges of the change in fair value of those debt obligations. These agreements are recorded at their fair value as an asset or liability. Gains and losses on these contracts are included currently in the consolidated statements of operations and are wholly offset by changes in the fair value of the related long-term debt. These hedges are considered to be perfectly effective under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by Statement of Financial Accounting Standards No. 138 (collectively SFAS 133). The interest rate swap contracts are with a number of major financial institutions in order to minimize counterparty credit risk. The Company believes that it is unlikely that any of its counterparties will be unable to perform under the terms of the contracts. Accounting for Stock-Based Compensation At December 25, 2005, the Company had stock-based employee compensation plans and plans for non-employee members of the Companys Board of Directors, which are described more fully in note 10. As permitted by Statement of Financial Accounting Standards No. 123, as amended by No. 148, Accounting for Stock-Based Compensation, (collectively SFAS 123) Hasbro accounts for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. As required by the Companys existing stock plans, stock options are 47

HASBRO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (Thousands of Dollars and Shares Except Per Share Data) include shares potentially issuable to settle liabilities. Options and warrants totaling 6,018, 10,207 and 3,451 for 2005, 2004 and 2003, respectively, were excluded from the calculation of diluted earnings per share because to include them would have been antidilutive. A reconciliation of earnings before cumulative effect of accounting change and average number of shares for the three fiscal years ended December 25, 2005 is as follows:
2005 Basic Diluted Basic 2004 Diluted Basic 2003 Diluted
Earnings before cumulative effect of accounting change $ Change in fair value of liabilities potentially settleable in common stock Interest expense on contingent convertible debentures due 2021 $ Average shares outstanding Effect of dilutive securities: Liabilities potentially settleable in common stock Contingent convertible debentures due 2021 Options and warrants Equivalent shares Net earnings per share before cumulative effect of accounting change $

212,075

195,977

175,015

(2,080)

(12,710)

212,075 178,303

4,263 214,258 178,303

195,977 176,540

4,263 187,530 176,540

175,015 173,748

4,263 179,278 173,748

178,303
5,339 11,574 2,220 197,436

176,540

5,629 11,574 2,305 196,048

173,748

11,574 4,736 190,058
In December 2004, the Company adopted Emerging Issues Task Force (EITF) Issue 04-8, The Effect of Contingently Convertible Instruments on Diluted Earnings per Share, which states that the dilutive effect of contingent convertible debt instruments must be included in dilutive earnings per share regardless of whether the triggering contingency has been satisfied. The earnings per share calculations for the three years ended December 25, 2005 include adjustments to add back to earnings the interest expense, net of tax, incurred on the Companys Senior Convertible Debentures due 2021, as well as add back to outstanding shares the amount of shares potentially issuable as if the contingent conversion features were met. As a result of the adoption in 2003 of Statement of Financial Accounting Standards No. 150 Accounting for Certain Financial Instruments with Characteristics of Liabilities and Equity (note 6), certain warrants containing a put feature that may be settled in cash or common stock are required to be accounted for as a liability at fair value. The Company is required to assess if these warrants, classified as a liability, have a more dilutive impact on earnings per share when treated as an equity contract. As of December 25, 2005 and December 26, 2004, the warrants had a more dilutive impact on earnings per share, assuming they were treated as an equity contract. Accordingly, the numerator includes an adjustment to earnings for the income 49

277,820 9,383 15,526 28,698 (16,514) (976) 313,937 289,720 188,054 28,537 9,524 (16,514) (976) 208,625 (105,312) 73,996 3,550 (27,766) (81,095) 3,550 49,779 (27,766)
251,185 8,632 14,630 15,257 (11,354) (530) 277,820 256,548 165,460 20,824 13,654 (11,354) (530) 188,054 (89,766) 60,115 4,131 (25,520) (68,716) 4,126 39,070 (25,520)
36,2,003 2,342 (2,495) 38,505 38,505 2,495 (2,495) (38,505) 11,552 (26,953) (26,953) (26,953)
39,2,285 (3,475) (2,839) 36,082 36,082 2,839 (2,839) (36,082) 9,564 (26,518) (26,518) (26,518)
The provisions of Statement of Financial Accounting Standards No. 87, Employers Accounting for Pensions, required the Company to record an additional minimum pension liability for certain of the Companys plans of $53,329 and $43,196 at December 25, 2005 and December 26, 2004, respectively. This liability represents the amount by which the accumulated benefit obligation exceeds the sum of the fair market value of plan assets and accrued amounts previously recorded. The additional minimum pension liability is offset by an intangible asset to the extent of previously unrecognized prior service cost. An intangible asset in the amount of $3,550 and $4,126 is included in other intangibles on the balance sheet as of December 25, 2005 and December 26, 2004, respectively. The remaining amounts of $49,779 and $39,070 are recorded as components of AOCE, along with related deferred taxes of $18,916 and $14,847, at December 25, 2005 and December 26, 2004, respectively. 62
HASBRO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (Thousands of Dollars and Shares Except Per Share Data) The assets of the funded plans are managed by investment advisors and consist of the following:

Asset Category 2005 2004

Large Cap Equity Small Cap Equity International Equity Domestic Core Fixed Income Domestic High Yield Fixed Income Total Return Fund Cash

31% 100%

Hasbros two major funded plans (the Plans) are defined benefit pension plans intended to provide retirement benefits to participants in accordance with the benefit structure established by Hasbro, Inc. The Plans investment managers, who exercise full investment discretion within guidelines outlined in the Plans Investment Policy, are charged with managing the assets with the care, skill, prudence and diligence that a prudent investment professional in similar circumstance would exercise. Investment practices, at a minimum, must comply with the Employee Retirement Income Security Act (ERISA) and any other applicable laws and regulations. The Plans shared primary investment goal is maximum total return, consistent with prudent investment management. The Plans asset allocations are structured to meet a long-term targeted total return consistent with the ongoing nature of the Plans liabilities. The shared long-term total return goal, presently 8.75%, includes income plus realized and unrealized gains and/or losses on the Plans assets. Utilizing generally accepted diversification techniques, the Plans assets, in aggregate and at the individual portfolio level, are invested so that the total portfolio risk exposure and risk-adjusted returns best meet the Plans long-term liabilities to employees. Plan asset allocations are reviewed at least quarterly and rebalanced to achieve target allocation among the asset categories when necessary. The Plans investment managers are provided specific guidelines under which they are to invest the assets assigned to them. In general, investment managers are expected to remain fully invested in their asset class with further limitations of risk as related to investments in a single security, portfolio turnover and credit quality. The Plans Investment Policy generally prohibits the use of derivatives associated with leverage and speculation, or investments in securities issued by Hasbro, Inc., except through index-related strategies (e.g. an S&P 500 Index Fund) and/or commingled funds. In addition, unless specifically approved by the Investment Committee (which is comprised of members of management, established by the Board to manage and control pension plan assets), certain securities, strategies, and investments are ineligible for inclusion within the Plans. 63

HASBRO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (Thousands of Dollars and Shares Except Per Share Data) The Company measures its liabilities and related assets at September 30 (the measurement date) to coincide with the upcoming year planning cycle. The discount rates used in the pension calculation were also used for the postretirement calculation.
Components of Net Periodic Cost Pension Service cost Interest cost Expected return on assets Net amortization and deferrals Net periodic benefit cost Postretirement Service cost Interest cost Net amortization and deferrals Net periodic benefit cost
9,384 15,526 (16,275) 3,136 $ 11,771 $ 573 2,2,930
8,632 14,630 (14,489) 2,750 11,2,3,419
8,263 14,026 (12,350) 3,060 12,2,3,461
Assumptions used to determine the year-end benefit obligation are as follows:
Weighted average discount rate Rate of future compensation increases Long-term rate of return on plan assets Mortality table
5.50% 4.00% 8.75% RP-2000

5.75% 4.00% 8.75% GAM 83

Assumptions used to determine net periodic benefit cost of the pension plans for each fiscal year follow:
Weighted average discount rate Rate of future compensation increases Long-term rate of return on plan assets

5.75% 4.00% 8.75%

6.00% 4.00% 8.75%

6.50% 4.00% 8.75%

Hasbro works with external benefit investment specialists to assist in the development of the long-term rate of return assumptions used to model and determine the overall asset allocation. Forecast returns are based on the combination of historical returns, current market conditions and a forecast for the capital markets for the next 5-7 years. Approximately 75% of the return assumption is based on the historical information and 25% is based on current or forward-looking information. All asset class assumptions are within certain bands around the long-term historical averages. Correlations are based primarily on historical return patterns. 64
HASBRO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) (Thousands of Dollars and Shares Except Per Share Data) Expected benefit payments under the defined benefit pension plans and expected gross benefit payments and subsidy receipts under the postretirement benefit for the next five years subsequent to 2005 and in the aggregate for the following five years are as follows:
Postretirement Gross Benefit Subsidy Payments Receipts

Revenue from External Customers Operating Profit (Loss) Depreciation and Amortization

Affiliate Revenue

Capital Additions

Total Assets

2005 U.S. Toys Games International Operations(a) Other segments Corporate and eliminations(b) Consolidated Total
1,074,540 730,635 1,231,49,868 3,087,627
1,920 23,359 2,348 948,048 (975,675)
79,991 69,477 148,135 18,720 20,697 (26,499) 310,521
45,900 34,820 39,728 45,13,605 180,132
733 11,308 6,201 42,9,515 70,584
1,137,971 1,724,339 1,229,191 747,315 115,864 (1,653,537) 3,301,143
Revenue from External Customers Affiliate Revenue Operating Profit (Loss) Depreciation and Amortization Capital Additions Total Assets
2004 U.S. Toys Games International Operations(a) Other segments Corporate and eliminations(b) Consolidated Total 2003 U.S. Toys Games International(c) Operations(a) Other segments(d) Corporate and eliminations(b) Consolidated Total
952,923 796,032 1,194,630 2,703 51,222 2,997,510 1,057,984 804,547 1,184,532 1,929 89,665 3,138,657
3,645 29,692 1,322 835,576 (870,235) 6,732 29,843 112,017 771,341 (919,933)
7,185 137,628 140,784 6,659 18,088 (17,332) 293,012 91,996 175,295 91,273 10,438 (13,082) (11,304) 344,616
27,073 30,590 33,654 38,15,841 146,180 33,486 34,676 52,167 35,694 2,875 5,225 164,123
1,430 8,315 8,752 46,14,213 79,239 2,282 7,675 4,722 38,9,443 63,070
1,040,460 1,598,867 1,582,223 636,215 178,913 (1,796,018) 3,240,660 1,037,754 1,471,286 1,353,546 591,674 106,176 (1,397,060) 3,163,376
(a) The Operations segment derives substantially all of its revenues, and thus its operating results, from intersegment activities. (b) Certain intangible assets, primarily goodwill, which benefit operating segments are reflected as Corporate assets for segment reporting purposes. For application of SFAS 142, these amounts have been allocated to the reporting unit which benefits from their use. In addition, allocations of certain expenses related to these assets to the individual operating segments are done prior to the start of the year based on budgeted amounts. Any difference between actual and budgeted amounts are reflected in the Corporate segment. (c) Operating profit of the International segment includes a cash charge associated with severance costs of approximately $18,400 relating to the cessation of manufacturing in the Companys facility in Spain. In addition, the Company wrote-down certain property, plant and equipment that will not be used in its ongoing operations in Spain. (d) Other segments include a cash charge of approximately $14,040 in 2003 relating to costs incurred for leases and severance obligations relating to the announced closure of all of the Companys remaining retail stores. 69

.04.03 $ $ 22.98 19.38.06

.11.06 23.33 17.15.06

.50.43 19.64 16.98.06

.46.44 19.62 16.90.06

1.11.96 23.33 16.90.24
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures The Company maintains disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the Exchange Act), that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commissions rules and forms and that such information is accumulated and communicated to the Companys management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. The Company carried out an evaluation, under the supervision and with the participation of the Companys management, including the Companys Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Companys disclosure controls and procedures as of December 25, 2005. Based on the evaluation of these disclosure controls and procedures, the Chief Executive Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures were effective. Managements Report on Internal Control Over Financial Reporting The Companys management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) promulgated under the Exchange Act. Hasbros internal control system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Hasbros management assessed the effectiveness of its internal control over financial reporting as of December 25, 2005. In making its assessment, Hasbros management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on this assessment, Hasbros management concluded that, as of December 25, 2005, its internal control over financial reporting is effective based on those criteria. Hasbros independent auditors have issued an audit report on managements assessment of its internal control over financial reporting, which appears below. 72
Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders Hasbro, Inc.: We have audited managements assessment, included in the accompanying Managements Report on Internal Control Over Financial Reporting, that Hasbro, Inc. maintained effective internal control over financial reporting as of December 25, 2005, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the Companys internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, managements assessment that Hasbro, Inc. maintained effective internal control over financial reporting as of December 25, 2005 is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Hasbro, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 25, 2005 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Hasbro, Inc. and subsidiaries as of December 25, 2005 and December 26, 2004, and the related consolidated statements of operations, shareholders equity, and cash flows for each of the fiscal years in the three-year period ended December 25, 2005, and our report dated February 21, 2006, expressed an unqualified opinion on those consolidated financial statements. /s/ KPMG LLP Providence, Rhode Island February 21, 2006 73

(b) (c) (d) (e) (f)

(h) (i)

(j) (k) (l) (m) (n) (o)

Lease between Hasbro Canada and Central Toy, together with an Addendum thereto, each dated as of May 1, 1987. (Incorporated by reference to Exhibit 10(f) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1987, File No. 1-6682.) Addendum to lease, dated March 5, 1998, between Hasbro Canada and Central Toy. (Incorporated by reference to Exhibit 10(c) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 28, 1997, File No. 1-6682.) Letter agreement, dated December 13, 2000, between Hasbro Canada and Central Toy. (Incorporated by reference to Exhibit 10(d) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2000, File No. 1-6682.) Indenture and Agreement of Lease between Hasbro Canada and Central Toy, dated November 11, 2003. (Incorporated by reference to Exhibit 10(e) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 28, 2003, File No. 1-6682.) Toy License Agreement between Lucas Licensing Ltd. and the Company, dated as of October 14, 1997. (Portions of this agreement have been omitted pursuant to a request for confidential treatment under Rule 24b-2 of the Securities Exchange Act of 1934, as amended.)(Incorporated by reference to Exhibit 10(d) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1998, File No. 1-6682.) First Amendment to Toy License Agreement between Lucas Licensing Ltd. and the Company, dated as of September 25, 1998. (Portions of this agreement have been omitted pursuant to a request for confidential treatment under Rule 24b-2 of the Securities Exchange Act of 1934, as amended.)(Incorporated by reference to Exhibit 10(e) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1998, File No. 1-6682.) Seventeenth Amendment to Toy License Agreement between Lucas Licensing Ltd. and the Company, dated as of January 30, 2003. (Incorporated by reference to Exhibit 10(g) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 29, 2002, File No. 1-6682.) Agreement of Strategic Relationship between Lucasfilm Ltd. and the Company, dated as of October 14, 1997. (Portions of this agreement have been omitted pursuant to a request for confidential treatment under Rule 24b-2 of the Securities Exchange Act of 1934, as amended.) (Incorporated by reference to Exhibit 10(f) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 27, 1998, File No. 1-6682.) First Amendment to Agreement of Strategic Relationship between Lucasfilm Ltd. and the Company, dated as of September 25, 1998. (Incorporated by reference to Exhibit 10(g) to the Companys Annual Report on Form 10-K for the Fiscal Year ended December 27, 1998, File No. 1-6682.) Second Amendment to Agreement of Strategic Relationship between Lucasfilm Ltd. and the Company, dated as of January 30, 2003. (Incorporated by reference to Exhibit 10(j) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 29, 2002, File No. 1-6682.) Warrant, dated October 14, 1997 between the Company and Lucas Licensing Ltd. (Incorporated by reference to Exhibit 10(h) to the Companys Annual Report on Form 10-K for the Fiscal Year ended December 27, 1998, File No. 1-6682.) Warrant, dated October 14, 1997 between the Company and Lucasfilm Ltd. (Incorporated by reference to Exhibit 10(i) to the Companys Annual Report on Form 10-K for the Fiscal Year ended December 27, 1998, File No. 1-6682.) Warrant, dated October 30, 1998 between the Company and Lucas Licensing Ltd. (Incorporated by reference to Exhibit 10(j) to the Companys Annual Report on Form 10-K for the Fiscal Year ended December 27, 1998, File No. 1-6682.) Warrant, dated October 30, 1998 between the Company and Lucasfilm Ltd. (Incorporated by reference to Exhibit 10(k) to the Companys Annual Report on Form 10-K for the Fiscal Year ended December 27, 1998, File No. 1-6682.) 77

Chairman of the Board

February 22, 2006 February 22, 2006 February 22, 2006
President, Chief Executive Officer and Director (Principal Executive Officer) Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Director
/s/ Basil L. Anderson Basil L. Anderson /s/ Alan R. Batkin Alan R. Batkin /s/ Frank J. Biondi, Jr. Frank J. Biondi, Jr. /s/ John M. Connors, Jr. John M. Connors, Jr. /s/ Michael W.O. Garrett Michael W.O. Garrett /s/ E. Gordon Gee E. Gordon Gee /s/ Jack M. Greenberg Jack M. Greenberg /s/ Claudine B. Malone Claudine B. Malone 83
February 22, 2006 February 22, 2006 February 22, 2006 February 22, 2006 February 22, 2006 February 22, 2006 February 22, 2006 February 22, 2006

Director

Signature
/s/ Edward M. Philip Edward M. Philip /s/ Paula Stern Paula Stern 84
February 22, 2006 February 22, 2006
HASBRO, INC. Annual Report on Form 10-K for the Year Ended December 25, 2005 Exhibit Index
Articles of Incorporation and Bylaws (a) Restated Articles of Incorporation of the Company. (Incorporated by reference to Exhibit 3.1 to the Companys Quarterly Report on Form 10-Q for the period ended July 2, 2000, File No. 1-6682.) (b) Amendment to Articles of Incorporation, dated June 28, 2000. (Incorporated by reference to Exhibit 3.4 to the Companys Quarterly Report on Form 10-Q for the period ended July 2, 2000, File No. 1-6682.) (c) Amendment to Articles of Incorporation, dated May 19, 2003. (Incorporated by reference to Exhibit 3.3 to the Companys Quarterly Report on Form 10-Q for the period ended June 29, 2003, File No. 1-6682.) (d) Amended and Restated Bylaws of the Company, as amended. (Incorporated by reference to Exhibit 3.4 to the Companys Quarterly Report on Form 10-Q for the period ended June 29, 2003, File No. 1-6682.) (e) Certificate of Designations of Series C Junior Participating Preference Stock of Hasbro, Inc. dated June 29, 1999. (Incorporated by reference to Exhibit 3.2 to the Companys Quarterly Report on Form 10-Q for the period ended July 2, 2000, File No. 1-6682.) (f) Certificate of Vote(s) authorizing a decrease of class or series of any class of shares. (Incorporated by reference to Exhibit 3.3 to the Companys Quarterly Report on Form 10-Q for the period ended July 2, 2000, File No. 1-6682.) Instruments defining the rights of security holders, including indentures. (a) Indenture, dated as of July 17, 1998, by and between the Company and Citibank, N.A. as Trustee. (Incorporated by reference to Exhibit 4.1 to the Companys Current Report on Form 8-K dated July 14, 1998, File No. 1-6682.) (b) Indenture, dated as of March 15, 2000, by and between the Company and the Bank of Nova Scotia Trust Company of New York. (Incorporated by reference to Exhibit 4(b) (i) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 26, 1999, File Number 1-6682.) (c) Indenture, dated as of November 30, 2001, between the Company and The Bank of Nova Scotia Trust Company of New York. (Incorporated by reference to Exhibit 4.1 to the Companys Registration Statement on Form S-3, File No. 333-83250, filed February 22, 2002.) (d) Third Amended and Restated Revolving Credit Agreement, dated as of November 14, 2003, by and among the Company, the Banks party thereto, and Fleet National Bank, as Agent for the Banks. (Incorporated by reference to Exhibit 4(d) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 28, 2003, File No. 1-6682.) (e) First Amendment to the Companys Third Amended and Restated Revolving Credit Agreement dated March 11, 2005. (Incorporated by reference to Exhibit 4.5 to the Companys Quarterly Report on Form 10-Q for the period ended March 27, 2005, File No. 1-6682.) (f) Rights Agreement, dated as of June 16, 1999, between the Company and Fleet National Bank (the Rights Agent). (Incorporated by reference to Exhibit 4 to the Companys Current Report on Form 8-K dated as of June 16, 1999.) (g) First Amendment to Rights Agreement, dated as of December 4, 2000, between the Company and the Rights Agent. (Incorporated by reference to Exhibit 4(f) to the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2000, File No. 1-6682.) 85

"(1) Upon the occurrence of an event constituting a Change in Control, all awards outstanding on such date shall become 100% vested and the then value of such awards, less all applicable withholding taxes, shall be paid to the participant in cash (or, in the case of Stock Options, SARs, Stock Awards and any other awards providing for equity in the Company, either in cash or in shares of Common Stock, or in any combination thereof, as may be determined by the Committee in its sole and absolute discretion) as soon as may be practicable. Upon such payment, such awards shall be cancelled." 2. A new Section 16(b)(4) is hereby added to the 1995 Plan as follows:
EXHIBIT 10(bb) THIRD AMENDMENT TO HASBRO, INC. 1997 EMPLOYEE NON-QUALIFIED STOCK PLAN The Hasbro, Inc. 1997 Employee Non-Qualified Stock Plan (the "1997 Plan"), as amended, is hereby further amended in the manner set forth below by this third amendment (the "Third Amendment"). The effective date for this Third Amendment is December 23, 2005. 1. Section 16(b)(1) and (2) of the 1997 Plan are hereby deleted and replaced in their entirety with the following: "(1) Upon the occurrence of an event constituting a Change in Control, all awards outstanding on such date shall become 100% vested and the then value of such awards, less all applicable withholding taxes, shall be paid to the participant in cash (or, in the case of stock options, SARs, stock awards and any other awards providing for equity in the Company, either in cash or in shares of Common Stock, or in any combination thereof, as may be determined by the Committee in its sole and absolute discretion) as soon as may be practicable. Upon such payment, such awards shall be cancelled. (2) The amount of cash to be paid with respect to stock awards, stock options and SARs shall be determined by multiplying the number of such awards by (i) in the case of stock awards, the CIC Price, provided, however, that in the case of stock awards where the performance period, if any, has been completed on or prior to the occurrence of a Change in Control, or when the stock awards will vest solely as a result of continuous service with the Company, the number of stock awards to be multiplied shall be the number of shares issued pursuant to the award as determined in accordance with the award agreement and in the case of stock awards where the performance period, if any, has not been completed upon the occurrence of a Change in Control, the number of stock awards to be multiplied shall be the higher of the target number of such awards as determined by the Committee at the time of grant and the number of shares issuable based on actual performance to date, in each case prorated based on the number of fiscal years then completed during the performance period, (ii) in the case of stock options, the difference between the exercise price per share and the CIC Price, if the CIC price is higher, and (iii) in the case of SARs, the difference between the exercise or designated price per share and the CIC Price, if the CIC price is higher. In the case of cash awards the amount of cash to be paid shall be determined, (i) where the performance period, if any, has been completed on or prior to the occurrence of a Change in Control, the value of such award as determined in accordance with the award agreement and (ii) where the performance period, if any, has not been completed upon the occurrence of Change in Control, the higher of the target value of such awards as determined by the Committee at the time of grant and the value of such awards based on actual performance to date, in each case prorated based on the number of fiscal years then completed during the performance period. In addition, all accrued dividends and dividend equivalents or interest accrued on deferred settlements shall be paid. (3) In the event that the Committee determines pursuant to Section 16(b)(1) above to pay participants the value of an equity award in shares of Common Stock, the number of shares of Common Stock to be paid to each participant will be determined by taking the cash value which would have been paid if the Committee had elected to pay in cash, computed in accordance with Section 16(b)(2) above, and dividing such value by the Payout Fair Market Value of the Common Stock. No fractional shares of Common Stock will be issued. The value of any fractional share amount will be paid to the participant in cash. For purposes of this Plan the term "Payout Fair Market Value" shall mean the average of the Fair Market Values of the Stock for the ten trading days immediately preceding the date on which the Change in Control shall have occurred.

Q: What was behind the high growth rates in North America?
A: Modifications to our product range, including new polymer blends and the introduction of American standard sizes, made our foams more attractive to customers in North America.
A range of knee pads have been developed in Canada; an example of an application in Europe being transferred, with our support, to the North American market.
Shown below are a range of products designed to be used for returnable packaging.
The average foam sheet contains around 1.5 billion cells (bubbles) containing gas
Early indications are that the loss of sales in the final quarter will not adversely affect 2001. However the fire came at a sensitive time as we began to offer new products to customers as an alternative to Sekisuiproduced foams. It is therefore likely that some customers intentions to switch to Zotefoams products were affected by the fire.
MANUFACTURING AND CAPACITY The majority of capital expenditure during 2000 was in our new satellite plant in Northern Kentucky, which is expected to be commissioned in the first half of 2001. This facility will utilise the technology development, announced during 1999, of shipping non-expanded nitrogen saturated plastic sheets before final expansion at our Kentucky site. The only other significant item of capital expenditure relates to our investment in a fully integrated, multi-site computer system, which is due for commissioning in the second quarter of 2001. Gross margins fell to 32% compared to 43% in 1999. There are three main reasons for the fall; adverse macroeconomic variables, lower plant utilisation due to the fall in turnover and one-off stock and capital equipment write-downs.
The environment of continued Euro weakness, combined with high raw material prices, is estimated to have reduced profits by 1 million compared to 1999. The average price of LDPE, our main raw material, increased by 19% (while similar movements were evident in other commodity polymers). In addition we estimate the fall in turnover reduced our gross margins by some 4.2%. Our June strategic review resulted in a write-down of 0.8 million of stock and assets; of which 0.7 million was a non-cash charge to cost of sales.

TECHNICAL DEVELOPMENT

Zotefoams has a unique technology and is able to make products which other, competing technologies cannot achieve. We therefore believe development of new products is a key area for the future success of our business. However during the year much of our focus has been to develop products which have similar attributes/characteristics to those foams produced by Sekisui, our alliance partner. These developments have allowed Sekisui to offer Zotefoams products to their customers in Europe; paving the way for the closure of their low-density block foam manufacturing operation in December 2000.

technology and innovation
Q: What does cross-linking do?
A: Cross-linked plastics and foams have enhanced material strength, durability and temperature resistance. This is achieved by the formation of a lattice-like structure at molecular level. This gives enhanced performance in many applications such as moulding and long life packaging.
The purity of our products ensures that they are widely used in medical applications such as this orthopaedic brace.
Zotefoams products have a number of key properties, which make them the preferred solution in a wide variety of end-use markets and applications.
1 Foam (cellular) structure our foam cell structures are regular and approximate the ideal theoretical structure for shape packing. This benefit leads to better and more consistent physical properties such as strength and toughness. Imagine a bees honeycomb. It is the most efficient use of space and material to give the required structural strength whilst maximising volume.
2 Environmental benefits no hazardous or environmentally damaging gases, regularly used in competitive processes (such as isobutane, propane, CFCs or HCFCs) are used in the expansion of our foams. Nitrogen is an inert gas and makes up around 78% of the atmosphere of our planet and we therefore borrow the gas to make efficient use of other earth-derived materials (the plastic is produced from oil).
Most modern fabrication methods are developed from traditional techniques, but enhanced through the addition of CNC (computer numerical controls). Multi-axis routing machines and water-jet cutters are typical examples. CNC controlled machines are able to rapidly produce parts with high engineering tolerances. Such highly specified parts can only be made from materials with
sufficient durability to withstand processing and have a consistent structure to make each part identical. In addition the materials must be stable so the tolerances of the machined part do not change after manufacture. PLASTAZOTE foams meet these exacting requirements allowing our customers to create new applications, extending the markets where foams are used.
Purity there are no chemical residues such as ammonia present in our foams as our expansion is a physically rather than a chemically induced one. Residues of ammonia gas, flammable gas residues such as iso-butane and other solid substances are common in competitive materials.
Continued growth was seen in both North America and Europe for our range of products used in the automotive components market.

This multi-axis routing machine is a typical example of modern fabrication methods.
Willhelm Kopp Zellkautschuk, our main German distributor, approached us to develop a product that could be used for insulation in the building industry. The product had to pass the stringent German building flammability requirement and be easily mouldable to fit the complex outer profile of the pipe valves and taps, as well as match the colour of the product
being used in other parts of the system. After extensive trials a grade was successfully developed with a modified colour, flammability and cross-link level that fully met the requirements. The material is now being used in Germany and is being sampled for the Austrian market.
4 Flexibility the process offers great scope in production and in product range. It is capable of producing foams not physically possible by other means, such as our HD grade foams and polypropylene grade range.
Fundamental to our success is that our foams create advantages for our customers, advantages which are not available through competitive products. A profile of properties such as high strength to weight ratio; energy absorption; ease and consistency of moulding and cutting; inherent water resistance and buoyancy as well as foam purity all contribute to our sales success. Zotefoams employs a truly unique manufacturing process. At its heart is our proprietary high pressure gassing system to produce foams. The process produced the first cross-linked polyethylene foams in 1962 however the last two decades have seen a transformation in scale, flexibility and scope to achieve the world leading process technology that now exists in Croydon. The process involves heating a plastic slab in an atmosphere o of pure nitrogen gas. Process temperatures of 250 C and pressures up to 10,000 psi (670 bar) combine to dissolve nitrogen gas into the molecular structure of the softened plastic. The plastic sheet is then transferred to an expansion autoclave where the sheet is expanded into the finished foam. Having the flexibility to vary the processing conditions of our equipment over a wide range allows us to explore materials which cannot be foamed by other means. Higher temperature
resistance, improved chemical resistance and non-flammable foam products are properties valued by key customers and are all prime targets in development. As the raw materials used directly influence such properties of the foam, the ability to process a wide range of material gives an advantage in developing these characteristics. Our process operating conditions support the development of these key attributes while most other foaming methods are less flexible. Successful exploitation of these capabilities is fundamental to Zotefoams future growth. Our philosophy is to concentrate resources where the differential advantage of our process is greatest and the benefit to our shareholders is greatest. Since its stock market flotation in 1995 Zotefoams has concentrated development resource on improving its process capability and working with customers to meet their specific needs in product variants. While development of variants will continue to be an important element in customer service and sales growth, the time is now right for Zotefoams to focus on increasing development of new products and areas of greater opportunity. This means future investment will concentrate in establishing an organisation capable of exploiting Zotefoams unique technology in areas of high differential advantage.

Q: Why transport intermediate products to Kentucky for foaming?
A: Shipping unexpanded sheets to Kentucky then foaming them for delivery to our customers significantly reduces transport costs. We estimate a 70% reduction in the number of container miles travelled.
Expanding the plastic by up to 65 times means the foam sheets contain as little as 1.5% plastic by volume
EUROPE Sekisui will market and sell Zotefoams product in exclusion to all other block foams through its Alveo subsidiary. In December 2000 Alveo ceased production of competing block foams.
NORTH AMERICA Voltek, the foam division of Sekisui in America, have a cross-agency agreement with Zotefoams. This allows both companies exclusive agency rights to a portfolio of foams.
During the stage where the nitrogen gas is dissolved into the plastic sheets, the gas pressure is regularly held at up to 10,000 pounds per square inch. This is 350 times the normal pressure of a car tyre.
Sekisui and their affiliates will act as exclusive distributor of Zotefoams products. The European co-operation is already considerably advanced giving Zotefoams access to Alveo customer base and increasing our visibility of market trends. This allows us to work more closely to the specifier of the end application, driving product development and ensuring a partnership approach to meeting customer requirements.
DB STIRLING MANAGING DIRECTOR

finance directors review

9.3 7.8 6.7
PERCENTAGE GROWTH IN NON-PUZZLE SALES
Sales growth 1998 September 2000 in constant currency

RESULTS

Turnover fell 7%, from 22.4 million in 1999 to 20.8 million in 2000. The major reasons for the reduction were the fall of sales to the toys business (2.4 million) and adverse foreign exchange rates (0.5 million). Underlying turnover excluding these factors grew at 9.3% for the nine months to September 2000, the period preceding the fire.
ANALYSIS OF EXPOSURE TO MAIN CURRENCY GROUPS MILLION EQUIVALENT million incurred in US$ Euro Total
Turnover Cost of sales Gross profit Distribution costs

7.5 (11.6) (4.1) (1.0)

4.4 4.4 (0.9) 3.5

8.9 (2.6) 6.3 (0.1) 6.2

20.8 (14.2) 6.6 (2.0) (2.2) 2.4
Administrative expenses (2.2) Operating profit (7.3)
Cost of sales includes 3.0 million depreciation charge.
Profit was impacted by these factors. A table showing the 2000 results by currency is shown above. The net impact of currency was 0.4 million adverse compared to 1999. For major currencies to which the Group is exposed the exchange rates used in the financial statements are:

CASH FLOW AND FUNDING

Operating cash flow was 5.5 million positive. However, with the investment in the North American manufacturing facility there was a net cash outflow before financing of 3.3 million. The final dividend proposed is 5.0p making a total dividend for the year of 7.5p. Many of the factors which have impacted on the 2000 results the fire and the 0.8 million write-off of stock and capital equipment at the half year were non-recurring in nature and the dividend has therefore been kept at the same level as last year. The balance sheet remains strong with net borrowing of 0.4 million against net assets of 28.1 million.
TREASURY AND ACCOUNTING POLICIES
The Board has defined policies and procedures relating to treasury management and accounting practices. These are designed to provide appropriate business support, consistency of reporting and to mitigate financial risk. In accordance with these policies sales invoices, net of purchases, are normally hedged forward to the date of currency receipt. Translation exposure of foreign currency denominated net assets is not currently considered material and is therefore not hedged. Cash requirements are reviewed weekly and surplus cash is placed on Treasury Deposit for periods ranging from overnight to one month. Net borrowing has not been significant and neither finance or interest rate risk to date has been considered material. With the new manufacturing facility in America the net exposure of the Group will change significantly and the hedging policies of the Group will be restructured to minimise the risks that may result.
TAXATION The effective tax rate for the Group was 24%. Corporation tax has been provided for at the rate of 30%. However, there was a deferred tax credit of 0.1 million due to the benefit of capital allowances on the investment in North America. As this project is completed the effective tax rate for the Group is expected to rise to 30%.
GOING CONCERN STATEMENT After making enquiries, the Directors have a reasonable expectation that the Group has adequate resources to continue in operational existence for the foreseeable future. For this reason they continue to adopt the going concern basis in preparing the financial statements.

DIRECTORS REMUNERATION AND EMOLUMENTS Remuneration in Basic salary /fees Profit share scheme Car allowance Other benefits Total 2000 Comparable 1999
W H Fairservice A C Gingell A Eldrett M P Lewsey D B Stirling R V Redd C G Hurst I M Buckley J C Marley C J Ryan
91,500 134,834 81,422 71,290 93,364 35,634 18,750 18,375 20,000 18,450

3,440 9,162 9,788 2,300

1,1,412 9,7,236
92,876 138,669 91,996 81,146 103,989 42,870 21,050 18,375 20,000 18,450
115,839 112,258 93,824 81,621 83,254 32,427 17,589 19,464 1,500
(1) Fees, car allowance and other benefits are non-pensionable. (2) Only M P Lewsey and Mr R V Redd are entitled to use of a fully expensed company-owned vehicle. All other executive Directors are entitled to a company car cash allowance as determined by the Remuneration Committee. (3) A C Gingell resigned from the Board on 3 May 2000. (4) R V Redd resigned from the Board on 14 July 2000. (5) Other benefits: Other benefits are calculated in terms of taxable values in the UK. (6) C G Hurst joined the Board on 2 October 2000. (7) Included in the remuneration of A C Gingell is a payment of 100,260 in respect of early termination of his contract at the request of Zotefoams plc.

DIRECTORS SHAREHOLDINGS

The beneficial interests of the Directors (including persons connected with them within the meaning of Section 346 of the Companies Act 1985) in the ordinary shares of the Company is set out below:
31 December 31 December 2000 1999
Number of ordinary 5p shares at:
W H Fairservice A Eldrett M P Lewsey D B Stirling I M Buckley J C Marley C G Hurst
1,108,392 1,112,615 993,358 1,004,863 1,435,912 1,433,727 20,510 20,000 40,208 18,071 20,000 40,208
There have been no changes to Directors interests between the end of the financial year and the date of this report. Directors with shareholdings in excess of 3% as at 31 December 2000 were M P Lewsey (4.0%), and W H Fairservice (3.1%).

SHARE OPTIONS

Options over ordinary shares granted:
As at 31 December 1999 As at 31 December Lapsed 2000 Exercise price

Date from

Granted

Exercisable

Expiry date
W H Fairservice M P Lewsey A Eldrett D B Stirling
10,582 10,582 9,027 9,027

163p 163p

1.8.2000 31.1.2001 1.8.2000 31.1.2001 1.4.2002 1.4.2002
108p 1.10.2001 108p 1.10.2001

D B Stirling

32,085
93.5p 23.2.2002 22.2.2009
UK resident Directors and UK-based employees of the Company with a contractual working week of at least 20 hours and at least one years service are eligible to participate in Zotefoams Savings Related Share Option Scheme. Directors interests are set out above. The option shown in italics of 32,085 shares for D B Stirling has been granted under an Inland Revenue Approved Share Option Scheme. This option is not exercisable unless the Groups earnings per share, before exceptional items, increases over a three year period by at least 6% in excess of the increase in the Retail Price Index over the same period. There have been no changes in options granted between the end of the year and the date of this report. No options have been granted under the Zotefoams Employee Share Option Scheme. The middle market quoted share price at 31 December 2000 was 79.5p and the high and low prices during the year were 137.5p and 74.5p respectively. By order of the Board

J C MARLEY Non-Executive Director and Chairman of the Remuneration Committee

corporate governance

The Directors are fully aware of the provisions contained in the Combined Code: Principles of Good Governance and Code of Best Practice. The principles set out in Section 1 of the Combined Code have been applied consistently throughout 2000 as follows.
BOARD COMPOSITION AND RESPONSIBILITY At the beginning of 2000 the Board structure composed six executive Directors and three independent, non-executive Directors. W H Fairservice serves as the part-time Chairman and J C Marley as the senior independent Director. A C Gingell resigned from the Board in May 2000 and was replaced as Managing Director by D B Stirling. R V Redd resigned from the Board in July 2000. C G Hurst was appointed to the Board in October 2000. There were no changes in the non-executive Directors during the course of the year. Membership of various Board committees is disclosed in the Directors and advisers section of the annual report. Appointments to the Board are proposed by a Nominations Committee and approved by majority vote of the full Board. Re-election is required at the first Annual General Meeting following appointment and at least every three years thereafter. On average there are seven Board meetings scheduled each year. In 2000 six Board meetings were held, and attendance by the Directors at these meetings was over 90%. A formal schedule of matters which require Board approval is in place. Each month all Directors receive management reports and briefing papers in relation to Board matters. All the Directors have access to the Company Secretary and independent professional advice at the Companys expense if required for the furtherance of their duties. Training is provided for all new Directors and is available subsequently in order to fulfil the requirements of being a Director of a listed plc.

DIRECTORS REMUNERATION

The principles and details of remuneration policy for Directors are set out in the Report of the Board on

Directors remuneration.

RELATIONS WITH SHAREHOLDERS
Meetings with institutional shareholders are held twice a year following announcement of the Groups interim and final results. Other meetings may be held at institutional shareholder request. The Board considers the annual report and financial statements and Annual General Meeting to be the primary vehicles for communication with private investors. Our corporate website www.zotefoams.com contains information on the Company.

ACCOUNTABILITY AND AUDIT The Audit Committee, chaired by I M Buckley, meets at least twice a year. The Committee has written terms of reference which comply with the Combined Code. It assists the Board in ensuring appropriate methods of internal financial control are adopted and that the Groups annual report and other published information comply with the relevant statutory requirements. Meetings are attended, at the invitation of the Committee, by the Managing Director, Finance Director and a representative from KPMG Audit Plc.
The Company is required to report on compliance with the detailed requirements of the Combined Code. In relation to all provisions of the Combined Code other than those mentioned, the Company complied throughout the period under review. Where non-compliance is reported, the reasons for non-compliance are explained. The Board has considered the requirement for the performance-related element of remuneration to form a significant proportion of the total remuneration package of executive Directors as required under provision B.1.4. It has therefore proposed a bonus and share option scheme which has been described in more detail in the Report of the Board on Directors remuneration. The executive share option scheme applies to those Directors who were not part of the Management Buy-Out. The Board believes that the interest of those executive Directors who participated in the Management Buy-Out of the Company in 1992 and who retain significant interests in the shares of the Company are aligned with the interests of other shareholders.
STATEMENT ON COMPLIANCE INTERNAL CONTROL
The Board is ultimately responsible for the Groups system of internal control and for reviewing its effectiveness. However, such a system is designed to manage rather than eliminate the risk of failure to achieve business objectives, and can provide only reasonable and not absolute assurance against material misstatement or loss. The Combined Code introduced a requirement that the Directors review the effectiveness of the Groups system of internal controls. This extends the existing requirement in respect of internal financial controls to cover all controls including financial, operational, environmental, health and safety, compliance and risk management. Guidance for Directors on the Combined Code (the Turnbull guidance) became operational for the accounting period ending 31 December 2000.
INTERNAL CONTROL (CONTINUED) The Board confirms it has established a system of procedures and controls to ensure compliance with the Combined Code. This system was tested by the fire on the Companys Croydon site in October 2000 and the Board was pleased with the ability of the Company to recover from a potentially difficult situation. Attention at the end of 2000 however, was necessarily directed to dealing with the impact of the fire and the resulting immediate business risks. In 2001 the Board will focus again on wider business risks and their management. Key elements of the Groups system of internal financial controls are as follows:

CONTROL ENVIRONMENT The Group is committed to the highest standards of business conduct and seeks to maintain these standards across all of its operations throughout the world. The Group has adopted a Code of Business Conduct, approved by the main Board, which provides practical guidance for all staff. This guidance is included in the employee handbook and incorporated into an induction process which all employees must complete. The Group has an appropriate organisational structure for planning, executing, controlling and monitoring business operations in order to achieve Group objectives. Overall business objectives are set by the Board and communicated through the organisation. Lines of responsibility and delegations of authority are documented.

RISK IDENTIFICATION

Group management are responsible for the identification and evaluation of key risks applicable to their areas of business. These risks are assessed on a continual basis and may be associated with a variety of internal or external sources including control breakdowns, disruption in information systems, competition, natural catastrophe and regulatory requirements. Strategic reviews which include consideration of long-term financial projections and the evaluation of business alternatives are held annually. Annual budgets are a key part of the planning process and performance against plan is actively monitored at Board level supported by quarterly forecasts. Actual operating performance is made available to all Directors monthly, and forecasts are presented to the Board quarterly. Through these mechanisms, Group performance is continually monitored, risks identified in a timely manner, their financial implications assessed, control procedures re-evaluated and corrective actions agreed and implemented. The Group has implemented control procedures designed to ensure complete and accurate accounting for financial transactions and to limit the potential exposure to loss of assets or fraud. Measures taken include physical controls, segregation of duties, reviews by management, and external audit to the extent necessary to arrive at their audit opinion. As executive Board members are in close proximity to Group operations, an internal audit function covering financial control is not considered necessary at this time. However an internal audit function does exist to ensure compliance with procedures for environmental, quality and health and safety procedures. A process of control self-assessment and hierarchical reporting has been established which provides for a documented and auditable trail of accountability. These procedures are relevant across Group operations and provide for successive assurances to be given at increasingly higher levels of management and, finally, to the Board. Planned corrective actions are independently monitored for timely completion. There are clear and consistent procedures in place for monitoring the system of internal financial controls. The Audit Committee meets at least twice a year and, within its remit, reviews the effectiveness of the Groups system of internal financial controls. The Committee receives reports from external auditors and management.

We conducted our audit in accordance with Auditing Standards issued by the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements. It also includes an assessment of the significant estimates and judgements made by the Directors in the preparation of the financial statements, and of whether the accounting policies are appropriate to the Groups circumstances consistently applied and adequately disclosed. We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of information in the financial statements.
BASIS OF AUDIT OPINION OPINION In our opinion the financial statements give a true and fair view of the state of affairs of the Company and the Group as at 31 December 2000 and of the profit of the Group for the year then ended and have been properly prepared in accordance with the Companies Act 1985.

KPMG Audit Plc

Chartered Accountants Registered Auditor London 23 February 2001
consolidated profit and loss account
for the year ended 31 December 2000

2000 Note 000

1999 000
Turnover continuing operations Cost of sales Gross profit Distribution costs Administrative expenses Operating profit continuing operations (Loss) on disposal of fixed assets continuing operations Profit on ordinary activities before interest and tax Interest receivable Interest payable and similar charges Profit on ordinary activities before taxation Tax on profit on ordinary activities Profit for the financial year Equity dividends paid Equity dividends proposed Total dividends paid and proposed Retained (loss)/profit for the financial year Earnings per ordinary share Diluted earnings per ordinary share
20,828 (14,265) 6,563 (2,037) (2,175) 2,351 (94) 2,257
22,426 (12,843) 9,583 (1,945) (1,932) 5,706 5,(9) 5,773 (1,704) 4,069 (906) (1,813)

9 (906) (1,813) 8 8

93 (42) 2,308 (557) 1,751

(2,719) (968) 4.8p 4.8p

(2,719) 1,350 11.2p 11.2p
consolidated statement of total recognised gains and losses

2000 000

Profit for the financial year Currency translation differences on foreign currency net investments Total recognised gains and losses relating to the year

1,1,803

4,4,085
consolidated balance sheet

at 31 December 2000

Fixed assets Intangible assets Tangible assets 30,112 30,112 Current assets Stocks Debtors Cash at bank and in hand 2,148 5,889 1,518 9,555 Creditors: amounts falling due within one year Net current assets Total assets less current liabilities Creditors: amounts falling due after more than one year Provisions for liabilities and charges Net assets Capital and reserves Called-up share capital Share premium account Capital redemption reserve Profit and loss account Total shareholders funds equity 18, 20 1,813 13,12,618 28,143 1,813 13,13,534 29,(7,349) 2,206 32,318 (433) (3,742) 28,143 2,487 4,858 2,975 10,320 (5,411) 4,909 32,970 (36) (3,875) 29,28,034 28,061

The aggregate payroll costs of these persons were as follows: Wages and salaries Social security costs Other pension costs 5,419 6,157 Directors remuneration and emoluments are dealt with on page 18 in the Report of the Board on Directors Remuneration. 5,368 6,351
5. INTEREST RECEIVABLE 1999 000
Interest on bank deposits
6. INTEREST PAYABLE AND SIMILAR CHARGES 1999 000
On bank overdrafts On finance leases
7. TAX ON PROFIT ON ORDINARY ACTIVITIES 1999 000
UK corporation tax at 30% (1999: 30%) Overseas taxation Adjustment to prior year tax charge Current taxation Deferred taxation

(89) 690 (133) 557

1,1,1,704
8. DIVIDENDS AND EARNINGS PER SHARE 1999 000
Interim dividend of 2.5p (1999: 2.5p) net per ordinary share Proposed final dividend of 5.0p (1999: 5.0p) net per ordinary share

906 1,813 2,719

906 1,813 2,719 7.5p
Dividends per ordinary share
EARNINGS PER ORDINARY SHARE
Earnings per ordinary share is calculated by dividing profit after tax of 1,751,000 (1999: 4,069,000) by the weighted average number of shares in issue during the year. Diluted earnings per ordinary share adjusts for the potential dilutive effect of share option schemes in accordance with FRS 14.
Average number of ordinary shares issued Deemed issued for no consideration Diluted
36,255,772 2,071 36,257,843
36,255,772 132,628 36,388,400
8. DIVIDENDS AND EARNINGS PER SHARE (CONTINUED)
Shares deemed issued for no consideration have been calculated based on the potential dilutive effect of the three save as you earn share option schemes and options granted under an Inland Revenue Approved Share Option Scheme:
Exercise price Average number of shares under option 2000 1999
Date from which exercisable
1 August October October February 2002

1.63 1.70 1.08 0.935

317,973 32,085
81,805 8,289 398,652 64,170
The average fair value of one ordinary share during the year was considered to be 0.9995 (1999: 1.1650).

Book value 000 Fair value 000
US dollars Trade debtors Trade creditors and accruals Cash at bank 1,118 (182) 1,168 2,104 Euros and Euro legacy currencies Trade debtors Trade creditors and accruals Foreign currency contracts Cash at bank 1,541 (490) 180 1,231 Other Cash at bank 7 3,3,330 1,587 (492) (69) 180 1,206 1,131 (182) 1,168 2,117
The analysis above includes trade debtors and creditors as the primary purpose of the foreign currency contracts is to hedge the net exposure of these items. All trade debtors and creditors and foreign currency contracts mature within six months of the balance sheet date and are not interest bearing. Cumulative aggregate gains and losses unrecognised as at 31 December 2000:
Gains 000 Losses 000 Net loss 000

At 31 December 2000

All gains and losses that were unrecognised at 31 December 2000 are expected to be recognised in the six months to 30 June 2001. Foreign exchange rates used in the preparation of these financial statements are shown in the Finance Directors review on page 12. The Group has a short-term bank facility of 5 million that may be utilised in any currency which is freely transferable and convertible into sterling. Interest is payable at floating rate plus a bank margin. This facility expires in February 2002.

22. COMMITMENTS 1999 000

(I) Capital contracts at the end of the financial year for which no provision has been made (ii) The Group has annual commitments under non-cancellable operating leases which expire between two and five years: Other operating leases (iii) As at 31 December the Group had foreign currency forward exchange contracts amounting to:

248 1,364

36 2,121

23. PENSION SCHEME

As explained in the accounting policies set out on page 30, the Company operates a funded pension scheme providing benefits based on final pensionable pay, contributions being charged to the profit and loss account so as to spread the cost of pensions over employees working lives with the Company. The contributions are recommended by a qualified actuary. The most recent valuation, based on the ongoing funding method was at 6 April 1999. The assumptions which have the most significant effect on the results of the valuation are those relating to the rate of return on investments and the increases in pensionable salaries and dividends. Assumptions used by the actuary were as follows: Rate of return on investments at 7.0% per annum; Rate of increase in salaries at 5.0% per annum; Rate of dividend increase 3.75%. Following the actuarial report, the principal employer, in agreement with the trustees of the pension fund, determined a Company contribution rate of 12% of pensionable salaries, in addition to the employee contribution of 5%. These contribution rates were effective from 1 January 2000. The actuary in his report stated that he had tested the short-term solvency of the scheme and confirmed that an employers contribution rate of 12% of pensionable salaries was adequate for a certificate of solvency covering a period of three years and six months from 6 April 1999. At the date of the valuation, the market valuation of the fund was 10,652,000. Company contributions of 399,000 were charged to the profit and loss account and were paid during the year. For US-based employees Zotefoams Inc. operates a 401(k) plan and a defined contribution pension plan to which Zotefoams Inc. contributes 6.2% of pensionable salary.

Notice is hereby given that the Annual General Meeting of Zotefoams plc (the Company) will be held at the offices of Zotefoams plc, 675 Mitcham Road, Croydon CR9 3AL on Tuesday 24 April 2001 at 10.00am for the following purposes:

ORDINARY BUSINESS

To consider and, if thought fit, pass the following resolutions as ordinary resolutions: 1. To receive and adopt the audited accounts and the Directors and auditors report for the year ended 31 December 2000. 2. To declare a final dividend for the year ended 31 December 2000 of 5.0p net per ordinary share, such dividend to be payable on 1 May 2001 to shareholders on the register at the close of business on 30 March 2001. 3. To re-elect Mr D B Stirling as a Director. 4. To re-elect Mr I M Buckley as a Director. 5. To re-elect Mr C G Hurst as a Director. 6. That the Company hereby approves and adopts a new Executive Share Option Scheme for Zotefoams plc, as summarised in Appendices I and II to the letter to Members of the Company dated 9 March 2001, in the form presented to the Annual General Meeting, and that the Directors be and are hereby authorised to do all acts and things which they may consider necessary or expediant for implementing and giving effect to the same. 7. That KPMG Audit Plc be and are hereby re-appointed as auditors of the Company to hold office from the conclusion of this meeting until the conclusion of the next Annual General Meeting at which accounts are laid before the Company at a remuneration to be fixed by the Directors. 8. That the Board be and is hereby generally and unconditionally authorised to exercise all powers of the Company to allot relevant securities (within the meaning of Section 80(2) of the Companies Act 1985) of the Company up to an aggregate nominal amount of 604,263 to such persons and on such terms as it thinks fit provided that this authority shall expire on the date of the next Annual General Meeting after the passing of this resolution or 15 months after the passing of this resolution (whichever shall be earlier) save that the Company may before such expiry make such an offer or agreement which would or might require relevant securities to be allotted after such expiry and the Board may allot relevant securities in pursuance of such an offer or agreement as if the authority conferred hereby had not expired, such authority to be in substitution for any existing authorities conferred on the Board pursuant to Section 80 of the Companies Act 1985.