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<b><font style="font-family: 'Times New Roman', Times">1.  </font></b>
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<b><font style="font-family: 'Times New Roman', Times">Significant
Accounting Policies</font></b>
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<i>Basis of presentation — </i>Lorillard, Inc.,
through its subsidiaries, is engaged in the manufacture and sale
of cigarettes. Its principal products are marketed under the
brand names of Newport, Kent, True, Maverick and Old Gold with
substantially all of its sales in the United States of America.
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The consolidated financial statements of Lorillard, Inc. (the
“Company”), together with its subsidiaries
(“Lorillard”), include the accounts of the Company and
its subsidiaries after the elimination of intercompany accounts
and transactions. The Company manages its operations on the
basis of one operating and reportable segment through its
principal subsidiary, Lorillard Tobacco Company (“Lorillard
Tobacco”).
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On May 7, 2008, the Company amended its certificate of
incorporation to effect a 1,739,234.29 for 1 stock split of its
100 shares of Common Stock then outstanding. All common
share and per share information has been retroactively adjusted
for the periods presented.
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On June 10, 2008, Loews Corporation (“Loews”)
distributed 108,478,429 shares of common stock of the
Company in exchange for and in redemption of all 108,478,429
outstanding shares of Loews’ Carolina Group stock, as
described in the Registration Statement (File
<font style="white-space: nowrap">No. 333-149051)</font>
on
<font style="white-space: nowrap">Form S-4</font>
filed with the Securities and Exchange Commission (the
“SEC”) under the Securities act of 1933 as amended
(the “Separation”). Pursuant to the terms of the
Exchange Offer, described in the Registration Statement, on
June 16, 2008, Loews accepted 93,492,857 shares of
Loews common stock in exchange for 65,445,000 shares of the
Company’s Common Stock. As a result of such distributions,
Loews ceased to own any equity interest in the Company and the
Company became an independent publicly held company.
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Prior to the Separation, Lorillard was included in the Loews
consolidated federal income tax return, and federal income tax
liabilities were included on the balance sheet of Loews. Under
the terms of the pre-Separation Tax Allocation Agreement between
Lorillard and Loews, the Company made payments to, or was
reimbursed by Loews for the tax effects resulting from its
inclusion in Loews’ consolidated federal income tax return.
In September 2009, Loews reimbursed Lorillard $14 million,
which was recorded as a receivable in 2008, related to
pre-Separation tax benefits and payments.
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Subsequent to the issuance of the Company’s 2008
consolidated financial statements included in
<font style="white-space: nowrap">Form 8-K,</font>
filed on June 11, 2009, the Company determined that
immaterial errors existed in the footnote disclosure containing
the condensed consolidating statement of cash flows for the year
ended December 31, 2008. The Issuer’s statement of
cash flows for the year ended December 31, 2008 has been
corrected to reflect $150 million return of capital,
previously reported as a financing inflow, as an investing
inflow. In addition, the statement of cash flows for All Other
Subsidiaries for the same period has been corrected to properly
include the $150 million payment to the Issuer, previously
reported as return of capital outflow within financing
activities, as a component of dividends paid also within
financing activities. These immaterial errors did not impact
operating cash flows for any consolidating entity and had no
impact on the consolidated statement of cash flows for the year
ended December 31, 2008.
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Additionally, subsequent to the issuance of the Company’s
2008 and 2007 financial statements included in
<font style="white-space: nowrap">Form 8-K,</font>
filed on June 11, 2009, the Company amended the
presentation of pension and postretirement cash inflows and
outflows on the statement of cash flows by adding the lines
“Pension, health and life insurance benefits expense”
and “Pension, health and life insurance contributions”
to enhance the disclosure of pension related activities. These
changes have been reflected on the consolidated statement of
cash flows as well as the consolidating statements of cash flows
for the years ended December 31, 2008 and December 31,
2007.
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Also, subsequent to the issuance of the Company’s 2008
consolidated financial statements included in
<font style="white-space: nowrap">Form 8-K,</font>
filed on June 11, 2009, the Company determined that
immaterial errors existed in the consolidated statements of
income for the years ended December 31, 2008 and 2007. The
consolidated statement of income has been corrected to properly
classify $6 million for each of the years ended
December 31, 2008 and 2007,
previously classified as selling, general and administrative
costs, as cost of sales. Within the consolidating financial
information footnote (Note 17), the correction of the error
was reflected in the Issuer column.
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<i>Use of estimates</i> — The preparation of financial
statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions
that affect the reported amounts in the consolidated financial
statements and related notes. Significant estimates in the
consolidated financial statements and related notes include:
(1) accruals for tobacco settlement costs, litigation,
sales incentive programs, income taxes and share-based
compensation, (2) the determination of discount and other
rate assumptions for defined benefit pension and other
postretirement benefit expenses and (3) the valuation of
pension assets. Actual results could differ from those estimates.
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<i>Cash equivalents</i> — Cash equivalents consist of
short-term liquid investments with a maturity at date of
purchase of 90 days or less. Interest and dividend income
are included in investment income. The cost of securities sold
is based on the specific identification method and transactions
are recorded on the trade date.
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<i>Repurchase agreements</i> — During 2009 and 2008,
Lorillard loaned cash to unrelated parties, primarily major
financial institutions through collateralized repurchase
agreements. Borrowers are required to deposit treasury
securities as collateral with Lorillard of at least 102% of the
amount of cash loaned. The securities received as collateral by
Lorillard are not reflected as assets of Lorillard as there
exists no right to sell or repledge the collateral. There were
no repurchase agreements outstanding at December 31, 2009
and $236 million outstanding at December 31, 2008.
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<i>Inventories</i> — Inventories are valued at the
lower of cost, determined on a
<font style="white-space: nowrap">last-in,</font>
first-out (“LIFO”) basis, or market. A significant
portion of leaf tobacco on hand will not be sold or used within
one year, due to the duration of the aging process. All
inventory of leaf tobacco, including the portion that has an
operating cycle that exceeds 12 months, is classified as a
current asset and is generally consistent with recognized trade
practice.
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<i>Depreciation — </i>Buildings, machinery and
equipment are depreciated for financial reporting purposes on
the straight-line method over estimated useful lives of those
assets of 40 years for buildings and 3 to 12 years for
machinery and equipment.
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<i>Derivative agreements — </i>In September 2009,
Lorillard Tobacco entered into interest rate swap agreements,
which the Company guaranteed, with a total notional amount of
$750 million. The interest rate swap agreements qualify for
hedge accounting and were designated as fair value hedges. Under
the swap agreements, Lorillard Tobacco receives a fixed rate
settlement and pays a variable rate settlement with the
difference recorded in interest expense. Changes in the fair
value of the swap agreements are recorded in other assets or
other liabilities with an offsetting adjustment to the carrying
amount of the hedged debt. See Note 9.
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<i>Accumulated other comprehensive income (loss)
</i> — The components of accumulated other
comprehensive income (loss) (“AOCI”) include the
pension liability and any unrealized gains (losses) on available
for sale investments, net of related taxes.
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<i>Revenue recognition</i> — Revenue from product
sales, net of sales incentives, is recognized at the time
ownership of the goods transfers to customers and collectability
is reasonably assured. Federal excise taxes are recognized on a
gross basis, and are reflected in both net sales and cost of
sales. Sales incentives include retail price discounts, coupons
and retail display allowances and are recorded as a reduction of
revenue based on amounts estimated as due to customers and
consumers at the end of a period based primarily on use and
redemption rates. Sales to one customer represented 26%, 26% and
24% of total sales of Lorillard in 2009, 2008 and 2007,
respectively.
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<i>Cost of sales</i> — Cost of sales includes federal
excise taxes, leaf tobacco cost, wrapping and casing material,
manufacturing labor and production salaries, wages and overhead,
research and development costs, distribution, other
manufacturing costs, State Settlement Agreement expenses, the
federal assessment for
tobacco growers, Food and Drug Administration fees, and
promotional product expenses. Promotional product expenses
include the cost, including excise taxes, of the free portion of
“buy some get some free” promotions.
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<i>Advertising and marketing costs</i> — Advertising
costs are recorded as expense in the year incurred. Marketing
and advertising costs that include such items as direct mail,
advertising, agency fees and point of sale materials are
included in selling, general and administrative expenses.
Advertising expense was $40 million, $47 million and
$50 million for the years ended December 31, 2009,
2008 and 2007, respectively.
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<i>Research and development costs</i> — Research and
development costs are recorded as expense as incurred, are
included in cost of sales and amounted to $19 million<b>,
</b>$20 million and $18 million for each of the years
ended December 31, 2009, 2008 and 2007, respectively.
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<i>Tobacco settlement costs</i> — Lorillard recorded
pre-tax charges of $1.128 billion, $1.117 billion and
$1.048 billion for the years ended December 31, 2009,
2008 and 2007, respectively, to accrue its obligations under the
State Settlement Agreements (see Note 18). Lorillard’s
portion of ongoing adjusted settlement payments and legal fees
is based on its share of total domestic cigarette shipments in
that year. Accordingly, Lorillard records its portion of ongoing
adjusted settlement payments as part of cost of sales as the
related sales occur. Payments are made annually and are
generally due in April of the year following the accrual of
costs. The settlement cost liability on the balance sheets
represents the unpaid portion of the Company’s obligations
under the State Settlement Agreements.
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<i>Share-Based compensation costs</i> — Under the 2008
Incentive Compensation Plan, the fair market value of the
exercise price per share is based on the closing price at the
date of the grant. Share-based compensation expense is
recognized net of an estimated forfeiture rate and for shares
expected to vest, using a straight-line basis over the requisite
service period of the award.
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<i>Legal costs and loss contingencies</i> — Legal
costs are expensed as incurred and amounted to $98 million,
$80 million and $55 million for the years ended
December 31, 2009, 2008 and 2007, respectively. Loss
contingencies related to pending or threatened litigation are
accrued as a charge to selling, general and administrative
expense when both of the following conditions are met:
(i) a determination that it is probable that an asset has
been impaired or a liability has been incurred, and
(ii) the amount of loss can be reasonably estimated. See
Note 18 for a description of loss contingencies.
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<i>Income taxes</i> — Deferred tax assets and
liabilities are determined based on the differences between the
financial statement and tax bases of assets and liabilities,
using enacted tax rates in effect for the year in which the
differences are expected to reverse. Judgment is required in
determining income tax provisions and in evaluating tax
positions. For uncertain tax positions to be recognized, a tax
position must be more-likely-than-not to be sustained upon
examination by taxing authorities. The amount recognized is
measured as the largest amount of benefit that is greater than
50% likely of being realized upon ultimate settlement. Where
applicable, interest related to uncertain tax positions is
recognized in interest expense. Penalties, if incurred, are
recognized as a component of income tax expense. Certain
provisions of ASC 740 were effective for fiscal years beginning
after December 15, 2006, with the cumulative effect of the
change in accounting principle recorded as an adjustment to
opening earnings retained in the business. A liability was
recorded for unrecognized tax benefits of $25 million that
was accounted for as a reduction to the January 1, 2007
balance of earnings retained in the business.
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<i>Recently adopted accounting pronouncements</i> —
Lorillard adopted FASB ASC
<font style="white-space: nowrap">Paragraph 260-10-45-60</font>
“Participating Securities and the
Two-Class Method.” ASC
<font style="white-space: nowrap">260-10-45-60</font>
addresses whether instruments granted in share-based payment
transactions are participating securities prior to vesting and,
therefore, need to be included in the earnings allocation in
computing earnings per share. This interpretation was effective
for financial statements issued for fiscal years beginning after
December 15, 2008 and interim periods within those years.
The adoption of ASC
<font style="white-space: nowrap">260-10-45-60</font>
did not have a material impact on Lorillard’s financial
position or results of operations.
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Lorillard adopted FASB ASC Subtopic
<font style="white-space: nowrap">715-20</font>
“Employers’ Disclosures about Postretirement Benefit
Plan Assets.” ASC Subtopic
<font style="white-space: nowrap">715-20</font>
requires disclosure of investment policies and strategies in
narrative form. ASC Subtopic
<font style="white-space: nowrap">715-20</font> also
requires employer disclosure on the fair value of plan assets,
including (a) the level in the fair value hierarchy,
(b) a reconciliation of beginning and ending fair value
balances for Level 3 assets and (c) information on
inputs and valuation techniques. See Note 12 for related
disclosure.
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Lorillard adopted FASB ASC Topic 808 “Collaborative
Arrangements.” ASC 808 defines a collaborative arrangement
as an arrangement where the parties are active participants and
have exposure to significant risks. Transactions with third
parties should be classified in the financial statements in the
appropriate category according to ASC Subtopic
<font style="white-space: nowrap">605-45</font>
“Principal Agent Considerations.” Payments between the
partners of the collaborative agreement should be categorized
based on the terms of the agreement, business operations and
authoritative literature. ASC 808 was effective for fiscal years
beginning after December 15, 2008. The adoption of ASC 808
did not have a material impact on Lorillard’s financial
position or results of operations.
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Lorillard adopted FASB ASC
<font style="white-space: nowrap">Section 815-10-50</font>
“Disclosures about Derivative Instruments and Hedging
Activities — an amendment of FASB Statement
No. 133.” ASC
<font style="white-space: nowrap">815-10-50</font>
requires qualitative disclosures about the objectives and
strategies for using derivatives; quantitative data about the
fair value of, and gains and losses on, de rivative contracts;
and details of credit-risk-related contingent features in hedged
positions. ASC
<font style="white-space: nowrap">815-10-50</font>
also requires enhanced disclosure around derivative instruments
in financial statements accounted for under ASC Subtopic
<font style="white-space: nowrap">815-20,</font>
“Accounting for Derivative Instruments and Hedging
Activities,” and how hedges affect an entity’s
financial position, financial performance and cash flows. ASC
<font style="white-space: nowrap">815-10-50</font>
was effective for fiscal years and interim periods beginning
after November 15, 2008. Lorillard adopted ASC
<font style="white-space: nowrap">815-10-50</font> in
September 2009. See Note 9 for related disclosure.
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Lorillard adopted FASB ASC Topic 820 “Fair Value
Measurements and Disclosures” on January 1, 2008,
utilizing the one year deferral that was granted for the
implementation of ASC 820 for all nonrecurring fair value
measurements of non-financial assets and liabilities. The one
year deferral expired on January 1, 2009. ASC 820 defines
fair value, establishes a framework for measuring fair value and
expands disclosures about fair value measurements. The adoption
of ASC 820 did not have a material impact on Lorillard’s
financial position or results of operations.
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Lorillard adopted FASB ASC
<font style="white-space: nowrap">Section 820-10-35</font>
“Determining the Fair Value of a Financial Asset When the
Market for that Asset is Not Active.” ASC
<font style="white-space: nowrap">820-10-35</font>
clarifies the application of ASC 820 (described above) in a
market that is not active. The effective date for ASC
<font style="white-space: nowrap">820-10-35</font>
was October 10, 2008. The adoption of ASC
<font style="white-space: nowrap">820-10-35</font>
did not have a material impact on Lorillard’s financial
position or results of operations.
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Lorillard adopted FASB ASC
<font style="white-space: nowrap">Section 820-10-35</font>
“Determining Fair Value When the Volume and Level of
Activity for the Asset or Liability Have Significantly Decreased
and Identifying Transactions That Are Not Orderly.” ASC
<font style="white-space: nowrap">820-10-35</font>
includes factors for evaluating if a market has a significant
decrease in the volume and level of activity. If there has been
a decrease, then the entity must do further analysis of the
transactions or quoted prices to determine if the transactions
were orderly. The entity cannot ignore available information and
should apply appropriate risk adjustments in the fair value
calculation. The effective date was for interim periods ending
after June 15, 2009. The adoption of ASC
<font style="white-space: nowrap">820-10-35</font>
did not have a material impact on Lorillard’s financial
position or results of operations.
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Lorillard adopted FASB ASC
<font style="white-space: nowrap">Section 825-10-65</font>
“Interim Disclosures about Fair Value of Financial
Instruments.” ASC
<font style="white-space: nowrap">825-10-65</font>
requires interim disclosures on the fair value of financial
instruments. The effective date was for interim periods ending
after June 15, 2009. The adoption of ASC
<font style="white-space: nowrap">825-10-65</font>
was reflected in our
<font style="white-space: nowrap">Form 10-Q</font>
filed for the second and third quarters of 2009.
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Lorillard adopted FASB ASC Topic 855 “Subsequent
Events,” which sets forth (1) the period after the
balance sheet date during which management of a reporting entity
shall evaluate events or transactions that
may occur for potential recognition or disclosure in the
financial statements, (2) the circumstances under which an
entity shall recognize events or transactions occurring after
the balance sheet date in its financial statements and
(3) the disclosures that an entity shall make about events
or transactions that occurred after the balance sheet date. ASC
855 applies to the accounting for and disclosure of subsequent
events not addressed in other applicable generally accepted
accounting principles (GAAP). ASC 855 was effective for
financial statements issued for interim periods and fiscal years
ending after June 15, 2009. The adoption of ASC 855 did not
have a material impact on Lorillard’s financial position or
results of operations. Lorillard has evaluated subsequent events
through February 25, 2010, the date the consolidated financial
statements were issued.
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Lorillard adopted FASB ASU
<font style="white-space: nowrap">2009-05</font>
“Fair Value Measurements and Disclosures (Topic
820) — Measuring Liabilities at Fair Value.” Fair
value of liabilities is defined as a price in an orderly
transaction between market participants, but often liabilities
are not transferred in the market due to significant
restrictions. If a quoted price in an active market is
available, it should be used and disclosed as a level 1
valuation. When that is not available, an entity can use either
a) the quoted price of an identical liability when traded
as an asset in an active or inactive market, b) the quoted
price for similar liabilities traded as assets in an active
market or c) a valuation technique, such as the income or
present value approaches. No adjustments should be made for the
existence of contractual restrictions that prevent transfer. The
update is effective for the first period after the issue date of
August 2009. ASU
<font style="white-space: nowrap">2009-05</font> did
not have a material impact on Lorillard’s financial
position or results of operations.
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<i>Accounting pronouncements not yet adopted.</i>  In
January 2010, the FASB issued Accounting Standards Update
<font style="white-space: nowrap">2010-04</font>
“Accounting for Various Topics — Technical
Corrections to SEC Paragraphs” effective upon the issue
date of January 15, 2010. ASU
<font style="white-space: nowrap">2010-04</font>
contains various technical corrections to the Accounting
Standards Codification for the SEC sections. Lorillard is
evaluating the impact that adopting ASU
<font style="white-space: nowrap">2010-04</font> will
have on its financial position or results of operations.
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In January 2010, the FASB issued Accounting Standards Update
<font style="white-space: nowrap">2010-06</font>
“Fair Value Measurements and Disclosures (Topic 820):
Improving Disclosures about Fair Value Measurements.” ASU
<font style="white-space: nowrap">2010-06</font>
establishes additional disclosures related to fair value.
Transfers in and out of Level 1 and Level 2 and the
reasons for the transfers must be disclosed. Level 3
purchases, sales, issuances and settlements should be presented
separately rather than net. In addition, the level of
disaggregation and input and valuation techniques need to be
disclosed. The effective dates are periods beginning after
December 15, 2010 for the Level 3 purchases, sales,
issuances and settlements disclosure, and periods beginning
after December 15, 2009 for all other provisions. Lorillard
is evaluating the impact that adopting ASU
<font style="white-space: nowrap">2010-06</font> will
have on its financial position or results of operations.
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In February 2010, the FASB issued Accounting Standards Update
<font style="white-space: nowrap">2010-08</font>
“Technical Corrections to Various Topics” effective
upon the issue date of February 2, 2010. ASU
<font style="white-space: nowrap">2010-08</font>
contains various technical corrections to the Accounting
Standards Codification including the glossary, Statement of Cash
Flows, consolidations, embedded derivatives, and cash flow
hedges. Lorillard is evaluating the impact that adopting ASU
<font style="white-space: nowrap">2010-08</font> will
have on its financial position or results of operations.
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